The thirty-three pages of financial statements were exceedingly opaque, if not perverse. A summary showed $2.3 billion of net income—profit in lay terms—but just $1.12 billion in revenue. How could that be? It made more than it took in? One had to burrow twenty-nine pages into the financials to find a line showing $1.55 billion in investment gains that fell outside the definition of “revenue.”
Once the prospectus was on file, the SEC’s “quiet period” rules kicked in and Schwarzman and others at the firm were barred from giving interviews. It should have been smoother sailing, but the project instead lurched forward and back as a succession of out-of-the-blue events caught Schwarzman, James, and the rest of Blackstone off guard.
The first was utterly fortuitous. Through friends, Antony Leung, the newly hired head of the firm’s Asian operations and Hong Kong’s former finance minister, contacted the managers of a new Chinese government sovereign wealth fund that was being formed to invest the billions of surplus dollars China was accumulating because of its yawning trade deficit with the West. Leung had in mind that the fund might buy a few Blackstone shares, but the managers of the new fund, later named China Investment Corporation, or CIC, instead expressed interest in buying a major stake.
Schwarzman wasn’t sure at first if the offer was worth the potential complication and delay of negotiating a side deal, but the Chinese offered to invest $3 billion and their terms turned out to be simple. All they wanted was the chance to buy in without paying the investment banks’ fees and commissions. They didn’t seek any special access to information beforehand or a seat on Blackstone’s board, and they agreed to keep the stake under 10 percent so that the investment didn’t have to go through a national security review in the United States. In addition, their shares would be nonvoting.
On May 20, barely three weeks after Leung first spoke to CIC’s head, Lou Jiwei, on April 30, a deal was signed for CIC to invest through a subsidiary optimistically named Beijing Wonderful Investments, Ltd. One person familiar with CIC calculated that in those three weeks of talks China accumulated $15 billion in new reserves and so he figured that its managers were just too busy putting out their money to haggle.
For Blackstone, the investment was a huge coup. The firm was several years behind competitors like Carlyle, KKR, and TPG developing its business in Asia. Now it had won the imprimatur of the Chinese government without any real strings attached, a link that promised to give it the inside track on many investment opportunities in China. The investment solved another problem as well: how to cash out Peterson. Up to then, the banks had figured that $4 billion was toward the upper limit of what Blackstone could raise in the IPO based on investor demand, and much of that money would go into the firm’s coffers rather than partners’ pockets. With the additional $3 billion from the Chinese, Blackstone would be able to sell 75 percent more shares than it had first planned, enough to allow Peterson and other partners to sell much bigger portions of their holdings. Now Blackstone would sell nearly $7.6 billion of stock and almost $4.6 billion of that would go to partners.
In exchange for Peterson’s selling a higher proportion of his stake than other partners, James asked him to cut his equity stake ahead of the IPO. Peterson’s son, a banker, negotiated the terms, and after some back and forth, they agreed he would give up 15 percent of his holding.
“I said I wanted to be able to look my partners in the eye,” Peterson says. “What I get in liquidity they don’t get.” After he unloaded shares in the IPO, Peterson’s stake in the firm would drop to 4.2 percent, and he confirmed that he would formally retire from Blackstone at the end of 2008. Schwarzman would be left with 23.3 percent, James with 4.9 percent.
The other surprises were not as auspicious as the Chinese overture.
While Blackstone was negotiating with the Chinese, the staff at the SEC, which vets prospectuses and the financial statements in them, was raising objections to Blackstone’s quirky method of booking income based on projections of future profits. Blackstone’s bankers had never been enthusiastic about the idea, because they thought it would be hard to explain to investors. Now the regulators thought it was too clever by half and threatened to nix the idea. Just when the hard work of getting the initial IPO prospectus on file, with all the financials, was complete, James was forced to go back to the drawing board and rethink both the accounting and the restructuring of the firm. Once again doing much of the math himself, he came up with a new scheme in which partners would exchange their shares of the profits on past investments for more equity in the new entity—the tricky swap he had tried to avoid originally. Ultimately the firm used a formula based on the average multiple of its money it had earned on its investments historically. The arrangement was clear and fair enough that partners went along, and on May 21, when the prospectus was next amended, it contained revamped financial statements. On page 83, the document mentioned in passing that Blackstone would not rely on the new accounting rules after all.
