IPO marks end of the cheap-debt era

By Jim Jubak

You can learn a lot about the state of the stock market from the popularity of a bad deal.

And since the proposed initial public offering (IPO) by the Blackstone Group is a very, very, very bad deal for investors but one that I expect to be hugely popular anyway, I think investors are about to learn a great deal about this market.

What are we likely to learn? That we're witnessing the end of the cheap-debt era that has provided so much support for stock prices. Equities, which have been along for the ride, are going to have to start carrying more of their own weight -- and that's not good for stock prices in general.

Let me start by telling you why this is such a bad deal for investors and then explain why it is a bad sign for stock prices in general.

Should sell like hot cakes

Here's the outline of the deal. The Blackstone Group, a private investment group with almost $80 billion in assets under management, has filed to go public. Those assets broke down this way on March 1, according to the group's filing for a potential initial public offering: $31 billion in private-equity funds that do buyouts of public companies, $18 billion in real estate investment funds, $17 billion in funds of hedge funds, $7 billion in senior-debt investments and $6 billion in hedge funds that invest in distressed bonds, stocks, near-equity debt (called mezzanine debt) and closed-end mutual funds. The IPO aims to raise about $4 billion in the public markets by selling 10% to 15% of the firm that manages all that money.

I expect this offering to sell like ice water in the Sahara if the Feb. 9 IPO of Fortress Investment Group (FIG, news, msgs) is any indication. The hedge fund manager, with $30 billion under management, became the first private-equity/hedge fund management firm to sell shares to the public. That IPO soared from an offering price of $18.50 a share to $35 by the time shares opened for trading as investors clamored for a piece of the offering. Shares have since dropped back, closing at $27.18 on March 28. But I don't expect that the 22% loss that investors who bought at $35 suffered will deter many prospective Blackstone buyers since those Fortress investors who got an allocation of shares at $18.50 made a quick 90% flipping their shares.

Up, up and away

On form, the Blackstone Group IPO should be even more popular. The group manages almost twice the assets of Fortress. It and its co-founders, Pete Peterson and Steve Schwarzman, have a much higher profile on and off Wall Street -- thanks to Schwarzman's 60th birthday party, which featured 1,500 guests and entertainment by Rod Stewart.

The returns its funds have garnered -- for example, the annual 23% on average for the company's private-equity funds since 1987, about twice the average return for the S&P 500 Index ($INX) for the period -- are enough alone to create the kind of demand that drives an IPO up in price on the first day of trading.

None of which makes this a good deal for investors. Frankly, I think it's terrible. Why? Let me count the ways (from bad to worse):

1. Investors aren't buying the funds themselves. The Blackstone Group is trading on the returns and reputation of its managed funds, but what it's selling isn't a piece of any or all of those funds but of the company that manages that money. I doubt that everyone buying shares will understand the difference. (If they don't know what they're buying, shame on them, of course.)

2. Investors are paying a big premium. That business, to be renamed, Blackstone Holdings, is certainly profitable -- at least it was last year, when the management company made $2.3 billion from management fees and other sources. But that's not as big a profit as it sounds, considering that the IPO will value Blackstone Holdings at $40 billion or so. Lehman Bros. (LEH, news, msgs) earned $4 billion in the past 12 months, and that company's market capitalization is only $37 billion.

3. Investors are paying for past performance. Only about half of that $2.3 billion in earnings comes from management fees, a relatively stable source of continuing future earnings. The bulk of the rest came from carried interest, the Blackstone Group's slice, usually about 20%, of any profits earned by the buyout funds. By its nature, carried interest represents the profits on past deals. Investors buying shares in the IPO are betting that current and future deals will earn the same profits as Blackstone has reaped during the current top of the buyout cycle. With increased competition for deals driving the prices paid for public companies ever higher, it's unlikely that the next part of the cycle will be as profitable.

4. Investors will have no say in how the company will be run. Since Blackstone Holdings will be structured as a master limited partnership, investors will be unit holders instead of shareholders. The minor difference is critical: Shareholders vote to elect company directors, and a public company with shareholders must have a majority of independent directors on its board of directors. Unit holders don't have those basic rights. They won't be entitled to vote to elect directors, and master limited partnerships aren't required to have a majority of independent directors on the board of directors. The rules of the Blackstone Holdings master limited partnership even allow the directors of the company to sell the business without the consent of the unit holders.

5. Investors will have no say, again, on what Peterson, Schwarzman and the other partners pay themselves. Again, because this is a master limited partnership, Blackstone Holdings isn't required to have an independent compensation committee that decides who gets paid how much. Admittedly, compensation committees run by independent directors haven't exactly done a great job in limiting executive paychecks at public companies such as The Home Depot (HD, news, msgs) and Pfizer (PFE, news, msgs), but any checks on the power of managers to pay themselves whatever they want are better than no checks at all. Don't pay too much attention to the promise in the IPO filing that Schwarzman will take a salary of just $350,000. In buyout firms, the big compensation comes from owning a stake in the company and from receiving a cut of the carried interest earned by managed funds. The Wall Street Journal calculates that Schwarzman, now worth about $10 billion, could see his net worth double as a result of the IPO.

 1 | 2 | next >