While the stock and debt markets were still sliding in late 2001 and 2002, it was nearly impossible to pull off a buyout. Companies were still struggling and cash flows were tanking, so financing one was an ordeal. But Blackstone was sitting on billions it had raised in better times. Going into 2001, it still had more than $1 billion left from its $4 billion 1997 fund, as well as nearly all of the communication fund’s $2 billion, and it was gearing up to raise a fourth generalist fund. Sooner or later it would have to deploy this money. It could wait until the credit markets recovered, or it could find alternatives to the classic leveraged buyout. The strategy that unfolded revealed a truth about private equity that is seldom observed by those outside the financial world: It is defined more by opportunism than by the conventional LBO. Other things being equal, buyouts are the norm. But things were anything but equal in 2001 and 2002.
In a rising market, leveraging equity with debt produces supercharged returns by amplifying any gain in the value of the equity. In troubled times, however, it can pay to invest instead at other levels of a corporation’s capital structure, or to make unleveraged equity investments. Relatively low-risk senior debt of a company may pay as much as 15 percent—not too far short of the 20-percent-plus returns buyout firms typically aim for. Riskier, more junior debt may pay even more and may be swapped for equity down the road. When stock and bond markets fall, that’s another way of saying that the price of capital has risen: Investors demand higher returns because they perceive more risk, and companies have to offer more stock to raise the same amount of new equity capital and must pay higher interest rates to borrow. When the world at large is preoccupied with what can go wrong and afraid to stake money, those brave enough to invest can exact a very high price. Blackstone’s deal making in 2001 and 2002 reflected that fact of economic life.
The events of September 11, 2001, provided a case in point. One of the collateral casualties of the terrorist attacks was the insurance industry, which found itself staring at billions of dollars of unexpected claims not only from those hurt directly at the World Trade Center, but also from business interruption and other commercial policies covering companies far removed from New York and Washington. Overnight, capital reserves that had been built up over years as a cushion against losses were exhausted. Reinsurance companies, which protect other insurers against freak and catastrophic claims, were hit particularly hard because the attacks were so far outside any actuarial predictions, and the damage penetrated beyond the original insurers’ coverage up into the reinsurers’. Because insurance companies are required by law to maintain reserves to back the policies they write, the losses forced many insurers to curtail business, writing fewer new policies. That sent premiums skyward.
Private equity firms pounced on the opportunity, pouring money into the sector—KKR, Hellman & Friedman, TPG, and Warburg Pincus, to name just a few. Rather than invest in existing companies that still had big claims to work off, however, they set up new reinsurers with clean balance sheets that now would face little competition from existing, wounded companies.
Two months after the terrorist attacks, Blackstone plowed $201 million into Axis Capital, a new reinsurer it formed with four other private equity firms. The next June it invested $268 million alongside the London buyout firm Candover Investments and others to form another new reinsurer, Aspen Insurance, around assets that a troubled London reinsurer, Wellington Re, was forced to sell. These were 100 percent equity investments in start-ups without leverage. In a crippled industry, they had the potential to match the returns Blackstone expected on LBOs in good times because the new players would be abnormally profitable.
At the time, it looked like “probably a three-year opportunity,” says Schwarzman. After that, more capital would flow into the industry, boosting competition, driving down premiums, and causing returns to fall back to historical levels. “We would not make an amazing return, by the nature of the industry, but you could make twenty-one or twenty-two or twenty-three percent a year for a few years.” Ultimately, Blackstone made a 30.2 percent annual return on Axis. Aspen might have matched that but it suffered big losses from Hurricane Katrina in 2005, so Blackstone ultimately earned only a 15 percent return.
In mid-2002, with the stock markets still falling, Blackstone veered even further from its customary investment formulae, detouring into vulture debt investing, a treacherous new territory where it had ventured only a few times before, such as when it bought debt of the shopping mall owner DeBartolo in 1993 and Cadillac Fairview, the Canadian property developer, in 1995.
