08-05-2019

All of a sudden this small outfit, three guys—Kohlberg and Kravis and Roberts—is making an offer for a public company. What’s that all about?”

The financial techniques behind Houdaille, which also underlay the private equity boom of the first decade of the twenty-first century, were first hatched in the back rooms of Wall Street in the late 1950s and 1960s. The concept of the leveraged buyout wasn’t the product of highbrow financial science or hocus-pocus. Anyone who has bought and sold a home with a mortgage can grasp the basic principle. Imagine you buy a house for $100,000 in cash and later sell it for $120,000. You’ve made a 20 percent profit. But if instead you had made just a $20,000 down payment and taken out a mortgage to cover the rest, the $40,000 you walk away with when you sell, after paying off the mortgage, would be twice what you invested—a 100 percent profit, before your interest costs.

Leveraged buyouts work on the same principle. But while homeowners have to pay their mortgage out of their salaries or other income, in an LBO the business pays for itself after the buyout firm puts down the equity (the down payment). It is the company, not the buyout firm, that borrows the money for a leveraged buyout, and hence buyout investors look for companies that produce enough cash to cover the interest on the debt needed to buy them and which also are likely to increase in value. To those outside Wall Street circles, the nearest analogy is an income property where the rent covers the mortgage, property taxes, and upkeep.

What’s more, companies that have gone through an LBO enjoy a generous tax break. Like any business, they can deduct the interest on their debt as a business expense. For most companies, interest deductions are a small percentage of earnings, but for a company that has loaded up on debt, the deduction can match or exceed its income, so that the company pays little or no corporate income tax. It amounts to a huge subsidy from the taxpayer for a particular form of corporate finance.

By the time Jerome Kohlberg Jr. and his new firm bought Houdaille, there was already a handful of similar boutiques that had raised money from investors to pursue LBOs. The Houdaille buyout put the financial world on notice that LBO firms were setting their sights higher. The jaw-dropping payoff a few years later from another buyout advertised to a wider world just how lucrative a leveraged buyout could be.

Wesray, which was cofounded by former Nixon and Ford treasury secretary William E. Simon, paid $80 million, but Wesray and the card company’s management put up just $1 million of that and borrowed the rest. With so little equity, they didn’t have much to lose if the company failed but stood to make many times their money if they sold out at a higher price.

Sixteen months later, after selling off Gibson Greeting’s real estate, Wesray and the management took the company public in a stock offering that valued it at $290 million. Without leverage (another term for debt), they would have made roughly three and a half times their money. But with the extraordinary ratio of debt in the original deal, Simon and his Wesray partner Raymond Chambers each made more than $65 million on their respective $330,000 investments—a two-hundred-fold profit.

Much of what investment banks do, despite the term, involves no investing and requires little capital. While commercial and consumer banks take deposits and make loans and mortgages, investment bankers mainly sell services for a fee. They provide financial advice on mergers and acquisitions, or M&A, and help corporations raise money by selling stocks and bonds. They must have some capital to do the latter, because there is some risk they won’t be able to sell the securities they’ve contracted to buy from their clients, but the risk is usually small and for a short period, so they don’t tie up capital for long. Rivers of securities flow daily through the trading desks of Wall Street banks. Most of these stakes are liquid, meaning that they can be sold quickly and the cash recycled, but if the market drops and the bank can’t sell its holdings quickly enough, it can book big losses. Hence banks need a cushion of capital to keep themselves solvent in down markets.

Schwarzman began to press the rest of management to consider merchant banking again. They even went so far as to line up a target, Stewart-Warner Corporation, a publicly traded maker of speedometers based in Chicago. They proposed that Lehman lead a leveraged buyout of the company, but Lehman’s executive committee, which Peterson chaired but didn’t control, shot down the plan. Some members worried that clients might view Lehman as a competitor if it started buying companies.

“It was a fairly ludicrous argument,” Peterson says.

“I couldn’t believe they turned this down,” says Schwarzman. “There was more money to be made in a deal like that than there was in a whole year of earnings for Lehman”—about $200 million at the time.

Warren Hellman, an investment banker who took over as Lehman’s president shortly before Peterson was tapped as chairman and chief executive, thought Lehman needed Glucksman. The trader was the one who understood why Lehman had bought the securities and what went wrong. “I argued that the guy who created the mess in the first place was in the best position to fix it,” Hellman says. Peterson concurred, believing, he says, that “everyone is entitled to one big mistake.” Glucksman made good on his second chance.

