By then Chinh Chu, the firm’s chemicals industry guru, had shifted his focus to pharmaceuticals and medical devices, where demand tends to be more steady across the business cycle. For the same reason, Neil Simpkins, who specialized in industrial companies like the auto-parts maker TRW, was spending his time scoping out health services businesses, which had the same characteristics. Food looked like a safe bet, too. Prakash Melwani, who had worked on three highly cyclical energy investments in 2004, oversaw the purchase of Pinnacle Foods, the parent of Duncan Hines cake mixes and Mrs. Butterworth’s syrup, and in London, David Blitzer led buyouts of the British cookie maker United Biscuits and the soft-drink bottler Orangina.
But the temptation for Blackstone to grab what it could while the money was flowing so freely was hard to resist, and Blackstone continued to take part in fiercely contested auctions where prices ran up. The buyout group’s biggest deal in 2006, negotiated in a torrent of bids and counterbids for two companies, was one that would have been unthinkable in a tighter credit market. It would later be seen as a case of reaching too far.
It began in May 2006 when Paul “Chip” Schorr IV approached Freescale Semiconductor, Inc., about going private. Schorr had joined Blackstone as a partner the year before from the private equity arm of Citigroup, where he led technology buyouts. For several years at Citi, he had cultivated the management of Freescale and its former parent, Motorola Corporation. Schorr had offered to invest in Freescale before Motorola spun it off as an independent company in 2004, and in late 2005, shortly after moving to Blackstone, he had discussed the possibility of investing in Freescale to help finance an acquisition. In May 2006, with the capital of Blackstone behind him, Schorr was prepared to buy the company outright and he approached Freescale’s chairman and CEO, Michel Mayer, about doing so.
Freescale agreed to let Schorr’s team look at confidential business information to size up the company. No sooner had they begun to burrow into the business, however, than the Dutch company Philips Electronics announced that it planned to sell its semiconductor business, known as NXP, complicating the choices for Schorr. The two companies were similar. Like Freescale, NXP made a range of chips used in everything from cars to cell phones, and NXP and Freescale executives had even explored a merger. Schorr let the Philips bankers know that Blackstone was interested in NXP, and the firm teamed up with TPG and London’s Permira for a bid. It could buy one or the other or, conceivably, both.
Like many subsidiaries of big European companies, NXP seemed ripe for restructuring, and other buyout firms, too, soon flocked to Philips’s headquarters in Eindhoven in the Netherlands to scope out the operation. Many of the bidders had been allies in the SunGard buyout earlier that year but were now competitors in the NXP auction. The Blackstone group found itself pitted against two other consortiums, one made up of KKR and Silver Lake (both in SunGard) and the Dutch buyout firm AlpInvest, and a second consisting of Bain Capital (also in SunGard), London’s Apax Partners, and Francisco Partners.
No one else—not even Blackstone’s bidding partners in NXP, TPG and Permira—knew that Blackstone was wooing Freescale at the same time as NXP. “We were working Freescale alone and we were not allowed to tell anyone we were doing it,” Schorr recounts. “We’d be in Eindhoven looking at NXP and then we’d have to fly down to Austin for Freescale meetings, but we couldn’t tell our partners.” Not only was Schorr evaluating each company on its own, but also what synergies there might be if they merged.
It would have been a stretch to buy both, though, and in the summer, when it appeared that the Blackstone group was in the lead to win NXP, Blackstone slowed down work on Freescale. “We went a little cold on Freescale in July,” says Schorr. “We had kind of a three-week walk in the woods.” When KKR and Silver Lake ultimately prevailed in the NXP auction with a $10.6 billion bid on August 3, Schorr threw himself back into Freescale again.
Blackstone told Freescale initially that it expected to offer $35.50 to $37 a share, but Freescale held out for more, and over the course of August Blackstone inched up its offer until the two sides agreed on $38. Blackstone would need more than $7 billion of equity to pull off the buyout—more than one firm could afford to risk on a single deal—so on August 31, Freescale gave Blackstone permission to reach out to TPG and Permira, its partners in the NXP bid. It also approached Carlyle, another SunGard backer, which quickly signed up as well.
Blackstone’s and Freescale’s bankers and lawyers were hammering out the final details when they were blindsided. Out of the blue, KKR wrote Freescale on September 7 to say it had gotten wind of the Blackstone talks and wanted to make its own bid. Three days later it told Freescale’s board it expected to make an offer with Silver Lake of $40 to $42 a share, well above Blackstone’s offer, which hadn’t yet been revealed publicly.
