Inefficient Market: Blackstone Letter
1 June 2012
The Blackstone Group
345 Park Avenue,
New York NY 10154
Ladies and Gentlemen:
I am, together with my general partners and funds managed by our firm, pleased to propose to acquire, for a purchase price of $15 in cash per unit, all of the outstanding common units, representing limited partners’ interests in Blackstone Group L.P. (the “Group”). Our offer to acquire the Chinese government’s minority stake in the Group for the same price has already been accepted. Our proposal provides a substantial premium for all of the Group’s common unit holders. If this offer is accepted, Blackstone Group will de-list from the New York Stock Exchange (“NYSE”).
Conditions in our business have not been easy in the five years since we first issued securities on the NYSE. To many unit holders, who bought into the initial public offering and are now sitting on a large capital loss, that may seem like an understatement. Yet although we have made our share of mistakes, the substantial decline in the value of Blackstone’s securities is largely a result of factors beyond our control.
Looking back over this difficult period, most of our problems can be ascribed to deteriorating economic conditions; extraordinary convulsions in the credit markets; a worsening political and legal environment for the buyout industry; and the consequences of what is now commonly referred to as the “private equity bubble.” I will briefly examine each of these issues in turn.
1. The Macro-Economic Climate: When Blackstone came to the market in the summer of 2007, economic conditions were remarkably benign. Most economists agree that the decision by Congress to impose punitive tariffs on Chinese imports during the first year of the Clinton Administration represented a turning point. Since that date, consumer price inflation has returned to levels not witnessed for two decades. Both nominal and real interest rates have soared as Asian savings were no longer recycled into dollar-denominated assets. These developments have had a negative impact on the prices of all long-dated assets. Our real estate business has been particularly badly hit by the collapse of property prices.
Blackstone, along with other private equity firms, was prepared for a downturn. We had hedged against a rise in interest rates. Weak covenants on many of our loans and the increased use of payment-in-kind notes provided a respite for many of our portfolio companies when the hard times began. However, the severity of the recession of 2010, which was statistically a three-standard deviation event, was worse than our models had anticipated. Even though we have experienced only a handful of bankruptcies among our companies, many of the survivors are currently valued by the market at less than we paid for them.
2. The Credit Market Crisis: You will all be familiar with the convulsions of the credit markets in recent years. During the buyout boom, loans to finance LBOs were available in seemingly limitless quantities and risk premiums were absurdly low. This was largely a consequence of the recycling of Asian savings and innovations in the credit markets.
In those days, hedge funds had a stupendous appetite for leveraged loans which were bundled into securities, such as collateralized debt obligations. This market had never been stress-tested by a recession. During the late financial crisis, however, many credit hedge funds blew up. Since then, the rating agencies have become stricter in their ratings of CDOs. As a result, the market for securitizations of corporate loans has contracted. Furthermore, commercial banks are now wary of our industry after several of them experienced sizeable losses on their bridge loans to LBOs. Today credit is less available and risk premiums on leveraged loans have risen – permanently, I fear.
3. The Buyout Backlash: By early 2007, it was clear that the rapid growth of private equity was inciting a wave of public opposition in both the US and Europe. That is why our industry established the Private Equity Council in Washington to explain our case. At the time, I personally expended much time and effort educating the media on this subject.
I wish our efforts had been more successful. Since 2007 two tax changes have hurt our industry’s profitability. Several countries in Europe, including Germany, have followed Denmark’s lead in removing the tax deductibility of interest payments for leveraged buyouts. Although the US did not follow, the Internal Revenue Service has succeeded in forcing a change in the tax treatment of private equity’s performance fees (known as the “carried interest”). Previously, the carried interest was taxed at the capital gains tax rate of 15%. After this tax loophole was closed, these fees have been taxed at corporate rate. This change wiped nearly 20% off our 2008 earnings.
