King of Capital: The Remarkable Rise, Fall, and Rise Again of Steve Schwarzman and Blackstone

by David Carey;John E. Morris;John Morris

  By the time Jordan Kaplan mooted the idea of Blackstone buying EOP, the Hilton plans had fizzled out and Gray had time to think about taking another run at EOP. A beguiling proposition began to take shape in his head. If people like Kaplan would now buy buildings at a cap rate of 4, Gray could afford to pay a godfatherly price for EOP and sell off a third or so of its assets, leaving Blackstone owning the balance for a song. In effect, Blackstone would buy wholesale and sell retail. His team had recently done just that with two other publicly traded office property companies, CarrAmerica Realty and Trizec Properties, Inc., where the whole had proved to be worth less than the sum of the parts. If Blackstone bought EOP, Gray would want to unload many of its buildings anyway because he coveted only its properties in four key markets—New York, Boston, West Los Angeles, and the San Francisco Bay Area—where geography and zoning restrictions prevented the kind of overbuilding that periodically plagues many other cities.

  Though Kaplan couldn’t know it at the time, his impromptu remark would launch the biggest, most daring, and most complicated deal Blackstone had ever attempted—a gutsy bet that would pit the mild-mannered, thirty-six-year-old Gray and his thirty-something partners against two of the wiliest veterans of the real estate business, and would draw Blackstone into a public bidding war for the first time ever. Like Freescale and Clear Channel, the final price was far higher than the winning bidder expected at the outset. Unlike those investments, however, Blackstone in EOP would use the overinflated valuations to its advantage, selling most of the company so it could snare a small portion of EOP’s assets for a bargain-basement price.

  Blackstone was a pioneer in a type of investing that became known as real estate private equity: raising funds to buy properties and improve them or ride the market cycle up, and selling them a few years later. In the recession and savings-and-loan crisis of the early nineties, when Schwarzman recruited John Schreiber to set up the business, the firm had bought distressed properties. But over time it had adopted an approach more like the buyout group’s. In 1998, for instance, the real estate funds bought Britain’s Savoy Group hotel chain, which included the namesake hotel plus three of London’s other most swanky inns, Berkeley’s, Claridge’s, and the Connaught. Together they accounted for about half the ultraluxury class rooms in London, but the family-run company hadn’t maximized their potential. Blackstone took offices, closets, and other space that didn’t make money and created two hundred new rooms at the four buildings, upgraded the decor, and hired new chefs to create a buzz around the establishments before selling the company in 2003.

  The private equity approach to real estate had produced an average return of 36 percent across Blackstone’s various real estate funds by 2006, on a par with the buyout funds, but the real estate group’s record had been more consistent. Only a dozen or so of its two hundred–odd deals had ever lost money, and those had been relatively small.

  The buy-and-sell strategy contrasted with the approach of most traditional property firms, which hold buildings for the long term and manage them to maximize income rather than sell them at a profit. Goldman Sachs, Lehman Brothers, and Merrill Lynch had funds with strategies similar to Blackstone’s, but real estate private equity was still a small niche in the investment world, and Blackstone seldom faced the intense bidding wars there that it did when buying other businesses.

  Gray, a lean six feet, with boyish features and cropped black hair, looked and acted more like an Eagle Scout than a Master of the Universe. He walked to work from his apartment twenty blocks straight up Park Avenue from Blackstone’s headquarters. His attire—a cheap digital watch from Wal-Mart, sedate ties and suits, sturdy wingtips—completed the quotidian effect. He joined Blackstone in 1992 as a research analyst straight from college at the University of Pennsylvania. He and his London-based counterpart, Chad Pike, who took over as coheads of real estate in 2005, had both been tutored by Schreiber from their early days at the firm. Within Blackstone, the group saw itself as having a distinct culture, based on geographic roots. Gray, a Chicagoan, and Pike, a native of Toledo, never missed a chance to point out that their team was dominated by midwesterners, beginning with Schreiber, its éminence grise, who had remained in his home Chicago all along.