That was a headache, but another problem brewing in Washington threatened to derail the IPO altogether.
Private equity had long enjoyed two big tax advantages. First, its companies can deduct the interest on their debt, which gives them an advantage over companies that finance themselves with a higher portion of equity. Second, because most of the money that the partners in private equity firms make takes the form of carried interest—their 20 percent share of any investment gains—most of their income is taxed as capital gains. Instead of paying the top rate in the United States of 35 percent for high earners, buyout executives paid the 15 percent capital gains rate on most of their income. Similar rules apply in Britain, so that in both countries private equity kingpins, as one British investment fund manager pointedly put it, pay lower tax rates than their cleaning ladies.
On top of those long-standing tax traditions, Fortress and Blackstone were taking advantage of tax laws used originally for oil and gas and investment partnerships to avoid corporate taxes when they went public.
Off and on over the previous year, various senators and congressmen had brought up the idea of altering the treatment of carried interest for private equity and hedge fund managers. The press was filled with stories of hedge fund gurus who made more than $1 billion in 2006, and Fortress had revealed during its IPO that its three founders, Wesley Edens, Peter Briger Jr., and Michael Novogratz, and two other senior managers had received $1.7 billion from their firm shortly before Fortress’s IPO.
The capital gains advantage was not unique to private equity or hedge funds. It stemmed from general principles of tax and partnership law and the gaping differential between the tax rates on ordinary income and capital gains. Carried interest by definition consists of investment profits, which are capital gains for tax purposes, and partnership law allows profits to be allocated to different classes of partners as the partnership chooses. In many family and other businesses organized as partnerships, for instance, managers receive a bigger share of the profits—whether ordinary income or capital gains—than the passive owner-partners, regardless of whether the managers invested their own capital. The same thing is true of many real estate investment partnerships. Changing the law for private equity and hedge fund managers thus would have required creating an ad hoc law targeting them or a much larger revamping of the tax code.
Still, it seemed unfair. How could the richest of the rich pay tax at the lowest possible rate? Even former U.S. treasury secretary and former Goldman Sachs cochairman Robert Rubin argued that carried interest was essentially compensation and should be taxed as ordinary income. From a political standpoint, too, raising taxes on a bunch of wealthy private equity and hedge fund managers was tempting because it would raise revenue and placate voters resentful of the huge profits being earned by financiers.
The political situation for private equity was only exacerbated by a string of deals in the hospital and nursing home industries by KKR, Carlyle, and others. The Service Employees International Union, a feisty group that ha
d been working to unionize that sector, saw a chance to win concessions from the new owners by holding a political hammer over their heads, and it threw its support behind the tax reform effort. In May, SEIU officials charged before Congress that private equity treated employees badly and would put nursing home residents at risk. A few days later, the larger American Federation of Labor–Congress of Industrial Organizations joined the antibuyout chorus, dropping a thirteen-page letter on the SEC arguing that Blackstone came under the Investment Company Act of 1940, which governs pure investment funds.
Though the pressure tactics from unions were a powerful goad, the catalysts that spurred Congress to action were Schwarzman’s birthday gala and the looming Blackstone IPO, say people who followed the congressional discussions.
“It was Steve’s party,” says Henry Silverman, “because they were getting pressure from their constituents—‘Look at these fat cats and look at the way they’re living their lives!’ ” Senator Max Baucus, who was behind one of the proposals, had a particular antipathy toward Schwarzman, people on the industry side say.
The political forces all converged the week of June 11, just as Blackstone’s senior management was dispersing around the globe for the IPO road show, to woo investors in person.
