Private equity has lost its taste for U.S. banks because of the stringent rules imposed by regulators, says Hamilton James.
The president and chief operating officer of Blackstone Group LP also said some rules by regulators held private equity to a higher standard than foreign banks. As a result, the wave of private-equity investment in the banking industry "is pretty much over."
James is also concerned that the economy may not bounce back as dramatically as some investors expect. The "pretty pessimistic view" he and colleagues at Blackstone have of the nation's economy has made his firm cautious when it comes to prices on certain businesses that are up for sale.
"If you have a more optimistic view, you can get to a higher price," James said. But he is skeptical about the Federal Reserve Board's efforts to jump-start growth with its quantitative easing policy. The Blackstone dealmaker expects 1% to 2% real growth per year in the United States. Despite a pessimistic outlook for the economy, James sees pockets of value in businesses such as refineries, which are included in Blackstone's portfolio.
The 25-year-old Blackstone has $119 billion of assets under management. In addition to private-equity investments, the firm seeds hedge funds and gives advice on corporate restructurings and mergers and acquisitions. Though it has an in-house investment banking business, James does not see this line supplanting bulge-bracket firms and banking boutiques.
In a recent interview, James said he does not expect direct investment by limited partners to replace traditional private-equity firms, because the partners do not have the resources to build up a staff to manage the operations of a business as well as a financial sponsor.
Here are some excerpts from the interview.
In a recent investor call, you said you had been priced out of the market when it comes to acquisitions. Are there any industries that you believe still have value, or does this observation apply to all sectors?
James: Like so many things, that is a generalization. And there are always things that are mispriced and misunderstood. We're in a business that is highly idiosyncratic, so we don't have to buy the S&P index. We don't have to own dozens of stocks or dozens of companies. We are looking each year for a very small handful, three or two companies in the whole U.S. that aren't … overvalued. So there's always something — if we work hard enough to find it and we're lucky enough to come across it or smart enough to create it.
We found some value in the refinery industry, for example. We have now bought two refineries at between five and 10 cents of replacement value [and] definitely not overpriced right now. Some would say a difficult industry. The future of refining is uncertain. Who knows what happens? Carbon taxes, a lot of risks.
There are things that aren't expensive. We have another company where we are buying a lot of aggregates and cement companies, building products. Again, people are pretty negative about the construction cycle, and we think we are getting a good company with some upside. But it's not expensive. So there are definitely pockets of value out there.
Is that richness in price coming on the back of the improvement in the credit markets, or is it tied to expectations the economy will improve?
It is probably several factors. Because we view them as rich in price doesn't mean they might not be good investments. We have a pretty pessimistic view of the American economy. If you have a more optimistic view, you can get to a higher price, obviously. I think what's driving prices higher is, first of all, hot credit markets, and the amount of leverage is high, and the cost of that leverage is low. Secondly, there is a conviction some people have that we don't: that the economy has seen the bottom. I do think it has seen the bottom, but I do not think that it is going to bounce back strongly.
We think it could be essentially flat through 2012. That negative outlook on the economy means that there are certain companies you are just not going to go for today. We are just finishing a fund and starting a new fund. We have got six years on the new fund, and we have plenty of time to be patient.
There is talk of a rush to sell companies by yearend because of tax issues. Would this not bring prices down?
There have been some sellers of businesses, particularly privately owned by families, who are looking at the risk of a capital gains tax increase. You have some buyout businesses looking to sell, not for tax reasons, but because they are getting ready to raise a new fund, and there have not been much in the way of realizations for the last few years, because the market conditions have been crummy. LPs like to see some realizations before they re-up. So you have two forces driving some of the sales.
Even with these sales, we have a half a trillion of dollars [industrywide] that was raised and was not invested. This year's LBO values are something like 20% of 2006 and 2007 peaks and much less than in the years before the peaks, so it's hardly high volume if you look at it that way.
Going back to the economy, what is your growth outlook?
One to two percent real growth per year, basically, in the U.S. Unemployment stays high and might even sneak up a little bit. I think QE2, the quantitative easing, won't help. That's my own view. I don't really see the engine of economic growth for America for the near term.
Because of the consumer?
The consumer is ailing. There is two years of unsold housing stock. I don't see prices rallying a lot until you work that down. You have an ailing consumer who will chip away at it, but I don't see that boon there. I don't see companies investing much in new plants and equipment, except as productivity-enhancing investments, which, of course, cut jobs.
