Most of the other mistakes were small, but not all. In addition to the Callahan setbacks, the Argentine cell operator CTI Holdings cost Blackstone $185 million and two companies that aimed to build new cable systems from scratch, Utilicom Networks and Knology, were complete losses. So was the investment in Sirius, the satellite radio company.
“The pain we took [on the investments of 2000] was a real turning point,” says David Blitzer, who had joined Blackstone out of college not long after the disastrous collapse of the Edgcomb investment and become a partner in 2000, just as the firm again was about to stumble badly. “Losing money again was really a jolt to the system. How could we let this happen? What did we do wrong?” It was a time of “real soul-searching,” he says.
Blackstone was hardly alone. The losses it suffered in 2001 and 2002 came as the technology and telecom bubbles were pricked, and air hissed out of the entire stock market. European stocks topped out in the winter of 1999 and 2000. In the United States, the IPO market cooled off in early 2000. The technology-heavy Nasdaq stock index crested in April 2000, at five times its 1995 level. The broader S&P 500 index, which had tripled in five years, inched up until that August. From there it was all downhill.
The skepticism that had poured cold water on the IPO market that spring spread to junk bonds. New issues were down by three-quarters in the spring of 2000 from their peak two years earlier. Across all the capital markets, worries grew that the economy might slow and that the miracle markets of the past five years might be coming to an end, just as they had at the end of the 1980s after a long run-up. Investors no longer wanted to roll the dice on profitless start-ups, and they didn’t want to lend to highly leveraged companies whose cash flows might evaporate if the economy slowed.
The downturn was most catastrophic for tech companies and their investors, but buyout firms—particularly those that had forged deeply into telecoms—soon began to take their lumps. The dare-to-be-great telecom build-outs that Blackstone and others had funded began to totter and collapse, victims of both the buyout firms’ overoptimistic projections and the slumping stock and debt markets, which made it impossible to raise new money if the projects hit a snag.
As stinging as Blackstone’s losses were, they paled by comparison to the debacles of some competitors. At Hicks Muse Tate & Furst, the Texas firm that grew to be a major player in the later years of the nineties, well over $2 billion of its investors’ money was incinerated in eleven disastrous deals over three years, mostly in telecoms.
Ted Forstmann, who had railed publicly against the risks KKR and others were taking with leverage in the 1980s, proved to be one of the most reckless gamblers of the nineties, plunking $2.5 billion—much of his funding—into just two companies, XO Communications and McLeodUSA, which were building phone, cable, and Internet networks to compete with the Bell phone companies. Forstmann Little lost it all when both had to be restructured in 2002.
Welsh Carson, J.P. Morgan Partners, DLJ Merchant Banking, Madison Dearborn—some of the best names in the business—watched as one telecom investment of theirs after another cratered. Many found it harder to raise their next funds and were knocked down a peg or two in the pecking order. Forstmann’s and Hicks’s losses put their firms near death’s door. Forstmann Little made only two significant investments after 2000 and slowly sold off old holdings. Exacerbating its woes, the state of Connecticut, which had invested in Forstmann’s fund, sued in February 2002, claiming the firm had breached its agreements with investors by putting so much of its capital into just two risky investments. Ted Forstmann found himself on the witness stand in 2004, where he was grilled publicly about the calamitous decisions. (In a quirky outcome, the jury found that the firm had violated its investment contract but awarded no damages.)
When Tom Hicks tried to raise a new fund in 2000 to match his $4.1 billion pool of 1998, his investors balked. Most weren’t convinced the firm deserved a second chance, and in 2002 it had to settle for $1.6 billion. In 2004, Tom Hicks announced that he plans to retire. The firm’s London team, which had a good track record, split off in 2005. The remaining U.S. organization renamed itself HM Capital Partners and regrouped, focusing on smaller deals.
