10. Private Vices
In the film Rain Man, the institutionalized, autistic savant Raymond Babbit (Dustin Hoffman) informs his brother Charlie Babbit (played by Tom Cruise) that he won’t fly on any airline except Qantas because it had never crashed. Qantas remains a profitable, full-service airline, with its safety record more or less intact. When Ralph Fiennes, the English actor, who was alleged to have been involved in an intimate encounter with a flight attendant in an aircraft toilet, some dubbed the carrier—Quickies available near toilet ask staff.
In 2007 a consortium of private equity investors bid A$11.1 billion ($9.2 billion) for Qantas, around A$8.5 billion ($7 billion) (77 percent) borrowed from banks. LBOs were now private equity and investors were keen to join the Mile High club.
Excess Returns
After the 1987 equity crash, Milken presciently had warned of increasing risk: “The byword is equitize.”1 After Drexel’s demise, the focus was on restructuring legacy deals. RJR Nabisco required $1.7 billion of additional equity from KKR in 1990. Around 1992, leveraged buyouts (LBOs) started to recover. It was back to basics, buying quiet companies and extracting value from the operational side. Margins of safety improved and leverage of 60–80 percent was down from the 85–95 percent of the boom years.
New players joined familiar players, who had never gone away. There was the Blackstone Group—originally a mergers and acquisitions boutique founded in 1985 by Pete Peterson and Stephen Schwarzman of Lehman Brothers. There was Carlyle—founded in 1987 by Stephen Norris and David Rubenstein. There was Texas Pacific Group (now TPG Capital)—created by David Bonderman and James Coulter. Citicorp Venture Capital, spun out of CitiGroup, became CVC Capital Partners. Schroder Ventures (a part of venerable English merchant bank Schroders) morphed into Permira, derived from the Latin adjective permirus meaning “very surprising,” “very different.” Guy Hands created Nomura’s Principal Finance Group, which eventually became Terra Firma Capital Partners.
Disillusioned with poor returns in equities and declining interest rates in the 1990s, investors invested in alternative assets, including buyouts and hedge funds promising high returns. Asset consultants cited alpha, beta, and diversification benefits based on historical performance. Investors ignored industrialist Warren Buffett’s advice: “If past history was all there was to the game, the richest people would be librarians.”
Debt now came increasingly from banks, who formed leveraged finance groups covering buyout firms (rebranded financial sponsors) supplying acquisition debt (leveraged loans). In the junk bond market, investors diversified out of buyouts into borrowers from emerging markets. In 1997/8, borrowers from Asia, Latin America, and Eastern Europe defaulted, inflicting large losses. Investors retreated to traditional areas like telecommunications, only for the dot.com bubble to burst, losing from the failure of firms like WorldCom, Adelphia, and Global Crossing.
The collapse of the technology stock bubble and the events of September 11, 2001 paved the way for a new buyout boom. Corporate and accounting scandals such as Enron, Tyco, and Worldcom led to the 2002 U.S. Corporate and Auditing Accountability and Responsibility Act—the Sarbanes–Oxley Act or SOX, named after sponsors U.S. Senator Paul Sarbanes and U.S. Representative Michael G. Oxley. SOX established legislative standards of auditor independence, corporate governance, internal controls, and enhanced financial disclosure for U.S. public companies, backed by criminal penalties. Public company boards and managers became extremely cautious, retaining excess cash and setting high hurdle rates for investments, making them buyout targets. Public companies went private just to avoid SOX.
In 2002, Alan Greenspan cut interest rates sharply to prevent the U.S. economy going into recession, reducing the cost of debt and increasing the ability to borrow to finance acquisitions. Lower rates encouraged investors to invest in higher risk debt and junk bonds for higher returns.
Subordinated debt reemerged as mezzanine (mezz) debt. PIK (pay in kind) debt was rebranded toggle loans, allowing interest payments in cash or by issuing IOUs. If the PIK feature was activated, toggled, then the interest rate increased by 0.25 percent per annum to 0.75 percent per annum. Toggles triggered by a cash flow trigger were known as PIYW (pay if you want) and PIYC (pay if you can). Cov-lite (covenant light) loans dispensed with protective covenants—financial tests designed to monitor the borrower’s financial condition.
