The financial crisis called into question everything about private equity—its future, its role in the economy, and its capacity to create value. The business had expanded over three decades in benign economic conditions, with generally rising markets and low interest rates, and that growth plainly owed a lot to the rising economic tide. The debt crisis of the late 1980s and bursting of the equity bubble in the early 2000s were small corrections compared with the global meltdown in 2008 and 2009, which put to the test the industry’s claims that it is a catalyst for value creation.
Despite rebranding itself as “private equity,” and notwithstanding its attempt to cast itself as a business of corporate craftsmen who create value by reshaping businesses, the buyout industry has never outrun the reputation that stuck to it in the eighties. The image of buyout artists was enshrined then in books like Barbarians at the Gate and Oliver Stone’s movie Wall Street. In the public’s mind, they were ruthless job cutters who loot their companies of cash and assets for the sake of short-term profits. Fifteen years after the Wall Street Journal won a Pulitzer Prize for its story about the fallout for employees from KKR’s restructuring of Safeway, BusinessWeek reprised the theme that private equity hurts the businesses it buys. In “Buy It, Strip It, Then Flip It,” a 2006 feature about the buyout of Hertz Corporation the year before, the magazine told readers to be wary of buying stock in Hertz’s upcoming IPO because the “fast-buck artists” hadn’t “been shy about backing up the Brinks truck” to the rental car company, milking it for a $1 billion dividend.
But is it a game of stripping, slashing, and flipping that hurts companies and the economy?
Even if buyouts don’t inherently harm companies, do private equity firms actually add value to businesses while they control them? Or are they instead just like other successful equity investors, such as mutual funds or hedge funds, which buy and sell at a profit without altering the businesses in which they invest?
The answer to the first question is clearly no. Private equity as an industry does not harm the economy.
The answer to the second and third is that they do sometimes add fundamental economic value, but a good portion of their profits derive from buying and selling at the right moments and leveraging up to accentuate their gains. But that’s no sin.
Despite the persistence of the bogeyman, strip-it-and-flip-it image, it isn’t borne out by the facts. Take BusinessWeek’s portrayal of the Hertz case.
Hertz was a classic case of an orphan subsidiary crying out for new management when Clayton Dubilier, Carlyle, and Merrill Lynch bought it from Ford Motor Company in December 2005. Ford viewed Hertz as a captive customer for its slow-selling cars and had paid it little attention.
The new owners rethought the way Hertz financed its fleets, saving money by buying more cars outright rather than leasing them, and lowered its borrowing costs by issuing bonds backed by the vehicles instead of unsecured corporate bonds. Under Ford, in the quest for market share, Hertz had opened non-airport rental offices in the United States that lost money. Many were shut. Overhead costs in Europe, which were several times higher than in the United States, were slashed. Employees’ suggestions for more efficient cleaning and car return procedures were adopted, and consumers were encouraged to book online or use self-service kiosks, which cut costs. Executive compensation, which had been tied to market share—a factor in opening the money-losing offices—was changed to focus on cash flow and other metrics.
The changes quickly paid off. Hertz’s revenue rose 16 percent in the two years after the buyout and cash flow was up 24 percent or 35 percent, depending on which measure you use. The $1 billion dividend that the magazine lambasted the owners for taking was actually no strain on the company, which threw off $3.1 billion in cash that year, and its cash flows were rising. Despite the payment of two dividends, in the two years after the buyout the company paid down more than a half-billion dollars of its debt. The bulk of the improvement took place with only minimal job cuts—barely 2 percent in the first year, despite the office closures. (When home construction slowed in 2007, severely hurting Hertz’s large equipment rental businesses, there were bigger cuts. The company ended that year with 9 percent fewer employees than it had at the time of the buyout, but by then the economy was in recession.)
Investors who heeded BusinessWeek’s warnings to shun Hertz’s IPO lost out, for Hertz’s shares nearly doubled in the year and a half after they were offered. When the economy and travel slowed further in 2008, Hertz’s stock fared at least as well as its main competitors’. Plainly investors did not see Hertz as hobbled by its LBO.
