The New Tycoons: Inside the Trillion Dollar Private Equity Industry That Owns Everything (Bloomberg)

by Jason Kelly

  With all the talk of retirement, it’s easy to forget the relative youth of the industry. I’ve come to think of private equity as a teenager with a lot of potential, but still struggling with adolescent tendencies—at times unresponsive, rash, selfish, and fluctuating between arrogance and self-doubt. By virtue of some hard work and a lot of luck, it’s ended up in a position to potentially be an upstanding member of society. To ignore it or wish it away is foolhardy. It’s here and the influence is growing. And whether it’s the price of your morning cup of coffee, your bed sheets on a business trip, or the size of your retirement check in the mailbox, you’re involved.

  Notes

  1. Paul Hodkinson, “Logjam Gives Buyout Firms $1.2 Trillion Hangover,” Financial News, March 19, 2012. http://media.efinancialnews.com/story/2012-03-19/logjam-gives-buyout-firms-hangover

  2. Katie Gilbert, “New Green Portfolio Program Could Change Private Equity,” Institutional Investor, September 6, 2011. www.institutionalinvestor.com/Article/2895315/New-Green-Portfolio-Program-Could-Change-Private-Equity.html

  Chapter 1

  Find the Money

  Oregon to Abu Dhabi

  From Steve Schwarzman’s corner office 44 stories above Park Avenue, the northern landscape of New York City unfurls before you, Manhattan melting into the Bronx. It calls to mind the old cartoon, “The New Yorker’s View of the World,” where the details of the city quickly give way to everything else beyond. On a clear day, Schwarzman can see both the George Washington and Tappan Zee bridges as the Hudson River snakes northward. Looking west, he can peer deep into New Jersey. In both views he can also pick out a couple of his fiercest competitors and sometime collaborators. Henry Kravis’s office is perched on the 42nd floor of a building on 57th Street, a 10-minute walk from Schwarzman. A five-minute stroll to the west is the Carlyle Group’s New York office, its biggest outpost despite its Washington headquarters. When Carlyle co-founder David Rubenstein is in town, he sits on the 41st floor. A couple more avenues toward the Hudson, TPG’s David Bonderman and Jim Coulter decamp 37 stories up when they’re visiting from San Francisco.

  This dozen square blocks in the middle of Manhattan is the undisputed home of the private-equity industry. Walk into just about any skyscraper along Park Avenue and the building’s directory is bound to feature a handful of firms practicing leveraged buyouts or some variation thereof. This is where the moneymen ply their trade. At first glance, they are indistinguishable from the rest of the always-in-a-hurry New Yorkers of a certain stature, ferried about in black sedans, catching up and cutting deals over expense-account lunches at restaurants tucked into the towers.

  The story of how the money flows really begins on the opposite side of the country, along U.S. Interstate 5. Dotted along the country’s western-most north-south highway, the only road to touch both Canada and Mexico, sits a handful of nondescript offices that have played a crucial role in the formation and the history of private equity. It’s there where the journey begins, and what happens from there has profound consequences on the global economy and our individual livelihoods.

  Any serious exploration of private equity has to start with the simple question: Where does the money come from? Money doesn’t magically appear in private equity funds. Someone has to give it to them, and what buyout managers discovered over the past 30 to 40 years is that there are a lot of someones—pensions needing to pay their retirees, universities looking to grow their endowments, rich people looking to get richer, and foreign governments looking to diversify their state-run funds—willing to listen to their promise to turn money into more money. Lots more than they could get simply by plunking it in stocks or bonds. These are the so-called limited partners in private equity.

  Tigard, Oregon, is a suburb of Portland, about a 20-minute drive from downtown. The low-slung building that houses the offices of the state pension fund’s investment division sits a couple of blocks from a sandwich shop called Big Town Hero, a local chain.

  It was in a small conference room at the Oregon Treasurer’s office in suite 190 that Hamilton “Tony” James, the president of the Blackstone Group, found himself in July 2010 with a group of Oregonians seated in a semicircle around him, peppering him with questions about his funds’ performance, the types of fees he was charging, and the state of his current investments.

