Francisco Castillo, Secretary Board of Directors and Lead Counsel for Iberia, Italy, Russia & CIS, DCC EMEA of Dow discusses the role of legal in times of extreme circumstances...
Interview: Prakash Melwani (Chief Investment Officer, Blackstone)
Blackstone is the largest private equity firm in the world. The CIO of its private equity division spoke to us about private equity returns versus public markets; ESG considerations; and how Blackstone has weathered a turbulent year.
How have Blackstone’s private equity (PE) allocations shifted between Q1 and Q3 this year?
Private equity doesn’t look at things on a quarterly basis. We’re long-term investors: our average hold is 5-6 years. A lot is written about private equity, but the fact that it provides a better governance model is something that’s often overlooked. It’s one of our greatest strengths. Most public companies care a lot about the next quarter’s earnings; we take a 5-10 year view on what we invest in, allowing us to create long-term value in a way that public companies are constrained from doing.
COVID-19 has affected pricing and the short-term outlook. But in terms of strategy, nothing has changed. What’s changed about the cycle more generally is that in most previous cycles, when there was a downturn, you could make money by buying anything. As markets recover, beta takes the stock markets up. After 2009, everything – chemical companies, retailers, software companies – went up.
Our view in the last few years is that the speed of change of technology and consumer behaviour has accelerated. It’s really important to pick sectors with those tailwinds. Some sectors may temporarily look cheap, but if they’re secularly challenged, it’s like picking up pennies in front of a bulldozer. Unlike in 2010-’11, we’re not going near them, because they’re facing headwinds. And the ones with tailwinds didn’t get as cheap as you’d think; they kept performing very well in Q2 and Q3. Many, such as e-commerce companies, actually accelerated their growth. Picking good neighbourhoods – companies in good sectors – might cost more in the short term but will deliver value.
How can PE investments be optimised at a time of crisis-level low growth?
The whole decade has been slow growth for the OECD.
Every investment we make has a well articulated, detailed value-creation plan. We aim to generate meaningful alpha – 500-600 basis points above the public markets – for our limited partners (LPs). If we’re not doing something to improve the business of our portfolio companies, we can’t generate that kind of alpha.
If you sat on one of our investment committees, you’d see that the discussion is always about what we can do to change and improve the business. This has been the case for every deal we’ve done since the great financial crisis (GFC). All Covid did was accelerate the need to implement this change in some of those companies, but that change has been part of our playbook for those companies since we acquired them. This is especially true for, say, location-based entertainment companies, whose revenues were meaningfully hurt. If we made a good decision to invest in a certain company before Covid, it will be proved right when the virus passes.
Meanwhile, you’ve got to ensure balance sheets are robust enough to ride out dislocation. During Covid we fixed or paid attention to the right-hand side of the balance sheet, working with lenders and liquidity providers to make sure that the companies affected had adequate liquidity to ride out the dislocation. Most lenders understood that the current troubles were not the fault of the company management or the PE sponsor, so they’ve been pretty flexible and cooperative.
The exception is that if you buy a secularly challenged company – say, a brickand-mortar retailer – and Covid has accelerated that decline, lenders would be less forgiving. But we have avoided those bad neighbourhoods.
PE firms that specialize by sector tend to enjoy higher returns. How does Blackstone approach and foster specialization?
Every one of our partners has one or two sector specializations. Private equity is not about financial engineering, it’s about improving the businesses in which you invest. So you have to understand the business very well, look around corners, see where the industry’s going, think about add-on acquisitions, consider how to position the company. Sector expertise is necessary.
Our international offices specialize in their respective geographies – India, greater China, Japan, Australia. It’s no accident that we haven’t done deals in Indonesia or the Philippines. You need local expertise. We try to be very disciplined about that.
Trump’s administration recently allowed 401(k) pension fund managers access to private equity. How would you characterise the current climate between pension fund managers and private equity?
PE returns have been very good through many cycles. If you’re a pension fund manager today, you’ve got bonds yielding practically nothing, and expensive public markets. Our asset class generates double-digit returns over long periods of time. They find it attractive, which is why a lot of money has come from pension funds and sovereign wealth funds to private equity.
As for our fee structure, there’s no carry paid unless our LPs get at least an 8% return. That’s a great preferred return in a world of 0% interest rates. So there’s real alignment between the interest of pensioners and private equity.
A recent report by Bain Capital revealed that the IRR [internal rate of return] of public stocks has been matching or outperforming PE in the US for the last few years; in Europe, PE still performs better. Why do you think this might be?
Over long periods of time, we’ve generated meaningful alpha against any public indices in the US and Europe. If you take a moment in time – say, this year – and look at the S&P or the NASDAQ, there are short windows of great returns. But over 10- to 15-year periods, the top PE managers demonstrate the ability to consistently generate meaningful alpha. For example, if you look at public equity from 2010-2015, where the markets were recovering from a big upset, you’d see great returns. But if you were to smooth that to 2006-2015, you’d have a different result. You have to be very careful to look at the timeframe of the indices you’re using for the public markets, as well as the composition of those indices. The FANMAG [Facebook, Amazon, Netflix, Microsoft, Apple and Google] stocks have done well during Covid-19, which has driven the entire S&P up disproportionately.
