Contrary to the allegation that buyout firms are just out for a quick buck, CEOs of companies like Merlin and Gerresheimer say they were free to take a longer-term approach under private equity owners than they had been able to do when their businesses were owned by public companies that were obsessed with producing steady short-term profits.
Notwithstanding the controversy over the new wave of buyouts and the brouhaha over Schwarzman’s birthday party, Blackstone succeeded in going public. By then, however, Schwarzman and others at Blackstone were nervous that the markets were heading for a fall. The very day Blackstone’s stock started trading, June 22, 2007, there was an ominous sign of what was to come. Bear Stearns, a scrappy investment bank long admired for its trading prowess, announced that it would bail out a hedge fund it managed that had suffered catastrophic losses on mortgage securities. In the months that followed, that debacle reverberated through the financial system. By the autumn, the lending machine that had fueled the private equity boom with hundreds of billions of dollars of cheap debt had seized up.
Like shopaholics who hit their credit card limits, private equity firms found their credit refused. Blackstone, which had bought the nation’s biggest owner of office towers, Equity Office Properties Trust, that February for a record $39 billion and signed a $26 billion takeover agreement for the Hilton Hotels chain in July 2007, would not pull off a deal over $4 billion for the next two and a half years. Its profits sank so deeply in 2008 that it couldn’t pay a dividend at the end of the year. That meant that Schwarzman received no investment profits that year and had to content himself with just his base pay of $350,000, less than a thousandth of what he had taken home two years earlier. Blackstone’s shares, which had sold for $31 in the IPO, slumped to $3.55 in early 2009, a barometer for the buyout business as a whole.
LBOs were not the root cause of the financial crisis, but private equity was caught in the riptide when the markets retreated. Well-known companies that had been acquired at the peak of the market began to collapse under the weight of their new debt as the economy slowed and business dropped off: household retailer Linens ’n Things, the mattress maker Simmons, and Reader’s Digest, among others. Many more private equity-owned companies that have survived for the moment still face a day of reckoning in 2013 or 2014 when the loans used to buy them come due. Like homeowners who overreached with the help of subprime mortgages and find their home values are underwater, private equity firms are saddled with companies that are worth less than what they owe. If they don’t recover their value or renegotiate their loans, there won’t be enough collateral to refinance their debt, and they may be sold at a loss or forfeited to their creditors.
In the wake of the financial crisis, many wrote off private equity. It has taken its hits and will likely take some more before the economy fully recovers. As in past downturns, there is bound to be a shake-out as investors flee firms that invested rashly at the top of the market. Compared with other parts of the financial system and the stock markets, however, private equity fared well. Indeed, the risks and the leverage of the buyout industry were modest relative to those borne by banks and mortgage companies. A small fraction of private equity–owned companies failed, but they didn’t take down other institutions, they required no government bailouts, and their owners didn’t melt down.
On the contrary, buyout firms were among the first to be called in when the financial system was crumbling. When the U.S. Treasury Department and the Federal Reserve Bank scrambled to cobble together bailouts of financial institutions such as Lehman Brothers, Merrill Lynch, and American International Group in the autumn of 2008, they dialed up Blackstone and others, seeking both money and ideas. Private equity firms were also at the table when the British treasury and the Bank of England tried to rescue Britain’s giant, failing savings bank Northern Rock. (Ultimately the shortfalls at those institutions were too great for even the biggest private funds to remedy.) The U.S. government again turned to private equity in 2009 to help fix the American auto industry. As its “auto czar,” the Obama administration picked Steven Rattner, the founder of the private equity firm Quadrangle Group, and to help oversee the turnaround of General Motors Corporation, it named David Bonderman, the founder of Texas Pacific Group, and Daniel Akerson, a top executive of Carlyle Group, to the carmaker’s board of directors.
The crisis of 2007 to 2009 wasn’t the first for private equity. The buyout industry suffered a near-death experience in a similar credit crunch at the end of the 1980s and was wounded again when the technology and telecommunications bubble burst in the early 2000s. Each time, however, it rebounded and the surviving firms emerged larger, taking in more money and targeting new kinds of investments.