  James arrived confident that he could win a commitment, which would be the state fund’s first investment with Blackstone after decades of trying. Oregon’s staff had already vetted Blackstone’s proposal and met or talked with fund-raisers who worked for James numerous times. The investment board, wary about the damage the global financial crisis had inflicted on their investments across the board, wanted to ask James several questions to his face.

  For an hour, he fielded mostly friendly, but occasionally pointed, questions. “That all sounds really great, and you probably raised money at the right time so you could go out and get deals,” board member Katherine Durant said to James during the meeting. “That said, why does Fund V look so bad?” James said the firm’s fifth buyout fund was valued at a loss of 2 percent, compared with a 7 percent loss in the Standard & Poor’s 500 Index during a specific period.1 Another board member pressed James to promise that they wouldn’t throw fancy investor meetings that the pension would have to pay to attend. James smoothly assured him that instead of a resort, they held their meetings in New York, at the Waldorf-Astoria hotel, which had the benefit of being Blackstone-owned through its control of the Hilton hotel chain.

  James eventually emerged victorious, with a $200 million commitment for Blackstone Capital Partners VI, a fund that eventually would total in excess of $16 billion when James and his colleagues finished collecting commitments the following year. To secure Oregon’s money, Blackstone agreed to reduce some fees, a deal it then extended to all of its investors. The firm already had told potential investors it would lower the management fee to 1 percent a year, from 1.5 percent, for those who committed $1 billion or more.

  Less than a year later, the same group of Oregonians entertained a visit from KKR co-founder and co-CEO George Roberts and committed $525 million to KKR’s latest fund.2 While that was smaller than previous investments (Oregon invested $1.3 billion in KKR’s 2006 fund), the new pool was targeted at $8 billion, about half the size of the previous fund. Roberts may have edged out James in the fund sweepstakes by dint of familiarity. He was making a pitch to a group he had sold on KKR for the first time three decades previous.

  Roberts made his first meaningful contacts with Oregon’s pension fund in the early 1980s, a series of meetings that helped create the modern private equity, industry. Oregon is widely credited with being among the first U.S. pension funds to commit meaningful sums to private-equity funds and then keep re-upping. Oregon was quickly followed by the state pension up the road in Washington State. By 1990, the California Public Employees’ Retirement System, known as CalPERS, would create a program for so-called alternative investments like private equity that would become the nation’s biggest such effort.

  Soon pensions across the country got into the act and, in addition to going to the likes of Tigard and Olympia, private-equity managers trekked to Austin, Texas, and Harrisburg, Pennsylvania, to make their case.

  The motivation for the pensions was simple: investment returns that weren’t available anywhere else, money they needed to pay their retirees what they’d promised. KKR, and later its competitors, proved they could take a small slice of a pension and double it, or better. Oregon’s early investments in KKR funds yielded more than three times what the pension gave Roberts and co-founder Henry Kravis, an annual average return in some cases of close to 40 percent a year.

  University endowments also are influential LPs, and schools like Yale and Harvard have benefited from long associations with some of the most successful buyout managers. Endowments are attractive to private-equity managers in part because schools tend to be comfortable locking some of their money up for long periods of tim
e, a key element of private equity’s business model. Funds tend to have lifespans of 10 years, giving the managers the ability to spend the first handful of years investing the money, and the latter part of the fund selling those investments to reap profits for themselves and for their backers. Unlike hedge funds, where the best managers can reap profits in seconds or minutes, private-equity managers’ pitch involves buying companies that will take in most cases years to fix, expand, or grow but will eventually generate huge gains when they’re sold. Pensions are arguably the most interesting way to explore the limited partner world because they ultimately invest money for hundreds of thousands of retirees. They also have seen fit to release some of their data to the public, making it easier to analyze their strategies and those of the managers they choose.

  Without these institutions, without the people sitting in that conference room in Oregon and their counterparts in state and national capitals around the country and around the world, Tony James wouldn’t have his job.