If he sometimes seemed oblivious to underlings, he was assiduous in cultivating celebrities in the media, the arts, and government—Barbara Walters, David Rockefeller, Henry Kissinger, Mike Nichols, and Diane Sawyer, among others—and was relentless in his name-dropping.

The traders viewed the bankers as pinstriped and manicured blue bloods; the bankers saw the traders as hard-edged and low bred. Peterson tried to bridge the divide.

Peterson would angle for a chief executive’s attention, then Schwarzman would reel him in with his tactical inventiveness and command of detail, figuring out how to sell stocks or bonds to finance an acquisition or identifying which companies might want to buy a subsidiary the CEO wanted to sell and how to sell it for the highest price.

CEO, William Agee, came on board there in 1976. Agee wanted to remake the diversified engineering and manufacturing company by buying high-growth, high-tech businesses and selling many slower-growing businesses. Peterson handed the assignment off to Schwarzman, who became Agee’s trusted consigliere, advising him what to buy and to sell, and then executing the deals. “Bill was a prolific deal-oriented person. I would talk to him every day, including weekends,” Schwarzman says.

While Peterson adored the role of distinguished elder statesman, Schwarzman had a brasher way and a flair for self-promotion.

Not that CSX would have been displeased. The newspapers generated only about $6 million in operating income, so $200 million was an extraordinarily good price. “CSX was saying, ‘Sign them up!’ ” says Schlosstein, who worked on the sale with Schwarzman. Schwarzman instead advised CSX to hold off. Zeroing in on the fact that Morris had a major bank backing its bid, he reckoned Morris could be induced to pay more. Rather than reveal the bids, he kept the amounts under wraps and proceeded to arrange a second round of sealed bids. He hoped to convince Morris that Cox and Gannett were hot on its heels. The stratagem worked, as Morris hiked its offer by $15 million.

At the same time, the notion of a “core business” had penetrated the corporate psyche, prompting boards of directors and CEOs to ask which parts of their businesses were essential and which were not. The latter were often sold off. Together these trends ensured a steady diet of acquisition targets for the buyout firms.

But it was the advent of a new kind of financing that would have the most profound effect on the buyout business. Junk bonds, and Drexel Burnham Lambert, the upstart investment bank that single-handedly invented them and then pitched them as a means to finance takeovers, would soon provide undreamed-of amounts of new debt for buyout firms. Drexel’s ability to sell junk bonds also sustained the corporate raiders, a rowdy new cast of takeover artists whose bullying tactics shook loose subsidiaries and frequently drove whole companies into the arms of buyout firms.

The trio’s inaugural fund in 1976 was a mere $25 million, but they quickly demonstrated their investing prowess, parlaying that sum into a more than $500 million profit over time. That success made KKR a magnet for investors, who anted up $357 million when KKR hit the fund-raising trail for the second time in 1980. A decade after KKR was launched, it had raised five funds totaling more than $2.4 billion.

Goldman’s partners agonized over their first deal, a pint-sized $12 million takeover of Trinity Bag and Paper in 1982. “Every senior guy at Goldman obsessed about this deal because the firm was going to risk $2 million of its own money,” remembers Steven Klinsky, a Goldman banker at the time who now runs his own buyout shop. “They said, ‘Oh, man! We’ve got to make sure we’re right about this!’ ”

The clear number two to KKR was Forstmann Little and Company, founded in 1978. It was only half KKR’s size, but the rivalry between the firms and their founders was fierce. Ted Forstmann was the Greenwich, Connecticut–reared grandson of a textile mogul who bounced around the middle strata of finance and the legal world until, with a friend’s encouragement, he formed his firm at the age of thirty-nine. He swiftly proved himself a master of the LBO craft, racking up profits on early 1980s buyouts of soft-drink franchiser Dr Pepper and baseball card and gum marketer Topps. Though he had less money to play with, his returns outstripped even KKR’s, and like Kravis he became an illustrious and rich prince of Wall Street whose every move drew intense press scrutiny.

