The Tussauds business, like Legoland, dwarfed Merlin in value, but Baratta hatched a financing scheme to make the deal affordable. Borrowing a page from two other buyouts he’d worked on in the United Kingdom—of the Spirit pubs chain and the NHP/Southern Cross nursing homes—he sold some of the enlarged group’s valuable real estate to investors who then leased it back to Merlin. The investors were willing to pay a rich price because they thought the properties would rise in value, and they were glad to lease them at advantageous rates in exchange for the potential appreciation. Selling the real estate at the top of the market, Merlin raised enough to pay the Dubai fund $2 billion in cash. Like the Kristiansen family, the Dubai fund took a 20 percent stake in the merged business rather than cashing out entirely. Merlin’s biggest purchase by far was thus self-financed. Blackstone did not have to inject any new equity, retaining a 54 percent stake.
With the Tussauds attractions, by 2008 Merlin had become a major international business, drawing thirty-five million visitors annually and churning off some $300 million a year in cash, fourteen times what it did the year before Blackstone bought it. It had grown from seven hundred employees to more than thirteen thousand, including one thousand hired to fill new jobs stemming from organic growth unrelated to the mergers. Merlin was flourishing, with profits at existing properties ticking up at double-digit rates for ten years, not counting the add-ons.
Varney and Baratta say the company is now poised to generate more growth internally. With “chainable, brandable” attractions like Legoland and Sea Life, new sites can be rolled out at a fraction of the cost of a Disneyland-scale park. And with its big acquisitions under its belt, Merlin set out to expand in the United States, where it was building new Legoland and Sea Life sites. In 2010, it also bought the Cypress Gardens park in Florida, where it planned to create another Legoland. Like Disney’s parks, Merlin’s are aimed at families, but Merlin’s are in or near major urban centers and cater to day visitors, so they are cheaper.
Private equity ownership itself was an essential element in turning Vardon’s small-time Sea Life business into a major international company, Varney says. “In terms of the speed and focus of what we’ve done, you just couldn’t do that in the public arena.… We could not be where we could be without private equity.”
Merlin planned an IPO in early 2010, but called that off when European markets were shaken by worries about Greece’s solvency. Instead, Blackstone sold a 20 percent stake to CVC Capital Partners, a big London buyout firm, in a deal that valued Merlin at $3.6 billion. Including the 34 percent stake it retained, Blackstone’s original investment was worth three and a half times what it invested.
Travelport, Ltd.
In an era when lean operations are a mantra in the corporate world, there are fewer and fewer companies crying out to have their operations streamlined. The travel reservations company Travelport, Ltd., however, was riddled with the sort of inefficiencies that whet the appetites of private equity investors. Moreover, it threw off a bounty of cash—$554 million in 2006—that could support several billion dollars of LBO debt. In short, it was an ideal LBO candidate.
When Travelport’s parent, Cendant Corporation, put Travelport on the block in 2006, Blackstone’s Chip Schorr was eager to bid. At Citicorp Venture Capital, where Schorr had worked before Blackstone, he led a 2003 investment in Worldspan Technologies, one of Travelport’s chief competitors, and had wrung costs out there. His plan for Travelport called for a similar dose of old-fashioned cost-cutting plus a merger and a spinoff that would produce a bigger but more svelte Travelport.
The deal brought Blackstone full circle with one of its formative investments, for Cendant was the reincarnation of the HFS hotel franchise business Blackstone had owned in the early nineties and was still headed by Henry Silverman, the Blackstone partner whom Prudential had forced to resign in 1991. Through scores of acquisitions, Cendant had morphed into a sprawling franchising and travel business, with brands ranging from Wyndham hotels to the Avis and Budget car rental chains, real estate brokerages such as Coldwell-Banker and Century 21, and Travelport and its online reservations subsidiary, Orbitz.com.
