FEATURE: The reeducation of Blackstone

What does the world’s biggest private equity real estate firm, with $12.4 billion in dry powder, do when the house view is not to begin seriously investing until 2010 at the earliest? For Blackstone’s Real Estate Group the answer is, go back to school.

Earlier this year the firm proved that like most of its rivals, it has not been immune to the world’s financial crisis. It wrote down

Blackstone's London HQ

real estate investments in the first three months of the year by 19 percent, and while imparting the bad news, Blackstone co-founder Stephen Schwarzman said during an investor call that there would be little more property investment except into debt, rescue-financing, and non-controlling debt investments – made through the Blackstone Special Situations Fund – until late 2010. Messages about the firm’s hiatus from real estate investing, not to mention further write-downs, continued last month.

Delivering the firm’s second quarter results, Blackstone president and chief operating officer Hamilton James said the firm had deployed just $252.7 million of equity in the quarter, just slightly up on the $215.1 million in the first three months of the year, while the value of the portfolio was again written down by 19 percent.

Against this backdrop, Blackstone’s Real Estate Group has hit the pause button while it considers which plays to make next. The firm has enough capital to make a big noise with its latest fund, Blackstone Real Estate Partners Europe III, having closed on €3.1 billion of commitments in June. It was the latest addition to an equity haul that has now swollen to $12.4 billion for investment around the world. But the billion-dollar question is, how to invest it?

This question is no longer as straight forward as it used  to be. In the past, the firm would have analysed micro-trends in industries, sectors and cities to establish whether to invest in, say, hotels, logistics, the healthcare sector, pubs, offices or student accommodation.

However, given today’s worldwide uncertainty, micro-vetting alone is no longer sufficient. Partly for this reason, Blackstone has been busy for the past year deploying senior resources – namely its 75-strong investment team – to research the macro themes shaping the global economy. The work produced from the project – officially called the Macro Financial Institution Group Initiative – has been relayed to investors in detail and some of it was shared with PERE.

During the summer, we caught up with the London team that has been leading the initiative. Global real estate co-head Chad Pike (who runs the real estate platform alongside Jonathan Gray), managing director Douglas Kirkman; analyst Gustaf Backemar; and associate Marc- Antoine Bouyer gathered in Blackstone’s European headquarters in Mayfair to bring PERE up to speed on its progress to date.

Chad Pike

Pike explains that last year Blackstone began to feel that most of its deal flow would come from the financial-institutions sector. Kirkman, who focuses on deals involving financial groups, began researching all the major financial institutions around the world and assessing the likely impact of regulatory bodies (and other forces) on those firms. It soon became clear that banks were not about to sell their loan books at vast discounts as many had once thought. This led the firm to step up efforts to understand factors, such as the accounting treatment of investments. Around the same time, Blackstone analyst Gustaf Backemar had already begun researchingmacro trends, and this work was expanded.

“The initiative was aimed primarily at figuring out where and when the investment opportunities are going to arise and therefore, what we should focus on,” says Pike. “Our feeling was that the problems facing the world were truly global but they were not the same in China as, say, in Japan or the US. So we said: Before we dive in and assume rental and value patterns will continue along the same trends, we should get a lot more information about what is actually happening in the world.”

Over the course of one and a half hours with PERE, the Blackstone team gives an insight into how one of the most respected firms goes about its business. Lest we forget, this is the same firm behind the world’s largest-ever private equity deal – the $39 billion takeover and break-up of Equity Office Partners. The team also allows for glimpses of how it has worked in the past.

Blackstone has always taken a research-led approach to investing, says Pike, with work often complied in-house, for determining its investment decisions. However, he says method was historically to take a “micro level” approach.

In the late 1990s, for example, the European Union was enlarging and cross-border tariffs were being dropped. This affected logistics and distribution patterns. To exemplify the lengths to which Blackstone would analyse the potential for deals, the firm went as far as assessing which kinds of warehouses could accommodate the size of a new truck model popular at the time.

That sort of research, Pike maintains, is still crucial, however, given the economic shock that the world has experienced, he believes it is currently more important to form a view on the macro level of which countries and economies will prosper today.“We are focused on a much bigger picture right now than we typically were. The conclusions of our research are going to be influenced by everything from the relative level of debt that countries have to the response of their underlying governments to keeping the global economy going.” In other words, Blackstone has added to truck and warehouse sizes inflation trends, interest rates, the consumer, fiscal stimulus packages and asset protection schemes. What Blackstone has emerged with after a year’s work, to which much of the team dedicate up to two-thirds of their time, is not necessarily a set of definitive conclusions on which geographies and sectors to invest in, but rather a metric of the right questions to ask before investing. “This is something we felt was necessary for us to do before we embark on a large investment spree,” Pike says.

High five

The initiative initially focused on five key economies: US, UK, Germany, China and Japan. Kirkman explains this enabled

Blackstone to bifurcate its research into other economies: “The first thing we needed was an understanding of the components to each economy,” he says, “What does each country do? How does it do it? What did it use to do? How has that changed over time?” In order to answer those  questions, the team clocked up serious air miles, including frequent travel to Asia. Blackstone’s Kirkman and colleagues began calling  round analysts, central banks, commercial banks, federal agencies as well industry figures and operators for face-to-face meetings.

