I’m not going to get beat twice,” Schwarzman promised Michael Puglisi, Blackstone’s longtime chief financial officer, after KKR raised a $5 billion investment pool on the Amsterdam stock exchange in May 2006.
That offering demonstrated that public investors were hungry to buy into private equity, but KKR’s success in soaking up all the demand for such funds in Europe and preempting the field stung. Behind the scenes, amid the frenzied bidding for NXP, Freescale, Clear Channel, and Equity Office Properties, Schwarzman and James began crafting their response. This would be an even more groundbreaking deal: an IPO of Blackstone itself.
By 2006 the rivalry between Schwarzman and Henry Kravis had passed into legend—perhaps even myth. Was it a deeply personal mano a mano thing? Or just a run-of-the-mill testosterone-charged competition between Wall Street chieftains—Coke versus Pepsi with a financial twist? It was clear there was no love lost between them, and no professional camaraderie, but there were partisans of each who claimed their man didn’t give the other much thought and that any melodrama was a creation of the press. After all, their firms collaborated on some of the largest buyouts of the decade, including the data company SunGard, the TV ratings firm VNU/Nielsen, and TDC, Denmark’s telephone company, and they had teamed up for the unsuccessful bid for Clear Channel.
The two men were certainly different in background, temperament, and tastes. Kravis, who had grown up wealthy, was only three years older than Schwarzman but had a decade’s head start in the buyout business and was already fabulously wealthy in his own right by the early eighties, when Schwarzman was a little-known banker at Lehman. KKR’s deals had made Kravis an A-list celebrity in the eighties, and with his second wife, the fashion designer Caroline Roehm, on his arm, he had gained entrée to New York’s elite social circles. He had worked the charity circuit for decades and his third wife, Marie-Josée Drouin, a Canadian economist and TV personality, made a name for herself hosting dinner parties sprinkled with intellectuals. Kravis seemed comfortable with his position and had retreated from the public eye after the 1980s. Schwarzman still had something to prove.
One didn’t have to scratch hard to see the antipathy. Schwarzman never missed a chance to put down KKR, as he did when he called it “a one-trick pony” to BusinessWeek, and he conspicuously neglected to invite Kravis to his birthday party in 2007. While it was hard at times to distinguish between what was a genuine blood feud and what was simply good newspaper copy, there was nonetheless more than a bit of truth to the quip of someone who knows them both that “the psychodynamics of Steve and Henry drove an entire industry.”
The notion that a major private equity firm would soon go public was in the air by early 2006. The previous December, Art Peponis, a banker at Goldman Sachs, had floated the idea with Schwarzman, but Peponis had tossed out a possible valuation of just $7.5 billion, far less than what Schwarzman had in mind, so that discussion went nowhere.
By the spring of 2006, a chorus of bankers was serenading Blackstone with the same tune, and with the momentum of buyouts building and in the wake of the KKR Amsterdam fund-raising, the value the market would put on a business like Blackstone was rising. Michael Klein, a senior Citigroup banker whose job it was to liaise with buyout firms, brought it up with Schwarzman over lunch at Schwarzman’s weekend home in the Hamptons. Klein didn’t know how profitable Blackstone was, but he knew that it had roughly $70 billion in assets under management and was in the best niches of the alternative asset management business. It collected both its steady 1.5 percent management fee plus 20 percent of the profits on its biggest funds, buyouts and real estate, and the investors in those committed their money for up to ten years; they couldn’t cut and run like mutual fund or hedge fund investors if the firm had a rough year or two. “It made them decisively more valuable than hedge funds,” Klein says. As a rough number, he suggested to Schwarzman that Blackstone might be worth upward of $20 billion—a figure that was much more to Schwarzman’s liking.
James meanwhile was batting around the same ideas in more detail, with three senior bankers from Morgan Stanley: Ruth Porat, Edward Pick, and Michael Wise. In five brainstorming sessions in May 2006, they debated the merits both of raising a fund like KKR’s and of Blackstone itself going public. The benefits of an IPO were clear enough. It would raise money for the firm and allow partners to “monetize” their stakes—turn them into cash. James pressed the bankers instead to focus on the downsides to going public. Jotting prodigiously on yellow notepads, with a can of Diet Dr Pepper invariably at his side, James conducted a Socratic interrogation of the trio.
“Please tell us how bad this could be?” was the thrust, says Porat, Morgan Stanley’s head banker for financial services clients at the time and later the bank’s chief financial officer.
An IPO would make sense only if the price were right, but there was no way James and Schwarzman were going to open up Blackstone’s books to Morgan Stanley—not even to Porat, whom James had known for twenty years and had once tried to recruit to DLJ. No one outside the firm—not even rank-and-file Blackstone partners—knew what the firm as a whole made. And Morgan Stanley was a competitor in private equity, real estate investing, and merger advice. James’s solution was to give Morgan Stanley some theoretical numbers. “We told them they would be disguised” but representative of the business, James explains. “Then we created a fictional set of numbers that reflected trends, mix, and margins but did not give absolute levels.” Based on the valuations the bankers came back with, Blackstone would get a sense of what it might be worth without tipping its financial hand. From Morgan Stanley’s response, James could see that they would end up not far off Klein’s $20 billion figure.
