by Jason Kelly
The choice of whether to go public, when, and how stands as a way to explore the cultures, motives, and founders’ personalities at each of the largest private-equity firms. There is a standard set of talking points around why a firm would choose to sell shares to the public and open itself up to far greater scrutiny than it would have to otherwise endure. True, it gives the firm a way to raise “permanent capital”—money that can remain on its balance sheet indefinitely rather than funds that are committed by investors for a finite period. True, it gives firms a currency by which to make acquisitions beyond whatever cash they have set aside for those purposes. Still, a major, if not the major, reason to go public is so that the founders and senior executives of the firms can get paid for what they built, as was the case with Peterson at Blackstone and as Carlyle’s Rubenstein has expressed publicly. Cashing out smooths the transition to the next generation.
Some firms have managed to stay private while allowing their founders to move on. Warburg Pincus, one of the oldest private-equity managers (it was created in 1966) handed the keys to a younger pair of leaders in 2000. Charles Kaye and Joseph Landy took over that year from Lionel Pincus and John Vogelstein. Warburg has stayed firmly in the private-equity business and invests from one global fund; it has total assets of about $30 billion.1
Bain Capital, too, chose to stay private, even when its founding CEO decided to leave to pursue a life in government and politics. In 1999, when Romney left the firm he created, in favor of running the Salt Lake City Olympics, his partners negotiated a severance agreement with him that allowed for his ownership of the firm to be spread among the partners, helping avoid a sale to an outside investor or a public offering. In return, Romney continued to participate in some of the economics of Bain. Unlike rivals where one or two founders have remained in tight control of the firm, Bain took an approach more akin to that of a law or consulting firm. A nine-member committee is the primary decision-making body of Bain. The investment vetting process is similarly spread among a number of individuals. “By staying more focused on the pie than the slice, we’ve created an organization that’s truly sustainable,” Mark Nunnelly said.
The dispersion of ownership has allowed Bain to stay private and yet it’s grow the business dramatically since Romney’s departure; it has more than $60 billion globally in assets under management, versus $4 billion when he retired. Bain also has opted to pursue growth by growing new businesses organically and with homegrown talent rather than by buying them.
At Blackstone, Schwarzman and James were building a different type of firm, and going public was a means not only to transition the founders, but to give the firm a currency to expand the business rapidly. While a Blackstone IPO may have been inevitable, its completion was far from certain in 2007. When the time came to actually sell the shares to the public, in the middle of 2007, Schwarzman knew he had to hurry.
The year had been going exceedingly well. In addition to the birthday party, he’d been on the cover of Fortune (“Wall Street’s Man of the Moment”)2 and pulled off what was for at least a few weeks the biggest leveraged buyout in history (Equity Office Properties). In March, Blackstone had become the most prominent private-equity firm to file for an initial public offering, though not the first. Fortress Investment Group, which manages private-equity and hedge funds, along with real estate, had gone out in February.
But Blackstone’s S-1 filing with the U.S. Securities and Exchange Commission was a whole different matter. For the first time, public investors—not to mention Wall Street rubberneckers and curious students of the financial markets—would have a peek inside a buyout machine and get at least a taste of the secret sauce. Not to mention that they could find out how much Schwarzman and other Blackstone executives were actually worth. Journalists, me included, tracked every twist in the path to going public, scouring each new amended filing with the SEC for additional nuggets. Early one June Monday morning came the jackpot: the filing that detailed ownership and compensation. The previous year, Schwarzman had earned $398.3 million at Blackstone, a staggering figure, especially compared with the $54 million Lloyd Blankfein had been paid to run Goldman Sachs, then the world’s most profitable securities firm.
What we learned that day was that Schwarzman’s stake in the company he created would be worth almost $8 billion at the predicted IPO price. As planned, the 80-year-old Pete Peterson would cash out the vast bulk of his ownership and set up a foundation. Schwarzman would hang on to the bulk of his stock and keep ownership worth 24 percent of the total firm, but sell shares in the offering for a total of $684 million. The chattering classes were awed. The story about pay was among the handful of most-read Bloomberg News stories for the entire week.
Yet even as Blackstone’s bankers, led by Goldman Sachs and Citigroup, forged ahead with the road show, the leveraged buyout market was showing signs of strain. Word of record subprime mortgage defaults in the United States were rippling through the credit markets, causing banks to worry about financing new deals. On June 21, Blackstone sold 133 million shares at $31 apiece, at the high end of the predicted range. The investment bankers opted to sell additional shares, the so-called green shoe, or additional shares set aside for heavy demand. The following day, when it began trading, the stock rose to $38 before closing at $35.06. That remains Blackstone stock’s all-time high. It has yet to come close to that mark in the intervening five years and has at times dipped below five dollars a share.
Had they waited more than a few days, they simply might not have done the offering, potentially for several years. That was the case for KKR, which filed its own S-1 on the evening of July 3, and ended up getting public in the U.S. three years later through the complicated merger with its European fund. Carlyle put off its own IPO contemplations and debuted almost five years later.
