One of the reasons private equity companies have been able to see such tremendous gains over the years is that they have longer time horizons than many investors. A typical investor holds a stock in a publicly traded company for a mere 10 months these days. Despite some headline making quick turnarounds, private equity firms typically hold their portfolio companies for a number of years before finding what industry jargon calls an “exit”—either a sale to another private company or return to the public markets. This longer time horizon allows the to uncover value that is simply invisible to those with a more myopic investing schedule.
Blackstone’s move into the public capital markets has had many scratching their heads about how the company plans to continue its longer term approach in a world where it will be required to release quarterly financials to investors. Won’t the usual pressures for smooth quarterly performance start influencing the way they do business?
Part of Blackstone’s answer seems to be some complicated and creative accounting. (“Creative accounting” is sometimes a dirty term these days but that’s not how we’re using it here.) Blackstone’s plan is to treat its performance fees—the 20% “carry interest” it charges on gains beyond benchmarks on its funds—as options that can be assigned present day values even though they won’t be realized for years, according to the Financial Times. So Blackstone will be able to book paper gains as soon as it makes acquisitions, lowering the balance sheet hit from even larger acquisitions such as the EOP Properties deal.
By treating the carried interest as an option over future uplifts in the investments, Blackstone can use the Nobel prize-winning Black-Scholes option pricing model to put a value on it and record it as an asset, with a corresponding non-cash profit, as soon as an investment is made. The “option” would be revalued each quarter.
Blackstone to book profits earlier [$$] [Financial Times]