The New Tycoons

by Jason Kelly

  The appearance was classic rapid-fire Rubenstein, from wry jokes to a précis on the U.S. debt crisis, complete with a series of figures and back-of-the-envelope calculations about what impact changing the tax rate of private-equity firms would have on the country’s budget deficit. And a full-throated defense of the industry, along with a concession that the demands change as the scope of influence widens: “If you own a lot of companies on behalf of your investors, you have a social responsibility,” he said.

  And when the hour was up, he posed for a quick picture with conference organizers, slipped out a stage door, and jogged to his waiting car. He immediately joined a conference call, finished it, and was back on his plane by the afternoon.

  a In a private-equity twist, both Hilton and Burger King were eventually acquired by private-equity firms—Hilton by Blackstone, Burger King by TPG—and in both cases the new owners replaced the CEOs.

  b Levitt also serves on the board of directors of Bloomberg LP.

  Notes

  1. Georr Colvin, “Carlyle Chief: Opportunity Is Everywhere,” Fortune, April 5, 2010. http://money.cnn.com/2010/03/31/news/companies/carlyle_group_rubenstein.fortune/index.htm

  2. James Glassman, “Big Deals,” Washingtonian, June 2006.

  3. Ibid.

  4. Henry Sender, “From a Carlyle Founder, a Warning Shot,” Wall Street Journal, Deal Journal, March 1, 2007. http://blogs.wsj.com/deals/2007/03/01/from-a-carlyle-founder-a-warning-shot/

  5. Glassman, “Big Deals.”

  6. Dan Primack, “Could Carlyle Reunite with the bin Ladens?” Fortune.com, May 2, 2011. http://finance.fortune.cnn.com/2011/05/02/how-long-until-carlyle-reunites-with-the-bin-ladens/

  7. Jason Kelly and Katherine Burton, “Carlyle to Shutter Blue Wave Hedge Fund After Losses,” Bloomberg News, July 31, 2008.

  8. Jef Feeley and Miles Weiss, “Carlyle Group Sued by Fund Liquidator Over Losses,” Bloomberg News, July 7, 2010.

  9. Edward Evans, “Carlyle Capital Nears Collapse as Rescue Talks Fail,” Bloomberg News, March 13, 2008.

  Chapter 3

  The L Word

  Steve Schwarzman and James B. “Jimmy” Lee, Jr. were elated. It was the summer of 1989, and the two men had just finished a marathon negotiating session to buy CNW, a railroad company, for $950 million. The auction had been fierce. Schwarzman and Lee, a banker from Chemical Bank who was providing much of the debt financing for the deal, had worked on one floor of a Chicago law offices, bidding late into the night against a rival bidder tucked in a separate conference room one floor below.

  When the deal was finally won, with Chemical providing $585 million in loans for the purchase, Lee wanted to mark the event with some sort of celebration. Blackstone had arranged a tiny chartered jet to ferry the pair back to New York, and Lee finagled two Heinekens before they got on the plane. As they took off, the two men, wedged uncomfortably in the back of the plane, clinked glass bottles.

  At the time, the pairing was a marriage of convenience. Blackstone had yet to mark its fifth birthday, and Schwarzman was still figuring out exactly what the firm should be. He knew there were deals to be done, and that he needed financing to do them.

  Jimmy Lee was eager to win clients and build a book of business at Chemical, and later Chase’s investment bank. He knew he wasn’t Schwarzman’s first call (because he’d told him so). So he decided to make himself indispensable as Blackstone’s financier and later adviser on M&A.

  Lee was playing in an area once dominated by Drexel Burnham Lambert Inc., specifically by Michael Milken. It was Milken, a Drexel trader, who pioneered the use of high-yield, noninvestment-grade bonds (aka junk bonds), often in hostile takeovers. Drexel and Milken helped fuel the surge of mergers and acquisitions, including leveraged buyouts, during the 1980s. Milken was indicted for securities violations tied to insider trading, triggering Drexel to file for bankruptcy in 1990.1

  While that eliminated a major provider of debt for LBOs, Drexel was a de facto training ground for a number of men who went on to create or work at major private-equity and investment firms. Most notably, Leon Black, Joshua Harris, and Marc Rowan—all former Drexel executives—went on to create Apollo Global Management.

