Blackstone (BX) succeeded in expanding its assets under management “AUM” by 25% in Q3 2021, compared to Q3 2020, and 50% compared to 2019 levels. Several accommodative industry trends shaping the private equity and debt space help its partners attract capital from anyone who has it, from pension funds, college endowments, sovereign wealth funds to affluent retail investors. The spike in demand is industry-wide, but BX’s position allows it to gain a sizable market share of the sector’s capital inflows.
Low-interest rates, high equity valuations, and market volatility enhance BX’s value proposition in the alternative assets space. Combined with BX’s excellent performance record, these dynamics will continue to support BX’s expansion efforts this year.
The markets are overly distrustful over the effect of the Fed’s monetary shift on BX, citing rising opportunity costs as bond market returns grow compared to alternative assets. I don’t believe that 75 or 100 basis points change in interest rates would fundamentally shift the appetite for alternative investments. Even when/if interest rates rise, BX has levers to pull against a hawkish monetary environment. For example, its insurance and credit segment stands to profit from rising interest rates since most of its credit funds are tied to variable interest rates, protecting fair values and interest income.
Moreover, the company’s aggressive expansion strategy overshadows the intricate and competing dynamics of rising interest rates, dwarfing them to the point of irrelevance. Real estate prices are skyrocketing, and the private equity and credit market are burgeoning. BX’s pricing structure and its focus on perpetual and long-term capital guarantee a certain level of quarterly income from base management fees.
Last year, I celebrated 2021 by publishing a piece on BX which carried a buy rating based on the company’s expanding AUM and lucrative pricing model. Since then, BX shares have doubled, and these dynamics remain today and likely support its ticker through 2022. Admittedly, BX isn’t undervalued as it once was, but I believe that given its rapid growth and leading position, the ticker will generate returns above the market index.
If You Can’t Beat ’em, Join ’em
Nothing voices Wall Streets’ precarious riches than its fund managing industry. However, I believe categorizing BX in this group overestimates its risks, perhaps not for its safety as much as the industry’s notoriousness for greed and shadiness inherent from the SEC’s lax regulations of what was meant to be an industry serving accredited investors who know how to fend for themselves. BX risk misconceptions, most common among retail investors lacking knowledge of its business model, have long dampened its price multiples, at least until recently. I discuss valuation in a separate section below, but now, let’s examine BX’s revenue streams.
BX derives most of its revenue from Management and Advisory fees, a fixed percentage over AUM and NAV. BX will collect these fees regardless of market conditions or performance, providing a “reliable” income stream to the extent that AUM and NAV remain stable.
Source: Company filings
One might argue that although base management fees are based on a fixed percentage over AUM and NAV, the fair values of these assets fluctuate according to market conditions, affecting base Management fees. That is true to a certain extent. The method of calculating Management fees (as a fixed percentage of AUM) only partially explains the historical resilience of BX’s Management fees shown in the chart above (figures in red boxes). Two additional factors perhaps have a more significant influence.
The relative safety of BX’s funds, with a sizable concentration in real estate and fixed income securities.
The success of BX in attracting new funds, offsetting fair value write-offs during market turbulence
Given the illiquid nature of most BX assets, fair value calculations are in the hands of management and rely heavily on subjective opinions regarding appropriate values. In 2008, BX’s private equity portfolio, which accounted for a third of its AUM, depreciated 22%, compared to a 40% decline in S&P 500. During the pandemic, management wrote off a mere 11% of the Blackstone Secured Lending fund (BXSL) when comparable debt securities were trading sixty cents on the dollar. The algorithms used by private equity firms seem built to produce low volatility. It is not uncommon for private equity companies to trade below NAV, mirroring investors’ skepticism over fair value calculations. Nonetheless, from my experience analyzing private equity and debt firms, BX seems the most conservative among the lot, assuaging concerns from an ethical perspective. In any case, low fair value volatility translates to a stable base management fee, benefiting BX and its shareholders.
Another factor contributing to the stability of base management fees is BX’s success in attracting new capital inflows, which offset the decline in AUM fair values, stabilizing base management fees during economic turbulence. In 2008, capital inflows almost entirely offset the decrease in AUM. In 2020, capital inflows exceeded write-offs, leading to higher base management fees.
Moreover, BX calculates base fees at the end of each quarter, limiting the revaluation risk to 4 days annually. Suppose spreads increased at the beginning of a particular quarter and rebounded before its end. In that case, base management fees will mirror fair values at the exact day the quarter ends, ignoring intra-quarter volatility.
