It was arguably the most eagerly anticipated PERE conference session of the year. For the first keynote session at the PERE Summit: New York last month, we decided to try something new: we altered the format of the session from journalist-determined questions to reader-determined questions. PERE’s 38,000-strong registered user headcount was able to email in the questions they really wanted to ask the man in charge of the world’s most powerful private equity real estate business, The Blackstone Group. That was half of the equation. The other half was convincing Jonathan Gray to accept the challenge of being scrutinized in front of a live audience. Thankfully, he accepted. He suited up and entered the batting cage so that PERE senior editor Jonathan Brasse could throw the hard ball questions. Here is an abridged version of this unique Q&A session.
Jonathan Brasse: Blackstone’s latest global opportunity fund closed at $15.8 billion. When does big become too big in terms of fund size?
Jonathan Gray: We see size as a competitive advantage. Our fund’s institutional closing was six months ago, and we’ve already committed or invested 33 percent of that capital: GE called us and wanted to exit their real estate portfolio, which we did in a number of funds that we manage and we announced a couple of large public to privates with BioMed Realty Trust and Strategic Hotels. Being able to compete where the air is thinner has proven to be advantageous for us. We don’t just take whatever capital’s out there. We could’ve raised more than $15.8 billion but we liked the size of the capital we raised relative to the opportunity.
JB: Is it still possible today to launch a fund that could grow to Blackstone’s size in a relatively short period of time, or do you think this time is past in the industry?
JG: If other folks deliver for investors, if they do it in good times, if they do it in bad times, then they’ll attract more capital and they’ll grow in scale. So I think over time you’ll see other larger competitors.
JB: Where is the ceiling for Blackstone?
JG: If you think about these funds, it’s not like you raise the funds and you’re forced to deploy the capital on day one. You can wait to do it in different points in the cycle. The thing that’s most precious to us is the track record we’ve built. Spoiling that, which is taking what you’ve built brick by brick over 25 years and doing some errant investment or raising way too much capital or deploying it in the wrong way, would be a very poor long-term decision for us.
JB: How can Blackstone avoid making extraordinary valuation assumptions to justify winning a bid?
JG: We have a simple discipline in our business model. We call it ‘buy it, fix it, sell it’. We don’t develop things. We like to let other people do development and we like to buy it at a discount to replacement cost. Also, no one transaction is going to move our business in any direction.
In the recent case of Stuyvesant Town, a very complicated situation politically and otherwise, we stuck to our discipline. Because of the deal we cut with the city around affordability and the way the transaction was structured for our core-plus fund, we didn’t have to make any Herculean assumptions about what would happen over time.
JB: Blackstone’s the only money manager that can chase deals at any cost. Are you concerned about a lack of benchmarks that might lead to overpaying for an asset?
JG: I’d disagree with the contention here. We do have competitors who also operate at scale. If we’re buying a public company that owns real estate, we’re unlikely to turn it around and sell it as a company. What it is, is just an underlying collection of real estate. We have a pretty good sense of what a hotel in California is worth, for instance, and the market’s pretty liquid. I don’t feel like we’re setting pricing.
JB: Do you think Blackstone is or is close to becoming systemically important?
JG: No, I don’t. We don’t take any deposits, and if you think about the way our business is set up, we have a series of funds that are completely unrelated to one other. Within the funds, we do a series of transactions that are unrelated, and we have financings that are totally unrelated. There’s no house of cards. If you look at 2007, 2008 during the depths of the financial crisis, for example, we were really battle-tested. For something to be systemically important, problems in one area have to cause problems across different lines. Our model is set up where we have 12 years of capital from our investors. During the financial crisis when things were bad, we were able to hold the assets, then reinvest in them, because there was nobody who could demand their money and cause a ‘run on the bank’.
JB: We’ve all been reading about the recent economic turbulence in China. Does Blackstone see a red light there?
JG: In China, there’s not one storyline. There’s clearly this transition that’s going on from an investment-led, infrastructure development economy into more of a focus on consumption. As China becomes increasingly uninteresting to global investors, it becomes increasingly interesting to us. We own 30 middle market shopping malls that are up 16 percent in same-store sales. So there are pockets of opportunity, but we will continue to avoid investments such as residential in second-tier cities.
JB: In addition to the global, Europe and now Asia BREP funds, how involved are you in formulating similar strategies for Latin America and sub-Saharan Africa?
JG: We’ve been spending a lot of time now in Brazil. The economy there is obviously in very tough shape. The political environment is difficult. Because of currency depreciation and cap rates going up, values are down significantly in US dollar terms, and that can create some opportunity.
Mexico has been pretty hot. The challenge for us in Latin America is that once you get beyond Brazil and Mexico, the economy size is pretty small so the asset size is pretty small. We tend to like to walk before we run. I think Latin America is a possibility but it’s not happening overnight.
Sub-Saharan Africa is a longer wait. You need bigger economies, you need rule of law. Ten years from now, could something exist? Certainly, as those economies develop. But I don’t think they’re there yet.
JB: How do you combat an unhealthy reliance from staff on earning asset management fees versus the carried interest they theoretically should be prioritizing?
JG: When you look at the economics of the folks I work with, the vast majority of their economics come from incentive compensation, from carried interest. For them, selling things is very good because they obviously get compensation, and delivering great performance allows us to raise more capital to keep us going. But as soon as you stop focusing on delivering for investors, the wheels come off.
JB: We’re all well-versed in Blackstone’s success stories. What about Blackstone’s mistakes?
JG: I bought some buildings in northern California in the late 90s above replacement cost – tech buildings where I thought we were buying cheap because the yields were high. But the tenants weren’t sustainable and we got away from physical replacement cost. In 2006, we stayed completely out of the housing business, except for one transaction. We were worried about being late in the cycle but we convinced ourselves that if we structured the deal in the right way we could somehow deliver a great return. Of course, this huge housing storm came and we lost capital. And then we did some resort hotels prior to the crisis. We spent way too much money, had way too much displacement. We didn’t recognize how economically sensitive these investments were and we got hurt there. We spend time teaching our young people about our mistakes because those are the most important thing to avoid making again.
JB: If you’re promoted to Blackstone CEO or president, which is something a lot of people are certain is going to happen, do you always intend to retain direct oversight of the real estate group?
JG: I love what I do and the good news is [chief executive officer] Steve Schwarzman and [president] Tony James feel the same way about their jobs. I don’t see anything changing in the foreseeable future. If I get more responsibility, I think I’ll always have active involvement in the real estate business. It’s the largest business at Blackstone and it’s my love so I would always want to make sure this business is successful.
JB: You operate a global business, but you must have a preferred geography. If you had $1 left, where would you invest it today?
JG: I think the most compelling values are still in southern Europe. We’ve been a most active player in Spain. The math’s pretty simple to me in that you’ve seen a 40-plus percent decline in prices, you’ve seen a 97 percent decline in new home construction, and there are still 45 million to 50 million people who live in Spain. We’ve seen a bottom now in terms of employment, we’ve seen home prices go up for the first time in eight or nine years. Today that seems like pretty good value to me.