Looser lending conditions were encouraged by banks that no longer held on to the loans, repackaging them using securitization and derivatives for sale to investors. Financial alchemy, in the form of securitization, allowed low-quality (noninvestment grade) buyout loans to be repackaged into investment grade, even AAA rated bonds, increasing the number of potential buyers. In a virtuous spiral, increasing availability of cheap debt drove larger transactions, which in turn increased the flow of money into buyouts driving new transactions.
Sexy Private Equity
Rebranding buyouts as private equity was designed to distance them from the shameful history of Milken. In the period 2003 to 2007, 13,000 deals were completed, an increase of 140 percent from the 1996–2000 period. Between 2003 and 2007, 58 deals with a size of $5 billion or more were completed, an increase of 5,700 percent from the 1996–2000 period.
Transactions included household names—Toys R Us ($6.5 billion), Hertz ($15 billion) and Metro-Goldwyn-Mayer ($4.8 billion). RJR Nabisco was finally passed in nominal dollar terms by Blackstone’s acquisition of Equity Office Properties and then by KKR and TPG’s acquisition of TXU (formerly Texas Utilities). Private equity deal makers mused about the first deal of $100 billion.
In 2007, commitments to new private equity funds increased by 64 percent from 2000, and 2,250 percent from 1990. Some 75 funds of $5 billion or more were raised between 2003 and 2007. The Top 20 public pension funds allocations to private equity exceeded $100 billion between 2000 and 2007. Senior loan volumes for private transactions reached $485 billion between 2005 and 2007, an increase of 386 percent from the 1999–2001 period.
In 2007, to purchase businesses, private equity firms paid on average nine to ten times the company’s annual cash flow, an increase of 62 percent from 2001, when they paid around six times cash flow. The amount of debt increased by around 50 percent, as companies borrowed six times annual cash flow compared to four times in 2001. Interest coverage fell to around one to one and a half times cash flow. The margin of safety was small, with many transactions vulnerable to downturns in economic activity. Purchasers relied on squeezing more cash out to service the debt.
The emphasis was on selling businesses off quickly, piecemeal or as a whole, to private buyers or the public. Private equity firms paid themselves large cash dividends as soon as possible, sometimes from borrowings and asset sales, to improve returns. This was termed early return of capital; critics preferred strip mining. Firms worked together in club deals to minimize competition and spread the risk of ever-larger transactions. Sales of investments from one fund to another became commonplace to increase values.
The fees from transactions exceeded the excesses of the 1980s. In May 2006, Thomas H. Lee Partners purchased 80 percent of Hawkeye Holdings, an Iowa Falls ethanol producer, investing $312 million. Before the purchase even closed, the private equity firm registered to undertake an initial public offering expected to generate a large profit. Thomas H. Lee received a $20 million advisory fee from Hawkeye for negotiating the buyout, a $1 million management fee, and $6 million to meet its tax obligations. Private equity investors collected payments of around $27 million, while Hawkeye earned $1.5 million in the 6 months. One article described private equity as Fees R Us.
Speaking at the London Business School in July 2007, Niall Ferguson, the economic historian, asked: “Why are we here attending conferences when we should be setting up private-equity firms?”2
Inflight Entertainment
In December 2007, Marjorie Jackson (known as Her Madge), chairperson, and Geoff Dixon (Dicko), CEO, announced that the board endorsed a private equity proposal to purchase Qantas for A$11.1 billion. Airline Partners Australia (APA), the purchasers, included TPG and Onex Group, Allco Equity Partners, Allco Finance Group, and Macquarie Bank. Allco and Macquarie ensured that Qantas remained majority Australian-owned to maintain traffic rights.
The price—A$5.45 per share plus an interim dividend of A$0.15 per share—was 55 percent higher than the average share price over the previous 12 months, above the record high for Qantas shares of A$5.28 and almost 88 percent above its recent low of A$2.93. The chairperson urged shareholders to board flight QF 545 (as the bid came to be known).
Successful buyouts of airlines are rare. Airline earnings and cash flows are sensitive to economic conditions and unpredictable changes in oil prices. Airlines require massive investment; the industry is regulated and in some countries unionized. But QF 545 was a calculated gamble.