In the early days of the buyout, many of the target companies were family-owned businesses. Sometimes one generation, or a branch of a family, wanted to cash out. An LBO firm could buy control with the other family members, who remained as managers. But as the firms had greater and greater amounts of capital at their disposal, they increasingly took on bigger businesses

It worked like this: Suppose a conglomerate with $100 million of earnings per year traded at forty times earnings, so its outstanding stock was worth $4 billion. Smaller, less glamorous businesses usually traded at far lower multiples. The conglomerate could use its highly valued shares to buy a company with, say, $50 million of earnings that was valued at just twenty times earnings. The conglomerate would issue $1 billion of new stock ($50 million of earnings × 20) to pay the target’s shareholders. That would lift earnings by 50 percent but enlarge the conglomerate’s stock base by just 25 percent ($4 billion + $1 billion), so that its earnings per share increased by 20 percent. By contrast, if it had bought the target for forty times earnings, its own earnings per share wouldn’t have gone up.

Moreover, managing such large portfolios of unrelated businesses tested even very able managers. Inevitably there were many neglected or poorly managed subsidiaries.

Equity was the smallest slice of the leveraged-buyout financing pie—in that era usually just 5–15 percent of the total price. The rest was debt, typically a combination of bank loans and something called mezzanine debt. The bank debt was senior, which meant it was paid off first if the company got in trouble. Because the mezzanine loans were subordinate to the bank loans and would be paid off only if something was left after the banks’ claims were satisfied, they were risky and carried very high interest rates. Until the mid-1980s, there were few lenders willing to provide junior debt to companies with high levels of debt like the typical LBO company.

In 1977 Milken’s group began raising money for companies that finicky top-end investment banks wouldn’t touch, helping them issue new bonds. In that role, Milken’s team bankrolled many hard-charging, entrepreneurial businesses, including Ted Turner’s broadcasting and cable empire (including, later, CNN) and the start-up long-distance phone company MCI Communications.

At their peak in the mid-1980s, Milken and his group underwrote $20 billion or more of junk bonds annually and commanded 60 percent of the market. The financial firepower they brought to bear in LBOs and takeover contests redefined the M&A game completely.

Investors in KKR’s first five funds saw annual returns of at least 25 percent from each and nearly 40 percent from one. They earned back six times their money on the firm’s 1984 fund and a staggering thirteen times their investment on the 1986 fund over time, after KKR’s fees and profit share.

With Drexel’s backing, KKR went on from Cole National to execute five buyouts in 1986 and 1987 that would still be large by today’s standards, including Beatrice Foods ($8.7 billion), Safeway Stores ($4.8 billion), glass maker Owens-Illinois ($4.7 billion), and construction and mining company Jim Walter Corporation ($3.3 billion).

No one embodied the raider role better than Carl Icahn, a lanky, caustically witty New York speculator whose tactics were typical. After buying up shares, he would demand that the company take immediate steps to boost its share price and give him a seat on its board of directors. When his overture was rebuffed, he’d threaten a proxy fight or a takeover and rain invective on the management’s motives and competence in acidly worded letters to the board that he made public. Often these moves would cause the stock to rise, as traders hoped that a bid would surface or that the company would act on its own to sell off assets and improve its performance. Sometimes his tactics did in fact spark other companies to bid for the company he had in his sights. But either way, Icahn could cash out at a profit without having to actually run the target. Other times, the company itself paid him a premium over the market price for his shares just to get him to go away—a controversial practice known as greenmail

For starters, their intention was to gain control. Their investors put up money to buy companies, not to trade stocks. And unlike the raiders, buyout firms almost never pressed hostile bids against the wishes of management. In LBO circles, launching an all-out raid was all but taboo. KKR touted itself as sponsoring friendly collaborations with existing managers, which it dubbed “partnerships with management.” More than once—most famously in the case of Safeway in 1986—KKR played the “white knight,”

In some cases, in fact, they did the nearest thing to a hostile takeover, by publicly announcing unsolicited offers for companies. Even if they didn’t bypass the board, the move usually put the target in play and put intense pressure on the company to do something to boost the share price. KKR used this tactic, known on Wall Street as a bear hug, a number of times

There was serious talk of abolishing the tax deductibility of the interest costs on junk bonds in order to kill off the alleged menace.