The carnage extended far beyond telecoms. In one of the biggest crack-ups, the $1.4 billion buyout in 1996 of the bowling equipment and bowling lane operator AMF Bowling Worldwide proved to be a $560 million gutter ball for Goldman Sach’s private equity group, which had led the deal. Blackstone, which tagged along for the ride with a minority investment, lost $73.5 million of its money. Meanwhile, KKR, Hicks Muse Tate & Furst, and DLJ kissed good-bye to more than $1 billion in the Regal Cinemas chain.
Sixty-two major private equity–backed companies went bust in 2001, vaporizing $12 billion of equity by one tally. Another forty-six failed in the first half of 2002, wiping out a further $7.6 billion, and there were many more, smaller deals that never came onto the public radar.
By the end of 2000, virtually no LBOs were being done in the United States. Then came the terrorist attacks of September 11, 2001, and the stock and debt markets, which had been sputtering for a year, had the final wind knocked out of them. With the public afraid to fly, airlines and the rest of the travel industry saw business dry up, setting off a domino-like line of bankruptcies, from the airlines themselves to Samsonite, the luggage maker, which was part owned by Apollo. Blackstone narrowly escaped losing one of its real estate jewels, the Savoy Group, which owned four of the poshest hotels in London. One day, no guests checked into Claridge’s, perhaps the most exclusive hostelry in the city.
The mood was grim. With the World Trade Center ruins smoldering for five months after the attacks, people wondered out loud if New York would survive as a world financial center. As time went by, the slowdown took a growing toll on leveraged companies. By 2002, the default rate on junk bonds had shot to 13 percent. By September 2002 the broad S&P 500 index of U.S. stocks had fallen by almost half from its peak two years earlier, and the Nasdaq was 75 percent off its high.
Confidence was further sapped by corporate scandals. In December 2001 Enron Corporation, a pipeline operator and energy trading firm that had been a darling of Wall Street, imploded after it was revealed that the company had concealed billions of dollars of liabilities. WorldCom, a giant telecom that had grown through acquisitions to become AT&T’s chief competitor in long-distance phone service, filed for bankruptcy in July 2002 after its books, too, turned out to be cooked. Adelphi Communications, a big cable operator, also went bust after disclosing that it had kept secret several billion dollars of loan guarantees to its controlling shareholders, the Riga family. When the U.S. government indicted the global accounting firm Arthur Andersen, which had audited both Enron and WorldCom, for destroying Enron documents, that only reinforced the growing suspicion that corporate financial statements meant nothing.
The downturn was a boon to Blackstone’s restructuring and M&A groups, which won key roles in Enron’s bankruptcy—one of the largest and most complex reorganizations ever. Arthur Newman’s team was also tapped by Delta Airlines, whose bankruptcy was complicated by contentious labor relations, and by Global Crossing, one of the highest-flying international telecoms of the 1990s. But for the second time in a decade, Blackstone’s LBO business was cast into limbo. It was virtually impossible to obtain financing and sellers couldn’t accept that values had fallen. Big buyouts continued to be done in Europe, where the credit markets were healthier, and LBO activity there surpassed that of the United States from 2001 to 2003, but because Blackstone had been slow to focus on Europe, the opportunities went to its American competitors and big British buyout firms such as Apax Partners, BC Partners, CVC Capital Partners, Cinven, and Permira, which had the networks of connections and strong records there.
From the summer of 2000, Blackstone went nearly two years without closing a conventional buyout. After the Callahan projects in Germany in 2000, it was four years before Blackstone’s communications fund invested in the equity of a
nother company.
CHAPTER 15
Ahead of the Curve
While the stock and debt markets were still sliding in late 2001 and 2002, it was nearly impossible to pull off a buyout. Companies were still struggling and cash flows were tanking, so financing one was an ordeal. But Blackstone was sitting on billions it had raised in better times. Going into 2001, it still had more than $1 billion left from its $4 billion 1997 fund, as well as nearly all of the communication fund’s $2 billion, and it was gearing up to raise a fourth generalist fund. Sooner or later it would have to deploy this money. It could wait until the credit markets recovered, or it could find alternatives to the classic leveraged buyout. The strategy that unfolded revealed a truth about private equity that is seldom observed by those outside the financial world: It is defined more by opportunism than by the conventional LBO. Other things being equal, buyouts are the norm. But things were anything but equal in 2001 and 2002.
