Why Traditional Bond Managers Should Pay Attention to This Blackstone Deal
With the purchase of DCI, the private equity giant is quietly transforming the credit business.
When Tim Kasta, CEO of DCI, first met Blackstone Credit’s Dan Smith in the summer of 2019, he pitched Smith on the idea of subadvising investments for the firm’s growing insurance business.
Blackstone, like many of its peers, has been expanding from its historic footprint in complex and opportunistic investments like mezzanine debt, energy, and direct lending into managing the more conservative portfolios of insurance companies. Kasta thought Blackstone would want to outsource the management of these investments, primarily bonds of publicly traded companies, to a firm with which it didn’t compete and to one of the few asset managers that had a systematic approach to analyzing credit.
He was wrong. Blackstone wasn’t interested in outsourcing. (It rarely is.) Smith, head of liquid strategies for the $149 billion credit arm of Blackstone — formerly GSO Capital Partners — quickly turned Kasta’s proposal on its head and pitched him on the idea of DCI becoming part of Blackstone.
Here’s why: With DCI — whose predecessor firm KMV dates back to the 1980s and whose founders solved some of the earliest academic problems in understanding defaults — Blackstone could immediately scale the management of high-yield and investment grade credit of U.S. and international companies and emerging markets bonds without having to hire an army of analysts. Blackstone’s aggressive push into insurance, whose management fees are lower than other products, but also steadier, depends on its ability to manage corporate credit. But the firm has also recently pushed into liability-driven investments for corporate pension plans. Buying DCI would differentiate the alternative credit shop from the PIMCOs of the world.
“We could manage a lot of capital in that strategy and not necessarily have to continue to ramp up a huge amount of additional investment infrastructure. This is a great way to attack the more liquid, more competitive — and lower fee — part of corporate credit markets,” said Smith, who oversees, among other things, commingled credit funds and separate accounts, collateralized loan obligations, and closed-end funds.
Smith said there are about 600 managers of high-yield products and even more in investment grade. “A lot of them are very big, many have long track records, and as a result it is a very competitive business,” he added. “If we want to compete in that business, we wanted to do it in a way that is differentiated in terms of approach and track record and have a business that stands out from the masses.”
Several consultants, who didn’t want to be named, said Blackstone and the other publicly-traded private equity firms are shaking up the business of traditional fixed income managers, many of which have long counted on insurance company mandates and corporate pension plans to balance out their higher cost retail clients. Many of these managers have already been hurt by years of low interest rates, which have sent clients searching for higher-yielding alternatives like private credit.
DCI Needed a Partner Too
In late November, Blackstone announced the deal to buy $7.5 billion asset manager DCI, whose founders include Stephen Kealhofer and Mac McQuown, who started the first index fund at Wells Fargo and later co-founded Dimensional Fund Advisors. Speaking to II, Kealhofer recounted the struggle to get enough data on defaults so people could estimate default probabilities. Up until the late 1980s, “people thought if you went from a triple-B to a double-B, that your default risk went up 20 percent, but we found no, it doubled.”
Even with this high-profile pedigree, DCI needed a partner with scale and a well known brand. “The world advances by measurement. That’s our business. So this creates a much bigger sand lot for us to put our measures into more places,” Kealhofer said.
Meanwhile, the addition of DCI is helping Blackstone Credit transform alternative credit. The firm’s fundamental managers will be able to use the models and default probabilities, in addition to their research-driven process, to help them evaluate loans.
The credit unit is linking its proprietary database of private company balance sheet information to DCI’s models. That data set is rich. Blackstone Credit has about 85 percent of the universe of private leveraged loan issuers (or those that don’t have outstanding public funds or equity) in its database. Smith said as a result that the universe of private companies in the high-yield market, about 40 percent, will be fair game for high-yield strategies that are driven by the model.
“That was one of the challenges at DCI on the private side,” Smith said. “Where do you get balance sheet data? If you are not a lender [to these companies] you’re not getting the financials.”
DCI will also be able to incorporate Blackstone Credit’s fundamental views on sectors and industries, and include overweights or underweights in the models. Now that Blackstone Credit has very liquid, systematic strategies, it is researching how to use them to better manage cash-like positions in its funds. It is also thinking about new ways to address certain products and markets, such as the exchange-traded fund, a traditionally managed loan ETF, it manages with State Street.
DCI Is Systematic — But It’s Not a Quant
Critical to making the deal work was an understanding that DCI is a systematic manager, not a quant firm. It’s also not looking to exploit common style factors like size or momentum.
“Quant tends to mean statistical: finding relationships that may not have any fundamental basis,” said Kasta. For example, if a lot of overweight people drink diet soda, there’s a correlation between the two — but that doesn’t mean those drinks cause obesity.
“We’ve figured out how to measure default probabilities that are quite accurate and timely and importantly what causes a firm’s default risk to change,” Kasta said. “It’s a cause-and-effect structural model of default risk. We show investors why did Firm XYZ improve? Or get worse? How much worse? What does that mean?”
From the start, Smith understood that both firms were doing the same fundamental credit work and would complement each other once a deal was done and the parties were working together. It’s just that DCI was analyzing proprietary data and outcomes mathematically.
“The core focus for both DCI and Blackstone Credit is trying to evaluate the credit-worthiness of companies and then identify those debt securities that are mispriced or a good value relative to the actual risks,” he said. “In other words, we share the same last name – Fundamental credit, but we’re just from different branches of that family.”