Vultures, in financial jargon, are investors who scavenge bankrupt or distressed companies, buying up their loans or bonds. Investing in distressed debt entails many of the same analyses as an LBO—figuring out the value of a company’s assets and whether it generates enough cash to cover its debt. But when a company is going down the drain, it’s much trickier to estimate how much value will be salvaged and how much value creditors will come away with.
Under corporate law, creditors are ranked in a hierarchy that determines who gets what if the company becomes insolvent. At the top are banks, whose so-called senior loans are secured by the company’s assets. They are followed by bondholders, suppliers, and employees. Shareholders stand at the back of the line, getting nothing unless the creditors are all paid off. When the company’s assets are tallied up or sold off, creditors at the top of the ladder may be paid in full while those at the bottom may get little or nothing. In between, some creditors may be only partly paid off. Those groups often get to swap their debt for an ownership stake when the business is restructured, which gives them a chance to recoup their losses.
There are several ways to make money as a vulture, all risky. Some play the distress discount. For example, if a bond pays 10 percent interest on its face value and it’s selling for 67 cents on the dollar because it might go into default, the buyer earns a 15 percent return on its investment; the effective interest rate is 50 percent higher than the nominal rate because of the discounted price. That alone might attract some investors. If the bond doesn’t default and pays off in full at maturity, they also stand to collect the full $1 in principal and score a 50 percent gain on their 67-cent investment. The investor may not have to wait until maturity to cash in if the company’s fortunes improve, because the bond’s market price will rise and the investor can sell out at a gain.
Alternatively, you can gamble on layers of the company’s debt that may not be paid off in full but which are likely to be exchanged for equity when the business is restructured. This, however, is a game only for the bold, because the payoff hinges not only on the legal position of the debt, but on the performance of a troubled business and the volatile market for distressed debt. Restructurings and Chapter 11 reorganizations often spawn bitter disputes among creditors about who will be paid how much and who will get what when the company emerges from bankruptcy—battles that can drag out the rehabilitation of the company. No matter how many numbers you crunch through a spreadsheet, the payoff for any individual class of debt is hard to predict.
“When you look at distressed deals, you have to think very differently,” says Blackstone partner Chinh Chu. “The negotiations are much more complicated because you’re playing three-dimensional chess with the creditors, the equity holders—many tranches of creditors.”
With few LBO options on the horizon, though, Blackstone was ready to gamble. “We’re value investors and we’re pretty agnostic as to where we appear in the capital structure,” Schwarzman says. “In 2002 it became pretty clear that subordinated debt in a whole variety of companies was a terrific place to be.” In other words, buying distressed bonds on the cheap was as good as buying equity if you could turn a profit that way.
Blackstone tested its new strategy first on Adelphia Communications, the cable company that filed for bankruptcy in 2002 after admitting that it had fudged its books to conceal liabilities. Mark Gallogly, whose team had been steeped in the cable industry since the mid-1990s, understood the business and was comfortable betting on Adelphia’s debt. Art Newman, the head of Blackstone’s restructuring advisers, was called in to help strategize. “These guys knew the assets very well, and I understood the bankruptcy process,” says Newman.
In the secondary market, Blackstone bought up a sizable portion of Adelphia’s debt and won a seat on the creditors committee in the bankruptcy, where the firm pressed for a sale of the company.
A few months later, in September 2002, Blackstone began buying up debt of Charter Communications, Microsoft cofounder Paul Allen’s cable giant, which had mortgaged itself to the hilt to buy cable systems at outlandish prices, including Blackstone’s TW Fanch, Bresnan, and InterMedia holdings. In both cases, the underlying businesses were fundamentally sound. They simply carried too much debt, and that would be reduced in a restructuring.
“At that point, cable looked relatively well protected,” says Schwarzman. “Its systems were built out. Its systems were difficult to replicate. Customers liked watching television, and many of the new entrants that had tried to challenge cable had gone bankrupt.”