In a rising market, leveraging equity with debt produces supercharged returns by amplifying any gain in the value of the equity. In troubled times, however, it can pay to invest instead at other levels of a corporation’s capital structure, or to make unleveraged equity investments. Relatively low-risk senior debt of a company may pay as much as 15 percent—not too far short of the 20-percent-plus returns buyout firms typically aim for. Riskier, more junior debt may pay even more and may be swapped for equity down the road. When stock and bond markets fall, that’s another way of saying that the price of capital has risen: Investors demand higher returns because they perceive more risk, and companies have to offer more stock to raise the same amount of new equity capital and must pay higher interest rates to borrow. When the world at large is preoccupied with what can go wrong and afraid to stake money, those brave enough to invest can exact a very high price. Blackstone’s deal making in 2001 and 2002 reflected that fact of economic life.
The events of September 11, 2001, provided a case in point. One of the collateral casualties of the terrorist attacks was the insurance industry, which found itself staring at billions of dollars of unexpected claims not only from those hurt directly at the World Trade Center, but also from business interruption and other commercial policies covering companies far removed from New York and Washington. Overnight, capital reserves that had been built up over years as a cushion against losses were exhausted. Reinsurance companies, which protect other insurers against freak and catastrophic claims, were hit particularly hard because the attacks were so far outside any actuarial predictions, and the damage penetrated beyond the original insurers’ coverage up into the reinsurers’. Because insurance companies are required by law to maintain reserves to back the policies they write, the losses forced many insurers to curtail business, writing fewer new policies. That sent premiums skyward.
Private equity firms pounced on the opportunity, pouring money into the sector—KKR, Hellman & Friedman, TPG, and Warburg Pincus, to name just a few. Rather than invest in existing companies that still had big claims to work off, however, they set up new reinsurers with clean balance sheets that now would face little competition from existing, wounded companies.
Two months after the terrorist attacks, Blackstone plowed $201 million into Axis Capital, a new reinsurer it formed with four other private equity firms. The next June it invested $268 million alongside the London buyout firm Candover Investments and others to form another new reinsurer, Aspen Insurance, around assets that a troubled London reinsurer, Wellington Re, was forced to sell. These were 100 percent equity investments in start-ups without leverage. In a crippled industry, they had the potential to match the returns Blackstone expected on LBOs in good times because the new players would be abnormally profitable.
At the time, it looked like “probably a three-year opportunity,” says Schwarzman. After that, more capital would flow into the industry, boosting competition, driving down premiums, and causing returns to fall back to historical levels. “We would not make an amazing return, by the nature of the industry, but you could make twenty-one or twenty-two or twenty-three percent a year for a few years.” Ultimately, Blackstone made a 30.2 percent annual return on Axis. Aspen might have matched that but it suffered big losses from Hurricane Katrina in 2005, so Blackstone ultimately earned only a 15 percent return.
In mid-2002, with the stock markets still falling, Blackstone veered even further from its customary investment formulae, detouring into vulture debt investing, a treacherous new territory where it had ventured only a few times before, such as when it bought debt of the shopping mall owner DeBartolo in 1993 and Cadillac Fairview, the Canadian property developer, in 1995.
Vultures, in financial jargon, are investors who scavenge bankrupt or distressed companies, buying up their loans or bonds. Investing in distressed debt entails many of the same analyses as an LBO—figuring out the value of a company’s assets and whether it generates enough cash to cover its debt. But when a company is going down the drain, it’s much trickier to estimate how much value will be salvaged and how much value creditors will come away with.
Under corporate law, creditors are ranked in a hierarchy that determines who gets what if the company becomes insolvent. At the top are banks, whose so-called senior loans are secured by the company’s assets. They are followed by bondholders, suppliers, and employees. Shareholders stand at the back of the line, getting nothing unless the creditors are all paid off. When the company’s assets are tallied up or sold off, creditors at the top of the ladder may be paid in full while those at the bottom may get little or nothing. In between, some creditors may be only partly paid off. Those groups often get to swap their debt for an ownership stake when the business is restructured, which gives them a chance to recoup their losses.
