Kohlberg Kravis Roberts & Co. (kkr) today became the first private equity firm ever listed on the Fortune 500, slotting in at No. 256. It reported $9.67 billion in 2010 revenue, which puts it just above The Williams Cos. (wmb) and just below Liberty Global (lbtya).
Surprised? So were we. Not only at the mammoth revenue number, but also at how KKR made the cut while rival The Blackstone Group (bx) did not.
Here's what my Fortune colleague Allan Sloan wrote:
KKR is the first buyout firm to make the list, thanks to an accounting oddity that tripled its revenues from what they’d otherwise be, and because its move last year to the New York Stock Exchange from Guernsey means it now files financial reports with the SEC.
Allan's right (as he usually is). This is an accounting oddity. Not a trick to inflate revenue, or an indication that KKR had a blowout year.
To understand what happened, let's take a look at KKR's two primary sources of revenue:
- Fees, which include annual management fees paid by private investors (called "limited partners") in its various funds. In 2010, this worked out to around $435 million.
- Investment income, which includes both realized and unrealized gains (or losses, such as in 2008). In 2010, this was nearly $9.18 billion.
So Fortune added together these two numbers, tacked on around $53 million in interest expenses and came out with $9.67 billion.
But here's where it gets troublesome: KKR, like most private equity firms, is not actually entitled to all of the investment income it reports. Instead, it only gets around 20% -- a so-called "carried interest" -- while its limited partners (public pensions, universities, sovereign wealth funds, etc.) receive the remainder. Consider it like a performance bonus that helps better align everybody's interests. Certain KKR employees also invest in its funds, but returns from those investments are included in the 80% (even though it's not exactly the same, due to some reinvestment provisions).
To comply with Generally Accepted Accounting Principles (GAAP), however, KKR believes that it must consolidate the majority of its funds (including all of its private equity funds). In other words, that $9.18 billion of investment income includes both the money to which KKR is entitled (the 20%) and the money to which it is not (the 80%).
Blackstone Group, on the other hand, does not consolidate its private equity funds. Were it to do so, it easily would have made the Fortune 500.
So is KKR correct and Blackstone is wrong? Or vice versa? Or are they both right, due to differences within their firm and fund structures?
Honestly, it's impossible to tell without access the the original fund documents that better elucidate issues of economic interest and control. The 10-Ks are not really of much use in this endeavor.
But here's what I do know: Neither KKR nor Blackstone should be on the Fortune 500. At least not based on their 2010 financial results.
KKR even agrees with me. In a statement, the firm said: "While it’s an honor to be on such a respected list and we are pleased by our growth the past few years, we don’t think this accurately measures our firm results because the methodology used also includes the income on third party capital that we manage."
This is not to bash our methodology, or suggest that Fortune should treat private equity firms differently from retailers or big pharma. To do so would lead to a slippery slope that could end with charges of favoritism and the loss of credibility. Fortune has decided, properly in my opinion, to base its rankings on the top-line revenue figures reported by each public company.
Instead, I mean it's time for the FASB to play common sense catch-up with the slow wave of private equity firms going public. Stop allowing minor differences in fund structures to obscure the larger truths of ownership. Current regulations like FAS 167 -- which governs consolidation -- has created a situation in which public market investors are hard-pressed to compare GAAP financials from firms like KKR, Blackstone and Apollo Global Management (wmb). They all are measuring different things, often with very similar sounding names.
This is the reason that publicly-traded private equity firms often tout "economic net income" (ENI) -- an unconventional accounting measure that some feel is more representative of how much shareholder value such firms are actually generating (KKR's ENI last year was $2.14 billion, compared to Blackstone's $1.4 billion). I can almost guarantee that both firms would give up -- or at least downplay -- ENI were they to have more relevant/standardized GAAP rules.
Seriously, I am not overstating how backward FASB has been on all of this. Not too long ago, there was rumbling that the group would effectively require private equity firms to include underlying portfolio company revenue as its own revenue. Under such ridiculous accounting, Blackstone would be a Fortune 20 company.
The private equity firms themselves also bear some responsibility, in creating financial reports that are needlessly confusing. I know that such documents aren't meant to be Stephanie Meyers novels, but some of them make James Joyce look explicit by comparison. Would it be too much trouble to let your investors know what they own without a translator?
So congrats to KKR for making the list. Let's hope it doesn't happen again any time soon.