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

by Jason Kelly

  The story of the ILPA Private Equity Principles, as they’re officially called, goes back to the financial crisis, when the biggest pensions were scratching their heads about what had just happened to them and their portfolios. The question was more than academic—all of their investments had been crushed in the crisis as stocks plunged. Even the best hedge funds posted losses (though less than the broader indices), and private equity for its part was essentially frozen. The global meltdown had another real impact on pensions especially—they realized their own underfunding woes had become a full-blown crisis. Public pensions in the United States as of 2010 were facing $3.6 trillion in unfunded liabilities, according to a study by Joshua Rauh of Northwestern University and Robert Novy-Marx of the University of Rochester.6

  That left pensions in a pickle with private equity. Clearly, they needed the returns that buyout managers had delivered over the years. In a time of effectively zero interest rates, the siren song of double-digit annual returns was more than compelling. And yet the pension managers ranged from befuddled to furious at the behavior they’d witnessed over the previous decade, especially the high fees they’d paid in return for what was feeling like middling performance.

  Having poured money into funds raised during the first years of the new century, they watched as deals crept in size to never-before-seen heights in 2006 and 2007. Private-equity firms outmaneuvered each other on some deals, then pooled money with other firms—a practice known as “clubbing”—to buy bigger companies. The net effect was extraordinary exposure to giant deals, especially for big investors with commitments to multiple managers. Take Freescale, the semiconductor firm taken private in 2006 by Blackstone, TPG, Carlyle, and Permira. CalPERS had commitments to every one of the firms involved in the deal, according to data posted on its website, a bet made all the more painful as that deal ran into a buzz saw of a bad economy and the failure of its biggest customer.

  Private equity had long been touted as uncorrelated to the broader markets, its illiquidity—a technical way of saying you couldn’t get your money out anytime you wanted—seen as a safe haven of sorts. When the financial markets cratered around the world in 2008, private equity was far from immune. While they weren’t forced to sell what they owned, the companies they owned were struggling. And the buyout firms’ investors were worried. And mad.

  The stars aligned in 2009 to rally investors. That January, a group of roughly a dozen U.S. and Canadian pension managers—together they represented more than $1 trillion—met in a conference room at the Denver airport with the express purpose of talking about private-equity managers and whether they could grab control of the discussion around the industry’s economics. What became informally known as “the Denver Group” decided while snacking on peanuts to come up with a wish list they could bring to private-equity managers.

  The meeting was the brainchild of a Texan named Steven LeBlanc, a senior managing director at the Teacher Retirement System of Texas, a $110 billion pension fund run from Austin that has 1.3 million members. LeBlanc had responsibility for about $35 billion, the slug that’s been designated for private capital, which encompasses private equity and real estate.

  LeBlanc, whose mother was a teacher’s aide, took the Texas Teachers job after a career spent on the other side of the table, raising money for, and investing, real estate funds. His last job in the private sector was as the CEO of Summit Properties, a real estate investment trust (REIT), where he earned shareholders a 144 percent return during his tenure. He took a job teaching real estate at the University of Texas, a formalized way to do the mentoring he’d always enjoyed while he plotted his next move. Then Britt Harris called.

  Harris was the chief investment officer of Texas Teachers and worked to convince LeBlanc to join the pension. LeBlanc pressed back—the teachers at the time were organized to treat private equity and real estate separately and he wanted them both. Harris put them together and LeBlanc took the job in 2008, at a 75 percent pay cut from his last corporate gig.

  LeBlanc relished the fox-in-the-henhouse situation he’d created for himself and immediately started asking questions inside and outside the organization. As the broader economic situation worsened and he watched scores of private equity and real estate funds stumble through the post-crisis world, his voice only got louder. He found like-minded LPs who wanted to take action, which is how he found himself in Denver that January.

