Blackstone's Schwarzman: Alignment of interests is 'off the table'

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Blackstone's Stephen Schwarzman: “In many cases, Blackstone is one of the top three investors in our funds.”

Blackstone Group has taken “off the table” the issue of how the firm's interests are aligned with those of its investors, Stephen Schwarzman, Blackstone founder, chairman and CEO, said in an interview.

“In terms of alignment of interest, we have billions of dollars of our own money in our own funds,” which ensures the firm's interests match those of its investors, Mr. Schwarzman said in an interview in his New York office. “In many cases, Blackstone is one of the top three investors in our funds.”

During the financial downturn, even as the value of investors' investments dropped, Blackstone Group LP — along with other managers of multibillion-dollar alternative investment funds — made money from management fees.

Indeed, the first quarter of 2012 is the first period since Blackstone went public in June 2007 that the firm's performance-fee earnings exceeded net management fee earnings, according to a Pensions & Investments analysis of Blackstone's filings with the Securities and Exchange Commission.

While many other alternatives managers reduced their management fees in response to investors' demands for better alignment of interests, Blackstone did not. Instead, it has allayed investors' concerns by pointing out that it makes large commitments to its own funds.

The company and its top employees have committed about $6 billion to its funds over Blackstone's 20-year history, Mr. Schwarzman said.

“In terms of the alignment of interest, you will seldom see that much invested by a general partner in their own funds. It's always taught that it is the ultimate alignment of interest to put your capital up, and I think that does keep the mind sharp,” he said.

A recent example: Blackstone employees and the firm became the second-largest investor in $16 billion Blackstone Capital Partners VI LP, Blackstone's most recent private equity fund, Mr. Schwarzman said. Together, they committed $826 million.

“So, any question of alignment of interest, I think, has been taken off the table,” he said.

Catch-up uncertain

So far, it is hard to tell whether Blackstone's performance-fee income will catch up to management fees this year. Blackstone earned slightly less in net management fees than performance fees in the first quarter and more than double in net management fees than performance fees in the second quarter, according to the P&I analysis.

Management fees have been a hot-button issue since the economic downturn. The fees were designed to help sustain investment managers while they invested a fund's capital and, it was hoped, made money for themselves and their limited partners.

As private equity managers supersized their funds, the management fee economics were skewed. Management fees — traditionally 1.5% to 2% of committed capital — seemed to be far more than large fund managers needed to cover their operating costs.

Management fees were less of an issue when funds were smaller, said Laurence Bronska, partner and co-head of the private equity practice at Chicago law firm McDermott Will & Emery LLP.

“As funds have grown and as the types of fees generated by general partners ... expanded, the limited partners viewed all of this as more leakage from returns disproportionately to the general partner side of the ledger from the limited partner side of the ledger,” Mr. Bronska said.

In a number of cases, the management fees generated on the committed capital well exceed the costs they are intended to cover, he said.

The biggest institutional investors are pushing back on management fees because they think there is a lot of profit in them, said Lawrence J. Hass, partner, corporate department and head of the private investment funds practice in the New York office of law firm Paul Hastings LLP.

Big fund managers are offering 25-basis-point reductions for large investors committing $100 million or more, Mr. Hass said.

Newer managers might start out with lower-than-typical fees. More established, but still small, managers are not having this discussion because, “in a lot of cases, management fees are barely enough to keep the lights on,” Mr. Hass said.

At Blackstone, it is hard to tell whether the amount of management fees collected were just enough to cover the expenses of a sprawling global firm or almost twice the operating expenses. The difference is whether compensation is included.

For example, in the second quarter, Blackstone earned $373.4 million in net management fees, but had $113 million in non-compensation expenses and $269 in salaries.

(Under the Institutional Limited Partners Association principles, management fees should be based on reasonable operating expenses and reasonable salaries.)

Since Blackstone went public, net management fees exceed operating expenses excluding compensation by two or three times, depending on the year. But if compensation costs are added, net management fees barely exceed — and in some quarters don't cover — total operating expenses including compensation, according to a Pensions & Investments analysis.

Either way, Blackstone's investment in its own funds eliminates the issue, Mr. Schwarzman said.

As proof that investors are satisfied with the arrangement, he said, Blackstone has had a lot of success fundraising.

“This is a challenging fundraising environment but, thanks to Blackstone's strong track record, we were able to raise a new $16 billion private equity fund and $13 billion for our latest real estate fund,” Mr. Schwarzman said.

Still, that doesn't mean Blackstone has not given any fee concessions.

“Typically, in a fundraising environment that is more difficult, occasionally you give a concession for early closers or early closers of a certain size. What happens in those situations is that it doesn't work so badly for both sides because we get higher allocations from those participants,” Mr. Schwarzman said.

The $70.1 billion New Jersey Division of Investment, Trenton, which committed close to $2 billion with Blackstone in 12 months, did get a fee concession for a $750 million investment in a tactical opportunities separate account, said sources close to the firm. According to agenda materials from a December meeting of the New Jersey State Investment Council, which oversees the investment division, New Jersey got “significantly lower fees” in its series of customized accounts.

(Sources close to the firm said Blackstone's credit group, GSO Capital Partners, did not cut fees for its Capital Opportunities Fund II, despite reports to the contrary.)

“Whatever small fee pressure we have is mitigated by the significant increases in alternative assets that we are managing. So, on balance, for us, it has been a terrific environment,” Mr. Schwarzman said.

Still, there is pressure on Blackstone — and its publicly traded alternative investment firm peers — to increase management fees, or at least maintain them at their current levels.

Overly focused

Stock analysts recognize the value of management fees for publicly traded alternative investment firms like Blackstone. Thus, there is concern that these firms could be overly focused on building management fees by adding new investment strategies and funds, industry insiders say.

“Publicly traded private equity firms are being most frequently valued on a multiple-of-management-fee basis and on an assets-under-management basis,” said David Fann, president and CEO of private equity consulting firm TorreyCove Capital Partners LLC, La Jolla, Calif.

Analysts discount performance fees because they are unpredictable, Mr. Fann said. “The concern is that if key management shareholders are primarily focused on the stock price of their firm, they are incentivized to maximize management fees,” he said.

In order to keep management fees high, the worry is that manages will focus on increasing their assets under management and providing a larger number of investment offerings across the spectrum. This “could run counter to the best interests of the fund investors,” Mr. Fann said.

The other issue is that management fees of large funds create large income streams for a firm's key executives, Mr. Fann said. “The concern is that the incentives to work hard for the limited partners diminish.”

But Mr. Schwarzman stresses he is still working as hard as ever for Blackstone investors. “When we started in 1985 we had nothing. I always found it exciting to do new things, where there is a perception that there is a market opportunity, where we can do really well for our investors,” Mr. Schwarzman said. “I still find it exciting and fun, and fortunately other people here do as well.”

Data Editor Tim Pollard contributed to this story.

This article originally appeared in the October 1, 2012 print issue as, "Schwarzman: Alignment of interests is "off the table'".