Money Stuff: Blackstone Is for Everyone

If you work in financial markets and are very smart and diligent, you might occasionally notice something weird. Some stock is trading at too high a price, or too low. Some company is being run inefficiently, and if you take it over you can make it worth more. Some company has violated the terms of its bonds, and if you buy up the bonds you can put the company into bankruptcy and extract a lot of value. Some asset is trading at a tiny discount to some economically equivalent asset, and if you buy one and sell the other and lever up the trade you can make some money. The Ruritanian stock market goes up on Tuesdays when it rains, so you should buy Ruritanian stocks on Monday afternoon when the forecast is for rain. All sorts of anomalies and dislocations and inefficiencies and opportunities.

These opportunities have different scales. By some measures, one of the greatest of all trades is the reverse split arbitrage: When a tiny company does a reverse stock split, it will often round up, so if you buy one share of a company as soon as it announces a 1-for-10 reverse split, you can end up with a  quick and reasonably certain 900% return on your investment. But this only works with one share; you cannot in any sensible way scale it up. [1]  You can make, like, $4.50 on a $0.50 investment: It is a true market anomaly that you can exploit, but not very much. Other trades have much bigger scales. Jane Street Group was able to extract perhaps a billion dollars from, uh, let’s say noticing some anomalies in the Indian options market. Renaissance Technologies has spent decades taking billions of dollars out of financial markets by noticing anomalies on an industrial scale.

But there are tens of trillions of dollars in the financial markets. Jane Street and Renaissance are big in the sense that they have made billions of dollars for their executives, but in the scale of financial markets the anomalies they exploit are tiny. Somebody can make some money — billions of dollars — by finding weird inefficiencies in financial markets. But everybody can’t make all the money that way. In the aggregate, financial markets are not a grand bet on market anomalies; that would make no sense. Everyone can’t be noticing inefficiencies that no one else notices; everyone can’t be taking money from everyone else by being cleverer than everyone else. In the aggregate, financial markets are a grand bet on global economic growth. 

People sometimes divide investing into “alpha” and “beta.” Alpha is, approximately, finding opportunities that no one else has noticed and making contrarian bets on them. Beta is, approximately, using your savings to buy a share of global economic growth. BlackRock Inc., the giant asset manager, has more than $13 trillion of assets under management, more than half of which is in index funds and exchange-traded funds. You do not put your money into a BlackRock S&P 500 index ETF because you hope BlackRock will spot clever anomalies. You’re just there for your cut of global economic growth.

Many of the people who got rich and famous in financial markets did so by spotting anomalies. (That tends to work faster than global economic growth.) The most ambitious of them naturally want to scale up: run more money for more people to generate more returns and collect more fees for themselves. This is possible, at some scale. The biggest multimanager multistrategy “pod shop” hedge funds are essentially industrial anomaly factories: They compete fiercely to hire talented spotters of market inefficiencies, they deploy as much capital as they can against those opportunities, and they scale up by hiring more people to spot more uncorrelated anomalies. We talked about this the other day: One hedge fund investor told Business Insider that “historically, capital was the bottleneck,” but “now it’s 100% talent.” Another way to phrase that statement is: “The biggest hedge funds now manage as much capital as they can possibly put to work in market anomalies, but they just can’t find enough anomalies to get any bigger.” [2]  Those biggest hedge funds have net assets on the order of tens of billions of dollars. Tiny!

Perhaps the greatest financial anomaly-spotting story of the last 50 years is the leveraged buyout. As I have told the story, in the 1970s there were a lot of sleepy companies that were lazily run and underlevered, and a small group of pioneers realized that they could borrow money, buy those companies, align incentives, impose financial and operational discipline, flip the companies back to public markets a few years later, make huge profits and keep 20% of those profits for themselves. This opportunity — “the market undervalues and underlevers companies, so we can borrow money to buy them ourselves and extract extra profits” — turned out to be absolutely enormous. It turned out that you could do leveraged buyouts of companies worth tens of billions of dollars, and this business could support multiple big firms each with hundreds of billions of dollars under management. And those firms could, at least arguably, earn market-beating returns: They gave their investors not just the returns of allocating capital to economic growth, but also the bonus returns of spotting market inefficiencies and correcting them.

So they scaled up. They went from “LBO funds” to “private equity firms” to, now, “alternative asset managers.” They invest in real estate and infrastructure and private credit. The biggest of them, Blackstone Group Inc., now manages more than $1 trillion of assets: an order of magnitude more than the big hedge funds, though an order of magnitude less than BlackRock.