  The small clutch in Denver wasn’t the only group talking about pulling private-equity back into alignment. That March, in Atlanta, ILPA held an annual meeting where the group’s executive director, Kathy Jeramaz-Larson, held a working session with attendees about the same issues of transparency (what exactly are you doing with my money), and fees (what am I paying you, when and why). During the subsequent months, the Denver group and ILPA initiatives melded and refined the principles.

  The first version, released in September 2009, was strident in terms of public statements by pensions. Citing the complexity and length of agreements between private-equity managers and their investors, the principles read in part that “it has become increasingly difficult to focus on what aligns the interests of the limited partner with the general partner.”7 What it boiled down to was pretty simple: Tell us exactly what you’re doing and make tons of money only when we do. Private equity’s biggest investors were for the first time singing from the same songbook, and most buyout managers didn’t like the tune. ILPA’s intent was to get both sides of the equation—LPs and GPs—to publicly endorse the principles. Most private-equity firms balked. Despite ILPA’s explanation to the contrary, buyout firms viewed the principles as an all-or-nothing proposition and were worried they’d be blessing a set of rules they couldn’t, or wouldn’t, ultimately comply with.

  LeBlanc didn’t like that. He and his staff sent out a detailed survey to Texas Teachers’ own limited partners to drill down into the document and find out what individual firms did and didn’t like in the principles. He and a handful of other ILPA board members spent much of 2010 working the managers personally, figuring out how to revise the principles to get a larger number on board. In early 2011, more than a year after the initial volley, version 2.0 of the principles was released.

  The language was less aggressive (“This release retains the key tenets of the first Principles release while increasing their focus, clarity, and practicality”8) and ILPA made it clear that this was not an all-or-nothing document. Within weeks, KKR, arguably the best-known brand name in private equity, publicly endorsed the new version. Blackstone, Carlyle, and TPG followed.

  The ILPA principles are seen as a boon, especially to institutions with smaller staffs who don’t have the time or resources for extensive due diligence on a manager. The principles can serve as a cheat sheet, or at least a starting point for every fund-raising discussion. Understaffed pensions feel emboldened to press for better terms, knowing that their brethren were making similar demands. “It’s a game-changer,” said Joncarlo Mark, a former senior portfolio manager at CalPERS who served as chairman of ILPA from 2007 to 2010.9

  LeBlanc has another set of principles specifically for his pension, a PowerPoint manifesto of sorts called The Texas Way that takes the principles a step further, his way of hitting the reset button with the private-equity firms.

  I first met LeBlanc in October 2011, as he was finishing a dinner at Brasserie 8½, a French restaurant that sits just below 57th Street in midtown Manhattan. The name of the place is a nod to the famous-in-finance address of the building, 9 West 57th Street, known colloquially in private-equity and investment circles simply as “9 West.” It’s the longtime home of KKR, and fans of the book Barbarians at the Gate will recall many scenes set there. The building also houses private-equity firms Apollo, Providence, and Silver Lake.

  He was finishing dinner with Scott Nuttall of KKR. As the firm’s global head of capital and one of Roberts’s and Kravis’s chief lieutenants, Nuttall has broad responsibility within the firm, including fund-r
aising and investor relations. During the past several years, he’s overseen a rapid expansion of those efforts at KKR, growing the staff from about half a dozen to more than 40 employees around the world. The biggest investors like LeBlanc get a lot of special attention.

  How big and how special LeBlanc was would become publicly apparent several weeks later. The next morning, LeBlanc was back at 9 West for a separate meeting with Apollo’s top executives. At the two meetings, he was wrapping up a deal to commit a total of $6 billion to KKR and Apollo. The sweeping mandate of $3 billion to each firm was an unprecedented agreement in its scope.

  Because of the size of the commitment, KKR and Apollo agreed to lower management fees than they’d usually charge, a major victory for LeBlanc, who had pushed, through the ILPA principles and The Texas Way, to lower those levies and put the bulk of the economic benefit for the private-equity firms on the back end. In other words, don’t let them get rich getting the money; let them get rich when they make money for the investors.

