Private equity was in nowhere near as much trouble as the banking industry. Many banks, finance companies, and corporations relied on short-term borrowing that had to be refinanced constantly. When the capital markets froze up, institutions such as Bear Stearns, Lehman Brothers, and Merrill Lynch—even the giant Citigroup and the prestigious Morgan Stanley—faced insolvency when their debts came due unless they could find new capital in some other form. By contrast, buyout firms themselves bear essentially no debt, and the financing for their portfolio companies—both the equity and the debt—was safely locked in for years. Furthermore, even the most extreme LBOs were modestly leveraged compared with investment banks, many of which by 2007 were geared thirty to one. At that level, if the value of a bank’s assets fell by even one-thirtieth, just 3.3 percent, its capital was wiped out. Compounding matters, the banks were investing their own equity in leveraged investments—baroquely structured mortgage securities, real estate, and LBOs. It was leverage on leverage, which put their thin slivers of equity capital at extreme risk.
Still, as shudders passed through the financial system in 2008 and the economy began to slow, problems accumulated for private equity. By the time Bain Capital and Thomas H. Lee Partners finally closed the Clear Channel buyout in July 2008, two years after trumping Blackstone’s bid, advertising at the radio chain was evaporating. A year later, Clear Channel’s revenue had fallen by almost a quarter. The company the buyers had labored so hard to acquire, like RJR Nabisco twenty years earlier, began to look like a clunker.
Apollo, which had loaded up on cyclical businesses in 2006 and 2007, was hit particularly hard. In addition to the costly Hexion Chemical debacle, where it lost its court battle to get out of buying Huntsman Corporation, the struggling housewares retailer Linens ’n Things went south on Apollo. The chain was such a shambles when it filed for bankruptcy that it was quickly liquidated. Across Apollo’s portfolio, the results were dismal. At least five of its companies saw revenues plunge by 30 percent or more. They included Realogy, Incorporated, which licensed real estate brokerage brands such as Century 21, Coldwell Banker, and Sotheby’s and Realogy’s counterpart in Britain, Countrywide plc. When housing prices fell and fewer homes were sold, both companies saw franchise fees tumble. Creditors took over Countrywide in 2009.
Another Apollo casualty was Harrah’s Entertainment, the casino operator it bought with TPG. Harrahs saw a similar fall-off in revenue—the first time in memory that gambling had declined during a recession. (Blackstone’s buyout and real estate funds also took small, 2.5 percent stakes in Harrah’s because the firm thought the casino industry was attractive and it had no other investments in the sector.)
In an earlier era, under covenants in the companies’ loans, creditors could have stepped in and taken control if the companies’ cash flows fell below specified levels. Not this time. The “covenant lite” loans for many of the big LBOs had so few restrictions that there was little bondholders or lenders could do until a company actually ran out of cash and stopped paying. Companies like Freescale and Clear Channel that had pay-in-kind debt had even more flexibility. They could choose to pay their creditors with more paper, as both eventually opted to do—escalating rather than paying down their debt. So long as a company didn’t stop paying interest in some form, its day of reckoning would not arrive until 2011 to 2014, when its loans matured, giving its owners several years to turn things around. Blackstone’s due dates were fairly typical. Its companies had virtually no debt maturing before 2013, but that year $34 billion was scheduled to come due and would have to be refinanced if the companies hadn’t been sold by then.
Even with that latitude, the crunch took its toll. Scores of companies went bust, wiping out their owners’ investments.
Cerberus, the vulture debt firm that morphed into a major private equity investor, suffered the most catastrophic and public losses. Cerberus led a consortium that bought 51 percent of General Motors’ finance arm, GMAC, in 2006, at a time when GMAC’s mortgage lending operation was throwing off $1 billion in profits annually, much of it from subprime lending. Soon that business began to hemorrhage hundreds of millions and nearly brought down the whole company. Then auto sales collapsed. In 2009 GMAC took a government bailout that reduced Cerberus to a 15 percent voting position.