  And so that day in Oregon, James cut the sort of deal that makes it all possible. Oregon agreed to give Blackstone the responsibility for $200 million for the next 10 years. The pension agreed to pay the firm $3 million each year (1.5 percent of the total commitment) as a management fee, a levy meant to help Blackstone pay for salaries and rent. Blackstone would spend roughly five years using Oregon’s money to buy companies and roughly the next five selling what it bought, hopefully at a profit.

  Blackstone agreed that as those profits came back, 80 percent of them would go back to Oregon, with 20 percent staying at Blackstone. This is the fundamental partnership that defines private equity, between the investors (referred to as limited partners, “limiteds,” or simply “LPs”) and the managers (known as general partners, or “GPs”).

  James, Schwarzman, and a handful of other Blackstone executives would replicate this process dozens of times during a two-year period, piecing together promises of money like Oregon’s until they were satisfied they had an ample war chest. In mid-2011, they would “close” the fund, shutting it off from new commitments. At about $16 billion, it was the biggest pool for leveraged buyouts raised since the end of the global credit crisis. While less than Blackstone’s record-setting $21.7 billion fund that closed in 2007, here was proof that money was still available despite the still-visible scars of the financial crisis.

  The terms, though, had changed. Big investors, especially those outside the U.S. public pension system, have long weighed how to recapture some of the fees they pay to managers like Blackstone, KKR, and Carlyle. The most aggressive in this regard have been, interestingly, a handful of Canadian pension plans that have built large in-house investment teams to effectively work around the big private-equity firms.

  One of the most powerful investors in Toronto, Canada’s financial capital, sits not along Bay Street in the downtown banking district but in a squat suburban office building a 20-minute subway ride away.

  The Ontario Teachers’ Pension Plan during the past two decades has helped raise some existential questions about the private equity industry and pressed some of the most important economic issues around the business. Teachers’ has effectively voted with its feet, limiting its traditional third-party investments to a small group of managers, building an in-house staff to make direct deals, most of the time skirting the private-equity barons altogether.

  The strategy was born largely of necessity. In the early 1990s, Teachers’ saw what most every pension that was paying attention did—that leveraged buyout firms were delivering amazing returns to their small clutch of existing investors, far outstripping what those investors could get from public equities and fixed income. With a bias toward domestic managers, they looked around Canada for private-equity funds and found not very many. So they started their own effort.

  It barely survived its infancy because the first deal was a disaster. In 1991, Teachers’ paid $15.75 million for White Rose Crafts & Nursery Sales, a company that promptly went bankrupt within a year. The wipeout stands as a testament to the Canadians’ fortitude and a reminder of how deals can fail—it’s engraved right alongside the fund’s best deals in the Teachers’ boardroom at headquarters, dubbed the “Wall of Fame and Shame.”

  Teachers’ has gone on to invest in the likes of vitamin seller GNC, which it bought with Ares and later took public, as well as Canada’s Yellow Pages Group and luggage maker Samsonite. The fund also at one point owned several local sports franchises, including the Toronto Maple Leafs hockey club, the Raptors pro basketball team, and the city’s professional soccer outfit; it agreed to sell the company that controlled those teams in 2011. Its total assets under management were C$117.1 billion ($115 billion) at the end of that year.

  During the LBO boom and bust, Teachers’ arguably became most famous for a deal it ended up not doing. The fund was part of a consortium that had won a fierce auction to buy BCE, Canada’s biggest phone company. The $42.3 billion purchase price would have made it the second-biggest leveraged buyout ever announced, just behind KKR and TPG’s $43.2 billion TXU deal, according to data compiled by Bloomberg.