  New York-based Apollo has risen to become one of the biggest private-equity managers, best known for pursuing deals where it can use its expertise around complicated debt situations. Its investors give the firm broad latitude to invest not only through pairing equity with loans and bonds, but by buying debt at discounted prices as a way to eventually own the company, or in a bet that the company’s debt doesn’t reflect its underlying value.

  Drexel’s demise gave Lee a huge opening to become a major provider of debt for leveraged buyouts. Schwarzman and Lee pulled off dozens of deals in the mid-1980s through the 1990s. Two decades later, evidence of a relationship that evolved into a friendship peppered the deal memorabilia lining Lee’s office in the executive suite of JPMorgan Chase, where he is vice chairman. On the end table in Lee’s sitting area are two pictures, both featuring Schwarzman.

  One has the two men standing with JPMorgan CEO Jamie Dimon at a New York Public Library event in 2008 honoring Lee. The other, much older, picture shows Schwarzman presenting Lee with an award, one of a number that each has given the other over the years. Lee’s relationship with private equity isn’t limited to Schwarzman and Blackstone. He and his bank have financed deals from TPG’s seminal takeover of Continental in the 1990s to the record-setting LBO of TXU, by KKR and TPG, in 2007.

  Schwarzman was his willing guinea pig in those early days, as Lee searched for his competitive edge and Schwarzman started doing deals at a more rapid pace. Lee’s innovation was creating the syndicated loan market, which provided the foundation for a financing system of one-stop shopping, combining the loan business with the bond business. The first such deal, engineered by Schwarzman and Lee, was Blackstone’s 1994 purchase of UCAR International, where Chase underwrote more than $1 billion of debt and equity. “We experimented together,” Lee said. “It was like the late 1960s and 1970s in rock ’n roll.”

  Private-equity money is somewhat ordinary until it’s paired with debt. This borrowed money—the leverage in a leveraged buyout—is what gives private equity the chance to be a wildly lucrative business. Were debt removed from the equation entirely, the entire model would break down, simply because managers couldn’t deliver the returns to their investors, and reap the rich fees for doing so. Debt is the jet fuel that makes it all possible. Private-equity managers argue that prudent use of leverage (emphasis on the prudent) is not only reasonable but necessary, and part of running a healthy business that manages its cash appropriately and uses tools including debt to most appropriately grow.

  Still, leverage also has been one of the biggest drags on private equity’s reputation. As anyone who’s ever had a mortgage or a credit card knows, borrowing money comes with inherent risk. Whoever is lending it demands that it be paid back on certain terms. Throughout private equity’s history they’ve found eager lenders, the equivalent of the credit card companies who carpet-bomb college campuses with offers.

  When a private-equity firm wants to buy a company, it uses a mix of money from its own fund (equity) and some amount of borrowed money, usually in the form of bonds and loans. The money is borrowed using the target firm basically as collateral and the amount and terms are based on the company’s perceived ability to pay the interest, and ultimately repay all the debt.

  It’s a variation on the economics of purchasing a house using a mortgage. The buyer uses a blend of his own cash and a substantial bank loan to fund the purchase. Assuming the value goes up, the return is based on earning a multiple of that small amount of principle, after the loans are paid off. Let’s say you buy a house for $100,000, using $20,000 as a down payment and an $80,000 mortgage. If you were paying the entire purchase price in cash, you’d need to sell it for $200,000 to double your money.

  But you have leverage: borrowed money. That means you only ne
ed to sell it for $120,000 to double your money ($120,000 sale price minus the $80,000 loan = $40,000 profit). If you do sell it for $200,000, you’ll make five times your money.

  There are more similarities that make an LBO enticing from a profitability standpoint. Just as with a mortgage for a house, interest on corporate debt is tax deductible. Author and Bloomberg columnist William Cohan put it succinctly: “Since corporate debt is the mother’s milk of a leveraged buyout, there would be no private-equity/LBO industry without this huge tax benefit.”2 He went on to argue that this tax benefit is effectively a public subsidy of the business, since the rest of us end up making up the difference for revenue that would otherwise come from the LBO-backed companies. The private equity industry has staunchly defended the tax deductibility of debt, noting that its use is far from limited to leveraged buyouts. Beyond homeowners, corporations not owned by private-equity firms enjoy the same benefit.

