Why Stephen Schwarzman's Payday Risks Riling Blackstone Investors

Stephen Schwarzman, the boss of Blackstone, the world's biggest private-equity firm, made his fortune by buying, restructuring and selling companies -- delivering outsized returns for investors. These days, he is getting huge rewards for being the largest shareholder in what is more like an asset manager on steroids.

The chief of Blackstone Group LP is set to receive at least $120.6 million in 2011 dividends from his 21 percent ownership of the firm, based on regulatory filings. That is many times what he gets for being CEO -- he received a $350,000 salary and total compensation of $6.7 million in 2010. His compensation for 2011 has not yet been disclosed.

Fees for managing assets and advisory services accounted for 82 percent of Blackstone's dividend payouts in 2011, compared with 63 percent in 2010, the statements show. That means Schwarzman's payout includes a lot more from fees charged to investors for managing their money than from Blackstone's slice of the profits from its buyout business, also known as carried interest.

Co-founded by Schwarzman in 1985, Blackstone traditionally made most of its profits from the increase in value of the companies it bought, rather than from management fees. But fees have now provided the majority of Blackstone's cash distributions every year since the company went public in 2007.

The shift will increase concerns at pension funds, university endowments, and other investors -- which provide the funds for private-equity firms -- that public listings of outfits such as Blackstone means stockholders are being favored over them.

While these investors, or limited partners, focus on returns on their investments, shareholders want dividends that can come from carried interest and management fees.

Fees Already Sliding

The investors have already been able to push down the average fee charged on asset management to 1.5 percent from the more traditional 2 percent in the past few years, but stories like Blackstone's will only increase the momentum for more reductions, according to some private-equity executives and investors' representatives.

Other publicly traded private-equity firms, such as Apollo Global Management LLC and KKR & Co. LP, are also generating more of their revenue from fees, but as yet it hasn't reached the same proportion as at Blackstone.

"As the industry has matured , some unintended consequences -- like nine-digit management fees -- have become apparent and problematic," said Stephen Moseley, president of private-equity and advisory firm Rockland Management LLC. "Multiple sources of income can produce divided loyalties, and divided loyalties make limited partners nervous."

Blackstone's fee-earning assets under management increased 25 percent in 2011 to a record $137 billion. On an after-tax basis, $502 million out of $610 million in dividend payouts last year came from fee-related income.

The large fee component of Schwarzman's pay will "add fuel to the fire in the argument between limited and general partners on the structure of funds," said Michael Moy, a managing director at Pension Consulting Alliance Inc., which advises some of the largest U.S. pension funds on private equity, including the California Public Employees' Retirement System.

Blackstone representative Peter Rose said given the firm is the largest and most diversified alternative asset manager, private equity accounts for only about 25 percent of its business.

"Blackstone has a significant percentage of its businesses which generate fee income only, similar to all long-only money managers and financial advisory firms," Rose said. "We manage the business as we did before we went public, to maximize net returns to our limited partners, and, as such, we rank as one of the top-performing managers in the world."

Apollo and KKR declined to comment.

Maximize Assets or Returns?

The managers of private-equity funds, known as general partners, had traditionally followed the 2/20 model, seeking a management fee of 2 percent on committed capital and taking 20 percent of a fund's profits. They argue that compared with traditional asset managers, their work justifies higher incentive fees because returns are also outsized.

Moreover, the argument goes, sharing in profits from fund investments aligns their interest with limited partners, who commit their money for as long as 10 years in often illiquid assets that cannot easily be sold.

But internal rates of return from buyouts were down to 11.2 percent on a five-year basis in June 2011 from 29.6 percent in September 2008, according to market-research firm Preqin.

Although the impact of the financial crisis, including much tighter financing conditions, is at least partly to blame, critics also say it may be a sign the private-equity firms are losing some of their focus after growing much larger.

