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.