For years, Cendant had quenched the stock market’s thirst for relentless and predictable gains in revenues and profits by acquiring scores of companies. Unfortunately, that strategy was sometimes at odds with maximizing the potential of the businesses, because restructuring can stunt revenue, increase expenses, and lead to write-offs that depress earnings in the near term. By 2005, Cendant’s buy-buy-buy strategy was no longer paying off in the stock market and Silverman, who had devoted fifteen years to building the empire, concluded that Cendant would be worth more in pieces than as a whole, and the company announced it would split itself into four businesses. When Cendant auctioned Travelport the next year, Blackstone beat out Apollo with a $4.3 billion offer. Blackstone supplied $775 million of the $900 million of equity and Technology Crossover Ventures, a venture capital firm, put up the balance. (Five months after the deal closed, One Equity Partners, the private equity arm of JPMorgan Chase, put in $125 million. Blackstone later lifted its investment to just over $800 million.)
Shortly before the sale, Silverman installed Jeffrey Clarke, a veteran cost slasher, as Travelport’s CEO. Clarke had led the integration of Compaq Computer into Hewlett-Packard after the rival PC makers merged in 2002. The twenty-five thousand jobs eliminated yielded more than $3 billion in annual savings and paved the way for HP to later overtake Dell as the world’s largest PC maker.
Travelport, which was the product of twenty-two acquisitions in four years, was ripe for Clarke’s scalpel, and when the buyout closed in August 2006, Clarke set to work, aided by Patrick Bourke, a veteran technology executive Schorr recruited because of his success chopping expenses at Worldspan under Schorr’s old firm. A first wave of cuts zeroed in on obvious excess. The twenty-five data centers Travelport had piled up during the buying jag were whittled to three, resulting in hundreds of employees and contract workers being let go. Other information technology jobs were cut when Clarke dumped hundreds of costly new-product research projects and channeled resources instead to twenty or so projects deemed most critical. Two further moves saved another $60 million a year: Travelport ditched the thousands of dedicated, leased phone lines that it had used to communicate with travel agents and switched to far cheaper Internet links, and it ended an expensive outsourcing contract with IBM to run mainframe computers, replacing them with a network of cheaper server computers it could operate in-house. By the spring of 2007, cash flows were so robust that Travelport borrowed $1.1 billion and paid most of it out as a dividend. With that, Blackstone and Technology Crossover recouped virtually their entire investment seven months after they invested.
As Clarke worked on the internal streamlining, Schorr was out making deals, negotiating to buy Worldspan from its private equity owners and preparing to spin off its Orbitz retail travel website in an IPO. Adding Worldspan would beef up Travelport’s core business, catering to travel agents and airlines. Splitting off the consumer-focused Orbitz, which accounted for about 30 percent of revenues, would leave Travelport as a pure back-end business-to-business enterprise and resolve lurking conflicts between the consumer and wholesale sides of its operations. (Orbitz competes both with Travelport’s travel agent customers and with other travel websites that rely on Travelport’s reservations system.)
Worldspan would substantially boost Travelport’s market share among travel agents, particularly in Europe, and Worldspan had better technology that could be incorporated into Galileo, Travelport’s reservation system. The companies also had dovetailing airline customer bases. Travelport hosted United Airline’s data and Worldspan serviced Delta and Northwest. Together they would vie as an equal against the two biggest back-office reservations systems at the time, Sabre, which was number one in the United States, and Amadeus, Europe’s market leader.
A $1.4 billion agreement for Worldspan was sewn up in December 2006, to be paid
for almost entirely with new borrowings, and in July 2007, Travelport sold 41 percent of Orbitz to the public, netting $477 million, which it used to pay down debt. Less than a year after the buyout, Travelport was a very different business.
When the Worldspan merger closed in August 2007, a second round of cuts began as overlaps were eliminated, producing another $195 million of savings. By Clarke’s tally, Travelport whacked $390 million a year in operating expenses in the three years after the buyout—a staggering amount. That was 54 percent of its cash flow in 2008, the first full year after Worldspan was absorbed. Put another way, the cuts together with the addition of Worldspan doubled Travelport’s cash flow.
