BlackRock's Canucks Shaking Up PE

Jun 19 20:06 2019 Print This Article

Christine Idzelis of Institutional Investor recently reported that private equity is driving two Canadians at BlackRock crazy, and they're trying to fix it:BlackRock’s new private equity fund is nearing its first purchase of a company, with a chance it could do something unusual in the industry: Never sell it.It’s sure to be a highly scrutinized deal, coming as the firm seeks billions of dollars for the pool of capital, which is designed to push the evolution of the buyout industry.“We’re under exclusivity for one transaction right now,” says André Bourbonnais, the head of BlackRock’s long-term private capital team, known as LTPC. The fund, which aims to raise $10 billion to $12 billion, may complete the deal within weeks.BlackRock formed the LTPC fund to hold companies for “up to forever,” structuring it with input from cornerstone investors to create a better alignment of interests than in traditional private equity, according to Mark Wiseman, chairman of BlackRock’s alternative-investment unit and global head of active equities. That means lower fees, no pressure to sell companies, and investing in multibillion-dollar deals that BlackRock considers less risky.This step by the world’s largest asset manager may change the landscape formed by some of the oldest and most high-profile names in private equity, like KKR & Co. and the Blackstone Group.Wiseman, who says he began sketching his idea for LTPC in late 2017, has been working with Bourbonnais over the past year to fix what the two view as an outdated leveraged-buyout model. Their previous jobs in the vaunted Canadian pension system fueled their gripes about the model, which — to the detriment of investors — hasn’t changed much over the past 35 years.“It’s anachronistic,” says Wiseman, who started at BlackRock in 2016. “We’re trying to solve a lot of the things that drove us crazy.”Bourbonnais, previously the chief executive officer of the Public Sector Pension Investment Board in Montreal, joined BlackRock about a year ago to lead the firm’s long-term private capital team. Before becoming CEO at PSP Investments, Bourbonnais had been at the Canada Pension Plan Investment Board, where he and Wiseman were colleagues for years.There, private equity fees got under their collective skin.That’s why BlackRock’s new pool scraps the 2 percent management fee traditionally charged to investors such as pensions, endowments, and foundations. Paying 2 percent of assets when the private equity industry was young made sense, according to Wiseman, because the fees were truer to purpose: covering the cost of operating a buyout firm. Today those fees are excessive, with firms profiting from multiple funds that have grown significantly over the past few decades, he says.“It’s nonsensical,” Wiseman adds. “The funds got larger, larger, and larger, but the cost of running the firms didn’t grow proportionally.”Managers would begin raising a third investment pool when the first and second funds were still running, meaning they were now collecting three times the cost of managing the firm, says Wiseman. Sure, the cost of running a $10 billion fund is greater than that for a $500 million pool because more people are needed to monitor it, but it’s not 20 times higher, he notes.In his view, cutting the management fee by a small percentage doesn’t go far enough to align the interests of private equity firms and their investors. Shrinking it to 1.5 percent, for example, is a “tiny” concession when considering the massive amount of fees still being collected, Wiseman explains.Instead, the burden will be on BlackRock to accurately project the costs of running LTPC — or risk eating a portion of them. “You better be good at budgeting,” he says.The firm will provide its clients with a transparent budget to approve annually, according to Wiseman. “If more than the budget is spent, the excess cost is to BlackRock,” he says. And should expenses fall under budget, investors still benefit because they’re paying an explicit percentage over the cost of managing it, Wiseman says.Under the traditional fee structure — the so-called 2-and-20 model — a private equity firm pockets a 2 percent management fee and also takes a 20 percent cut of the profit from its deals.