  In the three years after Gray and Pike were put in charge of the group, they led it down a new path. Drawing on the firm’s buyout know-how, they had shifted from buying individual buildings to acquiring whole real estate companies. In two years starting in March 2004, Blackstone bought eleven public real estate investment trusts, or REITs, in the United States. (REITs have tax advantages, so many businesses that have substantial property assets, as well as firms that invest solely in properties, structure themselves as REITs.) Those included a string of hotel chains: Extended Stay America, Prime Hospitality, Wyndham International, La Quinta, and MeriStar. In the United Kingdom, the real estate and buyout groups teamed up to invest in three businesses that were rich with real estate that in one way or another had not been fully exploited or was inefficiently financed: Spirit Group, a pub chain with scores of underutilized buildings in prime urban locations; Center Parcs, a chain of upscale weekend holiday camps; and NHP and Southern Cross, two nursing home chains that Blackstone merged.

  Buying entire public companies not only allowed Blackstone to mine treasures buried inside them; it allowed the firm to invest larger wads of capital in one fell swoop. “That’s when our business took a step forward,” Gray explains. “It’s like when you’re turning a lock and all the tumblers all fall into place. We went from buying individual buildings to a business that was much more scalable.”

  In 2006, the U.S. team began to train its sights on office buildings, inking a deal to take CarrAmerica private for $5.6 billion and a $1.8 billion deal for much of Trizec. Those deals convinced Gray and the two other partners who worked on them, Frank Cohen and Kenneth Caplan, then thirty-two and thirty-three, respectively, that most publicly owned office companies managed their buildings to keep them full so they could maintain steady dividends and didn’t hold out for the highest possible rents, which might create temporary vacancies. They had also learned from Carr and Trizec that many publicly traded property companies were valued by the market at less than the sum of their parts. Before it acquired Trizec in October 2006, Blackstone had lined up buyers for thirteen of Trizec’s buildings, which it sold for $2.1 billion, earning an instant $300 million gain over its purchase price for the whole company.

  Perhaps, Gray thought, Blackstone could now work the same magic on a grander scale with EOP, a company six or seven times the size of Carr. A few days after Kaplan and March had visited Gray, he called back EOP’s banker, Douglas Sesler at Merrill Lynch. “What exactly would qualify as a godfather offer?” he asked.

  Though EOP’s CEO, Richard Kincaid, had been coy when Gray sounded him out about a buyout over lunch in September, Kincaid and Zell in fact felt that the office market was overheating and had begun to think that, if they were going to sell the company, now was the time they could fetch the best price for shareholders.

  After consulting with Zell and Kincaid, Sesler got back to Gray. EOP wasn’t going to name a price to Gray. “Sam’s a trader,” Sesler explains. “He’s never going to give you his exact number.” Instead, Sesler told Gray that any bid would have to be at least $45 a share to get the EOP board’s attention.

  Blackstone now had a target to shoot for, and Gray, Caplan, and Cohen set to work poring over the detailed tables of properties in EOP’s public filings, comparing the data there with information they had gleaned from owning CarrAmerica and Trizec to see if they could justify a price over $45.

  Gray was jittery about the bid. Not only would it be by far the biggest he had executed; it would be the largest LBO ever, and he was looking at writing a check for $3.5 billion or more, the most Blackstone had ever risked in a single deal. The firm’s buyout group was already nervous that prices for corporations were getting out of hand and had begun to pull back, and Gray had the
same concerns about real estate. If this was going to work, everything—the bid itself, the choreography of the asset sales, and the swift reduction of EOP’s debt after the buyout—had to be executed perfectly. It would be disastrous if Blackstone paid top dollar and then found itself stuck with overpriced assets it couldn’t unload.

  For reassurance, Gray put in a call to Alan Leventhal, the head of the real estate investment firm Beacon Capital Partners, who had been a mentor and sounding board over the years. Leventhal had a pet theory that he had expounded to Gray in the past, and Gray wanted to hear it again. Leventhal’s view was that, in the best markets, where it was hard to build new offices, you would make money over the long run if you bought buildings below their replacement cost, because prices had a natural tendency to rise where the supply couldn’t expand much. Gray didn’t tell Leventhal what he had in mind. He simply asked Leventhal to walk him through the theory again. Leventhal happily launched into a speech about how an explosive rise in construction costs on the coasts made it a good time to invest, even though building prices had been shooting up.

