The offering was not simply a breakthrough for private equity, but was the biggest IPO in the United States in five years, and it put Blackstone squarely in the top tier of Wall Street firms. Blackstone was now worth as much as Lehman Brothers, where Peterson and Schwarzman had launched their banking careers, and a third as much as Goldman Sachs. Blackstone had arrived.
Eleven days later, on July 3, KKR filed to go public, but Kravis’s firm was too late. The very day that Blackstone units began trading, Bear Stearns announced that it would lend $3.2 billion to a hedge fund it managed that was facing margin calls as the value of its mortgage-backed securities tumbled, and the bank said it might have to bail out a second, larger hedge fund. It was an omen. By mid-July, the credit markets were in full retreat and it was hard to muster financing for big LBOs. The growing losses on mortgage securities were unnerving hedge funds and other investors, and buyout debt looked a little too similar, so banks could no longer raise money through CLOs to make buyout loans.
Peterson and Schwarzman had closed Blackstone’s first fund on the eve of the market crash of 1987. With the IPO, too, they had sneaked in just under the wire.
CHAPTER 23
What Goes Up Must Come Down
For ten days after Blackstone’s IPO, the buyout juggernaut rolled on, seemingly gaining speed. On June 30, a new record was set when BCE, Inc., Canada’s biggest phone company, agreed to a $48.5 billion buyout led by the private equity arm of Ontario’s teacher pension plan, edging out the $48 billion record KKR and TPG had set four months earlier with TXU, the Texas power company. Days later, on the eve of the July Fourth holiday, after ten months of off-and-on talks, Jon Gray finally cinched his deal to buy Hilton Hotels for $29 billion, Blackstone’s second-largest LBO ever after EOP. At the end of that day, as people were filing out of their offices for the holiday, KKR at last filed its papers to go public.
It was a spectacular finale—like the climax of a Fourth of July fireworks—followed by silence. As the fallout from subprime mortgages spread that spring, the larger edifice of debt that had built up over years began to teeter. The floors were creaking and cracks were emerging in the walls, and the markets were spooked. In early June, the spread on junk bonds—the difference between their interest rates and ultrasafe U.S. treasury bonds—fell to its lowest level ever, below 2.5 percentage points, indicating that investors saw little risk in the debt. But then it abruptly switched directions. By mid-August, the spread was nearly 4.6 points, as demand for CLOs evaporated and investors balked at buying debt of highly leveraged companies, particularly when there were few covenants on the loans and bonds and the borrowers could opt to pay interest on bonds by issuing more paper. It was eerily familiar to veterans of the buyout world who had lived through 1989. Risk, which had been virtually banished from the financial lexicon, had returned to the discussion, and now the term “credit crunch” was being bandied about.
There was no single event that triggered the shift, as there had been in 1989, when the collapse of the financing for the employee buyout of United Airlines sent the debt markets tumbling, but the pivot in 2007 was nearly as swift, and just as disastrous for private equity’s investment banks as it had been in 1989. As underwriters and loan arrangers, the banks had issued legally binding promises to provide loans to finance dozens of still-to-be-completed LBOs and had assumed the risk of peddling that debt to others.
Until then the buyout boom had been an absolute bonanza for the banks, generating hundreds of millions of dollars each year in investment banking fees. So long as investors were soaking up whatever CLOs the banks could offer, the banks could keep creating and selling those securities, funneling the money into buyout loans and bonds and passing on the risk to outside investors. But suddenly they couldn’t sell them at the low interest rates everyone had expected. If a bank had agreed to float 7.5 percent bonds and the market rate was now 10 percent, it would have to sell the bonds at a discount that would yield that higher amount: A $1,000 bond on which the company paid 7.5 percent would have to be discounted to $750 so the buyer would earn a 10 percent yield on its investment. With hundreds of billions of dollars in loan and bond commitments outstanding, selling them at a loss could wipe out years of bank profits. By late June, banks were begging private equity firms to make concessions that would make the debt easier to sell so they wouldn’t be saddled with billions of debt they hadn’t bargained on holding.
