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.