  “He gave me a pep talk. It was like a revival meeting,” Gray says. “In life, sometimes you need a little confidence booster when you’re thinking about risking your entire career.”

  By November 2, Gray’s team was ready to make a preliminary bid. Gray called Sesler, EOP’s banker, to say that Blackstone was prepared to offer $47.50 a share, or about $35.6 billion, including the value of EOP’s debt. Five days later, Blackstone signed a confidentiality agreement with EOP allowing it access to EOP’s internal books, which revealed rents, when leases expired, who the tenants were, and other information that wasn’t public. With that information, Gray could project how much additional income might be squeezed out of the buildings as space came off lease and was relet at higher prices.

  The Blackstone team mobilized dozens of in-house analysts and outside lawyers to comb the data in a blitz, which confirmed the surmises that Cohen and Caplan had made from EOP’s public reports to shareholders. The deal was viable. Six days later, on November 13, Blackstone put a formal $47.50 proposal on the table. EOP held out for an extra dollar, which would raise the total value to $36 billion. Blackstone soon agreed.

  Zell drove a hard bargain on a technical issue, too: the breakup fee that EOP would have to pay Blackstone if it opted to accept a higher bid. Zell was adamant that the deal have a low breakup fee so that other bidders would not be deterred from making offers. (A company that trumps the original deal with a higher offer effectively must absorb the breakup fee, because the target’s value is reduced by the amount of the fee it pays out.) EOP’s directors had not shopped the company around because they were worried that word would leak out, but they had fiduciary duties to their shareholders to try to get the best price. If they were going to sign a deal with Blackstone without inviting other bids up front, the cost of getting out of that agreement had to be cheap.

  Breakup fees are meant to reward the first bidder for putting in the work to formulate a bid—a sort of token of appreciation for the loser. Typically they run 2–3 percent of the total value of the target’s stock. Gray grudgingly agreed to a $200 million fee, or just 1 percent of EOP’s market capitalization—not high enough to deter a serious bidder. The takeover agreement was wrapped up on Sunday, November 19.

  Financing the EOP deal proved to be a cinch. It took Blackstone just five days to round up $29.5 billion in debt financing from Bear Stearns, Bank of America, and Goldman Sachs. As with Freescale, the terms on the loans were extraordinarily easy. In addition to the debt, the banks agreed to invest several billion dollars in equity, which Blackstone would repay at a small premium when it sold EOP assets. The banks would earn a return on that temporary equity, but they also bore part of the risk if the sales fell through and EOP ended up stuck with too much debt. Also, as it had with Freescale, Blackstone made sure none of EOP’s new debt would fall due before 2012, giving EOP latitude if there were a downturn.

  In size the deal would handily outstrip the $31.3 billion KKR paid for RJR Nabisco in 1989, and the $33 billion KKR had just agreed to pay for the hospital operator HCA. The unassuming, publicity-shy Gray was not only on top of the real estate world but was breaking records in private equity set by none other than Henry Kravis.

  But he didn’t have EOP locked up yet.

  Blackstone was offering just a small 8.5 percent premium to EOP’s stock price before the deal was signed, but Zell and Kincaid were happy because they were convinced that real estate values were peaking. Zell, always the trader, was content just to lock in the price for shareholders, including himself. “We thought the valuations were, frankly, excessive,” Kincaid says.

  Moreover, Zell and Kincaid knew something Blackstone did not: Zell’s old friend Steven Roth, who had built Vornado Realty Trust into a major rival of EOP’s, had approached Zell that summer about buying EOP. That was why Zell had insisted on a low breakup fee. He hoped that the Blackstone agreement would simply serve as the opening salvo in a bidding war.

