At first Peterson didn’t recognize how deep the traders’ indignation ran. He sensed that Glucksman, who had been elevated to president in 1981, was restless in that role and thought Glucksman deserved a promotion, and in May 1983 he anointed him co-CEO. But that didn’t placate Glucksman, who had long resented operating in Peterson’s shadow and wanted the title all to himself. Six weeks later Glucksman organized a putsch with the backing of key partners. “He had a corner on the trading area” and his traders had earned a bundle the previous quarter, Peterson says. “I guess he felt it was the right time to strike.” Figuring the internal warfare might ease if he stepped aside, Peterson acquiesced, agreeing to step down as co-CEO in October and to quit as chairman at the end of 1983.
It was a humiliating ending, but Peterson never was one to push back when shoved. Schwarzman and other Lehman partners told him that if it came to a vote of the partners, he would win. But Peterson thought he might save the bank from further strife by stepping aside. He felt “that such a victory would be both hollow and Pyrrhic,” Peterson later wrote. “Lew would take some of his best traders, leaving the firm seriously damaged.”
Some of Peterson’s friends believe his cerebral flights and preoccupations may have contributed to his downfall, by desensitizing him to the firm’s Machiavellian internal politics. For whatever reasons, former colleagues say he was largely oblivious to—and perhaps in denial about—the coup Glucksman was hatching against him until the moment the trader confronted him in July that year and insisted that Peterson bow out. Peterson owns up to being “naïve” and “too trusting.”
That summer, after his ouster, Peterson withdrew for a time to his summer house in East Hampton, Long Island. Schwarzman and most of his fellow bankers labored on amid the rancor. But in the spring of 1984, Glucksman’s traders suffered another enormous bout of losses and Lehman’s partners found themselves on the verge of financial ruin, just as they had a decade earlier. Glucksman, though still CEO, lost his grip on power and the partners were bitterly divided over whether to sell the firm or tough it out. If they didn’t sell, there was a very real risk the firm would fail and their stakes in the bank—then worth millions each—would be worthless.
It was Schwarzman who ultimately forced the hand of Lehman’s board of directors. The board had been trying to keep the bank’s problems quiet so as not to panic customers and employees while it sounded out potential buyers. In a remarkable piece of freelancing, Schwarzman—who was not on the board and was not authorized to act for the board—took matters into his own hands. On a Saturday morning in March 1984 in East Hampton, he showed up unannounced on the doorstep of his friend and neighbor Peter A. Cohen, the CEO of Shearson, the big brokerage house then owned by American Express. “I want you to buy Lehman Brothers,” Schwarzman cheerily greeted Cohen. Within days, Cohen formally approached Lehman, and on May 11, 1984, Lehman agreed to be taken over for $360 million. The merger gave Shearson, a retail brokerage with a meager investment banking business, a major foothold in more lucrative, prestigious work, and it staved off financial disaster for Lehman’s partners. (Years later Lehman was spun off and became an independent public company again.)
It meant salvation for the worried Lehman bankers and traders, but the deal came with strings attached. Shearson insisted that most Lehman partners sign noncompete agreements barring them from working for other Wall Street firms for three years if they left. Handcuffs, in effect. What Shearson was buying was Lehman’s talent, after all, and if it didn’t lock in the partners, it could be left with a hollow shell.
Schwarzman had no interest in soldiering on at Shearson, however. He yearned to join Peterson, who was laying plans to start an investment business with Eli Jacobs, a venture capitalist Peterson had recently come to know, and they wanted Schwarzman to join them as the third partner. As Schwarzman saw it, he’d plucked and dressed Lehman and served it to Cohen on a platter, and he felt that Cohen owed him a favor. Accordingly, he asked Cohen during the merger talks if he would exempt him from the noncompete requirement. Cohen agreed.
“The other [Lehman] partners were infuriated” when they got wind of Schwarzman’s demand, says a former top partner. “Why did Steve Schwarzman deserve a special arrangement?” Facing a revolt that could quash the merger, Cohen backpedaled and eventually prevailed upon Schwarzman to sign the noncompete. (Asked why Schwarzman thought Shearson would cut him a uniquely advantageous deal, one person who knows him replies, “Because he’s Steve?”)