Along the way, there were sixteen hundred layoffs and six hundred more jobs shed through attrition, but the company also added sixteen hundred jobs after the buyout, including programmers familiar with the Linux operating system used by the new servers, who replaced programmers specializing in IBM mainframe computers. The net loss of six hundred jobs amounted to about 10 percent of the Travelport and Worldspan workforce, excluding Orbitz. The new hires, some of whom were in Eastern Europe, India, and the Middle East, were generally younger and lower paid than the ones they replaced.
“Buying and integrating Worldspan has been the biggest single value driver since I’ve been here,” says Clarke. After the synergies from combining the two companies, he figures that Blackstone “in effect bought it for under four times cash flow, so it was a fantastic buy.”
Silverman had seen the potential years earlier in Worldspan and had contemplated buying it, but to realize the cost savings, Cendant would have had to take big write-offs, hurting its earnings. “There are a lot of things we might have done [with Travelport] that we, as a public company, could not do,” says Silverman. Blackstone, which was focused only on building the long-term value of the company, didn’t have to worry about Travelport’s booking expenses tied to the makeover that would cripple its share price. Blackstone was thus able to capture the benefits of the restructuring.
Even when it was pummeled by the drop-off in travel in the recession, Travelport spewed off cash—roughly $650 million in 2009. It was therefore able to take advantage of the meltdown in the credit markets and bought in some of its own bonds, with a face value of more than $1 billion, at a bargain-basement price of 46 cents on the dollar, shrinking its total debt to $4 billion. At that level, its cash flow was nearly 2.5 times its cash interest expense, giving it a healthy margin of safety.
Since Blackstone recovered virtually all its investment via the dividend in 2007, anything it collected after would be almost all profit. If Blackstone had sold in the recession in 2009, it might well have doubled its money. As the travel market rebounded and valuations headed up in 2010, the deal was primed to deliver a still greater payoff when Blackstone chooses to sell.
None of these investments was a pure cost-cutting play. In each case, Blackstone spearheaded acquisitions that enlarged and radically reframed the business. Only with Travelport was cost reduction a major element of the strategy, and even there the biggest cuts came when overlaps were eliminated as Worldspan was absorbed.
In fact, none of these three deals fits the simple LBO model. Many other Blackstone investments likewise deviate from the paradigm. When the firm seeded two reinsurance companies after 9/11, those were pure equity plays, without leverage. Other major investments like Kosmos Energy, an oil and gas exploration company Blackstone formed with Warburg Pincus in 2004, and Sithe Global Power, which builds and operates electric power plants, were start-ups. Blackstone’s ill-fated investment in the cable TV systems in Germany in 2000 and 2001, too, had more in common with a start-up investment than a standard LBO built upon existing cash flow. The companies were leveraged, but the equity Blackstone and the other backers put in was used to finance the upgrading of their networks so that they could become full-fledged telecom companies offering phone and Internet service as well as cable TV.
The common strand that runs through all these cases is that Blackstone saw the companies through tricky transitions that public-market forces and their prior owners would have made difficult, if not impossible. The CEOs Herberg, Vernay, Silverman, and Clarke, like Celanese’s David Weidman, testify to the impediments they faced trying to undertake big changes when their businesses were part of public companies that felt pressure to maintain steady earnings, even if the changes would improve financial performance in the long term. Under private equity owners, the managements were free to look out several years. The investors assumed the risks of making the changes because they controlled the company. As stand-alone businesses, with private equity owners, the companies were able to achieve much more of their potential.
Apart from the pressure public-company executives face from shareholders to deliver fast results, the compensation systems at public companies often fail to create incentives for managers to maximize long-term value. Too often, they make short-term success paramount—the most glaring example being the bonus programs at major banks, which in the years leading up to the financial crisis rewarded bankers and traders for taking huge short-term risks that sank (or nearly sank) the institutions.
