Tuesday, May 15, 2007

Taking from Rich to Pay Uncle Sam? AIG Expects a Slap on the Wrist from the OTS.

Will AIG use its profits from the Blackstone Group LP IPO to pay the costs of complying with the guidance issued by the Office of Thrift Supervision? In 1998, American International Group (AIG) acquired a 7% interest in the Blackstone Group for $150 million. According to analyst reports, if the Blackstone IPO goes as well as planned, AIG’s stake in the Blackstone Group will add approximately $2.8 billion dollars to the company’s bottom line.

Things were going well for the self-proclaimed world’s largest insurer and one of the largest sub-prime mortgage lenders until US federal regulators started investigating the sub-prime mortgage industry’s aggressive lending practices.

Last March, five US regulators, including the OTS, proposed new guidelines citing concerns that sub-prime borrowers did not understand the risks associated with their mortgage loans. According to a Business Week expose titled, “The Poverty Business:
Inside U.S. companies' audacious drive to extract more profits from the nation's working poor”:

“The recent furor over subprime mortgage loans fits into this broader story about the proliferation of subprime credit. In some instances, marketers essentially use products as the bait to hook less-well-off shoppers on expensive loans.”

According to the Financial Times, AIG is in discussions with the OTS over sub-prime mortgage loans made by AIG Federal Savings Bank, a subsidiary of AIG, over the last three years. The lender expects to pay a $128 million fine in relation to its aggressive sub-prime mortgage lending practices. An undisclosed AIG spokesperson, quoted in the article, said,

“Management expects that the application of underwriting criteria developed in consideration of regulatory guidance issued by the banking agencies will result in significant costs to the domestic consumer finance operations.”

Before we start feeling sorry for AIG, let us consider the following:

AIG’s book value is estimated at $102 billion. Jim Albers, an analyst with Victory Capital Management, is quoted in a recent Reuter’s article as saying about AIG, “It’s so huge that a $2.8 billion gain doesn’t look that big.” In other words, the gain relative to the book value is inconsequential. If $2.8 billion “doesn’t look that big,” then surely, $128 million is no cause for concern. Relatively speaking, would it not be great if we could all mend our more questionable business practices at such a low cost?

Tuesday, May 8, 2007

“Who’s Afraid of the Big Bad Taxman…Blackstone?”

Apparently, the Blackstone Group has reason to worry. Last March, Blackstone, announced it was going public as a $40 billion tax-favored private equity partnership. It is impossible to tell for sure, given their hush-hush nature, but according to reports, Blackstone’s principals may have foreseen the taxman's arrival and decided to cash out early. Or so they thought. (For more on the tax implications of Blackstone's proposed partnership structure, see the posting “The Taxman Cometh…But Only for Some” and Victor Fleischer's blog.)

Indeed, conditions are looking a bit unfavorable for private equity firms. Newspapers, from the Wall Street Journal to the Financial Times, are reporting on a growing flurry of activity in the U.S. Senate around increasing the tax rate paid by private equity fund founders and partners on their 20% cut of the profits from their investment funds. If the Feds decide to tax carried interest as income rather than capital gains, partners could see their tax bill more than double.

Is this a good thing? The jury is still out, but the prospect of a change in the carried interest tax rate seems to have spurred other private equity firms to follow Blackstone’s lead. Last week, TPG announced it was considering selling a 20% stake in itself to pension fund investors. Are we surprised that TPG would react to Fed activity much in the same way Blackstone did a few months ago, and try to cash out before any higher tax rate hits?

Unfortunately, for private equity firms, Senate deliberations are bringing the tax-favored private equity partnership IPO escape-hatch into question. Buyer beware is the news of the day for investors. According to the Financial Times, the Blackstone “IPO prospectus warns potential investors of the possibility that its bid to be treated as a partnership could fail,” if the Feds decide to treat the partnership as a corporation and tax it accordingly.

Moreover, to complicate matters for private equity firms, the Senate has started to meet with financial experts, like Law Professor Victor Fleischer of the University of Colorado, who are concerned that private equity firms, like Blackstone, put investment banks, like Goldman Sachs and Morgan Stanley, at a competitive disadvantage. Professor Fleischer argues that the partnership structure gives private equity firms an unfair tax rate advantage over investment banks whose traditional corporate structure subjects them to a higher corporate tax rate.

TPG and Blackstone aside, an unjust tax code – one that favors one type of business over another – has the potential to undermine true competition. The fact that the Senate is conducting a thorough inquiry into tax policy affecting the private equity world can only be a positive thing for everyone.

Thursday, May 3, 2007

The “E” Word Just Keeps Coming Up in Relation to the Brookstone IPO…

The Blackstone IPO filing just continues to be a font of information about how the mega-fund operates, but if the devil is in the details a lot of analysts are having a heck of a time figuring out how to estimate the potential profitability for investors. For some, their proposed use of “fair-value option accounting is setting off Enron alarm bells. See, for example, Keep an Eye on Blackstone's Valuations and Enron-style Accounting Under Scrutiny in U.S.

