Exec believes good times will get even better for Blackstone

Prakash A. Melwani, chief investment officer of Blackstone Group Inc.'s private equity group, is guiding the investments of the firm's private equity business at a time of record gains in assets under management, expected slow economic growth and almost $72 billion in dry powder, which nearly doubled in the year ended Sept. 30.

Blackstone Group's private equity segment continues to be its largest business by assets under management, at $173.9 billion as of Sept. 30, its most recent filing with the Security and Exchange Commission shows. Blackstone is poised to continue that trajectory as executives look to invest its latest $26 billion fund — Blackstone Capital Partners VIII, the largest private equity fund ever raised — in very large transactions.

In a world in which investors are heavily invested in buyouts and still investing with firms they know, fundraising has been strong, up 38% year over year as of Sept. 30, its latest SEC filing shows.

To manage the growth, Blackstone added a new layer of investment executives in December for its Asian and U.S. businesses. Martin Brand and Peter Wallace, both senior managing directors, were promoted to the new positions of co-heads of U.S. acquisitions. Amit Dixit and Ed Huang, both senior managing directors, were promoted to the new positions of co-heads of Asia acquisitions. All four report to Joseph Baratta, senior managing director and global head of private equity.

Mr. Melwani's title and duties were unaffected by the move. He also reports to Mr. Baratta.

Mr. Melwani has been a private equity investor for 30 years and said he believes that private equity markets are functioning well right now.

Even so, he acknowledges that valuations are high. "Those valuations are high but are not irrational given the cost of capital right now, and the economy is solid," he said in an interview. "The thing to watch are imbalances."

The imbalances Mr. Melwani said he sees today are in the public markets — in particular, the low government bond rates and negative interest rates in Europe.

"I don't see private-sector imbalances," he added. "I don't see an imminent recession given there are no obvious imbalances such as housing in the last cycle."

Mr. Melwani said he has been through four cycles in his career: the 1987 stock market crash, the 1990 savings and loan crisis, the 1999-2000 dot-com correction and the 2008 Great Recession.

"High yield was the first market to do silly things," he said. The high-yield bond market crashed in 1987, leading to the bankruptcy of investment bank Drexel Burnham Lambert. Junk bonds had fueled highly leveraged buyouts in the mid-1980s, but the party stopped when managers moved money into cash due to rising short-term interest rates, Pensions & Investments reported at the time.

These days, private equity firms are doing a better job of parsing between debt of high-quality and low-quality companies, he said.

However, he said he expects valuations to remain high in 2020. "With high valuations, you can't just be the money," Mr. Melwani said. Private equity managers also have to improve a company's operations.

"We want to earn midteen-type of (private equity) returns, and you have to create alpha."

Blackstone has a 50-person operations group that assists portfolio companies with their businesses.

"We have to make sure we do a good job identifying situations where we can add value to the companies," Mr. Melwani said. This makes the bar for new investments very high. If you pay a high valuation, you have to be able to improve the company, he said.

But Blackstone private equity executives are steering clear of the middle market. "There is too much undifferentiated capital chasing deals. The dry powder we have raised will better allow us to pursue our strategy of targeting larger deals where there is much less competition," Mr. Melwani said. "We are comfortable with $1 billion to $2 billion equity checks."

Blackstone has a new data sciences group, which he said is cutting-edge for private equity. Through machine learning and data analysis, the group helps portfolio company executives use their own data to make better decisions.

Private equity firms need to focus on companies' profit margins, he said. The economic upswing pushed up companies' profit margins.

"Profit margins have peaked in the U.S., unless you do something with the company," he said. "You're not going to get a lot in the public markets. If you are improving the company, you … are going to get more than what the economy can give you."

This ability to improve a private company's performance at a time when some investors believe the public markets have peaked is moving more investors into alternative investments, he said.

Across the private equity industry, Mr. Melwani said leverage levels have stayed in check and he has not seen the imbalances between debt and company earnings present before the global financial crisis.

"I don't see the irrationality of leverage of six times or seven times (earnings before interest, tax, depreciation and amortization)," he said. "When interest rates are low, leverage of six times (EBITDA) is not a problem."

He said that six to seven times EBITDA is not irrational, in part because the quality of companies that private equity firms are buying is generally higher than it had been in 2007 and 2008. In previous cycles, leverage levels in 2008 increased to as high as nine times EBITDA offered by banks, he said.

"The private equity industry has learned the lesson that as you progress later into an economic cycle, you should increase the quality of what you buy and avoid cyclical companies. That certainly is what we've been doing, and if you look at the high proportion of software, services and health-care buyouts being done, that is an industrywide phenomenon," Mr. Melwani said.

Blackstone uses leverage at the fund level of 1% to 25% of the capital commitments of the respective fund. Portfolio company level debt varies, its SEC filing said.

Indeed, Blackstone executives strive to earn the returns they promise investors by concentrating on portfolio company operations.

Operations executives are involved in the due diligence before an investment is made. Among other things, a focus on human capital, including portfolio company executives, is necessary for an investment's success.

"We have people who do nothing but help recruit executives. We are constantly upgrading the executive teams," Mr. Melwani said.

That focus on human capital also includes promoting diversity at Blackstone as well as portfolio company board and C-suite levels, he said.

Some 50% of Blackstone's largest businesses have a woman or minority as one of its top two leaders, and nearly 40% of all Blackstone business and group heads are women or minorities, Mr. Melwani said. Externally, Blackstone staffed 50% of its private equity independent board seats at portfolio companies with women in 2019.

"Diverse views help decision-making," Mr. Melwani said.

Blackstone executives also consider environmental impact when deciding whether to make an investment in a company, he said.

"If you have a company that is doing harm, you will have a hard time when you sell," Mr. Melwani said. "We will look at what a company is doing to the environment as a key part of our due diligence."