King of Capital: The Remarkable Rise, Fall, and Rise Again of Steve Schwarzman and Blackstone
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Bonderman was another child of the takeover boom who nimbly shifted course. A brainy ex-litigator known for his unorthodox sartorial getups—he often pairs plaid sports shirts with wildly clashing ties—Bonderman had executed a string of profitable takeovers as chief investment strategist to the Texas financier Robert M. Bass. But it was his pivotal role in Bass’s 1988 purchase of the country’s largest failed S&L, American Savings Bank, that brought him wide notice as a vulture investor of the first order. Bass invested $400 million, most of it borrowed, to buy American Savings. Less than a year later, with its bad debts handed over to the government, the thrift was solidly in the black. Bass would turn a fivefold gain on the investment.
Bonderman and another Bass alumnus, James Coulter, followed that in 1993 by buying Continental Airlines, Inc., out of bankruptcy with $400 million they’d rounded up from wealthy investors and institutions. Bonderman and Coulter ultimately came away with nine times their money on Continental. By then, they and a San Francisco business consultant, William Price, had launched their own buyout firm, Texas Pacific Group, based in Fort Worth and San Francisco, and raised a $720 million debut fund in 1994. They quickly became known as top-flight contrarians and turnaround artists who would take on financially or operationally hobbled companies most buyout firms wouldn’t touch.
Bonderman did not conform to the Wall Street mold. Even as a lawyer, he had deviated from the conventional corporate career path, living in the Middle East, where he learned Arabic and studied Islamic law, and later doing a stint in the Civil Rights Division of the U.S. Department of Justice. Like Schwarzman, though, he had a flair for partying. Four years before the Schwarzman bash, Bonderman held his own even grander sixtieth birthday, flying scores of friends to Las Vegas, where they were entertained by the Rolling Stones, John Mellencamp, and Robin Williams at the Hard Rock Hotel. The event reportedly set back Bonderman by $7 million, but staged far from the press hordes in New York, it generated only a few scattered press reports.
With the LBO business on ice at the beginning of the new decade, Peterson and Schwarzman continued their quest to round out Blackstone’s collection of businesses, bolstering the partner ranks with a string of high-profile hires. In addition to Henry Silverman on the buyout team, Schwarzman enticed David Batten, a seasoned capital markets executive, to join from First Boston in June 1990. The following year, Batten brought in Joseph E. Robert Jr., who had overseen the disposal of $2.3 billion worth of distressed real estate for the Resolution Trust Corporation, the federal agency changed with salvaging as much value as possible from the carcasses of failed S&Ls seized by the government. The inventory of troubled real estate, mortgage loans, and entire thrifts that the RTC was poised to auction off ran to tens of billions of dollars. Up and down Wall Street, people were salivating at the prospect of the RTC’s liquidation sales, and Batten arranged to work with Robert on scooping up real estate at distressed prices. (Robert didn’t join the Blackstone partnership, preferring to stay an independent contractor.)
A second new business emerged almost unintentionally, a by-product of the need to invest the $100 million Blackstone had received from Nikko. Blackstone’s abortive risk-arbitrage fling in 1989 had eaten into the original hoard, but Schwarzman shuddered at the thought of putting the cash at risk in the turbulent markets. Still, the firm couldn’t afford to leave the capital invested in low-paying certificates of deposit forever.
Batten, who had been charged with managing the money, hit on a solution. That summer he proposed that Blackstone divvy up the money and invest it with a half-dozen successful hedge funds, so named because they hedged their bets by deploying capital across an array of securities and currencies and could sell short when they thought the markets were headed down. The aim was to make money in down as well as up markets, and the best of the funds habitually had outstripped the stock market’s performance. At the time, hedge funds were a small galaxy in the financial cosmos, but a handful of proven stars had emerged, including George Soros, Michael Steinhardt, Paul Tudor Jones II, and Julian Robertson.