It pays to be skeptical, then, about the potshots that are routinely aimed at the industry. Many are simply false.
Hertz could be dismissed as an anomaly, but a growing mound of academic research refutes the charge that private equity damages companies for the sake of profiteering.
In a study of 4,701 IPOs in the United States over a twenty-three-year span to 2004, a French business professor commissioned by the European Parliament found that the stocks of private equity–backed companies did better than comparable companies, belying the notion that LBOs leave companies in tatters. It stands to reason. How could a form of investment that relies on selling companies for a profit survive if it systematically damaged the companies it owned? Why would sophisticated buyers like corporations acquire companies from private equity firms if they were known to strip them bare? The oft-repeated suggestion that buyout firms foist their companies on unsuspecting investors in IPOs likewise makes no sense. Most IPO investors are institutions such as mutual and hedge funds, banks, and insurers, which would have caught on long ago if private equity–owned companies were weak and overpriced. Moreover, buyout firms almost always retain substantial stakes in their companies for years after they have gone public, as Blackstone did with Celanese and TRW, KKR did with Safeway, and Clayton Dubilier did with Hertz, so their profits hinge on sustaining the companies’ success over the long haul, not on dumping the stock at an inflated price and hightailing it.
Academic studies also debunk most of the other standard knocks on private equity: that it kills jobs, strips vital assets, and takes a shortsighted view of research and development.
To be sure, buyouts often are followed by job cuts. But companies cut jobs all the time, with or without a takeover, so the test of private equity’s impact is how it stacks up against the corporate world at large. The most exhaustive survey of the impact of private equity ownership on employees, which looked at more than forty-five hundred investments from 1980 to 2005, found that private equity–backed companies tended to slash jobs at a slightly higher than average rate in the first two years after a buyout but over time created more jobs than they eliminated. Contrary to what critics say, in the first four years following a buyout, companies owned by private equity firms add new positions at a faster clip than their public-company peers, though the gap then narrows, according to the 2008 study led by Harvard Business School professor Josh Lerner and funded by the nonprofit World Economic Forum of Switzerland. The exception is in manufacturing, where the job growth is on a par with other companies.
As for quick flips, there are relatively few of those. Investments of less than two years accounted for just 12 percent of private equity–backed companies, while 58 percent of the companies were held five years or more. The survey also found that contrary to common wisdom, private equity–owned companies generally don’t stint on crucial research and development spending, though they do focus research dollars on core product lines, where the stakes are highest, while deemphasizing more speculative, peripheral research.
There are risks, of course, to leverage, which elevates a company’s fixed costs, potentially endangering the business in a slowdown. In every recession since 1990, scores of companies have given way under their LBO debt loads. Still, the overall casualty rate for private equity–owned companies has been remarkably light. The World Economic Forum study found that on average 1.2 percent of private equity–owned companies defaulted each year from 1970 to 2007—a thirty-seven-year span that included three recessions. That was higher than the overall rate for all U.S. companies, which was 0.6 percent, but still low, and it was well below the 1.6 percent for all companies that had bonds outstanding, which is arguably a more comparable pool than the set of all companies. Another study by the credit-rating agency Moody’s Investors Service in 2008 found that private equity–owned companies had defaulted at much lower rates than other similarly leveraged companies while the economy was expanding in the mid-2000s. Any way you figure it, only a small fraction of companies that have gone through LBOs have failed. Those that have were often forced to cut jobs, but few of the businesses ceased to exist. Most were simply taken over by other companies, by new investors, or by their creditors.
There is little support, then, for the contention that private equity ownership generally harms businesses. But how do buyout firms make their money if not by slashing costs to lift profits? And do they contribute anything to the economy at large in the process, besides generating profits for their investors?
Private equity executives, hoping to share some of the plaudits that venture capitalists garner for funding new technologies, often claim that their firms make their money by making businesses better, creating fundamental economic change that benefits society. David Rubenstein, the cofounder of Carlyle, has gone so far as to pitch yet another rebranding. Private equity should be called “change equity,” he has argued. (So far, there don’t seem to be many takers.) The boast is that private equity firms do not just make well-chosen, well-timed investments and plump up the gains with some leverage; they have learned how to manage and transform businesses to create lasting improvements.