As unsold debt piled up, interest rates spiked and new buyouts halted. The difference between 7.5 percent and 10 percent interest amounted to $25 million a year on every billion dollars of debt, which simply didn’t compute in the finely tuned spreadsheets that underlay the deals. Pending deals, too, looked vulnerable. After two years of speculating about which big company would go private next, the financial world was now on death watch, as shareholders and traders bet on which buyouts would come unstuck.
The first LBO to fall victim to the crunch was SLM Corporation, the student loan company better known as Sallie Mae, which alerted shareholders on July 11 that its $25 billion take-private by two private equity firms, J.C. Flowers and Company and Friedman Fleischer & Lowe, and two big banks, JPMorgan Chase and Bank of America, was in jeopardy. The buyers said they were worried about a reduction in federal loan subsidies, but it was widely suspected they had gotten cold feet because of the fact that Sallie Mae borrowed money constantly to buy loans from banks and other lenders and might not be able to do so at affordable interest rates. After SLM sued, JPMorgan Chase and BofA agreed to help refinance the company in lieu of the buyout and the private equity firms dropped out.
A few weeks after the SLM deal began to unravel, Home Depot, Inc., revealed that it was in talks with Bain Capital, Carlyle, and Clayton Dubilier and would likely have to reduce the $10.3 billion price tag on its wholesale division, HD Supply, which the three sponsors had agreed to buy two months earlier, because of slumping sales. At the end of August, the price was slashed to $8.8 billion.
Bain Capital and Thomas H. Lee Partners’ mammoth $25.5 billion Clear Channel deal was nearly scuppered, too, the next winter. Citi and Deutsche Bank, which had come up with an extra billion of financing in the spring of 2007 so the buyers could increase their offer, later dragged their feet about supplying the money. After the company, Bain and Thomas H. Lee, sued, everyone came back to the table, Clear Channel agreed to lower the buyout price, which reduced the debt needed, and the deal finally closed. In the renegotiations, the private equity firms managed to reduce their equity investment to $3 billion, so that in the end the buyout was financed with a meager 13 percent of equity.
Like many financial crises, this one began with a product that was at first benign: the subprime mortgage. There had long been niche players that offered mortgages to buyers with low incomes or poor credit histories, but over the course of the decade, mainstream banks and mortgage companies had moved onto this turf, envisaging millions of new customers. The mortgages paid high interest rates, and banks bundled them into newfangled securities that were then sliced and diced into multiple layers of equity and debt with different interest rates and risks. The most secure, senior tier of debt had first dibs on income from the underlying mortgages and came with insurance in case there was a default, which ensured that they carried strong credit ratings. The whole was supposed to be safer than the sum of the parts—less likely to default than the underlying mortgages were. In fact, the entities that were created to hold the mortgages shouldered so much debt that many layers could be wiped out if things didn’t play out precisely according to plan.
The resulting mortgage securities, like the CLOs backed by corporate debt, were so seemingly safe and proved so popular with investors that money flooded into the mortgage companies. To drum up even more business and keep fees rolling in, lenders lowered credit standards so that even more borrowers qualified. Many banks and mortgage companies stopped bothering to verify the borrowers’ jobs or income, and they offered adjustable-rate mortgages with such low initial
rates that even those with marginal incomes could afford to pay, at least for a while. Other home mortgages had negative amortizations: the buyers’ monthly payments were less than the interest owed so that the loan balance rose each month. The optimistic premise behind it all was that housing prices would continue rising and the mortgages could be refinanced a few years later, or the home could be sold at a profit to pay off the loan.
In four short years, the mortgage market was transformed. From 2001 to 2005, subprime lending leaped from 8 percent of all new home mortgages in the United States to 20 percent, and more than 80 percent of mortgages were securitized. It was a house of cards that kept rising until mid-2006, when housing prices crested and began gradually to fall. This coincided with step-ups in the interest rates on adjustable mortgages taken out a year or two earlier, which squeezed many home owners. Meanwhile, thousands of buyers who had lied about their incomes or had never been asked simply stopped paying. By the end of 2006, 10 percent of all subprime loans were in default, throwing all the calculations behind the mortgage-backed securities askew. The defaults first cut into the lower layers, which had to absorb the first losses if defaults exceeded projections. But soon the default rates were so high that they threatened even senior tranches that had top credit ratings and were supposed to be insulated from mortgage defaults. In the cascade of unforeseen consequences, the jump in defaults in turn threatened to bring down the bond insurers that had sold protection on the senior layers, figuring there was a one-in-a-million chance that the damage would ever penetrate that far.