European public markets offer lower returns on equity because they don’t have the weighting of those big tech stocks.
Speaking of IRR, the FT reported that IRR as a metric was blasted yesterday at an SEC meeting. Apollo has claimed an annual IRR of 39% over the past 30 years, which would turn $1 billion into $20 trillion. What do you think of IRR as a metric?
It’s a useful metric. I didn’t read that article, but I’m sure it’s not saying the IRR was applied to the entire pool of capital over those 30 years. Usually people talk about IRR over a certain period of time – three years, five years.
But you have to look at multiple of money too. Earning high IRR for a year is not particularly meaningful for pension investors, who have long-term liabilities, want long-term compounding and want to avoid reinvestment risk. So we look at both metrics. We’re targeting attractive IRRs over five-, six-, seven-year periods, which will compound into strong multiples of money.
How exactly has Blackstone been innovating?
Capital is a commodity, so we have to constantly innovate. Operational value-add is key to generating alpha. We have over 80 people in our portfolio operations division, 40 of whom are full-time, plus 40 senior advisors who are industry experts. We keep adding to that group, and we provide these resources free to our portfolio companies. We have experts in IT, procurement, healthcare and lean manufacturing, among others.
We also have 20 people in our data science group. Our PE business taps this inhouse resource. They’re a real competitive differentiator; most other firms can’t afford to invest in that capability. We can access different data sets for due diligence and analyse data from portfolio companies in a way that many of our competitors can’t. Many of our companies want to tap our data science group to perform better – for sales analytics, for example.
Critics have argued that in some ways, ESG principles are at odds with what PE firms do: dismiss and/or squeeze labor, while being reluctant to push for pricier “intangibles” like human rights-compliant supply chains. How would you counter this? What, specifically, does ESG in PE look like, besides allocations?
A lot of people have a lot of agendas when they spin that version of PE, but the argument that there’s a conflict between ESG and maximising value for your companies doesn’t resemble reality. If you’re simply cost-cutting, the next buyer, who will do exhaustive due diligence on your company, is not going to miss that. If you’re cutting corners on ESG, your consumers, who care, will stop buying your products. The next buyer will be concerned about your compliance with those things. Remember: we hold companies for five or six years, but the next buyer is looking to the next five to ten years after that. You have to look as far as you can see, and do things that are right for the business in the long term.
ESG is good business. You get higher exit valuations from it; consumers prefer it; employees care about it; LPs care about it. So the view you posit is outdated and wrongheaded. ESG and good investing go hand in hand. We care a lot about it, up and down the organization.
What about when PE invests in a company whose business model or profit driver relies on non-ESG-compliant activities?
We’re not going to buy someone who’s not sensitive to ESG issues, because that’s just not a good neighbourhood. We’ve made $7 billion in renewables investments. That’s the way the world is going, and that’s how you’re going to achieve the best exits. Even if you were going to make the mistake of buying a company that’s not ESG-compliant, the next buyer’s not going to. It’s just not good business.
Blackstone has an ESG steering committee. From the very first time we see a deal, ESG issues are brought to the fore. Companies have to comply with our standards. If you’re a polluter, or are unhealthy for your consumer, you will pay that price, through capital you have to spend, or a lower exit multiple.
I’m very proud of our ESG track record. It’s something we are really focused on.
One well-known criticism of PE aims at its leverage model – saddling a company with debt such that governance improvements and cutting the bottom line still can’t pull it back into the black. There’ve been many high-profile examples of companies running into trouble further on down the line because of this.
I can’t speak for every PE firm, but most of our alpha comes from operational value creation, not from financial leverage. For us, it’s not about the right-hand side of the balance sheet, it’s what you do with the business. There’s an optimum amount of leverage you put on a company, which is often higher than in the public markets, which prefer lower debt levels. But there’s no victory in putting too much debt on a company, because it’s at odds with what you’re trying to do: improve the business. It constrains a company’s capacity to invest capital and grow.
Maybe decades ago, financial engineering was the most importance source of returns. But that’s a very outdated concept. It’s really about the left-hand side of the balance sheet, and operational intervention – for us, at least.
PE dons like Henry Kravis have recently disavowed the “corporate raider” tactics of old, selectively engaging in strategies such as sharing stock with non-management employees. Since you joined the firm, what have you learned about extracting value and ensuring high-value exits?
There are certain key considerations: good governance; focusing on long-term value creation; and alignment of interests. This alignment of interests has been important as long as I’ve worked in private equity. Every buyout ends up with the portfolio company’s senior management owning equity. If we get the governance right, have a good longterm plan, have an alignment of interests with the management team, and pick good neighbourhoods, that should create alpha for our LPs.
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