Tuesday, May 15, 2007
The FT is reporting that the AFL-CIO has written the SEC arguing that private equity group Blackstone's planned initial public offering should be halted. According to the Financial Times, "the union says that the unique structure chosen by Blackstone’s senior executives to raise funds from stock markets while keeping a tight grip on the running of its business is an attempt to evade the coverage of the Investment Company Act of 1940." (Update: a copy of the letter can be downloaded here). In brief, the AFL-CIO is arguing that a majority of Blackstone's assets are in the form of carried interest that has been “marked to market” . Carried interest is the term for the 20% Blackstone takes on deal profits over and above its 2% administration fee. The AFL-CIO is arguing that because the carry is only paid when a deal reaches certain profit milestones, it is a form of call option. Call options are securities, and given that more than 40% of Blackstone's assets are in carry, if the union is right Blackstone would fall under the regulatory schematic of the Investment Company Act of 1940 as an investment company unless another exemption applied.
The argument is a clever and convoluted one, but is almost certainly an incorrect interpretation of the definition of a call option under the Act. The alternative view would arguably pick up a number of regular operating companies and investment banks who have profit participation contracts and mark those profits to market. Not to mention the argument would cause serious doctrinal problems for the SEC which recently let the similarly-structured Fortress ipo go forward without claiming the Investment Company Act applied (the AFL-CIO attempts to get around this problem by claiming that Blackstone's practice of marking-to-market makes it distinct from Fortress and is the key to qualifying the carry as a security).
But the AFL-CIO is absolutely correct that the Blackstone offering is an attempt to evade application of the Investment Company Act. Under the Act, it is very clear that the Blackstone funds themselves as currently structured cannot currently be offered to the public. But, Blackstone is getting around this prohibition by selling shares in itself, the fund advisor. Blackstone's evasion is permissible under the current structure of the U.S. securities laws. Despite almost certainly being wrong, the AFL-CIO argument does highlight the out datedness of the Investment Company Act and the increasingly bizarre results it engenders. Investing in a private equity fund adviser is essentially equivalent to investing in the funds themselves. There should be no regulatory difference in their regulation by the SEC, and no ability for private equity funds to game this regulation as Blackstone is doing here. In fact, if anything investing in the adviser is more risky. The subject is for a more extended post, but it is far past the time that the SEC updated the Investment Company Act, which was passed in 1940, to regulate mutual funds for the modern age of hedge funds and private equity.