As each month went by, more mortgage companies failed, and several steps down the financial chain, more margin calls were issued to investors who had borrowed to buy mortgage-backed securities that were no longer worth enough to suffice as collateral for the loans. Eventually the elaborately engineered mortgage securities that Wall Street had invented came home to roost, inflicting losses at the source—the banks. There was the collapse of the two Bear Stearns hedge funds the week of Blackstone’s IPO in June. The same month Germany’s IKB Deutsche Industriebank, which had invested heavily in American subprime securities, had to be bailed out. In Britain, which had seen its own subprime boom, there was a run on the giant British savings bank Northern Rock in September 2007 when it could not sell new debt to fund itself. As newspapers filled with photos of depositors lined up around the block at Northern Rock branches waiting to retrieve their money, the British government finally stepped in.
Until the spring of 2007, there had been a collective sense of denial about the mortgage problems and a persistent hope that they would not spread to other types of debt. But it was hard not to see the parallels to buyout lending—the escalating prices for companies, the extreme leverage, the loose lending terms, and the narrow margins for error. The securitization apparatus that had pumped up the mortgage markets since 2004 had gassed up the LBO market as well, so it was no surprise when the banks, hedge funds, and other investors that were already choking on subprime losses recoiled at taking on more LBO debt.
By the end of the summer, private equity firms, too, were getting skittish, and there was an epidemic of buyer’s regret. Buyout firms and their banks—which by then were on the hook for more than $300 billion of LBO financing they couldn’t sell—were squirming, looking for excuses to escape the deals they had struck. In some cases, like Home Depot’s wholesale subsidiary, where the target’s business dropped severely, there were legitimate legal grounds for calling things off or cutting the price. But many times the reasons looked like mere pretexts, and the targets cried foul and sued to try to force the buyers to go through with the deals so that their shareholders would get the benefit of the generous offers. The companies generally lost in court, because the takeover agreements had been drafted to make the buyers liable only for a fixed termination fee if they walked away—typically 2 percent or 3 percent of the deal value. Forking over hundreds of millions of dollars for nothing was a stiff penalty (that was the point), but it was better than being forced to pay a price that, as the economy and the markets headed south, now looked extravagant.
In one notorious case, Apollo was pilloried when it tried to back out of a $10.8 billion agreement to buy Huntsman Corporation, a chemical company in Texas. Huntsman had already agreed to merge with another company when Hexion Specialty Chemicals, a company owned by Apollo, topped that offer in July 2007. Hexion’s bid, orchestrated by Apollo, was almost 50 percent higher than Huntsman’s share price just a few weeks earlier, before the first merger was announced. In the months that followed, as the price of oil, a key raw material, soared and the economy began to slow, the offer looked like a dreadful miscalculation on Apollo’s part, and Hexion sued to get out of the deal, arguing that the merged Hexion–Huntsman would be insolvent because it would carry so much new debt at a time when profits were falling. Huntsman countersued.
Unfortunately for Apollo, Huntsman had negotiated a nearly airtight agreement, which specifically provided that the merger couldn’t be called off because of industry-wide problems, and the judge who heard the dispute came down hard on the buyout firm. He ruled that Apollo and Hexion had deliberately breached the agreement and that, consequently, the legal damages would not be limited to the $325 million breakup fee. Facing billions in potential liability, Apollo and Hexion paid $1 billion to Huntsman to settle the case. Credit Suisse and Deutsche Bank, which had sided with Apollo and Hexion, later chipped in another $1.7 billion to settle Huntsman’s claims against them for trying to call off the deal.
