The AFL-CIO is stepping into the ongoing fray over the role of private equity with a letter to the SEC as reported here: FT.com Union in move to halt Blackstone IPO. This is perfect timing in light of the announcement recently of the takeover of Chrysler – a company with thousands of unionized workers – by Cerberus, a private equity firm. Also, today in Congress hearings are being held on the impact of private equity on workers.
The AFL-CIO letter according to the Financial Times makes the important point that when a private equity firm goes public it should obey the requirements of the Investment Company Act of 1940, widely known as the 40 Act. The 40 Act is a firewall to protect investors against the potential misuse of their investment and a firewall against the growth of speculative financial interests as opposed to the real economy.
Congress understood that the first two securities laws they passed in the 1930s – 1933 and 1934 Acts were insufficient protection against investment pools and after an exhaustive four year study put in place the Investment Company Act. While the 33/34 Acts protected investors from potential abuse by corporate managers and financial intermediaries like broker/dealers, these statutes were not sufficient to protect investors from organizers of investment pools such as those put together by mutual fund companies or buyout funds.
Such pools pose particular problems because they say to the investing public: “trust me” to take your money and invest it wherever we want. Thus the 40 Act requires specialized governance mechanisms for investment companies. While mutual funds are the classic and best understood investment company, “special situation” companies like buyout funds have always been considered investment companies. Special situation companies have, until now, always functioned as either private investment companies or relied solely on investments from qualified purchasers.
The Blackstone IPO attempts to circumvent the governance protections that the 40 Act mandates even though it is no longer to be a private investment company. As one example, under the 40 Act the fund must have independent directors who represent the interests of public investors but that will not be the case if Blackstone gets its way. Congress and the SEC must understand that the substance of Blackstone pre and post IPO is to function as a special situation investment company that earns its income through its investment in target companies.
As the SEC itself found in Bankers Securities Corporation 15 SEC 1695: “In the course of its history applicant has obtained large and controlling interests in various businesses, disposed of some, and retained others. Its officers have actively managed controlled businesses for the purpose of rehabilitating important investments in the portfolio. This is a well-recognized form of investment company business, known as dealing in ‘special situations.’… Not only does this record fall short of sustaining applicant’s claim that it is primarily engaged in non-investment company business, but it demonstrates affirmatively that Bankers Securities Corporation was organized, and has always been operated, as an investment enterprise. Public investment in the company was invited and has been maintained on representations which meant, in essence, that the company was diversifying stockholders’ risk by a varied investment program. Stockholders were not asked to rely on the skill of applicant’s management in the merchandising, or in any other specific mercantile or commercial business. They were given to understand that the management was alert always to find profitable repositories of invested funds, and the history of the company bears out the understanding, created in stockholders, that the company was not committing itself primarily to any specific business.”
Blackstone attempts to escape the obvious conclusion that it is and has always been an investment company by interpolating two new layers in its corporate structure – Blackstone Holdings and Blackstone LP – and then selling units in Blackstone LP to the public. But as the prospectus makes abundantly clear investors are being told they will share in the rewards and bear the risks of Blackstone’s (special situations) investment activity.
This conclusion is reinforced by the importance of the 20% carried interest as a significant source of potential gain for investors.
A fundamental principle of US securities law is that substance – economic reality – trumps form. This is essential to enable regulators to stay ahead of the myriad ways that speculators will attempt to separate people from their money. The principle that substance trumps form is essential because the securities laws, including the 40 Act, are remedial in nature – their purpose is to protect investors and to act as a firewall between the real economy and financial speculators. Congress intended that the SEC not ignore the purpose of an investment scheme even if it appears formally to comply with securities regulation if a fundamental goal of the act is at stake.
In the Blackstone IPO which is reportedly now to be followed by an offering by Carlyle Group a fundamental goal – protection of the investing public from the potential risks of investment pools – is at stake. When a financial speculator like Blackstone seeks to raise capital in the public markets – to dip into what Justice Brandeis called “other people’s money” – it must meet the requirements laid out in the 40 Act or it must continue to operate as a private company.