King of Capital: The Remarkable Rise, Fall, and Rise Again of Steve Schwarzman and Blackstone
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Blackstone sank $190 million into Republic—the biggest investment in Blackstone’s second buyout fund. The whole investment would go up in smoke.
In addition to the stream of worrying financial news from Stockman’s portfolio, complaints about Stockman were filtering back to others at Blackstone from the managers of the companies, who were unhappy at his persistent meddling and niggling. Stockman questioned the judgment of executives who knew their businesses far better than he, and his suggestions sometimes seemed off-the-wall.
In August 1999, when Stockman was away on a two-week African vacation, Schwarzman decided to play detective. He personally hit the phones, calling executives at each of Stockman’s companies to find out about their relations with Stockman. From those soundings, “Steve came to the realization that David was a little out of control,” says a former associate. When Stockman returned, Schwarzman told him that he had in mind a new role for him, spotting trends and researching potential investments. His days overseeing companies, he was informed, were over.
Stockman was not booted out, but he could see that his role would be diminished. On September 16, 1999, he announced he was quitting Blackstone to form his own private equity firm, Heartland Industrial Partners. In a press release, Schwarzman and Peterson extolled his fine work on American Axle. Blackstone invested some of its own capital in Heartland, and Peterson served on Heartland’s board of advisers. The parting was smooth enough that even years later Stockman would still periodically drop by Blackstone’s offices. But few, if any, of his Blackstone colleagues were sorry to see him go.
At Heartland, Stockman was free to pursue his convictions unchecked, and he poured his investors’ money into midwestern manufacturers, many linked to the auto industry. Nearly all went bust. The most disastrous was an investment in the auto interiors and trims company that had launched his private equity career in 1988, Collins & Aikman (née Wickes), and that continued to hold an allure for him. Less than two years after he founded Heartland, he bought control of Collins & Aikman from Blackstone and Wasserstein and Company, which had taken the company public in 1994 but had never managed to cash out. After a dozen years, they were only too happy to get out even though they recouped less than half their original money.
Stockman appended other smaller parts makers to Collins & Aikman, but by 2003 it was being squeezed by rising raw-materials prices and falling profits at its customers, General Motors, Ford, and Chrysler. Stockman personally took the helm as CEO in 2003, but the company was taking on water and he could not keep it from sinking under the weight of the debt from its buyout and the acquisitions. In 2005 Collins & Aikman filed for bankruptcy, obliterating Heartland’s $360 million investment. In 2007 Stockman was indicted on charges of hiding Collins & Aikman’s true financial condition from investors while its situation turned dire. Two long years later, federal prosecutors dropped the charges, saying that “further prosecution of this case would not be in the interests of justice.” But by then the onetime wunderkind’s reputation as an astute wheeler and dealer in private equity lay in tatters.
CHAPTER 13
Tuning in Profits
So long as you didn’t cast your gaze too far beyond the center of the financial universe in Manhattan, Blackstone seemed to be enjoying a golden era in the late nineties. On the back of the spectacular profits of its second fund from 1992, it raised a new $4 billion investment pool in 1998. The world’s largest insurance company, American International Group, took a 7 percent stake in the firm, valuing Blackstone at $2.1 billion, and AIG promised to ante up $1.2 billion for Blackstone’s investment funds. Forbes and BusinessWeek each ran cover stories proclaiming the resurgence of leveraged buyouts.
But the truth was, by then Blackstone and private equity were a sideshow. The prosaic, cash-generating businesses that traditionally had been the bread and butter of the private equity business—short-line railroads like Transtar, graphite makers like UCAR, and auto-parts makers like Collins & Aikman and American Axle—had fallen out of fashion. The “old economy” of boring, profitable, but slow-and-steady companies was being eclipsed by the high-tech “new economy.”
The IPO of Netscape Communications in April 1995 is usually pegged as the turning point. At the time the Internet was still in its infancy. For most people, it meant e-mail and perhaps some America Online chat rooms. Netscape’s browser, which the company gave away free, enabled a new generation of websites loaded with photos and snappy typefaces and introduced a generation to what many still called by its formal name, the World Wide Web. For Netscape’s founders, the company was more than just a software business. They were on a mission to “democratize information” via the Internet, and they sold the public on the proposition—literally. The company went public at $28 per share, valuing the start-up at $1.1 billion. Investors who hadn’t been able to buy shares in the IPO itself were so desperate to get a piece of the action that they drove the stock up to $75 on its first day of trading.
To the cash-flow-obsessed private equity mind—and, frankly, under any conventional form of economic analysis—the price was absurd. Netscape had taken in just $16.6 million in revenue in the previous six months and lost $4.3 million in the process. The IPO demonstrated just how hungry investors were for start-ups that promised to remake the world with their technology and prepared the way for a new era of investing. The next year Yahoo!, the web portal and search engine, followed in Netscape’s footsteps, going public at a similar valuation despite revenues of just $1.4 million and a loss of nearly half that.
Make money? That was so old economy. There was no need to do that now. The mere prospect of huge profits down the road was enough to lure the public. Instead of profits, the financial metric became “burn rate”—how much of its backers’ cash a company chewed through every month or year.
