Blackstone Proves Its Mettle By Keeping The Ball Rolling

Summary

• While Blackstone provided dismal headline numbers for Q1 2018, a deeper dive into the plumbing would provide a different view.
• Blackstone's business model requires patience as investments are turned around.
• It is important to keep an eye on the Accrued Performance Revenues as it provides an insight into the health of Blackstone's stable of investments.

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A couple weeks ago, Blackstone (NYSE:BX) released its earnings report for Q1 2018. For me, the important metric within the report was the Accrued Performance Revenues, which increased by 7.68% to $3.6 billion at the end of the quarter. In the simplest terms, the Accrued Performance Revenues tracks the shareholders’ slice of the profits if Blackstone sells off its investments. This was achieved against the backdrop of increased volatility in the equity and real estate markets with the S&P 500 logging a 1.2% quarterly decline, the first since September 2015 and also, the REIT index logging a 8% decline. It is truly remarkable that Blackstone was able to deliver positive growth within its underlying investment strategies despite headwinds in the markets. Unfortunately, many investors focus on the quarterly distribution as the only benchmark to rate Blackstone’s performance. However, by digging a little deeper into the earnings report, investors would be able to unlock the true value of Blackstone’s business model and the timing of the distribution payouts.

As the largest alternative asset manager in the world, Blackstone earns its profits through a two-fee structure: Management and Advisory Fees (“management fees”) and Performance Revenues. The management fees is calculated as a fixed percentage of the total Assets Under Management (“AUM”). Blackstone earns this fee regardless of the returns generated by the investments the capital is deployed in. Therefore, it is nice too see that Blackstone was able to grow AUM by 22% year over year to a record $450 billion. Since there is no guarantee for positive returns and the requirement to pay a standard fee on the funds managed, it is critical for Blackstone to maintain a strong relationship and trust with the Limited Partners for them to continue investing with Blackstone.

Source: Blackstone - Home

As recently as October 2017, many private equity investors were consolidating their external managers to lower the high amount of fees they are required to dole out to these firms. However, it clearly looks like Blackstone was able to weather these storms and pull in more funds as Blackstone continues to steadily grow its AUM. Over the years, Blackstone has cultivated a strong relationship with the LPs through solid execution and by delivering strong returns for the assets they have entrusted with Blackstone. This in turn will continue to support the steady growth of management fees that will drop down into the distribution to the shareholders.

Source: Blackstone - Home

The Fee Related Earnings (“FRE”), management fees excluding expenses, is critical during times of volatility since it provides a stable source of earnings to cover a baseline distribution. This quarter, the FRE made up 66% of the Distributable Earnings (“DE”) while it was only at 26% for the previous quarter. The DE is basically the sum of the dual fee earnings available to be distributed to shareholders. In the unlikely scenario in which Blackstone is unable to realize any performance revenues for the quarter, the distribution derived from the FRE, 66% of $.35 = $.231, will provide a forward distribution yield of 2.99%. In my perspective, as a income investor, that is a pretty solid baseline yield to compensate for holding onto the stock during times of volatility. However, over the years, Blackstone has also demonstrated the ability to deliver performance gains even during times of uncertainty.

Source: Blackstone - Home

Performance revenues make up the other part of the two-fee structure. As the name indicates, performance revenues depend very much on Blackstone’s ability to deliver on its investment strategies. When an investment is profitably offloaded through a private transaction or an IPO, a share of the profits flows through to the Distributable Earnings as Realized Performance Revenues. However, while the investment is still on Blackstone’s books, the fair value performance revenues are tracked as Accrued Performance Revenues.

Since funds invested at Blackstone are locked in for a decade or so, Blackstone has been able to take a more measured approach to their investment strategies. They are able to buy distressed assets and invest to turn them around in order to be sold off at a premium whenever market conditions improve. In 2012, Blackstone started buying up homes in distressed residential market and accumulated over 48000 rental homes in 13 markets by the beginning of 2017. At the time of these purchases, home prices were still recovering from the housing crisis and many were may skeptical prices would ever recover completely. However, Blackstone had the vision, the money and the time to build a behemoth home rental business valued at $12 billion today. In 2017, Blackstone took the business public as Invitational Homes. Another highlight would be Blackstone’s buyout of Hilton Hotels in 2007 for $18.5 billion. The investment went through a volatile period as Blackstone invested in a turnaround strategy and was marked down by 70% at one point. However, Blackstone persevered and successfully took the company public as Hilton Worldwide. One important fact to note in regards to these investments is time. Blackstone is able to weather through turbulent times with limited pressure from fund investors in order continue pursuing its investment strategies to generate solid long-term returns.

As Blackstone offloads the more mature investments, it is also aggressively acquiring new assets such as the purchase earlier this year for Thomson Reuters’ Financial & Risk unit with plans to grow the business as an independent unit. Blackstone also plans to do the same with its $4.3 billion purchase of AON’s Human Resources outsourcing platform in 2017. During these periods of ‘incubation within the Blackstone labs’, very little is divulged in regards to the performance of these companies. In the earnings report, Blackstone reported Realized Performance Revenues of a meager $167 million, the lowest quarterly value since Q1 2016 and down a staggering 82% quarter on quarter. On the other hand, Blackstone grew Accrued Performance Revenues by 9% year over year to $3.6 billion. These two numbers provide a critical snapshot of the performance of the investments in Blackstone’s stable. While Blackstone drastically slowed down its realizations for the quarter, they also displayed solid progress in developing their existing portfolio. It was unfortunate that the quarterly distribution was on the low end but I would consider this a successful quarter since the growth in Accrued Performance Revenues will eventually be realized and contribute materially to Distributable Earnings down the road.

Finally, as the economy heads into the 8th year of the longest economic expansion, the odds of a recession are increasing based on historical standards. Moreover, prices in the equity markets are trading at elevated levels and the Federal Reserve is steadily increasing the interest rates. These factors provide strong headwinds for Blackstone to generate returns equivalent to the ones in the past few years. Blackstone would need to offer loftier premiums to acquire assets while also paying a higher interest rate on the debt financing for the transaction. This could shave off a few percentage points from the returns for these newer investments. In addition, the real estate market is also at an all-time high and physical properties are notoriously illiquid to be offloaded quickly. These multiple factors are concerning since private equity and real estate make more than 90% of the Accrued Performance Revenues at Blackstone.

However, I believe as long as Blackstone sticks to its investing principles and maintains a measured execution of it strategy, the shareholders will continue to be rewarded down the road. That is why it is critical to keep an eye on the Accrued portion of the Performance Revenues for future earnings to assess the health of investments managed by Blackstone. As I have been for awhile now, I am long Blackstone, not for the next quarter but for many quarters to come.

Analyst’s Disclosure: I am/we are long BX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.