King of Capital: The Remarkable Rise, Fall, and Rise Again of Steve Schwarzman and Blackstone
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Like Adelphia and Charter, the North Rhine Westphalia and Baden-Württemberg cable businesses were basically healthy. They had simply run out of cash because they had spent too much too quickly to upgrade their networks and hadn’t signed up enough new customers to keep pace. With new management and the costs under control, Blackstone saw a chance to atone for the earlier loss.
Guffey, who had relocated to London in 2002, took over from Mark Gallogly and Simon Lonergan, who had overseen the original German cable investments. The banks hadn’t formally foreclosed, but the businesses were in such grim straits that for all practical purposes they belonged to the banks. Together with its coinvestors from 2000, Quebec’s Caisse de Dépôt and Bank of America, Blackstone approached one of the Baden-Württemberg system’s banks and arranged to buy a big slice of the company’s loans at a meager 19 euro cents on the euro and then bought more in the open market at deep discounts. The investor trio also bought $20 million of debt of the sister company in North Rhine Westphalia in the open market.
The timing was as perfect as it had been disastrous in 2000 and 2001. The private equity firms swapped their debt in the Baden-Württemberg company for equity when the company was restructured, and Blackstone then bought out Caisse de Dépôt and Bank of America’s stakes, giving it a controlling position. Working with a new CEO who had been brought in at the tail end of Callahan’s involvement, they kept new capital spending in sync with revenues. “We slowed it down until the revenue caught up,” Guffey says.
The restructuring cut the company’s debt to manageable levels and the business was soon back on its feet. By 2005 profits were rising and the company was able to borrow money to refinance its debt and pay a huge dividend to Blackstone and other shareholders. By the time Blackstone cashed out its last piece of the two companies in 2006, it had booked a profit of $381 million—three times what it had invested in the second round. That more than made up for the $264 million loss on the original investment. On top of that, the communications fund raked in a $312 million profit on the debt of another troubled German cable firm, Primacom, in which Blackstone had not previously invested. Blackstone also made back some of what it had lost earlier on Sirius, the satellite radio company, by buying its debt on the cheap. The communications fund raised in 2000, whose situation had looked so dire in 2002, had been patched up and was now posting profits.
“We had just raised this $2 billion fund” when the original Callahan deal foundered, Guffey says. “This was 15 percent of the fund and it looked like it would be zero. We were down eight to one in the seventh inning and we turned the game around.”
Adelphia and Charter yielded big windfalls as well. Altogether, Blackstone more than doubled the roughly $800 million it gambled on the distressed debt strategy.
The communication fund for years was the least profitable of all of Blackstone’s funds, with an annual rate of return in the single digits. But thanks to the vulture plays and some later investments, by 2007 it had produced a respectable if not spectacular 17 percent annual return—better than Blackstone’s 1997 fund.
Slowly it became possible, too, to make equity investments again, in many cases as a by-product of the economic strains of the retrenchment.
Across America and Europe corporations had binged on acquisitions in the late nineties, and they were still gripped by indigestion. Many mergers had not panned out, and even those that had worked operationally had often left the buyers overindebted. Many companies needed to sell assets to pay down debt and shore up their balance sheets, but there were few buyers. The markets had no appetite for IPOs, so they couldn’t sell their subsidiaries that way. And the corporate world was generally reluctant to expand through acquisitions after the buying frenzy of the late 1990s. Flush with capital, Blackstone and other private equity firms were among the few buyers, and they began to fill the void.
It took some ingenuity to find deals that could get off the ground, and the first round of new equity investments Blackstone made deviated from the standard LBO model in one way or another.
When Blackstone took a minority stake in Nycomed, a Danish pharmaceutical company, as part of a consortium in October 2002, the buyers put up nearly 40 percent of the price in equity—far higher than the more typical 25 percent or 30 percent. They saw it as a growth play and calculated that the business would expand quickly enough that they could make LBO-level profits even without steep leverage.