They had no wish to emulate investment banks or brokerage firms, which need sturdy capital foundations to back the commitments they make to their clients and to tide them through when they lose money in the markets. “We didn’t want to have a lot of capital tied up in low-margin businesses,” Schwarzman says. “We wanted to be in businesses where we could either drive very high assets per employee or operate with very high margins.” Giving M&A advice was the ultimate high-margin work—enormous fees with very little overhead. Managing a buyout fund was appealing because a relatively small team could oversee a large amount of money and collect a commensurately large management fee along with a share of the profits on the investments.

The memory of the feuding at Lehman was still all too fresh, and they wanted absolute control of their business.

The solution they ultimately hit on was to set up new business lines as joint ventures—“affiliates,” they called them—that would operate under Blackstone’s roof. To lure the right people, they would award generous stakes in the ventures.

Schwarzman admits that the advertised figure was partly bravado, but it served a tactical purpose. Many potential investors had caps that barred them from providing more than, say, 10 percent of any one fund’s capital. By setting a lofty total figure, Schwarzman figured, investors might be persuaded to make larger pledges. The investors, who become limited partners in a partnership, don’t write a check for their full commitment at the outset; they merely promise to deliver their money whenever the general partner issues a demand, known as a capital call, when it needs money for a new investment. Even so, the general partner collects the full 1.5 percent from the limited partners every year no matter how much of the money has been put to work.

On top of that, the companies Blackstone bought would reimburse Blackstone for the costs it ran up analyzing them before it invested and for its banking and legal fees. Its companies would also pay advisory fees to Blackstone for the privilege of being owned by it.

Shortly after they opened shop, they drew up a two-page promotional letter describing their business plan, which they mailed to hundreds of corporate executives and old Lehman clients. They then waited. And waited. And waited. “Pete and I expected business to come flooding in.

As an anchor investor, Prudential drove a hard bargain, though. Back then, buyout shops laid claim to 20 percent of the investment profits from each individual company their fund bought. But that meant that if one very large investment in a fund was written off—say, an investment that consumed a third of the fund’s capital—investors might lose money even though other investments worked out. The manager, though, would still collect profits on the good investments. It was a kind of heads-I-win, tails-you-lose clause.

Prudential insisted that Blackstone not collect a dime of the profits until Prudential and other investors had earned a 9 percent compounded annual return on every dollar they’d pledged to the fund. This concept of a “hurdle rate”

In the end, these were small prices to pay for the credibility the Pru’s backing would give Blackstone. The Prudential name could open doors at top financial institutions in the United States and abroad, and Peterson and Schwarzman quickly parlayed Keith’s endorsement into further investments. It paid off particularly in Japan, where Prudential was a major player and where Peterson’s status as a former cabinet member carried weight.

There, with the help of First Boston and Bankers Trust, top U.S. banks with a presence in Tokyo that Blackstone had hired to help on the fund-raising, they lined up meetings with Japanese brokerage houses.

Nikko was part of the Mitsubishi industrial group, one of four enormous Japanese business combines that are linked by cross-ownership, commercial synergies, and a shared mind-set. As Schwarzman and Peterson trooped to meetings with other parts of the Mitsubishi network, they were greeted warmly. Mitsubishi Trust, Tokio Marine & Fire, and other group firms ponied up for the new fund.

GM, like GE, had brushed off Blackstone several times, but a First Boston banker tapped a church connection to get Blackstone access to GM, and the firm soon captured another $100 million pledge. The GM imprimatur brought Blackstone a raft of smaller commitments—$10 million to $25 million—from other pension funds.

No longer would Peterson and Schwarzman live off the unpredictable bounty of M&A fees. Blackstone now would collect 1.5 percent of the fund’s capital every year as a management fee for at least six years. This not only ensured Blackstone’s near-term survival, but it also meant that Blackstone, finally, could staff up and take on the trappings of a bona fide business.

Through it all, Blackstone would struggle to establish footing. It didn’t help that turnover at Blackstone was notoriously high in the early years, owing partly to Schwarzman’s mercurial and demanding personality. The young firm, too, would make some bum bets on companies and people. But it would do more right than wrong.