There are doubters. Even many limited partners and private equity executives are cynical about the source of the profits. “The bulk of the money that’s been made in the private equity industry is from declining interest rates, which started in 1982,” says the head of one established midsized buyout firm. “The use of leverage and the declining interest rates, I believe, are responsible for 75 percent of the value created in the last twenty-five years.”
Academics who have analyzed the nature of the profits, however, have found that leverage contributes a surprisingly small part of investment profits overall. The European Parliament’s study of IPOs concluded that while roughly a third of the gains on successful buyouts trace directly to leverage, the rest derive from long-term increases in companies’ values. A more detailed study of thirty-two highly successful European buyouts (they had an average internal rate of return of 48 percent) found that just 22 percent of the profits were due to leverage. Another 21 percent resulted from increases in valuation multiples; that is, the multiples of earnings that investors think companies are worth. The remainder, more than half, came from sales growth and profit-margin increases. (The study didn’t attempt to break out what portion of the gains in sales, cash flows, and profit margins stemmed from the business cycle—i.e., from buying at the bottom of the market and selling after a rebound.)
The truth is that private equity’s profits arise from a mixture of all these factors—leverage and other types of financial engineering, good timing, new corporate strategies, mergers and divestitures, and operational fine-tuning—some of which create more fundamental economic wealth than others. Big private equity has grown not only because debt was plentiful for most of the last twenty-five years, but also because these firms have been adaptable, squeezing profits out by pushing up leverage in good times to pay for dividends, wading in to perform nuts-and-bolts overhauls of underperforming businesses at other points, and when the economy was down, trading the debt of troubled companies and gaining control of others through the bankruptcy process. Private equity firms are nothing if not opportunistic, and their techniques vary with business and market cycles.
Playing market swings doesn’t create new wealth in the same way that wringing out inefficiencies, funding research, or repositioning a company to make higher-value products does, but it has produced high returns for pension funds, endowments, and other investors. If LBOs don’t tend to hurt businesses, there’s no more social harm to this form of ownership and capital structure than there is to a mutual fund that trades public stocks. Moreover, even bottom-fishing in a recession provides capital to companies when it’s hard to come by and provides liquidity to sellers when there are few buyers—a different form of economic and social contribution.
It’s an overstatement, though, to claim that private equity’s profits today come primarily from building better companies. Tony James frequently boasts that two-thirds of Blackstone’s gains come from increases in cash flow, implying that the businesses have improved fundamentally under Blackstone. But Blackstone can’t take credit for all of that. Perhaps even more than its competitors, Blackstone has made its money investing at troughs in the market, so that a larger share of the financial improvement at its companies can be traced to the business cycle than to operating refinements.
In an internal analysis of its investments through 2005, Blackstone calculated that more than 63 percent of its profits had come from cyclical plays like UCAR, American Axle, Celanese, and Nalco, though less than 23 percent of its capital had been invested in that kind of deal. By contrast, where Blackstone attempted profound transformations of the companies it bought, as it did with Collins & Aikman, Imperial Home Decor, Allied Waste, and the Callahan cable systems in Germany, its record was dismal. Fourteen percent of its capital had gone to such investments, and together they had lost 2 percent of all the capital the firm had deployed over seventeen years.
Even so, Blackstone and other big buyout shops have concluded that the only way they can outperform the stock market over the long haul is to systematically improve the companies they own. Bain Capital, which grew out of the Bain and Company consulting group, was one of the first to take that notion seriously and has the largest staff of experts and seasoned managers assigned to its investments. TPG long ago built a deep team of operational experts because it had a tradition of tackling messy turnaround situations that required a lot of know-how and attention. KKR, too, formed an internal team of managers in 2000 that now numbers forty, and Carlyle built up an inventory of executives on its payroll.