Qantas was forecast to generate A$2 billion in cash flow on revenue of around A$13.6 billion. It had low debt, paid a lot of tax, and also paid high dividends. The purchase would increase interest costs to A$600 million, but lower tax from higher interest would reduce the cash outflow to A$400 million. Unpaid dividends would cover the rest. Modest increases in revenue (by 5 percent) and cost cutting (around A$400 million per annum) would increase cash flow to around A$2.9 billion. Assuming Qantas was still valued at around 5.5 times cash flow (as before the buyout), the airline would be worth A$15.8 billion. After paying off A$8.5 billion of debt, the private equity investors would turn a A$2.5 billion investment into A$7.3 billion in 5 years—a return of 24 percent per annum.
The airline’s loyalty scheme (with 4.6 million members) could be sold for A$2 billion. The catering unit and valuable order positions in new generation fuel-efficient aircraft from Boeing and Airbus could be sold for cash. Deal fees (A$600 million) and a planned large special dividend to investors reduced the risk to the investors and increased the prospects of large returns. Qantas wheeled out a 96-year-old former employee George Roberts, who had been with the airline since 1936 and was still a part-time volunteer at the Qantas museum, to extol the bid’s virtues.
Earlier, in mid-2007, Guy Hands’ Terra Firma purchased the iconic EMI Group (formerly Electric & Musical Industries). EMI was famed for its His Master’s Voice record label and the legendary London Abbey Road recording studios. Its roster of artists included classical and contemporary giants such as Arturo Toscanini, Otto Klemperer, Frank Sinatra, Cliff Richard, The Beatles, The Beach Boys, Pink Floyd, David Bowie, Queen, Coldplay, Kylie Minogue, Robbie Williams, and Norah Jones.
Hands boasted that he made money out the worst businesses in difficult industries. EMI fitted the criteria perfectly, having lost £260 million in 2007. EMI’s share of the British market had dropped from 16 percent to 9 percent. CD sales had fallen 50 percent since 2000, in part because of illegal music downloads. The karaoke-loving Hands, a finance rock star, purchased EMI for a stunning £4 billion.
EMI earned royalties when its artists’ songs were broadcast or downloaded. Terra Firma planned to sell the future royalty cash flows of EMI Music Publishing and the EMI Music catalogue for £4 billion. Hands also planned to sell the residual businesses and cut costs (including reducing the firm’s £200,000 fruit and flowers annual budget) to boost earnings.
Anticipating a large and quick profit of £1 billion, Terra Firma invested the maximum permitted 30 percent of its two funds in EMI. CitiGroup agreed to provide debt funding of £2.6 billion, hoping to earn large fees for advising EMI, providing debt and arranging the securitizations and asset sales.
In 2007, Hands presented clients and bankers with John Kenneth Galbraith’s The Great Crash—the history of the 1929 stock market crash. In 2008, he sent Niall Ferguson’s The Ascent of Money, highlighting the statement: “Sooner or later, every bubble bursts.” In the music business, EMI stood for Every Mistake Imaginable. QF 545 and the EMI buyouts were done at the top of the market with undue haste.
Selling the Family Silver
Private equity techniques were now applied to infrastructure—roads, tunnels, bridges, ports, airports, hospitals, schools, prisons, and so on. Traditionally, infrastructure was built and financed by government. Believing that governments had a limited role, Margaret Thatcher privatized British Telecom, British Gas, and British Petroleum, using the money received to pay off government debt. Thatcher boasted of turning Britons from a race of shopkeepers into a nation of shareholders. The new shareholders unwittingly paid a second time for something that they already owned as citizens.
In an era of balanced budgets and smaller government, essential infrastructure was provided by public private partnerships (PPP), where governments would grant concessions, for example the rights to a road, for a fixed period of 30 years. A consortium raised the money, built the road and operated it, charging cars using the road a toll to pay back the investors over time. At the end of the concession period, the road reverted to public ownership. The government gained a road without having to spend money. Taxpayers paid for the road in tolls rather than taxes.
Advocates argued that the arrangement saved government money while ensuring essential infrastructure was built. Competition and private ownership would deliver infrastructure efficiently with lower prices, improved quality, greater choice, and less corruption or bureaucracy. Critics argued that infrastructure by its inherent nature was a monopoly, which was not subject to competition. This allowed private firms to charge the maximum price that the market would bear rather than focus on the delivery of affordable basic services. Governments could also raise money more cheapely than private firms to finance essential projects. But in an era of febrile neo-liberalism, the case in favor of PPPs prevailed.