Porat heard nothing back after the last meeting and thought perhaps James had cooled on the whole idea. In fact, she and her team had been so enthusiastic about the prospects that in early June, Schwarzman and James summoned Blackstone’s CFO, Puglisi, and Robert Friedman, its general counsel, and asked them to figure out what needed to be done to prep the firm to go public.
Schwarzman laid out a couple of conditions. Control of Blackstone would have to remain with him and management. He didn’t want to upset the system of benign dictatorship that had gotten the firm to this point and had suppressed internal rivalries. (“You have to understand where they came from—Lehman,” says Puglisi.) Second, the IPO would have to be engineered to retain employees and not to provide a means for them to cash out and walk away. However the IPO was structured, it also had to be done in a way that didn’t subject Blackstone to corporate taxes. (Blackstone was organized as a partnership and partnerships generally don’t pay corporate taxes. Instead, their partners pay income tax on their respective shares of the partnership’s profits.)
The top-secret project was dubbed Project Puma, an echo of Project Panther, the aborted bid to list a fund in Amsterdam. Only this small band and a handful of outside advisers would be let in on it. “I was fixated on confidentiality, in large part because I wasn’t completely sure I wanted to do this. I wanted to make sure that virtually no one at the firm knew,” Schwarzman says. “I didn’t want to raise expectations. It could be a diversion.” Joshua Ford Bonnie, a young IPO specialist at Simpson Thacher, Blackstone’s law firm, was brought in to work on the legal issues, and Deloitte & Touche, Blackstone’s audit firm, was consulted. But Blackstone required each individual outside lawyer, accountant, and banker to sign a personal confidentiality agreement—a virtually unprecedented demand. Other partners, even Peterson, would not learn about the plan for months.
There was no small irony in the move to take Blackstone public at a time when the firm was playing a starring role in a sweeping privatization of American and European business. But there were powerful reasons for Blackstone itself to move in the opposite direction. While its partners spent their days trying to devise ways to sell the assets Blackstone owned at a profit, they had no way of capturing the value in the business they had built. The issue was particularly acute for Peterson, who turned eighty in 2006. Under his original 1985 agreement with Schwarzman, if one of them died, his estate was entitled to receive income from the firm only for five to seven years; he could not pass on his stake in the firm to heirs, let alone sell it. Allowing the public to buy in would provide a route for Peterson to cash out and would help the firm ease out a founder who was de facto retired even though he shared fifty-fifty voting power with Schwarzman in its core businesses and continued to collect a sizable chunk of their profits.
Getting Blackstone into some form that could be taken public entailed a herculean effort by the lawyers and accountants. To begin with, there was no one Blackstone. The “firm” was a cluster of a hundred or so partnerships and corporations and funds with contractual ties and overlapping management and ownership but no single parent company whose shares could be sold to the public. Control was complicated, too. Peterson and Schwarzman alone had voting rights in the buyout and M&A businesses. They divvied up the profits to the partners in those groups and consulted them, but the other partners had no legal right to a say in management. By contrast, the managers of the real estate arm—including its founder, John Schreiber, who was not even a Blackstone partner or employee—controlled half of the voting rights for that business, with Blackstone holding the other half. To go public, Blackstone would have to create a single entity—and ultimately two entities—at the top of the corporate pyramid.
The restructuring posed a thicket of tax, regulatory, accounting, and governance barriers through which Blackstone had to navigate. The firm wanted to list on the New York Stock Exchange, but it did not want to submit to the exchange’s rules giving shareholders the right to nominate, elect, and depose directors. On the regulatory front, Blackstone had to be an operating business that took a hands-on role in managing its holdings so that it would not fall under the onerous regulations governing passive stock market investors such as mutual fund managers. But for tax purposes, Blackstone wanted to be treated as a passive fund collecting income so it could avoid paying federal corporate taxes.
Going public also raised profound intangible issues: Would it alter the firm’s culture and change the incentives for management? Would Blackstone over time concentrate more on producing predictable short-term profits for shareholders instead of bigger, but less predictable, long-term gains for the investors in its funds?
Schwarzman and James had many qualms about going public, but they knew that if Goldman, Citi, and Morgan Stanley had talked to them about it, bankers would assuredly be knocking on the doors at KKR, TPG, Apollo, and Carlyle as well.
“If we don’t do it, someone else will” was the consensus around the table at the first Project Puma meetings, Puglisi recalls. “If someone else does it, everyone will have to follow. That’s the law of Wall Street.”