These factors contribute to BX’s revenue resilience, reassuring investors of its ability to withstand current market volatility. The company continues to attract capital from portfolio managers worldwide, as mirrored in recently announced acquisitions, including Bluerock Residential (BRG), a publicly-traded REIT for $3.6 billion. Demand for alternative assets has been rising exponentially in the past five years, and BX has made it clear it plans to capitalize on those trends. Like 2020 and 2021, asset expansion will overshadow fair value variability if and when it occurs this year.
BX’s remaining income sources are not as volatile as many think, including incentive fees. A significant portion of BX investments are fixed income securities, which it leverages, making it easy to repeatedly pass the incentive fee hurdle rates, usually set at 5% ROE.
Below is an example of BX fee structure for one of its funds, showing more than a 7% fee rate over NAV annually. The fund in question is Blackstone Real Estate Income Fund (BREIF), which happens to be undergoing liquidation since November 2020. Latest records show $200 million in NAV, down from $1 billion. Some of the fees are now waived, in connection to liquidation, but that’s off-topic. BX charges its clients high prices to manage their funds, all for the benefit of its management team and shareholders.
Source: Company filings
Fund management fees have been a center of debate for years, putting pressure on BX and its peers to lower prices, as mirrored in the green line in the chart above. BX’s average fee rate decreased by 60% in the past decade, and seems to have stabilized at 0.6%. One should note that BX charges different rates for different funds, and not all funds are fee-earning.
Our buy thesis rests on the old adage if you can’t beat them, join them. From a moral perspective, I believe that BX has created value for its clients in a challenging environment characterized by low interest rates, warranting its high fees. If BX didn’t create value, we wouldn’t be seeing the levels of capital inflows it currently enjoys.
Revenue Streams and Trends
One might ask if BX is attracting capital from institutional investors, why does it need shareholders’ money? BX uses your capital to invest alongside its institutional investors. This alignment of interest assures its clients and helps its marketing efforts attract more funds. In return, BX management shares some of its profits with shareholders. The total propriety capital that BX deploys alongside its clients is $25 billion, representing 11% of the total AUM. That 11% is BX’s stake in its $730 billion AUM.
Below is a breakdown of BX’s AUM
AUM (billions as of Q3 2021)
Credit & Insurance
Source: BX revenue segments. Data from company filings.
Through its funds, BX controls the most extensive real estate portfolio in the world, with global assets consisting of both real estate properties and mortgage securities. Both asset classes are in an excellent position to capture accommodative industry and economic trends seen in the market today.
Its property portfolio (physical assets) stands to benefit from rising rents and real estate prices as millennials enter the residential market. Contrary to popular opinion, its mortgage assets are positioned to profit from rising interest rates since most of these securities are tied to variable interest rates, not only boding an increase in revenue but also protecting fair values as interest rises. However, these benefits are limited to the extent that interest floors are above the current LIBOR. For example, 65% of Blackstone Mortgage Trust (BXMT) mortgage assets have floors that are currently above LIBOR, limiting revenue tailwinds until the LIBOR rises above these floors.
The following paragraphs highlight two of BX’s real estate funds.
Blackstone Real Estate Income Trust (BREIT)
Source: Blackstone Website
BREIT is BX’s flagship real estate property fund. With $78 billion of AUM, it constitutes 34% of its real estate portfolio and 10.6% of its total AUM. BREIT is a non-listed fund, meaning that you’ll have to contact BX directly to buy an interest. Shares are priced according to NAV, but the minimum initial purchase is $25,000.
The fund aims to develop, acquire, and lease properties to generate stabilized income for its shareholders through monthly distributions. The fund includes some of the most iconic real estate properties in the US, including the Bellagio building in Las Vegas and the Coleman Highline office in California, which houses the video streaming platform Roku (ROKU).
BX generates lucrative base management from BREIT. Management fees are set at 1.25% of NAV, payable monthly. The latest data show NAV at $48 billion, translating to $600 million annually in management fees alone. Incentive fees are set at 12.5% of total ROE, subject to a hurdle rate of 5%. Since its inception, the fund generated 13% in annualized returns, which, if sustained, translates to another $480 million in performance allocation and incentive fees annually. BREIT is a golden goose for BX shareholders. Rising rents will feed into incentive fees and performance allocation, subject to lease contract limitations. It might take some time to see the full effect of rising rents on BX’s income statement, given that many of its contracts are locked with annual rent agreements, or long term tenancy contracts that only allow yearly rent adjustments.