Infrastructure attracted investment from pension funds and individuals saving for retirement. Long-term assets providing steady safe income, being less affected by economic cycles and competition. As infrastructure costs are mainly incurred in construction, increasing revenues from tolls as prices rose generated higher earnings to offset the effect of inflation. As returns from infrastructure were modest, banks boosted returns by using familiar private equity techniques—large amounts of debt.
Holey Dollar
Macquarie Bank, an Australian bank, was the global leader in infrastructure.3 The Macquarie model entailed buying a business or infrastructure assets using its own money. After restructuring, the assets were sold to an affiliated fund, managed by the bank. The funds, private or listed on stock exchanges, used a combination of equity, raised from individual and institutional investors, and debt from banks to finance the asset. Macquarie controlled more than $250 billion, with investments in more than 100 different projects across the world.
The usual process was that Macquarie’s bankers found the projects, then advised on the transaction, charging fees around 1 percent of the value. Macquarie then sold the project to a fund at a mark-up to what it paid for the asset. Macquarie charged fees for raising money for the funds. It charged fees for managing the funds, typically 1-2 percent plus a performance fee of 20 percent. Macquarie advised the business owned by the funds and raised money for them. The bank advised the funds on sales and restructuring of the projects it owned. It was a fee factory that competitors envied.
The projects had debt. Then the funds that owned the project used additional debt. The funds individually did not own a majority stake in projects, allowing them to avoid reporting the project’s borrowing. Different Macquarie managed funds owned minority stakes in the same project or stakes in each other. The structure disguised the fact the projects might be funded with high levels of borrowings, as much as 90 percent.
Australians were ambivalent about Macquarie. On one side, Australia’s “can do,” “underdog that punches above its weight” culture celebrated the firm as a world leader. On the other, Australians loathed the bank’s arrogance, political influence, and especially the rewards for its bankers. In 2007, Chairman David Clarke, Managing Director Alan Moss, Managing-Director-in-waiting Nicholas Moore and three other senior bankers together were paid A$209 million.
Ordinary individuals also objected to private ownership of public infrastructure and perceived price gouging. Macquarie-fund-owned Sydney Airport charged A$4 for a luggage trolley, a fee for taxis waiting to pick up passengers and usurious parking fees. Purchasers at the airport’s extensive duty free shopping were provided with a shorter, special customs queue. When Macquarie and Cintra, a Spanish operator, combined to complete a 99-year lease of the Chicago Skyway, a 7.8 mile toll road, the charges increased from $2.00 to $2.50. Taxpayers questioned the right of governments to sell public property, allowing private interests to make money.
Macquarie Bank’s namesake Lachlan Macquarie, governor of New South Wales between 1810 and 1821, notoriously doubled the colony’s money supply by punching out the center of Spanish silver dollars, using both the holey dollar and the punched-out piece as currency. Macquarie Bank, whose logo is the holey dollar, improved on the governor’s financial engineering. Powered by its model, Macquarie’s share price rose by more than 20 times since its public listing in 1996. Investors in Macquarie funds enjoyed returns of 20 percent per annum.
Money for Nothing
Unlike private equity investors that receive capital gains when the fund realizes an investment, infrastructure funds pay high levels of income, designed to attract pension funds and especially individual retirees. As these investors were happy with returns lower than the 20 percent required by private equity investors, Macquarie could pay higher prices for assets, sustain higher levels of debt, and so increase its own fees.
Unprofitable in their early phase, infrastructure projects could not pay dividends. Instead, the funds issued stapled securities, combinations of shares of two different companies, enabling the fund to borrow to make distributions to investors even where the funds were not making money. As the cash from the project did not cover the payments to investors, the fund’s debt increased rather than decreased over time.
Macquarie used proprietary models to value its holdings and determine earnings. Projected future cash flows were discounted back to today, using an assumed discount rate to generate values. A change of 1 percent in cash flows of a 30-year project alters the value of the investment by 14 percent. For a 99-year project, the same change alters the value by 35 percent. Long lives meant that valuation mistakes would only become apparent after the bankers had moved on. Macquarie justified the valuations citing few actual sales, some of which were between the funds.
