There are risks, of course, to leverage, which elevates a company’s fixed costs, potentially endangering the business in a slowdown. In every recession since 1990, scores of companies have given way under their LBO debt loads. Still, the overall casualty rate for private equity–owned companies has been remarkably light. The World Economic Forum study found that on average 1.2 percent of private equity–owned companies defaulted each year from 1970 to 2007—a thirty-seven-year span that included three recessions. That was higher than the overall rate for all U.S. companies, which was 0.6 percent, but still low, and it was well below the 1.6 percent for all companies that had bonds outstanding, which is arguably a more comparable pool than the set of all companies. Another study by the credit-rating agency Moody’s Investors Service in 2008 found that private equity–owned companies had defaulted at much lower rates than other similarly leveraged companies while the economy was expanding in the mid-2000s. Any way you figure it, only a small fraction of companies that have gone through LBOs have failed. Those that have were often forced to cut jobs, but few of the businesses ceased to exist. Most were simply taken over by other companies, by new investors, or by their creditors. (The latest recession, which has seen defaults spike, could put those comparisons to the test, of course.)
There is little support, then, for the contention that private equity ownership generally harms businesses. But how do buyout firms make their money if not by slashing costs to lift profits? And do they contribute anything to the economy at large in the process, besides generating profits for their investors?
Private equity executives, hoping to share some of the plaudits that venture capitalists garner for funding new technologies, often claim that their firms make their money by making businesses better, creating fundamental economic change that benefits society. David Rubenstein, the cofounder of Carlyle, has gone so far as to pitch yet another rebranding. Private equity should be called “change equity,” he has argued. (So far, there don’t seem to be many takers.) The boast is that private equity firms do not just make well-chosen, well-timed investments and plump up the gains with some leverage; they have learned how to manage and transform businesses to create lasting improvements.
There are doubters. Even many limited partners and private equity executives are cynical about the source of the profits. “The bulk of the money that’s been made in the private equity industry is from declining interest rates, which started in 1982,” says the head of one established midsized buyout firm. “The use of leverage and the declining interest rates, I believe, are responsible for 75 percent of the value created in the last twenty-five years.”
Academics who have analyzed the nature of the profits, however, have found that leverage contributes a surprisingly small part of investment profits overall. The European Parliament’s study of IPOs concluded that while roughly a third of the gains on successful buyouts trace directly to leverage, the rest derive from long-term increases in companies’ values. A more detailed study of thirty-two highly successful European buyouts (they had an average internal rate of return of 48 percent) found that just 22 percent of the profits were due to leverage. Another 21 percent resulted from increases in valuation multiples; that is, the multiples of earnings that investors think companies are worth. The remainder, more than half, came from sales growth and profit-margin increases. (The study didn’t attempt to break out what portion of the gains in sales, cash flows, and profit margins stemmed from the business cycle—i.e., from buying at the bottom of the market and selling after a rebound.)
The truth is that private equity’s profits arise from a mixture of all these factors—leverage and other types of financial engineering, good timing, new corporate strategies, mergers and divestitures, and operational fine-tuning—some of which create more fundamental economic wealth than others. Big private equity has grown not only because debt was plentiful for most of the last twenty-five years, but also because these firms have been adaptable, squeezing profits out by pushing up leverage in good times to pay for dividends, wading in to perform nuts-and-bolts overhauls of underperforming businesses at other points, and when the economy was down, trading the debt of troubled companies and gaining control of others through the bankruptcy process. Private equity firms are nothing if not opportunistic, and their techniques vary with business and market cycles.
Playing market swings doesn’t create new wealth in the same way that wringing out inefficiencies, funding research, or repositioning a company to make higher-value products does, but it has produced high returns for pension funds, endowments, and other investors. If LBOs don’t tend to hurt businesses, there’s no more social harm to this form of ownership and capital structure than there is to a mutual fund that trades public stocks. Moreover, even bottom-fishing in a recession provides capital to companies when it’s hard to come by and provides liquidity to sellers when there are few buyers—a different form of economic and social contribution.
