The new emphasis on value building was accompanied by a new terminology. “LBO” and “buyout” had become so tarnished that buyout firms started branding what they did as “private equity.” British buyout firms, meanwhile, took to calling their deals “management buyouts” to highlight that the business would be run by familiar faces, though the managers seldom had a controlling stake.
“Private equity” had long been used for venture capital investments in start-ups and other young companies—an investment approach that was widely lauded as fueling innovation and growth. But now the phrase was appropriated for the more controversial process of buying companies with borrowed money. The new term took hold, but it did little to free the buyout business from the stigma of its signature deals in the eighties.
In its new incarnation—with less leverage, more equity, and more prudence—the buyout business began to emerge from hibernation in 1993 and 1994. The stock markets were still traveling sideways, but the economy was climbing out of the 1991–92 slump. It proved to be a fantastic time to invest.
In the four years after the CNW deal closed in late 1989, Blackstone had pulled off only three sizable buyouts: Hospitality Franchise Systems, Six Flags, and Great Lakes Dredge & Dock Company, a Chicago dredging contractor it bought for $177 million in October 1991. But in late 1994 it returned to the hunt and lined up two new investments, a tiny wager on a broadcaster, US Radio, and a big bet on steel. The latter, like Blackstone’s maiden investment in iron ore and steel hauler Transtar, would yield a stratospheric return. Just as Blackstone had parlayed its success with Transtar into a bigger second fund, the $1.2 billion purchase of UCAR International, Inc., laid the groundwork for its third fund and Blackstone’s ascendancy in the late nineties.
UCAR, a joint venture of Union Carbide and Japan’s Mitsubishi Corporation, wasn’t itself a steelmaker but was the world’s largest maker of graphite electrodes used to produce steel: thick rods that, when heated to 5,000 degrees Fahrenheit and dipped into caldrons big enough to digest a house, could melt scrap metal into liquid steel. Because the rods had to be replaced often, UCAR was guaranteed a steady stream of orders so long as demand for steel held fast. But what particularly enthralled Blackstone was the fact that UCAR and its main competitor, Germany’s SGL Group, had slashed manufacturing capacity by about a third over the previous decade while aggressively boosting prices.
“David Stockman came up with an analysis showing that the price of electrodes was going up because there was no capacity left anywhere,” says Howard Lipson. “He understood the business, had analyzed it in terms of the end markets and capacity. His analysis got us comfortable to do the deal.”
By the time Blackstone set its sights on UCAR, its owners were just weeks away from taking the business public, and Blackstone had to race to preempt the IPO. Pete Peterson, who in 1991 had advised Union Carbide chief executive Bob Kennedy when it sold half of UCAR to Mitsubishi, reached out to his old friend about selling UCAR to Blackstone instead of taking it public. IPOs are inherently risky, because the offering price can change up to the last minute, and the seller can rarely sell more than a small minority of its shares at the outset. By contrast, a negotiated sale offers certainty and nets more cash for the seller because it can off-load as much of its holding as it wants.
Peterson suggested that United Carbide might want to retain a minority stake in case the company did well. “I told him it made sense to own some of it, because if we made a big profit on it, he’d wouldn’t look dumb, the way RCA did after it sold Gibson Greeting to Wesray,” he says.
Peterson sold Kennedy on the concept, but it was Chemical Bank’s Jimmy Lee who made the deal fly. Working against the ticking IPO clock, Lee took a gamble no commercial bank had ever taken before, offering to arrange not only the loans for the buyout but also junk-bond financing. It was a first, and a sign of how the once-sharp line between the securities business of the investment banks and lending by the commercial banks was fading. Lee added another sweetener as well by putting Chemical’s guarantee behind the entire $1.1 billion financing package.
“The only way we’re going to talk Bob Kennedy out of taking it public is if we give them certainty of financing,” Schwarzman told Lee. “You want to lead a big high-yield deal? Here is your chance.”
Lee was petrified. If he couldn’t syndicate the loans or sell the bonds and Chemical had to make good on the bridge financing, the bank would face far more exposure to a single company than it would ever ordinarily take. “We had never done a bridge of this size before, and I knew that if I took the bridge down and couldn’t sell the bonds, I’d be gone. Vaporized. Jimmy Lee would be toast, and maybe Chemical, too.”
Schwarzman eased Lee’s fears by assuring him that if Chemical had to fund the bridge “we’d be in it together,” Lee says. Though Schwarzman didn’t spell out specifics, he seemed to imply that if the need arose, Blackstone might cough up more money to buy bonds or agree to concessions on the bridge loan. “Those were the magic words I needed to hear,” says Lee. He was reassured, too, because he knew that Schwarzman had a vested interest in supporting Chemical. “He knew that if he could get me to be a major player in high-yield bonds, he would gain leverage” against other private equity firms. With Chemical in its corner, Blackstone would have an easier time trumping them in bidding contests.
