Private equity has evolved in both practice and perception. The 1980s were characterized by highly leveraged buyouts by corporate raiders. The 1990s saw the fall of Drexel Burnham Lambert, bringing about a roster of future industry titans. And the 2000s would prove that real estate isn't always a buy at any price. Blackstone (NYSE:BX), the largest manager of alternative assets, saw all these developments through.
Through the ages, one thing has remained constant: Private equity has attracted more and more money. But what hasn't changed is who's doing the investing. Today, institutional investors -- think pensions and sovereign wealth funds -- make up the majority of the industry's capital, just as they always have.
If one thing is true in private equity, it's that things change. And one of the most recent developments is the involvement of the individual investor -- a constituency that has, for the most part, lacked the ability to invest in this particular asset class.
A brief history
Private equity has tried, and largely failed, to cash in on individual investors. By design, private equity funds are illiquid, requiring multi-year lockup periods that generally aren't seen to be suitable for the average Joe retirement investor.
As Blackstone COO Tony James explained on the company's latest conference call, there are a number of problems standing between asset managers and the prototypical retirement account.
[...] there are a lot of institutional barriers for retail investors, not starting with Department of Labor and a lot of other things which just now prohibit it, because they require daily liquidity, daily mark-to-market. ... We are creating products that can accommodate that, but it's a small subset of what we do and a lot of the returns we make come from the fact that we can free ourselves from the tyranny of daily liquidity and take advantage of these substantially enhanced returns that come when you can do that without taking more risk.
There are some exceptions, of course. An obscure corner of the public markets -- business development companies -- offer something that is very close to the traditional private equity fund. But their history in courting individuals is rocky, too.
In 2004, Apollo Investment and Ares Capital Corp. went public with strategies that mirrored private credit funds. Following their successful IPOs, BDCs quickly fell out of favor, however. Blackstone and KKR, both of which filed paperwork to create their own variants the same year, quickly backtracked. It wasn't until the hunt for yield after the financial crisis that BDCs once again began going public in quantity.
Blackstone came back to the BDC structure following the financial crisis. Its FS Investment BDCs have attracted more than $10 billion in assets under management, or AUM. It's a drop in the bucket compared to its $330 billion in total AUM, but it is impressive given its flagship BDC had a mere $1 million in assets at the end of 2008. To Blackstone's credit, it has won assets in the industry in part because of its fairer fee structures designed to align its earnings with its investors' returns.
Making the case
Blackstone's CEO Steven Schwarzman isn't one to mince words, even when it comes to taking potshots at political types and Blackstone progeny. On the second-quarter conference call, he laid out the case for taking private equity styles to individual investors.
This is basically a political issue and it's a misunderstanding of risk and somebody thinks that they are protecting the public from firms and asset classes like -- that we are in, where we have been doing this for 30 years and have averaged about double the stock market. And some of our asset classes have lost virtually nothing. And so any rational look at this situation would come to the kind of conclusion that was implicit in your question and explicit in Tony's answer. And this should really happen, but there are certain political beliefs that just don't want to encounter reality.
Later, Schwarzman would clarify the opportunity for both his company, and investors.
I mean, there are people who have $4 trillion plus managing public money with returns that are a fraction of ours. Well, we can't deploy that much money in our current mode, but just think about that. I mean, there is huge opportunity for us at some point in the cycle.
There is some salesmanship here, to be sure. Blackstone is in the business of managing money, and it would always prefer to manage more. But it would be unfair to say that he doesn't have a point.
The superior returns Blackstone has generated have largely gone to institutions, wealthy investors, and a handful of individuals lucky enough to still have a defined-benefit pension. But that's it. The growing number of investors who manage their own retirement through 401(K) plans and IRAs simply don't have an easy avenue to employ private equity managers.
What comes next
As I think about the future of private equity, I think it almost certainly includes greater participation among individual investors. Where active management in public markets faces a massive competitive threat from index funds, there will never be an index for private investments. It simply isn't possible.
Thus, I'm left to conclude that the runway for private equity managers is much larger and longer than that of managers of public assets, with a much stronger "moat" underlying the model. It won't happen overnight. Individuals, just like institutions did nearly 40 years earlier, will likely test the waters with their toes before diving in.
The stakes are massive. Blackstone is the largest manager of alternative assets, with $330 billion in AUM. By comparison, BlackRock, which was once a Blackstone subsidiary, is the largest traditional asset manager, claiming $4.7 trillion in AUM. Even the No. 6 asset manager, a company few would think of -- JPMorgan -- has nearly five times as much in AUM as Blackstone, most of which is in active funds. (Blackstone would rank 50th if compared to traditional managers as of the end of the first quarter.)
In my mind, that makes private equity managers the "sweet spot" in the broad asset management industry. Their core customer will probably always be institutional investors, but individuals are a much bigger, mostly untapped, slice of the pie. There are hoops to jump through, and a reputation of greediness to shake, but one can't argue against the fact that an investment in Blackstone's funds has historically trumped public equity by a wide margin.
If I were to throw darts at what private equity will look like 10 or 20 years from now, I'd could only assume that the compelling returns of top-flight managers would lead to a change in who can invest in the asset class and how they can do so. The biggest winners from the "retail option" would have to be the companies with the best track records and largest scales. Blackstone has both.