“There was an expectation that all the dominoes would fall,” says Morgan Stanley’s Porat.
Moreover, there were huge benefits to going public. Not only would it allow Peterson, Schwarzman, and other partners to sell down their stakes and diversify their wealth. It would give the firm “acquisition currency”—stock with which it could buy other businesses and lure talent. With stock it could afford to add much larger new businesses than it could if it had to pay in cash or with an illiquid ownership stake in Blackstone. That advantage would soon be demonstrated with GSO Capital, a debt fund manager formed by former colleagues of James’s from DLJ. In January 2008, after the IPO, Blackstone agreed to buy GSO, which managed $10 billion in assets, paying for it largely with stock.
James also saw other, less obvious payoffs. Unlike most of their counterparts at other private equity houses, Blackstone’s partners became fully vested in their profit stakes the day an investment was made. If they left the firm the next day, they would still collect their share of any gains when a company was sold years later. An IPO would allow the firm to create incentives for people to stay for the long haul. Under the plan that emerged, partners would receive their new stock in the company over eight years, forfeiting what they hadn’t yet received if they left sooner.
James also saw going public as a chance to break down the silos in the organization—the tendency of its units to operate in isolation. Instead of just being paid a share of the profits from their own units, partners would now be awarded stakes in the entire enterprise, binding them together economically.
Still, the prospect of being public was daunting. “Everyone was a bit ambivalent,” says James. “Do we want to live in a fishbowl? Do we want to disclose net worth and private compensation? This was a fundamentally different kind of decision” than raising a new fund on the stock market as KKR had.
To pull off an IPO, management would have to satisfy a multitude of constituencies: the investors in its existing funds (who might worry that the firm’s priorities would be altered), the partners (whose financial interests would be completely restructured), as well as potential public investors. “A couple of times a week, Steve and I would sit down and say, ‘Do we really want to do this?’ ” says James.
For all his concerns, James was convinced that it made sense for the firm, and acted, in Puglisi’s words, as “the coach and quarterback” of the effort. Schwarzman, who would make the final call, reserved judgment through the fall and winter. “I didn’t invest myself personally,” Schwarzman says. Although he was involved in the discussions throughout, he “wanted to stay objective to make a balanced decision once all the facts were in.”
Like prosecutor and judge, James would make the case and Schwarzman would take it under submission.
By the end of the summer of 2006, the lawyers at Simpson Thacher had drafted a plan to reform Blackstone as a master limited partnership, a structure commonly used for oil and investment partnerships. The public investors would be limited partners, or unit holders, and the partnership would be managed by a second partnership owned by Blackstone’s existing partners. In this form, Blackstone would pay no corporate taxes and the public unit holders would have few rights. They would have no vote on directors, for instance, and it would be very difficult for them to dislodge management.
There was just one problem. Partners would have to swap their share of future profits for equity in the unified Blackstone. To do that would involve estimating the future gains on each investment, because partners had joined at different times and thus were entitled to different slices of the pie. Projecting future investment profits would be a dicey and a monumental exercise, and one potentially fraught with politics since individual partners might argue that the investments in which they had a stake were more promising than others.
James devised an end run around the difficulty. Partners would keep their stakes in most existing investments, and the public company would own only the profits on the most recent investments and those made after the IPO. This bypassed the need to predict the success of older investments, but there was a catch: The firm would have few if any investment profits in the first few years after the IPO, as it would take time for current investments to ripen and be harvested.
The solution was a new accounting rule, Financial Accounting Standard 159, which allowed firms in some circumstances to book income based on projections of future profits. Each quarter, Blackstone would appraise each investment in its portfolio, based on cash flows and values for similar businesses, and using complex financial models, it would calculate the present value of the carried interest—its 20 percent of the profit—that it was likely to collect down the road. It would be a stupendous feat of theorizing and speculation, but the new accounting rules seemed to authorize it. James did much of the number crunching himself to put the plan together.
By October 11, he had mustered enough information that he called Porat and told her he wanted Morgan Stanley to begin work in earnest on an IPO. One of the bank’s primary tasks was to estimate more precisely what price Blackstone could command in the market. This was no small challenge. Investors and stock analysts typically look to comparable companies, but there weren’t any public private equity firms that truly compared. In Britain there was 3i Group plc, but it was smaller and focused on midsized, not large, companies. Then there was Onex Corporation in Canada, but like 3i, it invested heavily in its own funds, so that buying its shares amounted to taking a stake in an investment fund whose profits and value could oscillate, rather than a piece of a fund manager, whose income and value tended to be more steady. Moreover, Blackstone wasn’t just a private equity firm. It had its M&A and restructuring businesses, and its hedge fund-of-funds business.