As it happened, June 11 was the day that Blackstone finally revealed Schwarzman’s pay: $398.3 million in 2006 alone. The figure was mind-boggling. It was nine times what Lloyd Blankfein, Schwarzman’s counterpart at Goldman Sachs, made that year in cash and stock, though Goldman had thirty times as many employees and was universally acknowledged to be the most successful firm on Wall Street. Schwarzman’s pay was twice what the top five executives at Goldman together took home. It attested to the profits private equity was churning out and revealed how rich Schwarzman had become owing to his nearly 30 percent stake in Blackstone.
That by itself might not have fanned the political fires much more, but a front-page profile of Schwarzman in the Wall Street Journal two days later made him the poster child for the campaign to sock the new barons of finance.
A cascade of headlines made the story an irresistible read: “Buyout Mogul—How Blackstone’s Chief Became $7 Billion Man; Schwarzman Says He’s Worth Every Penny; $400 for Stone Crabs,” and Schwarzman obliged the Journal with quotes conforming to every stereotype of the financial shark.
“I want war—not a series of skirmishes,” he was quoted as saying. “I always think about what will kill off the other bidder.… I didn’t get to be successful by letting people hurt Blackstone or me.” Nor was it just his competitors he treated mercilessly. The article implied that he was nasty to the help as well.
Once, while sunning by the pool at his 11,000-square-foot home in Palm Beach, Fla., he complained to Jean-Pierre Zeugin, his executive chef and estate manager, that an employee wasn’t wearing the proper black shoes with his uniform, according to Mr. Zeugin, who says he has great admiration for his boss. Mr. Schwarzman explains that he found the squeak of the rubber soles distracting.
The Journal portrayed him as a Marie Antoinette, nonchalantly spending hundreds of dollars on a casual lunch at his mansion:
He expects lunches consisting of cold soup, a cold entrée such as lobster salad or fresh grilled tuna on salad, followed by dessert, Mr. Zeugin says. He eats the three-course meal within 15 minutes, the chef says. Mr. Zeugin says he often spends $3,000 for a weekend of food for Mr. Schwarzman and his wife, including stone crabs that cost $400, or $40 per claw. (Mr. Schwarzman says he had no idea how much the crabs cost.)
Like the Fortune cover, the Journal piece came out of the blue. The interviews had been conducted months earlier, before the IPO plans were disclosed, and Blackstone assumed the story was dead. Now it surfaced at the worst possible moment.
The next day, Thursday, June 14, two senators, Baucus, a Democrat from Montana, and Charles Grassley, a Republican from Iowa, targeted the legal structures that Fortress and Blackstone were using to escape corporate taxes. Under their measure, any partnership that went public after January 1, 2007, would be taxed as a corporation. In practice, that meant Fortress and Blackstone, because the measure grandfathered in firms that had gone public earlier, and it quickly became known as the Blackstone Tax. It would have taken a big bite out of Fortress’s and Blackstone’s profits, and Fortress’s shares dropped more than 6 percent the following day. It was now open season on Blackstone and the rest of the buyout industry.
The evening Baucus and Grassley announced their proposal, as James waited at Kennedy airport in New York for an overnight flight to London for the next leg of the road show, Schwarzman caught up with him by phone. Should they call the whole thing off? To them, it seemed the entire world was lining up against the IPO. Drained from a week of numbing back-to-back, dawn-to-dusk presentations, the two pondered what to do. The firm’s lobbyists were assuring them that no bill was likely to pass soon, so they decided to press on.
They were in the home stretch now, just a week away from going public, but they would encounter ever more bizarre problems.
Early Saturday morning, when James arrived in Kuwait for meetings, he was in pain, those around him could see. He was whisked off to a hospital where tests confirmed he had a kidney stone. He was urged to stay in the hospital but returned to lead the presentations in Kuwait and more later that day in Saudi Arabia.
When the news got back to New York, the IPO team was alarmed. “I’m now going to speak to you like a mom,” Ruth Porat told James when she tracked him down by phone at the hospital. “What are you doing going to road shows!”
