The King of Private Equity Changes His Stripes
Steve Schwarzman's pivot at Blackstone... From private equity to private credit... It's all about risk-adjusted returns... Equity-like returns with less risk... Two ways to invest in private credit...
Editor's note: Today, we're sharing a guest essay from Stansberry Asset Management ("SAM") Chief Investment Officer Austin Root...
Many of you might be familiar with Austin, who worked for Stansberry Research from 2017 to 2021, including as editor of our Portfolio Solutions products. He was director of research from 2019 to 2021 before he joined SAM, a U.S. Securities and Exchange Commission-registered investment adviser.
SAM is completely separate from our Stansberry Research publishing business. But it uses our research, plus other sources, to help manage individual client's portfolios.
In today's essay, a follow up to one Austin wrote in September, he discusses one area of the market where investors can find "productive assets" that deliver stock-like returns with less risk... and how his former boss at one of the world's largest investment firms agrees.
As Austin also explains toward the end of today's essay, the folks at SAM have a free online event coming next Tuesday with more details on this sector and the opportunities in it. He wants to make sure all Stansberry Research readers have a chance to sign up to watch.
Enjoy...
Late last year, my old boss shocked me...
Steve Schwarzman, the co-founder and CEO of the powerhouse investment firm Blackstone, was speaking at an industry conference in Paris about the best place to invest in 2024 and beyond... and he said something I didn't expect.
You see, I (Austin Root) began my career out of college working for Blackstone. I saw up close why Time magazine named Schwarzman – a self-made billionaire more than 50 times over – one of the most influential people in the world back in 2007, when Blackstone was managing $100 billion in assets.
Today, Blackstone manages 11 times that, at more than $1 trillion, and is currently the world's largest alternative asset manager...
Most of Blackstone's assets under management ("AUM") are focused on privately held businesses and real estate... with a huge chunk in private equity investments, in which Blackstone takes a controlling stake in a business and then dictates exactly how it will operate and grow.
Over time, these private equity investments have been incredibly successful. According to Schwarzman, his private equity funds realized an annual average return of 23% from 1988 to 2008. Such success led Forbes magazine to dub Schwarzman "the undisputed king of private equity."
Even today, after all his success, Schwarzman is probably not the most famous private equity investor. That moniker likely belongs to Henry Kravis, founder of KKR, and star of the groundbreaking book Barbarians at the Gate, detailing the private equity buyout of RJR Nabisco in 1988.
But, for my money, Schwarzman is the best private equity investor.
And that's because through his leadership, Blackstone was able to make money in all types of market conditions, good and bad. I saw this firsthand while working at Blackstone in the late 1990s and early 2000s. Seemingly everyone made money in the moonshot year of 1999. But that euphoria quickly cratered as the U.S. entered a sharp recession in 2001. And only the best private equity investors like Schwarzman were able to thrive. He later wrote about this period in his autobiography What It Takes...
Making money in strong markets can be short-lived. Smart investors perform well through a combination of self-discipline and sound risk assessment, even when market conditions reverse.
So when the "king" spoke last year and did not highlight private equity as the best place to invest – or even, for that matter, mention equity investments of any kind – I was surprised. Instead, he championed the virtues of being a lender. He told attendees of the International Private Equity Market conference...
If you can earn 12%, maybe 13% on a really good day in senior secured debt, what else do you want to do in life? If you are living in a no-growth economy and somebody can give you 12%, 13% with almost no prospect of loss, that's about the best thing you can do.
He meant it. A year later, direct lending and, more broadly, private credit investments are now by far the fastest-growing part of the Blackstone empire. The king of private equity has changed his stripes.
So why has Schwarzman made the pivot to private credit?...
In my view, it's all about risk-adjusted returns.
In other words, Schwarzman's shift suggests the current environment favors optimizing returns relative to the risk you're taking, rather than stretching for the highest returns possible. Asset prices and risks are too high currently to aim for the latter. We at SAM agree. Let me explain why.
First, it's important to understand that in most cases, assets with higher levels of expected returns also tend to have higher risk of potential losses.
