King of Capital: The Remarkable Rise, Fall, and Rise Again of Steve Schwarzman and Blackstone
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“They told us, ‘This is our lifeline. If anything goes wrong with this, if we sold it to a buyout firm unwilling to invest enough capital or that held us up for higher transport rates, it could bankrupt us,’ ” Schwarzman recalls. Rather than focus on price at the outset, the three Blackstone partners zoomed in on USX’s anxieties and how to allay them. “The first meeting was not about price,” Peterson says. “It was about governance. We went over some major operating decisions we’d face—spending levels to maintain the equipment, how we’d set rates, a determination of what to do if either of us wanted to sell our interests and various other issues.”
That approach alone wouldn’t have won Blackstone the deal, Roderick says: “Governance was extremely important to us, but so was price.” But the attentiveness Altman, Peterson, and Schwarzman showed to USX’s concerns gave the company comfort. The trio convinced Hoffman “that they understood our problem very well,” he says. “They were head and shoulders above any other investment group that I saw. We saw probably five or six.”
Not everyone at Blackstone was keen on the deal. Back in New York, David Stockman was dead set against it. The partners agonized over doing it. The big concern was how the business would perform if there were a severe slump in the steel market—a common event in that highly cyclical industry that could ravage revenues and profits of the transport unit. It fell to James Mossman, a brilliant, twenty-nine-year-old banker Altman had lured from Shearson, to digest the patchy data Blackstone had been given. After crunching the numbers, he was enthusiastic about the deal and made his case at a staff meeting.
“James raised his hand and said, ‘We need to do this deal. We’re going to make a lot of money!’ ” says Howard Lipson, a young staffer at the time who helped Mossman draft the financial model. Mossman explained that even though steelmaking is notorious for its ups and downs, the business of shipping steel was much steadier. “We showed that most of the wild cyclicality in steel companies’ profits was due to what happened to pricing as volume rose or fell,” says Lipson. “Despite that, the railroads are affected only by steel volume, not prices, and volume is not nearly as volatile as prices.”
Mossman sketched an imaginary worst case. He assumed that steel volume tumbled to its lowest point in twenty years and stayed there for two years. He showed that, even then, the railroad and barge unit would be able to meet its costs and turn a profit. “James did a perfect analysis,” says Schwarzman.
Convincing the Blackstone partners was one thing. Persuading banks to finance the deal was another matter. Blackstone needed $500 million of loans or bonds for the spinoff, but it had no track record in buyouts, and bankers were unnerved at the prospect of lending to a highly leveraged business that was dependent on the boom-and-bust cycles in steel. They weren’t moved by Mossman’s analysis. “Their mind-set was they didn’t want to go anywhere near a cyclical business,” Lipson says.
Schwarzman put out calls to all the big New York banks that financed buyouts: Manufacturers Hanover, Citibank, Bankers Trust, Chase Manhattan, and J.P. Morgan. All but J.P. Morgan turned him down flat. The House of Morgan, whose name radiated prestige, had been U.S. Steel’s banker since the turn of the century, when J. Pierpont Morgan bought the steelmaker’s predecessor from the industrialist Andrew Carnegie. It offered to finance the deal with USX, but it declined to give a firm commitment to come up with the money, and its proposal was loaded with conditions. “We loved the J.P. Morgan name,” Schwarzman says, but reputation alone wouldn’t get the deal done.
A sixth bank offered much better terms, however. Chemical Bank, like Blackstone’s founders, had aspired for years to break into the LBO business, but it had been a distant also-ran in the world of high finance. Mocked for its dismal lending record, Chemical deserved its popular sobriquet, “Comical Bank.” It would shed that reputation only in the late 1980s under the leadership of Walter Shipley and his successor as CEO, Bill Harrison. The two gave Chemical’s new commercial lending chief, James Lee, a thirty-something banker, free rein to invigorate Chemical’s loan operation and lead the charge into LBOs.