  A deal between Vornado and EOP would have been a personal as well as business proposition for Zell and Roth, who enjoyed a close, if quirky, friendship. They and their wives regularly dined together, and the two got a kick out of skewering each other publicly. At one real estate conference where they shared the stage, Roth called Zell a “bald-headed chicken fucker.” Roth, whose own bare pate has been compared to Mr. Clean’s, was poking fun at himself as much as at Zell. “I like Steve very much, and he likes me very much,” Zell says.

  Like Zell, Roth had started off down-market, raising money to develop strip malls in New Jersey, and had cut his teeth early on distressed property. He won control of Vornado through a proxy contest in 1980, when the company was an air-conditioner maker and retailer, shut its stores, and then rented out the space. In 1992, he and other creditors of the ailing Alexander’s department store in New York forced the company into bankruptcy. Vornado kept Alexander’s prime property next to Bloomingdale’s department store on New York’s Upper East Side, which Roth later developed into the headquarters for Bloomberg LP, the news and financial information firm owned by New York City mayor Michael Bloomberg.

  As EOP had hoped, on November 24 Vornado’s president, Michael Fascitelli, contacted EOP’s banker, Doug Sesler at Merrill Lynch, to say Vornado was considering an offer. Yet, bizarrely, EOP would hear nothing more from Vornado for weeks. Zell grew alarmed. He had read newspaper reports about a Department of Justice investigation of possible collusion among buyout firms in bidding wars and began to wonder if Blackstone was freezing out competitors. When Gray arranged a get-to-know-you meeting with Zell over coffee one day when Zell was passing through New York, he found himself on the receiving end of a tirade from Zell, whom he hardly knew. For the sake of his career, Zell told Gray, he better not be doing anything to stifle rival bids. “No fucking around,” Zell told him, employing “a lot of colorful language,” as Zell recalls it. “The clear, unequivocal point” was to scare Gray, Zell freely admits. (Nothing ever came of the government investigation.)

  The rant rattled Gray, who cultivated a reputation of rectitude, but it did nothing to elicit an offer from Vornado. Finally, in mid-December, Zell called Roth and asked, “Where the hell are you?” Roth confided that he had been tied up in unsuccessful talks with a potential bidding partner. Several more weeks passed without word from Vornado until on January 8, 2007, seven weeks after the Blackstone–EOP agreement was announced, Fascitelli rang Sesler to say that Vornado wouldn’t bid for EOP after all. Instead, Vornado wanted to speak to Blackstone about buying specific properties. It looked like Blackstone had EOP to itself.

  A week later, on January 15, Vornado did an about-face. Fascitelli called to say that Vornado was again weighing a takeover bid. By the morning of the seventeenth, the markets were rife with rumors that Vornado would soon unveil an offer and Zell banged out an e-mail to his friend: “Dear Stevie: / Roses are red / violets are blue / I heard a rumor / Is
it true? / Love and kisses, / Sam.”

  The Vornado side was amused but flummoxed. None of Vornado’s executives or bankers or lawyers could come up with a clever rhyme. Finally, Roth made a lame stab at e-mail poetry: “Sam how are you? / The rumor is true / I do love you / And the price is $52.”

  Zell had his auction. “We were obviously thrilled,” says Kincaid.

  The joy soon was tempered when Zell, Kincaid, and the EOP team saw the details of the proposal, which was backed by two other investors, Starwood Capital Group Global and Walton Street Capital. Zell and Kincaid had made it abundantly clear that they wanted a cash bid because they were convinced that real estate stocks, like property itself, were topping out. If they sold EOP for Vornado shares and the stock fell, EOP’s shareholders wouldn’t have locked in the peak-of-the-market price.

  Vornado’s $38 billion offer, though, was 40 percent in stock. Moreover it was nonbinding, and Vornado had not yet lined up debt financing, as Blackstone had when it signed its deal. To make matters worse, Vornado demanded that EOP sell off assets Vornado didn’t want before the deal closed. Finally, for legal reasons, Vornado’s own shareholders would have to approve the deal, and it was far from certain that they would agree to Vornado’s borrowing more money and issuing so many new shares. Even if it had been a binding offer, there were so many conditions that it was far from a sure thing. It was really just a sketch of a possible deal, and not a very appealing sketch at that.