Likewise, the financing for the $4.6 billion buyout of TRW Automotive, a parts maker, that autumn was unorthodox. Northrop Grumman, a defense contractor, was acquiring TRW’s parent company, another defense supplier, and needed to off-load the auto subsidiary as quickly as it could to pay down the loans for the main takeover. Blackstone was unwilling to invest more than $500 million of its own, so Neil Simpkins, a young partner who was leading the deal, persuaded Northrop to keep a 45 percent stake while Blackstone tried to recruit other investors after the deal closed. In effect, the seller was offering installment financing for its own asset. Northrop even loaned Blackstone some of the money to buy its 55 percent stake. Still, it was hard to line up the debt needed to cover the balance. (Ultimately other investors joined Blackstone, allowing Northrop to sell down its stake to the 19 percent it wanted to retain.)
In another instance, Blackstone effectively provided financing for a public company to make an acquisition. There PMI Group, a bond insurer, wanted to buy Financial Guaranty Insurance Company, a municipal bond insurer, from General Electric, but PMI’s bond ratings were lower than FGIC’s and an outright purchase would have jeopardized FGIC’s ratings. To insulate FGIC’s credit rating from its new parent’s, Blackstone and Cypress Group, another private equity firm, stepped in and agreed to take 23 percent stakes each so that FGIC was not deemed to be a subsidiary of PMI. The expectation was that PMI would one day be in a position to buy all of FGIC.
Blackstone also made two bets on energy prices. In 2004 it took a flier on a start-up oil and gas exploration company, Kosmos Energy, that planned to drill for oil off the west coast of Africa, and it bought Foundation Coal, the U.S. subsidiary of RAW, a German company that was shedding assets.
In late 2001 and 2002, when the markets were still staggering from the shock of the terrorist attacks, Blackstone managed to put out more than $1 billion of equity from its buyout funds, and put a further $1.5 billion to work in 2003.
Apart from the profits the investments earned Blackstone and its investors, those deals and others by private equity firms during that period injected much-needed capital into companies at a time when the capital markets were shut down. It was Blackstone’s money, for example, that enabled Northrop and PMI to make key acquisitions. The firm helped fund the two start-up insurance companies as well as Kosmos Energy, another new company. In other cases, it bought assets that troubled companies badly needed to unload at a time when there were few other buyers. Its $1.7 billion deal with Bain Capital and Thomas H. Lee Partners to purchase the textbook publisher Houghton Mifflin in 2002, for instance, provided cash to the company’s parent, the French media giant Vivendi, which was near collapse after an ill-considered campaign of takeovers. Another deal, for Ondeo Nalco SA, which made water-treatment products, grew out of a restructuring of its French parent, the utility Suez SA.
It wasn’t just Blackstone that was stepping up when buyers were scarce. Across Europe, the United States, and Canada, private equity firms paid considerable sums for the phone book subsidiaries of big telecoms that had to pare their debt in those years. In Germany, KKR scooped up a grab bag of industrial businesses—a plastic extruding equipment company, a crane maker, and others—that the huge German conglomerate Siemens had acquired just a few years earlier.
The buyers were consummate opportunists, taking advantage of the disarray in the markets and the economic problems of the corporate world for their own and their investors’ benefit. But the billions they invested at the bottom of the market supplied sellers with capital they needed to make it through the
recession and helped set a floor under corporate valuations that had nose-dived. With a wealth of capital at their disposal, private equity firms performed a role the mainstream capital markets had relinquished at the time.
CHAPTER 16
Help Wanted
The upheaval in the markets wasn’t the only challenge facing Schwarzman in the first years of the new millennium. He was also wrestling with a business that had long outgrown its management. No longer was Blackstone the small shop he and Peterson had managed on the fly for the first decade. Between 1996 and 2000 it had doubled to 350 people. In addition to its giant buyout fund, it now had one of the largest real estate investment operations on Wall Street, and it had just raised a new mezzanine fund, which would make loans to midsized businesses. The real estate group was running swanky hotels in London and buying up office towers and warehouses in France and properties in Germany. The firm had finally opened a London office and now hoped to push into private equity across Europe, an expansion that would raise a host of new business, cultural, and legal issues.
Back at home, meanwhile, there were problems. The M&A group had been languishing for years, and the buyout group was down to only two seasoned deal makers, Mark Gallogly, the communications specialist, and Howard Lipson, the veteran generalist, with the eccentric, office-bound James Mossman coordinating deals and rendering judgments.
