60 minutes with Jonathan Gray
Private Assets, the ultimate form of active management: Myth or Reality?
César Pérez Ruiz, chief investment officer at Pictet Wealth Management, in conversation with Jonathan Gray, president and chief operating officer of Blackstone, on the macro background for private investing, how the market for private assets is changing and thematics, including innovation.
The macro picture
César Pérez Ruiz (CPR) – What is the Blackstone view on inflation?
Jonathan Gray (JG) – We are seeing pervasive and I think more persistent inflation pressure than some think. We’re seeing it across labour markets, commodities and supply chains. Some of this will dissipate, but I think the decision by governments to grow the money supply by a third in response to Covid and the number of areas where we have structural shortages are reasons to be concerned about inflation. All of us want a greener future but we reduced hydrocarbon investments by 50% over seven years leading to shortages in the US and in Europe. Likewise in housing, in the US we’ve built 40% fewer homes than in the decade prior to the financial crisis. And we have 10 million job openings in the US, but three million fewer people looking for work. So, inflation will stick more than people anticipate and long rates will start to move up across the globe. Central banks will have to move faster than they thought three or six months ago.
CPR – What do higher long-term rates mean for private-equity leverage?
JG – Of course, borrowing costs go up but I think it’s more about the terminal value of an asset. There are two questions to be asked when rates go up. One, does the cash flow grow? Second, what happens to multiples (multiple expansion is less likely when rates rise)? So, you need to buy businesses where cash flow will grow to offset this multiple compression that we expect.
CPR – Is real estate the best way to play inflation fears? If so, where in real estate?
JG – A building with a 20-year government lease will have a flat income stream. This leads you towards assets that have better fundamentals and shorter leases – think free-market rental apartments to offset some of that rate pressure we see. About 40% of our real estate portfolio is in logistics, particularly last-mile logistics, to take advantage of the growth in e-commerce. Retail is more challenging. Offices too face headwinds given work from home. But while the picture is varied, overall I think real estate is a good asset class. The cost of physical replacement of real estate is increasing and it’s going to be harder and more expensive to build things. This means existing assets are going to be worth more.
CPR – How are you approaching China given the uncertainty there right now?
JG – You have to recognise that over time China will become the world’s largest economy. Just a few weeks ago, the US secretary for commerce said she believes in robust trade between the US and China to mitigate tensions. So I think the idea that we’re going to have full decoupling between the US and China Is unlikely.
The changing market for private assets
CPR – Does the democratisation of private assets mean this space it becoming too crowded?
JG – Definitely not. The alternatives business today, excluding hedge funds, is about USD8 trn. Stocks and bonds are USD250 trn. Traditionally private equity was a business that had a narrow mandate and narrow set of customers (pension funds, endowments). But now, after a decade of super low interest rates, more institutions and individuals are deciding to exchange a degree of liquidity for higher returns. So, we’ve extended our business into more perpetual structures and we have moved much more broadly into personal investors and insurers. We are in the early innings in this broadening of our business, but we are giving private investors the same experience and rates as institutional investors.
CPR – Given the amount of liquidity around, what about discipline in purchase prices? Are returns being impacted by rising prices for private assets?
JG – One of our advantages is the scale and breadth of our business. Scale means you can buy competitively in private markets. But I would fully acknowledge that prices have moved up.
CPR – How do you see the business evolving over the next five years? Are there any sectors you would avoid?
JG – I’m cautious on distressed debt. Over the past decade, apart from brief periods, there has been no great window and I’m seeing some adverse selection. There aren’t a lot of wonderful companies that have bad balance sheets. Emerging markets apart from China and India have been a challenge. Issues like the rule of law, the currency, the lack of liquidity have made it harder to look at some places. Carbon energy prices will be solid for the next couple of years, but we are more focused on energy transition and the coming green revolution. There is also more room for direct lending and for a broadening of investment in real estate. Infrastructure will grow, offering good yield and protecting against inflation. Life sciences is another area. People will look to hedge funds less to beat the S&P 500 and more for uncorrelated returns with downside protection. But the private asset market would still be very small even if it doubled.
CPR – What about regulatory risk?
JG – First, we need to deliver for our customers. Next, we need to make clear we are a force for good – what we do for decarbonisation and job creation are cases in point. There are risks around the sale of alternative assets to retail customers, but the rules are already pretty stringent, particularly in Europe. Nonetheless, private investment will inevitably attract more attention as the industry grows.
CPR – How are you looking at ESG?
JG – This is a big thematic that we are addressing in two ways. First, away from classic energy, we are pledging to reduce carbon emissions in each new investment by 15% in three years. Second, we are big believers in the green transition (wind, water, solar and battery power, charging stations). One of the challenges is how to tackle the high price of green energy. Often the best way is to invest one derivative off, so we have just bought a business that builds transmission poles. This is sort of a boring business, but as you have more distributed energy, it becomes much more interesting. When it comes to thematic investing, if you believe in a sector you have to figure out how to flood the zone.
Other thematics are the migration to everything online (shopping, media, education, healthcare). Because I like to look at one derivative off, that means investing in warehouses, digital infrastructure such as fibre cell towers and data centres. All this new media has led us to look at content providers, so we have invested in studio space in Burbank, for example. The next stop is life sciences and the bringing together of data analytics and genome sequencing– true precision medicine. We also like global travel, we continue to buy into rental housing and construction supply chain because of housing shortages and we continue to like the theme of aging populations. We are investing in secondaries and credit and, more generally, we like to invest in broad theme we define as “good neighbourhoods”.
CPR – Isn’t the speed of innovation a problem?
JG – Yes, the risk is higher because the pace of change is higher. But I think a bigger risk is not anticipating what is coming. If you believe in ‘good neighbourhoods’, you will try to play them in multiple ways. You need exposure, but you also need to be mindful of price and diversification.
CPR – What do you think of start-up culture?
JG – In the past, it was much harder; there were much higher barriers to entry for new businesses. Today, a start-up can go direct to consumers via Amazon and build a USD50 mn business. The amount of creative destruction is becoming much larger and faster. Does this mean incumbents cannot succeed? No, but getting exposure to new start-up trends is important.
CPR – What are the major risks and opportunities today?
JG – High on the list is inflation getting out of hand. It’s not my base case but, still, there is a risk that we become locked into a self-sustaining cycle of higher prices like in the 60s’ and 70s’. There are not many great assets where you can hide if you have high inflation--maybe ones with less input costs. Cyber (hacking) is a huge risk to the financial system. Geopolitics is also a risk. Another is income inequality. As for the biggest opportunity, I would say its the coming together of data and healthcare. This intersection will produce huge companies.