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.
But a cloud soon would be cast over the UCAR investment. On June 5, less than two months after Blackstone had cashed out, federal investigators subpoenaed UCAR as part of a price-fixing investigation. In March 1998 UCAR threw out its chairman and CEO, Robert Krass, and its COO, Robert Hart, and in April 1998 it pleaded guilty to antitrust violations and agreed to pay the U.S. government a $110 million fine. Krass and Hart were packed off to prison.
The production cuts and ensuing price hikes that had so captivated Stockman when he was first analyzing the company as a prospect, and which were the basis for much of UCAR’s growth, turned out to have been the fruit of illegal collusion. Starting in 1992, before Blackstone acquir
ed UCAR, the company and its chief rival, SGL, which together controlled two-thirds of the world market in graphite rods, had conspired to cut capacity in tandem. At least one Blackstone partner, Lipson, was questioned in the cases against Krass and Hart, but no one from Blackstone, Union Carbide, or Mitsubishi was ever charged. Says Lipson: “What we didn’t know, and what you learn, is that many price-fixing schemes involve capacity-fixing schemes. It was a shock.”
Fortunately, Blackstone had most of the commitments for its third buyout fund, Blackstone Capital Partners III, signed up by that summer, before the UCAR scandal fully unfolded. To investors, the stupendous profit on Blackstone’s huge investment in UCAR was a mighty draw. Nearly all the 80 percent annualized return that Blackstone touted to investors was attributable to UCAR. It was a pattern that would recur with future funds: One or two great investments made at a trough in the business cycle could make a fund a huge success.
The $4 billion third buyout fund, which had its final closing in October 1997, elevated Blackstone to the number-two position in private equity. Only KKR, the industry’s perennial kingpin, boasted a larger fund, a $5.7 billion vehicle raised in 1996. Forstmann Little, long KKR’s leading competitor, had rounded up just $3.2 billion in 1997 for its latest fund. The other megafunds of the period were all a safe distance behind: a $3 billion pool at Donaldson Lufkin & Jenrette’s private equity unit, Welsh Carson Anderson & Stowe’s $3.2 billion, and Thomas H. Lee Company’s $3.5 billion. Not until 1999, when Tom Hicks and John Muse’s firm, which now was called Hicks Muse Tate & Furst, closed on $4.1 billion, did anyone edge ahead of Blackstone.
With the new fund, Blackstone was no longer an aspiring upstart. It now was a player, and Schwarzman wasn’t shy about broadcasting the firm’s success. In an April 1998 interview with BusinessWeek, he drew the reporter’s attention to Blackstone’s complement of advisory, hedge fund, real estate, and buyout activities. By contrast, he said dismissively, KKR was a “one-trick pony.” If there had been any doubt that Schwarzman was vying to steal Kravis’s crown as the king of private equity, the put-down laid that to rest.
But the glow of triumph from UCAR and the new fund soon dissipated. Blackstone did make a handful of good investments in 1997 and 1998: Stockman’s bet on transmission maker American Axle & Manufacturing along with three telecom investments led by the up-and-coming partner Mark Gallogly. But many of the deals it struck in those years turned into clunkers.
A funeral home and cemetery investment was a wipeout. Blackstone paid an inflated fourteen times cash flow for Prime Succession and Rose Hills, which it bought in partnership with a funeral industry giant, Loewen Group, just as the funeral business was turning down. Blackstone had negotiated downside protection in the form of a put option that allowed it to sell its stake back to Loewen at a gain. But just when Prime Succession and Rose Hills were on the brink of insolvency, Loewen itself was teetering on the edge, succumbing to the industry’s general malaise and a huge court judgment. Loewen filed for bankruptcy in 1999, rending the put option worthless. Blackstone walked away $58 million poorer. Adding insult to injury, as Loewen was failing, Blackstone was fined $2.8 million for not disclosing to antitrust regulators an internal document when it sought clearance to buy Prime Succession in 1996. The document highlighted that Loewen and Prime were competitors. Howard Lipson, who had certified to the government that Blackstone’s application was complete, was personally fined $50,000.
Blackstone lavished a total of $441 million from its second and third funds on Allied Waste Industries, a trash hauler, landfill owner, and recycler in 1997 and 1990—up to then the most Blackstone had injected into one company. But the main premise of the investment proved to be flat wrong. Blackstone and Allied executives had predicted that a dwindling supply of unused landfill would jack up prices. Instead, a brutal price war erupted. More than ten years later, Blackstone was still sitting on its stake. “We preserved capital, but it was dead money,” says Lipson, who led the deal.
Schwarzman can still painfully tick off the names of other late-nineties Blackstone duds: Haynes International, a producer of aerospace alloys; plastic-bottle maker Graham Packaging; and the ostentatiously named Imperial Home Decor, the world’s biggest wallpaper maker. Haynes and Imperial—both Stockman deals—eventually went bankrupt, socking Blackstone with $127 million in losses.
