Private Equity For the Not-So-Rich

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All the big retirement pension funds have a significant allocation to private equity because it's smart. But other than the wealthy retail investors, retail was not really able to buy this type of product. So that change will be, I think, an important one over time for retail investors. In effect, it's democratizing access to private equity, which used to just be available for the very affluent or institutions.

Welcome to the Barron Streetwise Podcast. I'm Jack Howe. The voice you just heard is Stephen Schwarzman. He's the co-founder, chairman, and CEO of Blackstone Group, a major player in something called alternative assets. He's talking about one such asset called private equity. If you think that doesn't involve you, it could soon, thanks to some recent rule changes. We'll hear about what that could mean for U.S. 401(k) investors and for Blackstone shares. We'll also say a few words about factor investing. You know, some people call it the sexiest investment strategy ever devised. All right, no one's ever said that. I was trying to drum up some excitement. I think maybe I went too far. My apologies. Listening in, as always, is our audio producer, Meta. Hi, Meta.

Hi, Jack.

The weather here in the Northeast has turned cooler, Meta, and I think I have some questions for you about hygge. Am I saying that right?

Yeah, hygge.

Hygge. Several years ago, the folks at Oxford Dictionary called hygge, which is spelled H-Y-G-G-E, one of the most significant words of the year., and my sister bought me a little book that year of hygge tips for Christmas. For folks who don't know, the word is Danish, and I think it has to do with creating a sense of coziness and well-being. So Mette, my questions for you as a Danish person are: is there such a thing as hygge season, and have we entered it? And what are your top 2 cool weather hygge tips for listeners?

Wow, these are some great questions. And I'm delighted.

Hard-hitting.

Hard-hitting. So there is and there isn't a hygge season. Hygge is just something you can do all year round, right? But I will say when it gets colder, you sort of snuggle up under blankets and you light your fireplace and you light candles and stuff. That is definitely more hygge territory and easier to get some hygge going. Right. And what was the second question? Hygge tips. So I would say light candles and everything knitted works well for Hygge.

Yes, knitted.

So you should start knitting like a blanket or something.

Done. Now I spent this past week eating a massive tub of peanut brittle that I bought at Sam's Club. Is that Hygge?

Yeah, I wouldn't recommend that.

Let's talk about alternative investments. That term is a bit flimsy. By alternative, we mean not the regular stuff people invest in like stocks and bonds and cash or mutual funds that hold those things. Technically, alternative assets can include things like gold and real estate, but I think of those as pretty common holdings for ordinary investors. You can call fine art or rare stamps alternative investments, but I just call those collectibles. When I hear the term alternative investments, it usually has to do with an asset class like private equity, hedge funds, or venture capital that is restricted to people called accredited investors. Basically, those are investors who can prove that they are, at a minimum, fairly rich and fairly knowledgeable. In principle, stocks and bonds are closely regulated, so they can be offered to the general public. Whereas alternative investments are less regulated, so they're restricted to investors who are assumed to be sophisticated so that ordinary investors don't get hurt. I know in reality ordinary investors can and do get hurt sometimes in regular stocks and bonds. Also, I know plenty of ordinary investors who are at least as sophisticated as accredited investors. Reducing choices for ordinary investors doesn't necessarily help them. It could hurt their returns or their ability to diversify. Now, there are two big changes afoot. In June, the Department of Labor issued a letter that allows companies to offer private equity exposure in their 401(k) accounts with some important restrictions. More on that in a moment. And in August, the Securities and Exchange Commission issued a notice that it says modernizes the definition of accredited investor. There's a new category for investors with, quote, certain professional certifications, designations, or credentials, or other credentials issued by an accredited educate— you know what, this quote is killing me already. It basically means that instead of proving that you're rich and knowledgeable, now you just have to prove that you're knowledgeable. Both of these changes seem like big long-term opportunities for investment companies that manage alternative investments in exchange for fees. And the leader in that business is Blackstone, run by Stephen Schwarzman. Hi, Steve. It's Jack Howe from Barron's. How are you?

Hi, Jack.

