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Harry Newton's In Search of The Perfect Investment Newton's In Search Of The Perfect Investment. Technology Investor.

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8:30 AM Friday, September 16, 2005: How do private equity funds, also called buyout funds, perform? The answer -- not brilliantly for their investors, but brilliantly for themselves. One of the largest organizers of these funds is the Blackstone Group, formed in 1985 by Pete Peterson and Steve Schwarzman. Here are their results gleaned from a 100% accurate source I don't want to tell you about.

The most important thing to note about these returns is that they are before the fees paid to Blackstone for managing the funds. I don't know what the fees on these funds were. But the fees on the new fund -- BCP V -- they're raising at present are, in their words:

"Fees and expenses charged by the Fund are in addition to fees, expenses and carried interest charge by BCP V, which will generally include an annual management fee (1.5% of capital commitment up to $6.5 billion and 1% thereafter; the blended management fee on an $11 billion fund would be 1.3% and 20% carried interest after an 8% preferred rate of return."

This means, according to my top-of-the-head calculations that a return of 14.8% (see below) would be reduced to 11.38% after all fees. But that number of 14.8%, which uses Blackstone's average, is way high. Here's my chart:

How Blackstone's General Corporate Private Equity Funds have performed

Year Begun

Fund Size
No. of Invest- ments
Total Invested Capital
Total Realized Value
Unrealized Value
Total Realized Multiple
Annual Rate of Return*
BCP I 1987
$679 million
$679 million
$1.7 billion
BCP II 1993
$1.3 billion
$1.3 billion
$3.1 billion
$115 million
BCP III 1997
$4.0 billion
$4.0 billion
$3.3 billion
$3.5 billion
BCOM 2000
$2.0 billion
$920 million
$765 million
$540 million
BCP IV 2002
$6.5 billion
$3.6 billion
$1.9 billion
$1.9 billion

* My own calculation. This is before fees paid to Blackstone.
** Calculated over 7 years, which is my guess.
*** Calculated over 5 years.
**** Calculated over 3 years
Blackstone itself calculates14.8% "estimated adjusted net internal rate of return (IRR) for realized and unrealized investments on this bundle of funds. By contrast, shares of Warren Buffett's Berkshire Hathaway rose at a compound annual rate of 29.2% from 1970 to 1995.

+ BCP stands for Blackstone Capital Partners
+ Results until 12/31/04

Blackstone says its results are great, compared to others of its ilk. But I don't believe that it -- and many other big private equity funds -- actually report their numbers publicly. They're comparing themselves against a few who do and some guesses by various organizations. This chart is "iffy."

Top Quartile Performance*
  Vintage Year** Performance Ranking***
BCP I 1987 Top Quartile
BCP II 1993 Top Quartile
BCP III 1997 Top Quartile
BCP IV 2002 Top Decile
Blackstone Communications Partners I 2000 Top Quartile
* Blackstone's name for this chart
** Year it was formed
*** Sources: Venture Economics, National Venture Capital Association, Thompson Financial Securities Data, 2004

The business of running large private equity funds is enormously profitable. Let's form a $6.5 billion fund. Let's run it for five years. We will earn a management fee of $97.5 million a year. If, at the end of five years the fund earns, let's say, 14%, we will earn a "carry" fee of $78 million. Thus, over the entire five years, we (i.e. Blackstone) will have earned $565.5 million. And remember we have other funds we're running, also.

I'm not knocking these numbers. Nice work, if you can get it. Here are the reasons Blackstone says you should give it money for BCP V (which is now open):

Blackstone's Advantages in Large Transactions
Entry Advantages Operating Advantages Exit Advantages
+ Fewer competing bidders + Often better companies + Better IPO for today's capital markets
+ More efficient financing + Ability to attract superior management talent + More strategic options
+ More negotiated deals (fewer auctions) + More "fat" to cut  
+ More corporate partnerships available + Better able to weather downturns  
+ Lower relative transactions costs    
+ Blackstone frequently gets the "first call" and "last look"    

Heh, we amateurs aren't stupid: Delta and Northwest have filed for bankruptcy protection. When a company files for bankruptcy, the first to lose everything are typically the shareholders. Yet -- despite the obvious, namely these companies were doomed -- a whole bunch of professional investors have been buying their shares. From today's Wall Street Journal:

Who would be foolish enough to buy up the shares and debt of struggling Delta Air Lines and Northwest Airlines? Some of the smartest investors on Wall Street, that's who.