So you get a little bit of expenditure, but then you lose jobs. The companies are looking at their return on investment, which is positive for them, but, by definition, it's negative for society.
And American industry is not at high-capacity utilization anywhere, basically. So I don't see a lot of new plant-growth expenditures. I don't see what the new force driving the growth and recovery will be for a while. There will be something, and it will come along. We will chip away at it, but I think it will be slow, grudging improvement.
The improved credit markets — there seems to be a ceiling on leveraged buyouts in terms of what can be done. I've heard that $5 billion to $7 billion is the cap. Do you see this as the ceiling?
I think you can get into the $10 billion-plus range if everything is right.
What has to be right?
A good company. A good, steady industry. A good market position for the company. An industry that lenders and creditors can understand and have confidence in. You are talking about borrowing $5 or $6 billion in debt and putting up the rest in equity. The equity component of deals, in general, has been pretty high now as a percentage. Call it $6 billion of debt and $4 billion of equity, and you will get you to $10 billion. I think that is do-able in today's market.
Are you working on any deals in that price area?
We are looking at a few things. There was some publicity about a large deal we were looking at that was bigger than that. We did have the credit for it. At this point, we have one or two that are in that size range that we are sort of considering, but part of what we have to do is find good value. I think the size is financeable, but I'm not sure it's a value we like.
I know this varies by industry, but what kind of return on equity do you typically look for?
It varies by industry. It varies by country, and it varies by type of deal. It varies across a lot of dimensions, but, generally speaking, the minimum we want is a 20% return on equity.
For certain kinds of investments, we need something closer to 30. The kind of industry, the country, whether it's a control position or not and the level of control you have, whether it's an early-stage investment or later-stage investment, whether you have a lot of leverage or not — all those things go into the mix.
And the intuitive judgment for high-risk deals is that you need a higher return. But as low as we ever go is 20%.
In terms of the evolution of PE industry, pensions are investing directly. What's your response? Does this threaten the traditional PE model? What's your reaction to that direct investment?
There are some investors that do that, but there are a lot fewer today than there were three years ago. Three years ago, the sovereign wealth funds were racing out and making direct investments with skeletal teams. I don't feel threatened at all by it. I think it's a minor activity by a few of the biggest investors. It's not a big thing in terms of the volume of activity.
Secondly, I think those investors will have an experience which is very, very disappointing. They can't afford to attract the same level of talent as the dedicated firms. None of them can afford to retain the industry experts or the operating team that actually creates the value, so they are not actually playing with a full deck.
And they don't typically have the same relationships or clout with Wall Street to see proprietary deal flow and to see it early and all of the tactical advantages that come with that. I think it's going to be one of those things that works much better when they are focusing on low-risk, low-proprietary-content investing — debt investing and infrastructure assets and core real estate.
When you are talking about real estate opportunity investments, real estate development, private equity, venture capital — those kinds of high-risk investments require a lot of domain knowledge, and they require hands-on involvement with the operations of the assets. I think they will not do much of it. What they do end up doing will be disappointing.
So a large part of it is then having the operations team helping run a business and finding its inefficiencies?
That's a lot of it, but there are other things, too. We have an operations team, but we also have a lot of domain knowledge, a lot of industry knowledge. We have a big team. A pension fund or a sovereign wealth fund, they are trying to do this with two to five people. We have got 160. They are just way outgunned in terms of expertise, operating industry knowledge, deal flow, financing expertise. It's not any one thing. [But] no pension fund can afford to have a 160-person team in this one little asset class.
So this does not suggest a larger evolution going on here?
I'd say there is a long-term trend, in general, to the commoditization of private equity. When KKR started in the business, they were the only one, and now there are something like 2,000 private-equity firms out there. None of them have difficulty raising money, and none will get all that they want, so I'd say the balance of power has swung slowly but inexorably towards the LP versus the GP. And you have seen some erosion of economic terms for the GP as a result of that.
There is less erosion with the consistently top-quartile investors than with the more marginal players. I think you'll still see a shake-out of the more marginal players, but I'd say it is a trend where the balance of power has drifted to the LPs. That's not just a blip.
Looking at the evolution of PE firms and, specifically, your firm, you have taken up more traditional investment banking roles. You also have a hedge fund business that makes you appear almost like a traditional Wall Street firm.
I don't want to be a traditional Wall Street firm at all. I want to be a very focused alternative asset firm. I want to do that better than anyone in the world, and that's all I want to do. That's our mission, and that's our goal, and that's our approach.
