Private equity shops feel Blackstone's pain
Not so long ago, firms like Blackstone and Fortress were on top of the world. Now they're falling fast.
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| Blackstone CEO Stephen Schwarzman's reputation as one of Wall Street's savviest dealmakers has been sullied by his firm's troubles. |
NEW YORK (Fortune) -- Blackstone's meager quarterly earnings is just the latest example of the stunning reversal of fortune suffered by the private equity shops that once dominated Wall Street's food chain.
Blackstone's earnings plunge of 89 percent is a direct result of the fact that the private equity universe's lifeblood - cheap, abundant and occasionally desperate bank credit - has largely evaporated. And with the continuing credit market "meltdown," as Blackstone president Hamilton "Tony" James called it Monday, goes much of the firm's operating outlook until 2009.
The circle of pain is easy to trace: No bank lines for private equity equals no eye-popping bids for public companies that are supposedly managed poorly and in need of shelter from quarterly financial reporting. No eye-popping acquisitions equals no lucrative deal fees or performance fees for private equity firms - and no multi-million advisory fees for Wall Street banks like Merrill Lynch (MER, Fortune 500) and Credit Suisse (CS).
It gets worse. Many private-equity firms will be, at least theoretically, on the hook to pay massive break-up fees to the companies they offered to buy should they back out of a deal whose prospects have dimmed amid the market swoon. Already we've seen some costly battles between bidders and targets, including a high-profile fight between a private equity group led by J.C. Flowers and SLM Corp (SLM, Fortune 500)., the parent of student lender Sallie Mae, over $900 million in break-up fees (private equity prevailed).
What's more, Blackstone's stumbles in recent months - and the market malaise generally - have dashed the hopes of other private-equity shops looking to go public. Blackstone's high-flying IPO last summer fueled speculation that other shops, among them Kohlberg Kravis Roberts, would soon go public.
Not helping matters is the financial labyrinth that is Blackstone's financials.
While Blackstone reported fourth-quarter profits Monday morning of $88 million, down from $808.1 million in the same period a year ago, they were pro-forma numbers adjusted for costs related to compensation from its summer 2007 initial public offering.
Investing in Blackstone isn't like buying stock in Citigroup or some other publicly-traded financial company. This is because investors don't own Blackstone stock per se; they own units in a limited partnership, which will be writing-down goodwill related to its portfolio of investments for several years to come.
It gets even more confusing: Blackstone (BX) doesn't actually report net income. Instead, it reports "economic net income," an exceedingly rare and opaque calculation that represents net income minus income taxes, amortization of intangible assets and non-cash equity compensation charges.
While the operating environment for private equity shops is brutal, it's especially ugly for Blackstone and its publicly-traded peers because they can't hide their bottom-line pain.
Since its June initial public offering, Blackstone's stock has slipped 55%, to $14.06 in midday trading. Shares in Fortress Investment Group (FIG), meanwhile, have plunged 58% in the last year, to $11.13.
Simply put, the only investors cashing in these days on Blackstone and Fortress - among the crème de la crème of private equity firms - are short-sellers, or those who bet on falling stock prices.
To combat its reliance upon investment and commercial bank credit lines, Blackstone and rivals like Carlyle Group have bolstered their asset management units. Blackstone, for example, now has $102.4 billion in assets under management, a 47% increase from a year ago.
But leveraged buyout expertise doesn't always translate into money management skill. Witness Carlyle Capital Corp (CARYF)., Carlyle Group's publicly-traded mortgage fund. Last week, Carlyle Capital revealed that its creditors, led by JPMorgan Chase (JPM, Fortune 500), had seized collateral after it failed to meet margin calls, which are demands for additional collateral to back up loans.
Carlyle Capital couldn't meet those calls in large part because it was using leverage of about 32 times its equity. This means that, when its massive mortgage bond portfolio lost just 3% of its value, its wafer-thin equity position weakened dramatically.
Carlyle Capital's management hit the phones to reassure investors and the media, to no avail until it disclosed a $150 million line of credit from its parent.
It's a new era for private equity, which ruled Wall Street for much of the past decade with war chests stuffed with institutional investor cash. But that only worked as long as banks could provide multi-billion dollar credit guarantees - and investment banks could move that paper to hedge funds that also grew rich on low-cost loans.
Now that the cash spigot is off, private equity shops are facing a less gilded life. 
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