Blackstone’s Joe Baratta, Global Head of Private Equity, sat down with Christine Anderson, Global Head of Public Affairs, to discuss what he sees across the markets today. He reflects on our current low interest rate environment, trends in the energy market, the impact of the UK referendum and the lessons he’s learned over his career.
Christine Anderson: Welcome to the Blackstone podcast, our channel dedicated to the insights, conversations and news from across our firm. I'm Christine Anderson – global head of public affairs at Blackstone. Today we will be speaking with Joe Baratta – head of private equity – on what he's seeing in the markets today. Remember, you can subscribe to hear more Blackstone podcasts on iTunes. Hi, Joe.
Joe Baratta: Hi, Christine.
CA: Good to have you here.
JB: Thank you, happy to be here.
CA: So we'll dive right in. generally how are you thinking about the markets right now. How do you see sort of the private equity landscape as we sit here today?
JB: Well, we're in an interesting moment in the cycle – and things are cyclical. You've got historically low interest rates, and high PE multiples, multiples of cash flow and generally calm economic conditions, albeit with low growth and the expectation that people have is that rates will stay low for the indefinite future. And growth will be relatively low, so trying to generate high absolute returns in that environment is a challenge. So everything we're doing is geared towards finding companies where we can somehow transform the earnings profile of the business.
Or the scale of the company through sector consolidation, to justify the high prices we're having to pay. So I'd say the degree of difficulty to generate returns that we need to deliver to our investors is as high as it's been, which makes the environment difficult. I do believe that at some point in the next three or four years, you will see some sort of capital markets dislocation which will drive asset prices down. I think interest rates will have to rise because this is a world with lots of fixed obligations to employees, through defined benefit plans, and life insurance policies that need to be met. And unless returns are higher, those obligations won't be met. So we're at a really interesting moment, where we do expect PE multiple to come down and interest rates to rise.
We're just not sure when. And so navigating this market is tricky.
CA: So you mentioned having to go into these portfolio companies with a real plan. So is there an example – a recent example of something we've done where it's been hugely labor intensive on the operations side?
JB: Yeah, I mean, virtually everything we're doing is quite labor intensive. We own a company called Gates Global which is the largest manufacturer in the world of rubber belts and tubes and hoses used in automotive VAG equipment, industrial equipment – and with that business, we've gone through a comprehensive lean manufacturing implementation. Which means that in each of the facilities we're really trying to figure out how to move materials and goods and manufacturing processes more efficiently to improve the productivity of the plants and reduce costs. That's been a really significant investment that we've made in both time and money to do that, and it's yielded results. The operating margins of that business have increased significantly since we've bought the company.
Another example with a different kind of intervention plan is in the aerospace components business, we own a small company that does certain manufacturing processes in the manufacture of components for aerospace engines. Historically the large aircraft engine companies manufactured most things themselves, and like has happened in the automotive industry, they're outsourcing many steps of the manufacturing process and we have a platform that's taking advantage of us and acquiring assets so it can become a bigger and more comprehensive supplier of products to the big aerospace engine companies like GE and Pratt & Whitney and Rolls Royce.
So that's an example of sector consolidation becoming a better outsourcing partner for our big customers.
CA: Great. Well so obviously challenging time to invest. But energy – is that, you know, we've after seeing Blackstone sort of be on the sidelines for some time is now a very active investor in the space, so is it a better time and energy?
JB: For sure. You've had a big dislocation in the price of the commodities – oil and gas in particular. And you had significant overinvestment in the US, Shale and the related infrastructure to produce and transport that. a lot of companies had gotten over levered with the expectation of higher prices and more production and supply than actually panned out and so – and the capital markets have been shut to energy companies and that's what we've been able to step in an provide capital buy assets and –
CA: Upstream – downstream – what's –
JB: Mostly upstream, but also midstream – meaning the companies that are there to transport the hydrocarbons once they're out of the ground. And also prices are much lower and we – we have a reasonable expectation that prices over time will be meaningfully higher than they are today. We don't ever have a point estimate but we do believe that going forward the price of both natural gas and oil will be higher than they are today, so we think there's an interesting cyclical tailwind in the energy area.