Schwarzman desperately resented Shearson’s manacles and felt he’d been wronged. In the months after Shearson absorbed Lehman, he showed up at the office but groused endlessly and sulked, according to former colleagues. For his part, Peterson still wanted Schwarzman to join him, and by now he needed him even more because he and Jacobs had fallen out. Peterson now says Jacobs never was his first choice as a partner. “Steve and I were highly complementary,” he says. “I’d wanted Steve all along, but I couldn’t get him.” Peterson had to get him sprung from Shearson.
Eventually, Peterson and his lawyer, Dick Beattie—the same lawyer who had represented Lehman and Kohlberg Kravis—met with Cohen’s emissaries at the Links Club, a refuge of the city’s power elite on Manhattan’s Upper East Side, to try to spring their man. It was going to cost Schwarzman and Peterson dearly, because Cohen did not want to lose more Lehman bankers. “It was a brutal process,” says Peterson. “They were afraid of setting a precedent.”
Shearson had drawn up a long list of Lehman’s corporate clients, including those Peterson and Schwarzman had advised and some they hadn’t, and demanded that Schwarzman and Peterson agree to hand over half of any fees they earned from those clients at their new firm for the next three years. They could have their own firm, but they would start off indentured to Shearson. It was a painful and costly agreement, because M&A advisory fees would be the new firm’s only source of revenue until it got its other businesses up and running. But Schwarzman didn’t have any good legal argument against Shearson, so he and Peterson buckled to the demand.
In Schwarzman’s mind, Cohen had betrayed him, and to this day, friends and associates say, he has borne a deep grudge toward Cohen, both for making him sign the noncompete in the beginning when Cohen had agreed to make an exception, and later for demanding such a steep price to let Schwarzman out. “Steve doesn’t forget,” says one longtime friend. “If he thinks he’s been crossed unfairly, he’ll look to get even.”
Peterson isn’t much more forgiving about the episode. “The idea of giving those characters half the fees when they broke their word seemed egregious. But we couldn’t get Steve out on any other basis.”
They had survived the debacle of Lehman and now would have to labor under Shearson’s onerous conditions, but at last the two were free to set out on their own as M&A advisers and to pursue the mission they had to put on hold for so many years: doing LBOs.
CHAPTER 3
The Drexel Decade
By the time Peterson and Schwarzman extricated themselves from Lehman and Shearson in 1985, the buyout business was booming and the scale of both the buyout funds and the deals themselves were escalating geometrically. Kohlberg Kravis Roberts and a handful of rivals were moving up from bit parts on the corporate stage to leading roles.
Several confluent factors were fueling the rise in buyout activity. Corporate conglomerates, the publicly traded holding companies of the 1960s that assembled vast stables of unrelated businesses under a single parent, had fallen out of favor with investors and were selling off their pieces. At the same time, the notion of a “core business” had penetrated the corporate psyche, prompting boards of directors and CEOs to ask which parts of their businesses were essential and which were not. The latter were often sold off. Together these trends ensured a steady diet of acquisition targets for the buyout firms.
But it was the advent of a new kind of financing that would have the most profound effect on the buyout business. Junk bonds, and Drexel Burnham Lambert,
the upstart investment bank that single-handedly invented them and then pitched them as a means to finance takeovers, would soon provide undreamed-of amounts of new debt for buyout firms. Drexel’s ability to sell junk bonds also sustained the corporate raiders, a rowdy new cast of takeover artists whose bullying tactics shook loose subsidiaries and frequently drove whole companies into the arms of buyout firms. Over the course of five years, Drexel’s innovations revolutionized the LBO business and reshaped the American corporate establishment.
A decade earlier buyouts had been a cottage industry with just a handful of new and more established LBO boutiques. They typically cobbled together a couple of small deals a year, maybe $30 million at the biggest. Gibbons, Green, van Amerongen; E. M. Warburg Pincus, which mostly invested in start-ups; AEA Investors; Thomas H. Lee Company, started by a First National Bank of Boston loan specialist; Carl Marks and Company; Dyson-Kissner-Moran—it was a short list. But the scent of profit always draws in new capital, and soon new operators were sprouting up.
