Blackstone has had a bad week. But the private equity group, led by Stephen Schwarzman, is still shooting for a $30 billion (Rs1.23 trillion) valuation in its initial public offering. It may be worth only about two-thirds that—and not just because the US Senate is considering legislation that would push up its taxes.
To see why, look at Blackstone’s earnings. The firm reported pro forma economic net income after taxes of $1.2 billion last year. This is broadly speaking the amount of profit Blackstone would have made last year if it had been a public company rather than a private partnership. A $30 billion valuation is 25 times that figure—which would be reasonable for such a rapidly growing company. The snag is that the $1.2 billion figure comes with two caveats—both connected with the performance fees that it charges investors for the funds it manages.
First, Blackstone is taking an unsustainably low compensation charge in its pro forma accounts. The firm says that, in future, 40% of the performance fees will go to employees. But the 2006 pro forma accounts allocate only 18% to them. In the short term, Blackstone can get away with such a low percentage because senior employees will have shares in the company which they will lose if they leave. But as those shares vest, Blackstone will have to increase its compensation to hang on to its employees. That’s why it expects the percentage to rise over time.
Second, Blackstone’s pro forma accounts are struck after a tax rate of just 17%. That’s because, under current law, its performance fees would not be taxed at all at the company level. However, this situation looks unsustainable. Senators Max Baucus and Chuck Grassley last week introduced a bill that would force Blackstone and other private equity groups that go public to pay a normal tax rate.
If the bill becomes law, Blackstone’s tax rate would rise to about 40%—once local as well as federal taxes are taken into account.
Taking these two factors together, one can reconstruct an estimate of Blackstone’s sustainable earnings for last year. The net effect would have been to lop $500 million off Blackstone’s pro forma earnings—cutting them from $1.2 billion to $715 million.
The question then becomes what multiple to put these earnings on. Blackstone is growing extremely rapidly. Funds under management, which were $51 billion at the end of 2005, had grown to $69 billion at the end of last year. What this means is that Blackstone’s earnings will power ahead in 2007.
Such breakneck growth clearly deserves a high multiple. On the other hand, it is also arguably a symptom of the global everaged buyout bubble.
If the performance of private equity stalls because too much money has been chasing too few opportunities, or if the liquidity that has been fuelling the deal-making dries up, Blackstone’s growth could slow quite rapidly. In the circumstances, a multiple of 25 times last year’s reconstructed sustainable earnings seems about right. That would give the firm a base value of $17.9 billion.
To this, one should make a further adjustment to take account of the fact that low compensation and low tax do have some value even though they probably won’t last. A rough and ready way of making the adjustment is to note they were together worth $500 million last year and multiply by five (the number of years over which changes to both tax and compensation are likely to be phased in). The resulting $2.5 billion can then be added to the $17.9 billion base number to give a total value of $20.4 billion—or $21 a share.
This is, of course, a lot less than the $29.7 billion—or $30 a share—Blackstone is aiming for. If investors wish to buy in at that valuation, they should either believe that the buyout boom has many years left to run or that Blackstone can continue to outpace the taxman—or both.