Fair value accounting has always been at odds with a basic conceit of buyout shops – the belief that they are built for outperformance. Steven Schwarzman, the chairman and chief executive officer of mega-firm
In this instance, Schwarzman used the case of portfolio company Stiefel Laboratories as an example of FAS 157’s inefficiency. Blackstone agreed to make a $500 million minority investment in Stiefel in August 2007, purchasing convertible preferred notes. On April 20, Stiefel reached a deal to be acquired by GlaxoSmithKline for $2.9 billion in cash. The total value of the transaction could rise to $3.6 billion with the expected debt assumption of $400 million upon closing and a potential payout of $300 million related to future performance. The deal is expected to close in the third quarter.
During the call, Schwarzman pointed out that Blackstone is currently carrying its stake in Stiefel at 0.7x cost, a roughly 30 percent loss, under FAS 157. That pre-deal valuation, reflective of the quarter’s end, presumably takes into account the performance of both the overall equity market, using a broad index such as the S&P 500, as well as the health care sector, although there is no standard formula. The firm and its accountants make the final call.
The disconnect, at least in this case, is stark. The valuation set by the GlaxoSmithKline deal is 1.4x cost, or “twice the current mark,” as Schwarzman felt the need to note. He went on to say this sets up Blackstone for 15 percent IRR score on the investment, compared to 28 percent IRR decline over the same period for the S&P 500.
“Basically we have outperformed [with] Stiefel, as an example, by 43 percent over what’s happened in the general market,” he stated, “And that’s part of what makes private equity a very, very interesting asset class, at least the way we do it.”
Without getting carried away by a single deal, the Stiefel investment does provide ammunition for the argument against fair value accounting with regard to private equity due to the dramatic disparity of valuations arrived at over such a small timeframe. What it clearly illustrates is that buyout firms, for the most part, invest in individual, private companies, not whole sectors or indexes, and these companies have singular worths. Shops conduct substantial due diligence before entering deals, and have access to and influence over the financials of portfolio companies that the majority of investors in public companies don’t enjoy. Because of that, relying on comparables from public companies that could have vastly different balance sheets, or broad indexes that are influenced by wider economic forces and political developments, is questionable. These aren’t the only factors in why a shop marks an investment up or down but they do play a significant role in the process.
Stock prices can also influence strategy at public companies, a factor that simply doesn’t apply for private portfolio companies. This ties into private equity’s lengthy time horizon, a huge differentiating factor as far as Schwarzman is concerned.
“We control the timing of the sale of our funds’s holdings,” he said on the call. “There is no pressure — I repeat, there is no pressure to sell at inopportune times.”
That’s not the case for a public company, which can find itself squeezed to sell assets by a sagging share price, or else entertaining acquisitions due to a rising one.
Also, since Blackstone evidently didn’t truly believe the value of Stiefel had declined by 30 percent, and would presumably never supported a sale at that level, how valuable could that figure possibly have been to its limited partners?
In the recent ACG-Thomson Reuters Mid-Year 2009 Dealmakers survey, 51 percent of the more than 200 private equity respondents, who were allowed to check all applicable boxes, said the application of FAS 157 had no significant impact on their firms, while 37 percent viewed it as a time drain, and 15 percent felt it was a drain on the wallet. Only 13 percent of the respondents felt there was a positive impact.
Transparency is held up as the justification for fair value accounting but it remains to be seen how helpful it is to regularly posit the worth of holdings that, excepting the murky secondary market, aren’t likely to change hands for many years. Indeed, if the end result is lagging valuations that yo-yo months behind the fluctuations of the public markets, the picture could end up blurrier than ever.