The buyout backlash worsened after the recession, which was accompanied by bankruptcies at several high profile LBOs. During the Senate hearings into the private equity industry, the dismal performance of many buyout funds, especially the 2006 and 2007 vintages, came under scrutiny. The fees charged by private equity firms were also widely criticized in the light of losses experienced by many pension funds. It is scarcely an exaggeration to say that private equity has become the scapegoat for all our economic woes. The upshot was that public pension plans have been forbidden by federal law from making any further buyout investments. This has been a serious blow. Up to that date, public pensions accounted for around 40% of Blackstone’s investor base.
4. The “Private Equity Bubble”: The entire buyout industry, including Blackstone, must accept its share of responsibility for our current woes. At the time of our IPO, corporate valuations and profits had for several years been rising in tandem. This created a golden age for buyouts. With hindsight, it’s clear that we became overconfident.
At the time, too much private equity money was chasing too few opportunities. We found it difficult to resist the urge to raise ever larger funds. And we put that money to work too quickly. In the takeover frenzy, many private equity firms became overstretched. There was a collective loss of investment discipline. Too many businesses were bought at large premiums when profits were approaching a cyclical peak. Given the fees on offer and the ease of flipping assets only months after acquiring them, our behaviour is understandable.
Not only have corporate valuations substantially declined, it has become more difficult to exit from LBOs. Blackstone’s own success in rapidly cashing out of its $39bn investments in Equity Office Properties back in early 2007, encouraged others to pursue even bigger targets. Since the IPO market has been closed these past years, many private equity firms, including Blackstone, have been stuck with their mega-cap acquisitions.
When competition heated up during the “bubble” period, private equity firms were also driven into buying more cyclical businesses. The dramatic failure of Freescale Semiconductor, in which Blackstone was a minority investor, provides a cautionary tale against the dangers of putting too much debt on companies with volatile earnings streams. Furthermore, in order to boost returns, we piled too much debt onto companies.
Personally, I blame the banks which towards the end of the boom would offer to lend more than we estimated the businesses were worth. Still, had macro-economic conditions remained favourable, these investments would have proved extremely profitable. Alas, that has not been the case.
Finally, I would like to comment briefly on Blackstone’s own performance over the past five years. Although our recent investment record is disappointing by historic standards, Blackstone has retained its position among the top quartile of private equity firms. We have also experienced fewer bankruptcies pro rata than our competitors.
Despite recent losses, I am pleased to say that Blackstone has substantially outperformed the Dow Jones Private Equity Index, which comprises around dozen firms, including Apollo, Carlyle, Macquarie, and TPG, as well as a number of listed buyout funds. Nevertheless, we believe the market substantially undervalues our business. At the time of our IPO, Blackstone was valued at nearly 50% of assets under management. Today, it commands a small premium to traditional investment firms.
Although the private equity industry will never again be as profitable as it was a few years back, I believe opportunities remain. But our historic business model of leverage-and-flip no longer works. As Cerberus has shown with its successful investment in Chrysler, private equity really can add value when it tackles difficult situations. At Blackstone, we intend to roll up our sleeves and work harder in future.
However, we now view the stock market listing as a distraction. Although we have eschewed providing guidance to analysts, the quarterly Wall Street reviews have hampered our ability to take a long-term view with our investments. Activists investors have demanded that we change the status of our listed “units” into normal shares, with voting and other traditional rights accorded to shareholders.
This is not acceptable to us. Nor can we comply with the demands by our Chinese minority investors for senior management changes. Instead, my partners and I are offering to purchase all the Group’s outstanding common units. Although the offer is well below the flotation price, it represents a substantial premium to where the securities have traded lately.
Of course, no binding obligation on the part of the undersigned or the Group shall arise with respect to the proposal or any transaction unless and until a definitive agreement satisfactory to us and recommended by the Special Committee and approved by the Board of Directors is executed and delivered.
We look forward to discussing our proposal with you further in the near future.
Very truly yours,