“It was a completely proprietary deal until the eleventh hour, fifty-ninth minute, fifty-ninth-and-a-half second, when they threw in this letter over the transom on the evening we were supposed to sign the contract,” Schorr says. “It was pretty audacious because they were in the middle of buying NXP. The combined equity [for] the deals was $12 billion.”
Schorr and his team knew that many duplicate costs could be squeezed out if NXP and Freescale merged. They had run those calculations a few months earlier. In theory, then, KKR could afford to pay more for Freescale than Blackstone could because KKR could capture those savings if it owned both companies. But Blackstone had a four-month head start understanding Freescale’s business, an advantage it would have to preserve if it hoped to prevail.
“We were prepared to sign a contract. They were not,” says Schwarzman. “If we gave them sufficient time, they’d see the same kind of synergies that we thought existed because we had almost bought NXP.”
Blackstone needed to preempt a bidding war. To do that, it huddled with Carlyle, Permira, and TPG and quickly countered with a $40 per share offer on September 14. It was less than the upper range of KKR’s bid, but it was a firm offer.
Blackstone also played hardball. It vowed to walk away if Freescale didn’t respond by the following night. It further put the screws to Freescale with what amounted to a threat. By now there had been leaks in the press and Freescale had been forced to confirm that it was in talks. Blackstone told Freescale that if it bowed out and Freescale didn’t disclose publicly that it had, Blackstone might do so itself. In other words: Take our deal or you’ll be left with a nonbinding offer from KKR, and we’ll let KKR know that we’re not in the running anymore.
The tactics worked. On September 15, Freescale’s board opted for the bird in hand, accepting the $18.8 billion offer from Blackstone, Carlyle, Permira, and TPG rather than gamble that KKR and Silver Lake would eventually make a better offer. The next day KKR said it was no longer interested, and no one else emerged to trump Blackstone’s offer.
Schorr had captured the company he had been pursuing for four months, but KKR’s last-minute spoiler bid had cost the Blackstone consortium an extra $800 million. It was a steep price to pay for a semiconductor business that was notorious for its ups and downs, and Freescale had some worrisome problems. Cell phone chips sales for Motorola accounted for 20 percent of its revenue, but sales of Motorola’s wildly popular Razr model were cresting as competitors began to steal market share with snazzier models, and Motorola didn’t have any big product innovations in the pipeline. Freescale was also exposed to the vicissitudes of the auto industry, which provided another 30 percent of its sales.
In ordinary times, those vulnerabilities would have made Freescale an unlikely LBO candidate. But the Blackstone consortium put an unusually large amount of equity into the buyout, $7.1 billion, or 38 percent of the price, so that Freescale would have a large cash reserve as a cushion. Blackstone’s lenders, Credit Suisse and Citigroup, took care of the rest with extraordinarily liberal financing terms. Virtually none of Freescale’s debt was due until six years out, and much of it didn’t mature until even later. Moreover, the debt had no c
ovenants to speak of. Even if Freescale’s business deteriorated badly, the lenders had few rights unless Freescale actually stopped making debt payments.
To give the company yet more breathing room, the banks also recycled a trick from the 1980s and included payment-in-kind notes, or PIKs. A popular type of bond in the Drexel era, they paid interest not with cash but with more bonds. In other words, the company could take on more debt instead of paying cash to its creditors. In an added, company-friendly feature, these notes had a “toggle”: Freescale could pay in cash or with more notes as it wished. If sales plunged, Freescale could exercise the PIK option to conserve cash.
For Blackstone, the fine print of the financing made the investment a safe bet.
“Semiconductors, you knew, was cyclical—incredibly cyclical,” says James. “We knew we were buying nearer the peak than the trough, so we built a capital structure with no covenants, long maturities, tons of liquidity. We said, it’s going to be a wild ride, but the long-term trends for the industry were positive as electronics permeate everything. You’re going to have your down cycles, but you’ll have some great up cycles, too, so build yourself a bulletproof capital structure so you can ride through any down cycle and then harvest in the up cycle.”
Even with the hefty equity investment, Freescale’s balance sheet was torn up and rewritten, its debt load ballooning from $832 million before the buyout to $9.4 billion. It would now pay close to $800 million a year in interest, about ten times more than it had before.