And they want to scale up more. Historically LBO funds invested on behalf of sophisticated risk-seeking institutional investors. Now they run tons of insurance and annuity money. The next prize is retail money, investing individuals’ retirement accounts, which could add trillions of dollars in assets at the big alternatives managers.

Are there trillions of dollars of anomalies? Can you put trillions of dollars of retirement savings to work by spotting market inefficiencies? Bloomberg’s Dawn Lim has a fascinating profile of Jon Gray, the president of Blackstone, the thesis of which is that “Blackstone, once a fortress for the world’s richest institutions, is remaking itself under Gray into a financial superstore for the dentist, lawyer and teacher next door.” The subtext is that, as Blackstone gets huge and universal, some stuff doesn’t scale:

Gray also confronted differences of mind when he urged GSO Capital Partners, the credit arm once famed for audacious bets, to come around to his views. He argued that distressed investing was too hard to scale and created too many headaches for a firm that needed to stay in banks’ and rivals’ good graces.

Gray’s influence was unmistakable. GSO was recast as Blackstone Credit — losing the initials of its legendary dealmaking founders. The goal turned to capturing the broadest customer base and becoming more focused on performing companies and steady cash flows.

Yes at a very high level if you had to describe the debt market in a sentence, you might say “we lend money to companies to get steady cash flows.” And then historically a tiny pimple on the debt market was GSO, which did the opposite. It would do incredible things like lend money to companies to get them to default on their debts to trigger credit default swap contracts that GSO had also bought. That doesn’t generalize: The whole debt market doesn’t work like that; everybody couldn’t do that; everyone’s retirement savings can’t be invested in manufactured defaults on CDS contracts. [3] You cannot go around making money on manufactured debt defaults and at the same time will that it should become a universal law. That’s a weird trick, an anomaly. You can do that and get rich and have fun, but when you manage trillions of dollars you have to put away childish things and start getting steady cash flows from performing companies.

Or:

As Gray rallied investment teams around “megatrends” that were blessed by the top of the house, dealmakers deemed it career suicide to question big sanctioned themes like AI or India, according to some of the employees. Some veterans lamented that the swagger was gone and that investing felt akin to being in a factory or flipping burgers in a line.

Yes: If you run trillions of dollars, you are going to invest in big themes like AI or India. “Where can we get access to global economic growth,” you will ask yourself, and you will answer with words like “AI” or “India.” If your answer is “this company has particularly low-priced bonds so if we triggered its CDS with a manufactured default we could make a huge recovery,” that is the wrong sort of answer; you are thinking too small. If your answer is “we could put some more leverage on this $20 billion public company,” even that is now too small. The right sort of answer is “AI” or “India.” Your themes have to be big.

But that is not the business you once signed up for. “Private Equity Is Getting Boring,” I wrote in September:

In the beginning, when private equity was a novel risky arbitrage to correct systematic mispricing of companies, it was funded by sophisticated investors who could understand and appreciate that bet. If private equity is just “owning companies,” it will be funded by everyone’s retirement savings.

If you got into this business to spot inefficiencies and ruthlessly exploit them, and your job now is to invest people’s retirement savings in megatrends, that might feel boring.

Here is one way to think about how public companies work:

1. There are about 4,000 US public companies.
2. Each company is managed by a chief executive officer. The CEO makes the day-to-day decisions about how to run the company.
3. The CEO reports to the board of directors. The board oversees the CEO’s decisions, and if it is unhappy it can fire the CEO.
4. The board of directors reports to the shareholders. The shareholders oversee the board’s decisions, and if they are unhappy they can fire the board.
5. A majority of the shareholders of most public companies are not individuals, but rather institutional investment managers who manage money on behalf of their clients.
6. A few of those institutional shareholders — like BlackRock — own large chunks of every public company and so have enormous influence. (“I didn’t know Larry Fink had been made God,” as Sam Zell once said of BlackRock’s CEO.)
7. But a lot of those institutional shareholders are smaller, though collectively they also own big chunks of every public company. They don’t necessarily have the time or resources to oversee the decisions of all of the boards of all of the companies they oversee, so they outsource those decisions to proxy advisory firms that specialize in corporate governance and shareholder voting. (And historically even the biggest managers tended to follow the recommendations of proxy advisory firms, though “big money managers have increasingly emphasized that they make their own decisions.”)
8. There are two of them, Institutional Shareholder Services and Glass Lewis. There are others, but “ISS and Glass Lewis collectively control between 90% and 97% of the U.S. proxy advice market.”
9. So, at every company, the CEO reports to the board who reports to the shareholders who report to ISS and Glass Lewis. There are two companies that make the ultimate decisions for every US public company. Or maybe the number is more than two — maybe it’s like ISS and Glass Lewis and BlackRock and Vanguard and a few other giant investors — but it’s smaller than, say, 10. There are a handful of people who are the ultimate arbiters of the decisions made by every US public company.
10. Isn’t that an antitrust problem?