In the autumn of 1988, the firm moved to 345 Park Avenue, a bland, hulking, cream-colored skyscraper right across Fifty-second Street from its former offices in the Seagram Building. It took a ten-year lease on sixty-four thousand square feet, twenty times the size of its original quarters. Surveying the cavernous new expanse, Schwarzman wondered if he’d been batty to sign a lease for so much more space than the firm needed at the moment.

At the time, Fink was about to lose his job at First Boston after his unit racked up $100 million in losses in early 1988. But Schwarzman and Peterson had from the start hoped to launch affiliated investment businesses and thought Fink was the ideal choice to head a new group focused on fixed-income investments

Peterson and Schwarzman offered Fink a $5 million credit line to start a joint venture called Blackstone Financial Management, or BFM, which would trade in mortgage and other fixed-income securities. In exchange for the seed money, Blackstone’s partners got a 50 percent stake in the new business. Fink also got 2.5 percent interest in the parent, Blackstone.

They wanted to recruit top talent, but they were not about to surrender any significant part of Blackstone’s ownership. Altman received a comparatively meager ownership interest of around 4 percent. Stockman’s piece was even smaller.

Wasserstein Perella soon won the backing of Japan’s largest stock brokerage, Nomura Securities Company, which that July put up $100 million for a 20 percent stake in the firm.

Yamaichi Securities Company, Japan’s fourth-largest brokerage, would put up $100 million of the $500 million LBO fund Miller was raising and separately inject an undisclosed sum in Lodestar itself for one-quarter of the firm.

In May 1988, Henry Kravis and the other KKR partners personally pocketed $130 million in profits on just one investment: Storer Communications, a broadcaster they had bought just three years earlier, which they sold for more than $3 billion.

1988 was capturing its share of plum M&A assignments. Early that year Blackstone took in more than $15 million from two jobs alone: handling negotiations for Sony Corporation’s $2 billion purchase of CBS Records, an assignment Blackstone picked up from Sony founder Akio Morito, an old friend of Peterson’s, and from Sony’s top U.S. executive, whom Schwarzman knew; and advising Firestone Tire & Rubber when it sold out to Japan’s Bridgestone, Inc., for $2.6 billion, a deal Schwarzman guided. As Peterson and Schwarzman hoped, the M&A business gave the firm access to executives that eventually turned up LBO opportunities.

In 1986 Icahn had amassed a nearly 10 percent stake in USX and launched an $8 billion hostile takeover bid. U.S. Steel was three months into a strike that was crippling steel production and had pummeled the stock. Over the next year, Icahn hectored USX to off-load assets and take other steps to boost its share price. To back itself out of a corner and persuade Icahn to go away, USX eventually announced that it would sell more than $1.5 billion in assets and use the money to buy back some of its shares.

USX wanted to sell more than 50 percent of the transport business to an outside party so that under accounting rules it could take the unit’s debt off its books. However, it didn’t want to give up too much control. “They told us, ‘This is our lifeline. If anything goes wrong with this, if we sold it to a buyout firm unwilling to invest enough capital or that held us up for higher transport rates, it could bankrupt us,

Convincing the Blackstone partners was one thing. Persuading banks to finance the deal was another matter. Blackstone needed $500 million of loans or bonds for the spinoff, but it had no track record in buyouts, and bankers were unnerved at the prospect of lending to a highly leveraged business that was dependent on the boom-and-bust cycles in steel. They weren’t moved by Mossman’s analysis. “Their mind-set was they didn’t want to go anywhere near a cyclical business,” Lipson says.

Schwarzman put out calls to all the big New York banks that financed buyouts: Manufacturers Hanover, Citibank, Bankers Trust, Chase Manhattan, and J.P. Morgan.

To steal a march on other banks, Lee loaded Chemical’s $515 million debt package for Blackstone with seductive features. Most important, he gave Blackstone an iron-clad promise to provide all the debt, and to do so at a lower interest rate than Morgan. By contrast, Morgan had offered only to make its “best efforts” to round up the requisite funds, not a binding commitment. To sweeten Chemical’s proposal, Lee agreed to drop the interest rate by half a percentage point if the company’s profits sprang back to prestrike levels. To tide the business over if it ran into trouble, Lee further offered $25 million of backup capital in the form of a revolving credit facility—a now-conventional part of LBO financing that Lee helped popularize. This was credit the company could draw on if needed and pay back as it could, unlike the regular loans, whose amounts and due dates were fixed.