Blackstone splashed out a hefty $516 million from both the 1997 and communications funds for Adelphia and Charter debt. It was a massive bet, and for a while it looked like the investment had been badly mistimed. As Schwarzman looked on, the trading prices of the debt fell, recalls Larry Guffey, a young partner at the time who worked on the trades. “We were underwater. Painfully—particularly when Steve’s calling you and asking you why it’s underwater, which I remember very well.”
It still wasn’t clear if the Adelphia and Charter wagers would pay off in mid-2003 when Blackstone began weighing a third big investment in distressed cable debt. This one would be equally risky but also held the promise of redemption, for the companies in question were the two Callahan systems in Germany that Blackstone had written off just months earlier.
Like Adelphia and Charter, the North Rhine–Westphalia and Baden-Württemberg cable businesses were basically healthy. They had simply run out of cash because they had spent too much too quickly to upgrade their networks and hadn’t signed up enough new customers to keep pace. With new management and the costs under control, Blackstone saw a chance to atone for the earlier loss.
Guffey, who had relocated to London in 2002, took over from Mark Gallogly and Simon Lonergan, who had overseen the original German cable investments. The banks hadn’t formally foreclosed, but the businesses were in such grim straits that for all practical purposes they belonged to the banks. Together with its coinvestors from 2000, Quebec’s Caisse de Dépôt and Bank of America, Blackstone approached one of the Baden-Württemberg system’s banks and arranged to buy a big slice of the company’s loans at a meager 19 euro cents on the euro and then bought more in the open market at deep discounts. The investor trio also bought $20 million of debt of the sister company in North Rhine–Westphalia in the open market.
The timing was as perfect as it had been disastrous in 2000 and 2001. The private equity firms swapped their debt in the Baden-Württemberg company for equity when the company was restructured, and Blackstone then bought out Caisse de Dépôt and Bank of America’s stakes, giving it a controlling position. Working with a new CEO who had been brought in at the tail end of Callahan’s involvement, they kept new capital spending in sync with revenues. “We slowed it down until the revenue caught up,” Guffey says.
The restructuring cut the company’s debt to manageable levels and the business was soon back on its feet. By 2005 profits were rising and the company was able to borrow money to refinance its debt and pay a huge dividend to Blackstone and other shareholders. By the time Blackstone cashed out its last piece of the two companies in 2006, it had booked a profit of $381 million—three times what it had invested in the second round. That more than made up for the $264 million loss on the original investment. On top of that, the communications fund raked in a $312 million profit on the debt of another troubled German cable firm, Primacom, in which Blackstone had not previously invested. Blackstone also made back some of what it had lost earlier on Sirius, the satellite radio company, by buying its debt on the cheap. The communications fund raised in 2000, whose situation had looked so dire in 2002, had been patched up and was now posting profits.
“We had just raised this $2 billion fund” when the original Callahan deal foundered, Guffey says. “This was 15 percent of the fund and it looked like it would be zero. We were down eight to one in the seventh inning and we turned the game around.”
Adelphia and Charter yielded big windfalls as well. Altogether, Blackstone more than doubled the roughly $800 million it gambled on the distressed debt strategy.
The communication fund for years was the least profitable of all of Blackstone’s funds, with an annual rate of return in the single digits. But thanks to the vulture plays and some later investments, by 2007 it had produced a respectable if not spectacular 17 percent annual return—better than Blackstone’s 1997 fund.
Slowly it became possible, too, to make equity investments again, in many cases as a by-product of the economic strains of the retrenchment.
Across America and Europe corporations had binged on acquisitions in the late nineties, and they were still gripped by indigestion. Many mergers had not panned out, and even those that had worked operationally had often left the buyers overindebted. Many companies needed to sell assets to pay down debt and shore up their balance sheets, but there were few buyers. The markets had no appetite for IPOs, so they couldn’t sell their subsidiaries that way. And the corporate world was generally reluctant to expand through acquisitions after the buying frenzy of the late 1990s. Flush with capital, Blackstone and other private equity firms were among the few buyers, and they began to fill the void.