In 2006, Macquarie and Cintra paid $3.8 billion for an Indiana toll road concession, 50 times the road’s annual cash flows and around $1 billion more than the next bidder. Investor returns were projected at 12.5 percent per annum. Maunsell, an engineering firm, estimated traffic for the valuation model. Maunsell had a close relationship with Macquarie, being entitled to success fees if the bank won its bid. Indiana Finance Authority’s consultant came up with 50 percent lower traffic forecasts, valuing the toll road at half the $3.8 billion purchase price. A third consultant concluded that Maunsell’s forecasts exceeded the highway capacity after 2020.
Macquarie used derivatives, known as accreting interest rate swaps, to lower early payments by increasing later payments. Complex securities, such as TICKETs (tradeable interest bearing convertible to equity trust securities), with low early interest rates that increased over time, were used. The arrangements were identical to those used in subprime mortgages.
Projects routinely issued debt linked to inflation, prized by pension funds and insurance companies trying to minimize risk from change in price levels. As the inflation adjustment was paid at maturity, the structure conserved cash flows, which were distributed to other investors or to the bank as fees. Issuing these securities robbed shareholders in the infrastructure projects of at least some of the inflation hedge that they purchased.
Jim Chanos, whose fund Kynikos Associates bet on Macquarie’s share pricing falling, argued that the model was a giant Ponzi scheme. Edward Chancellor, a journalist, was also critical: “excessive fees, excessive leverage and excessive complexity.”4
Public Squalor, Private Profits
Over time, adjacency—close enough—allowed the techniques to be applied to mobile phone antennae, casinos, car parks, parking meters, shopping centers, water utilities, and even emergency services communications networks. The common theme was debt, lots of it.
In December 2010, snowstorms closed London’s Heathrow Airport, the busiest in the world, stranding thousands of passengers and revealing the dark side of private infrastructure. Heathrow Airport is owned and operated by BAA (British Airport Authority). Ferrovial, the Spanish construction company, which owns BAA, branched out into infrastructure investments financed with generous dollops of cheap debt because there was more money in running, financing, and owning infrastructure than in building it.
Although the weather was the primary cause, insufficient de-icing and snow-clearing equipment exacerbated Heathrow’s problems. Critics argued that BAA had failed to invest in basic infrastructure, favoring quick profits and cash to service large borrowings. They argued that the only real investment in Heathrow was to expand the terminals’ lucrative retail concessions. A Macquarie executive once described an airport as nothing more than real estate—a parking lot and shopping mall and a few runways attached. Airports are also monopolies, allowing the owner to extract large profits, with limited competition.
In the global financial crisis, the infrastructure funds and investors experienced problems due to their high level of borrowings. Many Macquarie clones went bankrupt. New infrastructure funding acronyms appeared complementing the familiar PPP—DOG (debt overburdened group), FOG (full of gearing), RTN (road to nowhere) and ROT (ruse on toll roads).
As asset values fell and debt became less abundant and more expensive, Macquarie Bank itself moved to unlisted funds reducing transparency and scrutiny of its operations even further. Infrastructure remained popular with investors. John Kenneth Galbraith once commented on America’s private wealth and public squalor. Facing infrastructure needs, governments sought to alleviate public squalor by appealing to private profits, with indifferent results.
Locust Plagues
At the 2007 Super Return annual industry conference, the financier Henry Kravis argued that private equity “leads not only to value creation, but also to economic and social benefits, for example, increases in employment, innovation, and research and development.”5 The reality was short-run profit-maximizing strategies where businesses were “starved of R&D, equipment modernization and advertising funds and/or prices are set at high levels inviting competitor inroads, leaving in the end a depleted non-competitive shell.”6
Under Terra Firma, EMI was not interested in developing new artists but exploiting its existing libraries. Investors in Qantas and EMI openly indicated their desire for an early exit. Private equity firms had never managed anything other than money. Qantas was well run and the existing management, who were adroit cost cutters, would be retained.