Cerberus’s buyout of the automaker Chrysler from its German parent in 2007 was even more disastrous. The investment had mystified most people in the financial and auto worlds, where the company’s problems were seen as incurable. No one could understand how Cerberus thought it could turn around the smallest of U.S. automakers or how it could make a profit on it. Even Cerberus’s investors were kept in the dark: It refused to share financial information when it raised the $7 billion in equity for the deal and told potential backers they would not receive regular financial reports even after they invested. “It was a blind-faith request—trust us,” says one investor who was approached but turned down the chance to join in. The same institutions that invested in buyout funds were demanding the opportunity to invest directly in companies alongside firms like Cerberus and Blackstone, because they then would not have to hand over 20 percent of the profits to the buyout firm as they would if they invested through a fund. With that enticemment, Cerberus had no trouble rounding up the money. When Chrysler went into bankruptcy in 2009, Cerberus and its coinvestors lost almost all their money.
More established buyout firms had investments go down the drain, too. KKR lost Masonite, a building products maker, and Capmark Financial Group, Inc., an $8.8 billion commercial real estate finance firm that it bought from General Motors with Goldman Sach’s private equity group, and Aveos Fleet Maintenance, an aircraft maintenance company it owned, went under. KKR also had to invest more equity in a German auto repair chain, the mattress maker Sealy, and in KION, a forklift maker, to prop them up.
Carlyle had five complete LBO wipeouts: Hawaiian Telcom Communications, that state’s main phone company, which had had severe operational problems after Carlyle separated it from its former parent in 2005; Edscha AG, a German auto-parts maker; SemGroup LP, an oil transport and storage company that had made bad bets trying to hedge the risk of oil prices; Willcom, Inc., a Japanese wireless phone operator that used a nonstandard technology; and IMO Car Wash Group, Ltd., a British chain of car washes.
TPG lost Aleris International, Inc., an aluminum company it bought in late 2006, to bankruptcy, and suffered a $1.3 billion rubout in Washington Mutual, a wobbly savings bank it tried to shore up.
Thomas H. Lee Partners had a particularly poor track record. On top of its near-death experience with Clear Channel, five of its companies slipped into bankruptcy: an ethanol producer, an air-conditioning equipment maker, a printing and advertising firm, an auto-parts maker, and Simmons Bedding, the mattress maker that had gone through five successive LBOs.
Forstmann Little, KKR’s main rival in the eighties, which nearly vanished after it made two massive, disastrous investments in telecoms at the peak of the market a decade earlier, lost one of its last holdings, the radio chain Citadel Broadcasting Corporation, to bankruptcy in December 2009.
In Britain, Terra Firma Capital Partners, one of that country’s most high-profile buyout firms, was forced to tap its investors for more money to save its struggling recording company EMI Group, Ltd., and sued Citigroup, which had financed the deal.
In most cases the companies lived on, taken over by their creditors or by new investors. Very few were shut down altogether like Linens ’n Things, but in most cases the buyout owners lost all their money, and the lenders and bondholders often took a haircut as well in the restructuring.
It wasn’t just the portfolio companies that were in trouble. In Britain there had long been a handful of publicly traded private equity vehicles like KKR’s Amsterdam fund that fed money into conventional LBO partnerships. That structure tripped up two of that country’s oldest and largest private equity houses, Candover Investments and Permira, when the credit crisis hit. Rat
her than keep billions of cash on hand waiting for capital calls from Candover and Permira, the public funds had lines of credit they could use when they had to write a check for a new deal. The system broke down when the market tanked because the value of the feeder funds’ assets—their stakes in the buyout funds—dropped and they were receiving no cash back from the funds, so their credit was cut off. They thus could not meet capital calls when Candover and Permira issued them. The collapse throttled Candover, which was forced to sell some holdings and for a while considered winding down. Permira survived but agreed to release all its investors from a portion of their capital calls to relieve pressure on the public fund. Its capital base shrank, and a key source of its funds was drained.