It’s an overstatement, though, to claim that private equity’s profits today come primarily from building better companies. Tony James frequently boasts that two-thirds of Blackstone’s gains come from increases in cash flow, implying that the businesses have improved fundamentally under Blackstone. But Blackstone can’t take credit for all of that. Perhaps even more than its competitors, Blackstone has made its money investing at troughs in the market, so that a larger share of the financial improvement at its companies can be traced to the business cycle than to operating refinements.
In an internal analysis of its investments through 2005, Blackstone calculated that more than 63 percent of its profits had come from cyclical plays like UCAR, American Axle, Celanese, and Nalco, though less than 23 percent of its capital had been invested in that kind of deal. By contrast, where Blackstone attempted profound transformations of the companies it bought, as it did with Collins & Aikman, Imperial Home Decor, Allied Waste, and the Callahan cable systems in Germany, its record was dismal. Fourteen percent of its capital had gone to such investments, and together they had lost 2 percent of all the capital the firm had deployed over seventeen years.
Even so, Blackstone and other big buyout shops have concluded that the only way they can outperform the stock market over the long haul is to systematically improve the companies they own. Bain Capital, which grew out of the Bain and Company consulting group, was one of the first to take that notion seriously and has the largest staff of experts and seasoned managers assigned to its investments. TPG long ago built a deep team of operational experts because it had a tradition of tackling messy turnaround situations that required a lot of know-how and attention. KKR, too, formed an internal team of managers in 2000 that now numbers forty, and Carlyle built up an inventory of executives on its payroll.
Blackstone was a laggard in that regard and has been playing catch-up since 2004, when it hired James Quella, a former management consultant who had worked at DLJ Merchant Banking, Credit Suisse’s private equity business, to set up what resembles a captive consulting firm. Quella’s twelve-member team of corporate managers vets companies before Blackstone invests, and its members are often assigned to work with portfolio companies when Blackstone takes over.
That shift toward a more hands-on approach to reshaping portfolio companies can be seen in Celanese and three case studies of other successful Blackstone investments in the mid-2000s. These examples show how much the emphasis has evolved over time from a crude paring of expenses at portfolio companies to laboriously improving their operations and expanding and reorienting them.
Gerresheimer AG
Call it a makeover. That was the gist of Blackstone’s strategy for the German packaging company Gerresheimer, which over the course of a decade shed its skin as a glass bottle maker and emerged as a producer of sophisticated, high-margin pharmaceutical containers. The result was one of Blackstone’s most profitable deals. In less than four years, it made more than seven times its money.
Some of the credit goes to two prior private equity
owners, Investcorp and Chase Manhattan Bank, which rescued the company in 2000 from an ungainly ownership structure. When they bought Gerresheimer it was 51 percent owned by the German industrial and utility company Viag AG, which was preoccupied with its pending merger with another utility company. The balance of Gerresheimer’s stock was publicly traded, so management had to answer to public shareholders as well as its parent.
Gerresheimer’s CEO, Axel Herberg, a onetime management consultant, had lobbied his bosses at Viag to take Gerresheimer out of the beverage bottle business, where competition was intense and profit margins were low. To no avail. Viag had scant interest in Gerresheimer and even less appetite for the painful layoffs the entrepreneurial Herberg felt were necessary to convert Gerresheimer from a humdrum packaging business into a much sexier health-care-oriented packager. “We were part of a German conglomerate,” Herberg says. Closing German factories, which he envisioned, “would have been too much bad news for Viag.”
Under Investcorp and Chase, Gerresheimer sold its beverages-packaging factories and focused instead on specialized products where there was less competition and the customers were loyal. Plants in Germany and the United States were closed, and a new one with cheaper labor was opened in Mexico. But the process slowed when the economy turned down in 2002 and 2003, at a time when the company’s owners had their own distractions. The Investcorp partner who had steered the deal had left, and Chase had recently merged with J.P. Morgan. “From their point of view, it was not the time to put more capital into the business,” Herberg says, and they began looking for a buyer.