None of the normal measures for assessing stocks worked well either. Assets under management—the benchmark for mutual fund companies and many other money management firms that derive their income from fixed management fees—wasn’t an apt measure for Blackstone, because two-thirds of its profits in 2006 were investment gains. Likewise, price-earnings multiples, a standard benchmark for stocks, were pretty much meaningless because Blackstone’s earnings took unconventional forms and fluctuated so widely quarter to quarter. It would take some ingenuity, then, to make the case for any valuation of the business.
Project Puma got an unexpected boost in November 2006 when Fortress Investment Group, a smaller private equity and hedge fund manager, filed papers to go public. Fortress had adopted a parallel legal structure and its business was similar enough to Blackstone’s that it would be a useful trial balloon to gauge which way the market winds were blowing.
Through the late fall and winter, the lawyers and accountants ground away on the particulars. By January 2007 the planning was far enough along that Schwarzman finally met with Peterson to inform him of the IPO and to discuss the delicate issue of reducing his stake. It was a measure of how marginalized Peterson had become that six months of groundwork had been laid before he was made aware.
Though Peterson stood to gain the most from the IPO because he would be able to sell part of his stake, he wasn’t keen on the project.
“I had run a public company, so I knew a lot about what public companies were about,” Peterson says. “Steve and I must have had a two-hour discussion one day and I said, ‘Look, I’m about to retire and, while I have the power [under the founders’ agreement] to block it, I’m not going to do that. But I am going to insist that you have really thought this thing through. And I’m going to tell you how being public is very different from being private. You’re used to the privacy of your compensation and all your arrangements and so forth. You’re used to privacy in your private life. You as a CEO will become a center point or lightning rod and you’ll have to become beholden to a board of directors. You’re going to have to be meeting endlessly with equity analysts, [making] investor telephone calls, spending an enormous amount of time. If there happen to be any public problems, you’re going to be the focal point.’ ”
By then the process was gaining momentum, and Blackstone was ready to bring in a second bank because the offering would be too big for Morgan Stanley to market single-handedly.
Adding bankers was more than an exercise in spreading the risk. It was also a division of spoils. The IPO would yield $246 million in fees and commissions for its underwriters, and every major investment bank would want a piece of the action. The first bone was thrown to Michael Klein, the Citi banker who had first floated the $20 billion valuation figure the spring before over lunch with Schwarzman. In January, Schwarzman chose Citi to colead the IPO with Morgan Stanley.
James summoned a team of Citi’s capital markets bankers to Blackstone’s headquarters on the evening of January 15, the Monday of the Martin Luther King Jr. holiday weekend, to let them in on the plans and to sign up Citi as an underwriter. Schwarzman and James were still so obsessed with secrecy that they didn’t tell Morgan Stanley that Citi had been hired, or vice versa, for several weeks. As leads, each bank would be responsible for selling 20 percent of the shares, but Morgan Stanley would receive a bigger part of the fees because its bankers had labored for months laying the foundation.
As the IPO date drew close, Blackstone repaid favors to other banks that had backed its investments, adding Credit Suisse, Lehman Brothers, and Merrill Lynch & Co., each of which got a 14 percent slice. Deutsche Bank, which had financed many of Blackstone’s LBOs but did not have the retail brokerage network needed to market large blocks of shares like those in Blackstone’s offering, was tacked on at the end, after complaining about being left out. It was allocated just 5 percent of the stock and appeared one symbolic line further down in the list of banks on the cover page.
While the IPO preparations were moving ahead in secret, Blackstone was everywhere in the public eye in the first months of 2007. Jon Gray’s real estate team was waging an all-out war for Equity Office Properties in January and February, and in Britain, Blackstone, KKR, TPG, and CVC Capital Partners were pursuing a closely watched $22 billion bid for J Sainsbury plc, one of the country’s leading supermarket chains—a deal that, had it come to pass, would have set a new buyout record for Europe.
Meanwhile, Schwarzman had gone on the conference circuit and had become something of a quote-meister. That January at the World Economic Forum in Davos, Switzerland, the annual conclave of business, financial, and political leaders from around the globe, he expounded on how executives dreaded the headaches of managing a public company. The CEO of an unnamed $125 billion corporation, he told the audience, was tired of the hassles of answering to the public markets and said to him, “Geez, I wish you could buy us, but we’re too big.”
It was Schwarzman’s sixtieth birthday party on February 13 that elevated him from being one more Wall Street bigwig to a symbol. It transformed him into a cliché for the age and a punching bag. The scale of the bash stunned even jaded Wall Streeters, and to the man in the street the extravagance reinforced every negative stereotype of financiers. It was the reality version of Bonfire of the Vanities, and the press had a field day, for the event encapsulated the power and wealth of private equity and of the small band of men who controlled its biggest firms.