CA: So you have an 80 plus portfolio companies right now, so you get this great sort of information and data from across the portfolio – sectors, geographies, and from all these CEOs who are out there kind of in the field. What are they telling you about sort of where the economy is and their sort of strength or lack thereof?
JB: The data we see in real time from our portfolio companies – we're struggling to generate much in the way of top line growth and that's been the real problem with the economy and with the large corporations in America is generating revenue growth, so much of the earnings growth in the last few years has been through margin expansion, you see margins now in the S&P 500 that are historically high as a percent of revenue and corporate profits as a percent of GDP are as high today as they've ever been. And you know, the top line has been disappointing, revenue growth has been disappointing to most market forecasters and corporate CEOs and we're seeing the same thing in our portfolio companies, particularly in the industrial economy in the United States.
Anything tied to industrial production has been really slowly growing or declining and that gives us cause for concern, we don't see any growth catalyst or inflection point where we will get more optimistic about growth rates in the US economy. There are pockets of I think cyclical tail winds, like in the housing sector, particularly single family home construction in the US where we're well below where we've been historically as far as housing starts for single family homes.
I think the energy sector will provide some cyclical benefit to the US economy and the one longer term driver of growth I think in the industrial economy will be as a US government and the federal government and local governments begin to spend money on infrastructure. And engage with the private sector to build roads and bridges and fix airports and what have you. That should add half a point or maybe a point of GDP growth for some period of time, however, the US is highly levered and the political will to run budget deficits doesn't seem to be there.
So that's not a complete no brainer that we will have giant fiscal expansion.
CA: But clearly there's – there's never been a time where I think conventional wisdom is that on both sides, no matter who wins the white house, there seems to be a consensus that infrastructure has to be the focus and an early focus.
JB: Agreed and we'd be advocates of that as one way to shock the economy out of the doldrums that it's in.
CA: You've talked a lot about interest rates and central bank policy. But how likely do you think the chances are that we see some sort of increase, do you think high?
JB: It looks unlikely in the short term. You can't identify a particular catalyst. But what I know from experience is that when capital is being misallocated for too long it tends to self-correct. And my personal opinion is that the interest rate policy that's been pursued for the last few years has now led and is accelerated the capital misallocation of the last couple of years has led to really wide scale misallocation of capital, meaning those organizations that have to provide returns for to meet retiree obligations, or life insurance companies, or banks, have been increasingly forced to invest in riskier assets and longer dated assets to generate the return and that's not like a natural state of being. Somehow something will happen to make that begin to unwind, in my opinion. And it could be some sort of banking crisis in Europe.
And you're seeing now some of the largest banks in Europe being talked about having to be restructured or broken up. There is much written about the Chinese banking sector needing more capital and having a bad debt problem. So you know that these sort of imbalances and excesses are out there, and kind of the way people knew that the housing market was overheated in the United States in 2006 and 2007. You weren't really sure what was going to be the catalyst to make it change but you could see the warning signs. And that's kind of where we are now. It could be in six months, or it could be in three years. But I think that's the time frame, I don't believe we're in a Japan-like scenario where long dated interest rates stay at 1% for decades.
CA: Also just on the international front – you spent a decade in the UK and spent – living there, investing there, etc. So how do you see the Brexit implications playing out?
JB: It's easy to believe that it's a disaster and it's going to be hard landing in Britain and the extraction of the UK from the EU will be complicated, but the reality is the EU needs Great Britain. They're too intertwined already in terms of the free transfer of capital, human beings and goods and I think that it's in their mutual interest to have that continue in the way it's been. So I think there will be volatility and bumps along the road. The UK is a strong, industrial and consumer economy, it's a well governed place, it's a transparent place, they've got open capital markets. They never were really fully integrated with the Eurozone in any event.
