Blackstone Risk Factors Worth Revisiting

Many investors confronting the 35-page “risk factors” section of The Blackstone Group’s offering prospectus last spring surely had a ho-hum reaction. “Difficult market conditions … timing and receipt of carried interest … cash flow can be highly variable …” Yeah, yeah, right, right, whatever. Hadn’t the firm generated 23 percent net returns over the hill and dale of investment cycles for since 1987? Weren’t buyout professionals referring to this as the golden age of private equity? And how likely was the market downturn that would be needed to turn these risks into realities?

In fact, many of the “risk factors” sections of most offering prospectuses paint doomsday scenarios difficult to take 100 percent seriously. Nevertheless, those listed in the Blackstone Group S-1 read a lot less like fiction today than they did nine months ago. And they’re worth revisiting. Institutional investors with significant stakes in LBO funds need to be in tune with the risks that the credit crunch and the rapidly slowing economy pose to those investments.

Indeed, that so many buyout pros repeat, at every public opportunity, the conventional wisdom that they generate their best returns during economic downturns suggests they may not be so in tune with these risk themselves. (Who’s to say this economic downturn won’t ignore the script of previous ones?) And if buyout pros don’t face up to the new risks posed, they won’t take steps to mitigate them, and they won’t communicate those steps to their staffs, management teams, and their investors, none of whom likes unpleasant surprises. I commend you to pages 32 to 67 of the Blackstone Group prospectus for the full list. But here are some excerpts:

* Portfolio Companies: … During periods of difficult market conditions or slowdowns in a particular sector, companies in which we invest may experience decreased revenues, financial losses, difficulty in obtaining access to financing and increased funding costs …

* Prior Club Deals: … Consortium transactions generally entail a reduced level of control by Blackstone over the investment because governance rights must be shared with the other private equity investors. Accordingly, we may not be able to control decisions relating to the investment, including decisions relating to the management and operation of the company and the timing and nature of any exit …

* New Investments: … In addition, during periods of adverse economic conditions, we may have difficulty accessing financial markets, which could make it more difficult or impossible for us to obtain funding for additional investments and harm our assets under management and operating results …

* Valuation Uncertainty: … Because there is significant uncertainty in the valuation of, or in the stability of the value of illiquid investments, the fair values of such investments as reflected in an investment fund’s net asset value do not necessarily reflect the prices that would actually be obtained by us on behalf of the investment fund when such investments are realized …

* In Rearview Mirror, Future Returns Are Not As Big As They Appear: … Our investment funds’ returns have benefited from investment opportunities and general market conditions that may not repeat themselves, including favorable borrowing conditions in the debt markets …

* Dark Side Of Leverage: … The incurrence of a significant amount of indebtedness by an entity could … give rise to an obligation to make mandatory prepayments of debt using excess cash flow, which might limit the entity’s ability to respond to changing industry conditions … [Significant leverage could also] limit the entity’s ability to obtain additional financing or increase the cost of obtaining such financing, including for capital expenditures, working capital or general corporate purposes …

* Exiting: … The ability of many of our investment funds … to dispose of investments is heavily dependent on the public equity markets … large holdings of securities can often be disposed of only over a substantial length of time, exposing the investment returns to risks of downward movement in market prices during the intended disposition period

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