First announced on June 21, 1989, the deal closed in December. That month, Blackstone and USX formed a new holding company, Transtar Holding LP, to house the rail and barge operations. As with the famous leveraged buyout of Gibson Greeting in 1982, equity was just a tiny sliver of the total financing package for Transtar. Blackstone shelled out just $13.4 million, 2 percent of the buyout price, for a 51 percent ownership stake. The new debt Chemical provided replaced much of the railroad’s equity, so USX was able to take out more than $500 million in cash. (USX also lent Transtar $125 million in the form of bonds—a kind of IOU known in the trade as seller paper because it amounted to a loan by USX to help Blackstone finance the purchase.) Roderick and USX got what they asked for: Despite holding just 49 percent, USX shared decision-making power over budgeting, financing, and strategy on equal terms with Blackstone.

The transaction was not a classic LBO at all. Strictly speaking, it was a leveraged recapitalization—a restructuring where debt is added and the ownership is shuffled. But whatever the label, it helped advertise the company-friendly approach that Peterson and Schwarzman had been touting for three years now. “We really wanted to put meat on our corporate partnership idea, and we hoped this deal did that,” Peterson says. “It sent a signal that we were good guys who did thoughtful, friendly deals as a real partner.”

a sturdy business on the rebound, which it had snared for an extraordinarily low price of four times cash flow. That was one-third to one-half below the stock market valuations of most railroads.

For a buyout investor, cash flow is the axis around which every deal turns. It determines how much debt a company can afford to take on and thus what a buyer can afford to pay.

One way that buyout firms make profits is to use the cash flow to pay down the buyout debt. In the industry’s early days, deals were formulated with the aim of retiring every dollar of debt within five to seven years. That way, when the business was finally sold, the buyout firm reaped all the proceeds because there was no debt to pay off.

A second way to generate a gain is to boost cash flow itself, through revenue increases, cost cuts, or a combination, in order to increase the company’s value when it is sold. Using cash flows, there is also a third way to book a gain, without an outright sale. If a company has paid down its debt substantially, it can turn around and reborrow against its cash flow in order to pay its owners a dividend. That is known as a dividend recapitalization.

In Transtar’s case, Blackstone used all three means to manufacture a stupendous profit. In 1989, in line with Mossman’s expectations, Transtar’s cash flow reached nearly $160 million, enabling it to repay $80 million of debt by year’s end. By March 1991 Transtar had pared $200 million of its original buyout debt. With substantially less debt than it had when the business was spun off and with Transtar’s cash intake growing, the company was able to borrow again to cover a $125 million A little more than two years after the deal closed, Blackstone had made back nearly four times the $13.4 million it had invested. By 2003, when Blackstone sold the last of its stake in a successor to Transtar to Canadian National Railroad, the firm and its investors had made twenty-five times their money and earned a superlative 130 percent average annual return over fifteen years.

If this seems a bit like conjuring profits from nothing, that’s largely what happened. Transtar, like Gibson Greeting, was a prime example of buying at the right time, leveraging to the hilt, and milking every drop of cash flow for profit.

Schwarzman also believed the partnerships heightened Blackstone’s odds of success. Having a co-owner intimately familiar with the business—typically one that was a major customer or supplier and therefore had an interest in its thriving—would give Blackstone an advantage over competing buyout firms, staffed as they were with financial whizzes who had never run a business or met a payroll.

“I just couldn’t figure out how to make money buying companies unless we brought unusual efficiencies to a company by way of cost improvements or revenue synergies.”

In some partnerships, Schwarzman went so far as to barter away some of Blackstone’s potential upside for downside insurance, in the form of a right to sell out to its partner several years later at a preset price or valuation.

“We are more risk-averse than other private equity firms, and part of it is visceral. I don’t like failure, and losing money is failing. It’s a personal thing that has turned into a strategy here.”

The failures also established a harsh new unwritten rule: Slip up badly enough, just once, and you’re out.

The new business was launched on a victorious note in December 1988, when Blackstone procured another $100 million from Nikko, the Japanese bank that had made a crucial early commitment to Blackstone’s first fund. This time the money would go not to the buyout fund, but to Blackstone itself. As with Wasserstein Perella’s headline-grabbing pact with Nomura six months earlier, Nikko was putting up $100 million for a 20 percent cut. But Schwarzman extracted sweeter terms from his Japanese backer than Bruce Wasserstein, his friendly rival and tennis partner, had.