Many private equity deals did not live up to expectations. Blackstone paid $26 billion for Hilton Hotels, financed by Lehman Brothers, Bear Stearns, and others. Financiers spent a lot of time in hotels and somehow assumed that this qualified them to own and run them. As recession hit, the hotels fell sharply in value and the rooms stood empty. In 2008, Steve Ratner’s Quadrangle, a specialist in media deals, purchased Maxim, a lad’s magazine, for $250 million, with a view to cutting costs and expanding the Maxim brand into movies, restaurants, and shops selling tchotchkes (a term used by Jewish Americans deriving from Yiddish meaning kitsch knick-knacks or trinkets). Finding itself in financial difficulties, Quadrangle tried to give back Maxim to its creditors. Cerberus, a large U.S. private equity firm, invested $7.4 billion in Chrysler. In March 2009, Cerberus lost its equity stake as a condition of the U.S. Treasury’s bailout of Chrysler. Chrysler Financial, in whom Cerberus maintained a controlling stake, underwent liquidation.
The private equity case relies on high investment returns. Studies found that average returns, net of fees, were roughly equal to those produced by the S&P 500 index between 1980 and 2001.7 Adjusted for additional risks, such as the high levels of debt and the fact that investments could not be taken out for long periods, private equity investments underperformed the stock market on average, by as much as 3 percent per annum.8 Returns were difficult to determine because of accounting practices and tricks like paying out large dividends shortly after purchases. Returns between funds and investors varied widely, some funds earning 14 percentage points above the average.
As in the 1980s, leverage, tax deductions and financial engineering drove returns. APA relied on increasing Qantas’ borrowings to generate high returns. Terra Firma relied on high levels of debt and on being able to repackage and sell off future royalty streams. In 2010, a report by the Centre for the Study of Financial Innovation, a London think-tank, analyzed 542 buy-out deals in the portfolio of Yale’s endowment, finding that they underperformed the stock market by 40 percent, after stripping out the impact of extra debt.9
The loss of tax revenues was increasingly a concern. The special status of partners and investors in private-equity firms, whose earnings were taxed at a low rate as capital gains, came under scrutiny. The lower tax rate was justified as a proper reward for risk taking. Nicholas Ferguson, chairman of SVG Capital, a listed British private equity firm, broke ranks by admitting the concessional tax rate was indefensible. The person in the boardroom was being taxed at a lower marginal rate than the person who cleaned it.
Advocates argued that management preferred to work for privately owned firms—unsurprising, given the huge rewards for managers. On QF 545, Dicko was forced to place his long-term incentives, valued at up to A$60 million, in a charitable trust to deflect criticism of the estimated A$600 million in fees and profits that would accrue to the private equity firms, financiers, and investors, including management.
As public criticism grew, trade unions picketed the launch of the Private Equity Foundation, a new charity for children. Protesters picketed the houses of leading private equity financiers. Private equity was no longer very private.
In 2008, Blackstone-owned Merlin Entertainments, a British amusement-park operator, negotiated to acquire a well-known Vienna landmark—the giant Ferris Wheel in the Wurstelprater, an amusement park in the center of Vienna, built in 1897 to commemorate the 50th anniversary of Emperor Franz Joseph I’s accession to the Habsburg throne. Heinz-Christian Strache, the leader of the far-right Austrian Freedom Party, was unhappy: “Hands off our Viennese giant wheel.” Strache warned darkly that it was a short step from the Ferris Wheel to a private equity acquisition of the Hofburg Imperial Palace. A German politician labeled private equity firms “locusts.”
At the 2007 Davos World Economy Forum, where private equity chiefs were being feted as financial royalty, David Rubenstein of Carlyle thought that the industry did a poor job in presenting its case.10 The Private Equity Council, formed to lobby for the industry, commissioned a research project to look at the economic impact. At Davos, financiers announced that the study would show that private equity was beneficial for the economy, generated high returns for its investors like public pension funds, created employment, and paid a lot of tax. Given that research had not commenced, the insight into its findings was impressive.
Vain Capital
Paradoxically, private equity firms now wanted to list on stock exchanges, signaling the beginning of the end of the boom. Listing of the management company contradicted private equity’s oft stated competitive advantages—patience, long-term focus, avoiding the pressure of quarterly earnings, and the high cost of regulatory compliance for public companies. Stephen Schwarzman, Blackstone’s CEO, previously argued that: “public markets are overrated.”11 One blogger described Schwarzman’s conversion as “the most unlikely...since Saul of Tarsus fell off his horse en route to Damascus.”12
It was Fortress envy. In February 2007, Fortress Investment Group, an alternative investment firm, sold 8.6 percent of the company for $685 million. Offered at $18.50 each, the shares rose 68 percent on listing to $31, trading at 40 times their historical earnings. It was private equity’s Netscape moment, reminiscent of when the Internet neophyte floated its shares to the public and the price skyrocketed. Blackstone, KKR, and others rushed to cash in on the gold rush.
