Wall Street doesn’t know how to value private equity firms

May 3, 2012, 1:00 PM UTC

Investors are ignoring a key source of income, and that means shares aren’t getting the respect they deserve.

FORTUNE — Shortly after the Blackstone Group went public in mid-2007, I advised friends not to buy the stock. Investors didn’t seem to understand how private equity firms like Blackstone should be valued, as illustrated by a 6% share price bump in the days after Blackstone agreed to acquire Hilton Hotels. Private equity firms recognize value when they sell assets, not when they acquire assets, I argued. They aren’t conglomerates that generate margin via economies of scale.

Today, as the Carlyle Group (CG) heads to the Nasdaq, I am reconsidering my advice. Not because the Street now properly values Blackstone or the handful of other publicly traded private equity firms. Instead, it’s because the fundamental mispricing persists, and it has created a ridiculous amount of upside potential.

For starters, it is important to understand that private equity firms have two primary revenue streams: management fees and performance fees. Management fees are recurring revenue, paid by limited partners in a private equity fund (typically 1%-2% of committed capital, on an annual basis). Wall Street analysts love management fees because they are consistent and easy to model. Performance fees, on the other hand, are the percentage of profits that a private equity firm gets to keep upon selling a portfolio company (i.e., the “carried interest”). Wall Street analysts despise performance fees, because they are notoriously uneven. Carlyle may sell a dozen companies one quarter and then sell none in the next — it’s all based on a messy recipe of macroeconomic conditions and company-specific factors.

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As a result, private equity firm valuations have been almost entirely based on management fees, to the exclusion of performance fees. Just take a look at target prices for Blackstone (BX) stock today: In most cases, they are calculated by stripping out the value of investments and cash on hand, and then applying a comparable multiple to what’s left (i.e., recurring management fees). In other words, the second revenue stream is being ignored.

“That’s largely correct,” says Marc Irizarry, a financial services analyst with Goldman Sachs. “A big part of it is that these firms only have been public in a period that hasn’t seen robust harvesting for private equity strategies… It’s still a bit of ‘show me’ for distributions.”

To a certain extent, Irizarry is right. Blackstone went public just before the financial markets took a dive, so the era of listed private equity has been burdened by a particularly difficult exit environment. At the same time, however, it’s strange to exalt management fees while ignoring performance fees. The former exist only because private equity firms have been able to raise large funds, presumably because of their proven ability to achieve outsize performance. It’s a direct correlation. If future performance becomes subpar, then management fees will tumble.

Irizarry acknowledges the disconnect, but that doesn’t mean he’s about to bump his target share price for Blackstone or KKR (KKR) by another couple of bucks. Instead, he’ll wait until the distributions begin to pile up.

And that’s why I think there’s potential upside to private equity shares today. Almost every fund manager I speak with believes that harvesting has already begun, and that 2013 will be a bumper crop. Some of them may just be talking their books, but a recent increase in private-equity-backed IPO activity gives credence to their claims (Vantiv LLC (VNTV), Rexnord Industries (RXN), Laredo Petroleum (LPI), to name a few). Plus, there is a giant pipeline of portfolio companies that, under more normal economic circumstances, would have been sold between 2009 and 2011.

When publicly traded companies are undervalued, it’s often private equity firms that swoop in to take advantage of the discount. But it’s highly unlikely that Blackstone or its peers will buy back their own outstanding shares, which means that the potential for returns is being left to everyday investors. As your friend, I suggest that you take a good, hard look.

This story is from the May 21, 2012 issue of Fortune.