  There is a philosophical element to the discussion around debt that I repeatedly encounter in my exploration of how the money flows into, around, and out of private equity. Practitioners describe it as a vital tool in delivering superior returns to their investors and themselves. They argue that debt provides a level of discipline in running companies crucial to its long-term success and that successful companies that aren’t controlled by private equity routinely use reasonable amounts of debt to fund growth, bet on new products and make acquisitions.

  Critics see placing large amounts of debt on a company’s balance sheet as nothing less than a destructive force that threatens all of our economic well-being. Their argument goes that forcing a company to divert cash to service debt crimps its ability to invest and grow. That just as a person or family shouldn’t overextend themselves in a house they can’t afford, private-equity firms shouldn’t place debt on a company that it won’t ultimately be able to pay off. Too much debt can overcome a company, sending it into bankruptcy and putting people on the streets.

  Leaving aside the philosophical argument around the use of debt, here’s how it’s used in an LBO. The money involved is stacked in several layers for purposes of importance. At the top is senior debt, secured against the company. Below that are other slugs of debt, which are subordinate (that is, in the case of a default, paid back after the senior debt). As a debt investor, the higher you are in the debt stack, the less risk you’re taking and, therefore, the lower your anticipated return.

  While banks had been in the business of providing the senior debt in the form of bank loans, Lee pushed deeper into the stack. A relentless salesman, he found that he could provide the next, riskier, level of financing by immediately selling portions of it to other investors, his clients. The syndicated loan market was born.

  While private-equity executives often contend that they are not part of Wall Street, a point made repeatedly during the depths of the financial crisis, during the height of the Occupy movement, and to every regulator or legislator who would listen during all of that time, the debt part of the equation inextricably ties buyout firms to investment banks and other lenders, as well as hedge funds.

  Big banks like JPMorgan and Goldman Sachs have evolved into the primary providers of debt for leveraged buyouts and as the private equity industry has grown, groups of bankers devoted to what bankers call financial sponsors (just another name for private-equity firms) have flourished, especially when deals were coming fast and furious. So just as investment bankers build careers specializing in calling on technology companies, retail concerns, and oil and gas partnerships, some spend their days and nights thinking about the likes of Henry, Steve, and David.

  Banks have a complicated, but extraordinarily lucrative, relationship with private equity. The biggest buyout firms have become some of the firms’ best clients, each paying hundreds of millions or more each year to Wall Street. Freeman & Co., a New York consultancy, estimated that in 2007, the likes of KKR and Blackstone paid Wall Street firms a staggering $16.3 billion in fees. That figure had fallen to a still-substantial $7.65 billion in 2010. Almost half of that came from the top 20 firms, Freeman found, underscoring how much of the private-equity business is dominated by a small cadre of institutions.3

  Private equity also sits in a fast-paced, cutthroat corner of Wall Street devoted to mergers and acquisitions, an area that has spawned an ecosystem of bankers, accountants, lawyers, and consultants all devoted to “the deal.” Merger activity mirrors the broader economy, which affects companies’ appetites to acquire, and certain industries go through periods of consolidation and divestiture. At no time since 2000, though, has total M&A activity worldwide dipped below $1.1 trillion. It peaked in 2007, largely driven by leveraged buyouts, at just over $4 trillion in deal volume, according to Bloomberg data.

  Private equity’s prominence in the broader M&A discussion, as measured by a percentage of deals that are buyouts, varies, depending on a number of factors, including debt and the willingness of corporations to sell divisions and compete with LBO firms for deals. In 2007, private-equity deals accounted for 20 percent of announced M&A transactions by dollar volume, Bloomberg data show. In 2009, at the depths of the credit crisis, private equity deals were less than 7 percent. By 2011, they’d regained their place, accounting for just less than 17 percent.

