Blackstone, liquidity and investment risks

Welcome to Finance and Fury.  We will look at Investment liquidity and how this relates to risk to markets and investors – liquidity issues are starting to become an increasing risk factor for many investments as interest rates are on the rise

1. With rising interest rates – some of the assets most susceptible to risk are illiquid – further compounding the potential for losses
2. In this episode – I hope to explain what is liquidity and what the risk to global markets may be based around the current trend – and if illiquidity is really a bad thing or something that can protect investors from themselves

What is liquidity – Liquidity refers to the ease with which an asset, or security, can be converted into ready cash without affecting its market price.

1. There are different types of liquidity – but the one we are looking at is market liquidity – selling assets to others on the markets – if an asset can be converted into cash in a day or so and doesn’t affect prices – it is considered to be highly liquid – if it could take weeks and can move the price of the asset by a fair amount, it has very low liquidity – i.e. illiquid
   1. The most liquid asset is cash – as it is the medium of exchange used in transactions – you use cash to buy share, property, pay your rent or food at the supermarket – cash is pure liquidity, as you cannot use your share to buy a property with – you first need to sell the shares and convert this into cash
   2. Beyond cash – shares and bonds are some of the most liquid asset classes – but this depends on the supply versus the demand for the asset, as you can have shares and bonds that are illiquid as well – but as an asset class goes, they are relatively liquid when compared to an assets like property
2. let’s look at shares to break down liquidity – Take some examples on the ASX –
   1. BHP is number one at the moment – Market cap of $236bn – Daily traded volume of 10m shares – at a price of $46 – this is a total value of $460m is traded each day on average – which seems like a lot – but based around their size, this is only 0.2% of their market cap
   2. Compare this to another large company – take Medibank – 67^th on the ASX with a market cap of $8bn – Daily average volume of shares is also around 10m, similar to BHP, but at the current price of $2.9 this is a total value of $29m is traded each day on average – and based around their size, this is 0.36% of their market cap – whilst the daily value traded is small compared to BHP, around 16 times less, it is more as a percentage when compared to BHP – almost twice the amount at a percentage – meaning they can be slightly more volatile, when compared to BHP shares – as the movement of more shares each day could increase the price volatility
   3. Or JB-HiFi – 100ths company – Market cap of $4.8bn – Daily average volume of shares changes from around 514k, so at the current price of $44 this is a total value of $22.5m is traded each day on average – and based around their size, this is 0.47% of their market cap – whilst this is still small as a percentage of their total shares outstanding, it is increasing as a percentage, also increasing their volatility slightly
   4. The further down the list you go, it is typical to see that shares become less liquid – as $500m worth of trade orders for JBHIFI could move the company 30 to 40% in price – but for BHP this is an everyday event and normally only moves the price by a percentage point here or there –
   5. But an interesting event occurs at the micro-cap end of the share market – some days the price of certain shares don’t even change in price – this is because nobody is buying is selling this investment – this is an illiquid share – as a small sale can move the price by a fair amount as there is nobody on the other end looking to buy the asset – this is the important part about liquidity in markets – it is a two way street – many people buying and selling an asset makes it liquid – many people looking to buy but nobody selling, or everyone selling and nobody buying makes it have low liquidity – when nobody is on the other side of the trade at the price you wish to buy or sell, the price at which you want to buy or sell has to change to match those on the other side of the trade – this can result in either picking up a barging or losing a lot of money
3. These have been some examples picked out of a hat for these shares – to illustrate liquidity
   1. But the same sort of principal works in regards to Fund redemptions –
   2. You want to sell your units in a managed fund or investment trust – well, the manager then needs to meet your redemption request – if they don’t have enough cash on hand to meet your sale order, they need to sell your allocations worth of the underlying investments to do so
   3. Therefore – if it is a large cap share manager – your sell orders probably won’t affect the market and you will get your money out in a timely manner
   4. But say for example that all investors are running for the door, wanting their money back through trying to sell small cap shares or illiquid property investments – then if they hold a large percentage share of the allocation, this can create above market losses – as investors demand for the sale are pushing prices down further – as nobody is on the other side of the trade at current market prices
4. Where this gets interesting and comes back to the main topic of this episode – what if the underlying investments are in an illiquid investment – say property
   1. Many examples of liquidity issues were seen in the GFC in relation to debt based or property-based funds – many funds that had high levels of gearing were frozen due to the liquid assets held by the investment trusts not being able to meet redemptions
   2. A type of these investments is a Real estate investment trust – REIT for short – operates as a fund where investors can access property allocations by pooling their investments with others
   3. The issue with this type of investment structure is due to the illiquid nature of the underlying investments in conjunction with the level of gearing – if say the fund holds 5% of its assets in liquid cash, but 95% is tied up in property – but on this property there is leverage – say these properties are leveraged at a 50% rate – a fund worth $110bn might have $5bn in cash, $210bn in equity (property) and $105bn in loans on the property – again assuming the properties are sitting at a 50% LVR, which is normal for the funds
5. Now – lets say that investors are wishing to withdraw their funds – 10% of investors want out – this is a total value of around $11bn that needs to be withdrawn – but this is a gross value of $22bn with the LVR – but when a loan is present against these assets, the loan value stays the same – this means that the liquid cash is quickly eaten up – and there is still $6bn of funds outstanding for redemptions – this means that to meet this redemption, some of the property holding need to be sold
6. If the market is going down, then the valuation on these properties is also an issue – as what was worth $210bn in property is now might only be worth $170bn, assuming a 20% decline – this further compounds the issue of redemptions, as the fund is still left with $105bn of loans, but now they need to sell some of their property allocation to meet the remaining $6m of redemptions – the investors take a hit in line with the property values – so investors may only get $5bn back – but the fund is now left with $160bn in assets and $105bn in loans – LVR is sitting at 65% – now other investors start to panic – the fund is left with no liquid assets – needs to sell more
   1. Think of it as a form of bank runs – the banks under the old system, which we are no longer under, used to have to hold deposits at a ratio of around 10 to 1 – so if depositors wanted their money back, this often was lent out – and this created a liquidity issue – the banks weren’t insolvent, as they has 9 times the deposit in assets – but they couldn’t easily redeem the loans to meet their liquidity issues
   2. The underlying investment though do need to be relatively liquid assets to meet redemptions – harder to recall loans or sell property
7. Recent Example of Blackstone – this company has been in the news over the last few years due to their practice of purchasing large amounts of properties across the US

