It was easy to understand why obituaries were written for big private equity. Heading into the second decade of the new century, the business looked to be in a dire, even terminal, state. Some thought it was destined to suffer the same fate that venture capital had in the 2000s, shriveling to a fraction of its former size. Market conditions had eviscerated the buyout business once before, at the end of the eighties. More than eighteen years passed before the records KKR set with the buyouts of Beatrice Foods and RJR Nabisco in 1986 and 1988 were eclipsed, and it wasn’t until 2002 that KKR topped its $6.1 billion 1987 fund.
For all its wounds, though, private equity weathered the crisis better than other essential suppliers of financing. It emerged with most of its capital intact while commercial and investment banks were hobbled by astronomical losses on mortgage products and derivatives and survived only because of stupendous bailouts from government. Even firms such as Apollo Global and Cerberus, whose portfolios were ravaged in 2008 and 2009, were showing decent profits by 2011, thanks to gutsy vulture investments in distressed debt at the bottom of the market and a few successful LBOs.
The buyout funds raised in 2005 to 2007 may end up delivering disappointing returns, just as many funds raised at the market peaks at the end of the eighties and nineties did. But the real test for private equity will be how it performs as an asset class against other investments. Notwithstanding the risks of leverage and the private equity–backed companies that went under, private equity funds have beaten the overall average returns at major pension funds over the last three, five, and ten years. In 2011, U.S. private equity funds collectively had beat the U.S. stock market by more than 5 percentage points annually over the previous five years. The top firms outpaced the markets even further, besting it by a remarkable 19 percentage points over a fourteen-year period.
That the crisis did not take a greater toll on buyouts is due in large part to the response of governments and central banks. The banks pumped billions of dollars, pounds, and euros into the Western economies so that businesses would not be choked for lack of credit. Buyout firms were on no one’s list for bailouts but, because they rely so heavily on leverage, they were unintended beneficiaries of the larger rescue efforts. By cranking up the printing presses and lowering interest rates, the central banks ensured that overstretched companies avoided insolvency and the values of those businesses were buoyed. Put bluntly, the Fed saved private equity’s bacon.
In addition, buyout firms reduced and extended the debt of many of the companies they owned. The wall of debt that looked so ominous in 2008 and 2009—the $800 billion of debt for highly leveraged companies that was set to come due between 2012 and 2014—had been whittled down to less than $500 billion by early 2011, mainly by obtaining extensions and by swapping old debt for new debt that was due further out. In many cases, too, companies or their owners were able to buy back debt at pennies on the dollar when the credit markets were panicked, cutting the companies’ debt burden cheaply. Thus the prospect that hundreds of vulnerable companies would all be looking for refinancing in a two- or three-year window no longer loomed over the market.
Many of the iconic deals of the era were still duds four years after the markets crested. Blackstone’s biggest headache, Freescale Semiconductor, was one. Chip sales to automakers picked up and smartphones and tablets created new demand, but Freescale took in 30 percent less revenue in 2010 than it had in 2006, the year of the buyout, and it seemed stuck at that level. Blackstone managed to take Freescale public in May 2011, but the company was so debt-laden that the IPO was a tough sell. The shares were priced at just $18—well below the original figures its bankers had estimated, and exactly half the price that Blackstone, Carlyle, Permira, and TPG had paid for their stakes. The four firms sold no shares in the offering; the entire $750 million that Freescale took in from the IPO went to pay down debt. Even then, with $6.5 billion of debt on its books, the company was as leveraged relative to its revenues as it was when Blackstone closed the deal. For Blackstone and the other investors just to break even, the stock needed to double. Chip Schorr, the partner who led the Freescale deal as well as the now troubled Travelport investment and the aborted Alliance Data buyout, left Blackstone in 2011 to launch his own tech-focused buyout fund.
