“We used to get up every morning and thank Paul Allen,” says Bret Pearlman, who worked on the InterMedia deal and became a partner in 2000, as Charter was forking over billions to Blackstone. “Hallelujah!”
In fact, the prices did not make a lot of sense: Two years later Charter was near bankruptcy. (It finally succumbed in the next recession, in 2009.) But Allen’s folly was Blackstone’s gain in 2000 and it walked away with $400 million—eight times its original investment—on TW Fanch-One, a bigger multiple of its investment than even UCAR had earned. It hauled in 5.5 times its money, or $747 million, on Bresnan.
On top of the cable deals, Gallogly logged another huge gain on a cell phone operator in Montana, Wyoming, the Dakotas, and Colorado. Like the cable systems, Blackstone was able to pick up CommNet Cellular cheaply in 1998 because its stock price was depressed owing to fears that new competitors would enter its markets. Gallogly was skeptical, calculating that it would not be economical to build new cell networks in CommNet’s sparsely populated territories. In 1999, less than a year and a half after Blackstone completed the purchase, Vodafone AirTouch, an emerging national firm that had bought a cell operator in the Denver area several years earlier, agreed to buy CommNet for $1.4 billion. Blackstone collected a $463 million profit, or 3.6 times its money.
By mid-2000, Blackstone had cashed out of almost all its telecom investments. In the process, Gallogly had brought home $1.5 billion in profit on five deals, making him the firm’s newest star. The successes were sorely needed, too, because the exits came just as the dud deals led by Stockman and Lipson in 1997 and 1998 had begun to founder: The funeral chain Prime Succession/Rose Hills, the wallpaper maker Imperial Home Decor, Premcor, the oil refiner, and steel-rod maker Republic Technologies were all in deep trouble.
Gallogly’s very success created a problem, however. With investors clamoring for ways to invest in communications companies, Gallogly saw a chance to hang out his own shingle, and he told Schwarzman in 1999 that he planned to leave. It was the last thing Schwarzman wanted to hear at the time, for the firm could ill afford the loss of another senior deal maker. Glenn Hutchins, who had been brought in as a partner in 1994, left to form a new firm, Silver Lake Partners, at the end of 1998. Stockman and Anthony Grillo, a partner who had moved over to buyouts from the restructuring team, departed in 1999. Without Gallogly, the buyout group would be down to just two full-time partners, Lipson and Mossman, and Mossman never left his office!
“There was a growing concern over our reputation as a place with a lot of turnover,” Peterson says.
“We hit a fork in the road,” says Schwarzman.
Schwarzman worked on Gallogly first, persuading him to stay by offering to raise a new, specialized fund that would invest only in telecom and media companies and putting Gallogly in charge of it. Gallogly would get pretty much what he wanted but under Blackstone’s banner. For Schwarzman, it kept Gallogly in the fold and allowed the firm to tap into the communications mania without having Blackstone’s main fund put too much money at risk in one sector. The fund-raising, which kicked off in early 2000, went quickly, and Blackstone Communications Partners, known as BCOM, hit its $2 billion target by June of that year.
That still left the buyout ranks worryingly thin, however. Through the fall of 1999, the management committee and the private equity partners debated whether to hire from the outside and which associates to elevate. Ultimately, they decided to gamble on the home-grown talent and promote a big new class of partners.
“There was more risk bringing people in from the outside, where you don’t know exactly how they’ll fit culturally,” Schwarzman says. In January 2000, the firm, which had only twelve partners at the time, expanded those ranks by five: David Blitzer, thirty, Chinh Chu, thirty-three, Larry Guffey, thirty-one, Bret Pearlman, thirty-three, and Neil Simpkins, thirty-three.
There were risks giving more responsibility to such a young crew. “It would require more supervision,” Schwarzman says. “We’d have to work with them more.” To keep an eye on them, Schwarzman recruited Robert Friedman, Blackstone’s lead outside lawyer at Simpson Thacher & Barlett, to join the buyout team to make sure “nothing dropped through the cracks.”