The potential political fallout from the party worried Henry Silverman, the ex-Blackstone partner who had left to run Cendant. He says he bluntly asked Schwarzman, “Why would you do this?” Silverman was involved in a business group that lobbied in Washington and he knew that there were people in Congress who were looking at ways to raise taxes on hedge fund and private equity partners. “I said to Steve, ‘This is a very bad idea because these guys read the newspapers, also.’ ”
It wasn’t just the party. In the month that followed, Schwarzman continued on what seemed from the outside like an orgy of self-promotion. Just a week after the party, a cover story in Fortune dubbed him “the New King of Wall Street.” Arms crossed, poker-faced, in his trademark blue-striped shirt with white collar and a navy pinstripe suit, Schwarzman looked every inch the Master of the Universe. “Steve Schwarzman of Blackstone wants to buy your company and has a $125 billion war chest to do it,” the subhead read. A few weeks later, on March 16, Schwarzman showed up on CNBC in a lengthy interview with the network’s glamorous anchor Maria Bartiromo.
Some of the press coverage was a fluke. Fortune had compiled a package of stories about private equity and whipped out the profile of Schwarzman at the last minute, without his knowledge, relying on a stock photo for the cover. But in the wake of the party, the exposure had made Schwarzman the very public face of the high-rolling world of leveraged buyouts.
Going into February, Schwarzman still hadn’t given the final go-ahead for the IPO. “The very last thing we wanted to do was file the papers to go public and then change our minds,” James says. “You get all the negatives of being public and none of the positives.” They didn’t want to launch an IPO “until we were absolutely sure we could complete it.”
When Fortress went public on February 9, it became clear that Blackstone’s plan was viable. Fortress priced its shares at $18.50, at the top of the estimated range, and they more than doubled on their first day of trading, hitting $38 at one point.
“Not only did they get public, but they got public with great success—with great fanfare and a great valuation,” says James.
Now there was a sense of urgency, for Schwarzman and James had learned that KKR had designs to go public and there were rumblings that TPG had sought out bankers for advice. They also were concerned that the window of opportunity might slam shut. “Steve and I both instinctively felt that the public markets are inherently flighty,” says James.
The publicity from the steadily escalating wave of buyouts unveiled that spring was bound to help, conveying that private equity was on a tear. On February 26, KKR and TPG announced they would buy TXU Corporation, a Texas electricity and gas utility, for $48 billion, eclipsing the record Blackstone had set just weeks earlier when it closed the buyout of Equity Office Properties. Three days later, KKR clinched the largest LBO ever in Europe, an $18.5 billion takeover of the publicly traded drug store chain Alliance Boots plc.
By then, a number of other partners had been consulted about Blackstone’s IPO or had caught wind of it, but Schwarzman and James still hadn’t officially informed rank-and-file partners when CNBC broke the news on TV on March 16 that Blackstone would soon file offering papers—the first leak since the planning had begun more than nine months earlier. Three days later Schwarzman and James convened partners in the thirty-first-floor conference room at Blackstone’s headquarters, with partners in other offices beamed in on video monitors, to explain the IPO and the restructuring that would precede it.
On March 22, Blackstone made it official, lodging a draft prospectus with the Securities and Exchange Commission for an offering that could raise up to $4 billion. The 363-page document was long on words but short on the kinds of juicy details others really wanted to know, such as how much Peterson, Schwarzman, and James made and what their stakes in the firm were. (Under SEC rules, details like that do not have to be disclosed until later in the months-long process of going public.)
The thirty-three pages of financial statements were exceedingly opaque, if not perverse. A summary showed $2.3 billion of net income—profit in lay terms—but just $1.12 billion in revenue. How could that be? It made more than it took in? One had to burrow twenty-nine pages into the financials to find a line showing $1.55 billion in investment gains that fell outside the definition of “revenue.”
Once the prospectus was on file, the SEC’s “quiet period” rules kicked in and Schwarzman and others at the firm were barred from giving interviews. It should have been smoother sailing, but the project instead lurched forward and back as a succession of out-of-the-blue events caught Schwarzman, James, and the rest of Blackstone off guard.
The first was utterly fortuitous. Through friends, Antony Leung, the newly hired head of the firm’s Asian operations and Hong Kong’s former finance minister, contacted the managers of a new Chinese government sovereign wealth fund that was being formed to invest the billions of dollars China was accumulating because of its yawning trade deficit surplus with the West. Leung had in mind that the fund might buy a few Blackstone shares, but the managers of the new fund, later named China Investment Corporation, or CIC, instead expressed interest in buying a major stake.
Schwarzman wasn’t sure at first if the offer was worth the potential complication and delay of negotiating a side deal, but the Chinese offered to invest $3 billion and their terms turned out to be simple. All they wanted was the chance to buy in without paying the investment banks’ fees and commissions. They didn’t seek any special access to information beforehand or a seat on Blackstone’s board, and they agreed to keep the stake under 10 percent so that the investment didn’t have to go through a national security review in the United States. In addition, their shares would be nonvoting.