Blackstone was a laggard in that regard and has been playing catch-up since 2004, when it hired James Quella, a former management consultant who had worked at DLJ Merchant Banking, Credit Suisse’s private equity business, to set up what resembles a captive consulting firm. Quella’s twelve-member team of corporate managers vets companies before Blackstone invests, and its members are often assigned to work with portfolio companies when Blackstone takes over.
That shift toward a more hands-on approach to reshaping portfolio companies can be seen in Celanese and three case studies of other successful Blackstone investments in the mid-2000s. These examples show how much the emphasis has evolved over time from a crude paring of expenses at portfolio companies to laboriously improving their operations and expanding and reorienting them.
Gerresheimer AG
Call it a makeover. That was the gist of Blackstone’s strategy for the German packaging company Gerresheimer, which over the course of a decade shed its skin as a glass bottle maker and emerged as a producer of sophisticated, high-margin pharmaceutical containers. The result was one of Blackstone’s most profitable deals. In less than four years, it made more than seven times its money.
Some of the credit goes to two prior private equity owners, Investcorp and Chase Manhattan Bank, which rescued the company in 2000 from an ungainly ownership structure. When they bought Gerresheimer it was 51 percent owned by the German industrial and utility company Viag AG, which was preoccupied with its pending merger with another utility company. The balance of Gerresheimer’s stock was publicly traded, so management had to answer to public shareholders as well as its parent.
Gerresheimer’s CEO, Axel Herberg, a onetime management consultant, had lobbied his bosses at Viag to take Gerresheimer out of the beverage bottle business, where competition was intense and profit margins were low. To no avail. Viag had scant interest in Gerresheimer and even less appetite for the painful layoffs the entrepreneurial Herberg felt were necessary to convert Gerresheimer from a humdrum packaging business into a much sexier health-care-oriented packager. “We were part of a German conglomerate,” Herberg says. Closing German factories, which he envisioned, “would have been too much bad news for Viag.”
Under Investcorp and Chase, Gerresheimer sold its beverages-packaging factories and focused instead on specialized products where there was less competition and the customers were loyal. Plants in Germany and the United States were closed, and a new one with cheaper labor was opened in Mexico. But the process slowed when the economy turned down in 2002 and 2003, at a time when the company’s owners had their own distractions. The Investcorp partner who had steered the deal had left, and Chase had recently merged with J.P. Morgan. “From their point of view, it was not the time to put more capital into the business,” Herberg says, and they began looking for a buyer.
Herberg met with Tony James and Doug Rogers, a Blackstone adviser on health-care investments, in 2003 but it was another year, after a drawn-out auction, before Lionel Assant of Blackstone’s London office finally inked the $705 million deal. The price was a modest 6.8 times Gerresheimer’s cash flow.
Because quality is crucial to drug makers and packaging is a small component of the total cost of a drug, Gerresheimer’s customers were unlikely to squeeze it on price. Herberg’s goal was to carve out a niche by offering big drug makers a wide variety of containers and to keep those customers so happy that they would not shop their business around. With Blackstone’s backing, over the next two years, Herberg aggressively expanded Gerresheimer’s range of pharmaceutical packaging by buying other businesses. Most of the acquisitions were small—a factory in New Jersey, three joint ventures in China, a Danish plant—but they added products such as pre-fillable syringes and specialized plastic containers. Negotiating privately, without going through auctions, Gerresheimer was able to snap up the assets at low multiples—just four to seven times cash flow. It was the same tactic that conglomerates had used in the 1960s and underlies many “roll-up” investments by private equity firms: Namely, buy assets at low multiples and merge them into a bigger company that will be valued at a higher multiple. Unlike the conglomerates, Gerresheimer was realizing synergies because its purchases were all in the same industry.
In one final, dramatic stroke in early 2007, Herberg arranged to buy the family-owned Wilden AG, which generated sales of more than $300 million a year making inhalers and other products. Wilden’s market was increasingly global, but the brothers who ran the business recognized that their company didn’t have the wherewithal to compete effectively on a global scale, Herberg says. The deal boosted Gerresheimer’s revenues by some 40 percent and broadened its product lines.