It also wasn’t clear how good the new partners would be at generating business. “The whole corporate partnership model was [to] go out and call on and sit down with a CEO or a board as an equal,” says Simon Lonergan, who was made partner in 2001. That had worked when it was Peterson, Schwarzman, and Stockman who were making the calls. “How do you do that when you’re in your early thirties?”
It was a risk, but Schwarzman and the other partners felt they had no choice.
CHAPTER 14
An Expensive Trip to Germany
In the beginning it had looked like a West Coast fad, the technology boom that shifted into high gear when Netscape, Yahoo!, and the first generation of big Internet companies went public. By the end of the nineties, though, the technology industries, the venture capitalists that supported them, and the religion for which they proselytized had become as disruptive to finance as their new inventions had been to established companies. Microsoft had displaced General Electric as the world’s most valuable company and seven of the top ten were in the computer or telecom industries. Coca-Cola, Toyota, and the oil and pharmaceutical companies—the old economy giants that had dominated the list for years—had been bumped off.
With some venture funds chalking up returns of 100, 200, and even 300 percent a year, the lure of venture investing proved irresistible, and pension funds and endowments began redirecting more money to investment funds that specialized in start-ups and other technology companies. To these investors, venture capital, private equity, and real estate were all in the category of “alternative assets”—alternatives that offered higher returns than their mainstay investments in stocks and bonds.
Venture firms, which had attracted a mere $10 billion in 1995, hauled in more than $59 billion in 1999, nearly the sum for buyout funds that year. More venture capital was raised in 1998 and 1999 than in the entire history of the industry through 1997, and in 2000 venture firms raked in $105 billion, for the first time surpassing buyout funds, which drew only $82 billion. Like a pile of poker chips pushed across the table from loser to winner, mounds of capital were being transferred away from traditional industries and investment firms to the technology and venture mavens—from New York to California.
This rearranged the map of wealth. Nearly one-quarter of the richest Americans were Californians, Forbes reported in 1998. The next year, John Doerr and Vinod Khosla of Kleiner Perkins Caufield & Byers, perhaps the best-known venture firm, were worth $1 billion each—as much as Henry Kravis and George Roberts, and considerably more than other buyout stars such as Teddy Forstman, Tom Lee, and Tom Hicks. Pete Peterson and Steve Schwarzman didn’t even make the Forbes list.
Blackstone couldn’t help but feel the pressure to jump on the bandwagon. Bret Pearlman, who became a partner in 2000, and other younger deal makers were lobbying to invest more in the tech sphere, and junior employees were clamoring to be paid partly in Internet company stocks, the preferred currency of New Economy workers.
The firm was hearing it from some investors, too. When Schwarzman hit the road in 1999 to raise money for Blackstone’s new mezzanine debt fund, which would lend money to midsized businesses, one potential investor who preferred venture funds just scoffed. “I make more money in a month than you make in a year in your mezz fund if things go well,” he told Schwarzman.
“We had enormous pressure here to be doing those deals,” Schwarzman says. “We were viewed as not being modern.”
It was all irksome to Schwarzman, who thought the prices being paid for Internet companies were ridiculous. But with firms like Doerr and Khosla’s reaping stupendous returns selling their tech start-ups in IPOs, it was hard not to be tugged in that direction. “As you got to the 1999 period and into 2000, the amount of money people were making so quickly by putting
capital in venture-type deals and flipping them in IPOs put enormous pressure on the buyout firms to participate in some level in that,” says Schwarzman. “Or else you could lose your people or lose your competitive returns.”
Competing with the VCs wasn’t really an option, though. That took in-depth knowledge of tech industries ranging from semiconductors and software to websites and biotechs—sectors where private equity firms had little if any expertise and few contacts. Moreover, entrepreneurs flocked to the venture firms that had backed the most successful investments. Why would they come to Blackstone, which had no track record and was on the wrong coast? Buyout firms that tried to intrude on the Californian finance turf were likely to get only companies that had been rejected by the top VCs. KKR formed a joint venture with the venture firm Accel, and Carlyle launched venture funds, but they never left a big mark.
