Private Equity Scambake

Thursday, Mar. 22, 2007

Abracadabra for Sale

By Michael Kinsley

As head of Blackstone group and the new "King of Wall Street" (according to FORTUNE), Stephen Schwarzman is said to pay himself $300 million or more a year. He may already have accumulated as much as $10 billion, and if, as expected, Blackstone goes public, he will pocket billions more.

What do Schwarzman and Blackstone do for all this money? Oh, this and that, but mainly they buy publicly traded companies, take them private (that is, replace the public stockholders with private equity from institutions and rich individuals), do some abracadabra that increases the companies' value and then take them public again. The $20 billion to $40 billion that Blackstone is said to be worth--Schwarzman may own 40% of that--does not include the value of any company that it happens to own. It is solely the value of the abracadabra. Blackstone and other private-equity firms collect a profusion of fees--from the companies they buy (like the charming Chinese custom of billing victims of capital punishment for the bullets used to kill them) and from their investors and usually a nice 20% of the profit when they sell the firms back to the public.

Because they are private, we don't really know how much private-equity firms make, but the amount is reliably assumed to be humongous. And so what? Right? If he can turn, say, a $5 billion company into a $10 billion company a couple of years later, what's wrong with a few hundred million in the tip jar for Uncle Steve?

Well, one wrong thing is that Uncle Steve's 20% fee gets a huge tax break. It is considered a capital gain rather than ordinary income, so it is taxed at 15% rather than 35%. There is no conceivable justification for this loophole. No one who benefits from it could possibly need the money. Why hasn't some private-equity billionaire taken this up as a cause, the way Bill Gates' father has taken up preserving the estate tax? What about Pete Peterson--a co-founder of Blackstone and longtime Cassandra about the national debt?

But the roaring success of private equity raises a much bigger question, about the nature and validity of the stock market: Why isn't that $5 billion company worth $10 billion already? Why does it take Blackstone's expensive intervention to get it there? More than $13 trillion is invested in publicly traded shares on the New York Stock Exchange. Another $3 trillion--plus is riding on the NASDAQ. Most of this isn't rich people's portfolios and trust funds; it's the savings and pension funds of middle-class Americans. Over the past couple of generations, they have been enticed into the stock market because it is supposed to be efficient and because everyone can get a piece of that efficiency.

The stock market is supposed to be efficient in two senses. First, it is supposed to distribute and structure capital efficiently to maximize the output of the economy. Second, it is said to deliver the bounty of prosperity efficiently to its loyal investors.

When a private-equity firm goes in and buys, say, a washing-machine company, it rarely does anything to improve the washing machines. Instead it concentrates on restructuring the company--selling off the dryer division, perhaps. Or it doesn't even get its hands dirty to this extent but just fiddles with the finances. I'm not knocking it. It seems to work. Shares in the company are suddenly worth double. But most of that increase in value has gone to the private-equity firm and its investors, not to the folks who have bought stocks in the ordinary way. They are the ones who sold the company at $5 billion and bought it back at $10 billion.

Why can't the stock market deliver that $10 billion in value? Why does it take Schwarzman and crew to squeeze it out (for themselves)? Some say it's the short-term perspective of the investing public. Some say it's excessive regulation, most of which doesn't apply to private-equity investments. Whatever the explanation, the billions earned by private-equity operations aren't "created," as the whimsical conceit of Wall Street troubadours would have it. These billions are a toll charge collected from ordinary investors.

Schwarzman is frank about this: "I think the public markets are overrated," he has said. Anyway, if you think private-equity firms are ripping off the rest of us, you'll soon be able to join in the rip-off yourself when Blackstone goes public.

Or will you? The consensus in the business world seems to be that Schwarzman and his colleagues may be selling full-price tickets to a ball game in the ninth inning, as the stock market fizzles out. These private-equity types are not in the habit of selling at the bottom. "I always think about what will kill off the other person," Schwarzman once noted, charmingly. Go ahead and buy Blackstone when it becomes available. But don't be disappointed if you take your shares home, unwrap them, wave your magic wand, say abracadabra ... and nothing happens.



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