Following our last article published in 2010 featuring an interview with BlackRock’s president, Robert Kapito (HBS’83), we kick off this year’s column with an excerpt from a conversation with Tony James (HBS’75), president and COO of the New York-based buyout empire The Blackstone Group (“Blackstone”). Mr. James also serves as a member of Blackstone’s board of directors and as a member of its Management and Executive Committees. He currently sits on each of the firm’s investment committees and works closely with Stephen Schwarzman, CEO. In an interview at the Harvard Business School in December, Mr. James shared with us his investment outlook for 2011, lessons from the frontlines of running the elite asset management firm, and strategic priorities for his team in a rapidly-changing market. He also offered some heartfelt advice for those students looking to join the private equity industry after graduation. replica watches Browse through the biographical pages of the management team at Blackstone and you will be impressed by the backgrounds of people at the helm of the world’s premier buyout shop. For one, many are affiliated with either Harvard Business School or the investment bank DLJ during its glory days (or both, as in Tony’s case); and more importantly, their experience spells out an impeccable track record of deal-making activities and industry expertise. Aside from the financial rewards doled out each year to attract top talent in the country, Blackstone’s name in the alternative assets management business allows the firm to tap a steady supply of high quality people. It also explains the firm’s irresistible appeal for highly driven graduates at America’s top universities who are eager to make a name for themselves in the ‘iconic business of this decade’ known as private equity. No Shortage of Talent Data provided by the career development office consistently show that a sizeable portion of the graduating class at HBS chooses to join private equity every year, and 2010 was no exception, despite coming out of the worst financial crisis in a decade. Some 9% of the Class of 2010 went to work in private equity, and the highest paid student at HBS reported a guaranteed pay package of $250,000 in the first year by a PE firm in New England. The MBA who landed the highest annual base salary in the U.S. (a whopping $350,000) to start in 2010 graduated from the Wharton School of Business and went to work for a PE firm in New York. Needless to say, the offers came with the expectation that the new hire will earn back just as much, if not more for the firm, to justify the expense. So why did we experience the large mispricing of assets in the last cycle given all the smart people in the field with supposedly laser-like focus on returns? According to Tony, it was primarily due to the availability of cheap credit and proliferation of fundraising activities. “It was an arms race mentality. Everyone joined the race to announce the next big deal and to capture the news headlines. The frenzy fed on itself. Private equity investments, for a long time, outperformed the public markets by 200 to 300 basis points, and sometimes more. They outperformed by an average of 1500 basis points over the S&P historically. The lesson to keep in mind is that it’s never about market share gains when it comes to private equity investing. It’s all about making good investments and avoiding bad investments. Getting caught up in the heat of the moment can be so easy, especially when people are confusing activity with progress”. Only the most experienced players know that those times are never good times to get active. But in reality this principle is difficult to execute even for the industry’s best asset managers. General partners often feel the pressure from limited partners pushing them to become more active when markets are buoyant. “We did the right thing by pulling back in all businesses by late 2006, such as in credit //www.replicaforbest.co.uk/replica-breitling-watches-sale-for-uk.html, where we marked-to-market all outstanding loans and securities; in private equity, where we sold 80% of our portfolio holdings; and in real estate, where we sold $80 billion worth of assets. We also pulled back in the hedge fund businesses,” said Tony. “But inevitably you get dragged along and young people tell you that you are getting old and you are missing the new economy. It’s a form of arrogance to think you are right and don’t see things the way the rest of the world does, so eventually you are persuaded to make investments.” Investment Outlook for 2011 When asked for his views of the U.S. and European markets in 2011, this industry veteran offered a somewhat mixed view, but is clearly feeling more upbeat about the U.S. than Europe. He made a point that, regardless of how well or poorly the economy performs, there always exist a number of attractive opportunities. It’s his team’s job and expertise to work hard enough to identify them. “We are at a point of great uncertainty and the crystal ball is murky. PIMCO is saying there is a 25% chance of deflation in developed markets, while emerging markets are said to be prone to excessive valuation across the board,” said Tony. “We will be very cautious and selective in Europe until it has found solutions to deal with its sovereign debt crisis and rapidly deteriorating credit markets.” He added that there is also more private capital in Europe chasing fewer deals at the moment. “We are bullish on America by comparison, where it’s easy to restructure companies for operational efficiencies. It’s also a big enough market that is more market driven, with lots of assets ready to be sold. The labor laws in the U.S. are also more flexible.” Generally speaking, we look for anomalies and only buy a few companies each year. Tony did specifically mention two industries in which he still sees value: energy and real estate. “Energy prices have got to go up, but may take any time between 6 to 10 years in the run up.” He is also bullish on commercial real estate, which is just starting to stabilize in the U.S. and in Europe. “Vacancy rates are still high. Rent still hasn’t gone up yet. This represents a great opportunity for us. Cap rates are low in fully leased buildings, which are typically what REITs buy, so real estate valuation of those properties is very high. You can never lose money if you hold onto the asset long enough, because it’s inherently a natural hedge against inflation and has the potential for very nice returns. There has been no new supply of commercial properties in the U.S. which is good, but the key is still identifying properties that you don’t have to pay too much for. REITS with just 5-6% yields are willing to pay a pretty high valuation but many of these assets will need to be repositioned and that is what we are interested in. The idea is to provide the fix and ride on the increase in valuation”. Strategic Priorities Blackstone will be turning 26 this year with over $119 billion of assets under management and a market capitalization of around $16.5 billion as of January 5th. The firm went public in a high-profile IPO in June 2007 that raised $7.6 billion and helped institutionalize its business. In addition