Despite his initial reluctance, Schwarzman signed off on Batten’s suggestion, and Batten proceeded to set up a fund-of-funds, taking stakes with six managers, the most illustrious being Robertson. But Schwarzman, who had never been a trader, was jittery as ever about losses and kept a sharp eye trained on the monthly results. “The first month the funds were up three percent and Steve was happy,” recalls Batten. “The second month they were up four percent, and Steve was even happier.” But around the fourth month Robertson posted a 4 percent loss and Schwarzman was beside himself.
“How could this happen?” he fumed to Batten. “Fire him! Fire Robertson!”
Batten answered by pointing out that Robertson was up substantially since Blackstone first placed money with him. Hedge funds’ results, he explained, are inherently volatile, and one bad month does not necessarily a bad year make.
Robertson wasn’t fired. Over the years, despite occasional setbacks, the fund-of-funds generated remarkably sturdy returns, and Blackstone later opened it up to outside investors, drawing in tens of billions of dollars, which created an important new source of fee income for the firm.
The buyout business remained the core, but it was still a source of headaches, notwithstanding the reforms Schwarzman had put in place in the wake of the Edgcomb fiasco. Blackstone’s first major leveraged purchase of the 1990s, and its first foray into distressed investing, Hospitality Franchise Systems, very nearly self-destructed as quickly as Edgcomb had.
Henry Silverman, who steered the HFS deal for Blackstone, was versed in the hotel franchise business from his years working for the financier and corporate raider Saul Steinberg, for whom he had led a successful LBO of the Days Inn of America chain. Steinberg was one of the early raiders, having wrested control of Reliance Insurance Group via a hostile tender offer in 1968 when he was just twenty-nine, and following that the next year with an implausible and fruitless bid to buy Chemical Bank. In the eighties, Steinberg and Reliance became stalwarts in Drexel’s troupe of marauders. For a six-year stretch in that period, Silverman led Steinberg’s LBO fund, which did mostly friendly deals, including Days Inn. (Later Steinberg would be linked to Blackstone in another way: When his financial empire crumbled in 2000, he was forced to sell many personal possessions, including his sumptuous duplex apartment at 740 Park Avenue. The apartment’s buyer, who paid a reported $30 million, was Steve Schwarzman.)
HFS was set up to take advantage of the financial ills of Prime Motor Inns, one of the world’s largest operators and franchisers of midpriced hotels and motels. In 1990, Prime ran into trouble and needed to dump properties to pay down debt, and Silverman leaped at the chance to get control of Prime’s two most prized possessions, the Howard Johnson franchise operation and an exclusive license to run the Ramada franchise. While the hotel business is cyclical, ebbing and spiking with the season and the economy, franchise fees are only partly tied to hotel earnings and are relatively steady, so it looked like a safe bet for an LBO. Moreover, Blackstone was buying in at a reasonable price: $195 million, or six times cash flow.
A month to the day after the buyout closed, however, on August 2, 1990, Iraq invaded Kuwait, an event that wasn’t in any of Blackstone’s investment scenarios. Almost immediately, as it became clear that the United States would lead a war to drive back Saddam Hussein’s army, oil prices shot up and hotel bookings plummeted as people were daunted by the costs and risks of travel. “Our reservation volume fell off a cliff,” Silverman says. “It was down 30 to 40 percent in one day.”
This quickly threatened to sink the investment. The problem was that HFS didn’t actually own the Ramada name; it simply licensed it from one of Hong Kong’s biggest property conglomerates, New World Development, and New World, in turn, had the right to withdraw the license if HFS fell behind on its royalty payments—which HFS quickly did. Losing the right to the Ramada name would have rendered HFS largely worthless. At that stage in Blacks
tone’s history, another failure could have threatened not just HFS but Blackstone itself. “Blackstone already had had issues with Wickes and Edgcomb when I got there,” Silverman says. “The fund was too new for Blackstone’s limited partners to start screaming, but they were very concerned. If this deal had blown up, it probably would have been the end of the fund, and maybe the end of Blackstone.”
Silverman and Schwarzman tried to win some breathing room from New World. After an exchange of faxes with New World managing director Henry Cheng, whose father had founded the business, Schwarzman and Silverman flew to Hong Kong in September to see if a face-to-face meeting could prevent the situation from deteriorating.