Coming out of the 2008–9 crisis, the groundwork was in place for another revival. For starters, the industry was sitting on a half-trillion dollars of capital waiting to be invested—a sum not so far short of the $787 billion U.S. government stimulus package of 2009. Blackstone alone had $29 billion on hand to buy companies, real estate, and debt at the end of 2009 at a time when many sellers were still distressed, and that sum would be supplemented several times over with borrowed money. With such mounds of capital at a time when capital was in short supply, the potential to make profits was huge. Though new fund-raising slowed to a trickle in 2008 and 2009, it was poised to pick back up as three of the largest public pension funds in the United States said in late 2009 that they would put even more of their money into private equity funds in the future.
The story of Blackstone parallels that of private equity and its transformation from a niche game played by a handful of financial entrepreneurs and upstart firms into an established business of giant institutions backed by billions from public pension funds and other mainstays of the investment world. Since Blackstone’s IPO in 2007, KKR has also gone public and Apollo Global Management, one of their top competitors, has taken steps to do the same, drawing back the veil that enshrouded private equity and cementing its position as a mainstream component of the financial system.
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.
Schwarzman and peers such as Henry Kravis represent a new breed of capitalists, positioned between the great banks and the corporate conglomerates of an earlier age. Like banks, they inject capital, but unlike banks, they take control of their companies. Like sprawling global corporations, their businesses are diverse and span the world. But in contrast to corporations, their portfolios of businesses change year to year and each business is managed independently, standing or falling on its own. The impact of these moguls and their firms far exceeds their size precisely because they are constantly buying and selling—putting their stamp on thousands of businesses while they own them and influencing the public markets by what they buy and how they remake the companies they acquire.
CHAPTER 2
Houdaille Magic, Lehman Angst
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 b
uy 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.”
Schwarzman wasn’t alone in his epiphany. “When Houdaille came along, it got everybody’s attention,” remembers Richard Beattie, a lawyer at Simpson Thacher & Bartlett who had represented KKR on many of its early deals. “Up until that point, people walked around and said, ‘What’s an LBO?’ All of a sudden this small outfit, three guys—Kohlberg and Kravis and Roberts—is making an offer for a public company. What’s that all about?”
The financial techniques behind Houdaille, which also underlay the private equity boom of the first decade of the twenty-first century, were first hatched in the back rooms of Wall Street in the late 1950s and 1960s. The concept of the leveraged buyout wasn’t the product of highbrow financial science or hocus-pocus. Anyone who has bought and sold a home with a mortgage can grasp the basic principle. Imagine you buy a house for $100,000 in cash and later sell it for $120,000. You’ve made a 20 percent profit. But if instead you had made just a $20,000 down payment and taken out a mortgage to cover the rest, the $40,000 you walk away with when you sell, after paying off the mortgage, would be twice what you invested—a 100 percent profit, before your interest costs.
Leveraged buyouts work on the same principle. But while homeowners have to pay their mortgage out of their salaries or other income, in an LBO the business pays for itself after the buyout firm puts down the equity (the down payment). It is the company, not the buyout firm, that borrows the money for a leveraged buyout, and hence buyout investors look for companies that produce enough cash to cover the interest on the debt needed to buy them and which also are likely to increase in value. To those outside Wall Street circles, the nearest analogy is an income property where the rent covers the mortgage, property taxes, and upkeep.
What’s more, companies that have gone through an LBO enjoy a generous tax break. Like any business, they can deduct the interest on their debt as a business expense. For most companies, interest deductions are a small percentage of earnings, but for a company that has loaded up on debt, the deduction can match or exceed its income, so that the company pays little or no corporate income tax. It amounts to a huge subsidy from the taxpayer for a particular form of corporate finance.
By the time Jerome Kohlberg Jr. and his new firm bought Houdaille, there was already a handful of similar boutiques that had raised money from investors to pursue LBOs. The Houdaille buyout put the financial world on notice that LBO firms were setting their sights higher. The jaw-dropping payoff a few years later from another buyout advertised to a wider world just how lucrative a leveraged buyout could be.