Now, the firm happened to start with an M&A advisory business, and we have for a long time also had a restructuring business. Those businesses are nice little businesses that give us profits and steady cash flow, but we are not in them for that. We are in them because they contribute industry expertise, deal flow, industry knowledge and outreach and brand development to our other businesses. They make us better at our investing businesses, but they are never going to be the main thrust of the firm, and nor do I want them to be.
I don't really have any plans to get in the capital markets business, for example, like some firms who get into underwriting to grow that traditional investment banking business. That's not where we are going.
Some of the other players in the industry have said they want to take on more of the role of Wall Street firms.
Some other firms may have a different view of that. I've been in that business. I know it's a tough business, and, frankly, we are only interested in being in businesses where we are as good as the best in the world. I don't want to be an also-ran competing against Morgan Stanley and Goldman Sachs that's got minor capabilities in relation to theirs in capital markets and equity underwriting and debt underwriting. To me, they do that very well. They serve us very well.
We pay Wall Street a lot of fees, but we get a lot from Wall Street, too, in terms of deal flow, access, outreach and so on. That's a symbiotic relationship, and I'm happy with that relationship. I don't want to disintermediate them, and I don't think that we'd ever build an organization of sufficient scale and depth to actually do it better than they do it.
Over the last three years, there's been so much chaos on Wall Street, where some have asked if boutiques will supplant traditional investment banks within commercial banks.
We think there is room for both, and there is a need for both. In the investment banking advisory business, there is room and need for boutiques, and there is room and need for the full-scale universal banks.
Why?
There are times when you want pure advice without any conflicts, where you are going to get access to a senior person, and he's going to not shunt it down to a vast team of junior people — where the chances of leaks are way smaller, because the whole place is small and mysterious, if you will.
And you want that kind of objectivity and security. Look at the markets around the world; there is a thriving set of boutiques, and there is a thriving set of banks. There is room for both. In the restructuring business, you almost can't use big banks, because you do have conflicts. For us, that is a very important part of our advisory mix, so, by definition, you will always have boutiques dominate [corporate workouts].
Given the evolution of your business, could you ever see yourself expanding into traditional mutual fund products, or do you want to always see yourself as an alternative asset manager?
We have one small division that does mutual funds now. They run two mutual funds, both of which are closed-end mutual funds, and both of which are listed on the NYSE. So it is a business we have, and it is a business we are familiar with, although it is smallish.
I think whether we expand that much would depend on what the business rationale is. I understand the market would accept it as a natural diversification, if you will, and that the two businesses fit together. But when we think about acquisition opportunities, there's got to be more to it than just something you can explain.
There has got to be something truly synergistic whereby having that business here makes our existing business stronger in some way — better investors, but it could be access to capital or something like that. And, similarly, by being part of Blackstone, that business we are thinking about acquiring gets stronger either in investment performance or its ability to serve the customer.
Right now, I don't see enough of that mutual benefit to justify being in the mutual fund business, broadly defined, particularly when it is selling to retail investors.
On the other hand, there are segments of the long-only asset management business where I could see some real fit — for example, in the high-yield bond area. We do a lot of credit work there anyway, so we can share the same analysts. Many of the same LPs are in our other products, so there is a lot of commonality there, and we have already some long-only product.
I could see something there in niches, but would we be interested in a T. Rowe Price? I'm just not sure there is a fit there. There is no strong case for "Why not?", but we are a firm with limited management bandwidth. I'm a real believer in not building bureaucracy and keeping it nimble and having a flat organization.
You had many Indian companies in your portfolio. What's the attraction to Indian markets?
One of the things we did start a couple of years ago, when it looked like the U.S. economy would get into some heavy weather, is we shifted a lot of our assets to India and China. We felt the fundamentals were strong enough that we would get continued growth.
Most of our Indian investments are a bet on domestic economic development. Some of it might be their [growing] middle class, but a lot of it is more focused on their need for infrastructure and the development of the infrastructure to support the development of the country.
In terms of IPOs from PE firms, are they getting the best pricing? Should the sponsors not have opted for an outright sale?
A private-equity sponsor, when they are taking a portfolio company public, is making a judgment that they are apt to get better long-term value for their LPs by going the public route. But often there will be a dual-track process where they will test the waters with some buyers while they are filing the company. Even if it is not an official dual-track process, a lot of times the assumption is "If I file a public offering and there is a buyer out there … he'll come to me." It is sort of like advertising that "I'm available."
