Why Blackstone is a buy

The private equity firm's shares have taken a drubbing since their summer debut. But there's plenty to like about this stock, argues Fortune's Adam Lashinsky.

By Adam Lashinsky, Fortune senior writer

(Fortune Magazine) -- Schadenfreude carries no scent. If it did, a slight odor would be emanating from the newly public shares of Blackstone Group, the New York City firm that ironically makes its living taking other firms private.

In one of the most talked-about debuts since Google's, Blackstone (Charts) netted nearly $3 billion in its June IPO at $31 a share, shot up to $38 - and promptly plunged to $21 as global credit markets unraveled and the music stopped on the long-running private equity party.

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Blackstone CEO Stephen Schwarzman cashed in on the firm's IPO, but the stock has since languished.
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Daily closes since IPO
Power portfolio
Selected Blackstone deals, with amounts invested by the firm. (All but Hilton have been completed.)
Freescale Semiconductor
$3.1 billion
Hilton Hotels
$2.5 billion
Deutsche Telekom
$1 billion
Catalent
$914 million (Catalent was formerly known as Cardinal Health Pharmaceutical Technologies and Services)
Michaels Stores
$828 million
Nielsen Co.
$816 million
Travelport Limited
$775 million
Health Markets
$610 million
Pinnacle Foods Group
$414 million
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Attention-grabbing Blackstone CEO Stephen Schwarzman made his, of course: a whopping $677 million that he took out in the IPO. But now Schwarzman and the original IPO investors - including the Chinese government's investment fund, which is more than $400 million in the hole on its $3 billion Blackstone bet - have the embarrassment of a loser on their hands.

The best part about all this rejoicing over other (extremely wealthy) people's misfortune is that it matters not one bit to potential investors. Indeed, the market meltdown and loss of general confidence in private equity present a solid opportunity to snap up shares of Blackstone, which represent ownership of Blackstone's management firm, not shares of the investments it makes in other companies.

Billions of dollars of uninvested capital, a stellar track record, restrictions that will keep Blackstone's top executives from fleeing, and even a healthy, more-or-less guaranteed dividend all make Blackstone a sound play for investors with a long-term time horizon. And such a deal, too, at 19% off the manufacturer's suggested retail price! (The offering price of $31, of course.)

To be prudent, let's dwell for a moment on two little words you just read: long term.

Blackstone earns its keep mostly by buying companies, fixing them up, and then reselling them. Think of the buyout barons as the rehab artists of the corporate finance world. The point is that all that spackling and wallpapering doesn't happen quickly.

What's more, when markets are turbulent it's tougher to sell, meaning paydays take longer. Blackstone itself said recently that it expects to hold its private equity investments for an average of 3 1/2 years, up from as little as two years in the buy-sell frenzy of 2005--06. That means there is little but sentiment to move Blackstone's stock on a day-to-day basis, and investors looking for a short-term killing are playing a game different from that of Blackstone itself.

Says Roger Freeman, an analyst with Lehman Brothers: "You need to think about this with a five- to six-year time horizon."

On that basis, there's a lot to like. Blackstone manages assets worth a staggering $98.5 billion, including its main private equity and real estate funds as well as various hedge funds. It also has a thriving M&A advisory group and a unit that helps troubled companies restructure themselves in or out of bankruptcy proceedings.

Its most lucrative revenue stream, though, is associated with the fees it charges investors in its funds. These so-called management fees are the easy money of Wall Street: Blackstone gets the dough whether it invests wisely or not. As Michael Puglisi, Blackstone's chief financial officer, pointed out in a mid-August conference call with investors, 37% of the company's revenues come in the form of fees. It's the least volatile portion of a decidedly risky business.

Blackstone isn't going to stop doing deals simply because banks have tightened lending requirements. The company has about $6.5 billion left to invest in its record-breaking $21.7 billion private equity fund, and it will begin raising another fund shortly. Its $10 billion real estate fund is only 40% committed. Right there that's more than $12 billion of ammunition to do more deals.

Thanks in part to its newfound best friend, the government of China, Blackstone plans to make a lot more investments in Asia, including India. It has said it sees no slowdown in dealmaking there.

What's more, Blackstone seems to have been considerably more prudent than some of its peers as conditions began to deteriorate earlier this year. In the first half of 2007, Blackstone's private equity funds deployed almost $1.7 billion, compared with $7.5 billion for all of 2006.

There also is a cushion beneath the stock price. Through 2009, Blackstone says it intends to pay out at least $1.20 a share in annual cash distributions before its senior executives receive similar payments. It also suggests that 30 cents a quarter is a conservative estimate and that the fourth payment of the year might be considerably more. At today's prices, that's a 4.8% yield with potential upside. (A technical point: When you buy a share of Blackstone, you are buying a "common unit," which looks and acts just like a stock. The cash distributions are equivalent to dividends.)

A similar shareholder-friendly provision buried in Blackstone's IPO documents stipulates that its most senior executives must maintain at least 25% of their stakes in Blackstone Group and that they can't do any selling at all until 2010.

None of this should be read to suggest that investing in Blackstone is without risks. Its investments could tank. Institutional investors could stop ponying up dollars for its fee-generating funds. Finally, proposed legislation in Congress could force the company to pay taxes on part of its earnings in the range of 35% to 40%, up from a current 15% to 20%.

Then again, this is the firm that has generated average annual returns (after fees) on private equity of 22.6% since 1987 and 31% since 1992 on its real estate funds. (Owners also get a share of the profits of those investments.) Morgan Stanley analyst Hojoon Lee crunched the data on all the risks, including a tax-rate increase, and still came up with a conservative price target of $31.

Blackstone's stock market debut so far has mostly benefited its famous founders. As long as its top dealmakers keep doing what they do best, the firm's unfortunate market timing could mean a huge opportunity for the less well-heeled too. Top of page