However fantastical the stock prices were, a profound technological revolution was in fact under way. Advances in personal computers and access to online information made workers more productive and created new pastimes. That, in turn, drove demand for more telecommunications services, which created a demand for new phone switching equipment and the software to go with it, which allowed more and more information and graphics to be moved across the Internet, in turn spawning the birth of new Internet businesses. Completing the virtuous circle, this led people to want more powerful computers and even faster connections to the Internet.
Private equity firms like Blackstone found themselves looking on from the sidelines of the revolution. The stratospheric profits from the IPOs of companies like Netscape, Yahoo!, Amazon.com, and eBay were flowing into the pockets of entrepreneurs and the venture capitalists who backed them. Those windfalls inevitably had a profound impact on buyout firms—profound and disastrous in some cases.
Venture capital funds share the same legal structures as buyout funds. They are limited partnerships and their sponsors typically collect 1.5 or 2 percent a year as a management fee and 20 percent of investment profits. They tap the same pension funds, endowments, and other institutions for money. But there the similarities end. The programmers, chip makers, biotech researchers, Internet merchants, and the venture capitalists, or VCs, who financed them operated in their own universe, on another coast, playing by their own set of rules.
The epicenter of the U.S. buyout industry is Midtown Manhattan, where Blackstone, KKR, Apollo, Warburg Pincus, and dozens of other firms are headquartered within a few blocks of one another in a world of starched shirts and Hermès ties, chauffeured Mercedes, and office towers. Ground zero of the venture world is Sand Hill Road, a landscaped boulevard rising into the gentle, suburban hills behind Palo Alto, California. There capital flows in a dress-down world of khakis and golf shirts, low-rise office compounds surrounded by groves of live oaks and towering eucalyptuses. Venture capitalists drive themselves to work in Ferraris and Porsches.
The investment styles were as different as the dress codes. Venture investing involves an entirely different type of risk. VCs seed sc
ores of small companies that often have little or no revenue, and many of those that do take in revenue are nonetheless losing money. No bank would lend to these businesses, but they need equity capital for research and to build out their businesses. The VCs know that many of their companies will fizzle but hope that a few will be spectacularly successful. It is a scattershot approach, like tossing apple seeds and hoping a healthy tree or two will spring up. VCs make bets on which entrepreneur will achieve a technological breakthrough first, who can get to market fastest, and whose product will dominate its market—events whose likelihood defies precise projections.
That is a world away from buyouts. If venture investing is a game of long, daring passes, many incomplete, the LBO game is fought a yard at a time on the ground. To be a private equity investor, you need to be a kind of control freak—someone who can patiently map out all the scenarios, good and bad, first to make sure your company won’t go bust and, second, to see how it can be improved incrementally to lift its value. Buyout investing focuses on cash flow because banks won’t lend money, and bond buyers won’t buy bonds, unless they are confident a company will be able to pay its creditors through thick and thin. Private equity investing means burrowing into businesses and performing minutely tuned analyses. Could revenue be boosted a point or two? How much would pass through to the bottom line? What costs could be taken out to notch up the profit margin a fraction? Could we shave a quarter of a point off the interest rate on the debt? If the company has problems, how much of a cushion is there before it defaults? If private equity investors do their job right, things more often than not will play out more or less in line with their projections.
Because venture investments are so much more unpredictable, venture investing requires a degree of passion—a belief in the product and its potential and, very often, in its value to society. Venture capitalists talk of nurturing “disruptive technologies” that will upend existing industries and lay the groundwork for new ones, in the way that diesel locomotives displaced steam engines, personal computers and laser and inkjet printers rendered the typewriter obsolete, and digital photography supplanted film. No amount of number crunching can predict if a new website will capture the public’s imagination or whether a biotech startup’s research will succeed in developing a drug to treat cancer. The payoff comes from seeding dozens of long shots. To sustain the process, the VCs and the entrepreneurs they back have to believe, and during the boom of the 1990s they had that faith in spades. The buyout types, with their dense spreadsheets and elaborately engineered debt structures, never promised to transform the world. They had no religion to offer the investing masses.
The passion for the new technology became contagious in the second half of the 1990s and began to alter the calculus for buyout firms far removed from Silicon Valley, as capital that might have gone to LBO funds began flowing into venture funds. Executives and business school graduates, too, were gravitating to tech companies, hoping to be paid in stock so they could make a fortune when the companies went public.
Blackstone wasn’t equipped to compete on the VCs’ home turf in pure technology plays. But Mark Gallogly, the youngest deal-making partner in the buyout group, succeeded, partly by accident, in riding the Internet wave.
Gallogly was the odd one out among the larger-than-life personalities and egos there. He generated none of the electricity that the brilliant and overbearing David Stockman did. He had a penchant for analysis, but he was not an eccentric mad-scientist number-grinder like James Mossman. Nor could he compete for laughs with the outgoing, wisecracking Howie Lipson. Gallogly, who began his career on the lending side at Manufacturers Hanover bank, was intense, reserved, and soft-spoken. Innately cautious, he retained a loan officer’s fear of risk, measuring his words and agonizing over investments.
