Independent Thinking^®

Q&A with Douglas Ostrover

An Interview with Douglas Ostrover at The Blackstone Group

Evercore Wealth Management supplements its core investment capabilities with carefully selected outside funds across the range of the firm’s asset classes. Here we interview Douglas Ostrover of The Blackstone Group, a founder of GSO Capital Partners, and the investment committee chairman of Blackstone Total Alternatives Solutions. Blackstone is the largest alternative asset manager in the world, with 25 global offices and approximately $300 billion in assets under management in private equity, real estate, credit and hedge fund solutions.
 
Q: Blackstone describes allocations to illiquid investments as “patient capital.” Please explain.
 
A: It can be a long wait to fully invest and an even longer wait to realize returns. In a private market fund investors, also known as limited partners, make an upfront commitment to invest a specific dollar amount into a limited partnership. The general partner, or fund manager, then calls down that commitment over a term of three to six years to fund investments in portfolio companies and to pay fees and expenses. Harvesting investments takes an additional three to six years. Invested capital is returned to the limited partners in the form of distributions generated from company sales or IPOs. In short, it takes time to achieve the kind of outperformance investors expect; time to identify and source the right deals; time to improve the underlying investment; and time to successfully liquidate the investment, through either the public markets or a sale to a strategic buyer.
 
Q: Are there advantages in illiquidity itself? How about in inefficient markets?
 
A: Yes, we believe there are advantages in illiquidity, even in the most efficient of markets. Equity market research shows us that, over the last 40 years, less liquid stocks outperformed those with higher liquidity by almost 3% per annum in large capitalization stocks, and by a greater margin in smaller cap stocks. The study also identified illiquidity as a market factor akin to more historically verifiable ones such as size and investment style.
 
For nontraditional assets beyond long-only equities, estimates of the illiquidity premium can range even higher. Funds with longer lockups, which enable managers to invest in less liquid holdings, tend to earn higher returns than those without. The data indicates that fund returns actually rise as their lockup period increases, from a median of 4.5% for funds with lockups of less than a quarter up to a median return of almost 13% for funds with a two- to three-year lockup.
 
While greater illiquidity may increase the inefficiency of a particular market, it does not by itself guarantee higher returns. Instead, it shifts the primary source of the return from the beta, or movements of the market itself, to the individual manager’s skill in managing the investment to a more successful outcome.
 
Q: Private investors tend to be underallocated to illiquid assets relative to institutions such as pensions or endowments, often for tax reasons. Are there other structural challenges? What role does perception play?
 
A: Many institutions with long investment horizons and known funding requirements have increased their allocations to illiquid alternatives, to well over 20% on average today. These institutional allocations to private market alternatives far exceed most individual investor allocations, which typically represent less than 5% of their portfolios. The structural realities of illiquid investments create a number of challenges that may constrain the appetite of individual investors for these assets. Three key challenges include gaining exposure, achieving a diversified allocation, and maintaining an allocation.
 
Gaining Exposure: Unlike the public markets, where investors can quickly and efficiently increase their allocation by purchasing shares in the open market, private market investors cannot gain instantaneous exposure – time is required to identify private market opportunities and to conduct due diligence negotiations.
 
Achieving a Diversified Allocation: Fund offerings are calendar-dependent, may not be accessible for smaller investors, and often require steep investment minimums. Individual investors seeking broad diversification in the space – across assets, strategies, managers, and “vintage years” – may have difficulty achieving that kind of exposure.
 
Maintaining the Allocation: Making a $1 million commitment to private equity for 10 years is not the same as achieving a constant $1 million allocation for the same period. The average exposure would probably reach about 50% of the total $1 million commitment over that time frame, meaning that only half of the capital is at work for much of the time.
 
Q: How should private investors deploy their own patient capital, across this asset class? What should their expectations be?
 
A: Investors who want to benefit from the performance upside of illiquidity need to be comfortable with the associated process and constraints. Private equity, real estate and distressed debt can be perhaps best understood not as new asset classes but as less liquid versions of existing strategies.
For example, think of an investor’s equity exposure within a “liquidity continuum.” An advisor might position private equity alongside other more liquid equity-like exposures, such as long/short equity, active long-only, and passive equity structures. They are all equity-oriented assets, the longer-term nature of private market vehicles being just one distinguishing characteristic (one that also impacts tax efficiency, as gains tend to be primarily long term, with correspondingly beneficial tax treatment).
 
The same can be said for allocations to fixed income, which would extend from the most liquid Treasury or bond ETF portfolio, into less liquid high-yield or senior loans, and then long/short credit, mezzanine and distressed debt in the illiquid extreme.
 
In other words, private market allocations may be best understood as a natural extension of the public or liquid portfolio, with related risk and return characteristics all derived from the overarching asset class that each belongs to.
 
Q: Where does Blackstone see opportunities today?
 
A: Generally, as patient investors, we are able to find investments across all our platforms throughout market cycles. Currently, we see particularly interesting opportunities in real estate, energy, and opportunistic strategies.
 
In real estate, we think the United States has largely recovered and, as such, our focus has moved to Europe, where overleveraged banks are reworking their balance sheets in light of new regulatory capital requirements, and Asia, which continues to demonstrate strong growth but is lacking the capital to support that growth.
 
Energy is another rich area for us. We believe that the current dislocation in commodity prices is a result of a temporary supply/demand imbalance as opposed to a secular decline. There will be distressed situations for equity-related investments and others seeking temporary support with rescue financing.
 
Last, the financial crisis and resulting regulatory reforms have created a lasting impact on the day-to-day operations of money center banks. Global and regional banks continue to assess the services and risks that they are willing to assume in light of the increasing capital requirements. We see attractive opportunities to step into some of voids created by this bank repositioning. In Europe, for instance, we expect to be active in private corporate origination and nonperforming loans.
 
For further information on the Evercore Wealth Management Efficient Architecture^® investment platform and the Blackstone Total Alternatives Solution, please contact Stephanie Hackett at [email protected].