King of Capital: The Remarkable Rise, Fall, and Rise Again of Steve Schwarzman and Blackstone
Chapter 1 - The Debutants
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The $3 million gala was a self-coronation for the brash new king of a new Gilded Age, an era when markets were flush and crazy wealth saturated Wall Street and especially the private equity realm, where Schwarzman held sway as the CEO of Blackstone Group. As soon became clear, the birthday affair was merely a warm-up for a more extravagant coming-out bash: Blackstone’s initial public offering. By design or by luck, the splash of Schwarzman’s party magnified the awe and intrigue when Blackstone revealed its plan to go public five weeks later, on March 22. No other private equity firm of Blackstone’s size or stature had attempted such a feat, and Blackstone’s move made official what was already plain to the financial world: Private equity—the business of buying companies with an eye to selling them a few years later at a profit—had moved from the outskirts of the economy to its very center. Blackstone’s clout was so great and its prospects so promising that the Chinese government soon came knocking, asking to buy 10 percent of the company. When Blackstone’s shares began trading on June 22 they soared from $31 to $38, as investors clamored to own a piece of the business. At the closing price, the company was worth a stunning $38 billion—one-third as much as Goldman Sachs, the undisputed leader among Wall Street investment banks.
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Private equity now permeated the economy. You couldn’t purchase a ticket on Orbitz.com, visit a Madame Tussauds wax museum, or drink an Orangina without lining Blackstone’s pockets. If you bought coffee at Dunkin’ Donuts or a teddy bear at Toys “R” Us, slept on a Simmons mattress, skimmed the waves on a Sea-Doo jet ski, turned on a Grohe designer faucet, or purchased razor blades at a Boots pharmacy in London, some other buyout firm was benefiting. Blackstone alone owned all or part of fifty-one companies employing a half-million people and generating $171 billion in sales every year, putting it on a par with the tenth-largest corporation in the world. The reach of private equity was all the more astonishing for the fact that these firms had tiny staffs and had long operated in the shadows, seldom speaking to the press or revealing details of their investments. Goldman Sachs had 30,500 employees and its profits were published every quarter. Blackstone, despite its vast industrial and real estate holdings, had a mere 1,000 employees and its books were private until it went public. Some of its competitors that controlled multibillion-dollar companies had only the sketchiest of websites.
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Private equity’s power on Wall Street had never been greater. Where buyout firms had once been supplicants of the banks they relied on to finance their takeovers, the banks had grown addicted to the torrent of fees the firms were generating and now bent over backward to oblige the Blackstones of the world. In a telling episode in 2004, the investment arms of Credit Suisse First Boston and JPMorgan Chase, two of the world’s largest banks, made the mistake of outbidding Blackstone, Kohlberg Kravis, and TPG for an Irish drugmaker, Warner Chilcott. Outraged, Kohlberg Kravis cofounder Henry Kravis and TPG’s Jim Coulter read the banks the riot act. How dare they compete with their biggest clients! The drug takeover went through, but the banks got the message. JPMorgan Chase soon shed the private equity subsidiary that had bid on the drug company and Credit Suisse barred its private equity group from competing for large companies of the sort that Blackstone, TPG, and Kohlberg Kravis target.
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To some of Blackstone’s rivals, the public attention was nothing new. Kohlberg Kravis, known as KKR, had been in the public eye ever since the mid-1980s, when it bought familiar companies like the Safeway supermarket chain and Beatrice Companies, which made Tropicana juices and Sara Lee cakes. KKR came to epitomize that earlier era of frenzied takeovers with its audacious $31.3 billion buyout in 1988 of RJR Nabisco, the tobacco and food giant, after a heated bidding contest. That corporate mud wrestle was immortalized in the best-selling book Barbarians at the Gate and made Henry Kravis, KKR’s cofounder, a household name.
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Though the strip-and-flip image persists, the biggest private equity profits typically derive from buying out-of-favor or troubled companies and reviving them, or from expanding businesses. Many of Blackstone’s most successful investments have been growth plays. It built a small British amusements operator, Merlin Entertainments, into a major international player, for example, with Legoland toy parks and Madame Tussauds wax museums across two continents. Likewise it transformed a humdrum German bottle maker, Gerresheimer AG, into a much more profitable manufacturer of sophisticated pharmaceutical packaging. It has also staked start-ups, including an oil exploration company that found a major new oil field off the coast of West Africa. None of these fit the cliché of the strip-and-flip.
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Many not all, as noted later lot of gains can be attributed to interest rate environment and buying cyclical businesses at the right time
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A history of Blackstone is also a chronicle of an entrepreneur whose savvy was obscured by the ostentation of his birthday party. From an inauspicious beginning, through fits and starts, some disastrous early investments, and chaotic years when talent came and went, Schwarzman built a major financial institution. In many ways, Blackstone’s success reflected his personality, beginning with the presumptuous notion in 1985 that he and Peterson could raise a $1 billion LBO fund when neither had ever led a buyout. But it was more than moxie. For all the egotism on display at the party, Schwarzman from the beginning recruited partners with personalities at least as large as his own, and he was a listener who routinely solicited input from even the most junior employees. In 2002, when the firm was mature, he also recruited his heir in management and handed over substantial power to him. Even his visceral loathing of losing money—to which current and former partners constantly attest—shaped the firm’s culture and may have helped it dodge the worst excesses at the height of the buyout boom in 2006 and 2007.
Chapter 2 - Houdaille Magic, Lehman Angst
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To Wall Street, the deal was little short of revolutionary. In October 1978 a little-known investment firm, Kohlberg Kravis Roberts, struck an agreement to buy Houdaille Industries, an industrial pumps maker, in a $380 million leveraged buyout. Three hundred eighty million bucks! And a public company, no less! There had been small leveraged buyouts of privately held businesses for years, but no one had ever attempted anything that daring. Steve Schwarzman, a thirty-one-year-old investment banker at Lehman Brothers Kuhn Loeb at the time, burned with curiosity to know how the deal worked. The buyers, he saw, were putting up little capital of their own and didn’t have to pledge any of their own collateral. The only security for the loans came from the company itself. How could they do this? He had to get his hands on the bond prospectus, which would provide a detailed blueprint of the deal’s mechanics. Schwarzman, a mergers and acquisitions specialist with a self-assured swagger and a gift for bringing in new deals, had been made a partner at Lehman Brothers that very month. He sensed that something new was afoot—a way to make fantastic profits and a new outlet for his talents, a new calling. “I read that prospectus, looked at the capital structure, and realized the returns that could be achieved,” he recalled years later. “I said to myself, ‘This is a gold mine.’ It was like a Rosetta stone for how to do leveraged buyouts.”
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Gibson Greeting Cards Inc., which published greeting cards and owned the rights to the Garfield the Cat cartoon character, was an unloved subsidiary of RCA Corporation, the parent of the NBC television network, when a buyout shop called Wesray bought it in January 1982. Wesray, which was cofounded by former Nixon and Ford treasury secretary William E. Simon, paid $80 million, but Wesray and the card company’s management put up just $1 million of that and borrowed the rest. With so little equity, they didn’t have much to lose if the company failed but stood to make many times their money if they sold out at a higher price. Sixteen months later, after selling off Gibson Greeting’s real estate, Wesray and the management took the company public in a stock offering that valued it at $290 million. Without leverage (another term for debt), they would have made roughly three and a half times their money. But with the extraordinary ratio of debt in the original deal, Simon and his Wesray partner Raymond Chambers each made more than $65 million on their respective $330,000 investments—a two-hundred-fold profit. Their phenomenal gain instantly became legend. Weeks after, New York magazine and the New York Times were still dissecting Wesray’s coup.
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By the 1980s, though, Lehman had regained financial strength and Peterson and Schwarzman began to press the rest of management to consider merchant banking again. They even went so far as to line up a target, Stewart-Warner Corporation, a publicly traded maker of speedometers based in Chicago. They proposed that Lehman lead a leveraged buyout of the company, but Lehman’s executive committee, which Peterson chaired but didn’t control, shot down the plan. Some members worried that clients might view Lehman as a competitor if it started buying companies. “It was a fairly ludicrous argument,” Peterson says. “I couldn’t believe they turned this down,” says Schwarzman. “There was more money to be made in a deal like that than there was in a whole year of earnings for Lehman”—about $200 million at the time.
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Peterson was appealing in many ways. He was honest and principled, and he could be an engaging conversationalist with a dry, often mordant, wit. He wasn’t obsessed with money, at least not by Wall Street’s fanatical norm. But with colleagues he was often aloof, imperious, and even pompous. In the office, he’d expect secretaries, aides, and even fellow partners to pick up after him. Rushing to the elevator on his way to a meeting, he would scribble notes to himself on a pad and toss them over his shoulder, expecting others to stoop down and gather them up for his later perusal.
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Lol, schwarzman’s boss at Lehman
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Schwarzman wasn’t the bank’s only M&A luminary. In any given year, a half-dozen other Lehman bankers might generate more fees, but he mixed easily with CEOs, and his incisive instincts and his virtuosity as a deal maker set him apart. Those qualities were prized by Peterson, and over the years, the two developed a kind of tag-team approach to courting clients. Peterson would angle for a chief executive’s attention, then Schwarzman would reel him in with his tactical inventiveness and command of detail, figuring out how to sell stocks or bonds to finance an acquisition or identifying which companies might want to buy a subsidiary the CEO wanted to sell and how to sell it for the highest price. “I guess I was thought of as a kind of wise man who would sit down with the CEO in a context of mutual respect,” says Peterson. “I think most would agree that I produced a good deal of new advisory business. But it’s one thing to produce it, and it’s another to implement it, to carry most of the load. I experimented with various people in that role, and Steve was simply one of the very best. It was a very complementary and productive relationship.”
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But in the spring of 1984, Glucksman’s traders suffered another enormous bout of losses and Lehman’s partners found themselves on the verge of financial ruin, just as they had a decade earlier. Glucksman, though still CEO, lost his grip on power and the partners were bitterly divided over whether to sell the firm or tough it out. If they didn’t sell, there was a very real risk the firm would fail and their stakes in the bank—then worth millions each—would be worthless. It was Schwarzman who ultimately forced the hand of Lehman’s board of directors. The board had been trying to keep the bank’s problems quiet so as not to panic customers and employees while it sounded out potential buyers. In a remarkable piece of freelancing, Schwarzman—who was not on the board and was not authorized to act for the board—took matters into his own hands. On a Saturday morning in March 1984 in East Hampton, he showed up unannounced on the doorstep of his friend and neighbor Peter A. Cohen, the CEO of Shearson, the big brokerage house then owned by American Express. “I want you to buy Lehman Brothers,” Schwarzman cheerily greeted Cohen. Within days, Cohen formally approached Lehman, and on May 11, 1984, Lehman agreed to be taken over for $360 million. The merger gave Shearson, a retail brokerage with a meager investment banking business, a major foothold in more lucrative, prestigious work, and it staved off financial disaster for Lehman’s partners.
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Shearson insisted that most Lehman partners sign noncompete agreements barring them from working for other Wall Street firms for three years if they left. Handcuffs, in effect. What Shearson was buying was Lehman’s talent, after all, and if it didn’t lock in the partners, it could be left with a hollow shell. Schwarzman had no interest in soldiering on at Shearson, however. He yearned to join Peterson, who was laying plans to start an investment business with Eli Jacobs, a venture capitalist Peterson had recently come to know, and they wanted Schwarzman to join them as the third partner. As Schwarzman saw it, he’d plucked and dressed Lehman and served it to Cohen on a platter, and he felt that Cohen owed him a favor. Accordingly, he asked Cohen during the merger talks if he would exempt him from the noncompete requirement. Cohen agreed. “The other [Lehman] partners were infuriated” when they got wind of Schwarzman’s demand, says a former top partner. “Why did Steve Schwarzman deserve a special arrangement?” Facing a revolt that could quash the merger, Cohen backpedaled and eventually prevailed upon Schwarzman to sign the noncompete. (Asked why Schwarzman thought Shearson would cut him a uniquely advantageous deal, one person who knows him replies, “Because he’s Steve?”)
Chapter 3 - The Drexel Decade
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On the debt side of the LBO equation, U.S. banks flush with petrodollars from oil-rich clients in the Middle East and Japanese banks eager to grab a piece of the merger business in the States began building their presence and pumping huge sums into buyout loans. At the same time, a new form of financing emerged from the Beverly Hills branch of a second-tier investment bank. The brainchild of a young banker there named Michael Milken, the new financing was politely called high-yield debt but was universally known as the junk bond, or junk for short.
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After a breakout year in 1983, when Drexel sold $4.7 billion of junk bonds for its corporate clients, the bank saw the chance to move into the more lucrative field of advising on and financing mergers and acquisitions. Drexel would no longer just finance expansion but now threw its weight behind LBOs and other corporate takeovers. By then the Drexel organization had become a master at selling its clients’ bonds to investors, from insurance companies to savings and loans, tapping a broad and deep pool of capital, matching investors with an appetite for risk and high returns with risky companies that needed the money. Milken had such sway with Drexel’s network of bond investors that he could muster huge sums and do it faster than the banks or Prudential ever could. KKR was one of the first clients to test Drexel at this new game, accepting Milken’s invitation to help finance a $330 million buyout of Cole National, an eyewear, toy, and giftware retailer, in 1984. Though Drexel’s debt was expensive, the terms still beat those of Prudential, and KKR soon stopped tapping insurers altogether and drew exclusively on Drexel’s seemingly bottomless well of junk capital. Kravis called Drexel’s ability to drum up big dollars in a flash “the damnedest thing I’d ever seen.” Before long, the insurance companies’ mezzanine debt mostly disappeared from large deals, replaced by cheaper junk from Drexel. At their peak in the mid-1980s, Milken and his group underwrote $20 billion or more of junk bonds annually and commanded 60 percent of the market. The financial firepower they brought to bear in LBOs and takeover contests redefined the M&A game completely.
