Morning Forum! Schwarzman Promises ‘Wonderful Time’ for Buyout Deals (Update1)
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By Jason Kelly
Jan. 28 (Bloomberg) -- On the 18th floor of American International Group Inc.’s headquarters in Manhattan, Blackstone Group LP executives regularly gather to carve up what was once the world’s largest insurer. The battered giant is unloading more than two dozen businesses worth about $60 billion to repay the government after its bailout last year.
Blackstone, the No. 1 leveraged-buyout firm, has a seat at the table, but not as a buyer. The company that orchestrated the then record $34 billion acquisition of Equity Office Properties Trust in 2007 is now playing a more modest role -- as an adviser to AIG as it sheds units from auto insurance to aircraft leasing.
Blackstone is searching for profits in acquisition and restructuring advising and distressed debt as LBO dealmaking enters its gravest crisis in its 40-year history. After buyout firms helped inflate the credit bubble, its obliteration has crippled the global financial system and spurred a spate of bankruptcies at companies owned by the industry’s most-hallowed names.
Buyout firms themselves may be next to go. As many as 40 of the biggest 100 companies may collapse by 2011 as their debt- strapped assets default, according to a 2008 report by Boston Consulting Group Inc., which didn’t identify the firms in its study.
“These guys had a sense they could do no wrong,” says Paul Schaye, managing partner of New York-based Chestnut Hill Partners, which helps firms find deals. “They were the new masters of the universe. Now they’re going through a very sobering experience. They have to figure out how to survive this environment.”
Swagger Personified
Blackstone founder Stephen Schwarzman, the son of a dry goods store owner in Philadelphia, was swagger personified. He owns five trophy homes in Manhattan, East Hampton, Florida, the South of France and Jamaica.
For his 60th-birthday party in February 2007, Schwarzman had the Park Avenue Armory in Manhattan redecorated to resemble part of his 35-room Upper East Side apartment, complete with a replica of a painting of himself by Andrew Festing. The guest list of 500 was stacked with notables, including Donald Trump and JPMorgan Chase & Co. head Jamie Dimon. Rod Stewart entertained them for a $1 million fee.
Four months later, Schwarzman crowned the era of megadeals with his own initial public offering. In June, he pocketed $684 million from his industry’s second IPO just three months before the stock market began its historic collapse. Schwarzman declined a request for an interview at his New York office.
$1.5 trillion
Now Schwarzman and his rivals -- Henry Kravis of KKR & Co. and David Rubenstein of Carlyle Group -- are trying to endure the hangover from their binge. Buyout firms went on a record-breaking shopping spree in 2006-07, saddling themselves with $1.5 trillion in assets that they intended to sell at a profit. Since then, they haven’t been able to find buyers for their companies, depriving them of their main source of income: the 20 percent fee they reap from a profitable sale.
After last year’s bankruptcies of Apollo Global Management LLC’s Linens ‘n Things Inc. and Carlyle’s Hawaiian Telcom Communications Inc., private equity shops face a flood of defaults that may eventually sink them too.
“The big fear for private equity is that the default rates go to an extraordinary level,” says Roy Smith, a former Goldman, Sachs & Co. partner who now teaches at New York University. “The worst outcome is that we have such a high level of default that it makes the whole buyout scene a wasteland. This is part of the biggest bubble to burst in our history.”
‘Wonderful Time’
Schwarzman, now 61, doesn’t buy the doom and gloom. Along with Peter G. Peterson, he left Lehman Brothers in 1984 and built Blackstone into a company with $116 billion under management. Last year, the firm posted its first quarterly losses in the first and third periods, spurring it to cut 70 jobs, or 7 percent of its workers, mostly in private equity. Its stock plunged 84 percent to $5.10 today from its $31 IPO price.
With his company sputtering, Schwarzman made public appearances in New York, Dubai and Quebec City in a seven-week span starting in August to try to persuade investors that good times were just around the corner.
“We’ll find a bottom, and we’ll be buying on the way up,” Schwarzman said in a speech at the Super Return Middle East conference of investors and buyout firms in Dubai in October. “Trying to catch falling knives is not what we do. The best returns in private equity have come in a period like the one we’re just entering. This is an absolute wonderful time.”
