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Blackstone IPO Is a Must-Miss

This deal is bad for shareholders, and it could signal the end of the cheap-debt era.
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You can learn a lot about the state of the stock market from the popularity of a bad deal.

And since the proposed initial public offering by the Blackstone Group is a very, very, very bad deal for investors -- though one that I expect to be hugely popular anyway -- I believe investors are about to learn a great deal about this market.

What are we likely to learn? That we're witnessing the end of the cheap-debt era that has provided so much support for stock prices. Equities, which have been along for the ride, are going to have to start carrying more of their own weight -- and that's not good for stock prices in general.

Let me start by telling you why this is such a bad deal for investors, and then I'll explain why it is a bad sign for stock prices in general.

Hot Cakes

Here's the outline of the deal. The Blackstone Group, a private investment group with almost $80 billion in assets under management, has filed to go public.

Those assets broke down this way on March 1, according to the group's filing for a potential initial public offering: $31 billion in private-equity funds that do buyouts of public companies, $18 billion in real estate investment funds, $17 billion in funds of hedge funds, $7 billion in senior-debt investments and $6 billion in hedge funds that invest in distressed bonds, stocks, near-equity debt (called mezzanine debt) and closed-end mutual funds.

The IPO aims to raise about $4 billion in the public markets by selling 10% to 15% of the firm that manages all that money.

I expect this offering to sell like ice water in the Sahara if the Feb. 9 IPO of

Fortress Investment Group


is any indication. The hedge fund manager, with $30 billion under management, became the first private-equity/hedge fund management firm to sell shares to the public. That IPO soared from an offering price of $18.50 a share to $35 by the time shares opened for trading, as investors clamored for a piece of the offering.

Shares have since dropped back, closing at $27.18 on March 28. But I don't expect that the 22% loss that investors who bought at $35 suffered will deter many prospective Blackstone buyers, since those Fortress investors who got an allocation of shares at $18.50 made a quick 90% by flipping their shares.

Up, Up and Away

On form, the Blackstone Group IPO should be even more popular. The group manages almost twice the assets of Fortress. It and its co-founders, Pete Peterson and Steve Schwarzman, have a much higher profile on and off Wall Street -- thanks to Schwarzman's 60th birthday party, which featured 1,500 guests and entertainment by Rod Stewart.

The returns its funds have garnered -- for example, the annual 23% on average for the company's private-equity funds since 1987, about twice the average return for the

S&P 500 Index

for the period -- are enough alone to create the kind of demand that drives an IPO up in price on the first day of trading.

None of this makes it a good deal for investors. Frankly, I think it's terrible. Why? Let me count the ways (from bad to worse):

    Investors aren't buying the funds themselves. The Blackstone Group is trading on the returns and reputation of its managed funds, but what it's selling isn't a piece of any or all of those funds but rather a piece of the company that manages that money. I doubt that everyone buying shares will understand the difference. (If they don't know what they're buying, shame on them, of course.)

    Investors are paying a big premium. That business, to be renamed Blackstone Holdings, is certainly profitable -- at least it was last year, when the management company made $2.3 billion from management fees and other sources. But that's not as big a profit as it sounds, considering that the IPO will value Blackstone Holdings at $40 billion or so. Lehman Bros. earned $4 billion in the past 12 months, and that company's market capitalization is only $37 billion.

    Investors are paying for past performance. Only about half of that $2.3 billion in earnings came from management fees, a relatively stable source of continuing future earnings. The bulk of the rest came from carried interest -- the Blackstone Group's slice is usually about 20% -- of any profits earned by the buyout funds.By its nature, carried interest represents the profits on past deals. Investors buying shares in the IPO are betting that current and future deals will earn the same profits as Blackstone has reaped during the current top of the buyout cycle. With increased competition for deals driving the prices paid for public companies ever higher, it's unlikely that the next part of the cycle will be as profitable.

    Investors will have no say in how the company will be run. Since Blackstone Holdings will be structured as a master limited partnership, investors will be unit holders instead of shareholders. The difference is critical: Shareholders vote to elect company directors, and a public company with shareholders must have a majority of independent directors on its board of directors. Unit holders don't have those basic rights. They won't be entitled to vote to elect directors, and master limited partnerships aren't required to have a majority of independent directors on the board of directors. The rules of the Blackstone Holdings master limited partnership even allow the directors of the company to sell the business without the consent of the unit holders.