Chapter 4 - Who Are You Guys?
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Blackstone Group, with Peterson as chairman and Schwarzman as CEO. The name, Schwarzman’s invention, reflected their ethnic roots, combining the English equivalents of schwarz, German and Yiddish for black, and peter, Greek for stone.
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They also hoped to tack on related businesses that made their money from fees. They weren’t sure yet what those would be, but they thought they could attract like-minded entrepreneurial types from other niches of the financial world who could benefit from a collaboration. They lacked the dollars to hire top talent, however, or to stake another business. Nor did they want to share the ownership of Blackstone. The memory of the feuding at Lehman was still all too fresh, and they wanted absolute control of their business. The solution they ultimately hit on was to set up new business lines as joint ventures—“affiliates,” they called them—that would operate under Blackstone’s roof. To lure the right people, they would award generous stakes in the ventures. In time, that arrangement was the foundation for two of Blackstone’s most successful affiliated businesses, its real estate investment unit, built by John Schreiber, and the bond investment business that was later spun off as BlackRock, Inc., now one of the preeminent publicly traded investment managers in the world, which Laurence Fink, who started it, still leads.
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For several months, they couldn’t scare up a single advisory assignment. By the time they landed their first, a project for Squibb Beech-Nut Corporation in early 1986, the $400,000 they’d started out with had dwindled to $213,000. The Squibb Beech-Nut job paid them $50,000. A pittance compared with the fees they’d commanded at Lehman, it was manna for the starving. Soon after that, Blackstone won two other assignments that paid modestly more, from Backer & Spielvogel, an advertising agency, and Armco Steel Corporation. “We were starting to earn back what we’d been losing,” says Schwarzman. “Those were the streams of revenue between us and oblivion.” Starting in April 1986, Blackstone’s M&A work picked up markedly. Yet even as its income rose, the firm continued to bump up against a prejudice in the corporate world against independent M&A boutiques. Not even CSX, which had collected an extra $15 million for its newspaper subsidiary thanks to Schwarzman’s cunning years earlier, was entirely comfortable using Blackstone. CSX supplied Blackstone its first major M&A assignment, hiring it to help craft a takeover offer for Sea-Land Corporation, a shipping company that was seeking a friendly buyer after receiving a hostile bid from a corporate raider. However, when it came time to order a fairness opinion—a paid, written declaration that a deal is fair that carries great weight with investors—CSX’s chairman Hayes Watkins sought out a brand-name investment bank, Salomon Brothers, instead. Disheartened that his client had looked elsewhere, Schwarzman asked Watkins why he wouldn’t accept Blackstone’s opinion when Schwarzman’s opinions had always sufficed when they were issued on Lehman’s letterhead. “I hadn’t thought of that,” Schwarzman remembers Watkins responding. Schwarzman then prevailed upon Watkins to commission fairness letters from both firms. Though Blackstone hadn’t managed to handle the deal solo, at least it won equal billing with the much more established Salomon.
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They’d set a most ambitious target for themselves: a $1 billion fund. KKR, the biggest operator at the time, was managing just under $2 billion. If Blackstone reached its goal, it would smash the record for a first-time fund and rank third, behind only KKR and Forstmann Little, in the amount of capital it had to invest.
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Shortly after they opened shop, they drew up a two-page promotional letter describing their business plan, which they mailed to hundreds of corporate executives and old Lehman clients. They then waited. And waited. And waited. “Pete and I expected business to come flooding in. Of course, it didn’t,” Schwarzman says. “We got a few ‘Congratulations, nice letter’ responses. That was it.”
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An excursion to Boston was equally galling. They flew there one Friday for a 4:00 P.M. meeting Schwarzman had lined up with officials at the Massachusetts Institute of Technology’s endowment. When they arrived at MIT, the receptionist informed them she had no record of the appointment, and there was no one remaining in the office on the eve of the weekend. The two partners left, muttering imprecations under their breath. Adding insult to injury, they emerged from the building to find themselves in a torrential downpour with no umbrellas. They retraced their steps in order to call a cab from the endowment office, but it was locked. They took up positions on opposite street corners, hoping to hail a taxi in the driving rain, but to no avail. Finally, Schwarzman, ever the bargainer, rapped on the window of a cab stopped at a red light and offered the passenger a deal: $20 to have the driver take him and Peterson to the airport. It was the only pitch they made that day that succeeded. After months crisscrossing the country, their quest had yielded only a single, $25 million pledge from New York Life Insurance Company. Eighteen institutions they’d considered strong candidates to invest with Blackstone had rebuffed them. By the winter of 1986, a year into the fund-raising, they were “about out of tricks,” says Schwarzman.
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As an anchor investor, Prudential drove a hard bargain, though. Back then, buyout shops laid claim to 20 percent of the investment profits from each individual company their fund bought. But that meant that if one very large investment in a fund was written off—say, an investment that consumed a third of the fund’s capital—investors might lose money even though other investments worked out. The manager, though, would still collect profits on the good investments. It was a kind of heads-I-win, tails-you-lose clause. Prudential insisted that Blackstone not collect a dime of the profits until Prudential and other investors had earned a 9 percent compounded annual return on every dollar they’d pledged to the fund. This concept of a “hurdle rate”—a threshold profit that had to be achieved before the fund manager earns any profits—would eventually become a standard term in buyout partnership agreements. Prudential also insisted that Blackstone pay investors in the fund 25 percent of the net revenue Blackstone made from its M&A advisory work, even on deals not connected to the fund. At the time, Blackstone still was forking out much of that revenue to Shearson under Schwarzman’s severance agreement, which would end the following year.
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There, with the help of First Boston and Bankers Trust, top U.S. banks with a presence in Tokyo that Blackstone had hired to help on the fund-raising, they lined up meetings with Japanese brokerage houses. Schwarzman knew that brokers like Nomura, Daiwa, and Nikko were hankering to do business on Wall Street, and he hoped Blackstone could leverage its Wall Street lineage into a capital commitment. Schwarzman’s hunch turned out to be right. In Tokyo, an exploratory meeting with Yasuo Kanzaki, executive vice president of Nikko Securities, Japan’s third-largest broker, went well. Kanzaki signaled that Nikko was willing to discuss an investment and asked the two not to talk to any other Japanese brokers. Unbeknownst to Peterson and Schwarzman, First Boston had scheduled a meeting the next morning with one of Nikko’s big competitors, Nomura. The two Americans weren’t sure what to do. They feared insulting Nomura by canceling on short notice but didn’t want to renege on their word to Nikko. Schwarzman and Peterson called Kanzaki from their car phone outside Nomura’s headquarters before the meeting and asked him how to resolve the awkward situation. Kanzaki responded by asking them how much money they wanted. Peterson cupped his hand over the phone while he and Schwarzman discussed how much to ask for. Finally they settled on $100 million. “No problem,” Kanzaki declared. “Done deal!” He then suggested they keep their appointment with Nomura so as not to breach Japanese business protocol.
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Their hot streak continued upon their return. In June, Peterson bumped into an old friend, General Electric chairman and chief executive Jack Welch, at a birthday party for Washington Post publisher Katharine Graham. “Where the hell have you been?” Welch inquired. “I know you and Steve have started this business, and I haven’t heard from you.” Peterson answered, “Dear God, Jack, we’ve called and called on GE, and they said you’re not interested.” Said Welch, “You should have called me directly.” Peterson did so the next morning, picking up $35 million. Even more momentous was the $100 million General Motors’ pension fund put up. GM, like GE, had brushed off Blackstone several times, but a First Boston banker tapped a church connection to get Blackstone access to GM, and the firm soon captured another $100 million pledge. The GM imprimatur brought Blackstone a raft of smaller commitments—$10 million to $25 million—from other pension funds.
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“I was exceptionally nervous and putting pressure on everyone to close,” Schwarzman says. He worked the phones, and on Thursday, October 15, 1987, Blackstone wrapped up the fund at around $635 million, with some mop-up legal work on Friday. The following Monday the U.S. stock markets nose-dived 23 percent. Black Monday, as it became known, was the biggest one-day drop since 1914, outstripping even the 1929 sell-off that ushered in the Great Depression. If Blackstone hadn’t tied up contractual loose ends before the crash, undoubtedly many investors would have backed out. Instead, Blackstone could boast of raising the largest first-time leveraged buyout fund up to that time. No longer would Peterson and Schwarzman live off the unpredictable bounty of M&A fees. Blackstone now would collect 1.5 percent of the fund’s capital every year as a management fee for at least six years. This not only ensured Blackstone’s near-term survival, but it also meant that Blackstone, finally, could staff up and take on the trappings of a bona fide business. After an exhausting, two-year struggle, Blackstone had arrived. “We got in just under the wire,” Schwarzman says. “It was probably the luckiest moment” in Blackstone’s history.
Chapter 5 - Right on Track
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Peterson and Schwarzman offered Fink a $5 million credit line to start a joint venture called Blackstone Financial Management, or BFM, which would trade in mortgage and other fixed-income securities. In exchange for the seed money, Blackstone’s partners got a 50 percent stake in the new business while Fink and his team, which included Ralph Schlosstein, a former Lehman partner and a good friend of Roger Altman’s, owned the other 50 percent. Eventually, the Blackstone partners’ stake would fall to around 40 percent as the BFM staff grew and employees were given shares in the business. Fink also got 2.5 percent interest in the parent, Blackstone. The arrangement with Fink reflected the Peterson and Schwarzman approach to building up Blackstone. They wanted to recruit top talent, but they were not about to surrender any significant part of Blackstone’s ownership. The implosion at Lehman had convinced them that they should keep tight control of the overall business. This was going to be their show. Altman, who might have gotten a bigger stake if he had joined his friends sooner, received a comparatively meager ownership interest of around 4 percent. Stockman’s piece was even smaller.
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Blackstone would have to vie for investors, talent, and deals with these flashier upstarts. None of the new players held a candle to KKR, though. It had recently amassed a $6.1 billion war chest—far and away the biggest buyout fund ever—and controlled about a third of the $15 billion to $20 billion of equity the buyout industry had stockpiled to date. It was no easy task to compete, for KKR was raking in profits on a scale its founders couldn’t have imagined a decade earlier. In May 1988, Henry Kravis and the other KKR partners personally pocketed $130 million in profits on just one investment: Storer Communications, a broadcaster they had bought just three years earlier, which they sold for more than $3 billion. KKR had pulled off gargantuan buyouts of name-brand companies—a $4.8 billion deal for the supermarket chain Safeway in 1986 and the $8.7 billion buyout of Beatrice Foods the same year. Late in 1988 KKR would reassert its dominance when it cinched by far the largest buyout ever, the $31.3 billion take-private of the tobacco and food giant RJR Nabisco—a bid that would define the era, crystallize the public image of private equity investors as buccaneers, and set a record that would not be matched for eighteen years.
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Barbarians at the gate
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As Peterson and Schwarzman hoped, the M&A business gave the firm access to executives that eventually turned up LBO opportunities. Blackstone’s first buyout developed that way. It was puny compared with KKR’s big deals—a mere $640 million—but it would have an immense impact on the young firm’s image and fortunes. It began when Altman telephoned Donald Hoffman, a top official at USX Corporation, the parent of U.S. Steel.
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Buy out of shipping subsidiary
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Blackstone shelled out just $13.4 million, 2 percent of the buyout price, for a 51 percent ownership stake.
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One way that buyout firms make profits is to use the cash flow to pay down the buyout debt. In the industry’s early days, deals were formulated with the aim of retiring every dollar of debt within five to seven years. That way, when the business was finally sold, the buyout firm reaped all the proceeds because there was no debt to pay off. A second way to generate a gain is to boost cash flow itself, through revenue increases, cost cuts, or a combination, in order to increase the company’s value when it is sold. Using cash flows, there is also a third way to book a gain, without an outright sale. If a company has paid down its debt substantially, it can turn around and reborrow against its cash flow in order to pay its owners a dividend. That is known as a dividend recapitalization. In Transtar’s case, Blackstone used all three means to manufacture a stupendous profit. In 1989, in line with Mossman’s expectations, Transtar’s cash flow reached nearly $160 million, enabling it to repay $80 million of debt by year’s end. By March 1991 Transtar had pared $200 million of its original buyout debt. With substantially less debt than it had when the business was spun off and with Transtar’s cash intake growing, the company was able to borrow again to cover a $125 million dividend to Blackstone and USX. A little more than two years after the deal closed, Blackstone had made back nearly four times the $13.4 million it had invested. By 2003, when Blackstone sold the last of its stake in a successor to Transtar to Canadian National Railroad, the firm and its investors had made twenty-five times their money and earned a superlative 130 percent average annual return over fifteen years.
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Transtar’s success showed the rest of Wall Street that Peterson and Schwarzman could excel at the buyout game. The deal also was a landmark for a second reason. It forged an abiding tie between Blackstone and Chemical Bank’s Jimmy Lee that would be of enormous consequence to both. A gregarious spark plug of a man who resembled a back-gelled Martin Sheen and was known for his spiffy silver-dollar suspenders, Lee soon emerged as a kingpin of leveraged finance, a banker’s banker to other LBO luminaries such as Henry Kravis and Ted Forstmann. Just as Drexel Burnham’s Michael Milken had created the junk-bond market, tapping the public capital markets to finance the corporate raiders and buyout shops of the 1980s, Lee reinvented the bank lending market with his syndicates, which allowed risk to be shared and thereby allowed much larger loan packages to be assembled. At Chemical and its later incarnations (Chase Manhattan Bank, the name Chemical adopted in 1996 after buying Chase, and later JPMorgan Chase, after Chase bought J.P. Morgan in 2000), Lee would go on to play as critical a role in the stupendous growth of LBO activity in the 1990s and 2000s as Milken had with junk bonds in the 1980s.