Schwarzman’s $5 million 60th birthday celebration, held in February 2007, was another sign of impending doom. The venue—the Armory—was decorated to replicate Schwarzman’s Park Avenue apartment, featuring a large portrait of the birthday boy. Children dressed in military regalia acted as ushers, and comedian Martin Short was master of ceremonies. Guests, including Colin Powell and New York Mayor Michael Bloomberg, dined on lobster and baked Alaska, whilst imbibing fine wines. Composer Marvin Hamlisch performed a number from A Chorus Line. Patti LaBelle led the Abyssinian Baptist Church choir in a song especially composed in honor of Schwarzman. Rod Stewart, the sexagenarian British rock star, performed his hits including Maggie May and Do’ya Think I’m Sexy.
In 2002, David Bonderman, co-founder of TPG, had staged a lavish $7 million party to celebrate his 60th birthday party for hundreds of his “closest” friends. Held at the Bellagio Hotel in Las Vegas, the party featured entertainment from the Rolling Stones and Robin Williams. Carlyle’s David Rubinstein was unimpressed: “We have all wanted to be private—at least until now. When Steve Schwarzman’s biography with all the dollar signs is posted on the web site none of us will like the furore that results—and that’s even if you like Rod Stewart.”13
In June 2007, Blackstone’s share offering was priced at $31 per share listed, trading upon listing in the stock exchange at around $37. The Chinese government invested $3 billion. Schwarzman cashed out stock worth over $650 million. His remaining 24 percent stake was valued at almost $8 billion, placing him near Rupert Murdoch and Steve Jobs on the list of richest people. In 2006, Schwarzman earned $398 million, around double the combined pay of the five largest American investment bank CEOs.
Amateur Hour
A leaked internal memo written by Carlyle’s William Conway dated January 31, 2007 showed that that the boom was almost over: “most investors in most assets classes are not being paid for the risks being taken...the longer it lasts the worst it will be when it ends...if the excess liquidity ended tomorrow I would want as much flexibility as possible.”14 Shortly after the Blackstone IPO, U.S. subprime problems overflowed into a general credit crunch, and the debt markets ground to a halt. As the global recession affected earnings and cash flows, companies that had been leveraged up in buyouts found it difficult to meet debt repayments. Drops in stock prices reduced values, making it difficult to offload businesses.
By July 2007, EMI was in difficulties. With CitiGroup unable to sell off the debt that it had underwritten, Terra Firma and the bank considered abandoning the deal. CitiGroup agreed to honor its commitment, becoming the sole provider of the £2.6 billion loan. The “whimpering dogs,” Hands’ term for bankers, had shown commendable loyalty. Hands later apologized for the term, prompting a banker to send him dog biscuits.
In the recession, EMI’s revenues fell by 20 percent and losses tripled as cost savings could not offset the higher interest charges. EMI’s value fell to £1.4 billion, below the level of its debt. Talent began leaving EMI. In 2009, Terra Firma wrote off half its investment in EMI—over 45 percent of its entire portfolio.
Hands, who lived on the island of Guernsey to avoid British taxes, blamed investors and banks: “We all had too much money. It was just too easy.” Hands admitted that the EMI deal was a mistake. If the lenders had been slower and the deal had been a few weeks later, “We wouldn’t have bought it. We’d have 90 percent of our funds still to invest and we’d look like geniuses.”15
In late 2009, Hands offered to inject £1 billion in equity into EMI but only if CitiGroup would write off a similar amount of debt. The bank refused. Terra Firma commenced legal proceedings against CitiGroup, claiming that CitiGroup encouraged Hands to make a binding bid by the May 21, 2007 deadline even though other bidders had allegedly dropped out. Due diligence on EMI was rushed, and Terra Firma claimed reliance on a CitiGroup analyst report in making its bid. Rivals found Hands’ claim puzzling: “He’s [not] some half-wit amateur.... It is buyer beware...it is ludicrous to say you paid too much because of what some banker told you.”16
In late 2010, a New York jury took only 5 hours to clear Citigroup and its bankers, but not before a jury member, Donna Gianel, a former circus performer, was removed. A Google search had revealed her part in Michael Moore’s film Capitalism: A Love Story. Hands’ hope for billions in damages to rescue his EMI investment seemed over.