Chemical simply wasn’t big enough to finance large buyouts alone, but Lee got around that limitation by mustering a network of banks that would back the deals he signed up. Canvassing loan officers he’d befriended in Australia, Japan, and Canada, he assembled a corps of banks that trusted Chemical and could be counted on to ante up quickly when new lending opportunities came along. By 1984 Lee’s syndication apparatus was in place, and he conducted trial runs on a handful of high-rated, low-risk corporate loan packages before he ventured into the dicier realm of buyouts. By the time of the USX rail and barge deal, Lee had notched a handful of small loan syndications for LBOs.
To steal a march on other banks, Lee loaded Chemical’s $515 million debt package for Blackstone with seductive features. Most important, he gave Blackstone an iron-clad promise to provide all the debt, and to do so at a lower interest rate than Morgan. By contrast, Morgan had offered only to make its “best efforts” to round up the requisite funds, not a binding commitment. To sweeten Chemical’s proposal, Lee agreed to drop the interest rate by half a percentage point if the company’s profits sprang back to prestrike levels. To tide the business over if it ran into trouble, Lee further offered $25 million of backup capital in the form of a revolving credit facility—a now-conventional part of LBO financing that Lee helped popularize. This was credit the company could draw on if needed and pay back as it could, unlike the regular loans, whose amounts and due dates were fixed.
“When I walked into Blackstone’s offices, I knew I could give them what they wanted,” says Lee. “I had a firm grip on how much money” Chemical could pledge to any deal.
Schwarzman, still angling to obtain the imprimatur of the more august J.P. Morgan, went back and asked Morgan to match Chemical’s terms. To no avail.
“Steve let us know he thought J.P. Morgan was classy, and we were not,” says Lee. “But he said our offer was vastly more clever and creative,” and Chemical won the day.
First announced on June 21, 1989, the deal closed in December. That month, Blackstone and USX formed a new holding company, Transtar Holding LP, to house the rail and barge operations. As with the famous leveraged buyout of Gibson Greeting in 1982, equity was just a tiny sliver of the total financing package for Transtar. Blackstone shelled out just $13.4 million, 2 percent of the buyout price, for a 51 percent ownership stake. The new debt Chemical provided replaced much of the railroad’s equity, so USX was able to take out more than $500 million in cash. (USX also lent Transtar $125 million in the form of bonds—a kind of IOU known in the trade as seller paper because it amounted to a loan by USX to help Blackstone finance the purchase.) Roderick and USX got what they asked for: Despite holding just 49 percent, USX shared decision-making power over budgeting, financing, and strategy on equal terms with Blackstone.
The transaction was not a classic LBO at all. Strictly speaking, it was a leveraged recapitalization—a restructuring where debt is added and the ownership is shuffled. But whatever the label, it helped advertise the company-friendly approach that Peterson and Schwarzman had been touting for three years now. “We really wanted to put meat on our corporate partnership idea, and we hoped this deal did that,” Peterson says. “It sent a signal that we were good guys who did thoughtful, friendly deals as a real partner.”
Blackstone got everything it bargained for: a sturdy business on the rebound, which it had snared for an extraordinarily low price of four times cash flow. That was one-third to one-half below the stock market valuations of most railroads.
For a buyout investor, cash flow is the axis around which every deal turns. It determines how much debt a company can afford to take on and thus what a buyer can afford to pay. Net earnings, the bottom-line measure mandated by accounting rules for corporate financial statements, factors in interest costs, taxes, and noncash accounting charges such as the depreciation of assets. Cash flow is the deal maker’s raw “show
me the money” measure—the amount that remains after operating expenses are paid. The financial structure of an LBO is built upon it.
One way that buyout firms make profits is to use the cash flow to pay down the buyout debt. In the industry’s early days, deals were formulated with the aim of retiring every dollar of debt within five to seven years. That way, when the business was finally sold, the buyout firm reaped all the proceeds because there was no debt to pay off. A second way to generate a gain is to boost cash flow itself, through revenue increases, cost cuts, or a combination, in order to increase the company’s value when it is sold. Using cash flows, there is also a third way to book a gain, without an outright sale. If a company has paid down its debt substantially, it can turn around and reborrow against its cash flow in order to pay its owners a dividend. That is known as a dividend recapitalization.