To be sure, you can sometimes find higher-returning investments that carry tiny amounts of risk. And sometimes seemingly safe instruments are anything but. Still... this relationship typically holds up over time.
Second, all else equal, credit investments tend to be lower risk and generate lower returns than equity investments.
Think about investing in McDonald's (MCD)...
If you hold McDonald's bonds, you're guaranteed interest payments and a return of your capital, so long as the legendary burger chain remains solvent. And McDonald's is in no risk of going bankrupt.
Shareholders have no such assurance. E. coli outbreaks, recessions, and poor management decisions can happen... And they can knock down the share price of this incredible company.
So that's why current McDonald's bondholders are satisfied generating a modest return of about 5% a year for the next 10 years. McDonald's shareholders expect far better returns in exchange for the risk they're taking. And in fact, over the past 10 years, McDonald's shareholders have received a lot extra. Assuming reinvested dividends, shareholders generated 14.8% annualized returns, or more than a 300% gain in total.
In the case of McDonald's, the greater risk-reward ratio offered by stocks is a good thing. It can build incredible wealth, especially when you own well-run, capital-efficient businesses – ones that grow profits while requiring little ongoing capital investment.
At SAM, we continue to believe that every investor should make these types of stocks the core of their portfolio. As I noted in September, the best way to protect your wealth and purchasing power from the government's money-printing and deficit spending is to "play offense" and own assets whose value can outpace inflation over time. Owning shares of well-run, world-class businesses is a great way to invest your capital.
But this comes with one very important caveat...
To be truly productive assets, the equities you own must be reasonably priced relative to their future earnings power. And reasonably priced equities are becoming harder to find these days. You can still find underappreciated gems out there – but it isn't easy.
Buying a stock at an unreasonable price is fraught with risk and usually ends up unproductive. Consider the IT-networking giant Cisco Systems (CSCO). In early 2000, Cisco reached a price of a little more than $80 a share and traded for more than 160 times its current earnings. Today, nearly 25 years later, shares trade for less than $60. This is despite growing revenues 3X and earnings per share more than 7X over that period.
Fortunately, like Schwarzman, we see the opportunity to invest in highly productive assets in the private credit market...
So what is "private credit," anyway? Private credit refers to loans and other fixed-income instruments that are neither publicly traded bonds nor loans originated by traditional banks. And the largest, most attractive part of private credit is "direct lending." That's where nonbank lenders provide cash directly to companies in privately negotiated transactions.
While forms of direct lending have been around for millennia, private credit didn't really exist as an asset class until around 2008. In response to the financial crisis, regulators increased capital requirements on traditional banks, which forced them to reduce virtually all types of lending activities. The hardest hit areas were loans to smaller businesses and to finance private equity deals.
The private credit industry stepped in to fill the gap. From less than $200 billion in 2007, the private credit industry surged to $800 billion by 2019, according to data from the International Monetary Fund.
After the COVID-19 shutdown of 2020, private credit got another boost of growth. The market for high-yield bonds effectively dried up. Many businesses still needed capital, of course. So again, private credit lenders filled the void. Assets grew to nearly $1.6 trillion by 2023.
We like to say private credit today provides equity-like returns with a lot less risk.
In a nutshell, that's the appeal of investing in private credit. You get bond-like safety, and you can also generate stock-like returns. As Stansberry Research's own Income Intelligence pointed out last month...
While there's no perfect index to measure private-credit returns, a good proxy is the Cliffwater Direct Lending Index, which serves as the U.S. private-debt benchmark.
Its annualized return, from September 2004 to March of this year, is 9.5%. That stacks up favorably to investment-grade and high-yield bonds and nearly matches U.S. equity returns...
But we expect future returns in private credit to be much higher than 9.5% per year, at least in our favorite areas of the market.
Keep in mind, the data above includes the 14-year period from 2008 to 2022 when the Federal Reserve kept short-term interest rates super low, often near 0%. We expect rates in the future to remain higher than that, pushing up the returns of private credit.