KKR, which opened its doors in 1976, was the most prominent. KKR’s doyen at the time was the sober-minded, bespectacled Jerry Kohlberg, who began dabbling in buyouts in 1964 as a sidelight to his main job as corporate finance director of Bear Stearns, a Wall Street firm better known for its stock and bond trading than for arranging corporate deals. In 1969 Kohlberg hired George Roberts, the son of a well-heeled Houston oilman, and later added a second young associate, Roberts’s cousin and friend from Tulsa, Henry Kravis. Kravis, whose father was a prosperous petroleum engineer, was a resourceful up-and-comer, small of stature, with a low golf handicap and a rambunctious streak. On his thirtieth birthday he fired up a Honda motorcycle he’d gotten as a gift and rode it around his Park Avenue apartment. In 1976, Kohlberg, then fifty, and Kravis and Roberts, thirty-two and thirty-three, respectively, quit Bear Stearns after a stormy showdown with Bear’s CEO, Salim “Cy” Lewis, a lifelong trader who considered buyouts an unrewarding diversion.
The trio’s inaugural fund in 1976 was a mere $25 million, but they quickly demonstrated their investing prowess, parlaying that sum into a more than $500 million profit over time. That success made KKR a magnet for investors, who anted up $357 million when KKR hit the fund-raising trail for the second time in 1980. A decade after KKR was launched, it had raised five funds totaling more than $2.4 billion.
While Lehman’s executive committee had balked at Peterson and Schwarzman’s suggestion that Lehman buy into companies, other banks had no qualms and by the early 1980s many were setting up their own in-house buyout operations. In 1980, two years after KKR’s landmark Houdaille deal was announced, First Boston’s LBO team topped that with a $445 million take-private of Congoleum, a vinyl-flooring producer. Soon Morgan Stanley, Salomon Brothers, and Merrill Lynch followed suit and were leading buyouts with their own capital. Goldman Sachs stuck its toe in the water as well. Goldman’s partners agonized over their first deal, a pint-sized $12 million takeover of Trinity Bag and Paper in 1982. “Every senior guy at Goldman obsessed about this deal because the firm was going to risk $2 million of its own money,” remembers Steven Klinsky, a Goldman banker at the time who now runs his own buyout shop. “They said, ‘Oh, man! We’ve got to make sure we’re right about this!’ ”
The clear number two to KKR was Forstmann Little and Company, founded in 1978. It was only half KKR’s size, but the rivalry between the firms and their founders was fierce. Ted Forstmann was the Greenwich, Connecticut–reared grandson of a textile mogul who bounced around the middle strata of finance and the legal world until, with a friend’s encouragement, he formed his firm at the age of thirty-nine. He swiftly proved himself a master of the LBO craft, racking up profits on early 1980s buyouts of soft-drink franchiser Dr Pepper and baseball card and gum marketer Topps. Though he had less money to play with, his returns outstripped even KKR’s, and like Kravis he became an illustrious and rich prince of Wall Street whose every move drew intense press scrutiny.
KKR remained the undisputed leader, though. Houdaille came to be recognized as the industry’s Big Bang—the deal that more than any other touched off the ensuing explosion of LBOs. Doggedly gathering new capital every two years or so and throttling up the scale of its deals, by the mid-1980s KKR dominated buyouts in the way that IBM lorded over the computer business in the 1960s and 1970s.
In the early days of the buyout, many of the target companies were family-owned businesses. Sometimes one generation, or a branch of a family, wanted to cash out. An LBO firm could buy control with the other family members, who remained as managers. But as the firms had greater and greater amounts of capital at their disposal, they increasingly took on bigger businesses, including public companies like Houdaille and sizable subsidiaries of conglomerates.
In their heyday in the 1960s, conglomerates had been the darlings of the stock market, assembling ever more sprawling, diversified portfolios of dissimilar businesses. They lived for growth and growth alone. One of the golden companies of the era, Ling-Temco-Vought, the brainchild of a Texas electrical contractor named Jimmy Ling, eventually amassed an empire that included the Jones & Laughlin steel mills, a fighter jet maker, Braniff International Airlines, and Wilson and Company, which made golf equipment. Ling’s counterpart at ITT Corporation, Harold Geneen, made what had been the International Telephone & Telegraph Company into a vehicle for acquisitions, snatching up everything from the Sheraton hotel chain to the bakery that made Wonder Bread; the Hartford insurance companies; Avis Rent-a-Car; and sprinkler, cigar, and racetrack businesses. At RCA Corporation, once just a radio and TV maker and the owner of the NBC broadcasting networks, CEO Robert Sarnoff added the Hertz rental car system; Banquet frozen foods; and Random House, the book publisher. Each of the great conglomerates—Litton Industries, Textron, Teledyne, and Gulf and Western Industries—had its own eclectic mix, but the modus operandi was the same: Buy, buy, buy.