In Transtar’s case, Blackstone used all three means to manufacture a stupendous profit. In 1989, in line with Mossman’s expectations, Transtar’s cash flow reached nearly $160 million, enabling it to repay $80 million of debt by year’s end. By March 1991 Transtar had pared $200 million of its original buyout debt. With substantially less debt than it had when the business was spun off and with Transtar’s cash intake growing, the company was able to borrow again to cover a $125 million dividend to Blackstone and USX. A little more than two years after the deal closed, Blackstone had made back nearly four times the $13.4 million it had invested. By 2003, when Blackstone sold the last of its stake in a successor to Transtar to Canadian National Railroad, the firm and its investors had made twenty-five times their money and earned a superlative 130 percent average annual return over fifteen years.
If this seems a bit like conjuring profits from nothing, that’s largely what happened. Transtar, like Gibson Greeting, was a prime example of buying at the right time, leveraging to the hilt, and milking every drop of cash flow for profit. Soon enough, rising prices and a floundering economy would change the rules of the game, forcing buyout firms to focus more intently on improving fundamental corporate performance to generate profits and less on financial sleights-of-hand.
That’s not to say the Transtar buyout served no purpose. It delivered a hefty profit to the pension funds and other institutions that put their money with Blackstone. The deal also assisted USX, allowing it to keep control of Transtar even as it restructured itself and sold off the subsidiary and other operations to increase the value of its stock. As to Transtar itself, the buyout didn’t particularly strengthen the company, but it certainly didn’t weaken it.
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Transtar’s success showed the rest of Wall Street that Peterson and Schwarzman could excel at the buyout game. The deal also was a landmark for a second reason. It forged an abiding tie between Blackstone and Chemical Bank’s Jimmy Lee that would be of enormous consequence to both. A gregarious spark plug of a man who resembled a back-gelled Martin Sheen and was known for his spiffy silver-dollar suspenders, Lee soon emerged as a kingpin of leveraged finance, a banker’s banker to other LBO luminaries such as Henry Kravis and Ted Forstmann. Just as Drexel Burnham’s Michael Milken had created the junk-bond market, tapping the public capital markets to finance the corporate raiders and buyout shops of the 1980s, Lee reinvented the bank lending market with his syndicates, which allowed risk to be shared and thereby allowed much larger loan packages to be assembled. At Chemical and its later incarnations (Chase Manhattan Bank, the name Chemical adopted in 1996 after buying Chase, and later JPMorgan Chase, after Chase bought J.P. Morgan in 2000), Lee would go on to play as critical a role in the stupendous growth of LBO activity in the 1990s and 2000s as Milken had with junk bonds in the 1980s.
Even though Lee would do brisk business with all the major LBO shops, he would work most closely with Blackstone. Beginning with Transtar and for the next fifteen years, Lee functioned as a kind of house banker to Blackstone, financing a great many of its deals and never siding with a competing LBO firm in a deal on which Blackstone was bidding. Theirs was a truly synergetic relationship, which helped propel both Chemical/JPMorgan Chase and Blackstone to the top in their fields.
“You could argue that Blackstone made JPMorgan Chase as much as JPMorgan Chase made Blackstone,” says one of Lee’s counterparts at another bank. “Neither would be where they are today without the other.”
Transtar also advertised Blackstone’s readiness to ally itself with corporate chieftains in the war against raiders, and just how far it would bend to accommodate corporate America’s financial and strategic imperatives. It helped establish Blackstone’s reputation as “an operating problem solver,” in Peterson’s words.
“In every way, it was a perfect first deal for us,” says Lipson. “It was highly successful quickly, and it showed we weren’t looking to antagonize corporations but to be friends. Corporate partnerships became our calling card.” Whereas competing buyout shops typically exercised dictatorial control over their acquisitions, Blackstone was adaptable. Its openness to splitting power or even taking a back seat to a corporate collaborator bolstered its deal flow, as Schwarzman and Peterson had hoped: Of the dozen investments that Blackstone went on to make with its 1987 buyout fund, seven would be partnerships akin to Transtar.