Hilton, Blackstone’s other big worry, turned out to be a much happier story. The debt restructuring agreement Blackstone negotiated with Hilton’s lenders when the business was still in the doldrums in the winter of 2009–10, shaving nearly $4 billion off the chain’s $20 billion in debt, proved to be extraordinarily advantageous for Blackstone—a master stroke by Jonathan Gray and the real estate team that had led the deal. The ink had barely dried on that agreement when business travel picked up sharply and Hilton’s business began to thrive again. By 2011, cash flows were nearly back to their peaks of 2008. Based on the valuations of big, publicly traded hotel chains in 2011, Blackstone’s investment was worth about 60 percent more than it paid, and the full payoff from Hilton’s aggressive expansion and cost-cutting after the buyout hadn’t yet been reaped, so it was a good bet that Blackstone would ultimately double its money on Hilton. Since Blackstone invested $6.5 billion altogether, in absolute terms the profit potentially could be the largest in Blackstone’s history.
For Blackstone, the clearest sign that business was normalizing came on the fund-raising front. After a protracted, three-year campaign, in 2011 it corralled $16.5 billion in commitments for its seventh buyout fund. That was smaller than the $21.7 billion it raised in 2007, but in the postcrisis era it was a resounding vote of confidence to raise a pool on the same order of magnitude, and the fund ranked as the sixth largest ever raised, just a hair behind rivals’ biggest pools in 2006 and 2007. It brought Blackstone’s buyout assets under management to $46 billion, well above the $33 billion it managed when it went public in 2007.
Still, the new fund was a quarter smaller than its predecessor, and Blackstone had to reduce its fees to woo investors this time. So, while the fund-raising was in relative terms a huge success, it hammered home the message that the buyout business would not be as big as it was, and the allure of huge LBO funds had diminished. With its investor base questioning how much opportunity there would be to make outsize profits on big buyouts, Blackstone began touting its focus on smaller deals and growth capital. Big buyouts? Who? Us?
In the postcrisis era, private equity won’t look like it did in 2006 and 2007, to be sure. Even the protagonists recognized at the time that it was a freakish period—too good to be true. With hindsight, the $20 billion—plus deals may look as anomalous as RJR Nabisco had in its day, when it was nearly four times the size of the next biggest LBO to that point. It may take a generation before there are buyouts on the scale of TXU, EOP, or Hilton again, many people in the business believe. The big question for private equity and its importance in the capital markets is not when the next $40 billion buyout occurs, but how long it takes before there is a regular stream of $5 billion to $10 billion deals—investments big enough to sustain private equity organizations on the scale they had reached before the crash. By late 2010 private equity executives and bankers were saying publicly that a $10 billion buyout could be financed, but no one pulled off any deals close to that size. The biggest through mid-2011, four years after the market turned, were in the $4 billion to $6 billion range, and there were precious few of those.
It wasn’t for lack of money, for the industry was still sitting on $350 billion to $500 billion of commitments from investors, depending on who was doing the counting. But rising stock markets in 2009–11 left few bargains, so instead of investing, buyout firms were net sellers, harvesting profits through IPOs and sales after a long hiatus. In 2011, Blackstone unloaded Graham Packaging, two Universal Studios theme parks in Florida, and Indian outsourcer Intelenet Global Services, all for handsome gains. It also reaped profits selling part of its stakes in Team Health and TRW Automotive, and posted paper gains when Kosmos Energy and Nielsen went public.
That was good in the short term for the firms and their investors, who were happy to receive some cash back at last, but it did not address where future profits would come from. With conventional big-ticket buyout candidates so scarce, buyout firms have turned to funding large start-ups, as they did in the down cycle of the early 2000s. In 2011, Blackstone backed a new company proposing to build a $3.8 billion power line under Lake Champlain and the Hudson River to bring hydro and wind power from Quebec to the New York City area, it contributed to a new $1 billion fund that will invest in shale gas fields in the United States, and it staked two wind farms off the northern coast of Germany to the tune of more than $1.5 billion. KKR likewise made a $400 million shale investment. These were not your father’s LBOs.
But such alternatives were not enough to soak up the remaining money from the massive pools raised in 2006 and 2007, which buyout firms had agreed to invest within five years. Fund managers were forced to go back to investors and ask for extensions. Again, this promises to erode investment returns, because the longer it takes to put out the money, the longer it will take to harvest profits, and over time, the firms will have bought and sold far fewer companies. Like any business, inventory turnover is key, and private equity’s current inventory is aging, and it has had trouble restocking its shelves.
