Credit Trading A Key Line For Public Firms

As David Rubinstein takes The Carlyle Group public, he joins colleagues including Henry Kravis of Kohlberg Kravis Roberts & Co., Leon Black of Apollo Global Management and Stephen Schwarzman of The Blackstone Group, who have begun to transform traditional private-equity firms into alternative asset managers, according to sister service Thomson Reuters LPC. As the transformation takes place one business segment has emerged as a core strategy—credit trading.

This move is part of the rise of the shadow banking sector, unconstrained by the tough new regulatory rules on capital and liquidity that are hobbling banks, which is producing new breeds of lenders as the lines between traditional investors blur. As the private-equity industry’s transformation continues, credit trading is emerging as a core strategy that could rival traditional private-equity models, as the decision to go public highlights exactly how much money sponsors are making from credit trading.

Private-equity firms traditionally earn a management fee of 1 percent to 2 percent, and a performance or incentive fee, typically 15 percent to 20 percent, for taking controlling stakes in companies. That model allowed Titans such as KKR, Apollo, Blackstone and Fortress Investment Group to milk the lucrative private-equity bubble. But as the industry becomes more crowded with new funds, these pioneers are turning their sights to by-products of their traditional private-equity activities—leveraged loans and high-yield bonds. Management and performance fees for running these platforms are just as profitable—or even more profitable—than traditional private equity, according to data compiled by Thomson Reuters.

“We’re seeing traditional private-equity firms diversifying into complementary businesses,” said Michael Kim, managing director of equity research at Sandler O’Neill.

In 2010, Blackstone Group earned $4.18 billion in revenue. Nearly 19 percent or $792.5 million of that total was attributed to credit trading, according to an SEC filing, while traditional private-equity activities accounted for only 15.37 percent, or $643.7 million. Blackstone’s major push into credit trading came with its acquisition of GSO Capital Partners—one of the industry’s largest credit trading businesses—in March 2008. At the time of the acquisition, GSO had $10 billion of credit assets under management. By June 2011 those assets had nearly tripled through a series of acquisitions of management contracts for CLOs.

“While private equity is a good business, it is not Blackstone’s biggest business, nor is it the firm’s fastest-growing business,” noted Morningstar Corporate Credit Research in a June 15 research report. “Blackstone’s fastest-growing business, GSO Capital Partners, had around $26 billion of fee earning (assets under management).”

For Blackstone, this revenue stream continued to increase into 2011. In the first half of the year, some 14.17 percent, or $211 million, of Blackstone’s $1.45 billion in revenues was generated from GSO, which slightly underperformed its private-equity business for the first half of the year with 17.63 percent of revenues. However, as the monetization of private-equity investments is unpredictable and subject to favorable market conditions, firms can realize large profits in one quarter, which could skew quarterly data. Said Kim: “Private equity is a cyclical business; firms need to balance out earnings by having these complementary businesses.”

JP Morgan’s North American equity research team wrote in a research report: “A multi-year bear market in fixed income could make financing and return of capital more challenging and could lower future private-equity returns and earnings.”

In stark contrast, credit trading provides solid management fees and also opportunities to earn hefty performance fees on distressed debt investments. Leon Black’s Apollo Global Management has one of the heaviest concentrations. In 2010, 37 percent of Apollo’s revenues from management and incentive fees came from its credit trading business. Another 60 percent was attributed to private equity. Again in the first half of 2011, credit trading posted 37.36 percent of revenue compared with private equity at 54.74 percent, according to regulatory filings. “Apollo’s roots are in fixed income, particularly distressed investing,” JP Morgan’s North American Equity Research team wrote in an August 10 research report.

Fortress Investment Group also posted healthy revenues from its credit trading business in 2010. About 30 percent of its $826 million in revenues from management and incentive fees for the year was derived from the trading of leveraged loans and high-yield bonds, as opposed to 21.7 4 percent from private equity. “We haven’t expected, nor do we expect any time soon, to see incentive income coming from the private-equity businesses,” noted Oppenheimer Equity Research in an August report on Fortress. “On the credit side we actually saw substantially stronger incentive income.”

If Blackstone, Apollo and Fortress are bellwethers for the private-equity industry at large, the diversification into complementary businesses could signal that major expansion is afoot. Asset allocations to credit trading are expected to continue to grow, despite recent outflows from mutual funds in August.

At least 30 other notable private-equity firms have credit trading businesses, including behemoths such as TPG Capital, with TPG Credit, CCMP Capital Advisors LLC (JPMorgan’s private equity spin-off) and its credit trading arm, known as Octagon, as well as Bain Capital‘s Sankaty Advisors, according to polls by Thomson Reuters.

“Pension funds, for example, have too many private-equity investments: they will soon consolidate into the larger private-equity firms—that’s great for bigger firms,” said Kim. “You’re continuing to see portfolio allocations diversify with specialized mandates towards different asset classes.”

Blackstone Group’s GSO Capital is expected to raise another $1.3 billion in the third quarter of 2011. Fortress Group, Apollo Global Management and Blackstone all declined to comment.

The S&P/LSTA Leveraged Loan Index returned 9.64 percent in 2010 and is down only 2.8 percent year-to-date, which could maintain demand for leveraged loans and high-yield bonds. S&P’s 500 index outperformed leveraged loans in 2010 at 15.1 percent but has since slumped by 5.7 percent.

(Clinton Townsend is a reporter with Thomson Reuters Loan Pricing Corp.)