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“You could argue that Blackstone made JPMorgan Chase as much as JPMorgan Chase made Blackstone,” says one of Lee’s counterparts at another bank. “Neither would be where they are today without the other.”
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Transtar also advertised Blackstone’s readiness to ally itself with corporate chieftains in the war against raiders, and just how far it would bend to accommodate corporate America’s financial and strategic imperatives. It helped establish Blackstone’s reputation as “an operating problem solver,” in Peterson’s words. “In every way, it was a perfect first deal for us,” says Lipson. “It was highly successful quickly, and it showed we weren’t looking to antagonize corporations but to be friends. Corporate partnerships became our calling card.” Whereas competing buyout shops typically exercised dictatorial control over their acquisitions, Blackstone was adaptable. Its openness to splitting power or even taking a back seat to a corporate collaborator bolstered its deal flow, as Schwarzman and Peterson had hoped: Of the dozen investments that Blackstone went on to make with its 1987 buyout fund, seven would be partnerships akin to Transtar. In addition to differentiating Blackstone from the competition, Schwarzman also believed the partnerships heightened Blackstone’s odds of success. Having a co-owner intimately familiar with the business—typically one that was a major customer or supplier and therefore had an interest in its thriving—would give Blackstone an advantage over competing buyout firms, staffed as they were with financial whizzes who had never run a business or met a payroll. With the prices for whole businesses escalating in step with the stock market in the late 1980s, Schwarzman felt Blackstone “needed an edge to safely do deals in a higher-priced environment.” “That’s really why we came up with the corporate partnership strategy. I just couldn’t figure out how to make money buying companies unless we brought unusual efficiencies to a company by way of cost improvements or revenue synergies.”
Chapter 6 - Running Off the Rails
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The business situation turned very bad so quickly that Edgcomb had trouble making its first interest payment that summer, a humiliating state of affairs for Blackstone. Right out of the gate, the buyout was racing toward insolvency. Schwarzman soon threw his energies into trying to rescue the deal. He cajoled Blackstone’s fund investors to stump up another $16 million of equity to try to keep the business afloat and worked tirelessly to ensure that the creditors didn’t lose a dime. If Edgcomb defaulted on its debt, it might irreparably taint the new buyout firm’s reputation in the credit markets. He was beside himself at that possibility and made his anxiety clear around the office. In July 1990, Schwarzman arranged to sell the nearly bankrupt company to a subsidiary of France’s Usinor Sacilor SA, then the world’s largest steel company, at a steep discount to the original price. Edgcomb’s senior lenders were repaid, but there wasn’t enough money left to repay Blackstone. Its fund investors wound up losing $32.5 million of the $38.9 million they’d put into the deal. That Schwarzman ultimately salvaged even one-sixth of the limited partners’ money was little short of miraculous in the circumstances, an ex-partner recalls. “That’s where I saw Steve’s brilliance,” this person says. “That’s where I saw how good he was. He saw the problem and he worked doggedly to resuscitate the company.”
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Blackstone couldn’t have picked a worse moment to ramp up in arbitrage. The economy was just beginning to slow, putting the brakes on takeovers, and by October 1989 LBOs and most takeover activity had screeched to a halt. The death knell for the M&A boom was the unexpected collapse of a $6.8 billion, employee-led buyout of UAL Inc., the parent of United Airlines, that October. McVeigh’s group, which had amassed a large position in UAL’s stock, lost a bundle when the airline’s shares plunged from a high of $294 to less than $130. Many other of his holdings nose-dived, as well. The arb unit took an 8 percent loss. Schwarzman’s reaction was quick and severe. Ten months after McVeigh had arrived at Blackstone, he and his team were axed, Blackstone Capital Arbitrage was shuttered, and the $46 million that remained of the original $50 million was stowed away in the very safest kind of securities: certificates of deposit.
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Realizing that a second costly stumble could do lasting harm to Blackstone, or perhaps even consign it to an early grave, Schwarzman decided that the firm’s process for vetting investments needed to be formalized. From then on, partners would have to submit a researched and tightly reasoned proposal that would be shared with all other partners. Schwarzman would remain the final arbiter, but henceforth there would be a full airing of every deal’s possible pitfalls before he decided whether to go forward.
Chapter 7 - Presenting the Steve Schwarzman Show
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His seeming compulsion to brag—about being the first Jew admitted to Skull and Bones and the first banker in history to orchestrate a sealed-bid corporate auction—rubbed many the wrong way.
Chapter 8 - End of an Era, Beginning of an Image Problem
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Reset notes were akin to adjustable-rate home mortgages, but instead of being tied to a broad index of borrowing costs, as adjustable mortgages typically are, the rates on reset notes are adjusted to reflect the going market value of the notes or bonds themselves. Suppose investors buy $1,000 bonds that pay $147.50, or 14.75 percent, annual interest, and the bonds’ market value falls to $970 a year later because interest rates in general have risen, making the old 14.75 percent bonds less desirable, or because the particular company is in trouble. The fall in value means that for an investor who buys them at $970, the bonds effectively are paying 15.2 percent interest. The reset clause would restore the bonds to their face value. To make up for the drop in price, the company would be required to boost the interest 3 percent to $152 a year, returning the bonds’ market value to $1,000, making the original bond buyers whole and happy.
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Within months of the Federated and United problems, the biggest LBO ever—the deal that had come to symbolize the buyout business—was teetering on the verge of collapse. KKR’s buyout of RJR Nabisco, the tobacco and food giant that peddled Oreo cookies, Ritz crackers, and Winston and Salem cigarettes, embodied the raucous, rapacious ethos of the late 1980s. It had everything: an imperial CEO who maintained a fleet of ten corporate jets, doled out $1,500 Gucci watches to employees, and surrounded himself with celebrities at company-funded golf events; Wall Street sharks circling the prey; and a teeming supporting cast of bankers and lawyers craving a cut. It was a tale of greed, excess, and hubris, with no small measure of farce. In the words of M&A banker Bruce Wasserstein, it was “the Roller Derby of deals.” It began in October 1988 with the CEO, F. Ross Johnson, who was frustrated that RJR’s stock wouldn’t budge even though profits were up, lodging a bid. That month, with backing from Peter Cohen at Shearson Lehman Hutton, Johnson won his board’s support for a $75-a-share management-led buyout. Management would put up equity and would borrow the balance. His bid, one-third higher than RJR’s stock price, was far from stingy, but Johnson saw value in a company that could not win the stock market’s love. He calculated that if they bought at the right price, he and his financial backers could all make a fortune selling pieces of the business, capturing the hidden value for themselves.
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More significant in the long term, KKR emerged from the RJR battle perceived as a raider. Technically, KKR’s was not a hostile bid. In Wall Street parlance, a hostile bid is one made at a time when the company has not put itself up for sale, and KKR came in only after RJR’s board had put the company in play by entertaining Johnson’s offer. But that was a legalism. The fact was that KKR had bid against the management and won. It had snatched control away from the CEO and now promised to slash costs and carve up the company. To the man in the street, that was no different from what corporate raiders did. At $31.3 billion, the RJR buyout smashed all records. It was more than three times the size of the next biggest, KKR’s $8.7 billion LBO of Beatrice in 1986. But KKR ended up paying a dangerously high eleven times cash flow, and there was a time bomb buried in the complicated mix of debt behind the buyout: $6 billion of reset notes whose interest rates were up for adjustment in February 1991. Like the CNW reset notes that had alarmed Schwarzman when Blackstone was arranging debt for that deal in October 1989, the interest on the RJR notes had to be readjusted upward if the notes traded below their face value. But unlike the CNW notes, where Schwarzman had insisted there be a ceiling on the maximum interest rate, the RJR reset notes had no limit on rates: RJR would have to pay whatever rate it took to restore the bonds to their original value so bondholders wouldn’t suffer a loss. With the investors fleeing risky securities, interest rates spiked and the notes were trading at such deeply depressed prices that RJR faced the prospect that the rate on the notes might jump from 13.71 percent to 25 percent. The hit would be lethal—adding more than $670 million in yearly interest costs that RJR could in no way afford.
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The slashing “cut plenty of muscle with the fat, both from [Safeway’s] holdings and from its labor force, and deferred capital improvements in favor of the all-consuming debt,” the Journal declared in its 1990 piece. But Safeway’s growth in the nineties disproved that. When the restructuring was complete, Safeway had contracted from twenty-four hundred to fourteen hundred stores, and from $20 billion in sales to $14 billion—a shrinking act that would have been virtually unthinkable for a public company to attempt, because stockholders and investment analysts would never tolerate the risks. Yet, remarkably, cash flow rose 250 percent during the coming decade.
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The full history of the Safeway buyout actually debunks many of the clichés about LBOs. Yes, there were big job and pay reductions, but the company’s workforce remained 90 percent unionized, and the asset sales, cuts, and new incentives had a dramatic impact on Safeway’s profitability, which had lagged for years. By 1989, three years after the buyout, the chain’s operating profit margin, which had been 2.2 percent in 1985, was up almost one half to 3.2 percent. Far from hamstringing the company, the brutal pruning of Safeway laid the foundation for an extraordinary run after the company went public in 1990. After a brief dip in the early nineties, Safeway’s stock skyrocketed more than twenty times in value, going from $2.81 at its IPO in 1990, adjusted for stock splits, to $62 by 2000, the year KKR sold the last of its stake. The buyout had been leveraged in the extreme, with just 3 percent equity, so the payoff was huge: KKR made more than fifty times its money. The deal also flew in the face of the notion that buyout firms seek quick flips. Despite its big profit early on, KKR retained a stake in Safeway for nearly fourteen years.
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In the 1990s raiders largely ceased to be a force. For buyout firms, the game had to change as well. No longer could they lean so heavily on the power of leverage to deliver gains or simply break apart what they’d bought. Now they would have to take companies more or less as they were and burrow deeper into the nitty-gritty of their operations to make them worth more. “Value creation” would be the new mantra.
Chapter 9 - Fresh Faces
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The credit lockdown and the recession that followed in 1991 and 1992 put an end to the lavishly leveraged, big-ticket takeovers of the previous decade. Schwarzman embellishes only slightly when he likens DLJ’s frenzied scramble to sell the CNW bonds in October 1989 to “catching the last helicopter out of Vietnam.” Nearly three years would pass before there would be another sizable junk-bond-financed LBO, a $1.5 billion deal by KKR for the insurer American Re, and then KKR had to invest 20 percent of the price in equity—far more than it had been accustomed to stumping up. Blackstone, too, had to lower its sights. While its first six deals had averaged $1.1 billion in size, the average from 1991 to 1995 fell to barely $300 million. Blackstone wouldn’t attempt another deal on the scale of the $1.6 billion CNW deal until 1996.
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Contrast to today
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The savage shakeout forever altered the industry’s power structure. Never again would KKR lord it over the business to the degree it had in the 1980s. Merely by surviving and safeguarding its investors’ money as more ballyhooed firms bombed out, Blackstone was positioned to compete on a more equal footing in the years ahead.
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Two of the biggest emerging stars, Leon Black and David Bonderman, stepped to the front of the pack a year or two later when the buyout business was shut down in the early nineties by demonstrating that they were shrewd opportunists who could seize on the crisis to buy up distressed businesses at fire-sale prices. Black, a towering man with the intimidating bulk of a linebacker, had been one of Drexel’s stars, rising by his midthirties to head Drexel’s M&A bankers. Based in Drexel’s New York office, he had instigated a host of takeover campaigns, which he passed off to Michael Milken in Beverly Hills for financing. Black emerged unscathed by Drexel’s scandals and collapse and proved as adaptable as a chameleon. In 1991, with the economy at its worst and the junk-bond market at its nadir, state regulators in California seized Executive Life Insurance Company, a prime customer of Drexel’s that had gone under as its bond holdings shriveled in value. When the state liquidated the company, Black, backed by money from a French bank, swooped in with a winning bid and snared the insurer’s $8 billion junk-bond portfolio at less than 40 cents on the dollar. Black was perfectly situated to evaluate the bonds, for he had advised many of the companies behind them. When the economy revived, he unloaded the securities piece by piece for more than a $1 billion profit, winning him an enduring place in the top tier of vulture investors. Apollo Advisors, Black’s new firm (later renamed Apollo Management and then Apollo Global Management), ultimately reaped more than $5.7 billion in gains on the $2.2 billion it raised from 1990 to 1992, from Executive Life and other distressed assets. Bonderman was another child of the takeover boom who nimbly shifted course. A brainy ex-litigator known for his unorthodox sartorial getups—he often pairs plaid sports shirts with wildly clashing ties—Bonderman had executed a string of profitable takeovers as chief investment strategist to the Texas financier Robert M. Bass. But it was his pivotal role in Bass’s 1988 purchase of the country’s largest failed S&L, American Savings Bank, that brought him wide notice as a vulture investor of the first order. Bass invested $400 million, most of it borrowed, to buy American Savings. Less than a year later, with its bad debts handed over to the government, the thrift was solidly in the black. Bass would turn a fivefold gain on the investment. Bonderman and another Bass alumnus, James Coulter, followed that in 1993 by buying Continental Airlines, Inc., out of bankruptcy with $400 million they’d rounded up from wealthy investors and institutions. Bonderman and Coulter ultimately came away with nine times their money on Continental. By then, they and a San Francisco business consultant, William Price, had launched their own buyout firm, Texas Pacific Group, based in Fort Worth and San Francisco, and raised a $720 million debut fund in 1994. They quickly became known as top-flight contrarians and turnaround artists who would take on financially or operationally hobbled companies most buyout firms wouldn’t touch.