That set the stage for Gerresheimer to go public, which it did in June 2007. In the less than two years since Blackstone had bought the company, revenue and cash flow were each up roughly 80 percent and there were 71 percent more employees. Most of the increase stemmed from the acquisitions, but Gerresheimer had also boasted strong organic growth, with sales rising 13 percent and cash flow up 18 percent excluding the new plants and businesses.
The IPO, which raised more than $1.4 billion, was the biggest new issue in Germany so far that year. With the trend lines at Gerresheimer moving so firmly upward, and stock prices rising globally, the company was valued at more than 10 times its 2007 cash flow, almost half again the 6.8-times ratio Blackstone had paid. Blackstone made back almost 5 times its money selling shares in the IPO. When it sold the last of its shares in 2008, it came away with 7.5 times the $116 million it had invested.
Having run the business as a subsidiary of a public conglomerate, under two sets of private equity owners, and as a stand-alone public company, Herberg believes the private equity stage was essential to the transition that created a bigger, more specialized, more profitable company. Gerresheimer couldn’t have reached that point as a public company, he says. “If you miss a quarter, you get beaten down immediately. You have more time under private equity so you can take more risk.” Contrary to the image of private equity backers as looking for a quick buck (or euro), they actually create wiggle room for managers to execute difficult strategies, he says. “You have long-term financing—six or eight years. You have a lot of stability under private ownership, which is underestimated because all you see is the leverage.”
Once the business was more predictable, it made sense for the company to be public. “We’re on a different plateau. The value creation by transformation is done,” he says, and the company will now grow organically. Its stock performed in line with other German industrial stocks for more than two years after the IPO, before falling harder than the broader DAX German stock index in late 2009. Four years after the IPO, however, it had caught up to the broader market.
With Merlin Entertainments, Blackstone did not so much buy a business and reshape it as concoct one from scratch. With a quick succession of acquisitions, it took a small, domestic English aquarium operator and in two years made it into the second-largest amusement park and visitor-attraction operator in the world after the Walt Disney Company. Blackstone’s handiwork was the very antithesis of a cost-slashing, asset-stripping scheme.
When Blackstone first eyed Merlin in 2005, it was a British company operating twenty-two Sea Life marine theme parks and the London Dungeon tourist attractions, all but a couple of which were in Britain. Like Gerresheimer, Merlin had an entrepreneurial CEO who had once been shackled by the management of its parent. Nick Varney had been running the business since the late 1990s, when it was owned by Vardon plc, whose core business was health and fitness clubs. He pressed to sell or close some of the smaller Sea Life parks and use the proceeds for capital expenditures on more promising attractions, but his bosses didn’t want to forego the parks’ cash flow during the time it would take to develop new properties.
“In a [public company] we were the Cinderella’s sister in the nest, not getting the [capital expenditures], not getting the attention,” Varney recalls. The stock market “was in love with health and fitness and out of love with visitor attractions.”
With financial backing from the big British buyout firm Apax Partners, Varney bought the business from Vardon in 1999 and began building new Sea Life sites. The expansion continued when Apax sold the business to Hermes Private Equity, a smaller firm, in 2003. Merlin was still a minnow, with just $27 million of cash flow in 2004, and Varney had his sights set on something grander: the Legoland theme parks, which had been put up for sale by its parent, the Danish toy maker Lego. Hermes couldn’t afford to finance the takeover of the much larger Legoland, but it was willing to sell Merlin if a buyer made an attractive offer.
Enter Blackstone, in the person of Joseph Baratta, a young partner in the London office. Blackstone knew the amusement parks industry, having invested in the Six Flags and Universal Orlando theme parks. Across Europe, there were midsized attractions, many owned by private equity firms, but no big operators. The properties were likely to come onto the market, since their owners would one day want to sell, and Baratta saw the chance to create an operator with heft.
