That month the firm announced that its earnings had dropped so much that it would not pay a dividend for the final quarter of 2008—the dividend that had been a key selling point for the IPO. Schwarzman, who had designed his own compensation to consist almost entirely of investment profits so that his interests would be aligned with those of Blackstone’s investors, collected only his base pay of $350,000 in 2008 and 2009—less than one-thousandth of the $398 million he made in 2006.
Its stock price notwithstanding, Blackstone fared better than many competitors. Three years after the credit crisis began, only one of its holdings had gone bankrupt: Freedom Communications, the parent of the Orange County Register newspaper, in which it had invested $280 million for a minority stake in 2004. But Blackstone also wrote off its $343 million investment in Financial Guaranty Insurance Company, the bond insurer that had expanded from covering state and local government bonds to riskier mortgage-backed products. FGIC was still in business, but like other bond insurers it faced potentially ruinous claims on securitized investment products it insured. A slew of other investments looked in 2009 like they might end with losses, too: the crafts retailer Michaels Stores, a socks maker, Gold Toe Moretz, and the German plastic films producer Klöckner Pentaplast—all bought in late 2006 or 2007. The $749 million Blackstone invested in 2006 to buy a 4.5 percent stake in Deutsche Telekom, Germany’s main phone company, was also deep underwater.
The biggest worry in Blackstone’s private equity portfolio was Freescale Semiconductor. Blackstone had rounded up more than $4 billion of the $7.1 billion of equity needed for the deal, including $1.2 billion from its own fund plus a large chunk from its fund’s investors. This was the deal Blackstone partner Chip Schorr had nearly sewn up when KKR dropped in a last-minute bid, forcing Blackstone to jack up its offer by $800 million. Blackstone and the three other private equity firms that invested alongside it—Carlyle, Permira, and TPG—knew the semiconductor industry was cyclical and anticipated that business from Motorola, Freescale’s biggest customer, would taper off, and they put up 38 percent of the price in equity to keep the company relatively lightly leveraged.
Things quickly veered off course. Motorola’s cell phones were eclipsed by competitors’ models, and its market share, which peaked at 22 percent in 2006, the year Blackstone signed up the deal, fell to 14 percent in 2007 and just 8 percent in 2008. Simultaneously, Freescale’s second-biggest business, selling chips to carmakers, went into free fall.
“In every fund you get one or two deals where literally everything goes wrong. Freescale was that deal in our fund five,” says Schwarzman. “The last time something like that happened was HFS [the Ramada and Howard Johnson franchisor], where we listed all the things that could go wrong and every one of them happened in the first six months: an invasion in the Middle East, oil prices spiking to then-unprecedented levels, the world being thrown into a global recession and, as a result of that, the [franchise] agreement was thrown into default.”
Motorola’s drastic loss of business “alone would have been problematic,” he says, and no one foresaw the downside on the auto-parts side. “The idea that the number of cars manufactured in the United States was going to plunge from 17 million at the top to 8.5 million units annually was unprecedented in my experience. In our lifetimes, I can’t remember when volumes went into single digits. A depressed year was twelve million.”
In early 2008, barely a year after the Freescale buyout closed, Michel Mayer, the CEO Schorr had cultivated for years, was pushed out by the private equity owners. In 2009 the phone-chip business was reeling so badly that Freescale unwound its supply contracts with Motorola and said it would sell or close the unit. Freescale shuttered plants in Scotland, France, and Japan. Chip sales, which had run $6.4 billion in 2006, the year Blackstone pursued and won the company, nose-dived 45 percent to just $3.5 billion in 2009. In 2009 some of Freescale’s bonds traded around 10 cents on the dollar because investors feared a default. The company went into the crisis with large cash reserves and no debt due for several years, and it restructured and bought in debt to ensure it remained solvent. By 2010 chip sales were rising again, and it looked like the company might be out of the woods. But unlike the HFS investment, which after its brush with disaster ultimately proved to be a roaring success, Blackstone will struggle just to recoup what it invested in Freescale.