  KKR and Apollo got their respective money on different terms, too. Instead of committing money to a single discrete strategy, Teachers told KKR and Apollo to use the money across a variety of investments, from traditional buyouts to energy to debt. In addition, the agreement had a “recycle” provision that gave each firm the ability to plow some of the pension’s profits right back into investments instead of returning the cash and going through the time-consuming and costly process of asking for it again. The biggest investors, like Texas Teachers, CalPERS, and sovereign wealth funds, are hamstrung to some extent by their size and the need to put large amounts of money to work in big slugs. The theory is that with fewer firms to oversee, pensions can do a better job with that oversight. They’re more likely to see a manager straying from his stated investment strategy if their attention is focused. LeBlanc’s desire to put more money with fewer managers is a key tenet of The Texas Way.

  His particular approach is to create a “Premier List,” an intense screening process to assess managers up front and then actively manage them once they do win a commitment. The best performers get more and more money, the worst get thrown out of the program, either through attrition (not re-upping on the next fund) or by being sold on the secondary market, where a handful of specialty funds shop for unwanted stakes in private-equity funds.

  What’s interesting is the confidence, and at times ferocity, with which pensions and other investors in private equity are evaluating their managers. The new approach is being driven largely by pension executives like LeBlanc, who’ve been in the room all along, just in a different seat. They know all the tricks of the trade and are blending their experience with the leverage provided by efforts like ILPA. (LeBlanc ultimately decided to leave that seat, after fulfilling what he and Harris described as a five-year plan. He stepped down to rejoin the private sector in mid-2012).

  Other former private-equity executives have taken on top roles at pensions. In New York City, Lawrence Schloss in 2011 undertook an ambitious plan to coordinate the investments of the numerous employee plans for city workers.

  Schloss also set about cutting the number of managers the city worked with, aiming to reduce it to 70 from more than 100 when he arrived at the start of 2010. The reason wasn’t just the large number of relationships, but poor performance. For the 12 years before he arrived, the average annual rate of return was 6.8 percent, which he characterized as “not very good,” especially in light of the pension’s desired 8 percent a year return for its entire portfolio. Yet the good managers stood to get more money under Schloss. He said in 2011 he was raising the percentage of the fund allocated for private equity to 6.5 percent from 4 percent.10

  Across the Hudson River in New Jersey, Robert Grady is the chairman of the New Jersey Investment Council. He’s a former managing director at Carlyle who at one time was responsible for the firm’s venture capital activities. He left Carlyle in 2009 and joined a small private-equity company in Wyoming called Cheyenne Capital. Grady’s pursuing a similar strategy of more money to fewer managers. At the New Jersey Division of Investment’s monthly meeting in December 2011, Grady unveiled a deal with Blackstone that was similar in scope and tone to the tie-up between KKR, Apollo, and the Texas teachers. New Jersey approved a plan to give Blackstone $1.8 billion, $1.5 billion of which would be divided into so-called separate accounts, pools that contain only New Jersey money instead of commingling with other investors’ commitments. Those allow Blackstone and New Jersey to invest together on individual investments, in this case a pool each for traditional buyouts, credit investments, and energy deals. New Jersey committed another $300 million into funds that included other Blackstone clients designed for natural resources, credit, and the firm’s flagship buyout fund.

  With the deal, Blackstone brought its total New Jersey commitments pledged in a 12-month period to $2.5 billion, the most it had attracted from a single investor during one year in its history. What did New Jersey get? In addition to the promise of future profits, Blackstone agreed to cut its fees to the tune of $122 million over the life of the agreement, according to New Jersey’s calculations.11 Blackstone cut a similar deal in May 2012 with CalPERS, agreeing to manage $500 million in a separate account for the giant pension. The clear message to Tony James and his cohorts was that the money is there, in some cases more than was available even at the height of the private-equity frenzy in 2006 and 2007. But from Oregon to New Jersey, the money’s a lot harder to get and you’ve got to assure your backers that they’ll get paid before you do. The relationships are different once you get on a plane bound for points overseas.