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Apollo and TPG
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A second new business emerged almost unintentionally, a by-product of the need to invest the $100 million Blackstone had received from Nikko. Blackstone’s abortive risk-arbitrage fling in 1989 had eaten into the original hoard, but Schwarzman shuddered at the thought of putting the cash at risk in the turbulent markets. Still, the firm couldn’t afford to leave the capital invested in low-paying certificates of deposit forever. Batten, who had been charged with managing the money, hit on a solution. That summer he proposed that Blackstone divvy up the money and invest it with a half-dozen successful hedge funds, so named because they hedged their bets by deploying capital across an array of securities and currencies and could sell short when they thought the markets were headed down. The aim was to make money in down as well as up markets, and the best of the funds habitually had outstripped the stock market’s performance. At the time, hedge funds were a small galaxy in the financial cosmos, but a handful of proven stars had emerged, including George Soros, Michael Steinhardt, Paul Tudor Jones II, and Julian Robertson. Despite his initial reluctance, Schwarzman signed off on Batten’s suggestion, and Batten proceeded to set up a fund-of-funds, taking stakes with six managers, the most illustrious being Robertson. But Schwarzman, who had never been a trader, was jittery as ever about losses and kept a sharp eye trained on the monthly results. “The first month the funds were up three percent and Steve was happy,” recalls Batten.
Chapter 10 - The Divorces and a Battle of the Minds
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Over time, however, there were growing strains and their camaraderie faded. Pinpointing the source is hard, but some trace it to the time around 1992 when Peterson’s slice of the profits was reduced. From the beginning, he and Schwarzman had had sole voting control over the buyout and M&A businesses and had an equal share in the profits, then about 30 percent each. As new partners arrived, they had each been given slices of what the firm made, which diluted Peterson’s and Schwarzman’s portions equally. That year the two founders agreed that, henceforth, as new partners joined, Peterson would cede more of his share to them. Thus, over time, his cut of the bottom line would steadily drop. By then, there was no dispute that Schwarzman was pulling more weight at the firm. Even so, the financial realignment marked the end of their equal partnership and an acknowledgment of Schwarzman’s primacy at the enterprise they’d created and built together. “I felt it was fair that our shares would be diluted as we added new partners, but my shares should be diluted somewhat more than his. That is what we did, and I fully agreed it was fair,” Peterson says.
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Altman’s exit from Washington in 1994 was even bumpier. That August he resigned under pressure over his handling of congressional inquiries into Whitewater—a financial and political scandal that grew out of a dubious 1980s Arkansas land deal involving Bill and Hillary Clinton. Though the Clintons were never prosecuted for their roles in the affair, other Whitewater figures were convicted of fraud. When Altman returned to New York, says a friend, he fully expected Schwarzman and Peterson to cast aside bygones and ask him to rejoin the firm, but the invitation was never extended. Altman went on to start an M&A–private equity boutique of his own, Evercore Partners, which swiftly established itself as a top deal adviser.
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Convinced that Blackstone had become a drag on his grand designs, Fink shelved his plans for an IPO and demanded the outright sale of his unit. Schwarzman, despite his strong initial resistance, finally relented. In June 1994, the business, which in the interim had adopted the name BlackRock Financial Management and seen its assets climb to $23 billion, was sold to PNC Bank Corporation of Pittsburgh for $240 million. Blackstone’s partners made out well, pocketing upward of $80 million in cash, in addition to about $30 million in dividends they’d collected from BFM over the previous six years. Schwarzman personally banked more than $25 million, enough to subsidize most if not all of his split from Ellen. (Though the size of the divorce settlement was never disclosed, BusinessWeek put it above $20 million.) BlackRock went on to surpass Fink’s headiest dreams. Over the next dozen years it grew into an investment empire comprising $1.2 trillion of assets, mostly fixed-income and real estate securities, reshuffled its ownership, and went public in 2006. By 2010, BlackRock was the world’s biggest publicly traded money manager, twice as big as its nearest rival, with $3.2 trillion in assets and 8,500 employees in 24 countries. Fink emerged as a Wall Street prince on a par with Schwarzman and became an adviser to the Obama administration on ways to resuscitate the U.S. economy. Schwarzman would later freely admit he’d sold BlackRock too soon. Though he personally earned a tidy sum on the sale to PNC, if Schwarzman had held on to even 3 percent of BlackRock—less than a third of his ownership stake when BlackRock was sold to PNC—he’d have been about $1.3 billion richer by 2010.
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Chapter 11 - Hanging Out New Shingles
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He told Schwarzman he’d be willing to consult and help Schwarzman recruit a hands-on management team in exchange for an ownership stake, but he would work just forty days a year and from Chicago. To the Schreibers’ amazement, Schwarzman agreed. The business was structured along the lines of Blackstone Financial Management, Larry Fink’s fixed-income operation. Blackstone owned 80 percent and Schreiber 20 percent, but Blackstone agreed to hand off part of its stake to managers as they were hired so that the business eventually would be owned fifty-fifty by its executives and Blackstone. Schreiber would remain, in his words, “third-base coach.”
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JMB had blazed the trail for real estate private equity long before Blackstone. But Blackstone was the first large corporate-LBO specialist in America to launch a real estate venture, and it was the only one that developed into a top-tier player. Apollo and the Carlyle Group launched their own units in 1993, but Apollo Real Estate Advisors eventually split from Leon Black and renamed itself, and Carlyle’s property business remained relatively small.
Chapter 12 - Back in Business
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The deal was signed in November 1994 and sealed two months later. Blackstone invested $187 million for 75 percent, taking half of Union Carbide’s stake and all of Mitsubishi’s. UCAR proved to be a watershed for Wall Street. Lee’s successful junk-bond offering for the buyout marked the birth of one-stop financing for large LBOs, a market that a small circle of banks, led by Chemical Bank and its successor, JPMorgan Chase, came to dominate. Lee had first concocted the debt-syndication model that transformed commercial banks from lenders into debt-distribution platforms, carving up loans and selling them to a multitude of investors, mutual funds, hedge funds, and the like. Now he had conjoined the lending and bond-issuing process under one roof. Lee’s debt-syndication machine would evolve into a font of profits for Chemical and other Wall Street banks. Now they could manage huge debt financings and rake off fees without packing their own books with risky loans. The market the banks built attracted a flood of capital from nontraditional lenders such as hedge funds, which triggered a surge in buyout activity and allowed larger and larger deals to be financed. By the late 1990s, loan syndications, including corporate loans not tied to buyouts, were a trillion-dollar-plus business, with Lee’s group at Chase handling a third of that. In the 2000s, the one-stop financing and syndication model would funnel hundreds of billions of dollars into LBOs and set off a wave of record-shattering megadeals. As much as any single figure on Wall Street, Jimmy Lee set the stage for the great leveraged buyout extravaganza of 2005 to 2007. UCAR was also a grand slam for Blackstone. The spring and summer after the investment was made, production cuts and price hikes drove up UCAR’s earnings, and in August 1995 the owners moved to cash in by taking UCAR public. When Blackstone sold the last of its shares in April 1997 after a surge in the stock, it had bagged a walloping $675 million gain, 3.6 times its investment, and an average annual return of close to 200 percent. That day at 345 Park Avenue, spirits ran high.
Chapter 13 - Tuning in Profits
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The company went public at $28 per share, valuing the start-up at $1.1 billion. Investors who hadn’t been able to buy shares in the IPO itself were so desperate to get a piece of the action that they drove the stock up to $75 on its first day of trading. To the cash-flow-obsessed private equity mind—and, frankly, under any conventional form of economic analysis—the price was absurd. Netscape had taken in just $16.6 million in revenue in the previous six months and lost $4.3 million in the process. The IPO demonstrated just how hungry investors were for start-ups that promised to remake the world with their technology and prepared the way for a new era of investing. The next year Yahoo!, the web portal and search engine, followed in Netscape’s footsteps, going public at a similar valuation despite revenues of just $1.4 million and a loss of nearly half that.
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VCs make bets on which entrepreneur will achieve a technological breakthrough first, who can get to market fastest, and whose product will dominate its market—events whose likelihood defies precise projections. That is a world away from buyouts. If venture investing is a game of long, daring passes, many incomplete, the LBO game is fought a yard at a time on the ground. To be a private equity investor, you need to be a kind of control freak—someone who can patiently map out all the scenarios, good and bad, first to make sure your company won’t go bust and, second, to see how it can be improved incrementally to lift its value. Buyout investing focuses on cash flow because banks won’t lend money, and bond buyers won’t buy bonds, unless they are confident a company will be able to pay its creditors through thick and thin. Private equity investing means burrowing into businesses and performing minutely tuned analyses. Could revenue be boosted a point or two? How much would pass through to the bottom line? What costs could be taken out to notch up the profit margin a fraction? Could we shave a quarter of a point off the interest rate on the debt? If the company has problems, how much of a cushion is there before it defaults? If private equity investors do their job right, things more often than not will play out more or less in line with their projections. Because venture investments are so much more unpredictable, venture investing requires a degree of passion—a belief in the product and its potential and, very often, in its value to society. Venture capitalists talk of nurturing “disruptive technologies” that will upend existing industries and lay the groundwork for new ones, in the way that diesel locomotives displaced steam engines, personal computers and laser and inkjet printers rendered the typewriter obsolete, and digital photography supplanted film. No amount of number crunching can predict if a new website will capture the public’s imagination or whether a biotech startup’s research will succeed in developing a drug to treat cancer. The payoff comes from seeding dozens of long shots. To sustain the process, the VCs and the entrepreneurs they back have to believe, and during the boom of the 1990s they had that faith in spades. The buyout types, with their dense spreadsheets and elaborately engineered debt structures, never promised to transform the world. They had no religion to offer the investing masses.
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Blackstone and Time Warner had assumed that Time Warner would one day buy back control of their systems, but in late 1999 Charter dropped a $2.4 billion offer on them for the two TW Fanch operations—an offer the two simply couldn’t refuse. Charter soon bought Blackstone’s InterMedia systems as well, and in February 2000, just a year after Blackstone had invested in Bresnan, Charter snatched that up, too, for $3.1 billion. Convinced that new technology would drive demand for his cutting-edge networks, Allen paid an eye-popping $4,500 per customer for the TW Fanch networks and $4,400 for InterMedia, about twice the price Blackstone had paid just a couple of years earlier. “Paul Allen seemed to believe at the time that there was a cure for cancer coming down the cable pipeline,” says Simon Lonergan, then an associate who worked with Gallogly on the investments. “We couldn’t believe the prices he was paying for those assets. It was hard to have a rational view that justified paying that amount of money for infrastructure.” “We used to get up every morning and thank Paul Allen,” says Bret Pearlman, who worked on the InterMedia deal and became a partner in 2000, as Charter was forking over billions to Blackstone. “Hallelujah!” In fact, the prices did not make a lot of sense: Two years later Charter was near bankruptcy. (It finally succumbed in the next recession, in 2009.) But Allen’s folly was Blackstone’s gain in 2000 and it walked away with $400 million—eight times its original investment—on TW Fanch-One, a bigger multiple of its investment than even UCAR had earned. It hauled in 5.5 times its money, or $747 million, on Bresnan.
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With investors clamoring for ways to invest in communications companies, Gallogly saw a chance to hang out his own shingle, and he told Schwarzman in 1999 that he planned to leave. It was the last thing Schwarzman wanted to hear at the time, for the firm could ill afford the loss of another senior deal maker. Glenn Hutchins, who had been brought in as a partner in 1994, left to form a new firm, Silver Lake Partners, at the end of 1998.
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Schwarzman worked on Gallogly first, persuading him to stay by offering to raise a new, specialized fund that would invest only in telecom and media companies and putting Gallogly in charge of it. Gallogly would get pretty much what he wanted but under Blackstone’s banner. For Schwarzman, it kept Gallogly in the fold and allowed the firm to tap into the communications mania without having Blackstone’s main fund put too much money at risk in one sector. The fund-raising, which kicked off in early 2000, went quickly, and Blackstone Communications Partners, known as BCOM, hit its $2 billion target by June of that year.
Chapter 14 - An Expensive Trip to Germany
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Schwarzman threw a bone to the troops by authorizing $7 million of the firm’s own capital to be allocated for technology investments. The investment committee also gave the green light to a string of tech deals by the main buyout fund. Most were ultimately complete write-offs. Fortunately, they were all small. “To Steve’s credit, no matter how many times people said we’re sort of missing the boat here on the Internet, Steve insisted over and over, ‘This is not what we do well,’ ” says Pearlman.
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Together, the third buyout fund and the communications fund shelled out $320 million, the second-largest sum Blackstone had ever invested.
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For buyout of two regional cable spin offs of DT
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Short on cash, the Callahan entities breached the terms of their loans. It was clear the equity was going to be erased, and Blackstone was forced to write off its entire investment at the end of 2002. When Callahan arrived at Schwarzman’s office to discuss what had happened, he got an earful from Schwarzman. “Where’s my fucking money, you dumb shit?” were the first words out of Schwarzman’s mouth, according to a person with ties to Callahan. “I was really furious because he was personally working on a lot of other transactions rather than keeping his focus on this particular transaction,” says Schwarzman, who calls it a “chilly meeting.” “I told him I believed he had failed.” The loss was most devastating for the new media and telecom fund, because the $159 million it had contributed from its kitty represented more than 70 percent of its invested capital to that point.
