US private equity: carry on
Rearranging lines in a ledger cannot undo a fundamental mismatch
The Masters of the Universe told us private equity was a simple cash-in, cash-out business. Alas, a decade or so on from the big US buyout groups — Blackstone, KKR, Apollo Global, Carlyle Group — starting to list their shares, anything but simple has been proven the case.
The P&L complexity is just one reason public market investors have failed to warm to the large alternative asset managers whose stock prices have not exactly soared since their listings. This has, regrettably, denied a few billions of dollars more of wealth from the likes of famed founders such as Leon Black, Henry Kravis and Stephen Schwarzman. What a pity.
But financial engineers cannot help but financially engineer. The latest manoeuvre — evident as the four companies announced earnings in the past week — to get public investors excited about private equity stocks is to dump a longstanding measure of earnings called economic net income. Who knows if it changes the valuation dynamic. But rearranging lines in a ledger cannot undo the fundamental mismatch. Stock market investing is a quarter to quarter exercise lined up against private market investing that has a horizon of several years.
The economic net income metric previously favoured included mark-to-market gains and losses. That meant investments that were not anywhere near being harvested were included in profits. Blackstone, for example, reported ENI of $3.4bn in 2017 versus $2.2bn in 2016. Now Blackstone and its rivals prefer a metric called “distributable earnings”. This, while also volatile, is a more cash-like measure comprising management fees and realised gains from investments.
The ugly reality for these groups is that public market investors have never appreciated the fat but erratic gains from buyouts called carried interest. Yet another accounting metric called fee-related earnings — the steady but far more modest management fees charged — is what investors have in reality zeroed in on.
Defining these sundry accounting artifices takes up pages and pages in investor decks. And while the addition and subtraction is not excessively complicated, it is mind-numbing nonetheless. But the situation need not be so complex. These firms should emphasise the simplest cash metric available: dividend yield. Apollo, Blackstone and Carlyle are each paying between 6 and 7 per cent.