Blackstone IPO Pits LPs Against Public Shareholders

When Blackstone Group laid bare its intimate financial details in a bid to lure public investors last month, the diversified buyout shop may well have exposed a rift with long-time investors.

The firm disclosed last month that it generated significant profit from management fees and portfolio company fees. That almost certainly has put the firm at odds with limited partners. LPs have typically viewed management fees as a way to cover only general day-to-day expenses—not as a profit center. And they have often tried to limit the incentive buyout shops have to generate portfolio company fees because of its potential to distract them from producing high returns. LPs prefer that general partner earnings come solely from its slice of profit on investments, thus aligning the interests of both parties.

No one can argue that Blackstone’s investment returns, at nearly 23 percent annually since 1987, haven’t been solid. But quarter to quarter, investment returns can be highly erratic. Its public shareholders will undoubtedly press to see Blackstone generate the kind of stable, steadily rising earnings possible from management fee and portfolio company fee income, whereas limited partners naturally want to keep a lid on management fees, and to take as big a share of the rest as possible. Blackstone has successfully resisted the trend toward sharing 80 percent or 100 percent of portfolio company fees with investors, insisting instead on a 50-50 split.

In filing an S-1 last month, the New York-based firm publicly disclosed its annual revenue and revealed how much of its profit—out of a whopping $2.26 billion in 2006—came from fees generated through fund-raising and deals. Blackstone’s management company, the portion of the firm that public shareholders would partially own, booked $852 million last year in revenue generated from fees charged to funds, limited partners and portfolio companies, according to the prospectus, filed March 22 with the Securities and Exchange Commission.

At the same time, Blackstone last year recorded $553 million in expenses for general overhead items such as compensation, rent and general administrative costs. That means that Blackstone cleared $300 million in profit from fees alone, regardless of how well it deployed any of its megafunds or how well any of its portfolio companies performed in 2006. In previous years, Blackstone’s fee revenue and administrative expenses fell more closely together. In 2005, for example, the firm generated $370 million in fees while reporting $361 million in general expenses; in 2004, it was $390 million vs. $277 million, according to the prospectus.

By comparison, Fortress Investment Group, the hybrid buyout shop-hedge fund whose initial public offering in February could set off a wave of IPOs, reported $81 million in fees in 2005 vs. $96 million in administrative costs, according to a regulatory filing. For the first six months of 2006, the most recent data, Fortress recorded $74 million in fees vs. $53 million in general expenses.

Blackstone, which is in a quiet period and could not comment, does little to hide its love of fee income in its prospectus. The firm touts its fee structure as a plus for public shareholders, since fees will provide a steady stream of income while the value generated by portfolio company investments fluctuates with market conditions. “We believe the stability of our fee revenue sets us apart from many financial services firms,” Blackstone said in its prospectus. “A majority of our aggregate fee income in 2006 was derived from multi-year contractual arrangements.”

But LPs simply can’t be pleased with their contribution to this stability. According to a recent survey of investors conducted by Probitas Partners, the San Francisco placement agent, nearly half of respondents, representing an overwhelming plurality, believe that general partners should return 100 percent of transaction fees to LPs. More than 27 percent said that firms should return four-fifths of those fees to LPs. Only 5 percent of respondents said they favor the Blackstone 50-50 sharing approach.

Moreover, Blackstone’s desire to generate a steady income stream could raise questions about whether it has an incentive to raise big funds, close deals prematurely, or complete quick recapitalizations to boost short-term profit rather than provide the larger, long-term gains normally associated with private equity management, said Kelly DePonte, a partner at Probitas, which does not invest in Blackstone. “It’s those sorts of delicate balances that are raised” by a public offering, he said, adding, however, that no one should “point the finger exclusively at Blackstone” since other buyout shops widely expected to file for their own IPOs operate on similar financial premises.

Rishi Kapoor, chief financial officer of Investcorp, said his firm has struck what it considers an appropriate balance since the firm’s founding in 1982 as a publicly traded alternative-asset manager. The company, which lists on the Bahrain and London stock exchanges and primarily funnels money from Persian Gulf states into Western investments, structured fees on the belief that extracting an “extra dollar or a point or two” would damage the “long-term franchise,” he said. For the year ended June 30, Investcorp’s private equity business reported a fee income of $164.4 million after subtracting $64 million in expenses, acording to a regulatory filing.

“There is a huge incentive right up front for alternative asset managers to find that balance between taking an appropriate amount of fees that is fair compensation for services rendered and generating an acceptable level of return that reflects the risk being taken by the investors that committed capital to you,” said Kapoor, who added his company fields the fees-vs.-returns question regularly from both public and private investors.—J.H.