“After Bruce did that deal,” Schwarzman says, “I went back to Nikko and said I wanted another $100 million, like he got, but I wanted it in the form of a joint venture with our advisory business.” Instead of taking a straight 20 percent ownership interest in the Blackstone partnership and all its operations, as Nomura had in Wasserstein Perella, the Japanese accepted a 20 percent share of the net earnings of Blackstone’s M&A advisory business over the next seven years. In addition, Nikko would receive 20 percent of any returns Blackstone earned investing the $100 million. In 1995, if either party chose not to extend the investment, Blackstone would repay the $100 million along with any returns Nikko was still due.

Conceivably Blackstone could have used Nikko’s money to fund expansion and hire top-tier talent, or tucked it away as a rainy-day reserve. But Schwarzman wasn’t eager to embark on a hiring spree and was thinking more short term. Soon after Nikko wired Blackstone the money in early 1989, he hit on a moneymaking formula that would throw off hefty dividends to Blackstone and his partners as well as to Nikko.

Schwarzman decided to sink half of Nikko’s money into risk arbitrage, or trading in stocks of takeover targets.

Hotshot investment bankers the firm had lured away from First Boston, Shearson, and Morgan Stanley came and went in less than a year, let go for failing to rustle up deals and revenue in a down market.

“Steve was a very tough boss,” says Henry Silverman, the former CEO of the travel and real estate conglomerate Cendant Corporation and a billionaire financier, who was a Blackstone partner from early 1990 to late 1991. “At one point I was in my office, working on a deal with the team, and Steve walked in and shook his finger at us and said, ‘Remember, I don’t like to lose money!’ I heard that many times from him over the years. He needed to remind us that he wasn’t among the minority who likes to lose money.”

Schwarzman decided that the firm’s process for vetting investments needed to be formalized. From then on, partners would have to submit a researched and tightly reasoned proposal that would be shared with all other partners. Schwarzman would remain the final arbiter, but henceforth there would be a full airing of every deal’s possible pitfalls before he decided whether to go forward.

M&A assignment: advising Sony on its $5 billion purchase of Columbia Pictures Entertainment, Inc., for a $9.9 million fee. But it was Schwarzman who performed the majority of the grunt work at the firm: hiring, firing, executing the business plan the two had devised, deciding which LBOs to pursue

Peterson says government borrowing is different from LBO debt. The former, he says, is done off the books or through “fictitious trust funds,” and the public that foots the bill has little understanding of its scope or consequences. By contrast, LBO borrowing is a controlled procedure carried out by “more or less sophisticated and knowledgeable” parties who are “far better able to assess the facts, the risks, and the rewards.”

Schwarzman – My dad had no interest whatsoever in doing it. He was a very bright person, but he was not aggressive.

Blackstone Financial Management, which turned profitable within months of its launch. Fink used just $150,000 of the $5 million credit line Blackstone had provided to start the joint venture, and he quickly repaid that. By the end of 1989 Fink was managing $2.7 billion of outside investors’ money, more than four times the $585 million his group had raised a year and a half earlier. That year Fink’s team pulled in $13.4 million in management fees, posting a $3.9 million net profit.

The turn of mood in the markets would clobber the firm a fourth time in 1989, nearly capsizing Blackstone’s $1.6 billion buyout of Chicago and Northwestern, a regional railroad, and threatening the very existence of Donaldson, Lufkin & Jenrette, Schwarzman’s first employer out of college and one of the main lenders for the purchase.

Although the $1.6 billion price was rich—Blackstone was paying eight times cash flow, twice what it had paid for Transtar—it was risking comparatively little: Blackstone injected $75 million of equity for a 72 percent ownership stake, while DLJ’s buyout arm put in $25 million for 24 percent. Union Pacific invested $100 million in preferred stock that paid a dividend. Though the preferred didn’t have the potential to rise (or fall) in value like common stock, UP had an option to convert it after five years into common shares for 25 percent ownership. Lenders, led by Chemical Bank and DLJ’s investment banking operation, furnished most of the remaining $1.4 billion.