Investors Flee
Investors, who are taking a beating in private equity funds worldwide, disagree. Investments in buyout funds fell by about 60 percent to $43 billion in the fourth quarter compared with a year earlier, according to Dow Jones Private Equity Analyst, an industry newsletter. Blackstone last year reduced the target for its sixth buyout fund to $15 billion by the end of 2009 from $20 billion.
“There’s a lot yet to go wrong,” says Bill Atwood, executive director of the Illinois State Board of Investment, an investor in Blackstone and other private equity firms. “It’s going to take all they can do to manage their existing problems.”
Blackstone leveraged cheap credit more than most firms during the boom. The extra yield over Treasuries that investors demanded to own high-risk debt hit an all-time low of 2.41 percentage points in June 2007, according to Merrill Lynch & Co. data. Schwarzman’s firm was involved in 30 announced private equity acquisitions worth $145 billion in 2006-07, a torrid spurt capped by its $34 billion purchase of Equity Office Properties. The deal sparkled as the biggest LBO ever -- but for only two weeks. KKR surpassed it with a $43.2 billion purchase of electricity producer TXU Corp. in February 2007.
Blackstone’s IPO
One month later, Blackstone filed to go public, heightening the frenzy over private equity. Fortress Investment Group LLC had beaten Blackstone to the money trough, raising $634.3 million on Feb. 8. Blackstone President Tony James, who was hired from Credit Suisse Group in 2002, took the lead in managing the firm’s expansion prior to its IPO.
Blackstone’s 200-plus-page prospectus provided the first in- depth look into the firm. Its net income rose 71 percent to $2.27 billion in 2006 from a year earlier. During its history, returns to investors were also impressive: 23 percent annually from private equity funds, 29 percent from real estate investments and 12 percent from its funds of hedge funds.
With the Standard & Poor’s 500 Index over 1,500 in June 2007, Blackstone went public at the top of the market. The shares jumped 13 percent on the first day of trading, raising $4.75 billion for Blackstone. The IPO made Schwarzman one of the world’s richest men, with his stake worth $8.76 billion at the stock’s peak. The value plunged to $1.19 billion.
GSO Capital Partners
Only a few months after the IPO, dealmaking began to seize up. In July, two Bear Stearns Cos. hedge funds devoted to subprime mortgages exploded, signaling the bursting of the credit bubble. Kravis, 65, waited too long: KKR had filed to go public the same month that the hedge funds collapsed and has yet to list its shares. By September, credit for LBOs almost evaporated.
“It’s a massive shift for the industry because people are scared to death of leverage,” says Brad Alford, who runs Atlanta-based Alpha Capital Management LLC, which helps clients choose funds to invest in. “They’ve never seen an environment where there was absolutely no credit.”
Flush with cash from the IPO, Blackstone found a way to exploit the crisis it helped create. In early 2008, as Wall Street firms began their bloodletting with thousands of job cuts, Blackstone bought GSO Capital Partners LP to acquire loans used for LBOs that banks were selling at deep discounts.
Linens ‘n Things
The New York-based hedge fund firm, which Blackstone bought for $932 million, was founded by Bennett Goodman, a friend and former colleague of James’s at Credit Suisse. In its hedge funds and funds of funds, Blackstone managed $59 billion as of September. The GSO Special Situations Fund was up by less than 1 percent compared with a 15 percent decline in Lehman’s high-yield index through the third quarter of 2008, Blackstone told investors. Its funds of hedge funds were down about 14 percent for the year, the firm said.
As Blackstone and other private equity firms move into distressed debt, they must still confront the nightmare scenario that begins with defaults. In May, Linens ‘n Things, the retail chain that Apollo and other investors bought for $1.3 billion in 2006, filed for bankruptcy. Mervyn’s, a department store chain that Cerberus Capital Partners LP, Sun Capital Partners Inc. and other investors purchased for $1.65 billion in 2004, went down in July.
Defaults to Soar
For 2008, about one quarter of the 86 S&P-rated companies that defaulted on debt were private equity backed, according to the Private Equity Council, an industry lobbying and research group.
More crackups are on the way. The Boston Consulting Group study, which examined the credit spreads of 328 unidentified companies owned by private equity firms, said as many as 50 percent of them may default by 2011. The spate of bankruptcies may cause more lenders and investors to lose confidence in buyout firms, forcing many of them to shutter their doors.
