A question of carry

Last month, public market investors valued The Blackstone Group at $33.6 billion. The IPO, which raised $4.1 billion for the firm, came amid a firestorm of criticism from labor leaders and concern from lawmakers, some of whom took umbrage to Blackstone's structure as a partnership.

Going forward, Blackstone and its new set of shareholders will have to steel themselves for possible new legislation that may affect, among other things, the tax environment in which the firm operates.

The existing rules for publicly traded partnerships have already proved a challenge for Blackstone and its team. In the weeks leading up to Blackstone's actual trading date, which finally occurred on June 22 (its IPO was reportedly seven times oversubscribed), one aspect of its SEC filings was particularly interesting ? its decision to early adopt Statement of Financial Accounting Standards No. 159, then two months later, a reversal.

SFAS 159 allows firms to measure the financial assets and liabilities of the management company at fair value. The first paragraph of SFAS 159 reads: ?The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. This statement is expected to expand the use of fair value measurement?? SFAS 159 was approved in February 2007 and becomes effective for fiscal years beginning November 15, 2007.

Blackstone's initial S-1 filing for public securities, filed on March 22, showed the firm intending to adopt SFAS 159 for its corporate private equity and real estate opportunity funds. According to the filing: ?Blackstone intends to early adopt SFAS 159 as of January 1, 2007. Upon adoption of SFAS 159, Blackstone currently intends to elect to apply the fair value option to selected investments in non-consolidated investment entities, which would otherwise be accounted for under the equity method of accounting. In the event the Company elects to account for such investments at fair value, the initial application of the fair value option to such interests is not expected to have a material cumulative effect on Partners' Capital or Investments, at Fair Value.?

Adopting SFAS 159 would have allowed Blackstone to treat carried interest compensation in the same manner as options, to book profits when an investment is made and smooth the volatility of earnings. Speaking prior to the firm's IPO, an LP advisory source explained: ?[Blackstone is] trying to accelerate recognition of profit so they can have an immediate impact on the valuation they can receive.?

To 159 or not to 159
The stakes were high ? the difference between adopting SFAS 159 and not adopting it was roughly $595 million, or 22 percent, of Blackstone's pro-forma earnings in 2006.

If Blackstone had adopted SFAS 159, there would have been two issues. One, carry is contingent upon the investment hitting a predetermined hurdle rate. If the investment underperforms, Blackstone would have to report a reduction in earnings. ?As an investor, if I see half the earnings Blackstone is reporting comes from this fairly squishy concept of carried interest, I'm going to try to discount it pretty heavily. That's not commonly understood by a lot of public private equity investors,? the LP advisor said.

The second issue is taxation. ?Treating carry as an option is exactly what everyone would like to continue doing,? continues the LP advisor. Recipients of options only pay ordinary income tax rates of 40 to 50 percent on the value of the initial grant, at the time of the grant. They then pay capital gain tax of 15 percent upon exercise if there is appreciation. ?Carried interest gets treated today like an option with no value, so there is no ordinary income tax when the fund is established, only capital gains tax on any value that eventually accrues,? the LP explains.

Not adopting SFAS 159 puts Blackstone's accounting more in line with Fortress Investment Group's, which was the first alternative investment giant to sell shares in its management company to the public. The reversal on SFAS 159 was also good PR ? it headed off comparisons to Enron, which had also booked fees up front.

Even so, booking carry each quarter as Blackstone will do now does not eliminate all controversy. A partner at a New York law firm, who weighed the decision of whether or not to adopt SFAS 159, says the choice is between the ?outrageous? and the ?incredible.?

?Blackstone shouldn't necessarily mark to market on a regular basis until they sell or dispose of [portfolio companies],? says the attorney. ?That makes it look like they're trying to treat as income what may be earned down the road. That sounds pretty aggressive to me.?

The attorney says he still finds it ?outrageous? that the non-SFAS 159 approach means ?if I disposed the investment today, the end of this quarter, I have to figure out what I have to get for it today and that would be deemed to be my income.?

On the other hand, he says, adopting SFAS 159 is an option that may well be even more objectionable: ?It's valuing potential future profit today. You project what anticipated future returns would be and book that today. That seems incredible to me that anybody would be able to do that.?

Many agree with Blackstone's final decision on the matter. ?I think not recognizing carried interest is clearly the right answer from an accounting and an economic perspective,? says the LP advisor. ?As an LP, we want the carried interest to be a substantial portion of the earnings of the firm, but we also want to make sure that the carried interest only comes if there's investment performance that comes with it.?

He continues: ?I think Blackstone was trying to take an initiative to apply 159 to an area where it isn't strictly required yet. Carry is unlike an option because there is no security you hold or is traded, there's no underlying asset that gets traded that can be valued. To value an option, you have to have a fair amount of information.

One of the biggest inputs is the volatility of the underlying asset. But there's no way to estimate the volatility of the carried interest of a private equity firm.

Countdown to liftoff: Four days that rocked the Blackstone IPO
The Blackstone IPO saw an array of forces line up against it, political and social. Many of the skeptics say they are concerned at the tax structure of the publicly traded partnership. A timeline reveals the increasing intensity of opposition to one of the 10 largest IPOs in US history:

May 15 – The AFL-CIO ? the largest federations of trade unions in the US ? sends a letter to the SEC decrying the Blackstone IPO as serving ?no practical purpose aside from creating a mechanism for Blackstone Group to sell its shares to the public without being regulated by the Commission.?

The letter was a reference Blackstone's impending status as a publicly traded partnership, and as such relying on certain exceptions related to corporate governance. Trade unions generally view private equity and hedge funds as forces inimical to the growth of organized labor, and the letter to the SEC is yet another attempt by union leaders to find the right footing in this match. June 14 ? Max Baucus and Chuck Grassley, leaders of the Senate Finance Committee, reveal a bill that would prevent Blackstone and any other firm with public aspirations from claiming a key tax exemption. The senators accuse Blackstone of ?pretending to be something [it's] not? in claiming that more than 90 percent of the firm's income is ?passive,? which in turn allows Blackstone to avoid being taxed as a corporation. The bill would disallow financial services providers from using this exemption as publicly traded partnerships. If made law, it would give Blackstone and similarly structured Fortress Investment Group a grace period of five years before they get the full corporate treatment. Every other alternative investment IPO gets the treatment starting now. Fortress' shares dropped roughly 10 percent on the news before surging back. Grassley, a self-declared foe of tax shenanigans, has since said that he might try to shorten Blackstone's five-year grace period. June 21 ? Senator Jim Webb, a Democrat from Virginia, sends letters to the Department of Homeland Security, the Treasury and the SEC asking that Blackstone's IPO be delayed while a full review of China's $3 billion investment in the firm is undertaken. Webb cites ?serious questions? about national security. Might sensitive technology owned by a Blackstone portfolio company somehow be transferred to the People's Republic of China by dint of its minority stake in the firm's management company? Webb would like to know. June 22 ? On the very day of Blackstone's IPO, the chairmen of the House Ways and Means Committee and the House Finance Committee, Charles Rangel and Barney Frank, unveil a bill that aims to change to tax characterization of GP carried interest from capital gains to ordinary income, which would more than double the tax rate on most carry.