  Any explanation of the leveraged buyout boom of 2005 to 2007 inevitably includes the phrases “cheap debt” or “easy credit.” The parallels to what led to the housing crisis are hard to ignore. Just as financing was available for homebuyers to buy houses beyond what they thought they could afford, so too was debt available for private-equity firms to eye targets, bid up prices and buy companies that had previously been far beyond their reach.

  Part of it was the size of the equity funds they’d collected from pensions and endowments eager, and in some cases desperate, for the returns buyout firms had historically delivered. The other crucial piece was the debt available, mostly through the high-yield market. The high-yield (meaning high interest paying) market is something of a catchall term for debt that is non-investment grade. Because of that grade (given by credit rating agencies), investors demand to be compensated for the additional risk through more yield (interest) than they’d get from safer bonds issued by investment grade companies or the government. High-yield bonds are more colloquially called junk bonds.

  During 2005 through 2007, the high-yield debt market was perfectly situated for the purposes of leveraged buyouts. Investors were eager to invest in debt vehicles like collateralized loan obligations (CLOs), which were assembled by banks by piecing together lots of loans and then dividing them into slices according to risk. Junk bond funds also thrived, so there were willing buyers for both loans and bonds.

  Banks also used a number of products that helped fuel the boom. One was “staple financing,” whereby the bank selling a company delivered the pitchbook for the deal with a separate document that offered to underwrite the debt financing for the proposed transaction at the same time it was pitching the sale. The terms for the debt were typically stapled to the book. That made it easy for a private-equity firm to pursue a deal since a key part of the transaction was already locked up. Many decried the practice as unsavory. In 2010, as banks revived lending for new deals, some with staple financing, the Wall Street Journal noted the trend: “[S]taple financing has its risks: Namely, potential for conflicts of interest, as investment banks advising a seller may have incentive to favor a buyer who takes advantage of the bank’s offered financing.”4

  The investment banks had other tools in their arsenal, including what were known as “covenant lite” loans, which were made without some of the tests that would trigger default. Those sorts of arrangements gave private-equity firms confidence that even if what they bought struggled financially, it wouldn’t trip the covenants that could lead to default. Then there were equity bridges, whereby a bank would “bridge” the equity part of the deal. That is, the bank would take part of the equity if the private-equity firm wasn’t able or willing to speak f
or it, allowing the deal to move forward. All of those elements meant there was lots of available equity and lots of available debt. Combined with a go-go economy, it was a potent cocktail for the buyout industry. And buyout firms went on a bender. To continue the comparison to the consumer housing market, just like would-be homeowners coaxed into more house than they could ultimately afford, private-equity firms pushed the envelope with the help of eager financiers.

  For context, KKR’s seminal takeover of RJR Nabisco in 1989 stood as the largest-ever LBO for about 17 years. When KKR itself, in partnership with Bain, finally topped that with the HCA deal in late 2006, HCA held the top spot for only three months. Nine of the 10 biggest deals in the history of private equity happened from 2005 to 2007, the lone outlier being RJR.

  The amount of debt layered onto companies during the leveraged buyout boom terrified some industry observers, and even some private-equity practitioners, as the credit crisis set in during 2008 and into 2009. Observers fretted over a “wall of debt”—money committed to LBOs from 2005 to 2007 that companies couldn’t pay off and for which there was no market to refinance.

  Surprisingly, even shockingly to some, there was no collective collision with that wall, though some companies struggled. The private-equity owners seized on a friendly credit market in 2010 to refinance billions of dollars of debt, pushing back maturities or forcing existing debtholders to trade in near-worthless debt for new paper that could be worth something down the line. They also benefited greatly from elements like covenant lite loans that allowed them to operate with debt ratios that under different circumstances might have triggered default.

  Yet the amount of debt committed to leveraged buyouts during that period left lingering questions about how much debt was too much, and the dangers of leveraging a company just because you could. One complicated lesson of the boom and bust is Freescale Semiconductor, the chipmaker taken private by a group of private-equity firms in 2006 in the biggest LBO of that type of company ever. While the final chapter on the company has yet to be written, its troubled recent history makes a strong case that not every company can bear the burden of heavy borrowings.