One of their flagship funds is BREIT – Blackstone Real estate investment trust created BREIT in 2017

1. Way for wealthy investors to gain access to real estate investments – through unlisted investments
2. Unlike its traditional funds designed for institutional investors like pensions, that came with 10-year lives, BREIT was designed as a “perpetual” fund with no expiration.
   1. invested the money mostly in logistics and multifamily US residential real estate – which was predicted that supply shortages would propel rising rental income
3. The portfolio now stands at $125bn in gross assets, which includes leverage Blackstone has used to purchase property – on this Blackstone would charge a 1.25% annual management fee and a 12.5% performance fee on its annual profits – representing about 10% of its fee-paying assets under management
4. The selling point is to diversify away from public markets and receive healthy dividends – to do so, they would have to accept giving up some liquidity rights
   1. The fund allows for 2% of total assets to be redeemed by clients each month, with a maximum of 5%
   2. Liquidity limits help to avoid the previous example – as it gives time for new investor money to come in to pay out investors wishing to redeem their assets
5. What is very interesting about this fund is that the year-to-date returns are sitting at about 9% – this is exceptional – how can this be?
   1. See – BREIT isn’t liquid – it is private – aimed at HNW – it doesn’t have the same level of disclosures – so whilst similar funds with underlying holdings had lost 20%+, this fund was still up by around 9% – a difference of almost 30%
   2. Maybe investors either wanted to exist their position before the fund followed course – or their felt like something fishy was going on – reports came in that some investors were leveraged in other assets and hit with margin calls, so selling other assets to meet these calls – either way – people wanted to sell BREIT
   3. Back in July – Redemption requests of more than 2% of the fund’s net assets that month – but this exceeds the threshold set on investor withdrawals – as the PDS does disclose the product is only semi-liquid
   4. But a growing tide of redemption requests month to month forced BREIT to announce that it would pause investor redemptions – no longer meeting their redemption rates of 2% p.m.
6. As BREIT is one of the biggest engines of growth and fee generation that Blackstone have, markets didn’t respond well when this was announced – with Blackstone’s shares falling by more than 7% and downgrades on the outlook on the company – as it may reduce their ability to raise money from wealthy investors in the future
7. The interesting psychology behind the decision to stall investor redemptions may intensify investor demand to pull their money from the fund – but it brings up an interesting question – are they hiding something, or doing this out of the best interest of their investors?
   1. Looking at the first option – that they are trying to hide something – rush for the exits has come before BREIT reported any financial hit from rising interest rates, a slowing economy, or falling property valuations.
      1. This is a private investment – and they employ people to value the properties on their books doesn’t have the same scrutiny as publicly listed investments – lack of disclosure requirements –
         1. This is speculation – but those employed to value the properties may want to keep their jobs – as a third-party contractor to Blackstone – so may have a more favourable assessment than the market would
         2. Alternately – Blackstone may not have updated the valuations for the year yet
      2. Many public REITs on the market have already dropped by 25% to 35% over the past year – Most REITs are leveraged, and drop more than property prices do in their unit pricing due to this –

• The Blackstone REIT holds many assets in the American southern belt, for which equivalent REITS have lost around 30% in value

1. It does raise some questions – as Blackstone says its valuations emphasise the underlying financial performance of its properties – but financial performance of has little to do with market values when panic selling kicks in

1. The second option is that they are acting in the best interest of all their investors – not just ones first out the door with redemption requests – the limitation on redemptions will stave off any risks of fire sales at a loss
   1. Blackstone have already announced a $1.27bn sale of a minority interest in two Las Vegas casinos owned by BREIT – these have been used to already support the fund’s liquidity – in total the fund has sold around $5bn in assets this year
   2. They have announced that BREIT is considering other asset sales, but insists it will not be a forced seller now due to the freeze on redemptions

• But Blackstone is still ahead – on paper – which is why investors want their money out – as they have losses to cover elsewhere – if you are getting a margin call and need an extra few mil to cover this to avoid selling at a 20% loss, and one of your investments is up 10% in a down market – you take the money from there – but now that investors are locked out from these funds, it could put some of these investors in a bad position

1. However – this doesn’t mean that all investors are in this boat – so the decision could have been around “why should most investors have to pay for the need of cash from others?” – the fund was advertised as an illiquid investment after all – therefore, if no redemptions are made, then a death spiral of the fund can be avoided

Looking further down the line = the major issue is that if this is not an isolated issue or if the valuations are more favourable than the market

It comes down to confidence and risks – if the assets are high risk, but investors have confidence they will survive the storm, then investors may be less likely to run for the doors and try to get their money out first in an illiquid environment

But even where investors have low confidence in a low risk product – like cash at the bank – this can lead to a situation where those that weren’t first in the door can lose everything

In summary – This issue with BREIT isn’t anything to worry about at this stage – unless you have money tied up in this product that you desperately need

1. What may create a problem is if other property funds that are not for HNW pause redemptions