“The game on a deal of this sort is basically to keep it alive,” Schwarzman says. “With all the things that went wrong, this is like a military operation where your platoon is cut off behind enemy lines. You’ve got to stay alive, you’ve got to fight your way out, you’ve got to get reinforcements. If you do that right and you’re a wise commander, a lot of your people will live to fight again some other day.”
* * *
Real estate was also a big concern. Jon Gray had called the market perfectly when he sold off two-thirds of Equity Office Properties’ towers in early 2007, but the prospects for commercial real estate had turned so bleak by 2009 that a pall hung over Blackstone’s investment.
EOP had proved to be a disaster for the moguls who had bought buildings from Blackstone. Gray’s deal had left a trail of carnage across the real estate industry. Harry Macklowe, who paid an unfathomable $6.6 billion for EOP’s Manhattan office towers, lost them all a year later when his interim loans came due. By then, the mortgage market was frozen and the properties were worth far less than he had paid, so he was forced to turn them all over to his lenders, along with another trophy property, the General Motors Building on Fifth Avenue in Manhattan, which he had pledged as additional collateral.
The fallout from EOP was felt all across the nation. Brian Maguire, the founder of Maguire Properties, which bought many of EOP’s southern California properties, was booted out as CEO after the purchase left the company overextended. Thomas Properties, which acquired EOP’s Austin, Texas, portfolio with Lehman Brothers, found itself in a bind when Lehman went bankrupt and couldn’t supply some of the financing it had promised. Morgan Stanley’s real estate fund handed its lenders the keys to five ex-EOP buildings in San Francisco two years after the bank bought them, and Tishman Speyer Properties defaulted on loans for three towers in Chicago it acquired from Blackstone.
Even the crafty Sam Zell, who had personally pocketed $1 billion selling his EOP shares, came away a loser. He redeployed some of that money in a wildly overleveraged $8.2 billion buyout of Tribune Corporation, the publisher of the Chicago Tribune and the Los Angeles Times, which went bust in 2008. It was a particularly devastating collapse, for Zell financed the LBO in part with an employee stock ownership plan, and some employees lost both their jobs and their savings.
Because Blackstone received such extravagant offers for the EOP buildings it sold, it ended up paying only half what the properties were worth in 2007, in effect earning a $3.5 billion gain on paper. But with office rents falling and few new leases being written, the rump of EOP was worth far less two years later. There was $3.5 billion of equity on the line—the most Blackstone had ever risked on a single deal. In mid-2010 Blackstone took the first steps to negotiate extensions on EOP’s debt so it wouldn’t all come due in 2012–14, when so many other companies will be trying to refinance.
An even bigger question mark was Hilton Hotels, in which Blackstone’s buyout and real estate funds and co-investors had sunk $5.5 billion of equity. Gray and Michael Chae, who led the deal for the buyout group, saw a chance to capitalize on an underdeveloped brand and turn around a poorly managed company. A year before the Blackstone takeover, Hilton had purchased its sister company, Hilton International, which owned the rights to the Hilton brand overseas. The namesake brand hadn’t been fully exploited abroad, and the American company’s lower-cost, limited-service brands such as Doubletree, Hilton Garden Inn, and Embassy Suites hadn’t been licensed at all overseas. As a result, there was room to expand the business at the same time costs were being trimmed. Under Blackstone, the company franchised fifty thousand new rooms a year in 200
8 and 2009, in places like Turkey, southern Italy, and Asia, which lifted cash flow sharply in 2008 and promised to elevate it permanently. Blackstone also moved Hilton’s headquarters from pricey Beverly Hills to unglamorous but cheaper suburban Virginia.
But with travel falling off sharply in the recession, Hilton’s business suffered badly. The company was in no danger of failing, because Gray had insisted on a financing package that wouldn’t trip up the company if there were a downturn. The firm knew from bitter experience how cyclical the hotel business could be. Not only had it narrowly staved off disaster in 1990 at HFS, when travel fell off during the Persian Gulf War and Schwarzman and Henry Silverman had had to fly to Hong Kong to beg for a break from the owner of the Ramada brand. It also had another scare in 2001 with the Savoy hotel chain, when the chain’s creditors threatened to foreclose after bookings dried up in the wake of the September 11 attacks.
