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By Breakingviews
Private markets seemed, for a while, the perfect antidote to the weirdness of public markets. Companies like Blackstone (BX), Apollo Global Management (APO) and KKR (KKR) offered investors the chance to buy assets that, because they weren’t publicly traded, didn’t swing wildly around in value when listed stocks, bonds and funds did. But that valuation anchor risks turning into a pair of concrete shoes.
Look at buyout Goliath Blackstone. Investors have been trying to pull their money out of its $125 billion unlisted Blackstone Real Estate Investment Trust, known as BREIT. Last week, the firm said that they have collectively demanded more than the 2% of net assets that it is prepared to pay back in a given month. A sibling credit fund with a similar structure, BCRED, has now seen redemptions touch its limit of 5% this quarter. And it’s not just Blackstone. Starwood Capital’s similar REIT also hit its limits in recent days.
These funds’ partial liquidity is different from a typical buyout fund that doesn’t let investors withdraw money at all until the end of its life. And it is both a blessing and a curse. It acts as a circuit breaker, sparing Blackstone from forced asset sales to meet redemptions. But investors wary of withdrawal limits, and who foresee trouble down the road, have an incentive to make sure they’re at the front of the queue.
Models over markets
For alternative asset managers like Blackstone, of course, illiquidity is supposed to be the point. Whether it’s a leveraged buyout or a private loan, these managers take money from investors patient enough to lock up their cash for a prolonged period in assets that are hard to trade. In return for the inconvenience, investors are promised high returns: In private equity, top pension-fund investors earned 15% annually after paying fees in the decade leading up to 2021, according to the American Investment Council.
Getting those returns requires accepting some uncertainty. Without constantly updating indicators like share prices, it’s hard for investors to know how much an asset in a private fund is really worth in between the moments it is acquired and sold, which can be years apart. So managers put together a valuation model; whatever it spits out is what they say their assets are worth.
Those models typically move much more slowly than the rapidly changing prices served up by public markets. Gaps can appear that could show genuine divergence in performance – or just a time delay. The net asset value of Blackstone’s BREIT, for example, has increased by 9% so far this year, while an S&P index tracking its listed peers is down 25%.
That has advantages. Unlike in public markets, the bottom doesn’t suddenly fall out of private valuations, leading to less anxiety for fund investors. The ability to push portfolio losses into the future can also spare the blushes of pension funds, which invest enthusiastically in private funds and have to report their performance to their own customers.
These charms became much more potent during the stresses of Covid-19, when it became clear that public markets are not always a ruthlessly efficient price-discovery mechanism. The S&P 500 Index cratered by about a third in early 2020, only to suddenly snap back. Mania took hold of stocks like AMC Entertainment (AMC) and GameStop (GME), and amid the irrational ebullience, a flood of money-losing software companies went public, as the BVP Nasdaq Emerging Cloud Index rose nearly 250%. Both meme stocks and cloud darlings have since slumped.
Private managers, meanwhile, were able to hold their nerve, and events sometimes proved them right. That’s true of BREIT, for example. Shares in public REITS tanked 44% at the pandemic’s onset. The selloff seemed overdone: they were back to all-time highs a little over a year later. BREIT’s net asset value per share fell only 8.6% in Covid’s immediate aftermath; the fund ended 2020 with a total return of nearly 9%.
Resilience or intransigence
Covid briefly scrambled the world, but bigger changes are coming that may scramble the calculus for private markets.
One is that interest rates are rising. Safe assets like U.S. government bonds are yielding more, which undercuts the pitch of private managers who could for years lure investors into higher-risk investments without having to promise very generous returns. It also raises the price of the debt that funds the sales of assets like real estate. This is critical for private asset managers, since sales are when they realize many of their gains and generate cash. Blackstone’s sale proceeds from its private equity business dropped 72% in the most recent quarter, year-on-year.
The pincer of high inflation and high rates also threatens the health of the economy, which in turn affects the value of the investments held in private funds. Jane Fraser, boss of U.S. banking giant Citigroup (C), said Wednesday that the country is on course for a recession. Similar warnings have come from rivals JPMorgan (JPM) and Bank of America (BAC).
That is a risk for funds like BREIT and BCRED. Their returns depend not just on asset sales but on collecting income from property rents or debt repayments. An economic slowdown could leave tenants unable to shoulder rising rents and could bankrupt borrowers. According to Redfin, rental prices in major cities are declining, falling nearly 1% in October from the prior month. Some 55% of BREIT’s portfolio is rental housing.
Cracks in the armor
If the market is due for a sustained downturn, assets like BREIT’s may be destined to be revalued at a lower level as their sale values or rental income fall. That process – known in the industry as marking down the portfolio – is embarrassing for asset managers. And it’s contagious: Once a few firms start making adjustments, others may follow, seeking safety in numbers.
Delaying that moment too long, though, is problematic for funds that offer some liquidity. If an investor thinks a valuation correction is coming, they have a strong reason to cash out at the inflated price before the reckoning arrives, depleting what’s left in the pot. That’s less of an issue with listed REITs, where investors can sell to each other in the open market.
Even though a Blackstone fund effectively started the domino rally, Steve Schwarzman’s firm is likely to emerge better than most of its peers from a downturn. BREIT’s properties are in the fastest-growing U.S. markets, and the cash flow from its portfolio has grown 65% faster than that of publicly traded counterparts. Blackstone’s sheer size and influence enable it to buy assets and swoop on opportunities that others can’t, so it’s possible it could buck broader market trends.
Moreover, if public markets do turn out to be overly pessimistic again – if recession doesn’t arrive, or central banks ease up – then the ability to sell assets rather than taking losses could offer a relief valve. If BREIT can find private buyers for its properties at values higher than the ones it reports, it could claim validation, avoiding markdowns. The fund has made over $5 billion of recent sales at premiums to its own stated valuations.
Nonetheless, a shift is underway, and Blackstone is already part of it. During Covid, public markets seemed backward-looking, overreacting to the present moment while private markets were able to focus on the future. Now, investors have reason to worry, it’s private funds that are stuck in the past. It may take a wave of markdowns to convince them that their portfolios are keeping up with events.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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