More PE Writedowns to Follow Blackstone, KKR, Carlyle

(Reuters) – U.S. private equity firms are in the process of reporting substantial writedowns on their portfolios for the year but investors are already anticipating the next round of cuts if the equity markets continue to fall.

Blackstone’s private equity funds were written down 31 percent for the year and 20 percent for the quarter, according to a source who saw a letter it sent to investors.

Amsterdam-listed fund KKR Private Equity Investors (KKR.AS) said Monday that its net asset value, which tracks the worth of its investment portfolio, nearly halved to the end of December from a year ago and dropped 32 percent from the third quarter.

For the fourth quarter, Carlyle Group CYL.UL wrote down its buyout fund Carlyle Partners IV by 13.8 percent, a source who saw the data said.

In Europe, some writedowns have been dramatically worse. UK firm Terra Firma, whose biggest investment is music firm EMI, reported a 70 percent writedown for the year, according to figures seen by Reuters.

One investor estimated that the industry average will be down 30 to 35 percent for 2008 compared with December 2007.

Private equity firms like Blackstone that are themselves publicly traded and buyout firms that have funds that are listed report their figures to the market.

Others send confidential reports directly to their limited partners — the powerful pension and endowment fund investors who invest in their funds.

The numbers vary widely among firms, and can be hard to compare as buyout firms use different methods to value assets.

But investors and analysts say unless the equity markets recover, more writedowns are expected for the three months to March. The Standard & Poor’s 500 Index .SPX is down 21 percent so far this year.

“I’d expect more markdowns … if current conditions hold — absolutely,” said Neil Beaton, National Partner in Charge of Valuation Services at accountancy firm Grant Thornton.

Steven Kaplan, a professor of finance specializing in private equity at the University of Chicago, said the values of the assets reported for the year end were almost “certainly too high” given where the equity market is now.

CONTROVERSIAL MEASURE

Many buyout firms argue that the cuts don’t reflect the long-term value of the companies they own or the price they expect to receive when they sell the asset.

Blackstone told investors on a call on Tuesday that if the accounting standards had been applied to one of Blackstone’s older buyout funds during a similar market trough, the portfolio would have been valued at just 0.3 times the cost of the investments, according to a source who heard the call.

But when the investments were sold, the value realized for investors was actually more than double the cost, it said.

Henry Kravis, co-founder of Kohlberg Kravis Roberts & Co KKR.UL, said on Monday that while KKR Private Equity Investors, also known as KPE, had cut the value of a number of its companies, many had in fact improved profits.

Private equity firms are obliged for the first time this year to value their companies as if they were to sell them today, rather than years in the future when they may be sold.

The controversial accounting rule known as FAS 157 came into effect for financial years beginning after November 15, 2007. Previously, firms held the asset on their books at the original cost price, for the years until they sold them.

CLEAR AS MUD?

One problem investors identify is the varying methods firms are using to mark their assets. Investors say that has resulted in some cases with one asset marked at a different price on two private equity firms’ books. This occurs when two or more buyout firms clubbed together to buy a company.

“Everyone does it differently and that’s the problem,” said Beaton. “There’s no guidance that says you have to use a particular methodology. It says ‘fair value’ and it is up to you to determine it.”

There are two methods that buyout firms use to value their portfolio companies. One is to look at how comparable publicly traded firms are performing. The second is to predict their asset’s future cash flow, known as discounted cash flow, or DCF.

Most companies prefer using the market method, but are deferring to the DCF model right now because the markets are so volatile, said Beaton.

Firms can also use both methods and weight them to come up with one number that is, for example, 70 percent based on DCF and 30 percent based on public multiples.

Other variables also come into the mix, such as if the portfolio company has itself got an independent valuation.

“Every time you enter into a subjective situation like fair value you are going to get differences,” said Beaton. “Is it more transparent than the traditional cost approach it replaced? Yes. At least it attempts with some structure to provide what the company and the auditors believe are the fair values for those companies.”

Kaplan said the increased disclosure was good for investors but it had downsides, too.

“The negative of mark-to-market is that it may exacerbate the boom-and-bust cycle that you see in private equity — that when returns go up money flows in, and when returns go down money doesn’t come in.”

(Reporting by Megan Davies; Editing by Gary Hill)