Blackstone’s sale of $7 billion of its management business simultaneously to China and on the public markets is fraught with potential conflicts for institutional investors, industry insiders say.
Any day now, The Blackstone Group, New York, will sell between 9.7% and 10% of its business in new non-voting common units to China’s State Investment Co., and another 12.3% in an initial public offering. If Blackstone is successful, executives at other private equity firms say they could pursue similar sales.
But the Blackstone deal could hurt institutional investors because the new cash infusion would lessen the risks for managing partners and otherwise upset the delicate alignment of interests between investors and the firm. It could also provide a stream of less demanding capital that could replace limited partner money in years to come.
In Securities and Exchange Commission filings, Blackstone officials counter that the nature of the business and the alignment of interests will be unchanged. They also maintain that this move is part of the natural institutionalization of the private equity investment management business.
Most investors and consultants are loath to air their concerns for fear of being shut out of new funds or co-investment in future plum deals. But a number of sources have said the pending sales of the common units have added more risks to the investment.
A recent survey by Coller Capital, a London-based secondary market private equity firm, showed one of investors’ top concerns is whether returns would be hurt by changes in the traditional relationship between private equity firms and their investors. The survey also found that management fees — a percentage of a fund deducted for firm expenses — have remained constant despite ballooning fund sizes.
Wealth, stock price linked
Consultants and investors who declined to be named said that top management’s personal wealth will now be tied to Blackstone’s stock price. They said if the stock tumbles, management might be tempted to take cost-cutting measures to bolster stock prices such as firing operating partners or increasing transaction fees to the fund for each deal. While Blackstone shares transaction fees with institutional investors, the fees can still be an income source for the firm.
The new sources of cash could also be used to co-invest in deals or invest in private equity funds, cutting out large institutional investors such as the $247.9 billion California Public Employees Retirement System, Sacramento, an investor in Blackstone funds.
CalPERS spokesman Clark McKinley said officials there wouldn’t comment on how Blackstone’s impending public sales will affect CalPERS’ portfolio. “We’re still evaluating the private-to-public trend…” he said.
Blackstone executives declined to comment, citing the pending IPO, but the latest SEC documents filed by company officials show the firm’s largest source of income is so-called “carried interest,” which a firm earns only if the fund performs well.
The documents also reveal that about $4 billion, or most of the proceeds from the IPO and sale to China, will be used to cash out senior management, with a smaller percentage — about $1.7 billion — re-invested in the firm. Some of the firm’s managers cannot trade their new common units for several years.
Some key owners are partially exempt from that restriction. They include American International Group Inc., which has owned a 7% interest in Blackstone since 1998; Peter G. Peterson, retiring senior chairman and co-founder; and Stephen A. Schwarzman, chairman and chief executive officer. AIG and Mr. Peterson can transfer one-third of their holdings on Dec. 31, 2008. Mr. Schwarzman can trade $250 million worth of units in the first year, “which may be donated to charities at any time” and up to one-third after the first year. And these transfer restrictions may be waived from time to time, the documents say.
While they are still employed by the firm, existing owners have to hold at least 25% of their vested partnership units, instead of converting them into common units created by the IPO. Mr. Schwarzman has to hold $1.5 billion.
Once partners take cash off the table, they reduce their personal risk and no longer have the same incentives to ensure their funds are winners, noted J. Scott Swensen, chairman, Conduit Capital Partners LLC, a New York-based buyout firm.
Biggest issues
For Blackstone investors, the biggest issues are dealing with a private equity manager that is publicly traded and having senior management capitalize the stream of profits, said Justin B. Wender, president of Castle Harlan Inc., a New York buyout firm.
But some of those interviewed said the bottom line is: If investors are uneasy with the new public firm, they can invest their private equity dollars elsewhere.
“I look at it as a natural evolution because the industry as such has seen enormous concentrations of capital in just a few years,” said Bruno E. Raschle, chief executive officer of Adveq Management AG, a Zurich-based private equity fund-of-funds manager. Adveq is not an investor with Blackstone.
Adding China as an investor in Blackstone is also part of this natural evolution, he said. “Why not have one institution be a significant shareholder? It is traditional thinking,” said Mr. Raschle, who, through his participation in the World Economic Forum, helped advise the Chinese government on its efforts to diversify its $1.2 trillion in foreign exchange reserves.
For investors, if fees rise as a result of these developments, they can invest with other private equity firms, Mr. Raschle said.
But others say this is easier said than done in private equity, where most of the money is invested with top-quartile funds.
“Right now, in this fundraising environment, people want to be with the top-performing firms that for a number of years have outperformed public markets,” said Frank Morgan, president and chief operating officer of Coller Capital-U.S. and a partner in Coller Capital Ltd. “There is very little choice.”