Cerberus Capital Management co-founder Stephen Feinberg, in a rare admission for an industry insider, argued last summer that many private-equity executives were overpaid, focused too much on fees, and hampered by the size of their assets.

"I do think there's an issue here in funds that are too large and funds that have acquired too many assets under management," Feinberg said at a conference. "If your goal is to maximize your returns as opposed to assets under management, I think you can be most effective with a big company infrastructure and a little bit smaller fund size."

The interests of the investors and the general partners of the firms are best aligned when the latter is making most of their money from carried interest, said Kathy Jeramaz-Larson, an executive director at Institutional Limited Partners Association, which has more than 250 member organizations representing over $1 trillion of private assets globally.

An Outlier

Besides the dividend payout and his CEO compensation, Schwarzman -- whose wealth was pegged at $4.7 billion by Forbes last year -- will also receive profits from co-investments through the firm, which are not disclosed.

The size of the dividend payout and its main source, though, is an outlier even among the handful of publicly traded private-equity firms.

At Apollo, co-founder Leon Black, who owns 24 percent of the firm, is set to receive $103.9 million in dividends for 2011, of which only 25 percent will come from fee-related income.

At KKR, co-founders Henry Kravis and George Roberts, who together own 25 percent of the firm, are set to receive $64.2 million each in dividends in 2011, of which 46 percent will come from fees.

Blackstone has diversified at a faster pace than have its rivals. It had assets under management of $166 billion at the end of 2011, compared with $44.4 billion in 1987 (when it was largely a buyout shop), and it has diversified through a credit arm, real estate business and hedge funds.

For example, BAAM, its hedge-fund group , manages $40 billion and is mostly a fees business, with just half the assets eligible for carried interest payments and the carry rate at 10 percent rather than 20 percent. GSO, Blackstone's credit arm, has a collateralized loan obligation business relying on fees.

Blackstone also runs advisory businesses that rely just on fees. Those businesses include an investment-banking arm and a placement agent that helps other private-equity firms raise funds.

Other private-equity firms are taking a similar approach. At Apollo, which has $75 billion in assets under management, the credit investment business is set to overtake the buyout arm in size. And KKR, which has $59 billion in assets under management, is moving furher into real estate, hedge funds, and capital markets.

Better Returns

It is not that Blackstone's performance is bad, it is the source of the returns that is the question. Blackstone said this month its private-equity portfolio was up 5 percent in 2011, its real estate portfolio was up 17 percent, and its credit-oriented hedge funds were up 9 percent, all outperforming benchmarks. The S&P 500 index of U.S. stocks was flat in 2011.

These returns have come during what has been a particularly difficult period for global financial markets, which buffeted firms and investors. In the private-equity business, exits from investments -- needed to turn paper profits into hard cash -- have fallen dramatically since the financial crisis, as initial-public-offering markets have remained choppy at best and frozen at worst.

Blackstone sees its business as cyclical and argues that carried interest will return as the global economy improves and it starts to sell its private-equity assets. "You'll see more [merger-and-acquisition] volume coming in a more traditional fashion in the private-equity area," Schwarzman told analysts on a recent call.

Negotiating Leverage

Blackstone and other publicly traded private-equity firms argue that ultimately the interests of public shareholders and limited partners are the same. They say that if the firm does not make money for limited partners, then they will stop giving it money to manage, which will also hurt public shareholders.

"I don't think there is a problem with the alignment of interest," said Steven Kaplan, a finance professor at the University of Chicago. "The founders of these firms are not selling their shares tomorrow and if their funds do not perform in the long term, the value of their holdings will suffer."

It also isn't easy for investors to negotiate the fees down.

"A lot of pension funds believe fees charged by the major private-equity firms are too high, but it's difficult to negotiate them down on an individual basis," said George Hopkins, an executive director of the Arkansas Teachers Retirement System, an investor in Blackstone. "The ability of these funds to charge large fees all depends on whether they continue to perform," Hopkins added.