Why investors should steer clear of Blackstone

(Fortune) -- Thanks to another dismal quarter and a cratering private equity market, Blackstone (BX) traded near its all-time low near $14 a share Monday before closing at $15, still 52% off the IPO price of $31. It would seem like a perfect opportunity to buy the revered private equity firm that has $102 billion in assets under management, diverse business lines, and a great track record even in down markets. Moreover, the stock is currently paying a huge 8% dividend yield to investors hoping to ride out the storm.

But that's not the case.

Before we delve into why this stock will continue to pummel investors, it's important to understand the most important components of Blackstone's earnings: the management and performance fees of its general partnership that the firm uses as a stand-in for revenue, rather than sales.

The management fee is what it charges limited partners for holding money in its myriad funds. Blackstone charges only 1.5% on its assets under management, versus a more typical 2%. So far, this flow of revenue has proved relatively stable. The firm has $102 billion in assets under management, so it booked about $1.553 billion in management fees in its fourth-quarter earnings report.

The performance fee, or incentive fee, is a 20% cut it takes if it generates a return on the capital it invests for its limited partners. For example, if a Blackstone buyout fund earns $100 on an investment, it keeps $20 and distributes the other $80 back to the limited partners. The shareholders do not get any of the $80 dollar distribution. Rather their fortunes rise and fall with the expansion and contraction of the incentive fee, which is as important, if not more so, than the management fee.

For example, look at how much Blackstone's plunging performance fee has weighed on earnings. Performance fees for 2006 were $776.3 million, or 61% of the company's $1.3 billion revenue. In 2007, performance fees plunged 118% to a $141.8 million loss and total revenues came in at only $345 million.

Even though Blackstone took a big hit on its performance fee, when you scratch the surface it is impossible to nail down a real value for this number on a quarter-to-quarter, or even year-to-year basis, because it is impossible to really know what those portfolio companies are worth until they are sold. This is the sort of uncertainty that's anathema to investors, particularly in a down market.

"Coming up with a current fair value for most of its portfolio companies is a big issue," says Jack Ciesielski, editor of Analyst's Accounting Observer. "It comes down to an exercise in black magic."

At any time, Blackstone holds dozens of companies and real estate investments that the firm presumably believes it can improve by streamlining the financials and cutting costs. It's a multi-year process, the results of which are only truly realized at the very end, when the company is sold to a strategic buyer or to the public markets, hopefully for a fat profit.

"How they value these companies on a continuing basis is a bit of a mystery to everybody outside the company," says Edward Ketz, an accounting professor at Penn State and author of the book Hidden Financial Risk, which examines how corporate culture has engendered accounting scandals. "They don't tell investors how they come up with these numbers, but it's presumable that it measures cash flow discounted at some rate of risk that the firm comes up with on its own."

"I can't think of anything quite like this," he adds. "It's a huge company saying they have a magic box and that they'll pull tricks out of it."

This sort of accounting is called fair value or mark to market. While it is acceptable in the eyes of the Financial Accounting Standards Board, it is more difficult for investors to swallow given that this company already behaves in ways that are difficult for Wall Street to understand. Blackstone is willing to take losses in its portfolio because it takes risks commensurate with its history of huge returns and it does not strive for consistent performance on the quarterly basis that investors want. Wall Street is still in disagreement over how much it likes Blackstone. Of 32 brokers who cover the stock, seven rate it a strong buy, 14 a buy, and ten a hold, according to Thomson Financial.

Ryan Lentell, a Morningstar equity analyst who is overall positive on the stock, says he expects an 18% return on the portfolio investments over a three-to-five year time horizon. "They don't disclose their internal rate of return quarterly," he says. "The short term outlook is always going to be volatile. We think it's fairly valued at $17 a share but our buy price on the stock is $11.10. We have a large safety margin."

Ciesielski points out that Blackstone has disclosed that there is no market for about 80% of its holdings.

"If there is no real market for many of the companies, it's not even mark to market accounting. Prices are marked to a model that the firm itself has created," says Ketz. "The next best thing is a rising overall economy. If the economy is rising, then these estimates may be okay. This bad market situation raises serious questions about whether their fair values can actually be achieved."

Blackstone spokesman Peter Rose emphasizes that the company in its prospectus explicitly said its primary fiduciary duty is to its funds and its fund investors, and that only a long-term investors should buy Blackstone stock. The hope is, says Rose, that the company can change the very mentality of your average investor, from earnings driven decision-makers to people who have faith in the management team's ability to eventually deliver returns.

But some investors may have grown tired of buying in good faith. Fair value accounting and investor optimism stung the banks and institutions who bought mortgage-backed securities and short-term debt issued by collateralized debt obligations, or CDOs. Though a very different situation, Blackstone's opacity could be hard for cautious investors to overcome.

"I don't know of a company that wouldn't say what Blackstone has said, that their shares should be held for the long term," says Scott Sweet, managing director of research firm IPO Boutique. "But this stock has disappointed investors every quarter and Wall Street is all about showing people the money if you want them to hold your stock."