How are you? Steve co-founded Blackstone back in 1985 using his own money, which today makes him one of the world's wealthiest people. Why is it called Blackstone? The Schwarz in Schwarzman means black in German. The other co-founder was a former boss of Steve's named Pete Peterson, and Peter means stone in Greek. By the way, don't confuse Blackstone, ticker BX, with BlackRock, ticker BLK. Blackstone is the world's largest alternative investment manager with assets under management of $564 billion. BlackRock is the world's largest investment manager of any kind with assets under management of over $7 trillion. It's not a coincidence that the two names are so similar. In the 1980s, Blackstone provided the funding to a guy named Larry Fink and his partners to start an asset manager called the Blackstone Financial Group. In the 1990s, it changed its name to BlackRock and the two companies parted ways. If that all seems like a bit of a black cloud inside a black box, just remember that Blackstone is the alternatives giant run by Steve Schwarzman and BlackRock is the indexing mega giant run by Larry Fink. Steve is well connected politically. He has the ear of world leaders, including President Trump, and Blackstone has real estate and business interests worldwide. So when I get the opportunity to speak with Steve, I like to ask how business conditions look to him. He says 2020 can be divided into 3 parts: a normal start, then a collapse in markets and confidence, and now a huge rally propelled by support from the Federal Reserve. Making these past months the most volatile period he's lived through. He points to the stark divide between recent winners like big tech, home entertainment, home improvement, and losers like movie theaters and cruise lines. And he notes that Blackstone ended its most recent quarter with $156 billion in dry powder. That's money that's been raised from investors but not yet put to work. In other words, Blackstone is in a position to do some serious shopping as bargains appear.

The money raising has been very strong because investors, after they got over the shock of the big decline, realized they have the same amount of money as they did when they started the year, for the most part, sometimes more. And so investors want to take advantage of these different types of activities.

Steve says Blackstone has been focusing its investment money on life sciences and technology. It recently bought Ancestry.com, the genealogy service, and Oatly, a maker of oat milk. Before that, it bought the online dating service Bumble. I told him that some of those sound like the type of dot-com businesses Barry Diller's investment company IAC buys. He said that's where the world is going. And he mentioned an asset class he's particularly bullish on.

Over the last decade, Blackstone's been the largest purchaser of warehouses because we saw the trend changing to, as you would call it, internet shopping, online shopping. And those trend changes led us to sell our malls and invest very heavily in warehouses, which is part of the delivery system. We bought a billion square feet. That's a huge number. A billion square feet of warehouses. It's our largest asset class in real estate. And before we identified that changing trend, we basically owned almost no warehouses.

Blackstone divides its businesses into 4 parts. Let's take a look at each of them. First is credit. That means loaning money. You do that if you own bonds or bond funds. Blackstone's credit funds invest in things like loans made to non-investment-grade companies. The next unit is hedge fund services. Hedge funds use fancy tactics and securities like leverage, short selling, and derivatives. I think ordinary investors sometimes view hedge funds as secretive, prestigious, money-making miracles, but in reality, they're all over the place. Some are defensive, some are aggressive, Some do well and some stink. If you find that confusing, so do big institutions. Some of them pay Blackstone good money to select hedge funds for them. Then there's the real estate unit. In addition to warehouses, Blackstone has some office and retail properties, and during the housing bust, it made a well-timed move buying big bundles of single-family homes. More recently, it's continued buying housing and apartments in suburbs. That brings us to private equity, which is simpler than it sounds. Equity means ownership. Think of stocks as public equity, ownership stakes that are listed on exchanges to be bought and sold by the public. Private equity refers to ownership stakes that don't trade on exchanges. Investors who buy these stakes often use leverage and often exert influence over the companies in which they invest. They meddle, in other words. Private equity funds can hold these stakes for years, so they usually require their investors to commit to not taking out their cash for years. Private equity stakes can be part of companies or entire companies. They can be sold by finding another buyer or by taking companies public through an initial stock offering. Private equity managers generally earn fees on the assets they manage, which are pretty steady. Plus they get a share of the upside if their investments do well. That's not a study. Private equity is much more of a pain in the neck for investors to buy than, say, an S&P 500 fund. So why would anyone bother? Because the returns can be excellent. At an investor day 2 years ago, Blackstone showed investors the returns it has generated over decades across its business units. Private equity had made 15% a year. Private equity managers will tell you that they do that with lower volatility than the stock market, and I take their point, but there's an asterisk. We only know the price of equity stakes for sure when people buy them. With stocks, that happens each trading day, so we know exactly how volatile the prices are. Private equity stakes trade infrequently, so rather than say they're not as volatile as stocks, I'd say that private equity managers can sit out periods of volatility and wait for better days to sell their stakes and capture their cut of the upside. I asked Steve to make the case for private equity.