So why do companies pay such high rates for private credit? Three reasons...
First, private credit lenders tend to be more flexible and are willing to lend in nontraditional ways. For example, they can lend against the value of future cash flows or intellectual property versus hard assets that banks typically demand. Second, they're able to act quicker, and provide capital in a matter of days or weeks rather than the months that most bank committees or bond issuances require. And finally, private credit lenders provide certainty. Too often, traditional banks and brokers can only tell a borrower that they will "try" to secure capital. Private credit can say: "Here's the money. Period."
Two ways to invest in private credit...
Short of setting up shop as a direct lender yourself, individuals have two ways to take advantage of the opportunity. The first and most accessible is to invest in publicly traded business development companies ("BDCs").
Once again, Income Intelligence explained this to subscribers last month...
It's a fairly simple setup. And it's almost identical to private credit, except that some BDCs trade their shares publicly in the stock market.
BDCs raise a certain amount of equity from investors. That can be an original sponsor or through an IPO. They then use that equity to borrow a big pile of capital, typically from a bank or other lender. Then, they lend that capital to small and midsize businesses that are frozen out of traditional debt markets.
Those businesses pay back their interest – which should be greater than a BDC's interest on its loans – and their principal.
As long as the BDC lends money carefully and gets paid back, it can pay huge yields to its public shareholders.
BDCs have been around for decades. Congress approved the creation of BDCs in the 1980s to serve as a lender of last resort to small businesses. For much of their history, BDCs were exactly that. They tried to generate outsized yields by taking outsized credit risk. When the economy was good, this bet paid off. But when things got rough, shareholders of those early BDCs suffered.
But over the course of the past 20 years, as banks pulled back on lending, BDCs began supplying capital to higher-quality companies. Today, many BDCs provide shareholder dividend yields of 10% or more on a book of loans with better credit ratings than those of many regional banks.
Today's BDCs still have their risks. BDCs use a healthy amount of leverage and lend to midsize companies. If a recession hits, BDC portfolios could see credit quality suffer, potentially enough to impair their dividends to shareholders. Even if their credits hold up, fearful shareholders could sell off their stocks. So investors need to be prepared to stomach some volatility.
But I expect the well-run BDCs will do just fine over the long term. And no surprise, one of the largest and best-managed BDCs on the planet happens to be run by Schwarzman's Blackstone. (Subscribers to Income Intelligence can read all about it here.)
As I said, BDCs are how most people can invest in this idea... But accredited investors have another way to invest in private credit.
When we say accredited investors, we're talking about individuals with an annual income of at least $200,000, couples who make $300,000 a year, or anyone with at least $1 million in net worth outside of their primary residence. So, this isn't for everyone. But if you qualify, it could be a great option.
Accredited investors can invest directly with the industry's best direct lenders themselves (rather than in their equity). And importantly, they can do so across a diversified basket of lenders that have been researched, vetted, and handpicked to optimize returns and mitigate risk.
Still, investing in the institutional class of offerings from these direct lenders is hard for individuals to access on their own. That's why SAM established an investment fund to do precisely that for clients who qualify (and for whom we feel such an investment is suitable). We've pooled investors' capital and allocated it to the best private credit managers that we've found in the market.
Net of all fees, we expect that a diversified group of world-class lenders will provide equity-like returns to our investors over the long run. This first fund is now closed, but if you are an accredited investor who might be interested in this type of investment, we'd love to talk with you about similar opportunities that might be available to you in the future.
With that said, I should note that this type of private credit investment does have one significant drawback... and that's a lack of liquidity. To invest in these institutional grade "drawdown funds," you need to be OK with much of your investment remaining illiquid for as much as five to seven years. And for that reason, this investment is not for everyone and certainly not for all or even most of your investible net worth.
But for those of you who are accredited and can tolerate illiquidity for part of your asset base, an investment into a diversified private credit fund might be exactly the highly productive asset you're looking for. In exchange for that illiquidity, we expect total returns that will materially exceed those of publicly traded BDCs with less volatility.
