Blackstone has pushed the envelope in a number of ways with its planned public offering. But one of the leveraged buyout house’s raciest ideas—wisely now abandoned—was to book profits as soon as it made investments. That said, the accounting treatment Blackstone has eventually settled on isn’t the most conservative one could imagine. It will still book profits on investments before it has exited from them.
Blackstone, along with other private-equity groups, takes a 20% cut of the profits made on the funds it invests. The issue is how and when to calculate this cut of the profits, known as “carried interest”.
In Blackstone’s initial prospectus in March, it said it planned to adopt a new accounting standard known as FAS 159 for calculating its carried interest. Essentially, this views carried interest like a stock option. If an investment performs well, Blackstone collects its carry, but if things don’t go well, it doesn’t lose out. It’s a one-way bet. This means that as soon as Blackstone makes an investment, it has generated value. Adopting FAS 159 would have allowed Blackstone to book that as an immediate profit—calculated by using options modelling.
Intellectually, there’s some validity in the approach. But the notion of booking carry as soon as one invests, rather than waiting until one sees what profits one has actually realized, is hardly conservative. After prospective investors in the IPO quibbled, Blackstone backtracked.
But the firm still hasn’t adopted a system of booking profits only when it realizes its investments. That’s broadly speaking the system used by Fortress, a similar firm that went public last year. Instead, Blackstone has stuck with its old practice of valuing its investments at the end of each year—whether it has sold them or not—and accruing its carried interest as if it had sold them all.
Last year, the group booked $1.2 billion in carried interest. If it had adopted the racy options style accounting, it would have chalked up an additional $595 million of revenue. But even now that it has stuck to its old accounting system, $333 million of the carry comes from accruing profits on unrealized investments. Investors in its public offering would do well to remember that.