In recent months, hedge funds including Ziff Brothers Investments LLC and Kingdon Capital Management LLC, as well as money managers like Charles Schwab Corp.'s U.S. Trust Corp., Wellington Management Co. and Deutsche Bank AG all piled into shares of the airlines, according to regulatory filings. And in recent days, a rush of hedge funds bought up Northwest's debt, betting that the airline would avert a bankruptcy filing.

Bad call. Northwest and Delta both made voluntary Chapter 11 filings Wednesday. Delta's shares, which hit $4 in June, yesterday were at 75 cents, up 5.6%, in 4 p.m. composite trading on the New York Stock Exchange. Northwest tumbled 53% yesterday to 88 cents in 4 p.m. composite trading on the Nasdaq Stock Market, after trading above $6 in June.

New York-based Ziff reported Aug. 10 that it had built a new position of almost 5.3 million Northwest shares, or about 6% of the airline's outstanding shares. For its part, Wellington established a new position in Delta during the second quarter of this year, buying up 5.3 million shares, though the Boston-based firm reduced its position in Northwest to 2.4 million shares from about 5.1 million in the first quarter, according to regulatory filings.

Others got out in the nick of time, though not without having losses. On July 28, large hedge fund SAC Capital Advisors LLC said it had added 2.8 million shares to an existing 2.1 million-share position in Northwest, while on July 14 SAC reported that it added 5.8 million shares to a 3.7 million stock position in Delta, according to FactSet Research Systems Inc. People close to the firm say SAC exited these big positions a few weeks ago, selling Northwest stock when it was still around $3 a share, avoiding some of the pain. But SAC still lost money on the trades.

Regulatory filings provide a snapshot of holdings on a certain date, of course, and the investors may have adjusted their positions, or offset them with other trades. Still, all the buying is surprising because it came in the face of persistent worries about the impact on airlines of hefty fuel and labor costs, onerous pension obligations, strained union relations, brutal competition and a history of well-regarded hedge funds getting burned by betting on airlines.

Representatives of Ziff, Kingdon, Deutsche and Wellington declined to comment.

So what were these guys thinking? Some of these investors say they were hopeful that Northwest could forge a closer relationship with it unions, helping to send shares close to $10. Others viewed the investments as inexpensive ways to bet that oil prices would fall. Had jet-fuel prices dropped, instead of soaring after Hurricane Katrina, the airlines would have been much healthier, and the stocks likely would have climbed. Indeed, shares of other airlines, such as AMR Corp. and Continental Airlines rose over the summer as business travel picked up.

The days leading up to Northwest's bankruptcy have seen particularly strong buying of the airline's debt, traders say. One reason they had hope: Northwest never arranged debtor-in-possession financing from creditors, usually a precursor to a bankruptcy filing, suggesting to the investors that the airline wasn't about to file. Northwest has said that it decided against a DIP because it believes it has sufficient cash and most of its assets already are pledged.

Some sophisticated investors are trying to establish large positions to gain a seat at the table when the airlines' fates are negotiated. Still others are hoping that the airlines could end up merging with rivals or think Congress will step in to provide pension relief.

Yesterday, trading in the debt was heated, as some traditional money-management firms and mutual funds sold bonds, while some investors covered short positions, or bets against the price of the bonds, by buying back the debt. In recent weeks, others traded "recovery swaps." These new instruments are an obligation to buy the cheapest bond within 30 days of a default, an attractive investment for those convinced that the value of the debt will rise during the bankruptcy process.

Northwest's most heavily traded bonds, those maturing in 2008, traded at about 24 cents on the dollar yesterday, down from 26 cents late Wednesday and from about 34 cents last week. Though the equity of the airlines likely will be wiped out, there likely is some value to the bonds at these levels, some say, because the bonds will be converted into equity in the airlines when they emerge from Chapter 11.

