When Your Fund’s Returns Look So Good and Your Peers Look So Bad

One-time Chairman of the Nasdaq Stock Exchange Bernie Madoff managed to successfully attract many prominent and wealthy people to invest into his gigantic Ponzi scheme partly because of a unquie historical track record.

The fund delivered good returns with little drawdowns or volatility.

The table shows the month-by-month and annual fund performance associated with Madoff.

Many investors are looking for decent returns with minimum drawdowns. Just take a look at the lowest month’s drawdown. This is truly a sleep-well-at-night portfolio.

This is the holy grail in investing that many people want to find and some spend a long time continue to try and find such. They been disappointed by what they found, lost money, but are still tethered to the concept that low volatility and high returns strategy still exist.

I think some do not get that the reason that a large premium to risk free returns can come about because there exist risk in some forms and that it requires the investor to deal with some kind of uncomfortableness.

Perhaps some refuse to accept that.

In the same way, many are attracted to private equity because they find the historical returns presented good and with little drawdown in the value of their investment.

Business Insider has an investigative piece by Bethany McLean on Blackstone Real Estate Income Trust or BREIT for short. You can read it here. Bethany is famous or infamous for writing a few investigative pieces including one on Enron, Overstock, the governance at Fannie Mae and Freddie Mac and the fracking revolution.

I remember the first time I saw the historical performance of BREIT perhaps a couple of years ago. For someone who have written so much on publically traded real estate investment trust (REITs) (you can check out my dedicated, but outdated section here), the performance of almost no calendar year drawdowns was astounding.

Even more so if they can maintain a good performance during the last couple of years, which have not been kind to commercial real estate.

A big part of what Bethany wrote about discusses about the lower mark-to-market frequency of the assets on the fund, compare to public markets. This is a feature of private equity and may be a feature why investors, or institutions favor them.

I always wonder how people will feel if they see their investment:

1. Show better than other people’s returns.
2. When other people own similar stuff but not fetch the same value as your stuff.
3. But you don’t know the value of your stuff at this current point.

Does anxiety build up or do people feel good that they have a winning investment?

I some how think that if an investment is less tethered to fundamentals such as risk and return, a lot of trust is involve here.

Anyway, here are my short notes. I think most cautious wealthbuilders may find some of the questions that Bethany brought up to be good considerations when thinking about your own private equity investments or your publically traded real estate investment trusts. I personally think that the truth is somewhere in the middle.

Also, if you are familiar with private equity investments or in the space and have some strong views, please feel free to comment. Thank you.

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Blackstone created the Blackstone Real Estate Income Trust (BREIT), and it became one of the most popular investments out there because:

1. It allows ordinary investors an opportunity to gain Blackstone’s expertise in real estate.
2. Gives an annual dividend yield of 4% in a world where interest rate is close to zero (a few years ago)

BREIT portfolio:

And performance:

So What is the Big Deal Around BREIT?

1. It’s attractive proposition allowed it to grow the AUM to $114 billion today.
2. This is 8% of Blackstone’s entire fee-earning assets and generates over $5 billion in management and performance fees. It means a significant chunk to the bottom line.
3. But after the pandemic, the commercial real estate sector is pretty beaten down but yet… BREIT still show very pristine investment performance.
4. Upon seeing the rapid raising of rates, some opportunistic BREIT investors decide they want out of the fund.
5. But as more and more investors want to take money out, BREIT faced a “run on the fund”. (About $15 billion redemption to date)
6. BREIT cited a provision that allowed the fund to take its time to refund pissed-off investors.
7. Now… imagine if the fund deliberately slow you don’t from taking out the money… what does that look like to you? Would you be more worried?
8. BREIT could only fulfill the redemptions after raising new cash from investors. The university of California decided to invest $4 billion into the fund only after BREIT agreed to award the university an additional $1 billion in stock in the event that the fund’s rate of return fell below 11.25%.
9. Last year (2023), BREIT failed to generate enough cash to cover its annual dividend.
10. Blackstone share price tumbled during the period when investors could not get money out of the fund, but have recovered since.

There are still a lot of naysayers about BREIT. Some of it is about the private equity structure that does not need to mark-to-market:

1. Many analysts, accountants and investors think that the value of BREIT is based on BREIT’s own estimate. Skeptics believe the value is wildly inflated (most likely in light of recent commercial real estate valuation changes).
2. Some believe the fund’s survival is contingent on real estate recovery. (Kyith: but this can be said for almost any asset class that what drives their returns fundamentally must do well!)
3. Economist at Securities Exchange Commission (SEC): “Surveying some of the ways that Blackstone has misled investors over the past five months, we are more convinced than ever that BREIT is a bad investment created for the benefit of Blackstone. Investors should not accept anything Blackstone and BREIT state as truthful.”
4. BREIT adjusts its NAV monthly.
5. BREIT doesn’t let investors or regulators see some of the crucial assumptions that go into calculating its NAV. The methods used to calculate it are “not prescribed by rules of the SEC or any other regulatory agency,” and the NAV “is not audited by our independent registered public accounting firm.”
6. Chilton Capital Management, which invest in public REITs, analyze the way Blackstone adjust the value of BREIT. Since multifamily housing, and industrial buildings prices have came down sharply, the value of the properties in public REITs have come down. But BREIT value still held up! Chilton figures BREIT is overstating the value of its NAV by more than 55%.
7. The economist at SEC, now working elsewhere, reached a similar conclusion. The properties in sectors similar to BREIT went down 30% yet BREIT claimed its value INCREASED during the same period.
8. Blackstone in its defence, say their performance is better because they own better assets than their competitors. Their assets are concentrated in the best performing sectors (data centers, logistics and student housing). BREIT owns only 3% of office buildings, which felt the most pain.
9. It is hard to see how BREIT selection is so good they avoided the fall in property prices.
10. The sectors cited, data centers and student housing, make up only a small part of the portfolio.
11. Other private real estate funds market value were also marked down. Bluerock Total Income + Real Estate, which has over $300 billion invested in a host of institutional real estate funds, has marked its NAV back to pre-pandemic levels — down more than 20% from its peak. Other major investors, unlike Blackstone, apparently don’t see their real estate holdings as immune from the chaos buffeting the rest of the market.
12. Overvaluing the value of BREIT clouds BREIT investors or prospective investors from accurately assessing how much to pay for this portfolio, the potential return and the margin of safety in their investment.
13. Another problem of overvaluing the properties is that you cannot sell the properties as selling off will create a valuation event, which will let everyone know the value of the properties are much lower than what it is stated.
14. While BREIT managed to secure $62 billion in debt at an effective interest rate of 4.3%, they have $47 billion in debt due in the next four years that has to be secured to reasonable rates.
15. BREIT claims that as of June 2023, 100% of dividends are funded by cash flow from operations but those have not deduct expenditures required to maintain properties.
16. In this fine print, BREIT does provide metrics how the typical REIT define cashflows. Going by these measures, BREIT has never be able to cover its dividend from its cash flow.
17. If we subtract the fees earned by Blackstone, BREIT covered less than 50% of its dividend distribution since inception.
18. The management fees are paid in units.
19. The reason why BREIT can still pay distributions is because half of all shareholders have elected to receive their dividends not in cash but in more BREIT shares.

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