Blackstone aborted two of its deals. One, to buy the mortgage arm of PHH Corporation, fell apart when the banks financing it said they would not lend as much as they had originally indicated. Blackstone coughed up the $50 million termination fee and walked away.
It had a much harder time extricating itself from its $7.8 billion deal to buy Alliance Data Systems Corporation, a credit card transaction processor. The May 2007 deal—one of the few big LBOs Blackstone’s buyout group signed up that year—was delayed by federal bank regulators, who were concerned that a highly leveraged Alliance would not be able to back up its bank subsidiary if the bank got in trouble. They demanded that Blackstone provide more than $600 million in financial guarantees to Alliance’s bank operation in case that occurred. But because buyouts are structured legally so that neither the fund nor the private equity firm that manages it is liable for the portfolio company’s debt, providing a guarantee was problematic. Blackstone eventually made an unusual offer to have its buyout fund issue a $100 million guarantee, but that didn’t satisfy the regulators.
When Blackstone pulled the plug on the buyout in April 2008, Alliance sued, charging that Blackstone hadn’t lived up to its obligation to make its best effort to complete the deal. The case was thrown out in 2009 on the grounds that the buyout agreement didn’t require Blackstone to provide any guarantees, and the firm got off without having to pay the breakup fee. Still, it was a costly episode. Blackstone had laid out $191 million to buy Alliance shares at $78 a share while the offer was pending, and the stock then slumped. Three years later, its investment was still underwater.
In a coda for the age, the mother of all buyouts, that of the Canadian phone company BCE, was canceled in December 2008, after a year and a half of regulatory and financing delays. The company’s auditors took the deal off life support when they said they might not be able to certify the company’s solvency, as required. That saved the buyers—the Ontario Teachers’ Pension Plan, Providence Equity Partners, Madison Dearborn Partners, and Merrill Lynch’s private equity fund—from what might have turned into the biggest private equity blunder ever. KKR and TPG were left holding the dubious record for history’s biggest LBO, with TXU.
Whatever the merits of the legal positions, the cancellations and the wrangling took a toll on private equity’s reputation. For a decade, private equity had sold itself as the fast and sure solution for sellers. Buyout firms had been pitching themselves as solid corporate citizens, telling companies
that it was easier to do business with them than a corporation, where decisions had to filter through committees and boards of directors and sometimes were subject to shareholder approval. They may have won in court when challenged, but the fact was that many of the industry’s stars—Apollo, Bain, Blackstone, Carlyle, Cerberus, Clayton Dubilier, Fortress, Goldman Sachs Capital Partners, and KKR—had all bailed out of deals or cut their prices when the going got tough.
CHAPTER 24
Paying the Piper
Market conditions worsened steadily as 2007 dragged on, and buyout firms breathed a sigh of relief every time they wiggled out of a deal. Most of the time, though, they couldn’t undo the mistakes they had committed or weren’t yet persuaded that they had overpaid. But soon the leverage that magnified returns when the markets were moving up began to work in reverse. The value of private equity–owned companies fell, but the debt on their books remained the same, a combination that threatened to pulverize billions of equity that buyout firms had plowed into their megadeals. It was payback time for an industry that had gorged on the debt it was offered and flagrantly bid up companies, trying to grab as much as it could while the going was good.
The dividend recaps that had yielded such quick, rich profits just a few years earlier caught up with some firms. Apollo had been particularly aggressive about ratcheting up the debt on its companies in order to pay itself dividends, milking a whopping $2 billion from twelve of its companies in late 2006 and 2007. Two of them, Noranda Aluminum Holding Corporation and Metals USA Holdings Corporation, saw their revenues collapse in 2008 and 2009 and ended up short of cash. Blackstone, too, had engineered two large dividend recapitalizations at the top of the market: a $1.1 billion payment from its travel reservations company Travelport after Travelport sold a big piece of Orbitz.com, its online travel website, in an IPO, and a $173 million payout from Health Markets, a health insurer catering to small businesses and the self-employed. Neither company sank under the added debt, and Travelport in fact held up well in a very difficult market.
King of Capital: The Remarkable Rise, Fall, and Rise Again of Steve Schwarzman and Blackstone Page 31