Cheng started off by asking why he shouldn’t rescind the license. Schwarzman countered by offering to give New World a higher percentage of HFS’s income, a proposal he and Silverman already had made in a fax. “There must be some arrangement we can come to,” Schwarzman said.
Dissatisfied with the offer, Cheng told them, “Okay, why don’t you go and figure out whether there’s anything that might be of interest to me.” He then dispatched the two Americans to a nearby conference room, with a gargantuan tropical fish tank, to draft a proposal.
Schwarzman and Silverman pondered the fish and their predicament, eventually formulating what they thought might be a workable compromise. When they returned to Cheng’s office, however, he dismissed it as unacceptable. “Try to come up with something better,” he told them, and they returned to the conference room. Their second suggestion, offered a few minutes later, didn’t win over Cheng either.
It was now a quarter to noon and Cheng told them he would be leaving soon. “I’m going to play golf at twelve. If we can’t work out some arrangement by then, we’re just going to take the company.”
Back to the conference room they trudged. Schwarzman stared glumly at the brilliantly colored fish gliding through the water, thinking, “Here’s my whole career about to disappear like those fish bubbles.”
With only minutes to go, Schwarzman and Silverman returned and offered yet another revised proposal. This time Cheng swiftly endorsed it.
Before heading to the links, Cheng revealed that he’d been toying with them.
“You know, I never would have taken the company, because I had heard that Henry Silverman is a very good operator, and the U.S. is quite far away,” Schwarzman recalls him saying. “I really was very pleased you bought this. Thank you for your proposal.”
Schwarzman was so relieved, he didn’t mind the ruse.
Though HFS was a problem, Blackstone’s other early holdings—Collins & Aikman, CNW, Transtar, and a small investment in a chemical company—weathered the recession without crises. There was still no way to get financing for major new LBOs, but when the economy showed signs of improving in late 1992, the IPO market began to pick up and Blackstone had a chance to show just how well its investments were doing by taking some companies it owned public.
In an IPO, typically, big stockholders like Blackstone sell at most a small portion of their shares. The market often can’t absorb all the stock of a company at one time, and investors will balk if they think existing investors want to cut and run. In many cases, the existing shareholders sell no shares, and the IPO consists solely of shares newly issued by the company equivalent to, say, a 15 or 20 or 25 percent stake. While the new stock waters down existing investors’ stakes, the IPO raises new capital for the business and establishes a public-market value for the stock, opening an avenue for the company’s backers to sell their shares and lock up profits later.
CNW was the first of Blackstone’s companies to undergo an IPO. In April 1992, the railroad sold a 22 percent stake to the public. The IPO price equated to 12.3 times CNW’s cash flow, compared with the 7.2 times Blackstone had paid, and put CNW’s overall worth at $3.2 billion, twice the LBO’s original $1.6 billion price tag. The plum valuation partly reflected a 20 percent rise in CNW’s cash flows, but more than anything it attested to the IPO market’s ravenous appetite for new issues. “CNW didn’t hit one of its [earnings targets]. Our operating projections were wrong. But our view of the overall value was right,” says Howard Lipson. Blackstone, which sold the last of its CNW shares in August 1993, wound up with a profit of 217 percent on its original $75 million investment, and a gross annual return of 34.2 percent.
Amazingly, it was HFS that yielded the firm’s second IPO bonanza. A year after Schwarzman and Silverman’s gut-churning negotiation with Henry Cheng in Hong Kong, they had expanded HFS by buying another franchiser out of bankruptcy, Days Inn of America. Silverman’s old boss Saul Steinberg had once owned Days Inn, and in 1989 Silverman had arranged the sale of the chain for $765 million to Tollman-Hundley Hotels, one of Days Inn’s largest franchisees. The price was stratospheric: fourteen times Days Inn’s cash flow. Silverman and Steinberg were happy to take the money, but Silverman thought the price was excessive and was convinced that Days Inn was bound to go bust.