On May 20, barely three weeks after Leung first spoke to CIC’s head, Lou Jiwei, on April 30, a deal was signed for CIC to invest through a subsidiary optimistically named Beijing Wonderful Investments, Ltd. One person familiar with CIC calculated that in those three weeks of talks China accumulated $15 billion in new reserves and so he figured that its managers were just too busy putting out their money to haggle.
For Blackstone, the investment was a huge coup. The firm was several years behind competitors like Carlyle, KKR, and TPG developing its business in Asia. Now it had won the imprimatur of the Chinese government without any real strings attached, a link that promised to give it the inside track on many investment opportunities in China. The investment solved another problem as well: how to cash out Peterson. Up to then, the banks had figured that $4 billion was toward the upper limit of what Blackstone could raise in the IPO based on investor demand, and much of that money would go into the firm’s coffers rather than partners’ pockets. With the additional $3 billion from the Chinese, Blackstone would be able to sell 75 percent more shares than it had first planned, enough to allow Peterson and other partners to sell much bigger portions of their holdings. Now Blackstone would sell nearly $7 billion of stock and almost $4 billion of that would go to partners.
In exchange for Peterson’s selling a higher proportion of his stake than other partners, James asked him to cut his equity stake ahead of the IPO. Peterson’s son, a banker, negotiated the terms, and after some back and forth, they agreed he would give up 15 percent of his holding.
“I said I wanted to be able to look my partners in the eye,” Peterson says. “What I get in liquidity they don’t get.” After he unloaded shares in the IPO, Peterson’s stake in the firm would drop to 4.2 percent, and he confirmed that he would formally retire from Blackstone at the end of 2008. Schwarzman would be left with 23.3 percent, James with 4.9 percent.
The other surprises were not as auspicious as the Chinese overture.
While Blackstone was negotiating with the Chinese, the staff at the SEC, which vets prospectuses and the financial statements in them, was raising objections to Blackstone’s quirky method of booking income based on projections of future profits. Blackstone’s bankers had never been enthusiastic about the idea, because they thought it would be hard to explain to investors. Now the regulators thought it was too clever by half and threatened to nix the idea. Just when the hard work of getting the initial IPO prospectus on file, with all the financials, was complete, James was forced to go back to the drawing board and rethink both the accounting and the restructuring of the firm. Once again doing much of the math himself, he came up with a new scheme in which partners would exchange their shares of the profits on past investments for more equity in the new entity—the tricky swap he had tried to avoid originally. Ultimately the firm used a formula based on the average multiple of its money it had earned on its investments historically. The arrangement was clear and fair enough that partners went along, and on May 21, when the prospectus was next amended, it contained revamped financial statements. On page 83, the document mentioned in passing that Blackstone would not rely on the new accounting rules after all.
That was a headache, but another problem brewing in Washington threatened to derail the IPO altogether.
Private equity had long enjoyed two big tax advantages. First, its companies can deduct the interest on their debt, which gives them an advantage over companies that finance themselves with a higher portion of equity. Second, because most of the money that the partners in private equity firms make takes the form of carried interest—their 20 percent share of any investment gains—most of their income is taxed as capital gains. Instead of paying the top rate in the United States of 35 percent for high earners, buyout executives paid the 15 percent capital gains rate on most of their income. Similar rules apply in Britain, so that in both countries private equity kingpins, as one British investment fund manager pointedly put it, pay lower tax rates than their cleaning ladies.
On top of those long-standing tax traditions, Fortress and Blackstone were taking advantage of tax laws used originally for oil and gas and investment partnerships to avoid corporate taxes when they went public.
Off and on over the previous year, various senators and congressmen had brought up the idea of altering the treatment of carried interest for private equity and hedge fund managers. The press was filled with stories of hedge fund gurus who made more than $1 billion in 2006, and Fortress had revealed during its IPO that its three founders, Wesley Edens, Peter Briger Jr., and Michael Novogratz, and two other senior managers had received $1.7 billion from their firm shortly before Fortress’s IPO.
The capital gains advantage was not unique to private equity or hedge funds. It stemmed from general principles of tax and partnership law and the gaping differential between the tax rates on ordinary income and capital gains. Carried interest by definition consists of investment profits, which are capital gains for tax purposes, and partnership law allows profits to be allocated to different classes of partners as the partnership chooses. In many family and other businesses organized as partnerships, for instance, managers receive a bigger share of the profits—whether ordinary income or capital gains—than the passive owner-partners, regardless of whether the managers invested their own capital. The same thing is true of many real estate investment partnerships. Changing the law for private equity and hedge fund managers thus would have required creating an ad hoc law targeting them or a much larger revamping of the tax code.