“The biggest impact of the perfect storm will be on the private equity firms themselves,” the study says. “There are no precedents for the current situation, given the potential number of defaults, the structure of the debt and the difficulties faced by today’s equity owners.”
Buyout firms are now having to micromanage their hoard of companies.
“We’ve gone through every company’s plan to make sure they have adequate credit lines and told them to tighten expenses,” says Rubenstein, 59, co-founder of Carlyle. “Almost every private equity firm is doing the same sort of thing.”
CEO Summit
In October 2008, Schwarzman met with about 40 chief executive officers from his companies to deliver a warning. The bosses gathered for a day at the Waldorf-Astoria Hotel, a 77- year-old Manhattan landmark that Blackstone bought in 2007 as part of its $20 billion acquisition of Hilton Hotels Corp.
“At the CEO summit, we told them to redo their recession plans,” James, 58, said on a conference call after the meeting. “We told them to go back to the drawing board for a much more severe recession.”
Freescale Semiconductor Inc., the chipmaker that Blackstone and other firms bought for $17.6 billion in 2006, is hemorrhaging money. It’s burdened with $8.1 billion in debt from the LBO. Now the combination of debt payments and a drop in chip sales as demand for cell phones and electronics wanes leaves Freescale with little margin for error. The Austin, Texas-based company, which said sales would fall 10 percent in the fourth quarter, is rushing to sell its cell-phone-chip business.
Payouts End
“The cell phone transaction is critical to Freescale being able to cut costs in line with sales declines in 2009,” says Jason Pompeii, an analyst in Chicago with Fitch Ratings.
Freescale spokesman Mitch Haws says the company has doubled its cash position to $1.4 billion since the LBO and is set to grow once the credit crisis abates.
With an almost dead market for IPOs -- they fell 70 percent in 2008 from the prior year -- buyout firms can’t unload even their strongest companies. That means endowments and pension funds, after pouring into private equity pools during the boom, aren’t receiving payments.
“The distributions stopped abruptly, and a lot of investors are in a real bind,” says David De Weese, a New York-based general partner at Paul Capital Partners, which has $6.6 billion of assets under management, including funds devoted to secondary investments. “There’s just no capital coming out.”
Harvard’s Endowment
Investors such as Harvard University are taking losses, and other schools are selling their future commitments to funds on a secondary market at discounts as high as 50 percent. In 2009, investors may dump as much as $130 billion in commitments, De Weese says.
Harvard’s $28.8 billion endowment decreased 22 percent in the first four months of fiscal 2009, even before accounting for losses from private equity and real estate. That put the endowment, the largest of any U.S. university, on course for its worst performance in at least four decades.
Blackstone’s only profitable business is its advisory and restructuring unit. It’s exploiting the turmoil among banks that have posted losses of $797 billion stemming from the subprime mortgage meltdown and have cut 253,000 jobs.
In 2008, Schwarzman added 20 bankers from Lehman Brothers and other wounded firms to his 131-strong unit, the firm’s smallest. Ivan Brockman, who was co-head of West Coast technology investment at Citigroup Inc., joined Blackstone to run a new Silicon Valley outpost in Menlo Park, California.
Advisory Business
John Studzinski, who heads the advisory group after joining Blackstone from HSBC Holdings Plc, has nabbed marquee clients. The firm advised Procter & Gamble Co. on the $4.5 billion sale of its Folgers coffee unit to J.M. Smucker Co. and worked with Microsoft Corp. on its proposed takeover of Yahoo! Inc.
In all, Blackstone earned fees from clients on 18 deals worth $12.3 billion last year, according to data compiled by Bloomberg. The group’s profit almost tripled to $61.1 million in the third quarter of 2008 compared with a year earlier.
“The problems at all the major banks and securities firms are causing widespread cutbacks, distraction and personnel defections,” James told investors on a conference call in November. “This turmoil at our major competitors is clearly benefiting our advisory business.”
Blackstone wants to follow the rise of Perella Weinberg Partners, a boutique firm started by former Morgan Stanley banker Joseph Perella in 2006. It jumped to 19th in M&A advising in 2008 from 27th the previous year.