The deals done in the heady days of 2006 and early 2007 inflicted enough harm to last for years, but a string of misgauged bailouts of financial services firms in late 2007 and 2008, made before the financial system bottomed out in early 2009, cost investors billions more. At the time, the turmoil looked to many firms like a terrific opportunity to buy on the cheap, and they leaped at the chance to shore up banks and other destabilized financial businesses. Warburg Pincus sank $800 million into a troubled bond insurer, MBIA, Inc.; Thomas H. Lee Partners and Goldman Sachs Capital Partners agreed to provide MoneyGram International with $1.2 billion after it took big losses on mortgage securities; J.C. Flowers and Company pumped $1.5 billion into Hypo Real Estate AG, a Munich bank that invested in American subprime mortgages; and TPG fronted $1.3 billion of a $7 billion bailout of the savings bank Washington Mutual.
They were too early. When the crisis deepened, much of their bailout capital was lost. MBIA’s stock slid from $31 to barely $2, and the MoneyGram deal had to be rejiggered when the company’s assets deteriorated. The German government seized Hypo Real Estate, obliterating almost all of Flowers’s investment.
The rescue of Washington Mutual that TPG orchestrated was the most costly misjudgment of all. The $1.3 billion TPG invested in April 2008 was completely vaporized five months later when there was a run on the bank and regulators stepped in. It was an uncharacteristic misstep for the veteran turnaround investor David Bonderman, who had made his name originally spearheading a bailout of one of Washington Mutual’s predecessor banks in 1988 and who sat on Washington Mutual’s board after it absorbed the other bank. Executives at two other private equity firms that sized up Washington Mutual thought it needed $25 billion or $30 billion of new capital to ride out the storm. They were right. With hindsight, TPG underestimated the risk that customers would pull their money out and overestimated the bank’s ability to regain its footing.
Even the investments that survived were in many cases now worth far less than what their owners had paid. The paper losses were alarming. One of Blackstone’s coinvestors in Freescale wrote its investment down by 85 percent in 2008. KKR wrote off 90 percent of its chip maker, NXP, and its German satellite TV company ProSiebenSat.1 Media. The deal makers who had fought fierce bidding wars two or three years earlier to snare companies now faced the prospect of spending years laboring to keep them afloat and trying to devise a way to eke out even a small profit. It often was hard to see how they could, given the inflated prices they had paid and how steeply market values had fallen. If you paid ten times cash flow for a company, and valuations in its industry then recede to an historical norm of 7.5 times (a common scenario in 2009 and 2010), you would have to lift the company’s cash flow by a third just to get back to break-even on your investment. In a protracted and weak economic recovery like the one many people were anticipating, that feat would tax the skills of the ablest corporate executives.
Many buyouts done at the market peak may turn out to be dead money—investments that may not lose money but tie up capital for years because they can’t be sold, dragging down returns. TXU, the record-breaking buyout of a utility by KKR and TPG, looked to be such a case. Regulators set TXU’s electricity rates based chiefly on the price of natural gas, but the company relied heavily on coal to generate power. It had minted money when gas prices were high relative to coal, but gas prices unexpectedly dropped after the buyout because of new gas discoveries and falling demand, squeezing the utility’s profit margins severely. At the same time, electricity usage tumbled as the economy slowed.
By 2009 the company was barely making enough money to cover its expenses, including interest payments, and its outstanding loans and bonds likely exceeded the company’s value, extinguishing the value of the equity, at least on paper. Little of the debt would come due before 2014, but the company started to renegotiate and extend its loans and bonds. It appears that it will take years of hard work for the owners just to preserve their investment, let alone make a profit. It could easily go down in the books like RJR Nabisco: the largest deal of its era and the biggest dud. KKR ultimately booked more than 20 percent loss on RJR when it unloaded the last piece of the investment eighteen years after the buyout closed.
In the rosiest scenario for the buyout business, values and cash flows generally will recover over several years. But the longer that takes, the lower the investment returns will be: Selling at a 50 percent profit after two years yields a robust 25 percent return. After five years, it’s a mere 10 percent. Returns on most of the megabuyouts that epitomized the boom times are therefore likely to be dismal. Many industry insiders predicted that, collectively, private equity funds raised in the mid-2000s would not break even, performing even worse than funds raised at the end of the 1990s that were invested during the last market high.