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Most of the other mistakes were small, but not all. In addition to the Callahan setbacks, the Argentine cell operator CTI Holdings cost Blackstone $185 million and two companies that aimed to build new cable systems from scratch, Utilicom Networks and Knology, were complete losses. So was the investment in Sirius, the satellite radio company. “The pain we took [on the investments of 2000] was a real turning point,” says David Blitzer, who had joined Blackstone out of college not long after the disastrous collapse of the Edgcomb investment and become a partner in 2000, just as the firm again was about to stumble badly. “Losing money again was really a jolt to the system. How could we let this happen? What did we do wrong?” It was a time of “real soul-searching,” he says. Blackstone was hardly alone. The losses it suffered in 2001 and 2002 came as the technology and telecom bubbles were pricked, and air hissed out of the entire stock market. European stocks topped out in the winter of 1999 and 2000. In the United States, the IPO market cooled off in early 2000. The technology-heavy Nasdaq stock index crested in April 2000, at five times its 1995 level. The broader S&P 500 index, which had tripled in five years, inched up until that August. From there it was all downhill.
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Sixty-two major private equity–backed companies went bust in 2001, vaporizing $12 billion of equity by one tally. Another forty-six failed in the first half of 2002, wiping out a further $7.6 billion, and there were many more, smaller deals that never came onto the public radar. By the end of 2000, virtually no LBOs were being done in the United States. Then came the terrorist attacks of September 11, 2001, and the stock and debt markets, which had been sputtering for a year, had the final wind knocked out of them.
Chapter 15 - Ahead of the Curve
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The events of September 11, 2001, provided a case in point. One of the collateral casualties of the terrorist attacks was the insurance industry, which found itself staring at billions of dollars of unexpected claims not only from those hurt directly at the World Trade Center, but also from business interruption and other commercial policies covering companies far removed from New York and Washington. Overnight, capital reserves that had been built up over years as a cushion against losses were exhausted. Reinsurance companies, which protect other insurers against freak and catastrophic claims, were hit particularly hard because the attacks were so far outside any actuarial predictions, and the damage penetrated beyond the original insurers’ coverage up into the reinsurers’. Because insurance companies are required by law to maintain reserves to back the policies they write, the losses forced many insurers to curtail business, writing fewer new policies. That sent premiums skyward. Private equity firms pounced on the opportunity, pouring money into the sector—KKR, Hellman & Friedman, TPG, and Warburg Pincus, to name just a few. Rather than invest in existing companies that still had big claims to work off, however, they set up new reinsurers with clean balance sheets that now would face little competition from existing, wounded companies. Two months after the terrorist attacks, Blackstone plowed $201 million into Axis Capital, a new reinsurer it formed with four other private equity firms. The next June it invested $268 million alongside the London buyout firm Candover Investments and others to form another new reinsurer, Aspen Insurance, around assets that a troubled London reinsurer, Wellington Re, was forced to sell. These were 100 percent equity investments in start-ups without leverage. In a crippled industry, they had the potential to match the returns Blackstone expected on LBOs in good times because the new players would be abnormally profitable. At the time, it looked like “probably a three-year opportunity,” says Schwarzman. After that, more capital would flow into the industry, boosting competition, driving down premiums, and causing returns to fall back to historical levels. “We would not make an amazing return, by the nature of the industry, but you could make twenty-one or twenty-two or twenty-three percent a year for a few years.” Ultimately, Blackstone made a 30.2 percent annual return on Axis. Aspen might have matched that but it suffered big losses from Hurricane Katrina in 2005, so Blackstone ultimately earned only a 15 percent return.
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With few LBO options on the horizon, though, Blackstone was ready to gamble. “We’re value investors and we’re pretty agnostic as to where we appear in the capital structure,” Schwarzman says. “In 2002 it became pretty clear that subordinated debt in a whole variety of companies was a terrific place to be.” In other words, buying distressed bonds on the cheap was as good as buying equity if you could turn a profit that way.
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It still wasn’t clear if the Adelphia and Charter wagers would pay off in mid-2003 when Blackstone began weighing a third big investment in distressed cable debt. This one would be equally risky but also held the promise of redemption, for the companies in question were the two Callahan systems in Germany that Blackstone had written off just months earlier.
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The restructuring cut the company’s debt to manageable levels and the business was soon back on its feet. By 2005 profits were rising and the company was able to borrow money to refinance its debt and pay a huge dividend to Blackstone and other shareholders. By the time Blackstone cashed out its last piece of the two companies in 2006, it had booked a profit of $381 million—three times what it had invested in the second round. That more than made up for the $264 million loss on the original investment. On top of that, the communications fund raked in a $312 million profit on the debt of another troubled German cable firm, Primacom, in which Blackstone had not previously invested. Blackstone also made back some of what it had lost earlier on Sirius, the satellite radio company, by buying its debt on the cheap. The communications fund raised in 2000, whose situation had looked so dire in 2002, had been patched up and was now posting profits. “We had just raised this $2 billion fund” when the original Callahan deal foundered, Guffey says. “This was 15 percent of the fund and it looked like it would be zero. We were down eight to one in the seventh inning and we turned the game around.” Adelphia and Charter yielded big windfalls as well. Altogether, Blackstone more than doubled the roughly $800 million it gambled on the distressed debt strategy. The communication fund for years was the least profitable of all of Blackstone’s funds, with an annual rate of return in the single digits. But thanks to the vulture plays and some later investments, by 2007 it had produced a respectable if not spectacular 17 percent annual return—better than Blackstone’s 1997 fund.
Chapter 16 - Help Wanted
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Harrison had shunted Lee out of administration, but he wasn’t about to lose one of the keys to Chase’s success if he could help it. Harrison pulled out all the stops, yanking on all the emotional cords. “They gathered together directors and other senior people,” Lee says. “They put me in what I like to call the rubber room, where you take the employee who is about to go away and bombard him with, ‘Oh! I remember you when you were just a kid.’ The old guys play on your loyalty. ‘This is your life, Jimmy Lee.’ ” It worked. In the end, Lee couldn’t bring himself to jump the Chase ship. That night Lee reached Schwarzman at the Ritz Carlton Hotel in Naples, Florida. Schwarzman took the call on the veranda. “Jimmy said, ‘I just can’t do it. Bill’s asked me to stay. I’ve worked with Bill my whole adult career,’ ” Schwarzman says. Schwarzman couldn’t believe it. “He was like, ‘Hey! What’s going on? I thought you were going to resign and come back and sign,’ ” Lee recalls. “He said, ‘Is it money? Do you need more money?’ ” Lee told him it wasn’t about money.
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In his pièce de résistance, James helped engineer the merger of DLJ into Credit Suisse First Boston in 2000. CSFB’s
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In a quiet way, too, he chafed at the conventions by which überbankers were expected to abide. He rode the subway, and as a longtime director of Costco, the discount retailer, he often wore Costco dress shirts to the office. While Schwarzman vacationed at his homes in the traditional playgrounds of the super rich—the Hamptons on Long Island, Palm Beach in Florida, and St. Tropez in France, or on his yacht in the Caribbean—James was a die-hard fly fisherman who tied his own flies and ventured up the Amazon and to Mongolia on fishing trips with his friend David Bonderman, the iconoclastic founder of TPG.
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Blackstone had been the Steve Schwarzman show for a decade and now he would be sharing the role. It was more like finding a spouse than a deputy. None of his counterparts at other buyout firms had ever attempted to bring in someone at this level from the outside, and few had clear succession plans, so in every way it would be a first. James understood what it represented. “It’s a very intense firm with a very intense leader and intense people. If he meant what he said about turning over the core businesses to me, and helping him run the firm, it was a huge leap of faith for him—to [trust] any outsider that he didn’t really know that well.”
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It came as no surprise that the firm had profited mightily by timing the markets shrewdly—buying during troughs and selling at the peaks. But there were some surprising patterns over the years. It turned out, for instance, that partners had a tendency to overestimate the abilities of those managing the companies Blackstone bought. In deals where the partners in charge had rated management highly at the outset, returns tended to be disappointing. “Management acumen drives ability to meet the plan,” the headline in the summary read. “Unfortunately, we don’t seem to be able to accurately determine this and calibrate the operating projections up front,” the subhead wryly noted. The results led the firm to turn to outside consultants and psychologists to evaluate executives at potential portfolio companies. The study also made clear that Blackstone was lagging behind competitors at improving operations at its companies—a discovery that led to the expansion of its in-house consulting and management support group. James also reexamined Blackstone’s relations with its bankers. He began tracking how much Blackstone paid to individual investment banks so it could see which bankers were bringing it deals, and which weren’t. At the same time, he made overtures to the banks, hoping to counter the reputation the firm had gained for being a hard-nosed and difficult customer. “Tony said, ‘We’re not in this for the last basis point’ ”—haggling over fractional differences in interest rates—remarks one banker. “You know Steve—that’s not really his speech.” Across the board, there was more structure. Before James arrived, “we were run like a small company that had gotten big—like five boutiques,” says real estate partner Chad Pike. “We had no standard operating procedures.” Now, Pike says, “the back of the house is kind of catching up to the front of the house.”
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Over time the two developed a bond, talking or leaving long voice mails for each other ten or twelve times on a typical day. Schwarzman could often be seen slouched comfortably in a chair in front of James’s desk.
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For Bret Pearlman and Mark Gallogly, the boom in private equity in the years that followed James’s arrival enabled them to raise their own funds, as investors deluged the private equity world with new capital. Pension funds and other institutions that a few years earlier would not have considered handing over money to a firm with no past record were suddenly open to doing so. In 2004, Pearlman, who had pressed Schwarzman to wade deeper into the technology and media sectors in the late 1990s, teamed up with a group of Silicon Valley executives and investors and Bono, the lead singer of the rock group U2, to form Elevation Partners to invest in media, entertainment, and consumer companies. The next year Elevation raised $1.9 billion. In October 2005, Gallogly, who had mulled going out on his own in 1999, finally took the plunge, forming Centerbridge Partners with a veteran vulture investor. By the next year they had a $3.2 billion fund at their disposal—half again as big as the 2000 Blackstone communications fund Gallogly had headed. Lipson left that year, too, to join Bob Pittman, an ex–Time Warner executive Lipson had known from the Six Flags theme park deal, at Pilot Group, a private equity firm specializing in media deals. John Kukral, who had returned from London when his cohead of the real estate group, Thomas Saylak, left in 2002, served notice the same month as Gallogly. Other than Peterson and Schwarzman, by the end of 2005 there was just one partner who had joined the firm before 1990: Kenneth Whitney, who oversaw relations with Blackstone’s investors.
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Only one partner >15y
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Three years after James arrived, Blackstone was a very different place—more disciplined, more collegial, and a little less colorful. In private equity, the partner class of 2000—the thirty-somethings on whom the firm had gambled in a clutch situation—had firmly assumed the mantle. As junior partners, their worlds were altered less by James’s assumption of the reins, and the departures of Mossman, Lipson, and Gallogly cleared the way for their ascension. Even before Gallogly and Lipson left, the new partners were taking the lead on many of Blackstone’s biggest investments in 2003 and 2004—deals that would establish new records for profits and set the stage for Blackstone’s own ascendancy later in the decade. It was the final step in a transition away from the freewheeling, personality-driven culture of the firm’s first early years.
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The successful integration of James into the firm was plainly due in part to his talents. But the process revealed even more about Schwarzman’s evolution over the years. Schwarzman had pulled off a feat that none of his peers—and few other entrepreneurs—had managed: bringing in a successor from the outside and sharing real power with him. Moreover, he engineered the transition without the turmoil, bitterness, and recriminations of the firm’s first decade. The raw, and raw-edged, ambition he had shown in driving Blackstone to the top of the private equity heap with time had tempered. “He’s pretty self-aware,” one banker says of Schwarzman’s decision to bring in James. “He hides it well.”
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Chapter 17 - Good Chemistry, Perfect Timing
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“We got very active, very aggressive, and went out and bought big, chunky, industrial assets,” says James. In 2003, the year the economy turned the corner and began expanding again, Blackstone far outpaced its rivals, signing up $16.5 billion worth of deals. Goldman Sach’s private equity unit was the only other buyout investor that came close. The totals for TPG and Apollo, Blackstone’s next closest competitors, were only half Blackstone’s.
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Long before he began pursuing Nalco, though, another company had caught Chu’s eye: Celanese AG, a publicly traded, Frankfurt-based chemical company. It would take two years to get it to agree to a buyout and another two years to complete the last step of the transaction, but when it was all over Celanese would generate by far the biggest profit Blackstone had ever seen. It would prove to be a showcase for the art of private equity, a brilliant mix of financial wizardry with a hefty dose of nittty-gritty operational improvements. Together with Nalco, which also repaid Blackstone’s money many times over, Celanese secured Chu’s position as the fastest-rising star of the buyout group.