Schwarzman threw a bone to the troops by authorizing $7 million of the firm’s own capital to be allocated for technology investments. The investment committee also gave the green light to a string of tech deals by the main buyout fund. Most were ultimately complete write-offs. Fortunately, they were all small. “To Steve’s credit, no matter how many times people said we’re sort of missing the boat here on the Internet, Steve insisted over and over, ‘This is not what we do well,’ ” says Pearlman.
Telecommunications was a different matter, however. Many conventional phone companies and wireless and cable operators made money but needed additional capital. Many were large enough that private equity firms could put hundreds of millions of dollars to work at one company, which was nearly impossible with start-ups. So no sooner had Blackstone cashed out of the cable and cell companies it had bought in 1996 to 1998 than it waded back in, drawing on both its main 1998 fund and the new $2 billion media and telecoms fund that Mark Gallogly oversaw.
This time, though, many of the investments were a far cry from the stable, rural cable and cell systems of the nineties. Some of the new round of deals looked more like speculative venture plays on a grand scale—big bets on start-up businesses where Blackstone took only a minority stake and thus didn’t control the business. And unlike a run-of-the-mill VC deal, these investments tended to be heavily leveraged.
It plowed $227 million into Sirius Satellite Radio, a start-up that was building a satellite broadcasting network, taking just a 9 percent stake. Another $176 million went into three “overbuilder” cable networks that hoped to compete with existing cable operators—ambitious and dicey deals premised on projections that the upstarts could steal away enough customers to pay for the huge build-out costs. “It was definitely a dare-to-be-great sector,” Pearlman allows.
Another $187 million went for a small stake in an Argentine cellphone operator, and Blackstone wrote a $23 million check to a Brazilian online service.
The grandest plan of all the second round of telecom deals, and the first major investment for Gallogly’s new fund, was in Germany. Richard Callahan, a cable executive from Denver whom Gallogly knew, had set up a private equity firm and invested in cable companies in France, Belgium, and Spain. In 1999, he approached Gallogly about backing his firm in a bid to take over two regional cable systems being sold by Germany’s state-owned phone company, Deutsche Telekom. Regulators mandated the divestitures so that new owners could offer phone and Internet service over the cable lines, creating competition for Deutsche Telekom, which had long held a monopoly.
Blackstone had been investing heavily in European real estate for several years, but it did not yet have an office in Europe and was far behind Carlyle, KKR, TPG, and other American private equity firms in penetrating the buyout market there. The Callahan deals, which together were worth $5.2 billion, would be the largest private equity investments to date in Europe and a dramatic debut for Blackstone.
Blackstone and Quebec’s public pension fund, Caisse de Dépôt et Placement du Québec, were the lead investors, with the private equity arm of Bank of America and the Bass family of Texas also writing checks. It was an unusual deal for Blackstone, because it would own just a 14 percent position amid a large consortium of investors, and Callahan’s people would be taking the lead in managing the project. But Caisse de Dépôt and BofA had backed Callahan when he built a cable system from scratch in Spain and they thought highly of David Colley, the British executive who had spearheaded that project and was slated to head up the German business. The physical networks and the customer base were already in place, so it looked like a simpler undertaking than the one in Spain.
“We looked at this and said, ‘Geez. It’s a massive market, there’s only one guy, Deutsche Telekom, offering local telephony. If we upgrade the infrastructure and get a small piece of the phone market,’ ” the payoff could be huge, says Simon Lonergan, the associate who relocated to his native Britain in 2000 and was Blackstone’s liaison to Callahan’s managers.
The two networks, one in North Rhine Westphalia along the central Rhine and the other in Baden-Württemberg, stretching east from the southern Rhine to Stuttgart, covered some of Germany’s densest and most prosperous urban areas. The twin deals were signed in early 2000 and Callahan closed the purchase of the North Rhine network in July 2000, and that of the Baden-Württemberg system the following year. Together, the third buyout fund and the communications fund shelled out $320 million, the second-largest sum Blackstone had ever invested.
