LONDON, June 14 (Reuters Breakingviews) - Private-capital pioneers, such as Blackstone’s (BX.N) Steve Schwarzman, benefit from public-market inefficiencies even as their listed buyout shops grapple with chronic valuation problems. Investors prefer pedestrian but steady management fees over the lumpy share of fund profit that is the industry’s special sauce. It’s yet another inefficiency on which to capitalize, but only up to a point.
Blackstone, KKR (KKR.N), Apollo Global Management (APO.N) and Carlyle (CG.O) on average trade at about 13 times forecast earnings over the next year, a roughly one-third discount to the S&P 500 Index (.SPX). One reason is carried interest, or “carry” for short, the 20% of fund profit that money managers keep for themselves. The other 80% goes to backers known as limited partners. The split is designed as an incentive to keep everyone’s interests aligned. Private equity firms with a public listing funnel some of the carry to employees and some to shareholders.
Although generating profit on investments is the essence of these specialty financiers, it tends to be inconsistent. Blackstone’s realized performance revenue, which includes carry, has oscillated between a recent trough of $1.5 billion in 2016 and $4.5 billion last year. Compare that with the steadier stream of fees that Schwarzman and his rivals charge annually for managing money. JPMorgan analysts assign a multiple of 26 times to Blackstone’s recurring earnings and just 8 times to the lumpier, performance-related ones.
For financially savvy buyout barons who live mainly for investment profit, there’s an obvious trade: give shareholders more of the reliable income they covet and less of the volatile return they discount. KKR, for one, has done this. The firm co-founded and chaired by Henry Kravis and George Roberts, which made its market debut in 2010, used to throw all the revenue into one big pot and paid out 40% as compensation to staff. In February 2021, however, it started giving employees 60 to 70% of carry and just 20 to 25% of fee-related income, while keeping overall pay steady relative to revenue.
The change effectively boosted the share of the company’s earnings derived from fees, and reduced the proportion from the investments themselves. It made KKR look more like Swedish rival EQT (EQTAB.ST), which floated with a chunky valuation in 2019 and a policy of keeping 65% of carry for staff and giving 35% to the listed company. TPG (TPG.O) last year went public with a similar strategy of paying around two-thirds of performance-related revenue to employees.
Even Blackstone, a relative laggard in this particular sense, has since mid-2021 nudged up the share of carry-like revenue directed to employees. Its first-quarter figure was 46%, compared with closer to 40% in recent years. It would be logical if Carlyle started doing the same under new CEO Harvey Schwartz.
None of these moves has delivered a decisive valuation boost, however. The average forward earnings multiple for Blackstone, KKR, Apollo and Carlyle is still about one-third below the S&P 500 Index, roughly in line with the average discount since 2013. One explanation is that the carry switcheroos have been too modest so far, meaning that volatile earnings still account for a huge chunk of the bottom line.
For KKR, analysts reckon that between 10% and 20% of distributable operating earnings, a measure similar to pre-tax profit, will come from carry and other performance-related income in the coming years. Throw in net investment income, which includes the money KKR makes from putting its own capital into funds, and the inconsistent performance earnings should account for almost two-fifths of the total pre-tax haul in 2025 and 2026, using broker forecasts gathered by Visible Alpha. Little wonder the public equity discount persists.
Taken to its logical extreme, all the performance-linked payouts should go to insiders. It would leave a publicly traded unit composed almost entirely of recurring management fees and other steady income, like BlackRock (BLK.N) or T. Rowe Price (TROW.O), which trade at much higher valuation multiples.
There are two major problems. First, it would expose a wider conflict of interest between a buyout shop’s shareholders and its limited partners. Public investors would have less short-term reason to care about whether the underlying funds performed well, since only the volume of assets would drive the bottom line. Meanwhile, big pension and sovereign-wealth funds might prefer to park their money with unlisted rivals such as Bain Capital and Thoma Bravo, whose interests would arguably be more aligned with theirs.
Second, private equity staff might push back. Assuming the general idea is to keep overall earnings steady, then higher fee-based income for shareholders must be matched by lower cash compensation for employees. In other words, pleasing shareholders means dumping the uneven revenue stream on dealmakers instead.
Imagine if KKR wanted to squash down the proportion of its distributable operating earnings from performance income to just 10% by 2026, compared with the 16% forecast by brokers. Doing so would require holding back three-quarters of carry and other incentive fees for staff, well above its existing target. To keep the bottom line steady, KKR would then have to slash the employee share of fee-related earnings by 36%, according to Breakingviews calculations, using consensus estimates. All else being equal, annual cash salaries and bonuses would have to fall by more than a third.
The industry could gradually inch toward this combination of lower fixed pay and higher staff carry over time, leaving a steadier stream of highly valued fee-based earnings for shareholders. If any one firm moved too far ahead of the pack, however, it would risk a wave of defections to competitors offering higher yearly cash pay packages.
The flipside of a steadier bottom line for the listed company, then, is a less steady one for the dealmakers working there. It suggests that for KKR, TPG and the rest, there is a limit to just how much of their own secret sauce employees can eat. And it means the industry’s head-scratching valuation problem will outlast even private equity’s typical long-term horizon.
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CONTEXT NEWS
Major listed alternative asset managers on average pay about 60% of their performance-related revenue to employees rather than shareholders, according to a Breakingviews analysis of company filings.
The highest is Ares Management, with 70%, using the mid-point of its target range. The lowest is Blackstone, with 46% in the three months to the end of March 31, 2023.
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