Schwarzman got into the act, calling David Blitzer in London. “Blitz, Tony won’t admit this, but he’s really sick,” Schwarzman told him. “He’d shoot me for saying this, but you need to get on a plane right now.” Blitzer caught the first flight out, arriving in Dubai in time to kick off the meetings scheduled there Sunday morning. No sooner were they under way than James walked in. “I did start a meeting or two without him, but he showed up straight from the hospital and just plugged his way straight through, as only Tony can do,” says Blitzer.
After one last day of meetings Monday, the exhausted troupe boarded a chartered corporate jet for the return to London only to confront one last, alarming hiccup. An hour or so into the flight, the plane suddenly dropped sharply—enough to wake up the dozing passengers. A few minutes later, the pilot came back into the cabin. “I don’t want to panic you,” he began, and then went on to explain that the plane had lost an engine. In ordinary circumstances, the pilot said, he would land at the nearest airport, but they were in Iranian airspace and it was the middle of the night. He thought they could reach Athens on one engine, but he left it to James and Blitzer to decide what to do. They called Schwarzman and, after debating their choices, decided that it would be tempting fate for top executives of a pillar of American capitalism to make an unscheduled landing in Iran in the middle of the night. They told the pilot to try for Athens.
They made it there in the wee hours, and after boarding a replacement plane that had been sent for them, they headed for London, touching down as the sun was coming up. There was just enough time for James to dash to an 8:00 A.M. meeting with investors at Claridge’s, the posh Mayfair hotel that Blackstone had once owned.
Back Stateside, the political bombardment continued. On Wednesday, June 20, Peter Welch, a Democratic congressman from Vermont, offered a bill to tax fund managers’ carried interest as ordinary income rather than as capital gains. The next day, as Blackstone and its banks were finalizing the price for its shares, two new congressional hand grenades were lobbed at them. Democratic representatives Henry Waxman of California and Dennis Kucinich of Ohio wrote the SEC asking it to halt the IPO, arguing that Blackstone’s investments were too risky for ordinary investors. Meanwhile, in a letter to the treasury secretary, the secretary of homeland security, and the chairman of the SEC, Democratic senator James Webb of Virginia demanded that the offering be postponed so that the government could investigate the
national security implications of a foreign government taking a “reported” 40 percent stake in Blackstone. Never mind that it was a matter of public record that the Chinese were taking just a 9.9 percent, nonvoting stake.
“Every gun was pointed at us that week, trying to stop this thing,” says Jon Gray, who was in Los Angeles that week for the road show and had to be briefed every morning on the latest bombshell from the capital.
The SEC had already signed off on the prospectus, so the last-minute objections came to nothing. By Thursday, June 21, the only thing that remained was to set the price. The banks had earlier estimated they could sell out the offering at $29 to $31 per unit. Around a table in Blackstone’s boardroom that afternoon, James asked each of the Morgan Stanley and Citi bankers to write down on a piece of paper the price they would recommend, then reveal their numbers and explain their thinking. The Citi bankers each said $30; the Morgan Stanley bankers had written $31. Schwarzman asked if it might be better to price it at $30. He said he didn’t want to be accused of taking every last dime if the stock later fell below the IPO price. But there was so much demand for the issue that the group finally agreed that they could easily sell out several times over at $31, and there was no reason to charge less.
That evening the banks bought the shares from Blackstone and sold them to their customers. The next day, when the new shareholders were free to trade their units on the New York Stock Exchange, the price soared to $38 as investors who hadn’t been able to buy shares directly from the underwriters bid up the price. (The price settled back to $35.06 by the end of the day.)
When the accounts were tallied up, Peterson walked away with $1.92 billion and Schwarzman collected $684 million. James, who had been at Blackstone less than five years, pocketed $191 million. Tom Hill, Blackstone’s vice-chairman and manager of the hedge fund arm, got $22.9 million and Mike Puglisi, the CFO, $13.8 million. The other fifty-five partners received $1.74 billion, or an average of almost $32 million each.
King of Capital: The Remarkable Rise, Fall, and Rise Again of Steve Schwarzman and Blackstone Page 30