Tuesday, April 24, 2007

Using Fuzzy Math to Calculate What is Fair

Didn’t fuzzy math go the way of the crooked “E”? Back when the smartest boys in the room were booking unbelievable profits, Enron relied on what is referred to as “fair value” accounting. Spring is here and it seems that Blackstone thinks that practice is back in vogue. A recent piece from the WSJ highlights how Blackstone plans to adopt this accounting practice once it becomes a public company. Fair value accounting would give Blackstone full discretion in deciding what its investments are worth and consequently, what performance and management fee revenue it can book in interim periods. The problem with this practice is that most of those investments are very illiquid and coming up with some fair market value can quickly become an exercise in subjective self-affirmation. “Good job Mortimer! Good job Randolph!”

How many of us couldn’t have used a “fair grade” system in college. Imagine it, our professors would have trusted us, and let us give ourselves a mid-term grade based on how we thought we’d do on the final exam at the end of the semester. So much for being merit-based. This is the same concept, except with dollar signs and IRR figures instead of a GPA. According to the WSJ, even accounting experts express doubt that Blackstone’s intentions are sound. All of this should remind us of the KISS principal. Earning an honest buck shouldn’t be so complicated. Or is that being too na├»ve? Is it the machinations that allows one to make a buck in today’s world? What would we call this, “Smarts Arbitrage” or “Hired Gun Arbitrage”? I guess the rest of us should have studied harder for those mid-terms . . . or stumbled upon fuzzy math sooner.

Tuesday, April 10, 2007

Private Equity Feasting at an "All You Can Eat" Debt Buffet

News came in yesterday that private equity has so far raised more than $35 billion this year for buyout deals. That will make for a nice down-payment for a lot of big deals, which would lead to a lot of new debt. While many speculate on how legislators on the Hill will address the question of how to tax private equity profits, others are looking at where these firms get the money to make their deals. Specifically, what are the ramifications of buyouts that depend on high levels of debt?

Standard & Poors warns that the debt levels of European private-equity deals means there is a one in five chance that companies taken private using debt financing will go into default and CNBC’s David Farber recently reminded readers about the 1989 deal that nearly bankrupted its creditors. So why are financial institutions lining up to finance these deals with leveraged loans that require few, if any, covenants? (Remember, Blackstone's record-breaking $39 billion purchase of Equity Office Properties, for example, included $16 billion in debt.) Some suggest that the handsome fees investment banks earn for their advising services might be one answer. The fees to advisors in the Equity deal totaled $75 million, and Bloomberg calculates that banks stand to collect over $2 billion in fees for deals announced in the last few months alone. As Goldman Sachs CEO Lloyd Blankfein is reported to have said recently, if a company wants to be an advisor on these deals, "one of the consequences of that is we will have to do more financing in addition to the advice we give."

With the deals getting ever larger, feasting on cheap debt, we are left wondering who is going to have to pay the tab if private equity’s plans to create value in their portfolios don’t pan out. The availability of easy credit and the lowering of underwriting standards led to the current collapse in the subprime mortgage market, are we to see the same with private equity?

Wednesday, April 4, 2007

APOLLO...are you cleared for takeoff?

It appears that Blackstone’s proposed IPO and the investment practices of its private equity brethren are now deserving of their own section in the New York Times. Today's edition includes a full Special Section on the DealBook, with a cover story looking at all the cash that is fueling leveraged buyouts. This acknowledgement by the NYTimes that private equity is on the mind of the modern-day average Joe is likely not lost on Blackstone's Stephen Schwarzman or the other "Masters of the Universe" whose business ties are mapped out by A.R. Sorkin's team.

Today's news that Apollo Management, another leading private equity firm based in New York, is exploring going public, only validates concerns that these investment firms are seeking to get out while they still have chips on the table. Private equity firms, like other cohorts in the financial markets, tend to graze in herds and move from grassy knoll to grassy knoll. Fortress kicked off the IPO train and others now feel compelled to get on the tracks. One posible motivator for Apollo Management is worry that investors looking to participate in a private equity IPO will quickly have their appetites satiated by the Blackstone IPO and not want to take another bite of the same apple. If that is the case, we should not be surprised to see other mega-cap private equity firms come out from behind the shed and make their intentions clear. Seems a bit like the political tarmac that continues bringing new presidential candidates to the American voter, or in this case the American investor.

Friday, March 30, 2007

The Taxman Cometh...But Only for Some?

Today Bloomberg reports that the partnership structure Blackstone is proposing in its IPO could give it a tax advantage over such rivals as Goldman Sachs and Morgan Stanley. This is just the latest of the tax-related questions that have come up around the public offering. Last week on NPR's Marketplace, Alan Sloan noted the complications common shareholders might have accounting for Blackstone shares on their own tax forms; a challenge Blackstone itself noted in its filing, stating "Our counsel has not rendered an opinion on the state or local tax consequences of an investment in our common units," and informing potential shareholders that they "should anticipate the need to file annually a request for an extension of the due date of their income tax return" because the firm anticipated delays in furnishing tax information in time. (For more analysis of the tax implications of Blackstone's proposed partnership structure, see Victor Fleischer's blog at http://www.theconglomerate.org/2007/03/blackstone_ipo.html)

Of course, this debate pales next to that over the overall tax structures that private equity firms operate under, specifically questions about whether the money firms make on the "carry"--or their share of the profits of the fund, typically 20%--should be taxed as capital gains or income tax. Private equity firms stand to lose a lot of money if Congress decides to clarify the law and treat their carry as income (taxable at 35%) rather than as capital gains (taxable at 15%). Avoiding such a hike could be one of the reasons that Blackstone wants to make a public offering now. Stay tuned for responses from politicians, potential shareholders and everyday taxpaying Americans.