The Blackstone Group is a large U.S.-based investment company whose operations include investing in public companies and taking them private. A major component of its earnings from these investments derives from “carried interest.” This is a management fee based on a preferential interest in the profits earned by unconsolidated companies in which it has invested. For example, a typical arrangement would be for Blackstone to receive an annual payment of 20% of a company’s profits in excess of a hurdle rate of return on equity. These payments could continue for, say, five years, after which Blackstone would plan to sell its interest in the company.
Under historical cost accounting and the equity method of accounting for unconsolidated subsidiaries, carried interest fees would be recorded as revenue each period, if and as they are earned, with offsetting debit to the investment account. Note, however, that Blackstone’s preferential right to receive future fees conditional on a hurdle rate of return on equity of a firm in which it has invested has option-like characteristics, expiring in five years in the above example.
In 2007, Blackstone planned an initial public offering of its stock. In its preliminary prospectus, date March 22, it revealed that for many of its unconsolidated investments it would use the fair value option to value future carried interest fees on a fair value basis, with the offsetting credit to current earnings. Presumably, an option pricing model, such as Black-Scholes, would be used to determine fair value. If this accounting had been applied in 2006, Blackstone indicated that its 2006 earnings would have increased by $595,205, relative to earnings reported using the equity method of accounting for its unconsolidated investments.
Note that fair value has to be re-evaluated each period. Blackstone pointed out that this could introduce considerable volatility into its reported earnings. It seems that Blackstone was willing to bear this volatility in order to secure earlier revenue recognition.
Concerns about reliability of Blackstone’s proposed accounting soon appeared in the financial media, despite the greater relevance of this approach. A major source of concern was that since bought-out companies are typically taken private, the amount of public information about them is minimal. This makes it particularly difficult for the market to assess Blackstone’s valuation, and puts considerable onus on Blackstone to fully disclose its assumptions in determining fair value. Concern was also expressed that Blackstone could bias its financial results by means of these assumptions.
(Source: Scott, W. R., 2012, Financial Accounting Theory, Pearson: Ontario)
a) As a rational investor who is considering investing in the shares of Blackstone’s initial public offering, would you find fair value accounting more or less decision-useful than historical cost accounting for the value of Blackstone’s carried interest? In your answer, consider issues of relevance, reliability and full disclosure of accounting information produced under historical cost and fair value approaches. (10 Marks)
b) As an investor, would the increased volatility of Blackstone’s earnings resulting from fair value accounting affect the amount you would be willing to pay for its shares? Explain your answer referring to an appropriate theory you have studied in this unit. (5 Marks)
c) Using Positive Accounting Theory introduced by Watts and Zimmerman explain Blackstone’s decision to adopt fair value accounting for carried interest fees in 2007. (5 Marks)