There are several ways to make money as a vulture, all risky. Some play the distress discount. For example, if a bond pays 10 percent interest on its face value and it’s selling for 67 cents on the dollar because it might go into default, the buyer earns a 15 percent return on its investment; the effective interest rate is 50 percent higher than the nominal rate because of the discounted price. That alone might attract some investors. If the bond doesn’t default and pays off in full at maturity, they also stand to collect the full $1 in principal and score a 50 percent gain on their 67-cent investment. The investor may not have to wait until maturity to cash in if the company’s fortunes improve, because the bond’s market price will rise and the investor can sell out at a gain.
Alternatively, you can gamble on layers of the company’s debt that may not be paid off in full but which are likely to be exchanged for equity when the business is restructured. This, however, is a game only for the bold, because the payoff hinges not only on the legal position of the debt, but on the performance of a troubled business and the volatile market for distressed debt. Restructurings and Chapter 11 reorganizations often spawn bitter disputes among creditors about who will be paid how much and who will get what when the company emerges from bankruptcy—battles that can drag out the rehabilitation of the company. No matter how many numbers you crunch through a spreadsheet, the payoff for any individual class of debt is hard to predict.
“When you look at distressed deals, you have to think very differently,” says Blackstone partner Chinh Chu. “The negotiations are much more complicated because you’re playing three-dimensional chess with the creditors, the equity holders—many tranches of creditors.”
With few LBO options on the horizon, though, Blackstone was ready to gamble. “We’re value investors and we’re pretty agnostic as to where we appear in the capital structure,” Schwarzman says. “In 2002 it became pretty clear that subordinated debt in a whole variety of companies was a terrific place to be.” In other words, buying distressed bonds on the cheap was as good as buying equity if you could turn a profit that way.
Blackstone tested its new strategy first on Adelphia Communications, the cable company that filed for bankruptcy in 2002 after admitting that it had fudged its books to conceal l
iabilities. Mark Gallogly, whose team had been steeped in the cable industry since the mid-1990s, understood the business and was comfortable betting on Adelphia’s debt. Art Newman, the head of Blackstone’s restructuring advisers, was called in to help strategize. “These guys knew the assets very well, and I understood the bankruptcy process,” says Newman.
In the secondary market, Blackstone bought up a sizable portion of Adelphia’s debt and won a seat on the creditors committee in the bankruptcy, where the firm pressed for a sale of the company.
A few months later, in September 2002, Blackstone began buying up debt of Charter Communications, Microsoft cofounder Paul Allen’s cable giant, which had mortgaged itself to the hilt to buy cable systems at outlandish prices, including Blackstone’s TW Fanch, Bresnan, and InterMedia holdings. In both cases, the underlying businesses were fundamentally sound. They simply carried too much debt, and that would be reduced in a restructuring.
“At that point, cable looked relatively well protected,” says Schwarzman. “Its systems were built out. Its systems were difficult to replicate. Customers liked watching television, and many of the new entrants that had tried to challenge cable had gone bankrupt.”
Blackstone splashed out a hefty $516 million from both the 1997 and communications funds for Adelphia and Charter debt. It was a massive bet, and for a while it looked like the investment had been badly mistimed. As Schwarzman looked on, the trading prices of the debt fell, recalls Larry Guffey, a young partner at the time who worked on the trades. “We were underwater. Painfully—particularly when Steve’s calling you and asking you why it’s underwater, which I remember very well.”
It still wasn’t clear if the Adelphia and Charter wagers would pay off in mid-2003 when Blackstone began weighing a third big investment in distressed cable debt. This one would be equally risky but also held the promise of redemption, for the companies in question were the two Callahan systems in Germany that Blackstone had written off just months earlier.
King of Capital: The Remarkable Rise, Fall, and Rise Again of Steve Schwarzman and Blackstone Page 19