Graham, another Lipson deal, survived but struggled. A strategic merger with another packaging company that Blackstone financed in the hopes of boosting Graham’s market share utterly backfired. Some of Graham’s main customers, food and beverage companies, were unnerved by the prospect of being too dependent on one company and took business elsewhere. Graham, like Allied Waste, would languish on Blackstone’s list of holdings for more than a decade after the original investment—an eternity in the private equity business.
With hindsight, there was a pattern to the failures. All were highly cyclical companies whose fortunes seesawed with the economy. None were dominant, or even terribly competitive, in their fields. In some cases the opposite was true: The businesses had intractable problems that made it impossible for them to gain traction against bigger and stronger rivals. No one inside Blackstone really understood the businesses that well. On top of all that, Blackstone bought many of them at the wrong time in the economic cycle. It wound up overpaying and piling on too much debt. It had stacked the deck against itself.
“These were all medium-sized, cyclical businesses that we bought within two or three years of an economic top,” says Schwarzman. “We paid too much for some of them. We had ambitious turnaround plans for them that turned out to be very difficult to execute.” The losses taught the firm several lessons, he says. First, “don’t pay too much when you’re buying cyclicals,” he says. Second, “don’t have ambitious turnaround expectations for medium-sized companies. Don’t expect to reinvent them.” Third, if an investment calls for reengineering operations, “don’t have it be a Blackstone-manufactured plan.” Rather, develop a plan in consultation with seasoned executives and consultants knowledgeable enough to judge if the plan will fly.
Several of Blackstone’s debacles had something else in common: They had been championed and overseen by David Stockman, whose midwestern roots had instilled in him a zeal for rejuvenating Rust Belt businesses.
His eleven-year career at the firm had been remarkably checkered. His conviction in 1997 that demand for sport utility vehicles would continue to soar led the firm in 1997 to buy American Axle, a spinoff of General Motors that specialized in drive trains for SUVs. When the company went public in January 1999, a little over a year after Blackstone bought it, the market valued American Axle at four times Blackstone’s cost. But such hits were proving to be the exception, not the rule, and by the summer of 1999, Stockman’s stock inside Blackstone had reached bottom.
The SUV thesis tied in with the premise of another 1997 investment, in Premcor USA, an oil refiner that was as problematic as American Axle was successful. When oil prices dropped in 1997 and 1998 because of oversupply, Premcor was stuck with old inventory it had bought at higher prices and its earnings turned negative. When oil prices rose again several years later, Stockman’s belief that there would be a shortage of refining capacity was vindicated, but in 1999 it looked like another of his ornately argued investments had backfired.
At Haynes, which made alloy parts for planes and chemical refineries, his projections proved too rosy and by 1999 the company was headed toward bankruptcy. The story with Imperial Home Decor was equally disastrous but more comical. When Blackstone invested in 1998, Stockman projected big sales gains in post-Soviet Russia and Eastern Europe as incomes there rose. A young banker who worked on the original deal recalls Stockman explaining how people there would need wallpaper to cover up cracking plaster that was beyond painting. Not only did that seem far-fetched; to the twenty-something banker, just a year or two out of business school, wallpaper seemed passé. “I’m thinking, what do I know,” he says, “but I don’t know
anyone who buys wallpaper.” He was right. When Russia defaulted on its debt in 1998, the Eastern European economies sank and global wallpaper sales fell 10–15 percent. Sales in Western Europe and the United States remained anemic and the company resorted to bankruptcy in January 2000 to rid itself of its debt, taking $84.5 million of Blackstone’s money with it.
Then there was Republic Technologies International, a much grander fiasco. Stockman had hatched a scheme to create a moneymaking specialty steel business out of unwanted subsidiaries of bigger steelmakers. He began his buying spree in April 1996 with a $30 million purchase of Bar Technologies, the former wire and rod division of Bethlehem Steel, and later annexed two much bigger businesses, Republic Engineering Steels and a steel-bar venture once owned by U.S. Steel and Japan’s Kobe Steel. When Bar Technologies merged with Republic in 1998, the businesses were in such rotten shape that one Wall Street wag likened the combination to “two garbage trucks in a collision.”
Stockman’s plan was to shutter plants and lay off thousands of workers, which he did. But the price of union cooperation was an agreement to pay $178 million into the union pension plan. When the drastic downsizing didn’t produce the profits Stockman had forecast, the company found itself burdened with the pension liability and began to hemorrhage cash. “The pension payouts sucked it dry of liquidity,” says a person who was involved in the deal. “The Kobe–U.S. Steel deal really killed the company. It was the bridge too far.” In 1999, Republic was barely clinging to life, though it would be two more years before it declared bankruptcy.
King of Capital: The Remarkable Rise, Fall, and Rise Again of Steve Schwarzman and Blackstone Page 16