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.
There were mixed emotions at Blackstone. “Steve from the early days didn’t like the [public investment fund] idea,” says Edward Pick, a senior banker at Morgan Stanley who was advising Blackstone about public market options at the time. Blackstone had good relations with the investors in its funds, Pick says, and Schwarzman didn’t see the need to turn to the public markets to raise investment capital.
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
For Chinh Chu, the first sign that something was askew came in 2005 when Blackstone was weighing a bid for Tronox, which made titanium dioxide pigments used in paints. Like most chemical companies, Tronox’s cash flow had soared as the economy picked up speed. Lehman Brothers, the bank handling the sale for Tronox’s parent, Kerr-McGee, was offering buyers a generous package of guaranteed financing they could take advantage of if they wished.
With the Celanese and Nalco deals, Chu had earned a reputation as perhaps Blackstone’s most astute buyout investor. The $2.6 billion in gains on those deals accounted for more than a third of the profits that Blackstone’s 2002 fund realized through the end of 2008. Having snagged Celanese and Nalco at the bottom of the market, Chu understood well the swings of the chemicals industry. He was dumbfounded to learn that Lehman was offering debt of up to seven times Tronox’s current cash flow. He figured the chemical industry was near a crest and that if business slacked off, the company wouldn’t be able to handle such a huge debt load. If earnings fell back to what one might expect at the midpoint in the business cycle instead of the peak, he reckoned, Tronox’s debt could suddenly equate to fourteen times cash flow—a perilous level.
“The debt [offered] on that deal was twice what I thought the company was worth,” Chu says.
With Lehman’s backing, Blackstone could have paid what Chu considered an absurd price, but Blackstone walked away. No other bidders took Lehman’s bait either, and Kerr-McGee ultimately took Tronox public that November. After peaking that year, Tronox’s cash flow nose-dived 40 percent, back to 2002 recession levels, sending it into bankruptcy in 2009. By then, Lehman itself was out of business.
Tronox was not an isolated case. Lehman’s wildly optimistic package was symptomatic of the forces that were igniting a new buyout blitz that would eclipse that in the 1980s. The $10 billion and $15 billion LBO funds raised in 2005 and 2006 may have turned the ignition key, but it was the banks and the credit markets that shifted the buyout business into overdrive and jammed the pedal to the floor.
The first sign of the escalation to come was a buyout engineered by Glenn Hutchins, the Blackstone partner who left in 1998 to cofound Silver Lake Partners. In the spring of 2005, Silver Lake made headlines by leading a buyout of publicly traded SunGard Data Systems, which provides computer services to financial institutions and universities. At $11.3 billion, it was the second-largest LBO ever, upstaging the old number two, KKR’s $8.7 billion buyout of Beatrice Foods in 1986. Only the RJR Nabisco buyout in 1988 was bigger.
The SunGard deal was notable not only for its size but for the unusual and potentially unwieldy, seven-firm coalition that Silver Lake corralled in order to come up with the $3.5 billion of equity needed. It was a who’s who of the buyout world: Bain Capital, Blackstone, KKR, TPG, Goldman Sachs, and Providence Equity Partners. Private equity firms had occasionally teamed up in twos or threes in the past, but one firm usually had a larger stake and took a lead role. SunGard set a new precedent by including so many marquee names with roughly equal shares. No other consortium ever quite matched SunGard’s, but increasingly firms that competed on one deal allied on the next in order to come up with the requisite capital.
SunGard also signaled that the banks would fund deals on a scale far beyond anything in the preceding fifteen years. It was their debt packages that were pushing the envelope on deal sizes, and even the biggest private equity firms sometimes had to scramble to round up the equity.
SunGard was a turning point, but it wouldn’t hold its place in the record books for long. Soon Clayton Dubilier, Carlyle, and Merrill Lynch topped that with a $14.4 billion deal to buy Hertz Corporation, the rental car company, from Ford Motor Company. It seemed every time one blinked in 2005, another household name was being snapped up in a buyout: the retailer Toys “R” Us ($7 billion: Bain Capital, KKR, and Vornado Realty Trust), Neiman Marcus, Inc., the tony department store chain ($5.1 billion: TPG and Warburg Pincus), and the doughnut and ice-cream chains Dunkin’ Donuts and Baskin-Robbins ($2.4 billion: Bain, Carlyle, and Thomas H. Lee).
Apart from the size, the other striking thing about the rash of megadeals in 2005 was that, except for Hertz and Dunkin’ Donuts, the companies were all publicly
traded. The sheer scale of the new LBO funds all but dictated that their sponsors go after public companies, because there simply weren’t enough big subsidiaries and private companies for sale to soak up the billions that the firms had to deploy. That meant the focus would shift heavily back from Europe to the United States, where big targets were more plentiful and there were fewer legal impediments to taking public companies private.
The take-privates, as they were known, also reflected a new social acceptance of private equity. CEOs who had once looked askance at buyout artists were now only too happy to offer up their companies. The Sarbanes-Oxley law enacted after the Enron and other corporate scandals early in the decade had imposed new disclosure obligations and new liabilities on companies and their managers, which executives groused were a distraction and a drain on their time. Offered the chance to answer only to private equity executives, and not to stock analysts and hedge funds that always seemed to think they knew better than management what to do, many CEOs found the going-private option tempting. At least as important, the private equity firms offered executives equity stakes that potentially could make them much richer than they could ever hope to become collecting stock options in a public company. “Sign me up!” CEOs said.
As the pace of deal making picked up in 2005, the buyout wave became an epic land grab by the private equity shops. What set it off, in addition to their piles of equity capital, were innovations in the debt markets that were at least as profound as those wrought by Michael Milken in the eighties.