Still, it seemed unfair. How could the richest of the rich pay tax at the lowest possible rate? Even former U.S. treasury secretary and former Goldman Sachs cochairman Robert Rubin argued that carried interest was essentially compensation and should be taxed as ordinary income. From a political standpoint, too, raising taxes on a bunch of wealthy private equity and hedge fund managers was tempting because it would raise revenue and placate voters resentful of the huge profits being earned by financiers.
The political situation for private equity was only exacerbated by a string of deals in the hospital and nursing home industries by KKR, Carlyle, and others. The Service Employees International Union, a feisty group that had been working to unionize that sector, saw a chance to win concessions from the new owners by holding a political hammer over their heads, and it threw its support behind the tax reform effort. In May, SEIU officials charged before Congress that private equity treated employees badly and would put nursing home residents at risk. A few days later, the larger American Federation of Labor–Congress of Industrial Organizations joined the antibuyout chorus, dropping a thirteen-page letter on the SEC arguing that Blackstone came under the Investment Company Act of 1940, which governs pure investment funds.
Though the pressure tactics from unions were a powerful goad, the catalysts that spurred Congress to action were Schwarzman’s birthday gala and the looming Blackstone IPO, say people who followed the congressional discussions.
“It was Steve’s party,” says Henry Silverman, “because they were getting pressure from their constituents—‘Look at these fat cats and look at the way they’re living their lives!’ ” Senator Max Baucus, who was behind one of the proposals, had a particular antipathy toward Schwarzman, people on the industry side say.
The political forces all converged the week of June 11, just as Blackstone’s senior management was dispersing around the globe for the IPO road show, to woo investors in person.
As it happened, June 11 was the day that Blackstone finally revealed Schwarzman’s pay: $398.3 million in 2006 alone. The figure was mind-boggling. It was nine times what Lloyd Blankfein, Schwarzman’s counterpart at Goldman Sachs, made that year in cash and stock, though Goldman had thirty times as many employees and was universally acknowledged to be the most successful firm on Wall Street. Schwarzman’s pay was twice what the top five executives at Goldman together took home. It attested to the profits private equity was churning out and revealed how rich Schwarzman had become owing to his nearly 30 percent stake in Blackstone.
That by itself might not have fanned the political fires much more, but a front-page profile of Schwarzman in the Wall Street Journal two days later made him the poster child for the campaign to sock the new barons of finance.
A cascade of headlines made the story an irresistible read: “Buyout Mogul—How Blackstone’s Chief Became $7 Billion Man; Schwarzman Says He’s Worth Every Penny; $400 for Stone Crabs,” and Schwarzman obliged the Journal with quotes conforming to every stereotype of the financial shark.
“I want war—not a series of skirmishes,” he was quoted as saying. “I always think about what will kill off the other bidder.… I didn’t get to be successful by letting people hurt Blackstone or me.” Nor was it just his competitors he treated mercilessly. The article implied that he was nasty to the help as well.
Once, while sunning by the pool at his 11,000-square-foot home in Palm Beach, Fla., he complained to Jean-Pierre Zeugin, his executive chef and estate manager, that an employee wasn’t wearing the proper black shoes with his uniform, according to Mr. Zeugin, who says he has great admiration for his boss. Mr. Schwarzman explains that he found the squeak of the rubber soles distracting.
The Journal portrayed him as a Marie Antoinette, nonchalantly spending hundreds of dollars on a casual lunch at his mansion:
He expects lunches consisting of cold soup, a cold entrée such as lobster salad or fresh grilled tuna on salad, followed by dessert, Mr. Zeugin says. He eats the three-course meal within 15 minutes, the chef says. Mr. Zeugin says he often spends $3,000 for a weekend of food for Mr. Schwarzman and his wife, including stone crabs that cost $400, or $40 per claw. (Mr. Schwarzman says he had no idea how much the crabs cost.)
Like the Fortune cover, the Journal piece came out of the blue. The interviews had been conducted months earlier, before the IPO plans were disclosed, and Blackstone assumed the story was dead. Now it surfaced at the worst possible moment.
The next day, Thursday, June 14, two senators, Baucus, a Democrat from Montana, and Charles Grassley, a Republican from Iowa, targeted the legal structures that Fortress and Blackstone were using to escape corporate taxes. Under their measure, any partnership that went public after January 1, 2007, would be taxed as a corporation. In practice, that meant Fortress and Blackstone, because the measure grandfathered in firms that had gone public earlier, and it quickly became known as the Blackstone Tax. It would have taken a big bite out of Fortress’s and Blackstone’s profits, and Fortress’s shares dropped more than 6 percent the following day. It was now open season on Blackstone and the rest of the buyout industry.
The evening Baucus and Grassley announced their proposal, as James waited at Kennedy airport in New York for an overnight flight to London for the next leg of the road show, Schwarzman caught up with him by phone. Should they call the whole thing off? To them, it seemed the entire world was lining up against the IPO. Drained from a week of numbing back-to-back, dawn-to-dusk presentations, the two pondered what to do. The firm’s lobbyists were assuring them that no bill was likely to pass soon, so they decided to press on.