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.
Simon himself called his windfall a stroke of luck. Although Gibson Greeting’s operating profits shot up 50 percent between the buyout and the stock offering, Wesray couldn’t really claim credit. The improvement was just a function of timing. By early 1983 the economy was coming back after a long recession, giving the company a lift and pushing up the value of stocks. The payoff from Gibson was testament to the brute power of financial leverage to generate mind-boggling profits from small gains in value.
At Lehman, Steve Schwarzman looked on at the Gibson IPO in rapt amazement like everyone else. He couldn’t help but pay attention, because he had been RCA’s banker and adviser when it sold Gibson to Wesray in the first place and had told RCA the price was too cheap. The Houdaille and Gibson deals would mark the beginning of his lasting fascination with leveraged buyouts.
The Gibson deal also registered on the radar of Schwarzman’s boss, Lehman chairman and chief executive Peter G. Peterson. Virtually from the day he’d joined Lehman as vice-chairman in 1973, Peterson had hoped to coax the firm back into the merchant banking business—the traditional term for a bank investing its own money in buying and building businesses. In decades past, Lehman had been a power in merchant banking, having bought Trans World Airlines in 1934 and having bankrolled the start-ups of Great Western Financial, a California bank, Litton Industries, a technology and defense firm, and LIN Broadcasting, which owned a chain of TV stations, in the 1950s and 1960s. But by the time Peterson arrived, Lehman was in frail financial health and couldn’t risk its own money buying stakes in companies.
Much of what investment banks do, despite the term, involves no investing and requires little capital. While commercial and consumer banks take deposits and make loans and mortgages, investment bankers mainly sell services for a fee. They provide financial advice on mergers and acquisitions, or M&A, and help corporations raise money by selling stocks and bonds. They must have some capital to do the latter, because there is some risk they won’t be able to sell the securities they’ve contracted to buy from their clients, but the risk is usually small and for a short period, so they don’t tie up capital for long. Of the core components of investment banking, only trading—buying and selling stocks and bonds—requires large amounts of capital. Investment banks trade stocks and bonds not only for their customers, but also for their own account, taking big risks in the process. Rivers of securities flow daily through the trading desks of Wall Street banks. Most of these stakes are liquid, meaning that they can be sold quickly and the cash recycled, but if the market drops and the bank can’t sell its holdings quickly enough, it can book big losses. Hence banks need a cushion of capital to keep themselves solvent in down markets.
Merchant banking likewise is risky and requires large chunks of capital because the bank’s investment is usually tied up for years. The rewards can be enormous, but a bank must have capital to spare. When Peterson joined in 1973, Lehman had the most anemic balance sheet of any major investment bank, with less than $20 million of equity.
By the 1980s, though, Lehman had regained financial strength and Peters
on 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.
The two never gave up on the dream. Schwarzman would invite Dick Beattie, the lawyer for the Kohlberg Kravis buyout firm whose law firm was also Lehman’s primary outside counsel, to speak to Lehman bankers about the mechanics of buyouts. “Lurking in the background was the question, ‘Why can’t Lehman get into this?’ ” Beattie recalls.
All around them, banks like Goldman Sachs and Merrill Lynch were launching their own merchant banking divisions. For the time being, however, Peterson and Schwarzman would watch from the sidelines as the LBO wave set off by Houdaille and Gibson Greeting gathered force. They would have to be content plying their trade as M&A bankers, advising companies rather than leading their own investments.
* * *
Peterson’s path to Wall Street was unorthodox. He was no conventional banker. When he joined Lehman, he’d been a business leader and Nixon cabinet member who felt more at home debating economic policy, a consuming passion, than walking a trading floor. A consummate networker, Peterson had a clearly defined role when he came to the firm in 1973: to woo captains of industry as clients. The bank’s partners thought his many contacts from years in management and Washington would be invaluable to Lehman.
King of Capital: The Remarkable Rise, Fall, and Rise Again of Steve Schwarzman and Blackstone Page 2