Size and diversity became grail-like goals. Unlike companies that grow big by acquiring competitors or suppliers to achieve economies of scale, the rationale for conglomerates was diversification. If one business had a bad year or was in a cyclical slump, others would compensate. At bottom, however, the conglomerate was a numbers game. In the 1960s, conglomerates’ stocks sometimes traded at multiples of forty times earnings—far above the historical average for public companies. They used their overvalued stock and some merger arithmetic to inflate their earnings per share, which is a key measure for investors.
It worked like this: Suppose a conglomerate with $100 million of earnings per year traded at forty times earnings, so its outstanding stock was worth $4 billion. Smaller, less glamorous businesses usually traded at far lower multiples. The conglomerate could use its highly valued shares to buy a company with, say, $50 million of earnings that was valued at just twenty times earnings. The conglomerate would issue $1 billion of new stock ($50 million of earnings × 20) to pay the target’s shareholders. That would lift earnings by 50 percent but enlarge the conglomerate’s stock base by just 25 percent ($4 billion + $1 billion), so that its earnings per share increased by 20 percent. By contrast, if it had bought the target for forty times earnings, its own earnings per share wouldn’t have gone up.
Because stock investors search out companies with rising earnings per share, the acquisition would tend to push up the buyer’s stock. If the conglomerate maintained its forty-times-earnings multiple, it would be worth $6 billion, not $5 billion, after the merger ($150 million of earnings × 40). If the buyer borrowed part of the money to buy the target, as conglomerates typically did, it could issue less new stock and jack up earnings per share even higher.
This sleight of hand worked wonderfully in a rising market that sustained the lofty multiples. But reality caught up with the conglomerates at the end of the 1960s, when a bear market ravaged stocks, the numbers game fizzled out, and investors cooled to the conglomerate model. They came to see that the earnings of the whole were not growing any faster than the earnings of the parts, and
that the surging earnings per share was ultimately an illusion. Moreover, managing such large portfolios of unrelated businesses tested even very able managers. Inevitably there were many neglected or poorly managed subsidiaries. Investors increasingly began to put more store in focus and efficiency. Under pressure, the discredited behemoths were dismantled in the 1970s and 1980s.
In many cases, buyout shops picked up the cast-off pieces. A banner year for such deals was 1981, when interest rates spiked, the economy hit the wall, and stock prices fell, putting many businesses under stress. KKR bought Lily-Tulip, a cup company, from the packaging giant Owens-Illinois and also PT Components, a power transmission components maker, from Rockwell International, which by then made everything from aircraft to TVs and printing presses. Near the end of that year Forstmann Little struck a deal to buy Beatrice Foods’ soft-drink bottling operations, and Wesray negotiated its deal to buy Gibson Greeting from RCA.
As the decade wore on and their bankrolls swelled, bigger LBO shops took aim at whole conglomerates with an eye to splitting them up, as KKR would do with Beatrice Foods in 1986. By then Beatrice had branched out from its roots as a dairy and packaged-food company to include Playtex bras and the Avis car rental chain once owned by ITT.
What turbocharged the buyout boom was a colossal surge in the amount of capital flowing into buyouts—both equity and debt.
As KKR, Forstmann Little, and other buyout firms chalked up big profits on their investments of the late 1970s and early 1980s, insurance companies and other institutions began to divert a bit of the money they had invested in public stocks and bonds to the new LBO funds. By diversifying their mix of assets to include buyouts and real estate, these investors reduced risk and could boost their overall returns over time. The money they moved into the buyout funds was used to buy the stock, or equity, of companies.
King of Capital: The Remarkable Rise, Fall, and Rise Again of Steve Schwarzman and Blackstone Page 4