In addition to differentiating Blackstone from the competition, Schwarzman also believed the partnerships heightened Blackstone’s odds of success. Having a co-owner intimately familiar with the business—typically one that was a major customer or supplier and therefore had an interest in its thriving—would give Blackstone an advantage over competing buyout firms, staffed as they were with financial whizzes who had never run a business or met a payroll. With the prices for whole businesses escalating in step with the stock market in the late 1980s, Schwarzman felt Blackstone “needed an edge to safely do deals in a higher-priced environment.”
“That’s really why we came up with the corporate partnership strategy. I just couldn’t figure out how to make money buying companies unless we brought unusual efficiencies to a company by way of cost improvements or revenue synergies.”
The partnership approach also fit with Schwarzman’s innate cautiousness. In some partnerships, Schwarzman went so far as to barter away some of Blackstone’s potential upside for downside insurance, in the form of a right to sell out to its partner several years later at a preset price or valuation. Some of the firm’s rivals viewed such trade-offs with bemusement. To their way of thinking, ceding power and profit to hedge the downside was downright lily-livered. “We always thought Blackstone’s corporate model was bullshit,” sniffs one. “It was like they couldn’t stand on their own; they needed help and made a lot of concessions to get it.”
Schwarzman’s preoccupation with the possible downside was more than a reasoned response to the market dynamics of the day. It was a gut-level reflex, a kind of bête noire or obsession, former colleagues say. The rudimentary rule of investing, that one must risk money to make money, “is something Steve always had a hard time coping with,” says one former partner. For a world-class investor, “his risk-aversion was really extraordinary.”
Schwarzman acknowledges as much. “We are more risk-averse than other private equity firms, and part of it is visceral. I don’t like failure, and losing money is failing. It’s a personal thing that has turned into a strategy here.”
Over the next two decades, the corporate partnership deals had a mixed record. But the strategy was pivotal to Blackstone’s success early on, producing most of its early home runs, including investments in the Six Flags amusement parks and a second railroad, the Chicago and Northwestern Railroad.
Schwarzman’s caution sometimes worked against Blackstone by denying it promising deals. But it also spared it from perpetrating some of the colossal blunders that in the 1990s would damage and doom a few bullish (or bull-headed) rivals. Call it what you will, knee-jerk trepidation or prudence, Schwarzman’s instincts would be central to Blackstone’s success.
CHAPTER 6
Running Off th
e Rails
The Transtar triumph produced a warm afterglow. But it didn’t last long. Two misguided investments quickly ran off the tracks in 1989 and forced the young firm to rethink the way it vetted its investment options. The failures also established a harsh new unwritten rule: Slip up badly enough, just once, and you’re out. Everyone was on notice. Not even partners were exempt.
The first misfire was Wickes Companies, an unwieldy amalgam of three dozen disparate businesses that Blackstone took private for $2.6 billion in December 1988 in partnership with Wasserstein Perella, Blackstone’s rival as an M&A boutique and buyout shop. Conglomerates like Wickes, once stock market darlings, had fallen out of favor and were being ripped apart. David Stockman, Blackstone’s point man and strategist on Wickes, thought that Wickes would be worth more dismembered than intact.
Stockman was a relentless advocate for his own deals, bombarding his colleagues with minutiae—the actuarial details of pension plans, consumer vehicle preferences, or whatever other imaginative product of his research would be the key to making an investment successful. He became legendary inside and outside the firm for calculating and writing out voluminous spreadsheets by hand, often faxing the sheets of numbers to underlings at Blackstone who would type them into computer spreadsheets, as most other deal makers did from the outset. A banker who worked on one of Stockman’s deals remembers being dumbfounded as page after endless page of figures spat out of the fax machine during negotiations.
Stockman had cracked the Wickes nut, or so he thought. He plotted to break up the company, whittling it down to a single business: Collins & Aikman, a maker of textiles, carpeting, and wallpaper. Blackstone and Wasserstein Perella each sank $122 million into the buyout, which closed the same month as Transtar—the largest investment by Blackstone for the next seven years.