“When Henry joined us, he told us one thing we’d probably be able to do is to buy Days Inn,” Schwarzman says. “He said, ‘I don’t know why somebody paid fourteen times cash flow for it, but they’ll never be able to meet their debt costs, because these businesses don’t grow fast enough to outrun them.’ ”
As Silverman predicted, Days Inn filed for bankruptcy in September 1991, allowing Blackstone to grab it for $259 million—one-third the price Silverman had sold it for in 1989. Since HFS already had its franchising infrastructure set, there were huge cost savings to be gleaned from the merger. Most of the same staff that managed the Howard Johnson and Ramada franchises could readily handle Days Inn, too, and most of the Days Inn staff would be pink-slipped. A similar rationale would propel bank mergers later that decade—combine deposits and slash people—as well as thousands of corporate mergers driven by what CEOs euphemistically call “cost synergies.” It was capitalism with a chilly heart. From a stockholder’s standpoint, it also made HFS a far more valuable business with more staying power.
“Because of the people we already had in place, I thought we’d be adding $50 million of revenue at virtually no cost,” Silverman says.
In December 1992, with the Persian Gulf War over and travel and hotel bookings back to prewar levels, HFS went public at $16 a share, 255 percent above Blackstone’s investment cost of $4.50 a share. The shares jumped 17 percent the first day they traded and soared to $50 within a year. Blackstone exited HFS with a $362 million profit on its $121 million outlay, posting an annual gross return of 59.2 percent.
Almost battered into extinction in 1990, Blackstone had picked itself up off the canvas and was banging out gain after gain. In December 1993, on the strength of its performance in CNW and HFS, together with a smaller profit on a corporate partnership investment with Time Warner in Six Flags Theme Parks, Blackstone raised a new $1.3 billion buyout fund, nearly twice the amount it had raised in 1987. Rounding up pledges wasn’t easy, though. By then Japan’s markets and economy were stalling after a decade-long bubble in stock and real estate prices. The Japanese banks that had thrived in the boom years were now stuck with bad loans and assets that were shrinking in value, and they were retrenching on every front. Most every Japanese financial institution that had participated in Blackstone’s first fund, with the exception of Nikko, took a pass on the second. But Blackstone filled the void, and then some, with money from new investors, including several state pension funds, which increasingly were adding buyout funds to their mix of investments.
The new fund propelled Blackstone past Clayton, Dubilier & Rice into the number-three slot among independent operators in the buyout game’s capital hierarchy. Only the perennial kingpins, KKR and Forstmann Little, were larger.
CHAPTER 10
The Divorces and a Battle of the Minds
If Peterson and Schwarzman at times seemed like polar opposites as personalities, they in fact shared a deep craving for public recognition. Schwarzman had something to prove, it was clear for all to see. Pet
erson’s need to play the role of public-minded sage was more subtle but no less profound.
The personalities and ambitions of both, and the incongruity of their partnership, was never more apparent than in the Sunday New York Times on September 16, 1990. By a poetic coincidence of newspaper scheduling, both men occupied prominent spots in that issue. On the op-ed page, Peterson weighed in with an earnest, fourteen-hundred-word piece calling on Congress to enact a multiyear deficit-reduction program—the federal deficit having become an obsession with him. In a glossy “Men’s Fashions of the Times” insert, meanwhile, Blackstone’s CEO was on display in a three-quarter-page photo modeling a $1,300 Alan Flusser wool suit with matching silk Jacquard tie. To some people’s eyes, Schwarzman’s trousers, bunched at the shoes, accentuated his shortness. Peterson found Schwarzman’s Manhattan-dandy act so achingly funny that the next day at 345 Park Avenue he pinned up Schwarzman’s fashion shot in his office to draw laughs from those who dropped by. “Pete thought it was hilarious,” says a former Blackstone partner. “Steve was really pissed off.”
To those who knew Peterson, it was just another example of his irrepressible, impish reflex to tease those around him. He could be merciless, but for the frequently remote Peterson it was also a form of affection, a bonding ritual. Schwarzman, who could be thin-skinned, usually took Peterson’s taunts in stride and gave as good as he got. In that era “Steve and Pete were very close,” says Jonathan Colby, a partner at Carlyle who worked at Blackstone in the early 1990s. “Each knew what the other was thinking. It was like they communicated telepathically.”