But for all these limitations, the business is here to stay because the industry as a whole has produced superior returns over such a long stretch. Premier firms such as Blackstone have topped the stock market by miles, ensuring that investors will keep sending billions of dollars their way. Notwithstanding the scare of 2008 and 2009, a number of major pension funds have increased the portion of their money allocated to private equity since the crisis.
Morever, private equity has carved out a unique role for itself. Today private equity is best understood as a parallel capital market and an alternative, transitional form of corporate ownership. Unlike the money a company raises in the stock or bond markets, or with a bank loan, this capital comes with an agenda attached, and the supplier of the capital has the power to see that plan carried out. Put another way, private equity takes risks that other investors don’t want to shoulder, in exchange for control and high returns.
The LBO will continue to be the paradigm and will come to the fore again when the debt markets recover, but it no longer defines the business. At lows in the business cycle, buyout capital is used to deleverage struggling or bankrupt businesses or to buy debt at big discounts, because undercapitalized and distressed companies have the most upside for investors in a bad economy. In better times, investment flows to companies that need operational improvements. Some money will also go to stake start-up businesses, as it did with the two reinsurers Blackstone helped form after September 11, 2001, with Kosmos Energy, the oil exploration company it formed in 2003 to drill off the African coast, and more recently with the power transmission line, shale field, and wind farm operators.
The common thread in all these (except for pure distressed debt investing in down markets) is that private equity serves as a bridge between two stages of a company’s life. Just as venture capitalists fund young companies and lend management savvy, knowledge of financial markets, and connections, private equity’s activist ownership style can fill a real need when other forms of capital and ownership have fallen short. Sometimes the target is a public company like Celanese or Safeway that has not rationalized its businesses to maximize long-term value, or a major subsidiary of a public company, such as Travelport or Hertz, that hadn’t received the management it deserved. In other cases, private equity firms step in when a subsidiary such as Merlin or Gerresheimer has had its ambitions thwarted by its parent. In distressed and turnaround investments, private equity buyers provide capital and bear the risks while a troubled business regains its footing.
Two Chinese deals of Blackstone’s illustrate that transitional role. In 2007, the firm took a minority stake in China National BlueStar, a state-owned specialty chemicals company, for $530 million and agreed to work with it to acquire chemical makers elsewhere in the world. Two years later, Blackstone’s real estate group invested with a local Chinese developer to build a shopping mall. It wasn’t Blackstone’s money that won it these roles; the Chinese have a surplus of capital. In the China BlueStar case, Blackstone was an ideal investor precisely because it would bow out in a few years and did not want a permanent stake, as a Western chemical company would have had it been tapped for the role. Instead, in both cases, Blackstone was parlaying its financial, management, and real estate experience into stakes in high-growth businesses.
“If we don’t reinvent ourselves continually, we’re dead,” Schwarzman likes to tell his troops. At the end of the day, there are thousands of sources of pure capital. The trick is to supply something extra.
Faced with a sustained contraction of their core buyout businesses, the top tier of private equity firms have been scrambling to reinvent themselves, forming new types of investment funds, setting up shop in emerging markets where they see the potential for more growth, and, in some cases, offering advisory services.
The drive for diversification was particularly strong for firms that were public already (Blackstone, KKR, Apollo) and those with the hankering to be (Carlyle). Stock investors feel safer investing in businesses that don’t have too many of their eggs in one basket. Blackstone’s stock reflects that preference, for, even though it is far below its IPO price, it trades at a higher multiple of earnings than KKR, Apollo, or Fortress, which are less diversified.
In this push, the top-tier private equity firms are remodeling themselves into global investment emporia catering to the expanding tastes of pension funds, college endowments, tech billionaires, and oil sheikhs for high-return, high-risk investments—offering a greater range of alternative assets. It was a strategy any business school student would recognize: Use your reputation and relationships with existing customers to brand and market new products.
KKR, the pioneering outfit that once lorded over the industry, has played catch-up most aggressively. A decade after Schwarzman’s cheeky put-down that KKR was nothing more than a “one-trick pony”—i.e., a one-dimensional LBO shop—KKR founders Henry Kravis and George Roberts were stealing pages from Schwarzman’s playbook. KKR has tacked on more than eight new businesses since 2004, first with a debt investment and lending firm, later adding a real estate investment arm and hedge funds, plus a subsidiary to arrange stock and bond offerings that competes for the core business of investment banks.