As the stock market digested an increasingly bleak outlook for private equity, Blackstone shares foundered. While Schwarzman and James touted Blackstone’s ability to weather slow LBO times through their growing non-buyout businesses like hedge funds and real estate, the overall gloom was too much to overcome. Blackstone continued to trade largely on the perception of the private-equity business.
One nagging element from the beginning of the going-public trend was the concept of a publicly traded private-equity firm, which seems to be a contradiction in terms. There’s the whole notion that these are the guys who spend a good chunk of their time convincing boards and executives of public companies that the markets are inherently stupid and don’t understand them and unfairly judge them on a quarter-to-quarter basis. Go private, they whisper, and you can do all the things you want to do without all those people watching. The managers have found all too well that everything they’ve said all along about being public may be true, as they wrestle with Wall Street over how to fairly value the firms. Another issue that’s not been resolved to many people’s satisfaction is the real or perceived conflicts between the two classes of private-equity investors: the pensions and endowments who comprise the limited partners in their funds, and the institutional shareholders who buy shares on the public market.
The conflict seems straightforward. Limited partners count on their private-equity managers to deliver their money back to them, with a healthy profit, in due course, but only when it makes sense. The only pressure they should feel is to deliver the best return to their limiteds, with whom they are theoretically aligned in terms of economics. After all, a private-equity manager only gets paid the super big bucks off carry. And carry only comes when the limited partners get paid first.
But what if all of a sudden you’re part of a publicly traded company answering to shareholders looking for consistent profits, or at least some profits? The value of your stock is based in part on your ability to produce earnings. The clearest way to make money in the private-equity business is to sell what you own. Isn’t there a natural pressure then, at least potentially, to look to sell something to make those investors happy, too? And to boost the price of th
e stock, which by the way, now constitutes the buyout manager’s own stake in the firm?
Limited partners, while kvetching quietly behind the scenes, and to each other, have so far shown little appetite to avoid investing in funds managed by publicly traded firms. The firms themselves argue, loudly, that they are in fact all aligned and that public investors are getting a slice of the same profits that the managers themselves strive for. Blackstone laid out in its prospectus that it would favor the rights of its limited partners over that of its public shareholders if there was ever a question.
For their part, public investors seem to have decided that they can’t find a coherent and consistent way to value private equity. The problem stems from one of the most fundamental elements of the business, and it goes back to private equity’s core pitch. By the very nature of its ownership, private-equity owners don’t have to sell the companies they own and, because the underlying companies are closely held, they aren’t beholden to public shareholders. That’s theoretically very good news for the private-equity managers themselves and the investors in their funds, who count on them, and pay huge fees for the expertise that determines the best times to buy and sell. The problem for a public investor in a private-equity firm is that it’s basically impossible to gauge when a firm is going to sell a company and therefore reap the fees, or carry, from that deal. Public stock valuations are by their nature forward looking. Investors who buy stocks are betting the stock will gain in value in the short- or long-term, allowing the holder to profit by selling it at a later time. Or they may see that a company pays a predictable, generous dividend and hold it for that steady income stream, even if the stock doesn’t rise dramatically in value. With that in mind, investors and analysts place a value on a stock that’s usually based on a multiple of earnings. With private equity among the biggest questions is what actually constitutes those earnings and when investors will actually see evidence of them.
Blackstone, once effectively alone as a publicly traded private-equity firm, now has company, with Apollo and KKR listed on the NYSE, and Carlyle on the Nasdaq. More choices and comparisons may help raise the profiles of the private-equity managers in the eyes of would-be public investors, a fact that theoretically could boost some or all of the share prices. One obstacle arose from private-equity firms’ attempts to be more transparent to public investors, or at least guide their analysts and investors to an accurate picture of their business at any given moment. Blackstone and others rely on a complicated measure called economic net income, or ENI, that’s meant to more accurately reflect the earnings of the business without factoring in some costs associated with actions like going public. It has served to further confuse investors, in part because it swings wildly as companies held in private-equity funds get marked up and down in value.
The broad reaction from mutual funds and other institutional investors is to vote by just not showing up to buy the shares, despite a majority of research analysts who follow the firms posting “buy” recommendations. The lack of broad ownership is reflected in the relatively anemic volumes. In late 2011, Blackstone traded about 440,000 shares a day on average and KKR traded half that. Goldman Sachs traded, on average, about 860,000 shares during the same period.
Also, because the stocks aren’t widely held, volatility can be fierce. One or several shareholders deciding to buy or sell can have a dramatic effect on the price rising or falling as they drive up the price by snapping up stock, or drive it down by flooding the market. Blackstone’s stock especially can move on what could be called “the Steve effect.” Blackstone usually releases its results at around 8:30 in the morning, holds an on-the-record public call where reporters ask questions an hour later, then a call for analysts and investors, which is open to the public and transmitted through its website at 11 a.m. The complexity of the quarterly earnings often leaves investors confused in the several hours between the release of the results and the conference call. A few well-placed words from Schwarzman can reverse a stock slide, giving the impression, perhaps rightly, that the stock is a barometer of his mood on the broader markets.