For all intents and purposes, Schwarzman was senior management, and he was simply spread too thin. “I was working fourteen-hour days and much of Saturdays and Sundays. Ultimately, I would be a bottleneck to the growth of the firm. It became clear to me that I needed some help, and it was clear there was no internal person that was right for that. We talked about that among the partners. It wasn’t a secret,” he says.
Indeed, he was blunt about it with Mossman, Gallogly, and Lipson. “The truth is that none of the three of us were managers by nature,” admits Lipson. “Steve said, ‘Somebody has got to run this thing and I don’t think it’s going to be any of the three of you.’ ”
Resigned to looking outside, in 2000 Schwarzman thought he found the answer in the person of Jimmy Lee, the banker who had financed so many of Blackstone’s deals. Lee was at the very top of his game. After building Chase Manhattan into a top player in M&A finance, he had been named head of investment banking at Chase, and that spring Forbes magazine put him on its cover with the headline “Meet the New Michael Milken.”
Yet within weeks of Lee’s anointment by the magazine, he was pushed aside when Chase absorbed the M&A boutique Beacon Group to fortify its investment banking business. Chase chairman Bill Harrison, Lee’s mentor, put Beacon head Geoffrey Boisi, a onetime Goldman M&A hotshot, in charge of Chase’s investment bank. Harrison asked Lee to stay on as business generator in chief, but the management responsibilities—and the title—were now Boisi’s. Lee’s status, like that of all Chase’s investment bankers, was further clouded when Chase agreed to take over J.P. Morgan that fall. Chase coveted J.P. Morgan’s top-flight M&A and securities business, which would complement Chase’s own strength in lending, and it was anybody’s guess how the inevitable power struggles would play out when the two institutions combined.
Lee’s mastery of the leveraged loan and junk-bond markets, on which Blackstone’s buyout and real estate businesses relied, was unparalleled, and he had an intimate knowledge of Blackstone’s investments. Along the way, he had formed tight relations with its partners. “At the defining moments in Blackstone’s history, it always felt like Jimmy was there with you,” says former Blackstone partner Bret Pearlman, who worked at the firm from 1989 to 2004.
Lee, who had spent his career in far larger, more mature institutions, felt he could contribute immediately. “Most private equity firms had grown up like little, boutiquey law firms,” Lee says. “The partners sat around and said, ‘Let’s do that deal, let’s do this deal.’ There was no structure, no infrastructure, no HR, no risk management. But by the year 2000 they’d been at it for fifteen years and they knew they were ratcheting up their activity level. They were going global. A lot was going on.”
Peterson and Schwarzman offered to give him a substantial stake in Blackstone and to make him vice chairman and the hands-on day-to-day manager of the firm. By November they had hammered out a lengthy agreement, a press release had been drafted, and Lee was ready to make the move. Lee had informed Harrison that he was talking to Blackstone, but Lee told Schwarzman that he wanted to tell Harrison face-to-face that he was taking the Blackstone job before he signed on the dotted line. One day that month, Lee sent word to Harrison that the two of them needed to speak. Harrison broke out of a meeting with the bank’s board of foreign advisers to hear what he had to say.
“I said, ‘Hey, it’s been a great run. I loved it. This is my favorite place in the whole wide world. But this is something I want to do and I’m going to say yes to it,’ ” Lee recounts. “He said, ‘Would you please wait a day and let us circle the wagons and try to talk you out of it?’ ”
Harrison had shunted Lee out of administration, but he wasn’t about to lose one of the keys to Chase’s success if he could help it. Harrison pulled out all the stops, yanking on all the emotional cords. “They gathered together directors and other senior people,” Lee says. “They put me in what I like to call the rubber room, where you take the employee who is about to go away and bombard him with, ‘Oh! I remember you when you were just a kid.’ The old guys play on your loyalty. ‘This is your life, Jimmy Lee.’ ”
It worked. In the end, Lee couldn’t bring himself to jump the Chase ship. That night Lee reached Schwarzman at the Ritz Carlton Hotel in Naples, Florida. Schwarzman took the call on the veranda. “Jimmy said, ‘I just can’t do it. Bill’s asked me to stay. I’ve worked with Bill my whole adult career,’ ” Schwarzman says.