If you can’t buy large companies outright, then offer loans to cash-hungry corporate clients. “We’re no longer limited to private equity,” says KKR partner Scott Nuttall. “We can go up and down the capital structure.”
Carlyle made the biggest splash of all with the purchase in 2011 of AlpInvest, a Dutch fund of funds manager that places clients’ money with private equity firms. With that, Carlyle’s assets under management leaped to $150 billion, putting it neck and neck with Blackstone as the world’s biggest alternative investment house.
Blackstone, too, continued to expand its existing alternative businesses. In 2008, it bought GSO Capital, a debt fund manager, and folded it into Blackstone’s existing debt business. Capitalizing on the flood of distressed debt on the market during the downturn, that business expanded its managed assets from $10 billion to $30 billion. And in 2010, Blackstone took a 40 percent stake in Pátria Investimentos, a top Brazilian alternative asset manager.
As the Pátria alliance shows, the competition among private equity firms is increasingly playing out far from the industry’s home turf in Manhattan. Blackstone, Carlyle, TPG, and KKR have raised private equity funds in China denominated in Chinese yuan, for example. With the United States and Europe staring at years of slow economic growth, the drive to globalize will only accelerate.
The ad hoc business model Schwarzman and Peterson conjured up in 1985—a mix of fee-generating advisory work to keep the lights on with a mishmash of different types of investment funds—was partly vision and partly a matter of necessity because the two had no buyout experience and hadn’t yet raised a fund. Twenty-five years on, competitors are being forced to adopt a similar strategy by the fallout of the financial crisis and the demands of public shareholders.
The diversification is bound to have consequences. When coupled with the growing number of private equity firms that are public and report their earnings quarterly, the mystery surrounding the business is likely to diminish. The veil has already been drawn back as public companies disclose reams of information each quarter and executives like Schwarzman and James and Kravis routinely submit to questioning from stock analysts and reporters. With more openness, the image of private equity—as locusts, vultures, asset-strippers—is bound to hold less of a grip on the public and the press. And as these firms increasingly manage debt, real estate, and other funds, they may be seen more benigly, perhaps more like mutual fund managers than corporate marauders. Fund of funds and debt investment pools hardly make good newspaper copy, after all.
Harder to assess is the impact on the firms’ culture and their core businesses. All asset classes are not created equal. A fund of funds manager, for instance, which simply acts as a middleman between investors and the investment firms that actually buy stocks and other securities, collects a much smaller cut of the gains than does the manager of an LBO fund. As the Blackstones and Carlyles and KKRs enter more such businesses, will they become more institutionally cautious, less prone to taking the risks that produced the 20 percent–plus returns that attracted so much money to private equity?
How successful the retooling is remains to be seen, too. Some early initiatives, notably the mortgage investment funds that Carlyle and KKR created in the mid-2000s, crashed or barely survived. Many of the new KKR businesses, like the real estate and hedge fund divisions, are mere hatchlings. It isn’t clear yet, either, whether investors will take to the cross-selling—putting money into a new real estate fund sponsored by an LBO firm, say. Many limited partners worry that the gravitational pull of the new operations, along with the demands of public investors fixated on short-term earnings, will undermine the drive for long-term returns in private equity.
Another issue dogs the biggest firms: succession. A few major private equity shops have managed the delicate handoff from their founders to the next generation, most notably Bain Capital, Thomas H. Lee Partners, and Warburg Pincus. But most of the rest are still run by the men who launched them, now mostly in their sixties. Schwarzman moved to address the matter in 2002 by hiring Tony James as his officially designated successor. But nearly a decade on, James, now himself past the sixty mark, is still the heir-in-waiting; Schwarzman retains the CEO title. If it was a bold stroke to bring in an outsider as the number two, it reflected the fact that Blackstone, more than its competitors, had been a one-man show since Pete Peterson became less involved in the business in the early nineties. To one extent or another, however, most of Blackstone’s big rivals will have to grapple with the same generational challenge over the next decade, at the same time that they migrate away from their pure LBO roots.
A history of private equity in 2020 thus will have many new story threads and a new cast of characters.