  The Abu Dhabi Investment Authority occupies a soaring tower along the Corniche, the beachside road in the capital of the United Arab Emirates. Abu Dhabi is lesser known than its fellow emirate Dubai, about an hour’s drive through the desert, the long stretches broken only by what appear to be gates to Gulf-front palaces. Dubai gained international prominence in the first decade of this century for its unbelievable growth and shows of wealth, and the real estate crash that followed in 2009. It still boasts the tallest building in the world, the Burj Al Khalifa, its name an honorific to the president of the UAE and ruler of Abu Dhabi.

  Abu Dhabi, which sits on a massive oil reserve, bailed out its ultimately poorer, and oil-bereft, cousin Dubai after the collapse, leaving clusters of see-through buildings and sprawling half-finished developments like Dubai World. ADIA remains one of the most influential investors in the world, by virtue of its size and tentacles into money managers around the world. The government won’t disclose how big ADIA actually is, but studies have pegged ADIA’s assets at around $750 billion and have called it the largest sovereign wealth fund.12 With ADIA and its brethren funds in the Gulf Cooperation Council enjoying a rise in oil prices through the early 2000s, the region became an increasingly important subsector of potential limited partners. While Dubai favors glitz and spectacle and made a name for itself by pushing for superlatives, I found Abu Dhabi to be much more understated, the opulence less prominent. And yet it’s clear that money is abundant, much more so than at the public pension funds back in the United States. After showing ID and saying who I was there to visit, I was escorted to a small table and offered a menu with various coffee and tea beverages served by a waiter. Once upstairs, I took in panoramic views of the emirate, which sits on the Arabian Gulf. It felt much more KKR than CalPERS.

  ADIA was among the investors who went a step further than investing in funds, seeking a tighter relationship with some private-equity managers. The Abu Dhabi fund bought a stake in Apollo itself, paying to own a slice of the manager, not just participating in the funds. Carlyle cut a similar deal with Abu Dhabi-based Mubadala Development Company, another arm of the government whose specific charge was buying stakes in and backing companies that could benefit the emirate directly.

  The Middle East was an alluring and seemingly untapped part of the world for the private-equity barons, both as a proven source of capital and potentia
lly as a source of deals. After a speed bump around the financial crisis, when a number of funds in that region made bad bets on U.S. and European financial institutions, the latter theory about a source of capital has continued to be true. However, the notion that the Middle East could be a lucrative emerging market for deals has thus far not played out.

  The confluence of capital-raising and deal-making came into the open in 2007, when the well-regarded Super Return conference series decided to put on a regional version in Dubai. This was the time when Dubai had burst onto the international financial scene, with gleaming skyscrapers, an archipelago of manmade islands meant to mimic a world atlas with “countries” for sale to be developed as private getaways, and a nightlife whose thinly veiled excesses evoked Las Vegas.

  The collective private equity industry was salivating (mostly over the investment opportunities). Here was a dream combination—resident capital that appeared to lack the infrastructure and experience found in New York and London but wanted it; local companies eager to grow to meet the crushing demand of a fast-growing regional economy; and a market that was bending traditional financial and business rules tied to Islamic mores in order to accommodate outside investment to help fuel the growth.

  Carlyle co-founder Rubenstein and TPG co-founder Bonderman, two of the industry’s best-known and successful practitioners, headlined Super Return Middle East, each man using it as an excuse to make his pitch publicly and then meet with existing and would-be investors around the GCC. Ten months later, and only weeks after Lehman Brothers filed for bankruptcy, throwing the U.S. and global markets into turmoil, Blackstone’s Schwarzman showed up at the second-annual event, along with Kravis. Schwarzman—wrongly—declared the end of the credit crisis that had taken deep root with the collapse of Bear Stearns earlier in the year, praising U.S. regulators for their swift action. And at that moment, Dubai and its neighbors in the Gulf were at least removed from the troubles back in the U.S., and potentially a safe haven of real growth as the West stumbled.