Deutsche Telekom’s phone rates were so high that the investors figured they could easily skim off some of its customers. “The basic economics were incredibly attractive,” Lonergan says. “The basic thesis made a lot of sense. The problem was the execution.”
Callahan and Colley planned $1 billion of capital spending the first year, in a race to get the new equipment in place. But the management team that had performed so ably in Spain struggled in Germany. Colley and other senior staff didn’t speak German and commuted from Britain and Spain, arriving Mondays and leaving Fridays. Soon, everything that could go wrong did. There were delays getting the equipment and software running, so the revenue from new services that was supposed to help cover the ongoing upgrade costs didn’t materialize as planned. They also found they were hostage to Deutsche Telekom, which owned the conduits through which the cable wires ran. Callahan’s engineers had problems getting access, and they discovered the hard way that the phone company’s maps of cable paths didn’t always correspond to reality. When they installed their new equipment, they sometimes unwittingly blacked out whole neighborhoods. Once, much of Cologne lost its cable signal during a key soccer match and the company found itself pilloried on the front pages of the local papers.
Nor had Callahan’s people factored in the housing cooperatives that own many big German apartment complexes and control the last leg of the network into tens of thousands of homes. Deutsche Telekom and Callahan relied on the co-ops to collect the phone and cable bills from their tenants, but the co-ops proved lackadaisical about dunning tenants who were in arrears, so revenues fell even further behind budget.
Through late 2001 Colley’s team reported to Blackstone and the other investors that everything was more or less on track, when, in fact, the North Rhine Westphalia system was burning through money at an alarming rate and wasn’t completing enough of the upgrade or selling enough new services to keep pace. Worse still, management didn’t have proper accounting systems in place to monitor how much cash it had.
In early 2002, when the investors began pressing Colley and his people about the cash-flow situation, they couldn’t get an answer. “It was only by going to some of the regular meetings with them and digging into the numbers with them, all of a sudden there was this aha moment—something’s not right here,” says William Obenshain, who oversaw the investment for Bank of America. “Either we were being misled or the management just didn’t have a grip on it.… These [meetings] were very unpleasant.”
When Callahan’s crew finally did succeed in calculating its cash position, the company turned out to have more than a hundred mill
ion euros less than it should have had and was in imminent danger of violating the terms of its loans, which required it to have minimum cash flows and cash levels. Seemingly overnight, a massive investment had veered from on course to crisis. Two years earlier, at the height of the telecom boom, the company probably could have borrowed more money or refinanced its debt so it could complete the upgrade. But in 2002, that was impossible.
Gallogly, Lonergan, Obenshain, and the other investors scrambled to get things under control. Spending was reined in at the Baden-Württemberg company, where the upgrade had only just begun to get under way. But it was too late. Short on cash, the Callahan entities breached the terms of their loans. It was clear the equity was going to be erased, and Blackstone was forced to write off its entire investment at the end of 2002.
When Callahan arrived at Schwarzman’s office to discuss what had happened, he got an earful from Schwarzman. “Where’s my fucking money, you dumb shit?” were the first words out of Schwarzman’s mouth, according to a person with ties to Callahan.
“I was really furious because he was personally working on a lot of other transactions rather than keeping his focus on this particular transaction,” says Schwarzman, who calls it a “chilly meeting.”
“I told him I believed he had failed.”
The loss was most devastating for the new media and telecom fund, because the $159 million it had contributed from its kitty represented more than 70 percent of its invested capital to that point. Two years after it was raised, the fund was in a deep hole and, with the entire telecom industry in a severe slump by 2003, it wasn’t clear how it could dig its way out through new investments.
Callahan was only the biggest failure. Two-thirds of the investments Blackstone made in 2000, at the height of the market, were wipeouts. The write-offs were an object lesson in the dangers of wagering on companies in a frothy market—a lesson that would echo again when the credit markets crashed in 2007 and the economy began spiraling downward.
King of Capital: The Remarkable Rise, Fall, and Rise Again of Steve Schwarzman and Blackstone Page 18