    Investors will have no say, again, on what Peterson, Schwarzman and the other partners pay themselves. Again, because this is a master limited partnership, Blackstone Holdings isn't required to have an independent compensation committee that decides who gets paid how much. Admittedly, compensation committees run by independent directors haven't exactly done a great job in limiting executive paychecks at public companies such as Home Depot and Pfizer , but any checks on the power of managers to pay themselves whatever they want are better than no checks at all. Don't pay too much attention to the promise in the IPO filing that Schwarzman will take a salary of just $350,000. In buyout firms, the big compensation comes from owning a stake in the company and from receiving a cut of the carried interest earned by managed funds. The Wall Street Journal calculates that Schwarzman, now worth about $10 billion, could see his net worth double as a result of the IPO.

    OK, so maybe this is a bad deal for investors and an example of Wall Street greed at its worst, but stocks have survived overvalued IPOs and huge payouts to insiders before with hardly a ripple. Why is this deal an indicator of tough times ahead for stocks?

    Because the very smart guys at the Blackstone Group who are doing this deal see the handwriting on the wall. The success of buyout funds like theirs has been built on cheap debt. Cheap debt has made it possible for the Blackstone Group and other private-equity managers to buy



    auto parts business, to buy


    (HTZ) - Get Free Report

    , to buy

    Burger King


    . Cheap debt has made it possible for these private-equity funds to pay themselves big dividends on their investments in these companies, before taking them public, by having the newly private company borrow to fund the payout.

    And cheap debt has made it possible for these investors to leverage a modest equity investment in these deals by borrowing most of the purchase price, so that they can then reap returns of 30%, 50% or even 100% when they sell the acquired company back to the public markets.

    Nothing Lasts Forever

    But this game is coming to an end. Not so much because interest rates in general are rising -- they aren't -- but because interest rates for the riskiest of leveraged buyouts have started to rise. For example, TRW Automotive Holdings, a Blackstone buyout in 2003 that's now public again, recently paid 7.25% on an issue of $1.5 billion in bonds. Still cheap debt, yes, but more expensive than the 6.875% that investment bankers had predicted.

    The smart buyout money can also see debt getting expensive in other ways. For example, bankers and insurance companies, who even in this day quaintly like to write covenants into their loan agreements to protect themselves from potential default, have been willing to buy debt in buyout fund deals with very few covenants because defaults rates have been so low.

    But with higher default rates visible on the horizon, bankers and other debt purchasers have started to ask for more restrictions on the use of funds from these borrowings and on leverage ratios at the purchased company. That's not an attractive trend from the point of view of a buyout fund manager.

    Equity, the kind of money you raise by selling stock to the public, starts to look relatively attractive in this situation. The money is a permanent "loan," since it never has to be paid back to investors who buy the stock. And it comes without covenants or restrictions of any kind. Companies can use the proceeds for any "legitimate" corporate purpose, including paying dividends to buyout fund investors, for example.

    Debt and Equity

    You could say equity is making a (so-far modest) comeback, after years of taking a back seat to debt.

    That isn't great news for equity investors. Share prices have been propped up by debt during recent stages of this rally. Debt has funded corporate buybacks of shares, and those buybacks have made specific stocks look more attractive (fewer shares outstanding means higher earnings per share, since the earnings get spread over fewer shares) and supported the stock market in general by reducing the supply of shares and adding to earnings growth. Debt has funded dividends.

    Yes, I know dividends are supposed to come out of earnings, but recently many companies have discovered that it's easier to simply borrow the money in order to pay it out to investors. In that way, too, debt has supported stock prices by making dividend growth look better.

    Consider the IPO of the Blackstone Group an early indicator of the shift away from cheap debt. Where Blackstone has gone, other buyout funds will follow, so you can expect to see a steady stream of IPOs from Blackstone's competitors. In my opinion, each deal is just another bit of evidence that the era of cheap debt is moving toward a close.

    At the time of publication, Jim Jubak did not own or control shares of any of the equities mentioned in this column. He did not own short positions in any stock mentioned in this column.

    Jim Jubak is senior markets editor for MSN Money. He is a former senior financial editor at Worth magazine and editor of Venture magazine. Jubak was a Bagehot Business Journalism Fellow at Columbia University and has written two books: "The Worth Guide to Electronic Investing" and "In the Image of the Brain: Breaking the Barrier Between the Human Mind and Intelligent Machines." As an investor, he says he believes the conventional wisdom is always wrong -- but that he will nonetheless go with the herd if he believes there's a profit to be made. He lives in New York. While Jubak cannot provide personalized investment advice or recommendations, he appreciates your feedback;

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