So if you can make a company grow faster, invest more in it, and use leverage, then the rate of return, the profit for an investor, should be much better than just investing in stocks. And historically, that has been the case.

Needless to say, Steve is enthusiastic about the new guidance that will make private equity available in 401(k) accounts.

All the big retirement pension funds have a significant allocation to private equity because it's smart. But other than the wealthy retail investors, retail was not really able to buy this type of product. So that change will be, I think, an important one over time for retail investors. In effect, it's democratizing access to private equity, which used to just be available for the very affluent or institutions.

I want to point out that you're not going to see investors piling into private equity with all of their 401(k) money anytime soon. The new guidance allows plans to offer private equity exposure as part of certain types of custom funds. In other words, you might see a target date fund that's designed to adjust an investor's exposure to stocks, bonds, and other assets as that investor approaches retirement. And that target date fund might offer a sliver of private equity as part of its allocation. It's a foot in the door for private equity managers, but not necessarily their own set of keys to come and go as they please. I like the idea of a smidgen of private equity exposure for 401(k)s in principle. I want to see what the products look like before I decide for sure, but I think the change bodes well for Blackstone's ability to bring in more money from investors which could be good for its stock. I've written favorably about the stock since March 2017, back when the company was structured as a limited partnership. Since then, the shares have returned 116% versus 50% for the S&P 500, and Blackstone has converted to a regular corporation, which means it might one day be eligible for inclusion in the S&P 500 index. I know this can be confusing. Let me just be clear about one thing: Blackstone is a company that manages alternative assets, but the stock of that company, ticker BX, isn't an alternative asset. It's just a regular stock. Now, for investors in Blackstone stock, I like that its size gives it a couple of key structural advantages. First, some companies looking to sell business units will go straight to Blackstone and negotiate rather than shop the units around. In those cases, Blackstone can end up with favorable deal pricing. And second, with stocks, everyone pretty much has access to the same information. In fact, there are rules designed to make sure that's the case. In businesses like private equity and real estate, investment managers have to bring their own knowledge about things like pricing and local conditions. It helps to do a lot of deals because each deal creates more information. And more market knowledge. Steve says one other secret to being a great private equity manager is finding great business managers.

Just buying the company and putting it on leverage isn't a way to really create superior returns. What you have to do is recruit great management and invest money to grow faster. And it's that operating ability, as well as buying companies in the right sector in effect, overweighting, if you will, to where the world is going that helps create these returns.

Blackstone is headquartered in New York City and it owns real estate in cities around the world. I've heard about city residents fleeing to the suburbs. I asked Steve whether he thinks cities will come back. Some will sooner than others, he says.

Cities have always survived and thrived, but they've also gone through periods of great disruption. I think in answer to your question, it's really a function of how good the government is in those cities. How adaptable are they? To the extent that governments fall short, the recovery will be much longer. To the extent that governments are excellent, I don't think it will be a long-term issue. There'll be cities like Miami, for example, that I think will do extremely well. Austin. Dallas, a whole variety of cities. Many of them will do very well and some will not.

I don't think I heard New York on Steve's list of cities that are gonna do extremely well. I'm sorry about that, New York. I still love you. My last question was related to cartoons and the economy. I think there's a lot of folks who are wondering, are we now on a sustainable path to recovery or are we at this Wile E. Coyote moment where we've run off the cliff but we haven't yet started plunging, if you remember from the old cartoons.