Milken’s achievement had been to tap the bond markets to fund takeovers. Until Drexel created the junk-bond market, buyers had to scrounge up credit from individual commercial banks and, for unsecured junior debt, insurers. Drexel displaced the insurers by acting as a conduit, funneling money from the bond market to growing companies, corporate raiders, and buyout firms. Even before Drexel’s collapse, Jimmy Lee at Chemical had begun to assemble networks of banks to buy parcels of bank loans, channeling capital from banks around the world to M&A financing and distributing the risks.
By the 2000s, lending syndicates and bond financing were merging through a process known as securitization. Banks still made loans up front, but rather than divvying them up with other banks, they bundled them with scores of loans to other companies and sold slices of those bundles to investors. The process was known as securitization because it repackaged loans as widely sold securities similar to bonds or stocks.
Securitization had been a staple of the financial system since the 1980s, when it was first used for residential mortgages, auto loans, and, later, credit card receivables. Lenders would pool thousands of loans and sell them to newly created entities that would then issue debt securities, using the principal and interest on the underlying mortgages to pay interest to the investors. The process allowed banks to sell the loans they had made, raising cash they could then loan out again. On the buyer’s side, investors who wanted to own assets such as mortgages and credit card loans could buy them in a form that was freely tradable and relatively safe because the securities were backed by thousands of mortgages or credit card debts that collectively were supposed to pay more than enough to cover the principal and interest payments.
In the 1990s and 2000s, a similar process was later applied to corporate loans and bonds. Those bundles, dubbed collateralized loan obligations, or CLOs, functioned like bank loan syndication had in the past, distributing slices of bank loans, thereby drawing on a wider pool of capital sources and spreading the risks of the loans. Soon corporate bonds as well as loans were being bundled into new instruments.
CLOs quickly came to drive the lending process, absorbing an estimated 60–70 percent of all big corporate loans between 2004 and 2007, including the riskier leveraged loans backing LBOs. Hedge funds and banks across the globe poured money into CLOs and their mortgage counterparts, collateralized debt obligations, or CDOs, because their leveraged structures allowed them to pay higher rates of return than the investors could earn buying straight loans and bonds, and the diversified pools of debt backing the securities provided a hedge against defaults. Demand for CLOs and CDOs was so strong, and the fees for creating them so great, that the banks couldn’t raise the money and lend it fast enough. Banks were making loans just so they could satisfy the CLO and CDO appetite. This flooded the economy with credit and drove down interest rates. In early 2005, rates on high-yield debt were just 3 percent above those on U.S. treasury bonds, implying that they carried little risk. That spread was near its all-time low of 1987, and it stayed near there for the next two years.
The surplus of money had another effect. In their rush to make loans, the banks put few conditions on them. Historically, loans had come with covenants—clauses that allowed the lender to exert more control or even take over a borrower if it got in trouble and was merely in danger of defaulting. If a borrower’s cash flow fell below, say, 150 percent of its interest costs, the banks might be able to move in. No more. A new era of “covenant lite” loans had dawned, and the investors who bought the securities backed by the covenant-free loans didn’t seem to care.
There were several unintended, and ultimately ruinous, consequences of the explosion of securitized debt, sometimes called structured finance. One was that banks ceased seeing themselves as creditors and became mere middlemen between the market and borrowers, risking little of their own money. They therefore had less incentive to worry about defaults. (In fact, they had not escaped the risks because they also invested in CLOs and CDOs themselves and took them as collateral for some loans.)
The other side effect of the new financing machinery was to push up the prices of companies. Just as homeowners and speculators were bidding up house prices with the help of subprime and no-strings mortgages that were bundled up and sold into the bond markets, buyout firms were driving values higher because the banks were throwing so much debt at them that it didn’t cost the buyers anything to offer more.
The run-up in prices was startling. 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.
In economic terms, debt had become overwhelmingly the cheapest source of capital. Investors always expect higher returns for investing in stocks—from dividends and the expected rise in the share price—because stocks are riskier than bonds or loans. But debt had become so inexpensive, and the
terms so lax, that private equity firms could borrow money to buy a company’s stock from its shareholders and offer them substantially more than the company was worth on the stock market. At bottom, the LBO frenzy was a colossal substitution of debt for equity.
“Inevitably when people look back at this period, they will say this is the golden age for private equity because money is being made very readily,” Carlyle’s cofounder David Rubenstein told an audience at the beginning of 2006.
It was indeed private equity’s moment. That year private equity firms initiated one of every five mergers globally and even more, 29 percent, in the United States. Blackstone’s partners, though, had decidedly mixed feelings about the bonanza. They began to worry that the market was overheating.
“It’s not that you see problems coming. You never see problems coming at that point, or no one would be giving you ten times leverage,” James says with hindsight. “There are no clouds on the horizon. What you see is too much exuberance, too much confidence, people taking risks that in the last 145 years wouldn’t have made sense. What you say is, this feels like a bubble.”
The firm conducted no grand study of the economy. It was a consensus that emerged gradually from the partners’ scrutinizing many potential investments and asking over and over, “Where is this industry in its cycle? How would this company fare in a downturn?” The outcome was a decision to avoid heavily cyclical companies.
By early 2007, “we told our [investors] that, notwithstanding the fact that everyone else thinks it’s a fantastic time, the economy is rocking, there are no problems, we’re pulling back,” says James. “We’re not going to be investing, we’re going to be lowering the prices, we’re going to be changing the kinds of companies that we’re going to buy, because when everything feels good and you can’t see any problems, historically you’ve been near a peak.”
King of Capital: The Remarkable Rise, Fall, and Rise Again of Steve Schwarzman and Blackstone Page 25