The Blackstone Group (Blackstone) is a private equity firm founded in 1985 by two former employees of Lehman Brothers. In May 2007 the firm had $88.4 billion under management and had grown 41% annually since 2001.
The firm operated in several business groups but distinguished itself from other firms by extensive collaboration across divisions. It was divided into Corporate Private Equity, Real Estate Funds, Marketable Alternative Asset Management, Corporate Debt Funds, and Advisory Services.
In 2007 Blackstone started to evaluate the option of taking the firm public. Reasons why the firm should do an IPO, outlined by the firm’s internal project group, included: •Permanent pool of inexpensive capital and a wider group of investors •Long-term orientation in compensation package to employees •Shares could be used as currency in transactions
•The firm would become more reputable
•Partners could monetize their ownership in the firm
The firm also identified several drawbacks with going public, including: •Quarterly reporting requirements leading to higher costs and more insights in the firm from the market •Risk that the market is unable to tolerate the variation of earnings in the firm due to long-term focused investments •Changing the firm’s structure and compensation system from a partnership to a corporation includes several challenges
In 2007 the firm announced that it will go public and I will in the following five sections elaborate on some of the challenges the firm has to overcome and other implications following the IPO.
1.What are the built-in tensions with a public private equity firm? How does Black Stone’s structure attempt to reconcile them?
Openness vs. private governance
A challenge for private equity firm when going public is that it looses the
benefits associated with being private. In the case of Blackstone, the firm’s management mainly described the need for maintaining the current governance, where the partners manage the firm, in order to ensure the firm operates in the interest of its limited partners.
To handle the tension between maintaining governance and comply with the rules for listed companies the firm chose to adopt a Master Limited Partnership (MLP). Fortress Investment Group, that went public during 2006, has used this structure and considering the share price of that firm, it seemed like the investors appreciated the structure. MLP is a limited liability company with units of the firm that can be traded on the stock market.
The structure allows the firm to retain the limited partnership form of governance and hence, allow the management team to continue manage the firm. The unit holders (share holders) only have limited voting rights and cannot influence the management team in the firm. By choosing this structure the firm can maintain the decision power in the same way as when being a private company. There is however a risk that the firm should be aware of, the investors can use other form of pressure (media, etc.) to influence the managing partners.
Short-term vs. Long-term perspective
One of the advantages of being a private firm is that the firm only has to disclose limited information about its operations. Blackstone operates its investment on a long-term basis why the firm has a lot of variability in its earnings.
As an example, a fund usually has a return that can be visualized in a “J-curve”, meaning that the fund is basically loosing money in the beginning due to management fees but catches up in the long run. The stock market is known to be short-term focused and may interpret the fluctuation as negative news and therefore causing a fluctuation in the stock price or an undervaluation.
Blackstone is basically using two ways to approach the problem. First, they are aligning the compensation to its employees so it serves the interest of both the limited partners (long-term) and the stock market (short-term). This is further elaborated in the fourth question in this paper. Second, they are informing the potential investors through a prospect that holding a Blackstone unit (share) is different from other shares in the market. Third, to further smooth out potential fluctuations in the share price the firm guarantees a dividend during the first years after listing.
The fact that the stock market tends to be short-term focused further shows the importance of having the MLP structure. To maintain the long-term focus on investments the firm needs to separate the governance of the firm from the shareholders and the limited voting rights will ensure this.
2.If you were a limited partner in Blackstone, how would you view the structure Blackstone has put in place to go public?
As a limited partner in Blackstone I would consider the structure as chosen to ensure my interests. Given the fact that the firm chose to go public for the opportunities that a listing brings, it seems to be the best way of doing it.
I would be most worried about that the firm would try too much to stabilize the share price and fulfil the interest of the shareholders by focusing on short-term profits. Many of the limited partners in a private equity fund are pensions funds or similar and do not mind to lock their money over a longer time period and, by doing so, seek the long-term profit that the private equity firm can offer. I will highlight the two things that make me confident that my interests as a limited partner will be maintained with the structure that the firm is implementing.