If private credit investing seems like something you'd like to learn more about, we invite you to join SAM on Tuesday, November 19 at 4 p.m. Eastern time (1 p.m. Pacific time). In this online event, we'll be discussing:
- The virtues (and potential pitfalls) of investing in private credit.
- Why we believe SAM's targeted approach to private credit can lead to superior results.
- The best areas in private credit to invest in for the next decade.
- How SAM can help determine whether private credit is right for you.
Click the link here to secure your spot!
In closing, I want to address one final question you might have: If the private credit industry has raised so much capital recently, is it already too late to invest? Well, the short and likely unsatisfying answer is that it depends.
But here's a medium-length answer: I do think there are pockets of private credit that have become crowded. And these are areas where lenders are more focused on generating huge asset growth over attractive rates of return. We at SAM are avoiding these areas.
That's because there are also many niche areas that are still vastly undercapitalized, where lenders are generating truly fabulous risk-adjusted returns. And they're doing so by providing strategic capital to high-quality businesses that are either traditionally underbanked or consistently misunderstood.
I'm excited to tell you more about it on Tuesday, November 19. Again, I encourage you to join us here.
New 52-week highs (as of 11/13/24): American Financial (AFG), Amazon (AMZN), BWX Technologies (BWXT), Cencora (COR), Cisco Systems (CSCO), Commvault Systems (CVLT), Flutter Entertainment (FLUT), Kellanova (K), Lumentum (LITE), Altria (MO), Oracle (ORCL), Palo Alto Networks (PANW), Planet Fitness (PLNT), PayPal (PYPL), Ryder System (R), Spotify Technology (SPOT), Stryker (SYK), Toast (TOST), Trane Technologies (TT), Twilio (TWLO), Invesco DB U.S. Dollar Index Bullish Fund (UUP), and the short position in SolarEdge Technologies (SEDG).
In today's mailbag, continued discussion on nuclear energy, a subject in yesterday's mail and Tuesday's Digest... Do you have a comment or question? As always, e-mail us at feedback@stansberryresearch.com.
"I want to respond to subscriber Joe M. who's comment on nuclear power included this: 'If a fossil fuel plant goes up in smoke the environment takes a short-term hit, not a generational catastrophe – just ask the people that lived anywhere near Fukushima who will never be able to live there again.'
"The Fukushima accident caused zero deaths due to radiation, then or now… There is no uptick in cancers or radiation related illnesses in and around Fukushima. None. There were 16 injuries from the chemical hydrogen gas explosions and two workers in the plant suffered radiation burns, but no one was killed by radiation. [Editor's note: In 2018, seven years after the accident, one worker in charge of measuring radiation at the plant died of lung cancer caused by radiation exposure.]
"However, the evacuation around Fukushima resulted in at least 51 deaths of patients and the elderly who were evacuated. Those deaths were not caused by radiation in any form. Stress, including depression and PTSD, from the evacuations, and the inability to return home, negatively impacted a significant number of evacuees.
"The [World Health Organization] said that residents who were evacuated were exposed to so little radiation that radiation-induced health effects were likely to be below detectable levels. The impact on residents' lives was man-made and exacerbated by the evacuations and by refusing to let residents return home for quite some time. Sheltering in place would have been kinder to the residents than the mandatory evacuations..." – Subscriber Mark P.
"The Indian Point nuclear plant was shut down because of public outcry and politics in New York, not issues regarding where to store spent nuclear fuel rods (nuclear waste).
Although there have been a few global nuclear utility plant accidents, there has never been a nuclear reactor nor waste related accident on any of the 200+ US nuclear operated submarines that have been part of the U.S. Navy since 1954. That's an amazing track record!
"As for nuclear fuel waste storage, the government spent over $15B on the Yucca Mountain project to develop a repository for the long-term storage of spent nuclear fuel. Again, that project was canceled in 2011 due to public outcry and politics. Recall that concerned residents stated they would lay down in the streets to prevent trucks from delivering the waste." – Subscriber Steve P.
Warmest regards,
Austin Root
Towson, Maryland
November 14, 2024
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