Going public does not necessarily get you out [of an investment]. You just establish a market. A lot of sponsors will figure, "I'll get the company public, and I can sell it in six months or a year." Sponsor IPOs have outperformed other IPOs after going public. I also think sponsors don't do a good enough job positioning their companies in the public. Frankly, I think they get a little greedy up front in terms of the price range they are hoping to get their IPO at.
So the IPO target ranges are artificially too high?
They love their companies. They are very enthusiastic. It's kind of like their baby. You think your baby is beautiful, but maybe the rest of the world does not think they are quite so beautiful. I think private equity has lost sight, at times, that beauty is in the eye of the beholder sometimes.
Any examples of your own companies being overvalued?
Frankly, no. I mentioned sponsor IPOs have outperformed the public, and our IPOs have outperformed other sponsor IPOs. But that does not mean we are always happy with their execution. Often, we are not, frankly. None of us as responsible sponsors wants to put out a piece of merchandise that is overvalued, but we do want to get fair value for what we are selling, because we understand the company from inside and out.
It seems like a lot of times in the IPO [market], the public is not paying us what we think is fair value. And one of the reasons those IPOs outperform over time is, eventually, that value becomes clear, and the stock appreciates faster than nonsponsor IPOs. I think that's actually validation that the sponsors are right about what they think of the value, but it doesn't mean that, at the IPO date, the market necessarily buys off on that.
When you take over a business, what's the common denominator to inefficiencies in a business?
There really isn't any one. Some of the companies we have are starved for capital. It's been an orphan business or a privately owned company, and they haven't been able to get the capital investment or spend the R&D or marketing dollars they should have. Some of them were accumulated by acquisitions, and, frankly, those acquisitions were never glued together in one sensible whole. They have overlapping systems or whatever.
Others were run by management teams that were focused on the U.S. They had never expanded into Asia and didn't source raw materials from lower-cost countries, so you can change their cost structures and the markets into which they sell their products. We have a very global perspective on that.
One of the things we do is get a strong platform company and use that as a consolidation vehicle. Often, we bring in a management team that is very good — more than a company of its size could really afford by itself. We overinvest in management and use that and synergies to create a big, successful company. There is not any one common denominator.
What are your thoughts on secondary PE activity? Some say this sort of trade goes against the true spirit of uncovering an overlooked business on your own. Is it a valid way of investing?
I think it is a valid way of investing, for various reasons. First of all, one of the best deals, maybe the best deal we have done in the last five years, was a secondary buyout. We made seven and a half times our money in three years. At the end of the day, our LPs pay us to earn good returns. If we can do that, we should not worry about what label we put on it.
In that instance, we had a vision for that company that we thought would create a lot of value that the current owner didn't have. And we were able to execute on that vision, and it created a huge amount of value.
In other instances, we'll do a secondary buyout. Let's just, for example, say there is a smaller sponsor that has owned a company for a while, and we think it's a good company with a good management team, and there is a consolidation opportunity in the industry. But the smaller sponsor does not have the capital to put in the company to grow it that way. So we can give it more capital and allow it to grow much faster. It starts off as a secondary buyout but ends up as a consolidation play or a growth equity investment.
I think it would depend on the circumstance. A lot of times, a buyout firm will have an old investment. It will be at the end of the fund's life, and it's paid down the leverage, and, as a result, the returns for that guy to just continue to hold it are reasonably modest: low double digits, 10% or 12%.
But even if a new sponsor does not touch the operations at all, just by getting a lower-cost, more efficient capital structure with some more debt, they can get the equity returns significantly up over that 10% to 12% and earn a good return for their LPs. If someone can buy it and get a good return, that's perfectly valid.
PE's investment in banks — a lot was made of it on the eve of the credit crisis. Where does it go from here?
It is pretty much over. The FDIC doesn't really want to have PE taking over the ownership of banks. Politically, people worry that "If they [sponsors] control the banks, will they use the banks to do something that serves them?" I don't think that would ever happen, but, nonetheless, it is not worth the political flak of doing that.
So they have set up a set of rules where PE is held to a higher standard than other banks, even foreign banks, which are moving the jobs out of the United States into other countries, and which is an oddity. At least PE would keep the jobs here. But, nonetheless, reflecting the political realities, that's pretty much over in terms of a lot of PE capital going into banking.
Where do you draw most of the fee income? Is it seeding of the funds or management fees?