Schwarzman couldn’t believe it. “He was like, ‘Hey! What’s going on? I thought you were going to resign and come back and sign,’ ” Lee recalls. “He said, ‘Is it money? Do you need more money?’ ” Lee told him it wasn’t about money.
“Jimmy’s an exceptionally loyal person,” Schwarzman says now, “both to people and to institutions.” But Schwarzman was acutely disappointed, and he had no other candidates and so, for the time being, he abandoned the hunt for a number two.
The gap at Blackstone remained, however. The demands on Schwarzman only intensified when the firm went back on the fund-raising trail in 2001 and 2002 to sign up investors for its next fund, the $6 billion Blackstone Capital Partners IV. And so in mid-2002, two years after the go-around with Lee, Schwarzman set out again to see if he could find the right person. An executive recruiter, Tom Neff, suggested he meet Tony James, who had headed Credit Suisse First Boston’s investment bank and alternative assets groups. Schwarzman and James had faced off over the CNW buyout back in 1989, when Donaldson, Lufkin & Jenrette, where James worked at the time, and Blackstone clashed over the bond financing, but their paths had not crossed since.
On paper, James had all the right qualifications. He had been a superstar at DLJ. Just seven years out of business school, in 1982, he was made head of the bank’s M&A group—the same position Schwarzman attained at Lehman Brothers around the same time. Three years after that, James founded DLJ Merchant Banking, which mobilized DLJ’s investment bankers to spot companies in which the bank could invest its own money. In the nineties, DLJ Merchant Banking raised money from outside investors for a succession of funds that were only slightly smaller than Blackstone’s own. Along the way, James, who oversaw the investments closely until the late 1990s, put up some of the best numbers in the business. When Schwarzman reached out to him in 2002, investors in DLJ’s $1 billion 1992 fund had earned an average annual return after DLJ’s fees of more than 70 percent—an astronomical rate of return to sustain over such a long period. That was roughly twice the very respectable 34 percent Blackstone’s 1993 fund had posted over the same span.
As a manager, too, James had excelled, rising to head all of DLJ’s in
vestment banking operations in 1995. Though there were a couple of tiers of management above him, he was seen by many inside and outside the firm as DLJ’s de facto head and the driving force behind the bank’s transformation from a scrappy research boutique into a major player on Wall Street. “He wasn’t running the firm,” but he was “probably the most important person … to get the business from here to there,” says Sabin Streeter, a former DLJ banker who is godfather to one of James’s children. “Tony was the most valuable person who ever put on his suit at DLJ.”
“He was brilliant at DLJ,” says another banker who worked there in the 1990s. “He ran the investment committee, and DLJ [Merchant Banking] was dominated by him in those periods when he ran it.” James was always seen as “the smartest guy in the room,” this person says.
When Drexel Burnham Lambert imploded in 1990, James had swooped in to snare many of its top bankers, including Ken Moelis, an M&A star, and Bennett Goodman, a trader who helped DLJ build a high-yield debt group. Under James, DLJ added a restructuring advisory unit, a mezzanine lending arm, a fund-of-funds group, and even a modest real estate investment unit—a stable of businesses very similar to the one Schwarzman and Peterson had assembled.
In his pièce de résistance, James helped engineer the merger of DLJ into Credit Suisse First Boston in 2000. CSFB’s Swiss parent, Credit Suisse, paid $11.5 billion, hoping to catapult its second-tier U.S. investment bank into the top ranks by capturing DLJ’s bankers and clients. James was made cohead of CSFB’s investment bank and its alternative assets business. By 2002, however, things had turned sour at CSFB. The entire investment banking world, which had fed on the M&A and IPO boom of the late 1990s, was in retreat. Banks were losing money hand over fist and were laying off thousands of bankers. CSFB had greatly overpaid for DLJ at the top of the market, and many of DLJ’s biggest rainmakers, who had pocketed millions from the sale of their DLJ shares, had left soon after the merger. Some at CSFB blamed James for inducing CSFB to pay so much and then letting the talent slip away. When a new CEO, John Mack, was brought in after CSFB had a series of run-ins with regulators, he bumped James upstairs to a newly created position of chairman of global investment banking, where no one reported to him, and installed a new investment banking chief. James hadn’t actually been sacked, as so many bankers were in that period. It was, in the words of a DLJ colleague, “death with dignity.”