Blackstone stretched and won Freescale, but in the ensuing months it just couldn’t stretch far enough to win other bidding contests. In virtually every major auction over the next year, it was trounced, often by a wide margin. “It was frustrating sometimes,” says Chinh Chu, “looking in the mirror with a little self-doubt when we didn’t have resolve.”
One of the most frustrating cases was Clear Channel Communications, a deal that became a poster child for the excesses of the decade. Blackstone lost the deal despite having nearly a two-month jump on the competition.
In late August, as Schorr was still haggling with Freescale over price, Blackstone partner David Tolley began talking to Clear Channel, one of the nation’s largest radio chains and a major billboard owner. Tolley and Blackstone’s partner on the bid, Providence Equity Partners, which invests primarily in media and communications companies, managed to keep those talks a secret until October, when Thomas H. Lee Partners crashed the party, approaching the company. Soon, Clear Channel’s bankers began conducting a full-fledged auction.
The situation quickly escalated into the buyout equivalent of a swingers party, with two of Blackstone’s coinvestors from Freescale and SunGard—TPG and Carlyle—switching partners to compete against Blackstone while the ink was barely dry on the Freescale agreement. First, TPG paired up with Thomas H. Lee Partners and Bain Capital. Then Carlyle partnered with Apollo on a third bid. If that weren’t promiscuous enough, KKR, which beat out Blackstone for NXP and tried to grab Freescale, was an on-again, off-again ally this time, twice joining and then pulling out of the Blackstone–Providence consortium. Cerberus Capital Management and Oak Hill Partners, which had no part in Freescale or SunGard, also joined the fray.
When the final round of bidding came in November, Blackstone’s $36.85-per-share offer fell short of Bain and Thomas H. Lee’s $37.60. (TPG dropped out along the way.) “The banks were offering us ten times debt to cash flow,” says James. “No company can support that kind of debt. We wouldn’t take all the leverage because it didn’t make economic sense and, as a result, didn’t get to the price the board wanted.”
In its scale and its reed-thin equity base, Clear Channel was a high watermark, testimony to the extraordinary lengths to which lenders were willing to go. Bain and Lee’s agreement called for them to put up just $4 billion of equity while a sprawling syndicate of banks—Citigroup, Deutsche Bank, Morgan Stanley, Credit Suisse, Royal Bank of Scotland, and Wachovia Corporation—agreed to supply $21.5 billion of debt. The buyers would put up a mere 16 percent of the price in equity.
After a group of hedge funds and mutual funds that owned Clear Channel shares complained that $37.60 a share was too little and threatened to vote down the offer, Bain and Thomas H. Lee upped their offer to $39 a share in April 2007 and then, when that still looked like it might not be enough, to $39.20 the next month. When the details of the financing for the revised offer were revealed, it turned out that the buyers had actually reduced their equity investment from $4 billion to $3.4 billion and the banks had offered an extra $1 billion in debt to make up the difference and top up the offer. Clear Channel’s long-term debt would go from $5.2 billion to $18.9 billion after the closing, and it would spend $900 million annually on interest payments.
Similar scenarios played out time and time again that fall and into 2007, with Blackstone’s bids falling short of rivals’. It lost the electronic transaction processor First Data Corporation to KKR, which offered $34 a share, or $29 billion, versus Blackstone’s $30 a share. The cell phone carrier Alltel went to TPG and Goldman Sachs for $71.50 per share, or $27.5 billion. Blackstone had proposed $67 to $70 a share.
Bain and Clayton Dubilier won Home Depot Supply, the wholesale arm of the building supplies giant, with a $10.3 billion bid, roughly a billion more than Blackstone had offered. Textbook publisher Thompson Learning. Commercial caterer U.S. Foodservice. British food distributor Brake Brothers. Blackstone was outbid on them all.
“We lost seven out of eight in a row in early 2007,” remembers Prakash Melwani, who sits on Blackstone’s investment committee. “We kept losing by miles. It was very depressing.”
Blackstone outspent rivals like KKR and Apollo in 2006, writing equity checks totaling more than $7.5 billion for Freescale and other big buyouts that closed earlier in the year, such as VNU NV (later known as Nielsen Company), Biomet, and Michaels Stores, and it plunked down nearly as much in 2007, $6.3 billion. Equity Office Properties and Hilton and other deals soaked up another $8.2 billion from the firm’s real estate funds that year.
