But the mattress company flips illustrated the risks of overleveraging companies. Two of the previous seven buyouts of the companies had ended badly: Simmons and Sealy had each defaulted once when their owners overpaid and loaded the companies up with too much debt. (Simmons would go bankrupt in 2009 for the same reason, and Sealy would later need a huge shot of additional equity from KKR to stay alive.)
Nevertheless, Simmons’s three other prior buyouts had been very profitable, largely because of its superlative financial performance: From 1991, when Merrill Lynch bought Simmons, to 2007 its annual cash flow rocketed more than sixfold, from $24 million to $158 million. Even though Sealy’s growth wasn’t as steady, its cash flow tripled over the same stretch, and the cumulative increase in both companies’ value over nearly two decades was remarkable. Given the expansion of the mattress businesses and the aggregate profits made by private equity firms from them over time, it wasn’t surprising that when the companies were put up for sale, the buyers turned out to be other private equity firms.
With all the IPOs, recaps, and secondary buyouts, private equity firms and their investors were awash in incoming cash that they funneled right back into new investments. In 2001, the nadir of the market cycle, Blackstone’s buyout funds managed to pay out just $146 million to its limited partners. In 2004, it returned $2.7 billion, then $4.2 billion in 2005, and another $4.7 billion in 2006—testimony to the heady combination of a rising market and leverage. Competitors were cutting even larger checks. Carlyle touted in a press release that it had paid out $5.3 billion in 2004 and KKR returned $7 billion that year. Carlyle paid out another $7 billion in 2005. For four or five years private equity became self-sustaining, as investors recycled the distributions immediately back into new buyout funds. The sums matched up almost perfectly.
It wasn’t just the raw totals that were astonishing. The rates of return on buyout funds shot to the sky because firms were able to earn back their investments and begin taking profits so quickly. If you double your money in five years, your uncompounded annual rate of return is 20 percent, but if you double it in two years, it jumps to 50 percent. The economic turnaround was a godsend for everyone in the business, but Blackstone outpaced its big rivals. By the end of 2005 the firm’s fourth fund, which it began investing in early 2003, had earned an annual return of more than 70 percent after Blackstone’s share of the profits was taken out, about two and a half times the 20 percent annual rise in the stock market over that period. Funds raised by rivals such as Apollo, KKR, and TPG around the same time as Blackstone’s also outperformed the stock market, but not by nearly as much. Their returns were about 40 percent, and returns on most other buyout funds of the early decade were below that, so Blackstone stood out in the crowd.
Blackstone’s 2002 fund sustained its lead among the biggest buyout funds, generating roughly a 40 percent annual return through the end of 2008, or two or three times the returns on competitors’ funds raised at the bottom of the business cycle in 2001 to 2003. That performance was the payoff from Schwarzman’s and James’s gut feeling in 2002 that things were bottoming out then and from Chinh Chu’s two knockout deals: Celanese and Nalco. As Blackstone geared up to raise its next fund, its returns gave it a competitive edge.
It’s a law of finance and human nature that investment managers who make money for their clients attract more capital over time. With bucket loads of profits coming in and extraordinary rates of return, Blackstone and other private equity firms with good records were assured of raising gargantuan investment pools the next time they hit the fund-raising trail. Another factor magnified the effect: the quotas big pension funds and other investors set for private equity.
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.
Along with the rising quotas, the total assets of the pension funds were swelling as the population aged and the stock market roared back, so that year by year a given quota, whether 5 percent or 8 percent, equated to an ever-larger absolute amount. The formulas mandated that the pension managers pump billions and billions more into the next generation of buyout funds.
The stepped-up quotas made it possible for Blackstone partners such as Bret Pearlman and Mark Gallogly to strike out on their own and quickly raise multibillion-dollar funds, even though they had no independent investment record. In the main, though, the money flowed disproportionately to a handful of elite firms like Blackstone that had long outshone the stock market and their competitors. 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.) The industry wasn’t as concentrated as it had been in the eighties, when KKR single-handedly dominated the field
and was behind most of the largest deals of the decade, but the dozen-odd firms that were able to raise megafunds enjoyed a hegemony, because they controlled so much buyout capital and they alone could compete for the new megadeals.
The breathtaking sums pouring in changed the business in several ways. With such large war chests, the top buyout firms would not be content to buy a $500 million company here and a $1 billion company there. It would simply take too long and involve too much work to invest their money at that rate. They would have to find bigger targets, and now the debt markets allowed them to finance deals on a much grander scale.