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Scaring up the equity also proved to be a problem. Blackstone needed about $850 million of cash to close the deal, but that would amount to 13 percent of Blackstone’s new fund—far more than it was willing to risk on any single investment. Chu had assumed he would be able to bring in other buyout firms to take smaller stakes but soon found that he was alone in his conviction that the chemicals market was turning up. All six of the competitors he approached turned him down. “A lot of them thought the cycle would get worse before it got better and told us, ‘You guys overpaid,’ ” Chu recounts. Ultimately he lined up $206 million from Blackstone investors, which invested directly in Celanese in addition to their investments through Blackstone’s fund. Bank of America, Deutsche Bank, and Morgan Stanley, the lenders for the buyout, agreed to buy $200 million of preferred shares—a cross between equity and debt—to fill the remaining hole. In December 2003 the pieces finally came together and Celanese’s board agreed to sell the company to Blackstone for 32.50 per share, for a total of 2.8 billion ($3.4 billion). It was by far the biggest public company in Germany ever to go private. The 32.50 was 13 percent above the average price of the stock in the prior three months, but it still looked good to Chu, for that was just five times cash flow. There was still one more hurdle: getting the shareholders to agree. The Kuwaitis had committed to sell their 29 percent, but other shareholders were free to refuse the 32.50 offer, and German takeover rules gave them a perverse incentive to do so. In the United States and many other European countries, once a buyer gets 90–95 percent of the shares of a company, it can force the remaining shareholders to sell out at the price the other shareholders accepted. In Germany, by contrast, shareholders can hold out and insist on an appraisal, and the arcane formulas mandated for the appraisals almost always yield a far higher price—sometimes well above the stock’s highest price ever. Until the appraisal process was complete, Blackstone therefore wouldn’t know exactly what it would cost to buy Celanese. Because of the holdout right, Chu found himself playing a multibillion-euro game of chicken with the hedge funds and mutual funds that owned most of Celanese’s stock. Blackstone had conditioned its offer on winning at least 75 percent of the shares at 32.50. Any less than that and the whole deal was off. The hedge funds and mutual funds didn’t want that to happen, because Blackstone was paying a premium, and the stock would likely fall back well below 32.50 if the deal was scotched. However, it was in each investor’s interest to demand an appraisal so long as most of the other shareholders opted for the 32.50. “I remember sitting in my office negotiating with every hedge fund who had a stake and all the mutual funds,” says Chu. “They all wanted the deal to go through, but they did not want to be part of the 75 percent.” On March 29, 2004, the day the offer expired, the outcome still wasn’t clear, and Schwarzman was on pins and needles. “[Steve] walked into my office around three thirty and just sat there, because he was obviously concerned about the deal,” says Chu. “We had run up something like $25 million in expenses, which was no small matter. Steve said, ‘Chinh, how is it going?’ I’d say, ‘Steve, I’m on the phone negotiating with everybody. I don’t know how it’s going!’ ” Schwarzman returned again with only minutes to spare till the 6:00 P.M. deadline. “We were 15 percent short. At six o’clock, Steve asked me, ‘What is the official tally?’ At that point, we were 1.5 percent short, but I told Steve, ‘I think we’re going to be fine when you wake up in the morning because a lot of guys came in at the last minute, and there is still stuff stuck in the computer system.’ ” The next morning Blackstone learned it had garnered at least 80 percent of the shares, and the final tally the following day was 83.6 percent. Blackstone controlled Celanese.
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As the company was trimming fat and expanding through acquisitions, business was taking off as the global economy improved. Even before the deal closed in April 2004, demand had picked up enough that Celanese had begun raising prices. Over the course of that year it publicly announced thirty price increases, which helped lift its top line to $4.9 billion from $4.6 billion the year before and pushed cash flow up 42 percent. On the strength of that, Celanese was able to borrow more money in September 2004 to pay out a dividend. With that, Blackstone recouped three-quarters of the equity it had invested in April. Thereafter, most of what it would collect would be pure profit. Two months after the dividend, in November, Celanese filed papers for an IPO to go public and in January 2005, only eight and a half months after Blackstone won control of the company, Celanese went public again on the New York Stock Exchange. As Chu had predicted, American investors valued the company more highly: at 6.4 times cash flow, or 1.4 “turns” more than Blackstone had paid. Celanese raised close to $1 billion in common and preferred stock, $803 million of which went to Blackstone and its coinvestors, on top of the dividend they received earlier. Blackstone and the coinvestors had now collected $700 million in profit on their $612 million investment, and they still owned most of Celanese. By the time they sold the last of their Celanese shares in May 2007, Blackstone and the coinvestors raked in a $2.9 billion profit on Celanese—almost five times their money and by far the biggest single gain Blackstone has ever booked.
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Only 8m after BX took it private
Chapter 18 - Cash Out, Ante Up Again
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The mix of institutions investing in buyout funds looked very different in the 2000s from what it had when Peterson and Schwarzman first went rapping on doors in 1986 and 1987. Back then they called first on insurance companies and Japanese banks and brokerage houses. Only at the end did they raise money from two corporate pension funds, General Motors’ and General Electric’s. By the late 1990s, banks and insurers together were providing only 15 percent or so of the money in buyout and venture funds, and state and local government pension funds had emerged as the leading backers of buyouts, furnishing roughly half the investment capital. The typical pension fund still kept half or more of its money in ordinary stocks, and a large slice in bonds, but pension managers increasingly were adhering to an economic model known as modern portfolio theory. This taught that overall returns could be maximized by layering in small amounts of nontraditional, high-returning assets such as buyout, venture, and hedge funds and real estate. Although they were riskier and illiquid (the investor’s money was tied up longer), adding these so-called alternative assets diversified a pension portfolio so that the overall risks were no greater, the theory held. Giant pensions such as California’s state employee and teachers funds, CalPERS and CalSTRS, led the way, sprinkling billions of their beneficiaries’ money across alternative assets in the 1990s, setting percentage targets for each subclass of assets. By the beginning of the new century, CalSTRS and CalPERS were allocating 5 percent and 6 percent, respectively, to the category that included buyout and venture funds—$13.6 billion between them—and they bumped the amounts up every few years. In 2003 the targets were lifted to 7 percent and 8 percent, shifting an extra $4.6 billion from other types of investments. Both California plans were major Blackstone investors, and they set a precedent with their large allocations that others copied. Between 2003 and 2008, state pension funds overall raised their private equity allocations by a third, from 4.2 percent to 5.6 percent. After the tech bubble burst in 2000, the great bulk of the money earmarked for alternatives went to LBO funds rather than venture capital.
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Contrary to the common admonition, in the case of private equity, past investment performance is a good predictor of future performance. There was a welter of mediocre private equity firms that didn’t outrun the public stock market by a sufficient margin to justify the risk or the illiquidity of investing in their funds, and some even fell short of public stocks’ returns. But those whose profits landed them in the top quarter of the rankings tended to stay there year in, year out, and investors clamored to gain entry to their funds. As a consequence, the top ten firms controlled 30 percent of the industry’s capital in 1998 and held that position for the next decade. The planets were all aligned in private equity’s favor, and the forces converged to produce a fund-raising frenzy in 2005 and 2006. From the low ebb in 2002, fund-raising quadrupled by 2005. Blackstone’s record $6.9 billion fund was soon eclipsed when Carlyle closed a pair of new funds in March 2005 totaling $10 billion. The next month Goldman Sachs Capital Partners, an arm of the investment bank that raises money from outside investors as well as from the bank itself, rounded up $8.5 billion. That August, Warburg Pincus raised $8 billion, and Apollo was closing in on $10 billion. Across the Atlantic, Permira and Apax Partners, two British buyout firms with strong records, raised funds of more than $14 billion apiece. Soon KKR, TPG, and Blackstone vied to top those, laying plans to raise funds surpassing $15 billion. (Blackstone eventually would close on a record $21.7 billion in 2007.)
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By mid-decade, firms like Blackstone and KKR were deriving roughly a third of their revenue from the fixed fees rather than from investment profits, enough to make the firms’ partners exceedingly rich regardless of the fate of their investments. Cynics began to wonder if the partners’ cushy income was undercutting their motivation to make money for their investors. The driving force of the business, they feared, had become asset accumulation for its own sake, not investing for profit.
Chapter 19 - Wanted: Public Investors
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The product in this case would take the form of the business development corporation, or BDC. The BDC was a creature of the U.S. tax code, which gives tax breaks to certain kinds of investment funds that lend to midsized businesses. As long as a BDC pays out almost all of its income each year to shareholders, it is exempt from most corporate taxes. BDCs already existed, but in 2004, egged on by the investment bankers who would collect fees for selling shares to the public, major private equity firms started to perceive the BDC as a way of roping in more capital. Leon Black’s Apollo Management moved first, filing papers in February 2004 to raise $575 million for a new entity, Apollo Investment Corporation.
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The BDC was the closest thing to a publicly traded buyout fund anyone had formulated that was legal in the United States. (A company that buys companies but doesn’t plan to keep them indefinitely falls under the Investment Company Act of 1940, which governs mutual funds and other passive asset managers. That law limits the amount of debt an investment fund can use and restricts the fees it can pay to its management firm, constraints that are deal breakers for a normal private equity firm.) The BDC wasn’t a perfect substitute, but the prospect of permanent capital raised on the public markets was irresistible.
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As things played out, though, Apollo Investment Corporation was the undoing of the BDC. The banks that underwrote the IPO shaved 6.25 percent off the top in fees and commissions, so that there was barely $14 left to invest for every share the public had bought at $15. Had investors been optimistic enough about the prospects for profits, the stock price might have held at the IPO price, but they began to have doubts, and by May, Apollo Investment’s shares fell below $13, dampening interest in the other BDCs in the pipeline. Why would anyone want to buy into an IPO if the shares were destined to fall? Some big investors began to grumble, too, about the fees that Apollo and the others would charge, though the charges weren’t any higher than those for buyout funds. The market had proved fickle, and it soon became clear that the other offerings would meet a hostile reception. One by one, the other BDC deals were withdrawn or recast. Blackstone called off its plans on July 21. Ultimately, Apollo Investment paid dividends and by early 2005 its shares rose past $17, but it was too late to salvage most of the others. The BDC would not be private equity’s means to mine the public markets. Only a few smaller BDCs made it to market after Apollo. “The golden goose only laid one big egg and left foie gras all over the place,” one banker said when the BDC rush had faded in late 2004. Apollo had won round one in the quest to tap the public markets, garnering nearly $1 billion of new capital. For the rest, the BDC turned out to be a dead end.
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American buyout firms would soon look for another means, in Europe, to corral public investors’ money. In March 2005, Ripplewood Holdings, an American private equity firm that had invested extensively in Japan, made the next move, transferring seven of its investments to a new holding company, which then sold $1.85 billion of shares to the public on the Belgian stock exchange. The new entity, RHJ International, would manage and then sell off its holdings over time and reinvest the proceeds. In effect, it was a buyout fund with perpetual capital. Although quirks in Belgian law deterred others from following in Ripplewood’s footsteps, the seed was sown. In early 2006, Goldman Sachs, which had engineered the Ripplewood deal along with Morgan Stanley, hatched a plan for KKR to raise a $1.5 billion fund on the Amsterdam stock market that would invest directly in companies alongside KKR and also would invest indirectly as a limited partner in KKR’s buyout funds. This was the private equity manager’s dream, the Holy Grail—true permanent capital raised in the public markets, obviating the need for laborious fund-raising campaigns and broadening the class of investors sponsors could tap. Just as they had scrambled to catch up with Apollo to market BDCs, KKR’s rivals were close on its heels, mobilizing their own teams of bankers and lawyers to float their own Amsterdam funds. “There were twenty other Amsterdam deals ready to go thereafter,” says Michael Klein, a senior banker at Citibank, who worked on the KKR deal. Blackstone was secretly readying its own plans for a publicly traded fund in Amsterdam, a project code-named Project Panther. While KKR was raising a fund to supply equity for its funds and its buyouts, Blackstone’s would be a mezzanine debt fund, offering loans. KKR had a head start on the others, and it pressed its advantage to the fullest, stepping up the size of its offering week by week as its bankers lined up more and more investors for the offering. When KKR Private Equity Investors went public on May 3, 2006, it raised a whopping $5 billion. At the original $1.5 billion target, the KKR fund “would not have been enough to have a huge impact on the [private equity] industry,” Schwarzman says. At $5 billion, “it was a potential game changer.” This was a bona fide public buyout fund, and on a scale approaching the biggest traditional LBO partnerships. The BDC had been just a poor cousin. KKR had pulled off a double coup. Not only had it secured a huge new pool of money to manage, but in the process it had foreclosed that option for its big rivals. Henry Kravis had crossed the public bridge first and raised the bridge behind him. Competitors soon found that KKR had soaked up all the demand in the market for this kind of stock and surrendered the field to KKR. The subsequent anemic performance of the KKR fund’s stock also quashed demand for competitors’ products. KKR Private Equity Investors suffered from the same problem Apollo’s BDC did: The underwriters took their fees and commissions off the top, and investors came to understand that the fund might not earn cash profits for years. The shares, sold at $25 in the IPO, quickly slumped to the low $20s and never traded over the offering price. The IPO had sated the world’s appetite for a private equity stock, but it had also left a sour taste in investors’ mouths. Blackstone gave up on its plans for a public mezzanine fund.
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Still, KKR had raised $5 billion of permanent capital on which it would collect fees and carried interest. Round two in the race to the public markets had gone to KKR. The lesson Schwarzman drew: “Being the prime mover is critical.”