Herberg met with Tony James and Doug Rogers, a Blackstone adviser on health-care investments, in 2003 but it was another year, after a drawn-out auction, before Lionel Assant of Blackstone’s London office finally inked the $705 million deal. The price was a modest 6.8 times Gerresheimer’s cash flow.
Because quality is crucial to drug makers and packaging is a small component of the total cost of a drug, Gerresheimer’s customers were unlikely to squeeze it on price. Herberg’s goal was to carve out a niche by offering big drug makers a wide variety of containers and to keep those customers so happy that they would not shop their business around. With Blackstone’s backing, over the next two years, Herberg aggressively expanded Gerresheimer’s range of pharmaceutical packaging by buying other businesses. Most of the acquisitions were small—a factory in New Jersey, three joint ventures in China, a Danish plant—but they added products such as pre-fillable syringes and specialized plastic containers.
Negotiating privately, without going through auctions, Gerresheimer was able to snap up the assets at low multiples—just four to seven times cash flow. It was the same tactic that conglomerates had used in the 1960s and underlies many “roll-up” investments by private equity firms: Namely, buy assets at low multiples and merge them into a bigger company that will be valued at a higher multiple. Unlike the conglomerates, Gerresheimer was realizing synergies because its purchases were all in the same industry.
In one final, dramatic stroke in early 2007, Herberg arranged to buy the family-owned Wilden AG, which generated sales of more than $300 million a year making inhalers and other products. Wilden’s market was increasingly global, but the brothers who ran the business recognized that their company didn’t have the wherewithal to compete effectively on a global scale, Herberg says. The deal boosted Gerresheimer’s revenues by some 40 percent and broadened its product lines.
That set the stage for Gerresheimer to go public, which it did in May 2007. In the less than two years since Blackstone had bought the company, revenue and cash flow were each up roughly 80 percent and there were 71 percent more employees. Most of the increase stemmed from the acquisitions, but Gerresheimer had also boasted strong organic growth, with sales rising 13 percent and cash flow up 18 percent excluding the new plants and businesses.
The IPO, which raised more than $1.4 billion, was the biggest new issue in Germany so far that year. With the trend lines at Gerresheimer moving so firmly upward, and stock prices rising globally, the company was valued at more than 10 times its 2007 cash flow, almost half again the 6.8-times ratio Blackstone had paid. Blackstone made back almost 5 times its money selling shares in the IPO. When it sold the last of its shares in 2008, it came away with 7.5 times the $116 million it had invested.
Having run the business as a subsidiary of a public conglomerate, under two sets of private equity owners, and as a stand-alone public company, Herberg believes the private equity stage was essential to the transition that created a bigger, more specialized, more profitable company. Gerresheimer couldn’t have reached that point as a public company, he says. “If you miss a quarter, you get beaten down immediately. You have more time under private equity so you can take more risk.” Contrary to the image of private equity backers as looking for a quick buck (or euro), they actually create wiggle room for managers to execute difficult strategies, he says. “You have long-term financing—six or eight years. You have a lot of stability under private ownership, which is underestimated because all you see is the leverage.”
Once the business was more predictable, it made sense for the company to be public. “We’re on a different plateau. The value creation by transformation is done,” he says, and the company will now grow organically. Its stock performed in line with other German industrial stocks in the year after the IPO.
Merlin Entertainments Group, Ltd.
With Merlin Entertainments, Blackstone did not so much buy a business and reshape it as concoct one from scratch. With a quick succession of acquisitions, it took a small, domestic English aquarium operator and in two years made it into the second-largest amusement park and visitor-attraction operator in the world after the Walt Disney Company. Blackstone’s handiwork was the very antithesis of a cost-slashing, asset-stripping scheme.
