Friday, April 20, 2007

Blackstone's "Fair Value" Valuation

Wednesday's Wall Street Journal's Money & Investing section featured an article discussing the method by which Blackstone is valuing itself. The firm, on account of holding non-market priced assets, will use "fair value" to estimate the worth of its various parts.

To quote Charles Niemeier, a member of PCAOB, the accounting oversight board,

"The biggest problem with fair-value accounting is management bias."

Blunt and pregnant with implications, if ever a brief statement was.

The article quotes Mr. Niemeier again as stating that the rule is "bad business" and will "come back to haunt" the accounting rule makers.

Needless to say, Blackstone is keeping mum on the issue. No surprise there. As I wrote recently, here and here, I'd be very careful of being on the other side of Blackstone on any equity deal. This fair value issue explains much of why I feel that way.

Not only is Blackstone allowed wide latitude to account for revenues as it chooses, mixing fees it pays to itself from acquisitions, in effect, transferring funds from one pocket to another, but, now, it also is given wide latitude to determine the underlying value of those assets, too.

When I was at Chase Manhattan Bank years ago, I spent a lot of time troubleshooting our financial information services unit, IDC, in Boston. One of their businesses was providing bond matrix data- in effect, estimating value for infrequently-traded debt by using values from various issues with similar attributes. As the CFO for the business told me,

"Merrill's biased and we're wrong,"

meaning that Merrill, having the debt in its inventory, had an interest in specific valuation biases, while IDC, although objective, was less likely to get the valuation right.

Blackstone is now in the position of Merrill. Its investors are in IDC's position- on the outside, hoping to guess reasonably correctly about the actual value the assets in Blackstone's "poke."

A further complication is touched upon later in the Journal article. It notes that there is a risk of favoring current investors in Blackstone's deals, over new investors, due to the differing information flows to each.

This is a dilemma about which I have written before, and is the crux of why I favor using a 'consistently superior return' over time, rather than instantaneous measures of performance. It's too easy for management to 'maximize present value' when their interest is involved, essentially leaving no additional value to be created from the existing situation for future investors.

This is yet another reason I would be cautious about being on the buying side of a deal, when the seller is Blackstone, and the assets are its partners' interests.

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