They had their own currency, they had their own discrete capital markets. So I think it will be okay long-term, in short. We are investing in the UK, we have no – we're not factoring in their withdrawal from the EU as part of our investment underwriting. We do think it will effect growth, over time. I think the Eurozone is a low growth economy and there will be volatility and bumps along the way as I said. We might have a slightly higher discount rate for doing things than we would have. But not material, I'd say.
CA: Any other sort of hot spots or places around the world that you're concerned about or seeing opportunity?
JB: I think places we're concerned about. I'd say China. We're investing in China but we're doing it in a way where we're buying very easy to understand businesses without lots of complexity where we have some measure of control and control of our own destiny in terms of what we can do to the business and how we can exit. But overall there's lots of opacity in that economy and in those economies. Albeit lots of growth.
We're investing in that market, but carefully. I think India is a lot more interesting now than it's been over the last five or six years and we've deployed a lot of capital in the last year and a half – maybe a billion dollars – of our private equity funds have been invested in India. Again, we're investing in larger sized transactions where we have control, where we're not reliant on a counterparty you know, to control the outcome and it's you know – we're seeing good growth, we're seeing a commitment in that government to reduce complexity and regulations.
And so I'd say that's been a brighter spot outside of the US and Western Europe.
CA: So you spend an enormous amount of time on the road, meeting with limited partners – which are the investors in our funds. These are largely public institutions, public pensioners, etc., sovereign wealth funds. What's the one thing they want to know? What are they asking you right now?
JB: Well they want to know how to deploy their capital, because they have lots of liquidity as equity markets have recovered since the financial crisis. Their allocation to private equities have actually come down as much money has been returned, and so they're trying to redeploy that money. And they're very worried about some of the things I mentioned earlier – the low cost of capital in the world, and what might happen if that were to mean revert. And so they want to know what we're doing, how we're investing their money, what opportunities we see, but I think all professional investors everywhere are confronted with a moment in time that's unlike any one they've seen really in their careers.
CA: So finally, before you go, Joe is the one person at the firm who I don't think ever sits still so we're – it's great to have you for a few minutes, you know, you – you're sort of the key person at the firm in terms of helping to develop young talent. And what to you is the one thing that sort of makes a great investor?
JB: I'd say humility, and you know, a lack of preconceived notions. People who are really smart who have really only ever succeeded academically, tend to become overconfident or rigid in their thinking and to be a good investor you really have to have your mind open and constantly challenge your own biases and preconceived ideas. And be open to the brilliant people around you – we're all fortunate at Blackstone to work with some of the smartest people certainly in the finance industry, but also I'd say in business and being open to those points of views and being willing to listen and take on board with an open mind things that other people are saying and incorporate that into you own mental model for investing is really important.
And I'd say the most successful people at the firm over time have been not necessarily the people with the highest IQs or the smartest people but the people most willing to listen and modulate their own points of views and be open minded.
CA: Is that why you've been such an advocate here? I know you've been trying to increase the diversity of our teams, is that rooted in that different point of view?
JB: Yeah, for sure. Diversity, not just ethnically and gender but also backgrounds – where people are from in the world. Everybody who grows up in the northeast and goes to the best possible middle school and the best possible high school and the best possible college begins to – their experiences are more narrow and more limited. Those people are enormously talented and have something to add, but if you have a firm just of those people instead of people from other countries and other backgrounds and also socioeconomic diversity we find is really important and if you got to know our people you'd see people from all over the country, all over the world, from different backgrounds, whose parents did different things, who went to different schools and I think that who are of different ethnicities, women and men and that creates I think better decision making.
CA: Thanks Joe, I appreciate it. Thanks for your time.
The views expressed in this commentary are the personal views of Joe Baratta – global head of private equity and do not necessarily reflect the views of Blackstone itself. The views expressed reflect the current views of Mr. Baratta as of the date hereof, and neither Mr. Baratta nor Blackstone undertakes to advise in the views expressed herein. Neither this podcast nor any of the information contained herein constitutes an offer of any Blackstone fund.