For all the calculations and worries about the markets heading out of control, there was an irreducible human factor at work—the ambition and competitive drive of Blackstone’s partners.
“It’s very hard when everyone around you is bidding on things and buying a lot of things to stick to your guns and say, ‘No, no, I think it’s overpaying,’ ” says James. “Your people start pushing back. They’re deal people; they want to do deals. We allowed ourselves—the pull pressures from our own people and the push pressures from the market—to be dragged along. We had the brakes on but the car was still being pushed.”
The brakes took hold firmly in the buyout group only in late 2006. After playing lead roles in four of the twenty-five largest buyouts that year, Blackstone’s buyout team had a hand in just one of the top twenty-five in 2007, Hilton Hotel Corporation, and that deal was spearheaded by Jonathan Gray and the real estate operation. As the market was hitting its highs, it was Gray’s group that would lead the two biggest buyouts Blackstone ever attempted.
CHAPTER 21
Office Party
You should buy EOP,” Jordan Kaplan casually told Jonathan Gray, the young cohead of Blackstone’s real estate operations. If Blackstone acquired Equity Office Properties Trust, the nation’s biggest office property company, Kaplan went on, his company would be happy to buy EOP’s West Los Angeles buildings from Blackstone.
It was an offhand remark but a tantalizing thought for Gray. It was October 23, 2006, and Kaplan, the CEO of Douglas Emmett, Inc., a Los Angeles–based real estate investment trust, had stopped by Blackstone’s offices with Roy March, a top commercial real estate banker. Unbeknownst to Kaplan and March, Gray had been mulling a bid for EOP for more than a year.
Gray deflected Kaplan’s suggestion, but it intrigued him. Kaplan said he would pay top dollar for the L.A. buildings. He said he would buy them at a rich capitalization rate of 4—real estate terminology for a pr
ice at which the buildings would generate a 4 percent cash return. A cap rate is the inverse of a cash-flow multiple, so a lower rate means a higher valuation. A cap rate of 4 was equivalent to twenty-five times cash flow—two or three times the going rate for companies and enough to set Gray’s imagination to work.
As Gray walked with March and Kaplan toward the elevator, he tapped March on the shoulder and asked him to stay behind. Back in his office, an excited Gray peppered March with questions about how much the other parts of EOP might fetch if they were sold off on their own.
Equity Office Properties was the creation of Sam Zell, one of the most colorful investors on the American landscape. He’d made his mark originally in the 1970s, scooping up real estate on the eve of foreclosure. In all, he bought some $3 billion in assets that no one else wanted, putting up fractional down payments and waiting for the market to revive. He emerged with a fortune, and a reputation as perhaps the bravest and most astute property investor of the era. Zell’s personality had also ensured his prominence. In an industry of larger-than-life personalities, Zell stood out, shunning ties and suits, taking long motorcycle trips to strange corners of the world, and reliably shocking employees and audiences with off-color remarks.
EOP had been Zell’s bid to move up-market. Over two decades, from its base in Chicago, EOP collected 622 prime buildings in seventeen cities. Trophy holdings included the Chicago Mercantile Exchange headquarters, New York’s Verizon building overlooking Bryant Park, and the One Market Plaza complex across from San Francisco’s Ferry Building. But EOP’s stock had been a laggard, even as property values took off in the mid-2000s. The company owned too much in less-than-prime areas, and an ill-timed $7.2 billion investment in Silicon Valley property had dented EOP’s reputation. Real estate stocks were on the rise in 2006, but EOP hadn’t made up much of its lost ground.
Twice before Gray had tried to line up backers for a bid for EOP. First he had approached CalPERS, the California state pension plan, and later Mort Zuckerman, the head of Boston Properties, Inc., and the publisher of U.S. News & World Report and the New York Daily News. More recently, just six weeks before Kaplan and March showed up at Gray’s door, Gray had lunched with EOP’s chief executive, Richard Kincaid, and its chief operating officer, Jeffrey Johnson, and asked them point-blank what it would take to get them to sell the company. When they told him only a “godfather offer”—an offer EOP couldn’t refuse—Gray figured they weren’t interested in selling. He dropped the idea to focus on a bid for Hilton Hotels Corporation instead.
King of Capital: The Remarkable Rise, Fall, and Rise Again of Steve Schwarzman and Blackstone Page 26