Inside the firm, he was seen as a good investor, collegial, and uncommonly concerned about morale. In a firm that was notoriously hard on junior employees, it was Gallogly who hosted summer parties at his house in Rhode Island and organized the annual firm ski outing. He even lobbied once to install a plaque in the lobby inscribed with the name of every young analyst who had ever warmed a cubicle seat at Blackstone. (The proposal went nowhere.)
Gallogly became intrigued by the cable TV industry in the mid-1990s and had his underlings running numbers. At the time, the business was beaten down. Customers were up in arms about rising rates, which politicians and regulators were threatening to rein in, and cable operators, which had long enjoyed monopolies in their territories, suddenly faced a new threat from satellite TV. “They were calling it the death star. Satellite was going to kill cable,” says Blackstone partner Lawrence Guffey, who worked as an associate for Gallogly at the time. Gallogly thought the market had overreacted. Rural cable systems, in particular, looked like prime LBO material, with solid cash flows and very little threat of competition.
The first deal that came to fruition was a classic Blackstone corporate partnership. The cable subsidiary of Time Warner, the media conglomerate, was planning to merge some of its marginal rural cable systems with others run by Bob Fanch, a veteran cable executive whom Gallogly’s team had cultivated. Blackstone already had ties to Time Warner through the Six Flags theme parks investment in 1991 and offered to come to its aid again with the cable subsidiary. Blackstone invested $50 million for a one-half interest in the merged Time Warner–Fanch system, which covered parts of Pennsylvania, West Virginia, Texas, Ohio, and North Carolina. The business then borrowed so that debt could replace some of Time Warner’s equity, allowing Time Warner to take out cash. As a bonus, because it no longer held a controlling stake, Time Warner no longer had to report the system’s debt on its own balance sheet, which was massively leveraged at the time.
Much of the combined network, which was dubbed TW Fanch-One, was antiquated, transmitting as few as thirty channels. The plan was to update it to offer more programming, much of it to be provided by Time Warner at advantageous rates, and convince customers to pay up for more channels.
“In some cases, the systems were quite primitive,” says Gallogly. “We believed the business had real growth potential, both through price and through improved technology. Even if satellite TV took a greater share than we were expecting, the cable business was generating a lot of cash flow and we thought we could do well despite that.”
What happened next was not in the business plan, but it was extraordinarily fortunate.
When the Fanch deal closed in 1996, most people who used the Internet dialed in on their regular phone lines to America Online, CompuServe, or another Internet provider. But as websites developed richer and richer content and it became possible to move images and other large files over the Internet, conventional phone connections were painfully slow and computer users demanded high-speed data hookups. Cable companies, whose video transmission networks already had enormous bandwidth (the capacity to send heavy streams of electronic signals), found they could easily adapt their systems to carry phone calls and Internet traffic. In fact, they could modify their systems to offer high-speed Internet access more easily than traditional phone companies could.
“We didn’t know in 1996 that the Internet was going to be a boom, but we knew that we would be able to benefit from the fact that we’d be one of only two direct lines into the home,” Gallogly says. Offering Internet and phone service was icing on the cake.
Gallogly soon engineered a second deal combining other Time Warner and Fanch systems and invested in two unrelated companies, InterMedia Partners VI and Bresnan Communications, Inc., that were buying stakes in rural cable systems owned by TeleCommunications, Inc., one of Time Warner’s big national cable rivals.
By that point, the cable industry, which had been all but written off only a few years earlier, had become a crucial link in the Internet, and “triple play”—phone, Internet, and cable over the same connection—was the buzz in the telecom industry. The industry had also acquired its own high priest of triple play, Paul Allen, the co
founder of Microsoft Corporation. The billionaire combined the faith of a tech maven with a personal fortune of some $20 billion to back his dream of becoming a cable mogul of the first order. Beginning in 1998, with the purchase of a small cable business, Charter Communications, Allen went on a three-year shopping spree, leveraging Charter to the hilt and shelling out $24.6 billion to buy twenty cable systems. Soon he came knocking on Blackstone’s door.
Blackstone and Time Warner had assumed that Time Warner would one day buy back control of their systems, but in late 1999 Charter dropped a $2.4 billion offer on them for the two TW Fanch operations—an offer the two simply couldn’t refuse. Charter soon bought Blackstone’s InterMedia systems as well, and in February 2000, just a year after Blackstone had invested in Bresnan, Charter snatched that up, too, for $3.1 billion. Convinced that new technology would drive demand for his cutting-edge networks, Allen paid an eye-popping $4,500 per customer for the TW Fanch networks and $4,400 for InterMedia, about twice the price Blackstone had paid just a couple of years earlier.
“Paul Allen seemed to believe at the time that there was a cure for cancer coming down the cable pipeline,” says Simon Lonergan, then an associate who worked with Gallogly on the investments. “We couldn’t believe the prices he was paying for those assets. It was hard to have a rational view that justified paying that amount of money for infrastructure.”