The push by some firms like Apollo, KKR, and Carlyle to diversify away from LBOs into other asset classes by launching business development companies and publicly traded debt funds also proved calamitous. A $900 million mortgage debt fund that Carlyle raised on the Amsterdam exchange, shortly after KKR launched its $5 billion equity fund, was leveraged with more than $22 billion of debt and capsized in 2008 when its lenders issued margin calls and seized all its assets. It was a complete wipeout. KKR Financial, a leveraged mortgage and corporate debt vehicle in the United States, had to be propped up by KKR and barely survived. Its shares sank from more than $29 in late 2007 to less than 50 cents in early 2009. Apollo Investment Corporation, the business development company that Apollo created in 2004, beating Blackstone and others to the punch, took huge write-downs. Meanwhile, the shares of KKR Private Equity Investors, the landmark Amsterdam fund, lost more than 90 percent of their value by late 2008.
In addition to the choke hold the faltering economy put on highly leveraged companies, the buyout industry faced two other crises: Its investors were tapped out, and there was a looming mountain of debt to be refinanced beginning in 2011 and 2012.
For a decade, pension funds, endowments, and other institutions had stoked the LBO business by reinvesting their profits back into new funds. When the markets turned, there were no buyers for private equity–backed companies and no demand for IPOs, so there was no way to cash out of investments. The steady profits that had streamed back to investors for years dried up, depriving them of money to recycle back into private equity. Worse still for the investors, the distributions petered out while some of the biggest buyouts, including Hilton, Harrahs, Clear Channel, and TXU, were still pending in late 2007, and they faced the wrenching prospect of having to ante up amounts they couldn’t really afford. “By December [2007] distributions basically came to a screeching halt, but the capital calls kept coming, which burned a hole in [limited partners’] pockets,” says one investor.
Pension funds had to scramble to muster cash to pay retirees, and university endowments told their institutions they had nothing to give. Investors were forced to liquidate stocks and bonds into a falling market, widening the sell-off. California’s giant teachers’ pension plan, CalSTRS, was so cash-strapped that it pleaded with private equity firms not to call on existing commitments.
The colossal sell-off of stocks and bonds that ensued only compounded private equity’s fund-raising problems. As investors dumped stock
s, bonds, and other liquid assets at fire-sale prices, the value of their overall portfolios sank relative to their private equity holdings, which were valued based on their long-term potential and thus didn’t slump as much. As a result, private equity rose as a percentage of the investors’ total assets, which threw the investors’ asset allocations out of whack. Private equity’s investors had to curtail new commitments to buyout funds in order to rebalance their accounts.
Private equity also faced another enormous problem. More than $800 billion of leveraged bank loans and junk bonds were due for refinancing from 2012 to 2014. Even if the economy turned up by then, many companies might still be worth less than the bloated sums paid for them, meaning that there might not be enough collateral to refinance their debt. If not, the equity might be wiped out, and the companies’ creditors might seize control. There was a danger, too, even if the companies were worth more than their debts by then, that the debt markets would not have recovered enough to absorb all the scheduled refinancings, in which case there might not be enough credit to go around.
Any way you looked at it, private equity faced a forbidding landscape.
Blackstone was not spared when the financial roof caved in. With no investment profits on the horizon, and fewer new investments in the pipeline, the firm laid off 150 employees at the end of 2008, and its business remained in limbo the next year. As a public company, Blackstone’s stock price served as a daily referendum on the firm and its prospects. In February 2009, with the future in doubt, the stock dipped to $3.55, down more than 90 percent from its peak on the triumphant opening day. Peterson felt so badly about the money his assistant and his driver lost on their Blackstone stock that he reimbursed them for their losses.
King of Capital: The Remarkable Rise, Fall, and Rise Again of Steve Schwarzman and Blackstone Page 32