“The 2-and-20 model is broken,” says Christopher Ailman, chief investment officer of California State Teachers’ Retirement System, which oversaw $234 billion of assets at the end of April. “It is just far too expensive.”A long tail of management fees throws off the alignment of interests. “When you’re on fund nine, the idea of paying you a 2 percent management fee to run your operation” is tough to take, Ailman notes. “You should be living on your carry.”The structure traditionally used by private equity firms creates a fee spread of about 400 basis points to 700 basis points, according to Bourbonnais. “That’s why they need to underwrite to a 20-plus return for their deals: to deliver a mid-to-high-teens return on a net basis to the investor,” he says.BlackRock is willing to charge much less — 150 basis points — because the $10 billion to $12 billion targeted by LTPC will put it in a good position to make a profit despite the lower fees. “Because it’s permanent capital and it scales, the rewards in dollar terms to us as a manager are tremendous, even at 150 basis points,” says Wiseman.Ailman, who has been in conversation with BlackRock about LTPC, likes that the giant asset manager has gone much further than buyout firms in aligning with the interests of investors. “It’s a game changer,” he says.The question now becomes: Will BlackRock once again succeed in shaking up the asset management industry it has come to dominate with more than $6 trillion of assets?It’s not like investors never expressed a desire for longer holding periods in private equity to save money, says Ailman, CIO of CalSTRS in Sacramento, California, since 2000. He previously worked in institutional investment management for more than 27 years.“A lot of us have been clamoring for a long time for a longer holding period and more what I like to call ‘private capital’ structure,” notes Ailman. “You’re starting to see a few of those, but they’re coming out of the traditional private equity shops and they look a lot like the traditional partnerships, which we think are ineffective.”That’s why he says he was excited to see BlackRock step into private equity with an innovative structure that addresses the long-term interests of institutional investors.Most buyout funds have holding periods of less than seven years, says Ailman, which is not ideal for CalSTRS’s 30-year investment horizon. When firms exit their deals, the money returned to the pension has to be put back to work — again and again and again.Traditional partnerships between private equity firms and their investors may seem long-term based on a fund’s life cycle, but in reality they’re not. “The partnerships last for 14 to 15 years, sure, but the actual investment in a company, and the growth, is short,” says Ailman.Rather than own a good asset for decades, Wiseman says, private equity managers are incentivized to exit companies within a relatively short time frame to “crystallize their carry” and post higher internal rates of return. The constant selling of companies amounts to “massive frictional costs” for investors in buyout funds, he says.It can be worse. It’s not uncommon for private equity firms to sell companies to each other as a way to cash out. The problem is that the same investor may be in both the fund that’s selling the business and the fund that’s buying it.“Now I own the same thing I owned before, except I’ve paid a whole bunch of transaction costs and 20 percent carry to end up in the same position,” says Wiseman. “As the investor, why don’t I just hold it? Why does it have to pass from hand to hand to hand to hand?”Each sale involves millions of dollars in dealmaking fees being paid to bankers, lawyers, and accountants, according to Wiseman, who notes that “all of that is coming out of the pockets of the underlying investors because they’re realizing a lower net return on their transaction.”Secondary buyouts have climbed globally in number and volume, reaching the highest levels in more than a decade, according to alternative-assets data provider Preqin, which began tracking such data in 2008. Although recycling assets within the buyout industry pays off for the private equity firm cashing out, the CIOs of pension funds, for example, would rather avoid it.“It’s terrible for a long-term investor,” says Wiseman. “If I have a good asset, I want to hold it forever.”Preqin tracked 746 secondary buyouts last year totaling $128 billion globally, with the volume swelling 50 percent from 2017. The average holding period for buyout funds is about five years, according to the data provider.

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About Article Author

Pension Pulse

Leo Kolivakis is an independent senior economist and pension and investment analyst with years of experience working on the buy and sell-side. He has researched and invested in traditional and alternative asset classes at two of the largest public pension funds in Canada, the Caisse de dépôt et placement du Québec (Caisse) and the Public Sector Pension Investment Board (PSP Investments). He's also consulted the Treasury Board Secretariat of Canada on the governance of the Federal Public Service Pension Plan (2007) and been invited to speak at the Standing Committee on Finance (2009) and the Senate Standing Committee on Banking, Commerce and Trade (2010) to discuss Canada's pension system.

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