When Blackstone first eyed Merlin in 2005, it was a British company operating twenty-two Sea Life marine theme parks and the London Dungeon tourist attractions, all but a couple of which were in Britain. Like Gerresheimer, Merlin had an entrepreneurial CEO who had once been shackled by the management of its parent. Nick Varney had been running the business since the late 1990s, when it was owned by Vardon plc, whose core business was health and fitness clubs. He pressed to sell or close some of the smaller Sea Life parks and use the proceeds for capital expenditures on more promising attractions, but his bosses didn’t want to forego the parks’ cash flow during the time it would take to develop new properties.
“In a [public company] we were the Cinderella’s sister in the nest, not getting the [capital expenditures], not getting the attention,” Varney recalls. The stock market “was in love with health and fitness and out of love with visitor attractions.”
With financial backing from the big British buyout firm Apax Partners, Varney bought the business from Vardon in 1999 and began building new Sea Life sites. The expansion continued when Apax sold the business to Hermes Private Equity, a smaller firm, in 2003. Merlin was still a minnow, with just $27 million of cash flow in 2004, and Varney had his sights set on something grander: the Legoland theme parks, which had been put up for sale by its parent, the Danish toy maker Lego. Hermes couldn’t afford to finance the takeover of the much larger Legoland, but it was willing to sell Merlin if a buyer made an attractive offer.
Enter Blackstone, in the person of Joseph Baratta, a young partner in the London office. Blackstone knew the amusement parks industry, having invested in the Six Flags and Universal Orlando theme parks. Across Europe, there were midsized attractions, many owned by private equity firms, but no big operators. The properties were likely to come onto the market, since their owners would one day want to sell, and Baratta saw the chance to create an operator with heft.
Schwarzman and James weren’t sure Merlin was big enough to bother with. It was “a tiny, bitty little $50 million equity investment,” Baratta explains. (“The equity check was probably less than they usually spend on [deal] fees,” jokes Varney.) But with
the Legoland assets, there was the chance to create a more diversified and substantial business, and Baratta persuaded Blackstone’s investment committee to give him the go-ahead. He began to negotiate simultaneously with both Merlin and the Kristiansen family that controlled Lego, and in back-to-back deals in mid-2005, Blackstone agreed to buy Merlin for about $200 million and then got Legoland for about $450 million. Blackstone stumped up another $100 million in equity to fund the Legoland purchase, and the Kristiansens took a 25 percent stake in the combined business in lieu of cash for part of the price, reducing Merlin and Blackstone’s outlay.
In management argot, Legoland was a transformative merger. It made Merlin a substantial player in Continental Europe, and added a mix of indoor Legoland Discovery Centres and outdoor Legoland parks with miniature Lego buildings, roads, and trains, giving Merlin a hedge against northern Europe’s fickle weather. “When the sun shone, we didn’t do so well [at the indoor sites],” Varney explains. “When it poured with rain, [the outdoor attractions] didn’t do so well.”
He and Baratta thought Legoland could quickly be made more profitable. It was a strong brand, but its previous owners had seen it in part as a marketing tool for Lego toys and had not managed it aggressively. The parks “attract a very well-heeled crowd, [and] they had underpriced the property,” Baratta says. In other words, prices could be raised. Moreover, the management hadn’t timed advertising to coincide with improvements at the parks, so the company wasn’t reaping the full benefits when it made upgrades.
Two more major acquisitions rounded out Merlin in 2006 and 2007. First, Blackstone invested another $140 million to fund the purchase of Gardaland, a water and theme park on Lake Garda at the base of the Italian Alps near Milan, which brought a sunny outdoor venue. The next year Merlin merged with the Madame Tussauds wax museum chain, which gave it a new chain of internationally known indoor attractions. The former had been owned by an Italian private equity group and the latter by an investment fund run by the government of Dubai.
King of Capital: The Remarkable Rise, Fall, and Rise Again of Steve Schwarzman and Blackstone Page 34