The contrast between public-company pay packages and the ones private equity firms install is striking. Under buyout firms, bonuses may be rewarded for increases in cash flow or other benchmarks over the midterm. But the real payoff for managers comes from their equity stakes, and they collect those gains only when companies are sold—a strong inducement for them to focus on improving the companies to make them more attractive to buyers. Moreover, CEOs and other senior managers are usually required to invest money in their companies and not just collect stock or options for free. Hence, they have their own money at risk.
Furthermore, if a manager doesn’t measure up, he or she is much more likely to be turfed out quickly because the company’s directors are chosen by the owners, not by the CEO, as they often are in practice at big companies, and the executive won’t walk away rich. At public companies, too often stock options vest when an executive is fired, so he or she receives a windfall for failing. Private equity firms typically structure the pay packages so that executives forfeit unvested equity, and severance is usually miserly compared with that of public companies—a year or two of base salary at most.
It’s hard to measure how much the alignment of interests between managers and shareholders contributes to private equity–owned companies, but it is a crucial component of this alternative form of ownership, particularly when a company needs to chart a new course.
CHAPTER 26
Follow the Money
It was easy to understand why obituaries were written for big private equity. Heading into the second decade of the new century, the business looked to be in a dire, even terminal, state. Some thought it was destined to suffer the same fate that venture capital had in the 2000s, shriveling to a fraction of its former size. Market conditions had eviscerated the buyout business once before, at the end of the eighties. More than eighteen years passed before the records KKR set with the buyouts of Beatrice Foods and RJR Nabisco in 1986 and 1988 were eclipsed, and it wasn’t until 2002 that KKR topped its $6.1 billion 1987 fund.
The competitive landscape within private equity is bound to change as limited partners tally up whose portfolios held up and whose suffered unforgivable or catastrophic losses. Apollo, Cerberus, Fortress, Thomas H. Lee Partners, and other firms that miscalculated more often than the rest will face skeptical investors the next time they go to raise money unless they somehow recoup their losses by making smart investments at the bottom of the market.
For all its wounds, though, private equity was weathering the crisis better than other essential suppliers of capital. It emerged with most of its capital intact while commercial and investment banks were hobbled by astronomical losses on mortgage products and derivatives. The buyout funds raised in 2005 to 2007 may end up delivering disappointing returns, just as many funds raised at the peaks of the market at the end
of the eighties and nineties did. But the real test for private equity will be how it performs as an asset class against other investments. Notwithstanding the risks of leverage and the private equity–backed companies that went under, private equity funds have beaten the overall average returns at major pension funds over the last three, five, and ten years. For pension managers who need to make up for losses in stocks and real estate in 2007 to 2009, private equity will seem very tempting.
Even without new contributions, though, private equity firms have roughly $500 billion in their coffers at a time when other institutions are struggling to raise capital. The vast reserve ensures that private equity will play a major role as the economy recovers. By late 2009 private equity had started to reemerge, just as it had in 2002 when the economy and markets were still in the dumps after the end of the tech boom and 9/11.
The first signs were a string of distressed debt plays—typically the opening round of a new cycle of investments. Veteran vulture investment firms such as Oaktree Capital Management, Ares Management, and Cerberus were snatching up debt of distressed companies in hopes of gaining control of them. Many of the targets had been owned by buyout firms. Apollo, which made its name as a vulture in the early 1990s picking up the pieces of Drexel-backed companies that got in trouble, quickly joined in the scavenging, snatching control a failing German roofing materials maker, Monier Group, from one of France’s biggest private equity shops, PAI Partners. It also teamed up with Ares to buy Aleris, an aluminum company formerly owned by TPG, out of bankruptcy, and partnered with Cerberus and Goldman Sachs to take over the British casino operator Gala Coral Group, which had been owned by three of the biggest British buyout shops, Permira, Candover, and Cinven. But the vulture game works both ways, as Apollo discovered when Ares took control of the former’s ailing British real estate brokerage franchiser, Countrywide, by buying up its debt.
King of Capital: The Remarkable Rise, Fall, and Rise Again of Steve Schwarzman and Blackstone Page 35