"I can't guess the value of jet fuel in 18 months when the airlines emerge, but there is some value to the bonds at these levels," said David Feinman, managing director at Havens Advisors LLC, a New York hedge fund. He says he hasn't yet purchased debt of the airlines, though he has wagered against the shares of the carriers. "But you better have a strong stomach and a lot of patience to get involved at this point."

That hedge funds continue to place big bets on airlines is somewhat surprising given the poor track record many of the best in the business have in divining the future of this notoriously challenging business. Legendary investors Michael Steinhardt and Julian Robertson both suffered big losses from stakes in US Airways Group. Warren Buffett made money investing in US Air but not before writing off 75% of its value and calling it a "mistake." Carl Icahn had a difficult ride after gaining control of Trans World Airlines in 1986. In all, more than 100 airlines have filed for bankruptcy in the past 25 years.

Troubling exits at Microsoft: As a stock, it's all over for Microsoft (MSFT). The stock is going nowhere fast. (I've written this before.) The company has become excruciatingly slow and ponderous, with new products delayed and delayed. This weekend's Business Week's cover story reports:

For most of its three decades, Microsoft has faced intense criticism. But in the past it came from the outside world. Now much of the sharpest criticism comes from within. Dozens of current and former employees are criticizing — in BusinessWeek interviews, court testimony, and personal blogs — the way the company operates internally. More than 100 former Microsofties now work for Google, and dozens of others have scattered elsewhere. Microsoft certainly is chock-full of smart employees who want to do better. Still, many of them say that jumping through bureaucratic hoops and struggling to link products together is preventing them from being the best they can be. There’s a plea for action to Gates and Ballmer to do more — slash the bureaucracy, tend to morale, and make it easier to innovate. But is anyone listening?

Politics I:
Four surgeons are discussing who has the best patients to operate on.

The first surgeon says, "I like to see accountants on my operating table because when you open them up, everything inside is numbered."

The second responds, "Yeah, but you should try electricians! Everything inside them is color coded."

The third surgeon says, "No, I really think librarians are the best; everything inside them is in alphabetical order."

But the fourth surgeon shut them all up when he observed: "You're all wrong. Politicians are the easiest to operate on. There's no guts, no heart, no balls, no brains and no spine, and the head and the ass are interchangeable."

Politics II:
A woman from Los Angeles, who was a tree hugger and an anti-hunter, purchased a piece of timberland. There was a large tree on one of the highest points in the tract. She wanted a good view of the natural splendor of her land so she started to climb the big tree. As she neared the top she encountered a spotted owl that attacked her.

In her haste to escape, the woman slid down the tree to the ground and got many splinters in her crotch. In considerable pain, she hurried to the nearest doctor. She told him she was an environmentalist and an anti-hunter and how she came to get all the splinters. The doctor listened to her story with great patience and then told her to go into the examining room and he would see if he could help her. She sat and waited three hours before the doctor reappeared. The angry woman demanded, "What took you so long?"

He smiled and then told her, "Well, I had to get permits from the Environmental Protection Agency, the Forest Service and the Bureau of Land Management before I could remove old-growth timber from a recreational area. I'm sorry, but they turned me down."

Recent column highlights:
+ Manhattan Pharmaceuticals: Click here.
+ NovaDel Biosciences appeals. Click here.
+ Hana Biosciences appeals. Click here.
+ All turned on by biotech. Click here.
+ Steve Jobs Commencement Address. The text is available: Click here. The full audio is available. Click here.
+ The March of the Penguins, an exquisite movie. Click here.
+ When to sell your stocks. Click here.

Harry Newton

This column is about my personal search for the perfect investment. I don't give investment advice. For that you have to be registered with regulatory authorities, which I am not. I am a reporter and an investor. I make my daily column -- Monday through Friday -- freely available for three reasons: Writing is good for sorting things out in my brain. Second, the column is research for a book I'm writing called "In Search of the Perfect Investment." Third, I encourage my readers to send me their ideas, concerns and experiences. That way we can all learn together. My email address is . You can't click on my email address. You have to re-type it . This protects me from software scanning the Internet for email addresses to spam. I have no role in choosing the Google ads. Thus I cannot endorse any, though some look mighty interesting. If you click on a link, Google may send me money. That money will help pay Claire's law school tuition. Read more about Google AdSense, click here and here.
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