BlackRock's Valuation Business

This morning's Wall Street Journal featured an article in the Money & Investing section on BlackRock's valuation business. Referring to it as a "geeky guys" business, the piece actually confused me to some extent.

By way of background, when I was an internal strategy consultant/troubleshooter at Chase Manhattan Bank, working for my late boss and mentor, Gerry Weiss, the bank's market data and tools unit, Interactve Data Corp (IDC) was one of my charges. I spent quite a bit of time helping them grapple with product and market development issues and, later, worked to put down a mutiny led by the unit's head, who told his staff that he would force a sale of the unit to him and private equity backers.

I well recall how the unit's chief administrative officer referred to their bond matrix valuation service,

"Customers have a choice- we're wrong and Merrill Lynch is biased."

The point was not lost on me.

Bond matrices were essentially multifactor valuation models purporting to estimate the value of infrequently-traded securities by comparing their attributes to those of securities with some of the attributes, combining to hopefully predict a reasonable valuation with some connection to more-frequently-traded securities.

IDC didn't own an inventory of the bonds, as Salomon Brothers or Merrill Lynch did, so it wasn't able to provide valuations based on as rich a data set as Merrill. But Merrill Lynch was obviously biased in its valuation, since it was consulting on securities which were probably in its own inventory.

You can instantly see the same issue at BlackRock. And why the Journal article is clearly influenced by BlackRock's unit's head, Rob Goldstein, to emphasize a Chinese wall between his BlackRock Solutions and the asset management portions of the firm.

Gosh, they even have different elevators! Bet that's foolproof, huh?

It was confusing to read that this was supposed to insulate Solutions from "other parts of the firm that could profit from its knowledge," because I would think the reverse is the actual problem. Solutions provides somewhat sterile valuation information for which traders probably have their own preferred approach. But the Solutions staff would undoubtedly benefit from knowing trading information from BlackRock's asset management activity, and the article is silent on this directional information flow.

Getting past that, and the other details meant to reassure Journal readers that BlackRock really did consider this issue years ago, when it was founded as a separate and separable unit, the piece goes on to highlight the sort of dark assignments the unit has received from the Fed, other central banks, pension funds and even commercial banks.

The article also calls Solutions the risk-management division of BlackRock, too.

Risk management is typically more complex, as it seeks to impute the risk of loss to positions, trading desks and/or larger business units. The focus is on the volatility of valuations of the securities in a position or portfolio.

Valuation involves trying to determine a reasonable market value of a security, position or portfolio, when there are infrequently-traded or non-public securities involved.

But, according to the Journal article, these two services are offered from BlackRock Solutions, which earned revenues of $460MM last year, or 5% of the firm's $8.6B total revenues, with 1,850 people. That's revenue of roughly $250K/person. It leaves little room for profit, considering that risk management talent can be fairly expensive.

So if it doesn't make much money absolutely from this unit, why would BlackRock bother with it? The margins may be much higher than those of publicly-held asset managers, but the relative revenue volume is so small as to make that margin rather insignificant.

Well, maybe it has something to do with a point made obliquely in the article.

BlackRock may profess to have erected a Chinese wall inside of the firm. But that has nothing to do with what may happen outside the firm. Consider the following.

Pension funds like Calpers typically retain some of the best hedge funds to manage all or parts of their investment portfolios. The investment committees of those pension funds don't have the skills to do the actual work of daily investment management, nor risk management.

From the Journal piece, we also know that Calpers has retained BlackRock Solutions. It's not a stretch to envision the California pension giant retaining both parts of BlackRock. And perhaps even discussing the Solutions findings and models with BlackRock's own investment arm, as the client has paid for advice from both units.

Such flow of information from the client's portfolios through Solutions would be completely expected. And BlackRock investment managers could easily be privy to Solutions' tools paid for by Calpers.

It's an interesting twist or solution to an old Wall Street problem- how to get clients to pay for activities that don't seem to directly produce revenue for the firm.

If BlackRock used Solutions activities for its own traders/investment managers, it would probably have to absorb the costs as part of its management activities, because such management business is competitively bid.

But by offering valuation and risk management through a separate unit, it can get clients to pay for services, the value of which, if BlackRock also manages money for the same client, it will probably realize for free.

That said, it's useful to consider a larger issue involving asset managers selling auxiliary services such as risk management and valuation to their clients.

BlackRock is a publicly-held asset management firm.

Thus, you don't read of BlackRock in the same articles in which you read about Renaissance, AQR, or the other firms which were the focus of Scott Paterson's book (The Quants) last year. And BlackRock wasn't considered endangered by the financial meltdown of 2008, as it is both publicly-held and, thus, doesn't have huge pools of partner capital bet in a leveraged fashion.

Still, given the movement of people, ideas and technology among various asset management firms of various organizational stripes- private equity, hedge fund, or publicly-held- it's hard to believe that BlackRock's valuation and risk management services would be very much different or better, or for very long, than those of its competitors.

Hedge funds wouldn't bother to sell their own risk management and valuation services to clients, because, well, they don't really consult with their clients on these issues. But we know, from Paterson's work, that at least a few quant hedge funds nearly went out of business due to inadequate risk management and it's apparent poor implementation in trading.

BlackRock won't go out of business due to its own capital losses if its risk management advice is either of poor quality or badly-implemented. Their clients may lose assets, but BlackRock just loses income and, perhaps, clients.

But it's interesting to try to understand how its risk management tools, employed by some of its largest clients, won't contribute to market valuation effects, given how much money the firm manages. Or how its valuation opinions won't, at moments of maximum market stress, also effect markets.

Those effects nearly wiped out a few hedge funds several years ago. Now we learn that a competing asset management giant sells those services to clients, but not at prices that suggest BlackRock even makes much money from the effort. Margins

As its parent is managed by some very intelligent people, one assumes there is substantial value in operating BlackRock Solutions. If it's not in the operating income, where is it?