I mean! This is not the only way, or the most sensible way, to think about anything. Only a tiny fraction of all corporate decisions are put to a shareholder vote, and ISS and Glass Lewis mostly tend to tell investors how to vote on nonbinding proposals about executive pay or producing environmental impact reports, not on competitive strategy. No actual corporate CEO thinks that she “works for ISS,” or considers how her strategic decisions will be received within ISS. [4] It is not true in any practical sense that the decision-making at every public company ultimately rolls up to the two proxy advisory firms. But it is true in a loose galaxy-brained theoretical sense. The corporate buck stops with the shareholders, and if the shareholders all do what Glass Lewis and ISS tell them to then that’s weird.

The Wall Street Journal reports:

The Federal Trade Commission is investigating whether proxy advisory firms Institutional Shareholder Services and Glass Lewis violated antitrust laws through their business of guiding shareholder votes on contentious topics, people familiar with the matter said. 

The investigation is the latest move putting pressure on the two influential advisers, which investment managers rely on for research, analysis and recommendations on how to cast shareholder votes on issues ranging from executive compensation to board elections.

The probe, which is in its early stages, is focused on the firms’ competitive practices and how they steer clients on hot-button issues such as climate- and social-related shareholder proposals, people familiar with the matter said. The FTC told Glass Lewis it was investigating whether it and others may have engaged in “unfair methods of competition,” according to a letter sent in late September that was reviewed by The Wall Street Journal.

I am somewhat conflating two points here, though I have a feeling that the FTC is as well. One point is that ISS and Glass Lewis arguably have a lot of market power in the market for proxy advice, and some people worry about that and want more competition in that market. The other point is that ISS and Glass Lewis serve a powerful coordinating function for lots of investors in lots of public companies, and that it is troubling for 4,000 companies to all answer to the same few ultimate bosses.

I guess a third point is that the Trump administration substantively does not like the answers that ISS and Glass Lewis come up with on social and governance questions. We talked yesterday about a potential executive order to limit the power of proxy advisers and/or to restrict voting by index fund managers: Shareholder voting is now a culture-war matter, and there is a sense that the proxy advisers and index fund managers tend to have left-wing social preferences. So perhaps the FTC thinks that breaking up the proxy advisory duopoly will make public companies less woke.

Speaking of shareholder votes. It is rapidly becoming conventional wisdom that prediction markets are a good way to estimate probabilities and make decisions about the future. Here is Jeff Yass explaining that prediction markets could have prevented the Iraq War. My own view that “prediction markets” is a polite way to say “sports gambling” seems to be in the minority.

An extension this idea that we have discussed a couple of times is “multiverse finance,” a thought experiment from Dave White at Paradigm, in which you could buy financial assets conditional on some prediction-market-ish event. So like “I want to buy Treasury bonds contingent on the Democrats winning the Senate in 2026” or whatever, a trade where (1) I get the asset if the event occurs, (2) the trade is unwound if the event does not occur but (3) in the interim, the conditional asset itself trades and has a price. One benefit of this is, you know, more ways to manage risk, more ways to speculate, etc. But another benefit is that the prices of the conditional assets could give you information about possible futures: not about how likely the event is, but rather what the effects of the event might be. The price of “one barrel of oil contingent on invading Iraq” could tell you something about (market expectations about) what invading Iraq would do to oil prices. 

After I wrote about shareholder voting yesterday, reader Charles Wang emailed to suggest:

The obvious correct resolution for delegating shareholder votes is to have one publicly traded contract that is a forward contract for the stock conditional on the vote passing and another forward contract for the stock conditional on the vote failing. Then the stock is voted according to whichever side has the better forward price. ...

Really it's a bit bizarre that the markets are supposed to be about efficient allocation of capital but the one thing that's directly about allocation of capital is not settled by the markets.