They were in the home stretch now, just a week away from going public, but they would encounter ever more bizarre problems.
Early Saturday morning, when James arrived in Kuwait for meetings, he was in pain, those around him could see. He was whisked off to a hospital where tests confirmed he had a kidney stone. He was urged to stay in the hospital but returned to lead the presentations in Kuwait and more later that day in Saudi Arabia.
When the news got back to New York, the IPO team was alarmed. “I’m now going to speak to you like a mom,” Ruth Porat told James when she tracked him down by phone at the hospital. “What are you doing going to road shows! ”
Schwarzman got into the act, calling David Blitzer in London. “Blitz, Tony won’t admit this, but he’s really sick,” Schwarzman told him. “He’d shoot me for saying this, but you need to get on a plane right now.” Blitzer caught the first flight out, arriving in Dubai in time to kick off the meetings scheduled there Sunday morning. No sooner were they under way than James walked in. “I did start a meeting or two without him, but he showed up straight from the hospital and just plugged his way straight through, as only Tony can do,” says Blitzer.
After one last day of meetings Monday, the exhausted troupe boarded a chartered corporate jet for the return to London only to confront one last, alarming hiccup. An hour or so into the flight, the plane suddenly dropped sharply—enough to wake up the dozing passengers. A few minutes later, the pilot came back into the cabin. “I don’t want to panic you,” he began, and then went on to explain that the plane had lost an engine. In ordinary circumstances, the pilot said, he would land at the nearest airport, but they were in Iranian airspace and it was the middle of the night. He thought they could reach Athens on one engine, but he left it to James and Blitzer to decide what to do. They called Schwarzman and, after debating their choices, decided that it would be tempting fate for top executives of a pillar of American capitalism to make an unscheduled landing in Iran in the middle of the night. They told the pilot to try for Athens.
They made it there in the wee hours, and after boarding a replacement plane that had been sent for them, they headed for London, touching down as the sun was coming up. There was just enough time for James to dash to an 8:00 A.M. meeting with investors at Claridge’s, the posh Mayfair hotel that Blackstone had once owned.
Back Stateside, the political bombardment continued. On Wednesday, June 20, Peter Welch, a Democratic congressman from Vermont, offered a bill to tax fund managers’ carried interest as ordinary income rather than as capital gains. The next day, as Blackstone and its banks were finalizing the price for its shares, two new congressional hand grenades were lobbed at them. Democratic representatives Henry Waxman of California and Dennis Kucinich of Ohio wrote the SEC asking it to halt the IPO, arguing that Blackstone’s investments were too risky for ordinary investors. Meanwhile, in a letter to the treasury secretary, the secretary of homeland security, and the chairman of the SEC, Democratic senator James Webb of Virginia demanded that the offering be postponed so that the government could investigate the national security implications of a foreign government taking a “reported” 40 percent stake in Blackstone. Never mind that it was a matter of public record that the Chinese were taking just a 9.9 percent, nonvoting stake.
“Every gun was pointed at us that week, trying to stop this thing,” says Jon Gray, who was in Los Angeles that week for the road show and had to be briefed every morning on the latest bombshell from the capital.
The SEC had already signed off on the prospectus, so the last-minute objections came to nothing. By Thursday, June 21, the only thing that remained was to set the price. The banks had earlier estimated they could sell out the offering at $29 to $31 per unit. Around a table in Blackstone’s boardroom that afternoon, James asked each of the Morgan Stanley and Citi bankers to write down on a piece of paper the price they would recommend, then reveal their numbers and explain their thinking. The Citi bankers each said $30; the Morgan Stanley bankers had written $31. Schwarzman asked if it might be better to price it at $30. He said he didn’t want to be accused of taking every last dime if the stock later fell below the IPO price. But there was so much demand for the issue that the group finally agreed that they could easily sell out several times over at $31, and there was no reason to charge less.
That evening the banks bought the shares from Blackstone and sold them to their customers. The next day, when the new shareholders were free to trade their units on the New York Stock Exchange, the price soared to $38 as investors who hadn’t been able to buy shares directly from the underwriters bid up the price. (The price settled back to $35.06 by the end of the day.) Demand was so strong that the banks were able to increase the offering by 15 percent, raising an extra $620 million. In all, the Chinese and the public had anted up $7.6 billion, $4.6 billion of which was pocketed by Schwarzman and the other partners.
When the accounts were tallied up, Peterson walked away with $1.92 billion and Schwarzman collected $684 million. James, who had been at Blackstone less than five years, pocketed $191 million. Tom Hill, Blackstone’s vice-chairman and manager of the hedge fund arm, got $22.9 million and Mike Puglisi, the CFO, $13.8 million. The other fifty-five partners received $1.74 billion, or an average of almost $32 million each.
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.