Hindsight is so wonderful. A week after this column ran in the IHT, Blackstone pulled back from the proposed accounting treatment discussed here. In the circumstances it would be a shame to go back and re-edit the verb tenses.
It also brought its offering at $31, into the teeth of the subprime mortgage meltdown, and saw its price sag immediately below $22. For the company’s principals whose net worth expansion is measured in units with capital “B’”, little sympathy is indicated.
Private Equity Discovers the Value of Myth
Originally published in the International Herald Tribune on May 25, 2007
A timeless but troubling story lurks in the plans of Blackstone Group, the private equity giant, to raise $4 billion through an initial public offering.
Blackstone proposes, through the use of options accounting, to book as immediate profits the gains it estimates that will presumably be made once its transactions are ultimately wound up. In other words, as soon as it goes into a deal, Blackstone's 20 percent carried interest - that great profit engine of private equity - will be valued like a salable financial instrument, and recorded as an asset.
Noncash profits today, in eager anticipation of an undated and uncertain but rosy future, and investors - including the Chinese government - lining up to hurl their funds at the prospects. Sound familiar? Has everyone forgotten Enron, the creative energy trader that crashed, or the academics' darling among the trading models that flamed out, Long-Term Capital Management?
Generations ago, the investment maxim on Wall Street was "buy on the rumor, sell on the news." The lore in the bubble years of the 1990s then became, "Buy on the fantasy." All too often, the result was "hold till the debacle."
The lesson seems irresistible: The origins of the next wave of corporate misadventures will be a new set of compelling stories. After all, we have been eager to devour simplistic myths and fables ever since our ancestors gathered around the fires in front of their caves, to listen to tales spun by those hailed, rightly or wrongly, as the wisest men in the tribe.
Here's an example: Because I dislike shopping, I look increasingly to catalogs. One features clothing and accessories no different in quality or cost from a number of others, but its goods are promoted in seductive little vignettes that locate the wares in such modestly exotic locations as Mumbai, Portofino or West Egg. That's good enough for me.
Consumers willingly buy into a good story. Brands of premium ice creams are all as alike as Tolstoy's happy families, but think of the success of Häagen-Dazs - a word concocted from no known human language, but evocative of Danish quality. And think of two unknown guys from Vermont, Messrs Cohen and Greenfield - mythicized as Ben and Jerry.
We buy look-alike vehicles, by reference to wilderness spots those vehicles will never visit - Denali, Sierra, Tahoe, Kodiak. Again, why? Imagine a marketer trying to sell a 4x4 branded for its real venues - a Chevrolet Strip Mall, a Subaru Speed Bump, or that new luxury offering, the Cadillac Cul-de-Sac.
Financial products and services are subject to the same power of myth. The meltdown this year in the subprime mortgage-backed securities market destroyed a bubble built from two stories: first, that ever-increasing housing prices would forestall a reckoning for credulous but unqualified home buyers, and second, that the inverse relationship between bond coupon and default risk had somehow been suspended for equally credulous investors.
Neither proved true, but the crash in this industry segment has failed to dampen the appetite of a myth-driven market. No less a tale-spinner than Warren Buffett has warned of unsustainable returns for alternative investments. But, depressingly, it appears that the only information commanding attention is that conveyed in stories worthy of re-telling around the modern version of the prehistoric campfire.
So today, the story of Blackstone's IPO overrides two antagonistic realities: that the private equity funds are awash in the cash of ever-smaller investors, even while chasing deals that are bigger and richer but doomed to deterioration in quality and results.
Blackstone's circular approach to its profit picture - booking profits today based on a collective blind vote of confidence on a future bet, as a proxy for real results down the road - not only echoes the immediate past of Enron and LTCM. The same approach came to grief in the late 1960s for the investors in Bernie Cornfeld's Swiss-based Fund of Funds, which did the same in a wild bet on deep oil in the Canadian Arctic.
But memories are short, and if the stories are timeless, so are the failures to learn from the past.
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