I suppose that might be manipulable, and for almost all actual shareholder votes the result doesn’t matter to the stock price, but I like the general idea.

It would be cool if a business school hired a serial failed entrepreneur to teach a class like “How I Started Several Businesses But They Didn’t Work.” For one thing, there are probably good lessons there: “I started a company and did everything right, bask in my glory” might be less informative than “here are the mistakes I made, figure out how to avoid them.” But also one wonders about selection biases. If you hire the winners of coin-flipping contests to teach the business-school class in How To Succeed At Coin Flipping, their advice might be completely spurious. [5]  If you hire a cross-section of winners and losers to teach coin flipping, your students might get a better education.

Though they might not sign up. The Wall Street Journal reports that Chicago State University has a class on “How to Get Very, Very Rich”:

The person helping them get there is Pete Kadens, a wealthy white entrepreneur teaching the mostly Black CSU classroom strategies on getting very rich. Kadens’s pitch to the 33 students taking his weekly “Mastering Wealth” class: Affluence isn’t just for privileged people, but for anyone willing to take big risks and work like a demon.

Having the “balls and the guts to say ‘I’m going to make $50 million by the time I’m 35 years old’…that is not typically reserved for Black and brown students in this country,” says Kadens, who is worth roughly $250 million after founding companies in the solar and cannabis industries. “That’s typically reserved for rich white kids that come from Greenwich.” …

During another class, Kadens handed out $100 bills to students who volunteered to stand and describe how they planned to multiply their current incomes by 10. He also passed around a risk-tolerance quiz and chided students who proved risk-averse. “If you want to be Jay-Z rich…that’s not going to work,” he said.

I feel like an important implication of a class like “get very rich by taking huge risks” is that some of the people in the class will get the opposite of very rich? Like that’s what risk means?

This is just cool, hats off to them:

Robinhood Markets is betting its Gen Z and millennial clientele are as eager to send out for delivery of a wad of cash as they are to order pizza or a pint of ice cream.

The brokerage is joining with food-and-drink delivery app Gopuff to allow customers to withdraw cash from their Robinhood bank accounts and have it brought right to their door. For a $6.99 delivery fee—or $2.99 if they have more than $100,000 in assets across their Robinhood accounts—users can skip the ATM and have money delivered in a sealed paper bag while they are at home.

This strikes me as a silly thing to do, but that’s why Robinhood’s founders are billionaires and I’m not. Also I appreciate that Robinhood is making rigorous efforts to address every aspect of its customers’ financial lives. If you want to day-trade stocks or options or crypto, that is traditionally what Robinhood is for. If you have retirement savings that you want to invest in index funds and get some tax advice, that is increasingly what Robinhood is for. If you want to keep cash in the bank, sure, that’s what Robinhood is for, but where are the Robinhood ATMs? The Robinhood ATMs are they’ll bring the cash to your house. It’s a good pitch!

In yesterday’s column, I needed an example of a company that is (1) is in the S&P 500 index but (2) not especially memorable. I picked one that I found a little bit funny: Sealed Air Corp., which makes bubble wrap. There was no particular reason for that, and I’d have preferred a ball bearings company if one was available, but sealing air is a nice industrial business that you probably don’t think about very much. So I wrote about diversified retail shareholders’ rational indifference to goings-on at Sealed Air, as an example of their rational indifference to goings-on at virtually every company.

After the close yesterday, the Wall Street Journal reported:

Buyout firm Clayton Dubilier & Rice is in talks to take packaging-provider private, according to people familiar with the matter. 

A deal for the Bubble Wrap maker could come together soon, though it remains possible talks could fall apart or another buyer could emerge, the people said. 

Sealed Air had a market value of around $5.4 billion as of Wednesday’s close and a deal including a typical premium would value the company above that, the people added. 

Its shares jumped over 20% in after-hours trading after The Wall Street Journal reported on the talks.

The stock opened at $44.27, up 21.7% from yesterday’s close, though it traded down a bit from there. I just want to be clear that I had absolutely no idea that this would happen and it was a pure coincidence. Unless someone at CD&R read my column and was like “oh Sealed Air, I haven’t thought about them in a while, maybe we should buy them,” and moved quickly. Seems unlikely. 

Anyway if you made money by (1) reading Money Stuff yesterday afternoon, (2) thinking “huh Sealed Air that sounds fun” and (3) buying short-dated out-of-the-money call options, please let me know. This is extremely the opposite of investing advice, though, and don’t try it on the next random company I mention.

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