What we’re watching: Maintaining (B)Credibility

Like many, we have recently read the headlines around two Blackstone funds that hit redemption gates over the last quarter. Much of the reporting has bordered on sensationalism with more than a hint of schadenfreude. As such, we thought we tried to look through the headlines and share some perspectives of our own.

Firstly, the background. The two funds are BREIT, an unlisted real estate investment trust and BCRED, an unlisted private lending fund. Both funds invest in illiquid assets (commercial real estate and directly originated corporate loans, respectively) and by virtue of this fact have been structured as interval funds. Interval funds are so-called because they provide for a fixed amount of redemptions at various intervals. In this case, the funds would allow up to 5% of the fund to be redeemed in a given quarter and 2% in a month. Amounts exceeding this would need to be re-submitted for redemption in future periods. 

Both funds grew significantly during COVID; BREIT has a total asset value of US$126 billion (up 1.3x in 2022) and BCRED is US$50 billion (up 1.6x in 2022).

The controversy has arisen because in December Blackstone announced that both funds had hit the 5% redemption limit, albeit, in the case of BCRED, the SEC filing was that 100% of tender requests were met but also that the requests were circa 5% of the fund NAV. In contrast, BREIT only met 43% of redemption requests in October.

Following this news, shares in Blackstone fell 7%. During December US$17 billion has been wiped off Blackstone’s market capitalisation. 

You may ask why this is such a big deal. The funds were structured with these features in mind to allow Blackstone to invest in less liquid parts of the market. The redemption limits kicked in before Blackstone was forced to raise sell spreads or undertake forced liquidations of assets. Exactly as they should have.

So why is this front-page news?

Clearly, the fear is that hitting the redemption limit precipitates other redemption requests as fear of not getting out of the fund overwhelms the greed of the higher returns available. 

But we think there are other factors at play that are important to consider. 

The first factor we’ll discuss is valuations.

• BREIT is up 9.3% year to date (through September quarter end) compared to a 28% decline in the value of publicly traded REITs. Despite income growth, investors could be forgiven for some scepticism around valuations. This strong performance came even as cap rates on their portfolio increased.
• BCRED is only up 2% year to date and 3.7% on a 1-year basis (on Class I units, post fees) versus a distribution yield of around 10%. This compares to the Cliffwater Direct Lending Index (an index based on middle market loans in public Business Development Companies (BDCs)) which was up over 6% and the Credit Suisse Leveraged Loan index (an index of liquid syndicated leveraged buyout loans) which was down 2.6% over the same period. Listed BDCs have delivered a 1-year trailing return of -3.5%. 

In less liquid markets, establishing fair market values can be challenging. For BCRED, Blackstone updates valuations quarterly with most investments subject to both an independent external and internal valuation. The process includes consideration of publicly traded securities to arrive at a fair market valuation. The vast bulk of the BCRED portfolio is fair value level 3 as per the table below. (1) In our view, the process seems robust and you can observe a correlation between public market valuations and the valuations used in BCRED (i.e. credit spreads have widened in both over the last year).

The next relevant factor is leverage.

Both funds utilise meaningful amounts of leverage which will exacerbate the impact of outflows from the fund plus the impact of valuation movements.

• At the end of Q3, BREIT had a leverage ratio of 46%, a net asset value of US$70 billion against a total asset value of US$126 billion.
• At October month end BCRED had a total asset value of US$50.1 billion against a net asset value of US$23 billion, implying a fund leverage ratio of over 50%, broadly in line with publicly listed BDCs. To put in context a 50 basis point widening in credit spreads may reduce valuations by 1.5% for an unlevered fund with a 3-year spread duration. The impact of leverage increases the decline to 3.3%. 

Interestingly, the source of at least part of the leverage was the bond market. BCRED has US$13 billion of debt outstanding split 50/50 between 1st lien senior secured floating rate debt and senior unsecured debt. The senior unsecured bonds are rated BBB- but have always traded much wider than the BBB benchmark. Since the headlines around redemptions in early December the bonds have widened by around 30 basis points currently trading at 340 basis points asset swapped.

The third factor is fees.

Both funds were launched when interest rates were significantly lower than where they are today. Both charge a 1.25% management fee plus 12.5% of the net fee after a 5% fixed rate hurdle. (2)

For BCRED when LIBOR was virtually zero the 5% hurdle was effectively the credit margin on the investment. So, the incentive would kick in assuming a margin of greater than 6.25%, no leverage and no losses. Now 3 month LIBOR is 4.7% (and is projected to peak at 5.14% in mid-2023) which significantly changes the fee economics. We show this below.

Based on the above assumptions of a 7% average discount margin on the portfolio, a 2.5% spread-based cost of debt and 0.25% per annum in credit losses (0.5% on a leveraged basis), the change in base rates adds 0.6% to the overall fees of the fund. Effectively, 12.5% of any interest rate increase goes to Blackstone so if rates go to 5.1% the incentive fee component will go to more like 0.7%. 

The increase in fees may explain some of the reduction in the relative attractiveness of BCRED in the current environment.

The final factor is capacity.

Both BREIT and BCRED have grown extremely quickly. We noted at the outset the growth in 2022 but the more extraordinary point is that BCRED actually only launched in 2021. It is less than two years old. The 18-month CAGR of the gross asset value is over 300%!

Anytime a fund grows at this pace a key question is how the manager maintains discipline in credit selection and portfolio construction. An obvious outcome is that at such an increase the manager needs to adjust their origination strategy to target much bigger companies that may need much bigger loans. Of course, Blackstone is well placed to manage such a transition given the overall size of the platform (they manage US$269 billion in credit (public and private) and insurance strategies with around 50% in private credit) but even this has grown increasing by around 60% over the last 12 months, only slightly slower than BCRED itself. 

A focus on larger deals can result in sector concentrations, such as exposure to software that is close to a quarter of BCRED. It can also result in less credit discipline which is a very difficult thing for investors to assess and often only obvious after the fact.

In our view, the headlines around these funds have led people down the wrong path. 

This is not an issue with the redemption features of interval funds which are operating as intended. For credit strategies that have defined maturities interval funds allow managers to match assets (the underlying loans) with a liability (the redemption profile of the fund).

In our view the more important questions are fundamental ones that apply to all less liquid credit and real estate investment strategies, namely:

• How do you value your portfolio?
• Do you use leverage in your strategy? If so, how much and what are the terms?
• What is the range of possible fee outcomes?
• What is the capacity of the strategy and how do you manage around that?

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