New accounting rule adds to LBO pain

Looking over the recent Blackstone (BX:NYSE) and KKR (KPE:Euronext) financial results takes a strong stomach. The challenges of the recession are felt in most corners of the economy, and one would expect that any PE portfolio would have its share of troubles. For PE managers, however, a new accounting rule is making a bad situation far worse than it might otherwise be.

First, the good news: Blackstone said that 77% of their portfolio achieved flat or higher EBITDA in 2008 versus 2007. According to the WSJ, KKR had a similar experience.

In other years, a private equity portfolio company with flat or increased EBITDA might be valued at the “cost” of the acquisition price. Since it wasn’t being sold, there was no reason to mark it up or down. Under a new accounting rule, FAS 157, PE managers have to price their investments at whatever they might get for the asset if they tried to sell it at the end of that quarter — a far different proposition.

This is all part of the Fair Value Accounting theme that accounting firms have wreaked upon PE, venture capital and other firms such as ours. We’ve tried to warn readers about it before (See prior posts “Accountants are failing investors with ‘fair value’ accounting” August 6-07 and “D’Alessandro: fair market value accounting is ‘perverse”” September 30-08).

In a way, the pain that private investors are suffering is similar to the experience of public market investors, whose valuations are dramatically below what they are used to seeing. It isn’t uncommon right now to see good companies trading at 3 or 4x forward earnings; Wellington Financial Fund II portfolio company Critical Control Solutions (CCZ:TSX) is in that camp. For KKR to mark down their fully-valued 2007 acquisition of First Data by 20% should be no surprise. Particularly when the senior debt is trading at a discount.

The good news for Canada’s current and future pensioners is that more than three quarters of Blackstone and KKR names are performing fine on an operating basis. Since “flat” is the new “up”, we should be relieved that things are holding together. After all, the Canada Pension Plan Investment Board has $28.9 billion of private equity commitments (see prior post “Doubling Down on Private Equity at CPP Investment Board” February 20-09), $12.6 billion of which were made to the 2006 and 2007 vintage years.

The ones that were the most reliant on high leverage to make the high “going-in” valuations work. We can blame the accountants for the new mark-to-market rules, but carrying value calculations are nothing more than “time and place” decisions. The ultimate exit prices of the current portfolio companies will be what they will be: willing buyers and sellers. Nothing artificial about that.

The decision that certain pension funds made to double down on private equity during these vintage years can’t be blamed on the accountants. These PE writedowns will spill into the December quarter end financials; we have another 75 days to wait to see what it means for our own pension funds (see prior post “CPPIB U.S.A. general partner Q3 2008 performance numbers” February 17-09).

MRM