Rising real estate prices will have a small effect on management fees, given that GAAP accounting rules don’t permit real estate fair value adjustments beyond depreciation (downward adjustment) and repairs (upward adjustment). Nonetheless, rising real estate prices will generate performance allocation and incentive fees when BX sells the properties. In September, BX sold the Cosmopolitan casino in Las Vegas for $5.7 billion, nearly tripling its initial investment seven years ago.
Below are two charts from the Federal Bank of St Louis, demonstrating the rent and real estate price momentum:
Source: Rising rent and property prices provide accommodative tailwinds for the BREIT fund, at least in the medium and long run. Graphs from Federal Bank of St Louis.
Source: Company Filings
Blackstone Mortgage Trust
BXMT differs from BREIT in two ways. First, it is a mortgage securities fund. Second, it is listed on the NYSE. With $22 billion AUM, it constitutes 10% of BX’s real estate portfolio. I recently wrote about BXMT, praising its asset quality and what I see as a stable 8% dividend.
Total incentive and base fees from BXMT averaged $76 million annually in the past three years, and I believe this figure is positioned to increase for the following reasons.
Most BXMT mortgage contracts are bound to a variable interest rate that stands to benefit from rising interest rates, at least to the extent that LIBOR starts trading above applicable floors.
A significant portion of its assets contain inflation-adjustment covenants, allowing BXMT to raise interest in line with inflation.
The company is raising a significant amount of debt and equity, expanding NAV, and, subsequently, management fees.
BXMT’s aggressive expansion strategy saw NAV more than double in the past four years. Its high yields are so attractive that investors are buying BXMT shares above book value, allowing management to raise accretive equity offerings.
BX’s hedge fund segment is the most minor business line in the company’s portfolio. Base management fee averaged $552 million in the past three years, which is not bad, especially given that BX doesn’t directly manage these funds. Instead, its role is to pick third-party hedge fund managers to manage the $80 billion or so AUM, saving management’s time and effort. From my understanding, Blackstone Alternative Multi-Strategy Fund (BXMIX) is BX’s only hedge fund listed on the market. However, BXMIX trade volumes are low, making it hard to trade.
From a reputational perspective, BX’s hedge funds are delivering on its clients’ expectations, recording low volatility and moderate returns. A significant portion of BX’s hedge fund AUM is held in cash to support hedging positions, including currencies, derivatives, commodities, and exotic assets such as carbon allowances.
Private debt saw the second-largest expansion in Q3 after real estate, supported by a strong institutional and retail investors’ demand for alternative income solutions. Most of the company’s debt investments are floating rate, first lien secured loans with low Loan-to-Value ratio. The quality of BX’s private debt portfolio is mirrored in Blackstone Secured Lending fund (BXSL) investment-grade rating, rendering it one of the few Business Development Companies “BDC” to earn such a designation. BDCs liquidity limitations inherent in their business model highlights the significance of this rating.
BX’s private debt funds are expanding thanks to leverage and new equity offerings, filling BX’s coffers. Below is a list of BX’s private debt funds
Blackstone Private Credit Fund (BCRED)
Blackstone Secured Lending Fund
Blackstone Senior Floating Rate Term Fund (BSL)
Blackstone Long-Short Credit Income Fund (BGX)
Blackstone Strategic Credit Fund (BGB)
Blackstone Floating Rate Enhanced Income Fund (BGFLX)
Blackstone Senior Loan ETF (SRLN): Co-managed with State Street (STT)
BX’s price multiples lie at the upper bound of its peers’ averages, mirroring its asset quality, credit rating, and outstanding historical performance. It is not as cheap as when I first covered the company twelve months ago. However, I believe there is still room to run. Despite the surge in BX share price, I wouldn’t describe it as a bubble. The industry is growing, and so are the chances of positive surprises. The company’s focus on perpetual capital fundamentally changes BX’s valuation, signaling a “permanent” change in price multiples. According to some valuation metrics, BX lies at the mid-range of industry peers, supporting our buy rating.
BX is not as cheap as it once was. However, despite its 100% rally since my first piece covering the stock, it is nowhere near bubble territory. Accommodative industry and macro trends push rents, real estate, private equity, and debt higher. These are the exact markets where BX has a leading market position.
Some of these tailwinds will be felt sooner than others. Higher rents will take time to seep into BX’s income statement because tenants are already locked on their leases. Rising interest rates’ impact on revenue is limited by the portion of assets with interest rates floors above the current LIBOR.
Nonetheless, given the vitality of BX’s markets, I believe that the probability of positive surprises exceeds the risks of higher valuation. This, combined with BX’s distribution yield, place the ticker in a position to outperform the S&P 500 index.