In early 2011, Citigroup seized control of EMI, an event that came to be known as the “Fab Foreclosure,” an allusion to The Beatles, the company’s iconic stars. Citi wrote off £2.2 billion (around 65 percent) of EMI’s £3.4 billion in debt, in the process taking a substantial loss on its own loans.
The intriguing question was whether the £1.75 billion loss to Terra Firma and its investors would affect Hands’ ability to raise money for future deals. Investors and bankers remained loyal to him, based on past successes. The EMI deal was seen as badly timed and an unfortunate victim of unfavorable market circumstances. Given short memories, most observers thought that it would be only a year or so before everybody forgot what had happened.
Turbulence
QF 545 ran into head winds. The APA offer was subject to a minimum shareholder acceptance level of 90 percent, but two funds controlling more than 10 percent refused to sell, holding out for a higher price. The minimum shareholder acceptance level was reduced to 70 percent.
The company and private equity firms tried to convince shareholders of the “fantastic opportunity.” In the hospital suffering from DVT (deep vein thrombosis), fetchingly attired in a hospital gown, Her Madge had a brain explosion. She told reporters that shareholders had “a mental problem” if they did not understand that if the bid did not proceed, then the Qantas share price would collapse.
APA failed to secure the 50 percent shareholder acceptance it needed to extend the bid to try to achieve its target 70 percent. At the close of acceptance at 7:00 p.m. May 4, 2008, APA had 46 percent, claiming that a U.S. hedge fund had agreed to sell 4.9 percent of Qantas but had not accepted in time. The financial gods apparently lacked basic numeracy and the ability to read clocks. Amid claims, counterclaims, and legal suits, the bid faded away. After peaking at around $6.00 per share in anticipation of a new higher bid, the share price fell to a low of below $1.50 as the recession and earning downgrades hit.
The failed buyout of United Airlines (UAL) marked the beginning of the end of the 1980s acquisition boom. Coincidentally, the failure of QF 545 signaled the end of the subsequent boom. The cancellation of QF 545 proved fortunate. In the recession, the debt burden would have been fatal. The Rain Man—Raymond Babbit—would be relieved that Qantas dodged a surface-to-air missile, narrowly avoiding crashing and burning.
Financiers privately admitted that it would take a mathematical miracle for investors in many buy-outs to recover their investments. Hands summarized the state of play:
Neither the banks nor private equity want to come clean about mistakes...companies will live as zombies unable to grow their businesses or make long-term commitments...banks will try to suck out as much money as they can in fees and postpone recognizing the full extent of the losses. It was a case of “you’re not bankrupt, until people know you’re bankrupt.”17
Blackstone’s shares fell around 50 percent as earning fell almost 90 percent. Schwarzman and his partners had cashed in their chips at the top of the cycle. The Private Equity Council rebranded itself Private Equity Growth Capital Council. The new mantra was private equity created economic benefits and growth.
In the 1987 film Wall Street, Gordon Gecko (played by Michael Douglas) tells his star acolyte Bud Fox (Charlie Sheen) that in zero sum money games somebody wins and somebody loses but no money is ever made or lost. Private equity was always a zero sum game, with money simply being transferred between different perceptions.
In each boom cycle and period of easy money, private equity firms used large amounts of cheap debt in combination with their spreadsheets and selling skills to do deals, which enriched them extravagantly. Veteran private equity players argued that the industry would have to adapt—restructure existing deals, do smaller deals, use less leverage, and so on. It had all been said before, at the end of the last boom.
Locusts wait for favorable conditions to thrive, multiply, and devour everything in their path. The world had learned to love leverage. When market conditions were right, private equity would be back. Right on cue, in late 2010, Blackstone announced plans for a $15 billion fund, only slightly smaller than its previous November 2006 fund of $21.7 billion, the largest-ever fund. It signaled the return of private equity and leverage.