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Public Shares in Private Equity: Should You Buy?

The exclusive private-equity club is now accepting new members. But joining comes with risks.

Fortress Investment Group and the Blackstone Group have both gone public this year. Now Kohlberg Kravis Roberts, perhaps best known for its 1988 leveraged buyout of RJR Nabisco (remember Barbarians at the Gate?), says it will follow suit. So for the first time, average investors can buy stock in private-equity firms, whose investment funds were typically open only to institutional investors and wealthy individuals.

Private equity makes its money by acquiring public companies—like Blackstone's recently announced $27 billion buyout of Hilton Hotels—installing a new management team, and then selling the improved company back to the public or to another company for an often hefty profit.

Big numbers. Blackstone manages $88.4 billion in assets and reported $2.3 billion in profit last year. Fortress, with $36 billion in assets under management, netted $443 million. But prospective investors will want to look beyond that number-candy.

While private-equity funds have generated annual returns of 20 percent and higher over the past decade, many in the industry question whether they will continue to do so. The International Monetary Fund and the research company Moody's have both issued warnings about the industry, noting that the companies have thrived with historically low interest rates, which have been rising. Private-equity firms borrow extensively to finance deals; if that money costs more, they won't be able to leverage such steep gains.

The firms have also benefited from low tax rates, something Congress may soon change for those that go public. Many private-equity profits are taxed at the 15 percent capital gains rate; some legislators think the 35 percent corporate tax should apply.

"Any prudent investor should expect that over the next 10 years, returns will be lower," says Roger Freeman, senior analyst at Lehman Brothers. Still, he expects Fortress to outperform other stocks in the financial sector over the next year.

Private-equity firms charge not only a management fee, usually 1 to 2 percent of assets managed, but an incentive fee, often 20 percent of profits. That gives companies like Fortress and Blackstone a steady source of income from management, which generates about a third of revenue, and a more volatile one, which accounts for the rest. Buyers of shares in the firms aren't investing directly in the funds that the companies manage, though, but in the private-equity companies themselves.

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