Avoiding Conflicts
Without lending operations, small outfits are winning more business by avoiding conflicts. Clients don’t have to worry that their adviser is also lending money to one of their competitors or a buyer. Along with Blackstone, JPMorgan was working with AIG until it quit in December because it wanted to maintain relationships with potential buyers of AIG units.
“We’re interested in providing advice where there’s not a potential conflict,” Schwarzman said in an interview in Dubai. “There’s an opportunity to build that business with refugees from the financial crisis.”
Blackstone’s investment banking fortunes may diminish after Wall Street banks stop bleeding. While Citigroup plans to break itself up and Bank of America Corp. gets a second round of government loans, Goldman Sachs, JPMorgan and Morgan Stanley may earn a profit in the first quarter, according to analysts.
“Once it all plays out, you’re going to see the banks regaining their traditional role,” says Elizabeth Nowicki, a law professor who studies M&A at Tulane University in New Orleans. “It remains to be seen whether the private equity guys will continue to like that business.”
Future of Buyouts
Schwarzman lives for the headline-grabbing buyout. Yet Blackstone’s latest move -- the December purchase of tiny Underwater Adventures Aquarium LLC in Minnesota for an undisclosed sum -- suggests the days of the $20 billion Hilton deal may be over for years to come.
The biggest of Blackstone’s 17 acquisitions in 2008 -- $3.5 billion for the Weather Channel -- may be the dealmaking model of the future, at least in the near term. Bain Capital Partners LP, NBC Universal Inc. and Blackstone had to pony up about half of the purchase price in cash instead of the 20 or 30 percent they provided during frothier times. With the extra yield over Treasuries for high-risk debt reaching as high as 18 percentage points in December, the buyers took only $1.22 billion in loans from Deutsche Bank AG and GE Commercial Finance Ltd. The buyout firms had to fund the rest themselves: Blackstone’s GSO and Bain’s credit arm, Sankaty Advisors LLC, kicked in $610 million.
Timing the Bottom
Without leverage, buyout firm profits now depend on acquiring companies at very low prices.
“Instead of turbocharging returns on leverage, they’re going to have to rely on better prices,” says Robert Profusek, a partner at Jones Day in New York, who oversees the law firm’s M&A practice. “The valuations are the opportunities for returns.”
While Schwarzman masterfully timed the top of the market in 2007, buying companies at the bottom will prove tricky. Blackstone has never faced a recession like today’s. Unlike the eight-month U.S. contraction in 2001, which was caused by the bursting of the dot-com bubble, the current downturn is global -- encompassing banking, manufacturing, retailing and housing -- and longer lasting.
“When managers want to talk optimistically, they will say, ‘The best vintage years for LBOs were the recession years,’” says Colin Blaydon, director of the Center for Private Equity and Entrepreneurship at Dartmouth College’s Tuck School of Business.
Roger Daltrey
“When valuations come down, if you have the capital, that is a period where you do well. What you didn’t have in those cases was a really deep and multifaceted recession that’s going to last a while.”
Schwarzman’s dealmaking prowess elevated his stature outside the confines of the business world. The billionaire’s donations to groups like the New York City Ballet put him in the company of Hollywood stars and the political elite.
In early 2008, he announced his biggest gift ever: $100 million to the New York Public Library. Its venerable Beaux Arts building on Fifth Avenue, famous for the large lions that guard the entrance, will be renamed after him.
As chairman of the Kennedy Center for the Performing Arts, a group to which he gave $10 million, Schwarzman dined with honorees Roger Daltrey of The Who and actor Morgan Freeman at the State Department with then Secretary of State Condoleezza Rice in December. He later made a television appearance at the awards ceremony and sat with former President George W. Bush during the event.
Blackstone’s Losses
“He’s going to do everything he can to make Blackstone work because his reputation is on the line,” NYU’s Smith says. “That’s as important as his pocketbook.”
With analysts forecasting more losses for Blackstone in the first quarter, Schwarzman faces his toughest test in four decades on Wall Street.
“I believe that Blackstone itself will make some of its best investments these next few years,” Schwarzman said on a conference call in November.
The unflagging dealmaker will have to prosper in a changed world where credit is as scarce as company turnarounds.
