SEC defends private equity IPOs

The U.S. Securities and Exchange Commission is defending its decision to allow the initial public offering of private equity companies in the wake of mounting pressure from U.S. legislators, who want to subject private equity firms to greater scrutiny.

Andrew J. Donohue, director of the SEC’s Division of Investment Management, testified on Wednesday in Congress before the Domestic Policy Subcommittee of the Oversight and Government Reform Committee, and in the U.S. Senate before its Committee on Finance. In both instances, he offered testimony that defended the SEC’s decision to allow the IPOs of private equity giants Fortress Investment Group and the Blackstone Group LP.

The SEC’s decision to allow the IPO of Blackstone in particular has come under fire by some legislators. The chairmen of the congressional committees, Dennis Kucinich of Ohio and Henry Waxman of California, wrote a letter in June addressed to SEC chairman Christopher Cox, asking that the SEC postpone the Blackstone IPO until hearings could be held to determine its effect on smaller investors.

The letter contended that Blackstone’s IPO is a back door for non-accredited small investors to invest in the private equity and hedge funds that comprise a large portion of Blackstone’s revenue.

“As we understand it, the main value of the investors’ stake in Blackstone LP derives from the performance of the underlying hedge funds and private equity investments,” Kucinich and Waxman wrote. “According to legal and financial experts whom we consulted, the Blackstone LP IPO presents novel questions because it appears to be a vehicle for allowing public investors to participate in hedge-fund type investments that have previously been considered unsuitable.”

In December, the SEC unanimously approved a proposal to raise the minimum net worth standards of accredited investors to $2.5 million. But critics still contend that this measure is not effective if a company like Blackstone is viewed as an “operating” company rather than an “investment” firm.

As an investment company, Blackstone would be subject to limitations on capital structure, borrowing and its maintenance of custody of fund assets. They would also be required to maintain specific books and records, which are subject to examination by the SEC.

Donohue explained that in its review of the Blackstone IPO, it did not meet the definitions of an investment company as it is defined in The Investment Company Act of 1940 because under that definition Blackstone would have to be using its own assets to invest. The SEC viewed Blackstone as primarily an advisory firm where the majority of assets it invests are not owned by the company.

“Neither Fortress nor Blackstone are orthodox investment companies. Fortress and Blackstone are engaged primarily [and hold themselves out as being engaged primarily] in the business of providing asset management and financial advisory services to others and not primarily in the business of investing in securities with their own assets,” Donohue said.

Donohue said that as operating companies, Fortress and Blackstone complied with all of the appropriate compliance and reporting standards.

Lawrence Booth, a professor of finance at the University of Toronto’s Rotman School of Management, says that private equity IPOs do meet the regulatory requirements of the SEC.

“They are required to,” he says. “Whenever you have a prospectus, you have to provide all of the detailed securities you hold; you must constantly file fact forms and provide an information flow. That would be required [by other public companies].”

He thinks a much bigger issue for private equity in the U.S. is going to be justifying the income tax that its partners pay.

Currently, the majority of hedge fund managers and private equity managers in the U.S. derive their income through capital gains, which is taxed at a rate of 15%, compared to a much higher average income tax rate.

“Some of these managers are making hundreds of millions, if not billions of dollars,” Booth says. “Why should they only pay 15% of what they earn when the people cleaning their houses are paying 35%?”

Booth says it may be a moot point anyway, because he personally thinks that the IPOs of private equity is a signal that they have peaked and the partners are cashing out at the top of the market.

Private equity firms, particularly those engaged in leveraged buying, carry massive debt loads to finance acquisitions. The perception that interest rates are going to continue rising will significantly hinder their ability to effectively manage the debt loads they require to grow their asset base.

“I think it’s a good time to sell out if you’re at the top of the market,” he says. “Whenever you see people selling, you have to wonder if this is a timing issue because where is private equity? It’s at the top of the market.”

Filed by Mark Noble, Advisor.ca, mark.noble@advisor.rogers.com

(07/12/07)

Mark Noble