Schwarzman and James weren’t sure Merlin was big enough to bother with. It was “a tiny, bitty little $50 million equity investment,” Baratta explains. (“The equity check was probably less than they usually spend on [deal] fees,” jokes Varney.) But with the Legoland assets, there was the chance to create a more diversified and substantial business, and Baratta persuaded Blackstone’s investment committee to give him the go-ahead. He began to negotiate simultaneously with both Merlin and the Kristiansen family that controlled Lego, and in back-to-back deals in mid-2005, Blackstone agreed to buy Merlin for about $200 million and then got Legoland for about $450 million. Blackstone stumped up another $100 million in equity to fund the Legoland purchase, and the Kristiansens took a 25 percent stake in the combined business in lieu of cash for part of the price, reducing Merlin and Blackstone’s outlay.
In management argot, Legoland was a transformative merger. It made Merlin a substantial player in Continental Europe, and added a mix of indoor Legoland Discovery Centres and outdoor Legoland parks with miniature Lego buildings, roads, and trains, giving Merlin a hedge against northern Europe’s fickle weather. “When the sun shone, we didn’t do so well [at the indoor sites],” Varney explains. “When it poured with rain, [the outdoor attractions] didn’t do so well.”
He and Baratta thought Legoland could quickly be made more profitable. It was a strong brand, but its previous owners had seen it in part as a marketing tool for Lego toys and had not managed it aggressively. The parks “attract a very well-heeled crowd, [and] they had underpriced the property,” Baratta says. In other words, prices could be raised. Moreover, the management hadn’t timed advertising to coincide with improvements at the parks, so the company wasn’t reaping the full benefits when it made upgrades.
Two more major acquisitions rounded out Merlin in 2006 and 2007. First, Blackstone invested another $140 million to fund the purchase of Gardaland, a water and theme park on Lake Garda at the base of the Italian Alps near Milan, which brought a sunny outdoor venue. The next year Merlin merged with the Madame Tussauds wax museum chain, which gave it a new chain of internationally known indoor attractions. The former had been owned by an Italian private equity group and the latter by an investment fund run by the government of Dubai.
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. Merlin’s growth continued through the recession, with revenue rising by another third by 2010, to roughly $400 million, and forty-one million visitors passed through its gates that year.
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.
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 seemed to be an ideal LBO candidate. Five years into the buyout, though, it would be painfully clear to Blackstone that its high ambitions for the investment would not pan out.
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 reservations system. The companies also had dovetailing airline customer bases. Travelport hosted United Airlines’ 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,” Clarke remarked in 2009. After the synergies from combining the two companies, he figured 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,” said 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 so, Travelport has not turned out well for Blackstone. In 2009 and 2010, the considerable gains that Travelport reaped from the restructuring were undercut by events that hurt the whole travel reservations business. The hardest blow has been a steep and persistent drop-off in U.S. airline ticket bookings. Airline mergers have also taken a toll, costing Travelport more than $20 million from annual fees when one of its biggest customers, Delta, gobbled up another, Northwest. On top of all that, a sharp rise in the number of tickets booked directly on airline websites, rather than through go-betweens, has given airlines the clout to force Travelport and other middlemen into accepting lower fees.
Then there is Travelport’s debt. Although the company has managed to whittle down debt to $3.8 billion by buying back its own bonds at cheap prices and selling assets, debt has stayed high relative to cash flow, which dropped to $530 million by 2010. Even if the company was valued at the same level as its better-performing competitor, Amadeus—seven times cash flow—Travelport was worth less than its outstanding debt by 2011 and Blackstone’s stake was worthless on paper. By the fall of that year, with default looming on the bonds it had raised to fund the 2007 dividend, Travelport began to hash out terms of a debt restructuring with creditors. If creditors did not agree to revamp the debt, it warned, it might be forced to file for bankruptcy.
Since Blackstone recovered virtually all its investment via the dividend in 2007, anything it collects now would be almost all profit. But making any kind of profit will require pulling Travelport out of its funk.
Blackstone succeeded in pushing through much-needed efficiencies and a crucial merger that created value. But it wasn’t able to exit before industry forces made Travelport’s business much tougher, and, with hindsight, the debt taken to fund the dividend overburdened the firm.
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.