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Private Equity Split on Investments Valuations

It is the brass-tacks question every stock investor asks: What is this company really worth? But in the rarefied realm of private equity investing, the answer to that question is often hard to find, if it can be found at all.

Oliver Quilla for CNBC.com

After so many public companies passed into private hands during the boom years, buyout specialists who defined that era of Wall Street wealth are seemingly at odds over how their investments are — or are not — panning out.

Freescale Semiconductor, for instance, was taken over by a pack of private investment companies in 2006 for $17.6 billion, of which $7 billion came from the firms.

That $7 billion is now said to be worth $3.15 billion.

Or $2.45 billion.

Or $1.75 billion.

The owners — the Blackstone Group , the Carlyle Group,Permira Advisers and TPG Capital — disagree on its value.

What they do agree on is that this deal, one of the biggest buyouts of all time, has been a troubled investment.

Blackstone calculates that each dollar of its initial stake in Freescale is now worth 45 cents. Carlyle and Permira value their portions at 35 cents on the dollar, and TPG at 25 cents, according to investors in the buyout funds.

At one point last year, Blackstone made an informal offer to buy TPG out of its investment at its 25-cent price, but TPG refused, according to an individual with knowledge of the offer who spoke only on the condition of anonymity.

A second individual close to the deal who also spoke only on the condition of anonymity said no offer had been made. A spokesman for TPG declined to comment.

In the public stock market, investors put a clear price on listed companies every day. Anyone with a computer and an Internet connection can find out what Google is worth ($192 billion as of Tuesday).

After investors sank cash into Facebook this week, that private company was valued at $50 billion.

But private equity investing is private, so company values are negotiated confidentially and are not openly available.

Yet more than a few well-heeled Wall Street deal makers have an interest in how investments like Freescale play out.

Public pension funds, endowments and other institutions piled into private equity in good times. Some deal makers are trying to keep those investors happy by giving some investments higher values than they may deserve.

Accounting rules give the deal makers a lot of wiggle room, because even experts often disagree on how to value investments. At the big firms, at least, independent auditors examine the figures and how they were reached.

But analysts agree that valuations on the books of private equity firms can be skewed by the firms’ motivation to place high values on their investments.

In a business driven by big money and bigger egos, they want to claim the best returns possible to lure new investment dollars and the fat fees those dollars bring.

“If you’re a small group who’s heading into the market and not sure you’re going to be able to raise the money, being able to show better interim performance might tilt things in your favor,” said Josh Lerner, a professor who studies private equity at the Harvard Business School.

Private equity firms buy companies, restructure them and then sell them, often financing their deals with borrowed money.

While deal-making is nowhere near the heady levels of 2006 and 2007, just before the financial crisis struck, private equity made somewhat of a comeback in 2010.

Industry analysts expect big firms to start raising money for new buyout funds early this year. Blackstone, for instance, is completing a new $15 billion fund.

Most big institutions that invest in private equity do so for the long haul. They rarely worry about how an investment performs over one quarter or even one year.

What matters is the final payoff — the return when a private equity firm exits an investment, either by taking a company public or selling outright to another buyer.

But interim performance figures — akin to the score in the fifth inning of a baseball game — do sway decisions. They influence how pension funds and others allocate their money.

Under accounting rules adopted in recent years, private equity firms have leeway in valuing their investments, and the results can vary widely.

For instance, Kohlberg Kravis & Roberts , run by Henry R. Kravis and George R. Roberts, and TPG Capital, run by David Bonderman, place different values on their investment in Energy Future Holdings of Texas, the big energy company formerly known as TXU.

The company was taken private in 2007 in a deal valued at $48 billion— the largest in the history of private equity.

K.K.R. now values its investment at 20 cents on the dollar; TPG values its stake at twice that, 40 cents. That gap represents a difference of nearly $1.7 billion in the value of each firm’s equity stake.

In November, Harrah’s Entertainment, the casino operator, withdrew its initial public offering after prospective investors said the company was not worth what its private equity owners claimed.

Harrah’s is owned by TPG and Apollo Global Management , led by Leon D. Black.

How different buyout firms arrive at different values for the same companies has some investors scratching their heads.

“You would think at the end of the day, when they are looking at the same securities, the same company, the same data and the same information from board meetings, that they would come up with numbers that had a pretty tight range to one another,” said Jamie Ebersole, the senior investment director for private equity in North America for SL Capital Partners, a unit of the asset management company Standard Life Investments.

He added: “We have seen differences in valuations like this, but I’m not sure what to make of it.”

In the case of Freescale Semiconductor, some of the differences come down to accounting and timing. Permira is based in London and uses international accounting rules. Blackstone, Carlyle and TPG, based in the United States, use American guidelines.

Representatives of Permira, Carlyle and TPG declined to comment.

But according to two people with knowledge of how the firms value Freescale, the firms calculated their numbers at different times and placed different weights on measures like discounted cash flow.

In an e-mailed statement, Blackstone, whose own shares are publicly traded, said its valuations were “typically more current” than those of its peers and that it expected the others to catch up to it.

“Given that our valuations are typically more current and that the business has seen marked improvement in operating performance over recent quarters, when others update their valuations the spread should narrow considerably,” the statement said.

But some investors and analysts wonder to what extent the valuations that private equity firms put on their companies resemble reality, particularly during turbulent times in the market.

For instance, in the fourth quarter of 2008, when the Standard & Poor’s 500-stock index collapsed 22.5 percent in the wake of the Wall Street banking crisis, private equity firms reported a loss of nearly 16 percent in the quarter, according to data collected by Cambridge Associates.

When the S.& P. 500 soared almost 15 percent in the third quarter of 2009, private equity firms reported a gain of 6 percent.

Mr. Lerner of Harvard said that because private equity firms used borrowed money for their investments, “they are usually more risky than the underlying public markets.”

And so in late 2008, he said, they “should have declined at least as much as the public markets did, if not more — probably considerably more.”

He added: “There’s a lot of smoothing out in these numbers and even stagecraft here.”

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