  When the credit markets seized in mid-2007, almost everyone involved in the deal got nervous, especially the banks who’d agreed to finance the deal, including Citigroup, Deutsche Bank, and Toronto-Dominion. Were the deal to happen, the banks would be stuck with billions of dollars worth of debt tied to BCE on their balance sheets. The debt would be valued at less than face value and no one would want to buy it, and estimates at the time pegged the immediate losses to the banks if the deal went through at C$10 billion.3

  Teachers’, along with Providence Equity and Madison Dearborn and the buyout arm of Merrill Lynch, were similarly worried. The deal had been conceived in an economic environment defined by confident consumers and heady growth prospects. Now the would-be owners were staring at owning a huge corporation going into a nasty recession. All the parties scrambled through 2008 to recut the deal or get out of it. In December of that year, they got a much needed reprieve—an auditor judged that the company would be insolvent if the deal went forward, which allowed the buyers to walk away, and the banks to breathe a huge sigh of relief. A year after the deal collapsed, Teachers’ Chief Executive Officer Jim Leech was understated, saying, “It was the product of a euphoric time.”4

  The BCE near-miss didn’t dissuade Leech from his strategy, which blends direct investing and commitments to firms like Ares and Providence, where Leech and his team have determined the firm has a specific expertise they can’t easily replicate.

  Leech has become a strong and vocal advocate for the pension players in the equation, publicly questioning fee structures that he sees as unfair to the limited partners. “Private-equity firms are first and foremost in business for themselves,” Leech told me when I called to talk to him about the state of the business in late 2011. “They are perfectly misaligned on the fee side. I believe that’s because a lot of investment bankers got into the business and perverted the model.”

  It’s harder to stray, Leech said, when your investors are stopping by your office all the time. Most days, a handful of retired teachers show up at Teachers’ to deal with some sort of question. “The reason we can keep focused is we know who we work for,” he said. “In many asset management firms, the people who make the investments never even see their clients.”

  The Teachers’ hybrid model has been adopted selectively elsewhere. The Canada Pension Plan Investment Board, its Toronto neighbor, hired Mark Wiseman, Leech’s former lieutenant at Teachers’, in part to pursue a direct strategy. CPP has emerged as a significant direct investor and frequent co-investor in deals like Dollar General, Nielsen, and Univision. CPP has a larger number of investments than Teachers’ into traditional private-equity funds, with commitments to Blackstone, KKR, and TPG.

  Like Teachers’, Wiseman’s group is an active investor and engages heartily with the managers it backs. While limited partners in general are asking for more information, CPP is among
the few who will actually show up at a manager’s office for more information, and to soak up the knowledge and expertise of the GP.

  Public pensions in the United States quietly grumble that even if they wanted to pursue a Teachers’ or CPP-like strategy of direct investment, they couldn’t. U.S. pensions have neither the government permission, the political will to seek it, or the staff to execute a strategy like Leech’s or Wiseman’s. Part of the secret sauce for the Canadians is an ability to pay something closer to market rate for their staff, or at least far in excess of what a comparable staffer at a U.S. plan would make.

  Leech earned C$4.38 million ($4.39 million) total compensation in 2010 and Teacher’s head of investments, Neil Petroff, earned C$3.5 million, according to Teachers’ annual report that year. That’s almost six times more than Joseph Dear, the chief investment officer at CalPERS, who earned $552,052 in 2010, the most recent data available.5 While Leech may not be bidding against tycoons like Steve Schwarzman and Henry Kravis for a house, the paychecks far outstrip his U.S. peers.

  Where the Americans and Canadians have found the most fertile common ground is an effort that also has its roots in Toronto. The Institutional Limited Partners Association began as an informal supper club in Canada in the early 1990s, around the time Teachers’ was beginning its grand experiment. In the wake of the financial crisis, it’s become a much-needed megaphone for the institutional investor community to voice their concerns about the excesses embedded in the private equity industry.

  To get a private-equity manager’s attention in 2010 and 2011, especially if you had a pot of money to invest, you just had to utter the word “ILPA” (most people pronounce it as “ILL-puh”). That’s because, in 2009, ILPA released a set of investing “principles” that rattled the world of private equity for a simple reason: The industry’s biggest backers had never gotten together before and spoken with anything resembling a common voice.