Private equity had enjoyed a revival in the late 1990s, but it was nothing like this. In the previous decade, merger activity was dominated by huge corporate takeovers, with buyouts accounting for merely 3 percent to 4 percent of all mergers most years, measured by total dollar value. That figure, though, began to tick upward in the 2000s. Even with financing hard to come by, private equity led 10 percent of all takeovers worldwide in 2002, a level achieved only once before, in 1988, when the buyout numbers were skewed by the mammoth RJR Nabisco deal.
Private equity’s share kept ascending even after corporations began pursuing mergers again. By 2004 it hit 13 percent in the United States and 16 percent in Europe, and it would rise past 20 percent before the cycle was over. With plenty of cheap debt at its disposal, private equity became a potent force in the markets and the economy. The mere prospect of becoming a buyout target could lift the price of a stock that was otherwise languishing, and corporations began to rethink their own capital structures. If a buyout firm could put more debt on the company so that any gain in the company’s value was magnified in the value of its stock, companies began to ask themselves, why couldn’t we do the same to give our public shareholders a higher return on their shares? In some cases, hedge funds and other activist investors urged companies to perform their own dividend recaps, borrowing more money to pay a dividend or to buy in some of their shares.
The sheer magnitude of the funds and the deals had another side effect on the business, one that troubled some investors. The fixed 1.5 percent to 2 percent management fees the firms charged their investors, and the transaction fees they tacked on when they bought or sold a company, had grown so large in absolute dollar terms that they had become a wellhead of income at large private equity houses, rather than just a way of ensuring that some money was coming in the door in tough times. 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
From its earliest days, the buyout investing game had been the private reserve of institutions and the super rich. There was no way for the American public or even mutual funds to get a piece of the action. Pension plans could invest, yet the man in the street could not add private equity to his own retirement savings account. There was a small number of publicly traded companies in Britain and Canada that invested in buyouts, but American securities law had made it effectively impossible to raise money to invest in LBOs by selling stock to the public, and the foreign investment funds were barred from selling their shares to Americans.
With the business commanding headlines every week, and word spreading of the enormous profits being churned out by buyout funds, the broader investing world wanted in, and it is an immutable law that when Wall Street senses an appetite for “product,” it will find a way to fulfill that desire.
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. Apollo Investment would not buy control of companies the way that a conventional buyout fund would. Instead, it would be a mezzanine lender, making loans to small and midsized companies. Mezzanine debt—the type of debt that insurance companies provided for LBOs in the early days of the business—is subordinated to senior debt such as bank loans, so the interest rates are higher, and mezzanine lenders usually demand a slice of equity in their customers as well, so they can share in the profits if the customers’ stocks take off.
The BDC was a classic case of brand extension. Just as Procter & Gamble dreams up new soaps and toothpastes and sells them under established brands like Ivory, Tide, and Crest, Apollo was transferring the know-how and cachet of its buyout operations to a business that could sell shares to the public. Apollo, like other buyout firms, already had legions of analysts studying industries and potential target companies, and its knowledge of the debt markets was deep. Here was a way to capitalize on that expertise and collect management fees and profits on ever larger amounts of capital. The parent Apollo’s cut was similar to an LBO fund’s, a 2 percent management fee based on the total assets and up to 20 percent of the profits after investors had received a certain minimum.
The appeal of the BDCs to their sponsors was not just new capital to manage but permanent capital. The private equity business had long ago progressed from raising money deal by deal to amassing funds that could invest over many years. But sponsors still had to go on the road every few years, hat in hand, visiting limited partners to convince them to re-up in a new fund. The process consumed an enormous amount of time—time that the Leon Blacks and Steve Schwarzmans would rather have spent doing deals and raking in profits than justifying themselves. BDCs had to pay out most of their profits each year, but they retained their original capital in perpetuity and could raise new capital at any time by selling additional shares to the public, a process that could be handled by bankers and lawyers without senior management having to press the flesh.
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.
Apollo was the first out of the gate, and the usual suspects were close on its heels. When Apollo said in early April that it would boost the target size of its BDC to $930 million—a sign that there was market appetite—competitors rushed to launch their own BDCs. KKR filed for one on April 12, Blackstone on April 14. Within a month, more than a dozen were in the works from private equity firms like Thomas H. Lee Partners and Ares Capital Management and banks. It was “the pack moving and Wall Street was pushing, and there was no downside,” says one adviser involved in several of the offerings.
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.
It was a painful lesson in how quickly the markets could turn, but the broader investment world’s thirst for private equity, and the industry’s desire to slake that thirst, didn’t go away. American buyout firms would soon look for another means, in Europe, to corral public investors’ money.
King of Capital: The Remarkable Rise, Fall, and Rise Again of Steve Schwarzman and Blackstone Page 24