This time there were no loan covenants, and Hilton had no debt due until late 2013, giving Blackstone six years to make something out of the business. Even so, the recession pounded Hilton and in April 2010, after long negotiations with Hilton’s lenders, Hilton underwent a debt restructuring. Blackstone agreed to invest an additional $800 million to prop up the chain, and the banks, which had never been able to syndicate most of the debt from the deal and were stuck holding it, agreed to take a haircut. The accord reduced the $20 billion of debt on Hilton’s books to $16 billion.
On top of the slump in travel, Hilton became embroiled in a dispute with one of its biggest competitors, Starwood Hotels & Resorts Worldwide, Inc., which charged that two executives Hilton had hired from Starwood had stolen one hundred thousand Starwood documents and, with the knowledge of Hilton’s CEO, used the information to plan a new chain to compete against Starwood. Soon federal prosecutors launched an investigation as well. (Hilton and the executives denied wrongdoing.)
An economic recovery would give Hilton a lift. But the deal certainly was not going as Blackstone had expected.
CHAPTER 25
Value Builders or Quick-Buck Artists?
The financial crisis called into question everything about private equity—its future, its role in the economy, and its capacity to create value. The business had expanded over three decades in benign economic conditions, with generally rising markets and low interest rates, and that growth plainly owed a lot to the rising economic tide. The debt crisis of the late 1980s and bursting of the equity bubble in the early 2000s were small corrections compared with the global meltdown in 2008 and 2009, which put to the test the industry’s claims that it is a catalyst for value creation.
Despite rebranding itself as “private equity,” and notwithstanding its attempt to cast itself as a business of corporate craftsmen who create value by reshaping businesses, the buyout industry has never outrun the reputation that stuck to it in the eighties. The image of buyout artists was enshrined then in books like Barbarians at the Gate and Oliver Stone’s movie Wall Street. In the public’s mind, they were ruthless job cutters who loot their companies of cash and assets for the sake of short-term profits. Fifteen years after the Wall Street Journal won a Pulitzer Prize for its story about the fallout for employees from KKR’s restructuring of Safeway, BusinessWeek reprised the theme that private equity hurts the businesses it buys. In “Buy It, Strip It, Then Flip It,” a 2006 feature about the buyout of Hertz Corporation the year before, the magazine told readers to be wary of buying stock in Hertz’s upcoming IPO because the “fast-buck artists” hadn’t “been shy about backing up the Brinks truck” to the rental car company, milking it for a $1 billion dividend.
But is it a game of stripping, slashing, and flipping that hurts companies and the economy?
Even if buyouts don’t inherently harm companies, do private equity firms actually add value to businesses while they control them? Or are they instead just like other successful equity investors, such as mutual funds or hedge funds, which buy and sell at a profit without altering the businesses in which they invest?
The answer to the first question is clearly no. Private equity as an industry does not harm the economy.
The answer to the second and third is that they do sometimes add fundamental economic value, but a good portion of their profits derive from buying and selling at the right moments and leveraging up to accentuate their gains. But that’s no sin.
Despite the persistence of the bogeyman, strip-it-and-flip-it image, it isn’t borne out by the facts. Take BusinessWeek’s portrayal of the Hertz case.
Hertz was a classic case of an orphan subsidiary crying out for new management when Clayton Dubilier, Carlyle, and Merrill Lynch bought it from Ford Motor Company in December 2005. Ford viewed Hertz as a captive customer for its slow-selling cars and had paid it little attention.