To wit, in October 2011, the morning of Schwarzman’s Alfred E. Smith dinner address, Blackstone badly missed Wall Street’s consensus estimate of a 1-cent-per-share profit, posting a 12-cent-per-share loss. That was triggered by the fact that the firm was forced to mark down the value it put on the companies it owns, despite its argument that those companies were likely to regain value in the subsequent quarters. The stock dropped more than 3 percent.
Enter Schwarzman, whose comments buoyed the shares. By the time the stock market closed, the stock had reversed its losses and gained more than 3 percent, following his remarks that despite the economic gloom, Blackstone’s real estate group was poised to have one of its best periods ever and the firm had brought money into every one of its businesses during the quarter. The Steve effect that day was worth 6 percent.
The move away from private equity is among the most dominant and pressing questions facing the industry. A commonly held view is that there’s a bulge bracket of sorts among firms who made their name in leveraged buyouts—Blackstone, KKR, Carlyle, Bain, Apollo, and TPG being the most often mentioned names—are and should be considered fundamentally different from what are essentially monoline private-equity firms. While the big firms bristle at the notion that they’re somehow diminished as investors by expanding into non-buyout classes, their focus on growing assets is undeniable. Blackstone has more than doubled its assets under management since it went public, to $190 billion. The vast majority of that has come from bulking up credit funds and money invested for clients in hedge funds, along with new funds in private equity and real estate. Carlyle and Blackstone, especially, have engaged in what’s effectively an AUM arms race. Carlyle bought a majority stake in AlpInvest, a fund-of-funds manager, in 2011 that brought the firm to within striking distance of Blackstone, at about $159 billion in total assets. It also puts the two firms well ahead of their closest competitors by that measure, since KKR has about $62 billion in assets. That’s creating a more distinct rivalry between Blackstone and Carlyle, one that came up a number of times in discussions. One Carlyle executive equated it to great sports rivalries like Duke University and the University of North Carolina, or the New York Yankees and the Boston Red Sox.
With Carlyle public, it will become easier to judge who ultimately will win over shareholders, and many of the recent efforts to grow AUM involve businesses outside of private equity, underscoring Schwarzman’s designs on creating the modern financial services powerhouse. The moves in large part tie back to the conundrum of valuing stocks of these firms, who now rely on public shareholders to determine their worth. Those investors can’t get comfortable putting a value on carried interest, despite its outsized profitability for the managers and, at least theoretically, the shareholders of the firm. The fees from managing a fund-of-funds are much more predictable and therefore more attractive for public investors.
While public investors are increasingly important, and their support necessary if these firms are going to breed another generation of tycoons, private-equity firms still rely primarily on limited partners, the pensions and endowments whose money is the starting point for the industry. Ultimately, even as the founders contemplate making themselves emeritus, they are constantly on the road, solidifying those existing relationships and courting new partners. This is, after all, the heart of the business they started several decades ago.
Schwarzman is living proof. He’s rarely in his office at headquarters, but he’s almost never out of reach, or out of touch. Nor does he want to be. For one of our last interviews, I showed up at his office on Valentine’s Day, which is also his birthday, and took a seat in the small room adjacent to his corner office. Soon, Schwarzman appeared on the screen, in high definition from Paris.
He was in the midst of a month on the road, a trip that would bring him briefly back to the United States for a meeting of CEO collective The Business Council bu
t mostly involve forays into the Middle East, Europe, and Asia. The day before, he’d been in London, holding a town hall meeting of sorts aimed at ensuring that the Europeans were acting in concert with their U.S. and overseas counterparts. This is Statesman Schwarzman in all his glory, taking his peripatetic, always connected persona on the road. Over the course of two hours, we took a couple of 20-minute breaks so he could field other phone calls. While he mostly eschews e-mail, he’s constantly on his cell phone and almost never can resist picking it up.
Schwarzman passionately made the case that he’s worked hard to make himself redundant. “Even if I died, nothing would change,” he said. “I’m irrelevant. I’ve done my job.”
Within a few breaths, he partially undermined his own point. Talking excitedly, he described a town hall meeting the previous day in London, where he addressed 183 employees (he knew the exact number), many of whom had joined during the two years previous. “I went in and said, ‘This is what we believe. I don’t care what you’ve been told. This is how it is.’ That’s important. It’s just a like a car getting a tune-up every once in a while.”
He reflected on what it means to be the ultimate owner of dozens of companies that people know and use every day, noting that it fundamentally alters how people inside the firm think about what they do, even him. “When you own the world’s largest hotel chain, that changes things,” he said.