Chapter 20 - Too Good to Be True
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In 2004 the average large company that went through a buyout was priced at 7.4 times its cash flow. By 2007, the average had shot up to 9.8 times. But it wasn’t that buyout firms were cutting larger equity checks. Most of that rise in multiples consisted of debt, as banks promised bigger loans and larger bond packages for a given sum of cash flow. With the same amount of equity, a buyout firm could afford to buy a much more expensive company in 2007 than in 2004. To private equity firms it was like having a credit card without a limit, and they went on a shopping spree, setting their sights higher and higher. Hertz was followed by a $15.7 billion take-private of Denmark’s main phone company by a consortium including Blackstone. Then Carlyle and Goldman Sachs offered more than $20 billion for Kinder Morgan, Inc., a publicly traded pipeline operator, to become the new second-biggest buyout ever, in May 2006. Two months later the all-time record set by RJR Nabisco in 1988 finally fell, narrowly edged out of first place by a $33 billion buyout of HCA Corporation, a hospital chain. Fittingly, KKR led the HCA deal. Public companies were stampeding into the arms of buyout firms, lured by all-cash buyout offers well above their current stock prices. In a two-day span the week before Christmas 2006, no fewer than four public American companies agreed to go private: building supplies company Elk Corporation (Carlyle for $1 billion), orthopedic device maker Biomet, Inc. (Blackstone, Goldman Sachs, KKR, and TPG for $10.9 billion), real estate brokerage franchisor Realogy (Apollo for $9 billion), and Harrah’s Entertainment, a casino operator (Apollo and TPG for $27.8 billion). There had been competing bids for Elk and Biomet from corporations, but the corporations simply couldn’t match the prices or couldn’t afford to pay entirely in cash, as the private equity firms did.
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On September 15, Freescale’s board opted for the bird in hand, accepting the $18.8 billion offer from Blackstone, Carlyle, Permira, and TPG rather than gamble that KKR and Silver Lake would eventually make a better offer. The next day KKR said it was no longer interested, and no one else emerged to trump Blackstone’s offer. Schorr had captured the company he had been pursuing for four months, but KKR’s last-minute spoiler bid had cost the Blackstone consortium an extra $800 million. It was a steep price to pay for a semiconductor business that was notorious for its ups and downs, and Freescale had some worrisome problems. Cell phone chips sales for Motorola accounted for 20 percent of its revenue, but sales of Motorola’s wildly popular Razr model were cresting as competitors began to steal market share with snazzier models, and Motorola didn’t have any big product innovations in the pipeline. Freescale was also exposed to the vicissitudes of the auto industry, which provided another 30 percent of its sales. In ordinary times, those vulnerabilities would have made Freescale an unlikely LBO candidate. But the Blackstone consortium put an unusually large amount of equity into the buyout, $7.1 billion, or 38 percent of the price, so that Freescale would have a large cash reserve as a cushion. Blackstone’s lenders, Credit Suisse and Citigroup, took care of the rest with extraordinarily liberal financing terms. Virtually none of Freescale’s debt was due until six years out, and much of it didn’t mature until even later. Moreover, the debt had no covenants to speak of. Even if Freescale’s business deteriorated badly, the lenders had few rights unless Freescale actually stopped making debt payments. To give the company yet more breathing room, the banks also recycled a trick from the 1980s and included payment-in-kind notes, or PIKs. A popular type of bond in the Drexel era, they paid interest not with cash but with more bonds. In other words, the company could take on more debt instead of paying cash to its creditors. In an added, company-friendly feature, these notes had a “toggle”: Freescale could pay in cash or with more notes as it wished. If sales plunged, Freescale could exercise the PIK option to conserve cash. For Blackstone, the fine print of the financing made the investment a safe bet. “Semiconductors, you knew, was cyclical—incredibly cyclical,” says James. “We knew we were buying nearer the peak than the trough, so we built a capital structure with no covenants, long maturities, tons of liquidity. We said, it’s going to be a wild ride, but the long-term trends for the industry were positive as electronics permeate everything. You’re going to have your down cycles, but you’ll have some great up cycles, too, so build yourself a bulletproof capital structure so you can ride through any down cycle and then harvest in the up cycle.” Even with the hefty equity investment, Freescale’s balance sheet was torn up and rewritten, its debt load ballooning from $832 million before the buyout to $9.4 billion. It would now pay close to $800 million a year in interest, about ten times more than it had before.
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In its scale and its reed-thin equity base, Clear Channel was a high watermark, testimony to the extraordinary lengths to which lenders were willing to go. Bain and Lee’s agreement called for them to put up just $4 billion of equity while a sprawling syndicate of banks—Citigroup, Deutsche Bank, Morgan Stanley, Credit Suisse, Royal Bank of Scotland, and Wachovia Corporation—agreed to supply $21.5 billion of debt. The buyers would put up a mere 16 percent of the price in equity.
Chapter 21 - Office Party
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Blackstone was a pioneer in a type of investing that became known as real estate private equity: raising funds to buy properties and improve them or ride the market cycle up, and selling them a few years later. In the recession and savings-and-loan crisis of the early nineties, when Schwarzman recruited John Schreiber to set up the business, the firm had bought distressed properties. But over time it had adopted an approach more like the buyout group’s. In 1998, for instance, the real estate funds bought Britain’s Savoy Group hotel chain, which included the namesake hotel plus three of London’s other most swanky inns, Berkeley’s, Claridge’s, and the Connaught. Together they accounted for about half the ultraluxury class rooms in London, but the family-run company hadn’t maximized their potential. Blackstone took offices, closets, and other space that didn’t make money and created two hundred new rooms at the four buildings, upgraded the decor, and hired new chefs to create a buzz around the establishments before selling the company in 2003. The private equity approach to real estate had produced an average return of 36 percent across Blackstone’s various real estate funds by 2006, on a par with the buyout funds, but the real estate group’s record had been more consistent. Only a dozen or so of its two hundred–odd deals had ever lost money, and those had been relatively small.
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The deal was viable. Six days later, on November 13, Blackstone put a formal $47.50 proposal on the table. EOP held out for an extra dollar, which would raise the total value to $36 billion. Blackstone soon agreed. Zell drove a hard bargain on a technical issue, too: the breakup fee that EOP would have to pay Blackstone if it opted to accept a higher bid. Zell was adamant that the deal have a low breakup fee so that other bidders would not be deterred from making offers. (A company that trumps the original deal with a higher offer effectively must absorb the breakup fee, because the target’s value is reduced by the amount of the fee it pays out.) EOP’s directors had not shopped the company around because they were worried that word would leak out, but they had fiduciary duties to their shareholders to try to get the best price. If they were going to sign a deal with Blackstone without inviting other bids up front, the cost of getting out of that agreement had to be cheap. Breakup fees are meant to reward the first bidder for putting in the work to formulate a bid—a sort of token of appreciation for the loser. Typically they run 2–3 percent of the total value of the target’s stock. Gray grudgingly agreed to a $200 million fee, or just 1 percent of EOP’s market capitalization—not high enough to deter a serious bidder. The takeover agreement was wrapped up on Sunday, November 19. Financing the EOP deal proved to be a cinch. It took Blackstone just five days to round up $29.5 billion in debt financing from Bear Stearns, Bank of America, and Goldman Sachs. As with Freescale, the terms on the loans were extraordinarily easy. In addition to the debt, the banks agreed to invest several billion dollars in equity, which Blackstone would repay at a small premium when it sold EOP assets. The banks would earn a return on that temporary equity, but they also bore part of the risk if the sales fell through and EOP ended up stuck with too much debt. Also, as it had with Freescale, Blackstone made sure none of EOP’s new debt would fall due before 2012, giving EOP latitude if there were a downturn.
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Gray huddled with Schwarzman and James. Blackstone had already been forced to come up 11 percent from its original $48.50 offer in the fall, to $54. Did it make sense to increase its offer again, particularly when the Vornado bid seemed so unattractive? Time and again in Blackstone’s internal meetings, Schwarzman invoked the memory of KKR’s overpaying for RJR Nabisco. “We don’t want another RJR,” he would tell Gray. “We talked about putting the firm’s reputation at risk in so big a deal,” Gray said. “If we had overpaid and the deal had gone spectacularly badly, we could have really hurt a franchise that took twenty years to build.” But the offers for EOP properties were so high that the leftovers would end up costing Blackstone less than they would have at the original, November price, Gray demonstrated to Schwarzman and James. Blackstone went back to EOP and offered another $1.25, or $55.25 a share. EOP’s board pushed for an extra 25 cents, and the deal was struck at $55.50, with the breakup fee lifted to $720 million. The buyout would now be worth $38.7 billion, topping RJR Nabisco by an even wider margin than the original deal would have. Vornado folded. Two days after the shareholder vote, which had been postponed to February 7, Blackstone owned EOP. Gray’s team had no time for a victory dinner. Gray’s wife, Mindy, came to his office with a double magnum of Veuve Clicquot and a box of chocolate-covered raisins. The weary deal makers spent ten minutes toasting their accomplishment before turning to the daunting task of finalizing $19 billion of property sales they had in the pipeline. The biggest piece was already done: Macklowe’s $6.6 billion deal for most of EOP’s New York portfolio closed with the main buyout. A $6.4 billion sale of the Washington and Seattle holdings to Beacon Capital—the company headed by Alan Leventhal, whose theories of replacement value had inspired Gray—was nearly in the bag. But EOP emerged from the buyout with $32 billion in debt and the $3.5 billion of equity bridge financing, and knowing how torrid the market was, Gray sensed he had only a small window to sell off what he didn’t want to get those numbers down. From February to June, Blackstone unloaded sixty-one million of EOP’s roughly one hundred million in square footage for about $28 billion and was left holding only properties in prime markets. The prices it received were so extraordinary that its effective cost for the remainder was far below their market value. With the benefit of leverage, Blackstone’s $3.5 billion equity investment was worth about $7 billion when the sales were complete. It had doubled its money on paper simply by breaking up EOP.
Chapter 22 - Going Public—Very Public
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To begin with, there was no one Blackstone. The “firm” was a cluster of a hundred or so partnerships and corporations and funds with contractual ties and overlapping management and ownership but no single parent company whose shares could be sold to the public. Control was complicated, too. Peterson and Schwarzman alone had voting rights in the buyout and M&A businesses. They divvied up the profits to the partners in those groups and consulted them, but the other partners had no legal right to a say in management. By contrast, the managers of the real estate arm—including its founder, John Schreiber, who was not even a Blackstone partner or employee—controlled half of the voting rights for that business, with Blackstone holding the other half. To go public, Blackstone would have to create a single entity—and ultimately two entities—at the top of the corporate pyramid.
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On March 22, Blackstone made it official, lodging a draft prospectus with the Securities and Exchange Commission for an offering that could raise up to $4 billion. The 363-page document was long on words but short on the kinds of juicy details others really wanted to know, such as how much Peterson, Schwarzman, and James made and what their stakes in the firm were. (Under SEC rules, details like that do not have to be disclosed until later in the months-long process of going public.) The thirty-three pages of financial statements were exceedingly opaque, if not perverse. A summary showed $2.3 billion of net income—profit in lay terms—but just $1.12 billion in revenue. How could that be? It made more than it took in? One had to burrow twenty-nine pages into the financials to find a line showing $1.55 billion in investment gains that fell outside the definition of “revenue.”
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Through friends, Antony Leung, the newly hired head of the firm’s Asian operations and Hong Kong’s former finance minister, contacted the managers of a new Chinese government sovereign wealth fund that was being formed to invest the billions of surplus dollars China was accumulating because of its yawning trade deficit with the West. Leung had in mind that the fund might buy a few Blackstone shares, but the managers of the new fund, later named China Investment Corporation, or CIC, instead expressed interest in buying a major stake. Schwarzman wasn’t sure at first if the offer was worth the potential complication and delay of negotiating a side deal, but the Chinese offered to invest $3 billion and their terms turned out to be simple. All they wanted was the chance to buy in without paying the investment banks’ fees and commissions. They didn’t seek any special access to information beforehand or a seat on Blackstone’s board, and they agreed to keep the stake under 10 percent so that the investment didn’t have to go through a national security review in the United States. In addition, their shares would be nonvoting. On May 20, barely three weeks after Leung first spoke to CIC’s head, Lou Jiwei, on April 30, a deal was signed for CIC to invest through a subsidiary optimistically named Beijing Wonderful Investments, Ltd. One person familiar with CIC calculated that in those three weeks of talks China accumulated $15 billion in new reserves and so he figured that its managers were just too busy putting out their money to haggle. For Blackstone, the investment was a huge coup. The firm was several years behind competitors like Carlyle, KKR, and TPG developing its business in Asia. Now it had won the imprimatur of the Chinese government without any real strings attached, a link that promised to give it the inside track on many investment opportunities in China.
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The political forces all converged the week of June 11, just as Blackstone’s senior management was dispersing around the globe for the IPO road show, to woo investors in person. As it happened, June 11 was the day that Blackstone finally revealed Schwarzman’s pay: $398.3 million in 2006 alone. The figure was mind-boggling. It was nine times what Lloyd Blankfein, Schwarzman’s counterpart at Goldman Sachs, made that year in cash and stock, though Goldman had thirty times as many employees and was universally acknowledged to be the most successful firm on Wall Street. Schwarzman’s pay was twice what the top five executives at Goldman together took home. It attested to the profits private equity was churning out and revealed how rich Schwarzman had become owing to his nearly 30 percent stake in Blackstone.