The new owners rethought the way Hertz financed its fleets, saving money by buying more cars outright rather than leasing them, and lowered its borrowing costs by issuing bonds backed by the vehicles instead of unsecured corporate bonds. Under Ford, in the quest for market share, Hertz had opened non-airport rental offices in the United States that lost money. Many were shut. Overhead costs in Europe, which were several times higher than in the United States, were slashed. Employees’ suggestions for more efficient cleaning and car return procedures were adopted, and consumers were encouraged to book online or use self-service kiosks, which cut costs. Executive compensation, which had been tied to market share—a factor in opening the money-losing offices—was changed to focus on cash flow and other metrics.
The changes quickly paid off. Hertz’s revenue rose 16 percent in the two years after the buyout and cash flow was up 24 percent or 35 percent, depending on which measure you use. The $1 billion dividend that the magazine lambasted the owners for taking was actually no strain on the company, which threw off $3.1 billion in cash that year, and its cash flows were rising. Despite the payment of two dividends, in the two years after the buyout the company paid down more than a half-billion dollars of its debt. The bulk of the improvement took place with only minimal job cuts—barely 2 percent in the first year, despite the office closures. (When home construction slowed in 2007, severely hurting Hertz’s large equipment rental businesses, there were bigger cuts. The company ended that year with 9 percent fewer employees than it had at the time of the buyout, but by then the economy was in recession.)
Investors who heeded BusinessWeek’s warnings to shun Hertz’s IPO lost out, for Hertz’s shares nearly doubled in the year and a half after they were offered. When the economy and travel slowed further in 2008, Hertz’s stock fared at least as well as its main competitors’. Plainly investors did not see Hertz as hobbled by its LBO.
It pays to be skeptical, then, about the potshots that are routinely aimed at the industry. Many are simply false.
Hertz could be dismissed as an anomaly, but a growing mound of academic research refutes the charge that private equity damages companies for the sake of profiteering.
In a study of 4,701 IPOs in the United States over a twenty-three-year span to 2004, a French business professor commissioned by the European Parliament found that the stocks of private equity–backed companies did better than comparable companies, belying the notion that LBOs leave companies in tatters. It stands to reason. How could a form of investment that relies on selling companies for a profit survive if it systematically damaged the companies it owned? Why would sophisticated buyers like corporations acquire companies from private equity firms if they were known to strip them bare? The oft-repeated suggestion that buyout firms foist their companies on unsuspecting investors in IPOs likewise makes no sense. Most IPO investors are institutions such as mutual and hedge funds, banks, and insurers, which would have caught on long ago if private equity–owned companies were weak and overpriced. Moreover, buyout firms almost always retain substantial stakes in their companies for years after they have gone public, as Blackstone did with Celanese and TRW, KKR did with Safeway, and Clayton Dubilier did with Hertz, so their p
rofits hinge on sustaining the companies’ success over the long haul, not on dumping the stock at an inflated price and hightailing it.
Academic studies also debunk most of the other standard knocks on private equity: that it kills jobs, strips vital assets, and takes a shortsighted view of research and development.
To be sure, buyouts often are followed by job cuts. But companies cut jobs all the time, with or without a takeover, so the test of private equity’s impact is how it stacks up against the corporate world at large. The most exhaustive survey of the impact of private equity ownership on employees, which looked at more than forty-five hundred investments from 1980 to 2005, found that private equity–backed companies tended to slash jobs at a slightly higher than average rate in the first two years after a buyout but over time created more jobs than they eliminated. Contrary to what critics say, in the first four years following a buyout, companies owned by private equity firms add new positions at a faster clip than their public-company peers, though the gap then narrows, according to the 2008 study led by Harvard Business School professor Josh Lerner and funded by the nonprofit World Economic Forum of Switzerland. The exception is in manufacturing, where the job growth is on a par with other companies.
As for quick flips, there are relatively few of those. Investments of less than two years accounted for just 12 percent of private equity–backed companies, while 58 percent of the companies were held five years or more. The survey also found that contrary to common wisdom, private equity–owned companies generally don’t stint on crucial research and development spending, though they do focus research dollars on core product lines, where the stakes are highest, while deemphasizing more speculative, peripheral research.
King of Capital: The Remarkable Rise, Fall, and Rise Again of Steve Schwarzman and Blackstone Page 33