What do you think? I think we're somewhat a hostage to the recovery from COVID-19 to the extent that we develop a series of successful vaccines and people decide they want to take a vaccine to protect themselves. To the extent that we continue to develop antiviral medicines that are very effective, that is liable to take certainly into 2022, I think at a minimum. That doesn't mean we won't continue to improve in the interim, but to really get back to normal, whether it's 2022, 2023, we will get there.

Meta, I think that's good news. I mean, we're not in Wile E. Coyote territory. I like that. We're not quite running at Roadrunner speeds.

Is he the guy who sounds like this?

Meep meep.

That's the meep meep guy. Do you have a sound effect for, let's say, a slowed-down Roadrunner, maybe one that just spent the past week eating too much peanut brittle?

Let me see what I can find.

Meta, do we have a listener question?

We do. We got one from Josh from Louisville.

Let's hear it. I've been a listener since day one, and I love what you and Meta are doing. I got a question though. I hear a lot of hype these days about factor investing and the ETFs that offer it in low-cost passive quote-unquote strategies. What on earth is factor investing? Is it a good idea? Should I throw any money at it? Josh, if I were to create an index of listener questions ranked by factors like brevity, clarity, and overall excellence, Your question would be a top holding. I'm not just saying that because you said something nice about Meta and me, although I do have a long-standing policy of liking people who like me back. Now, factor investing exists halfway between active investing, where a fund manager picks stocks, and passive investing, where a fund tracks a stock index like the S&P 500. With a factor-based fund, stocks are selected automatically using a screening process. And the portfolio is periodically rebalanced. Here's an example: the Schwab Fundamental U.S. Large Company Index ETF, ticker FNDX. It weights companies by measures of economic size like sales, cash flow, and dividends. The S&P 500, on the other hand, weights companies by stock market value. What's the difference? The S&P 500 gives more emphasis to companies as their stock prices go up. The Schwab Fundamental Fund gives more emphasis to companies even if their stock prices go down, so long as the companies become more prosperous. Over time, that gives the Schwab Fund what's called a value tilt. Compared with the S&P 500, it will tend to overweight companies that are inexpensive relative to the money they make. The 5 largest holdings in an S&P 500 fund now are Apple, Microsoft, Amazon, Alphabet, and Facebook. In that Schwab Fundamental Fund, the top 2 are Apple and Microsoft, but the others aren't in the top 10. Factor funds don't depend on stock-picking ability. They depend on the tendency of certain company attributes to predict good stock performance over time. Value is one such attribute. It's been out of favor for most of the past decade, in part because the stock market's returns have been dominated by big, growthy tech companies. If that trend ever reverts back to historical patterns, a factor fund should do well if it has a value tilt. Even if that were to happen, don't expect factor funds to suddenly clobber the S&P 500 by, say, 20 points in a given year. They'd be more likely to begin outperforming by, let's say, a couple of points a year on average over long time periods. Should you throw money at a factor fund, Josh? Well, It's not totally necessary. You can do just fine with an S&P 500 fund, but you might want to shift some money to a factor fund with a value tilt if you think stock market prices at the moment have gotten out of whack. Just make sure of two things if you buy one of these funds. First, the factors they use must be dependable. That means there should be decades of evidence showing that these factors tend to predict healthy returns and a solid common sense explanation for why the factors work. And second, make sure fees are one of your factors. The Schwab fund I've been mentioning charges 1/4 of 1% per year in fees. I think that's reasonable for a shot at gradually beating the market over time, but there are higher fees out there. Could I be talked into 1/3 of a percent? Maybe, for a compelling strategy, after a glass of wine, if I were feeling an extreme sense of warm, cozy hygge. Half a percent? Let's not get crazy. Thank you, Josh, for sending in your question, and everyone, please keep the questions coming. Just tape on your phone using the voice memo app and send it to jack.hough@barons.com. Thank you for listening. Metalootsoft is our producer. Subscribe to the podcast on Apple Podcasts, Spotify, or wherever you listen to podcasts. And if you listen on Apple, write us a review. If you want to find out about new stories and new podcast episodes, you can follow me on Twitter. That's @jackhoug-h-o-u-g-h. See you next week.

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