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That evening the banks bought the shares from Blackstone and sold them to their customers. The next day, when the new shareholders were free to trade their units on the New York Stock Exchange, the price soared to $38 as investors who hadn’t been able to buy shares directly from the underwriters bid up the price. (The price settled back to $35.06 by the end of the day.) When the accounts were tallied up, Peterson walked away with $1.92 billion and Schwarzman collected $684 million. James, who had been at Blackstone less than five years, pocketed $191 million. Tom Hill, Blackstone’s vice-chairman and manager of the hedge fund arm, got $22.9 million and Mike Puglisi, the CFO, $13.8 million. The other fifty-five partners received $1.74 billion, or an average of almost $32 million each. The offering was not simply a breakthrough for private equity, but was the biggest IPO in the United States in five years, and it put Blackstone squarely in the top tier of Wall Street firms. Blackstone was now worth as much as Lehman Brothers, where Peterson and Schwarzman had launched their banking careers, and a third as much as Goldman Sachs. Blackstone had arrived. Eleven days later, on July 3, KKR filed to go public, but Kravis’s firm was too late. The very day that Blackstone units began trading, Bear Stearns announced that it would lend $3.2 billion to a hedge fund it managed that was facing margin calls as the value of its mortgage-backed securities tumbled, and the bank said it might have to bail out a second, larger hedge fund. It was an omen. By mid-July, the credit markets were in full retreat and it was hard to muster financing for big LBOs. The growing losses on mortgage securities were unnerving hedge funds and other investors, and buyout debt looked a little too similar, so banks could no longer raise money through CLOs to make buyout loans. Peterson and Schwarzman had closed Blackstone’s first fund on the eve of the market crash of 1987. With the IPO, too, they had sneaked in just under the wire.
Chapter 24 - Paying the Piper
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Another Apollo casualty was Harrah’s Entertainment, the casino operator it bought with TPG. Harrahs saw a similar fall-off in revenue—the first time in memory that gambling had declined during a recession. (Blackstone’s buyout and real estate funds also took small, 2.5 percent stakes in Harrah’s because the firm thought the casino industry was attractive and it had no other investments in the sector.)
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Cerberus led a consortium that bought 51 percent of General Motors’ finance arm, GMAC, in 2006, at a time when GMAC’s mortgage lending operation was throwing off $1 billion in profits annually, much of it from subprime lending. Soon that business began to hemorrhage hundreds of millions and nearly brought down the whole company. Then auto sales collapsed. In 2009 GMAC took a government bailout that reduced Cerberus to a 15 percent voting position.
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Blackstone was not spared when the financial roof caved in. With no investment profits on the horizon, and fewer new investments in the pipeline, the firm laid off 150 employees at the end of 2008, and its business remained in limbo the next year. As a public company, Blackstone’s stock price served as a daily referendum on the firm and its prospects. In February 2009, with the future in doubt, the stock dipped to $3.55, down more than 90 percent from its peak on the triumphant opening day. Peterson felt so badly about the money his assistant and his driver lost on their Blackstone stock that he reimbursed them for their losses.
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The biggest worry in Blackstone’s private equity portfolio was Freescale Semiconductor. Blackstone had rounded up more than $4 billion of the $7.1 billion of equity needed for the deal, including $1.2 billion from its own fund plus a large chunk from its fund’s investors. This was the deal Blackstone partner Chip Schorr had nearly sewn up when KKR dropped in a last-minute bid, forcing Blackstone to jack up its offer by $800 million. Blackstone and the three other private equity firms that invested alongside it—Carlyle, Permira, and TPG—knew the semiconductor industry was cyclical and anticipated that business from Motorola, Freescale’s biggest customer, would taper off, and they put up 38 percent of the price in equity to keep the company relatively lightly leveraged. Things quickly veered off course. Motorola’s cell phones were eclipsed by competitors’ models, and its market share, which peaked at 22 percent in 2006, the year Blackstone signed up the deal, fell to 14 percent in 2007 and just 8 percent in 2008. Simultaneously, Freescale’s second-biggest business, selling chips to carmakers, went into free fall. “In every fund you get one or two deals where literally everything goes wrong. Freescale was that deal in our fund five,” says Schwarzman. “The last time something like that happened was HFS [the Ramada and Howard Johnson franchisor], where we listed all the things that could go wrong and every one of them happened in the first six months: an invasion in the Middle East, oil prices spiking to then-unprecedented levels, the world being thrown into a global recession and, as a result of that, the [franchise] agreement was thrown into default.” Motorola’s drastic loss of business “alone would have been problematic,” he says, and no one foresaw the downside on the auto-parts side. “The idea that the number of cars manufactured in the United States was going to plunge from 17 million at the top to 8.5 million units annually was unprecedented in my experience. In our lifetimes, I can’t remember when volumes went into single digits. A depressed year was twelve million.”
Chapter 25 - Value Builders or Quick-Buck Artists?
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The image of buyout artists was enshrined then in books like Barbarians at the Gate and Oliver Stone’s movie Wall Street. In the public’s mind, they were ruthless job cutters who loot their companies of cash and assets for the sake of short-term profits. Fifteen years after the Wall Street Journal won a Pulitzer Prize for its story about the fallout for employees from KKR’s restructuring of Safeway, BusinessWeek reprised the theme that private equity hurts the businesses it buys. In “Buy It, Strip It, Then Flip It,” a 2006 feature about the buyout of Hertz Corporation the year before, the magazine told readers to be wary of buying stock in Hertz’s upcoming IPO because the “fast-buck artists” hadn’t “been shy about backing up the Brinks truck” to the rental car company, milking it for a $1 billion dividend.
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Despite the persistence of the bogeyman, strip-it-and-flip-it image, it isn’t borne out by the facts. Take BusinessWeek’s portrayal of the Hertz case. Hertz was a classic case of an orphan subsidiary crying out for new management when Clayton Dubilier, Carlyle, and Merrill Lynch bought it from Ford Motor Company in December 2005. Ford viewed Hertz as a captive customer for its slow-selling cars and had paid it little attention. The new owners rethought the way Hertz financed its fleets, saving money by buying more cars outright rather than leasing them, and lowered its borrowing costs by issuing bonds backed by the vehicles instead of unsecured corporate bonds. Under Ford, in the quest for market share, Hertz had opened non-airport rental offices in the United States that lost money. Many were shut. Overhead costs in Europe, which were several times higher than in the United States, were slashed. Employees’ suggestions for more efficient cleaning and car return procedures were adopted, and consumers were encouraged to book online or use self-service kiosks, which cut costs. Executive compensation, which had been tied to market share—a factor in opening the money-losing offices—was changed to focus on cash flow and other metrics. The changes quickly paid off. Hertz’s revenue rose 16 percent in the two years after the buyout and cash flow was up 24 percent or 35 percent, depending on which measure you use. The $1 billion dividend that the magazine lambasted the owners for taking was actually no strain on the company, which threw off $3.1 billion in cash that year, and its cash flows were rising. Despite the payment of two dividends, in the two years after the buyout the company paid down more than a half-billion dollars of its debt. The bulk of the improvement took place with only minimal job cuts—barely 2 percent in the first year, despite the office closures. (When home construction slowed in 2007, severely hurting Hertz’s large equipment rental businesses, there were bigger cuts. The company ended that year with 9 percent fewer employees than it had at the time of the buyout, but by then the economy was in recession.)
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In a study of 4,701 IPOs in the United States over a twenty-three-year span to 2004, a French business professor commissioned by the European Parliament found that the stocks of private equity–backed companies did better than comparable companies, belying the notion that LBOs leave companies in tatters.
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The most exhaustive survey of the impact of private equity ownership on employees, which looked at more than forty-five hundred investments from 1980 to 2005, found that private equity–backed companies tended to slash jobs at a slightly higher than average rate in the first two years after a buyout but over time created more jobs than they eliminated. Contrary to what critics say, in the first four years following a buyout, companies owned by private equity firms add new positions at a faster clip than their public-company peers, though the gap then narrows, according to the 2008 study led by Harvard Business School professor Josh Lerner and funded by the nonprofit World Economic Forum of Switzerland.
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As for quick flips, there are relatively few of those. Investments of less than two years accounted for just 12 percent of private equity–backed companies, while 58 percent of the companies were held five years or more.
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The World Economic Forum study found that on average 1.2 percent of private equity–owned companies defaulted each year from 1970 to 2007—a thirty-seven-year span that included three recessions. That was higher than the overall rate for all U.S. companies, which was 0.6 percent, but still low, and it was well below the 1.6 percent for all companies that had bonds outstanding, which is arguably a more comparable pool than the set of all companies. Another study by the credit-rating agency Moody’s Investors Service in 2008 found that private equity–owned companies had defaulted at much lower rates than other similarly leveraged companies while the economy was expanding in the mid-2000s. Any way you figure it, only a small fraction of companies that have gone through LBOs have failed.
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There are doubters. Even many limited partners and private equity executives are cynical about the source of the profits. “The bulk of the money that’s been made in the private equity industry is from declining interest rates, which started in 1982,” says the head of one established midsized buyout firm. “The use of leverage and the declining interest rates, I believe, are responsible for 75 percent of the value created in the last twenty-five years.”
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The truth is that private equity’s profits arise from a mixture of all these factors—leverage and other types of financial engineering, good timing, new corporate strategies, mergers and divestitures, and operational fine-tuning—some of which create more fundamental economic wealth than others. Big private equity has grown not only because debt was plentiful for most of the last twenty-five years, but also because these firms have been adaptable, squeezing profits out by pushing up leverage in good times to pay for dividends, wading in to perform nuts-and-bolts overhauls of underperforming businesses at other points, and when the economy was down, trading the debt of troubled companies and gaining control of others through the bankruptcy process. Private equity firms are nothing if not opportunistic, and their techniques vary with business and market cycles.
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In an internal analysis of its investments through 2005, Blackstone calculated that more than 63 percent of its profits had come from cyclical plays like UCAR, American Axle, Celanese, and Nalco, though less than 23 percent of its capital had been invested in that kind of deal. By contrast, where Blackstone attempted profound transformations of the companies it bought, as it did with Collins & Aikman, Imperial Home Decor, Allied Waste, and the Callahan cable systems in Germany, its record was dismal. Fourteen percent of its capital had gone to such investments, and together they had lost 2 percent of all the capital the firm had deployed over seventeen years.
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In one final, dramatic stroke in early 2007, Herberg arranged to buy the family-owned Wilden AG, which generated sales of more than $300 million a year making inhalers and other products. Wilden’s market was increasingly global, but the brothers who ran the business recognized that their company didn’t have the wherewithal to compete effectively on a global scale, Herberg says. The deal boosted Gerresheimer’s revenues by some 40 percent and broadened its product lines. That set the stage for Gerresheimer to go public, which it did in May 2007. In the less than two years since Blackstone had bought the company, revenue and cash flow were each up roughly 80 percent and there were 71 percent more employees. Most of the increase stemmed from the acquisitions, but Gerresheimer had also boasted strong organic growth, with sales rising 13 percent and cash flow up 18 percent excluding the new plants and businesses. The IPO, which raised more than $1.4 billion, was the biggest new issue in Germany so far that year. With the trend lines at Gerresheimer moving so firmly upward, and stock prices rising globally, the company was valued at more than 10 times its 2007 cash flow, almost half again the 6.8-times ratio Blackstone had paid. Blackstone made back almost 5 times its money selling shares in the IPO. When it sold the last of its shares in 2008, it came away with 7.5 times the $116 million it had invested. Having run the business as a subsidiary of a public conglomerate, under two sets of private equity owners, and as a stand-alone public company, Herberg believes the private equity stage was essential to the transition that created a bigger, more specialized, more profitable company. Gerresheimer couldn’t have reached that point as a public company, he says. “If you miss a quarter, you get beaten down immediately. You have more time under private equity so you can take more risk.” Contrary to the image of private equity backers as looking for a quick buck (or euro), they actually create wiggle room for managers to execute difficult strategies, he says. “You have long-term financing—six or eight years. You have a lot of stability under private ownership, which is underestimated because all you see is the leverage.” Once the business was more predictable, it made sense for the company to be public. “We’re on a different plateau. The value creation by transformation is done,” he says, and the company will now grow organically. Its stock performed in line with other German industrial stocks in the year after the IPO.
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The common strand that runs through all these cases is that Blackstone saw the companies through tricky transitions that public-market forces and their prior owners would have made difficult, if not impossible. The CEOs Herberg, Vernay, Silverman, and Clarke, like Celanese’s David Weidman, testify to the impediments they faced trying to undertake big changes when their businesses were part of public companies that felt pressure to maintain steady earnings, even if the changes would improve financial performance in the long term. Under private equity owners, the managements were free to look out several years. The investors assumed the risks of making the changes because they controlled the company. As stand-alone businesses, with private equity owners, the companies were able to achieve much more of their potential.
Chapter 26 - Follow the Money
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In the postcrisis era, private equity won’t look like it did in 2006 and 2007, to be sure. Even the protagonists recognized at the time that it was a freakish period—too good to be true. With hindsight, the $20 billion–plus deals may look as anomalous as RJR Nabisco was in its day, when it was nearly four times the size of the next biggest LBO to that point. It may take a generation before there are buyouts on the scale of TXU, EOP, or Hilton again, many people in the business believe. The big question for private equity and its importance in the capital markets is not when the next $40 billion buyout occurs, but how long it takes before there are $5 billion or $10 billion deals—deals big enough to sustain private equity organizations on the scale they had operated at before the crash.
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Did not age well
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Notwithstanding the contraction of credit, the private equity business will rebound for no other reason than its $500 billion capital stockpile. Blackstone alone went into 2010 with $29 billion to invest in corporate buyouts, real estate, and debt—the largest pool of any of the big private equity houses. If history is a guide, that money will earn rich returns because investments made when the economy was weak have performed best. Buyouts in 1991 and 1992 and 2001 and 2002 earned returns near 30 percent on average, about double what investments in other years made, and the most successful funds ever were those raised and deployed at earlier troughs in the business cycle.