We have a couple of seed funds, but they are 10% or less of our assets under management. But most of it comes from the management fees that our investors pay us.
The reason to ask about seed funds is that, with the Volcker Rule, you have seen some highly talented professionals leaving prop desks at Wall Street firms.
We think that will be very good for our seed fund, and we have made some commitments to some great teams coming out of these firms. Our first fund is only $1 billion. Our second fund, which I think is just in the process of being completed, is $2.5 billion.
What is the common strategy these newcomers are adopting?
It is not common, because what we try to do is get diversification, so we have long-short equities. We have credit. We have emerging markets and we have commodities. We want to get that kind of spread, so we don't have all of our eggs in one basket.
I keep thinking about Long-Term Capital Management in 1998. You don't want to be going down to the Fed.
That's true, but, on the other hand, for the seed fund, these are new managers, and they start off small. So they don't have that kind of systemic risk that LTCM represented.
Given your investments in real estate, what's your outlook? You got rid of a lot of your holdings on the eve of the credit crisis.
As a firm, in general, all of our businesses concluded in 2006 that things were too good. While we could not see any problems, we thought it was appropriate to pull back. We did that across all of our businesses. That served us very well in the crisis, because other people were accelerating and being more aggressive. In real estate, we sold over $40 billion worth of assets in 2006 and 2007.
What was the trigger? Cap rates on commercial mortgage debt?
No, it was just a feeling when there articles that [suggested] [former Fed Chairman Alan] Greenspan has done away with recessions, [and about] the golden age of leverage buyouts, to [the creation of a] $100 billion fund. When you start reading all of this stuff, it feels frenzied, and no one can see any problems.
We just decided that was too good to last, and it was priced into all the securities, and we decided it would be a good time to pull back. We actually went on record with our LPs in early 2007 and said in writing, "Guys, I know the rest of the world thinks this is the golden age, but we are pulling back, and we think it is an extremely dangerous time." This was before there was any downturn, in early 2007. It was the fall of 2007 when stuff started to happen. I think we have gotten a lot of credit from our LPs for having that sort of discipline and foresight to pull back then.
Back to real estate — we sold a lot there, which served us really well. All of our real estate funds returned positive returns.
In terms of our outlook, we don't do a lot in residential, so I don't have an educated view. I will point out that housing affordability, if you look at the cost of housing in relation to income, is at an all-time high, and it should be turning. But, on the other hand, it's not really [turning around], and I think you're going to have to see more consumer confidence and growth in jobs before you see much improvement there. We have two years of backlog to work through. I don't see a near-term bump in housing prices, but, as I say, I'm an amateur observer.
On commercial [real estate], operating cash flows are definitely bottoming out here and, in some markets, turning up. The shorter-cycle businesses, which move more quickly, like hotels, have turned up earlier and faster, and the longer-cycle stuff is starting to move faster. So we think we're somewhere near the bottom of the cycle in terms of real estate fundamentals, but the hot credit markets have also made cap markets pretty low. They have come down a lot already.
You recalled that in 2006 and 2007, things were not feeling right, and you wanted to focus outside of the United States.
We decided that things felt too good. Things felt too optimistic. We'd been in market peaks and bubbles before, and it felt bubble-like. That's not to say we could see why it felt bubble-like. We concluded it was appropriate to adopt a more conservative posture across all of our businesses. In our hedge fund business, we went short on subprime in mid-2006. In real estate, as I mentioned, we sold $40 billion of assets — probably the largest disposition program in real estate history. In private equity, we sold over 80% of what we had in the portfolio and pulled way back in investing.
In our credit business, we termed out all of our debt and got rid of mark to markets and shortened up maturities and moved up the balance sheet to more senior [debt]. Different businesses expressed our economic view differently, but it was a very consistent view. Similarly, we downplayed U.S. and Europe and moved to stronger economies.
Was there a eureka moment that spurred the change in outlook and stoked the concern about the bubble?
We think of ourselves and try to be contrarian investors. When markets are at their peak, by definition, when everyone is a buyer, we try to be a seller. When markets are at a trough, and no one wants to buy anything, we try to be a buyer. We try to find out-of-favor industries, not-in-favor companies and industries.
We are always challenging ourselves on that, and it's never easy. It's extremely difficult, because when markets are down, there are reasons. The world is scary. When markets are up, there are reasons things look pretty good, and no one can see the future. So you have to have a lot of conviction to adopt a strategy. When the world's going one way, and you are going another, it's hard to do.
