Private Equity Part II- Recent Events

This article is a continuation of the “Private Equity and Leveraged-Buyouts” article written by me. The previous article was an explanation of private equity as well as what was the current environment at the time. This article deals with the recent events, and emphasizes on the recent IPO’s. This article assumes knowledge of Part I as a prerequisite. Initial Public Offering of Private Equity Companies

The most significant news in recent months was Blackstone’s announcement to turn itself into a public company. The company claimed that its aim was to raise cash for acquisitions although many speculated that this was an attempt for Stephen Schwartzman and Peter Peterson to cash in on their investment.

From the time of its IPO, Blackstone made numerous announcements including plans to acquire the Hilton Hotels Corporation with all its debt, in a cash deal valued at around $26 billion, creating an industry record. In August 2007 Connecticut’s state pension system, Connecticut Retirement Plans and Trust Fund  invested $100 million in a Blackstone Group real estate fund. In the same month Blackstone announced that it will go east and make an offer to buy 50.1% of India based “Gokaldas Exports”, India’s largest apparel exporter and 12.2% stake in India’s Nagarjune Construction, a company based in south Indians city of Hyderabad. Blackstone is investing in India to take advantage of its rapid urbanization and economic growth.

Following Blackstone’s IPO, Kohlberg Kravits and Roberts (KKR) another major US private equity firm waited to see how well Blackstone will do before they will follow suit to go public on a $1.25 billion IPO.

Blackstone had its IPO on June 21st 2007 for over 150 million shares and opened on first day of trading at $31. The stock rose nearly $7 on its first trading day as investors who were not able to get IPO allocations rushed to get a piece of the most profitable private equity firm in the world. The stock dropped to 30 the next week. Now on August 28th it was trading at 22.99, loosing a quarter of its IPO value and making it the worst IPO this year. With Blackstone stock price suffering KKR waited to see if Blackstone will recover.

Current Environment of Private Equity Companies

Changes in Tax Laws

After Blackstone’s IPO the major news that entered the media was Senate Finance Committee Chairman, Max Baucus and Iowa Senator Charles Grassley proposing measures for publicly listed private equity firms and hedge funds to pay a higher rate of tax. Currently private equity firms like Blackstone have a tax advantage were they only pay a 15% capital gains tax, instead of a 38-40% corporate tax. Both politicians have called the lower rate an “abuse of the system”, allowing private equity firms to get away by paying little taxes.

If the “Grassley-Baucus” legislation passes through, Blackstone’s tax bill will increase from $250 million to $775 million. This will highly depress earnings and the market cap should drop to $10.5 billion from $25 billion.

To prevent the legislation from passing through, 24 private equity firms in the US are lobbying the US government to fight the legislation. This year they already spent $5.5 million on lobby expenses. Furthermore a separate “Private Equity Council” was developed in Washington DC whose members include Blackstone, KKR and Carlyle Group. So far they have spent $660,000 on lobbying, Blackstone on its own spent another $3.7 million. KKR hired two former White House Aids to help this cause.

The arguments private equity firms use against the legislation are: Higher taxes on Blackstone will offset to lower taxes on individual partners. Treasury will loose on capital gains taxes because as Blackstone’s market cap drops, the tax bill will drop as a result. Other arguments include that, if private equity firms are taxed more they will not have the incentive to go public, reducing potential government revenues. Senator Schumer said that he will not support any bill that singled out an industry, especially the financial sector or harm his home state. Other claims include that these types of taxes reduce the incentives for other types of entrepreneurship.

Supporters of the bill agree that there are small amounts of validity to the above claims, however the effects are short term. Other claim that although the bill isn’t a tax generator, it will increase the integrity of the corporate tax code. The UK is also passing a law to increase taxes on private equity firms from 10% to 40% (see my article “Private Equity and Leveraged Buyouts”   see section “Private Equity Under Attack”).

Subprime and Credit Crisis

The second explanation of Blackstone’s lack of success was the inception of the subprime crisis with the US stock market falling dramatically. Many investors in debt started to panic as a result, not even trusting credit worthy companies. This led to a credit squeeze which caused credit spreads to jump. This will surely affect leveraged buyout companies such as Blackstone, which relies heavily on issuing loans.

The number of leveraged buyouts in August have dropped by a 1/3 relative to the previous two months, according to Bloomberg news. Fortress Investment Groups CEO said that he doesn’t believe that it will improve in the next two months unless the debt market improves. Debt investors have rejected loans and bonds that will help fund LBO’s including Daimler Chrysler AG’s Chrysler unit and Alliance Boots Plc because the yields on the bonds do not adequately reward investors for the perceived credit risks in the market. The credit spread on non investment grade bonds has jumped to over 400 points from a low of 241 in the beginning of June 2007.

KKR which needs to raise $136 billion to fund takeovers this year is having trouble finding buyers for $20 billion loans used to acquire takeovers such as Alliance Boots and Chrysler. JP Morgan Chase and Deutsche Bank are among the banks holding on to the debt. KKR filed an amendment to its IPO prospectus stating the extra risks of the credit market and tax legislations (although if passed the new tax laws would not affect KKR until another 5 years).

Interestingly however, many LBO firms such as Blackstone, TPG Group and the Carlyle Group which have loaded acquired companies with heavy debt, are cheaply acquiring these debt securities in the market from hedge funds to which they were sold too. This should provide some reassurance to the public that private equity firms have trust that the markets will turn around.

August 29,2007