First, the structure allows the governing rights of the firm to remain with the partners and therefore the firm avoids that the short-term oriented market gets direct influence over decisions. Second, according to the firm, the suggested compensation package should align the interest of the managers in the firm with the limited partners, or at least maintain it similar to before.
However, I am slightly sceptical to this since the only thing that seems to change for them is that a part of their compensation comes in shares. Depending on how the stock market will turn out to react to news from the firm it might be so that the managers realize that they can earn more money by being short-term focused and that would not be aligned with my interests.
In addition, there are a few things that I am worried about as a limited partner despite the measures the firm has taken. The fact that the firm is a public firm is probably more prestigious for the managers than being private. Therefore I am afraid that the focus will gradually turn towards the interest of the shareholders.
The firm does not want to have an underperforming or fluctuating stock in the long run and, if this seems to be the case, I am afraid that the limited partners long-term interest may be down prioritized. Another thing that is also worrying is the risk of losing competent people due to the changed compensation package.
3.Would you rather be a unit-holder in Blackstone or a limited partner?
Everything taken into account I would rather be a limited partner in Blackstone. If the structure turns out to work the way that Blackstone says it will, the limited partner will be better off. From its history the firm has the competence and procedures to operate in the interest of the limited partner, i.e. long-term focused.
Being a shareholder does in general include some aspects that should be considered. The stock price may fluctuate due to information, lack of information, and speculation. Therefore the market may act inefficient and in worst case it can destroy the value of the stock. In the case of Blackstone, where the firm intends to leave less information to the market than a normal firm, the risk of under- or overvaluation of the stock is even higher. By being the limited partner you avoid the fluctuations in share price and if the firm manage to keep its focus and strategy, you can continue to expect a good return.
The main problem, which is outlined above, is that there is a risk the managing partners will gradually become more short-term focused so it is good as a limited partner to follow the development of the firm closely.
4.As a potential employee, how would you evaluate the Blackstone
compensation package against a commensurate offer from a similar large-scale PE firm that was not public?
The suggested compensation package from Blackstone has several intentions behind it. Some of the concerns that are mentioned in the case: •The employees should not be worse of than before
•Their interests should be aligned with both the limited partners and the shareholders •Partners and managers ownership should not be too monetized in order to retain competence in the firm The firm therefore decided on multi-phase approach where the compensation includes a combination the management fee, the carry interest, and a number of units (shares).
If I would consider starting working for Blackstone after the IPO, i.e. I would not receive any of the shares that the firm initially planned to give to its employees; I would prefer an offer from a non-public firm. The reason is mainly that a part of the salary comes in shares. There are several drawbacks with this. First, a part of your salary will be exposed to fluctuations in the stock market and as outlined in the previous question, these fluctuations may not always be justified.
Therefore, since part of the salary will be exposed to risk an employee should request a higher salary compared to if he/she would get it in cash. Second, even though I would, as a private person, want to hold a part of my capital in stocks, I would prefer something else than the firm that I am working for. By having the same shares I am exposed to the success of the firm not only with my salary (risk of losing my job), but also with my savings. I would as a private person prefer to have most of my savings at least in another firm and even better, in another industry.
If I would considering becoming an employee before the IPO I might reconsider my decision above depending on how much extra shares I would get initially and see if that outweigh the risk I see with being paid in shares.
5.The question outlined in the case
Even though it is not part of the assignment I would shortly like to comment on the offer Blackstone receives from China where they express interest in buying $3 billion of the offering. As Schwarzman outlines in the case, it would give Blackstone a great advantage if the firm whish to expand its business to China.
In today’s more global world this could be a strategic important move and even if the firm does not buy a Chinese firm, it can establish local knowledge and through that better handle deals involving U.S. firms with operations in China. However, by selling 75% of the initial IPO offering to China they may not satisfy the U.S. stock market. Schwarzman therefore considered increasing the offering to 20% of the firm.
This would have implications on several levels. The firm would experience an even higher pressure to give out information and it is likely that the managing partners will be influenced by the more involved stock market. Also the suggested compensation package would likely change to a situation where a bigger share of managers’ salary is coming in units (stocks). The risk with this is that the limited partners’ interests will be seen as less important and the firm might become more short-term focused than it is today.