In Asia, for example, firm executives spent time meeting logistics companies, retailers, Japanese trading houses and the like. Kirkman says: “We wanted to get a sense of what they thought would happen if, for example, Toyota’s production slowed [as it ended up doing] and inventory stock piled up.” In return, organisations wanted to learn how Blackstone saw the world.

So following a year of pooling research from all over the world, what important factors have come to light? Pike and team have determined that major economies can no longer rely on the consumer. Major exporting countries have been impacted by the fall of consumer driven economies. As a result, industrial production has rapidly decreased in exporting economies, leading to rising unemployment. The US consumer, for example, can no longer be relied upon as a source of growth, buying lots of TVs, cars, shirts, personal computers. “We will all have to get used to the fact that the US consumer is going to have to reduce expenditure over the coming years and is going to start saving,” says Pike, “I don’t think we can count on the US consumer to keep driving the global economy upward the way it used to.”

In China, Kirkman notes the lack of social infrastructure, with no national health service and no developed unemployment benefits. “So how do you get a guy who is saving his money in case he needs an operation for his child to address that? It may be difficult for the world to get the Chinese consumer to increase his spending,” he says.

In the banking sector, Blackstone has noted that writedowns and provisions have yet to run their course. To date, $1.5 trillion of write-downs out of an expected $4.1 trillion, according to International Monetary Fund figures, have been swallowed by global institutions. Some European banks still hold debt at between 95 percent and 99 percent loan to value.

All eyes must therefore be on the various government bailout schemes, says Kirkman. The UK, he notes, has introduced an asset protection scheme which simplistically allows for the transfer of 90 percent of future losses beyond a certain level to the government. It also actually keeps 100 percent of losses up to a certain level on the bank’s balance sheets until the government participates. Therefore, there will not be any quick moves by the banks to purge themselves. So instead of  pushing prices down, the scheme may make values move sideways for a long period of time.

And while the UK enters a period of  quantitative easing, Blackstone’s eyes have been on inflation. Blackstone’s Bouyer took a lead on this issue. Investors were already keen to find out the firm’s view on interest rates, so in order to understand that in detail, it needed to understand inflationary pressures. Currently, Blackstone believes we are still in a process of de-leveraging, of credit reduction, and this is making deflation the current risk for investment. In turn, the analysis Blackstone has carried out on inflation will colour its attitude to buying real estate related  debt. Kirkman’s view, for example, is that inflation will have an impact on returns for the holder of a 10-year or 15-year piece of paper paying 5 percent.

In general, the firm believes that low future leverage combined with a lower growth environment will likely lead to weaker returns. What this means for real estate investing is medium-term downward price pressures on commercial real estate with deleveraging,  long term inflation and hedging becoming important factors alongside real estate taxes. Given these broad conclusions, it is easy to see why Blackstone is among the more conservative investors at the moment.

And that, Pike argues, highlights one of the strange things about research – it can lead to outcomes that the firm might not have

Douglas Kirkman

wanted from the start. “Often research leads you into what you don’t want to do,” he says. “We spent years researching the UK office market in recent times, and that research resulted in no investments.” As Kirkman says, it is about being a disciplined investor. “The whole point  about research is that you don’t want to influence the outcome. It is what it is. We don’t want to encourage investment professionals to head in one direction if we don’t know the right direction from the start.” This is something that has been giving Blackstone’s investors some confidence, the firm says.

Friends with benefits

While not the priority, Pike says that the research has served as a useful tool to help communicate with its limited partners, of which there are more than 100 ranging from a “one-man shop” to “large sovereign wealth funds”. Upon the collapse of Lehman Brothers last year, LPs wanted to know the firm’s view on the world.

Pike points out that in the preceding years during the real estate bull-run, LPs did  not ask for much in the way of dialogue, but times have changed. The firm has been offering investors face-to-face meetings to discuss its research and consequently the frequency of investor meetings has increased rapidly (from one to two times a year to five times a year for certain investors). This is something that helped give confidence to LPs during fundraising efforts. Though it is  impossible to measure if this played a part in securing capital, the firm believes the high degree of contact with investors over the past year should have aided the cause.

Unfortunately for competitors, Blackstone is not about to offer up all of its conclusions. “We’ve seen some of our competitors doing directly what we think is not the right strategy given the macro-economic backdrop so the last thing we want to do is push them towards what we are focusing on,” says Pike. So for the time being, the detailed work will remain in-house and with investors. However, with deal opportunities beginning to pick up, it is likely that further clues as to how Blackstone  sees the world will emerge when individual investments eventually do materialise.

At press time, Blackstone was in talks to acquire a 50 percent stake in British Land’s Broadgate office complex near Liverpool Street station for around £150 million. If a deal materialises, this would mark the firm’s tentative return to UK property. The Broadgate complex consists of 16 office buildings. Such talks underline the fact that despite grappling with some meaty legacy issues – such as the Hilton Hotels business, acquired for $20 billion in 2007 – the real estate team is nevertheless in a position to put equity to work in fresh acquisitions. It also underscores the value of research. As Pike pointed out to PERE, Blackstone spent years researching UK offices and the result was zero investment. However, that research has been fed into the latest initiative, and the result looks set to be different.

The days of the $39 billion take private might be over, but given the firm has $12.4 billion of equity to deploy there are sure to be some large power plays ahead. An hour and a half later, the assembled team at Blackstone files out of the boardroom no doubt to  further its deal pipeline. Having gone back to school, the team is ready to go to work.