It took some ingenuity to find deals that could get off the ground, and the first round of new equity investments Blackstone made deviated from the standard LBO model in one way or another.
When Blackstone took a minority stake in Nycomed, a Danish pharmaceutical company, as part of a consortium in October 2002, the buyers put up nearly 40 percent of the price in equity—far higher than the more typical 25 percent or 30 percent. They saw it as a growth play and calculated that the business would expand quickly enough that they could make LBO-level profits even without steep leverage.
Likewise, the financing for the $4.6 billion buyout of TRW Automotive, a parts maker, that autumn was unorthodox. Northrop Grumman, a defense contractor, was acquiring TRW’s parent company, another defense supplier, and needed to off-load the auto subsidiary as quickly as it could to pay down the loans for the main takeover. Blackstone was unwilling to invest more than $500 million of its own, so Neil Simpkins, a young partner who was leading the deal, persuaded Northrop to keep a 45 percent stake while Blackstone tried to recruit other investors after the deal closed. In effect, the seller was offering installment financing for its own asset. Northrop even loaned Blackstone some of the money to buy its 55 percent stake. Still, it was hard to line up the debt needed to cover the balance. (Ultimately other investors joined Blackstone, allowing Northrop to sell down its stake to the 19 percent it wanted to retain.)
In another instance, Blackstone effectively provided financing for a public company to make an acquisition. There PMI Group, a bond insurer, wanted to buy Financial Guaranty Insurance Company, a municipal bond insurer, from General Electric, but PMI’s bond ratings were lower than FGIC’s and an outright purchase would have jeopardized FGIC’s ratings. To insulate FGIC’s credit rating from its new parent’s, Blackstone and Cypress Group, another private equity firm, stepped in and agreed to take 23 percent stakes each so that FGIC was not deemed to be a subsidiary of PMI. The expectation was that PMI would one day be in a position to buy all of FGIC.
Blackstone also made two bets on energy prices. In 2004 it took a flier on a start-up oil and gas exploration company, Kosmos Energy, that planned to drill for oil off the west coast of Africa, and it bought Foundation Coal, the U.S. subsidiary of RAW, a German company that was shedding assets.
In late 2001 and 2002, when the markets were still staggering from the shock of the terrorist attacks, Blackstone managed to put out more than $1 billion of equity from its buyout funds, and put a further $1.5 billion to work in 2003.
Apart from the profits the investments earned Blackstone and its investors, those deals and others by private equity firms during that period injected much-needed capital into companies at a time when the capital markets were shut down. It was Blackstone’s money, for example, that enabled Northrop and PMI to make key acquisitions. The firm helped fund the two start-up insurance companies as well as Kosmos Energy, another new company. In other cases, it bought assets that troubled companies badly needed to unload at a time when there were few other buyers. Its $1.7 billion deal with Bain Capital and Thomas H. Lee Partners to purchase the textbook publisher Houghton Mifflin in 2002, for instance, provided cash to the company’s parent, the French media giant Vivendi, which was near collapse after an ill-considered campaign of takeovers. Another deal, for Ondeo Nalco SA, which made water-treatment products, grew out of a restructuring of its French parent, the utility Suez SA.
It wasn’t just Blackstone that was stepping up when buyers were scarce. Across Europe, the United States, and Canada, private equity firms paid considerable sums for the phone book subsidiaries of big telecoms that had to pare their debt in those years. In Germany, KKR scooped up a grab bag of industrial businesses—a plastic extruding equipment company, a crane maker, and others—that the huge German conglomerate Siemens had acquired just a few years earlier.
The buyers were consummate opportunists, taking advantage of the disarray in the markets and the economic problems of the corporate world for their own and their investors’ benefit. But the billions they invested at the bottom of the market supplied sellers with capital they needed to make it through the recession and helped set a floor under corporate valuations that had nose-dived. With a wealth of capital at their disposal, private equity firms performed a role the mainstream capital markets had relinquished at the time.