to its private equity investments, the firm runs a hedge fund solutions business, invests in real estate, has various fixed income strategies and provides corporate restructuring and M&A advisory services that complement its alternative investing business. Given Blackstone’s industry leading position, many people look to the firm’s moves as indication for broad trends in markets. Everyone is curious about where Blackstone is headed next and whether it will adopt the full-fledged investment banking business model. In response to the question, Tony dismissed outright the idea of expanding into the capital markets business as he doesn’t believe it to be in the firm’s best interest and vowed to keep the advisory division small. However, he hinted that the firm might consider doing private banking one day, offering access to proprietary deals where clients can’t get elsewhere, and tap into the vast retail investor base. Blackstone has established 3 close-ended funds in the past 3 years, with more expected on the way. Meanwhile, fundraising environment is also looking up for the firm. Blackstone is in the process of closing a new private equity fund which is expected to be greater than $14 billion. Tony said that fund allocation has always gone through cycles and is expected to ‘come roaring back’. “It has to. Fixed income portfolios have low and unattractive yields. We are seeing a lowering of returns from 18% to the 16% for equities. Most LPs are shifting more assets to alternative investments. There is also an obvious shift away from U.S. The Asia-Pacific region represents huge potential and we are barely scratching the surface. We are not just talking about emerging Asia but also the developed markets such as Japan and Australia,” said Tony. For an executive who travels frequently to stay abreast of the latest developments in local markets, Tony recognizes the many differences of doing deals in emerging markets like China, India and Brazil, versus places like the U.S. and Europe, where Blackstone first began its operations. “There are lots of mega-funds that don’t do mega deals in BRIC countries and they are as local as any of their domestic counterparts. We need to be just as plugged in politically and socially as our local competitors. We need to be inherently as Chinese or as Indian as anyone if we want to do business in those countries.” Taxes and Compensation We asked Tony for his opinion on the two most talked about regulatory issues for the industry in 2010 – the hike in the tax rate on carried interest for private equity funds and compensation structure. First, Tony believes the current tax treatment is the wrong approach and that tax on carried interest should have some capital gains component to it and some service component. “I’m all for giving back to society, and paying fair taxes while I also think I should keep a reasonable amount of the money I make when we return gains to our investors”. Secondly, Tony pointed out that Blackstone currently uses a 1.1/20 fee structure. “Not everyone can invest at Warren Buffet’s liquidity premium. For us, it’s mostly contingent on the returns one can generate on an investment. The economics of private equity is shifting from cash compensation to more carry. LPs want to increasingly concentrate their capital with the same investors. Returns will go up a lot for the winners. I think this is a healthy trend in the sector and the way things should be. I believe that performance fees should be totally tied to results.” When asked whether Blackstone faced a lot of pressure on compensation structure from their LPs, Tony said no. Tony also isn’t worried about the phenomenon that some LP’s are trying to circumvent PE firms by making direct investments. “There is no way the LP can tap into the same talent pool that the private equity industry draws on. The most important thing at a private equity firm is its culture. It’d be difficult to replicate the process for institutionalizing mistakes and then passing the lessons onto generation after generation. The flip side of this is that people can get arrogant really, really fast, and you always need to keep that ego in check. This disciplined investment approach is hard to replicate. Many LPs will find it difficult to afford a large enough team of dedicated and specialized experts to make asset allocation decisions wisely.” The risk is a less-than-stellar performance, according to Tony. So how does Blackstone institutionalize mistakes in a way that doesn’t punish people for making bad deals? Tony said that although one gets a lot of individual scope for committing to deals at Blackstone, people are carefully monitored by the investment committee. “When mistakes are made we make them together. We own up to them. There is no hunt for the guilty individual or any blame games that take place when deals go awry. I encourage my people to take prudent, well-researched, and smart risks. I want them to stretch their creativity. Otherwise the organization loses its life and dies.” Having said this, he was careful to point out that there would certainly be sins he deems ‘unforgivable’, such as intentionally hiding facts from the investment committee. “If all information is properly shared, it’s my fault not yours,” added Tony. Career Advice Tony said he loves the field of private equity and considers it a rapidly changing and very exciting field. He also believes now is the right time to join the business. In his opinion, the best place to work for is the entrepreneurial firm that is small and non-hierarchical. Private equity incorporates both the purity of analysis aspect of hedge funds and the challenges of building companies in an operational role. Although it may sound trite, Tony reminds students to always ‘be true to yourself’ when picking an employer. “Find a firm that is at least filled with good people, and has an environment that reinforces your character.” He also added that one should find a small company with lots of growth potential, where one has the room to stretch oneself. “Big firms,” said Tony “may not offer the same opportunities.” He cautioned that one should definitely avoid a firm where there are a lot of old partners. “There are lots of routes leading to private equity, so find yours. Also remember that the business has become more operational and international in the last few years.” As for Tony himself, this HBS alum got to where he is today through a fast-tracked career in investment banking. Prior to Blackstone, Tony was Chairman of Global Investment Banking and Private Equity at Credit Suisse First Boston, and served as the Chairman of DLJ’s Banking Group, responsible for the firm’s investment banking and merchant banking activities until its acquisition by Credit Suisse. He joined DLJ in 1975 as an investment banking associate after getting his MBA at HBS and became the head of DLJ’s global M&A group in just seven years. In 1995, he was named Chairman of its Banking Group. Tony also spends time with a long list of charities and non-profit organizations, including the Kennedy Center Corporate Fund, American Ballet Theatre, and the Metropolitan Museum of Art, among many others.
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