The peril was magnified because bridge loans bore high, junk bond–like interest rates, which ratcheted up to punishing levels if borrowers failed to retire the loans on schedule. The ratchets were meant to prod bridge borrowers to refinance quickly with junk, and up until the fall of 1989, every bridge loan issued by a major investment bank had been repaid. But the ratchets began to work against the banks when the credit markets turned that fall. The rates shot so high that the borrowers couldn’t afford them.

After some heated give-and-take, they reached a middle ground, with Blackstone agreeing to raise the rate on the junk bonds from 14.5 percent, already very high, to 14.75 percent and to award bond buyers a 10 percent equity share in CNW as well. But James and his team wanted yet another inducement for bond buyers: an offer to raise the interest rate on the bonds after a year if the bonds had declined in value. It was known as a reset clause. Eventually Schwarzman said he could agree to a reset provided that there was a 15.5 percent cap on the adjusted rate.

Both bids offered shareholders a mix of cash and promissory notes—short-term bonds, in effect—but KKR’s terms on its notes were more generous.

If we sold this factory, could we reinvest the money and make a higher return than we do now? Would we be better to focus on the fastest-growing and most profitable parts of our company? Could we raise money to invest in them by selling off other subsidiaries?

These were the same questions people like Kravis and Roberts had been asking as they sized up investments. The pressure exerted by the enormous debt loads on companies that had undergone LBOs accelerated the process greatly

A second new business emerged almost unintentionally, a by-product of the need to invest the $100 million Blackstone had received from Nikko. Blackstone’s abortive risk-arbitrage fling in 1989 had eaten into the original hoard, but Schwarzman shuddered at the thought of putting the cash at risk in the turbulent markets. Still, the firm couldn’t afford to leave the capital invested in low-paying certificates of deposit forever.

Batten, who had been charged with managing the money, hit on a solution. That summer he proposed that Blackstone divvy up the money and invest it with a half-dozen successful hedge funds.

taking stakes with six managers, the most illustrious being Robertson. But Schwarzman, who had never been a trader, was jittery as ever about losses and kept a sharp eye trained on the monthly results. “The first month the funds were up three percent and Steve was happy,” recalls Batten. “The second month they were up four percent, and Steve was even happier.” But around the fourth month Robertson posted a 4 percent loss and Schwarzman was beside himself.

“How could this happen?” he fumed to Batten. “Fire him! Fire Robertson!”

Robertson wasn’t fired. Over the years, despite occasional setbacks, the fund-of-funds generated remarkably sturdy returns, and Blackstone later opened it up to outside investors, drawing in tens of billions of dollars, which created an important new source of fee income for the firm.

Before heading to the links at noon Wednesday, Cheng revealed that he’d been toying with them.

“You know, I never would have taken the company, because I had heard that Henry Silverman is a very good operator, and the U.S. is quite far away,” Schwarzman recalls him saying. “I really was very pleased you bought this. Thank you for your proposal.”

In an IPO, typically, big stockholders like Blackstone sell at most a small portion of their shares. The market often can’t absorb all the stock of a company at one time, and investors will balk if they think existing investors want to cut and run. In many cases, the existing shareholders sell no shares, and the IPO consists solely of shares newly issued by the company equivalent to, say, a 15 or 20 or 25 percent stake

A year after Schwarzman and Silverman’s gut-churning negotiation with Henry Cheng in Hong Kong, they had expanded HFS by buying another franchiser out of bankruptcy, Days Inn of America. A similar rationale would propel bank mergers later that decade—combine deposits and slash people—as well as thousands of corporate mergers driven by what CEOs euphemistically call “cost synergies.” It was capitalism with a chilly heart. From a stockholder’s standpoint, it also made HFS a far more valuable business with more staying power.

“Because of the people we already had in place, I thought we’d be adding $50 million of revenue at virtually no cost,” Silverman says.

HFS went public at $16 a share, 255 percent above Blackstone’s investment cost of $4.50 a share. The shares jumped 17 percent the first day they traded and soared to $50 within a year. Blackstone exited HFS with a $362 million profit on its $121 million outlay, posting an annual gross return of 59.2 percent.

From the beginning, he and Schwarzman had had sole voting control over the buyout and M&A businesses and had an equal share in the profits, then about 30 percent each. As new partners arrived, they had each been given slices of what the firm made, which diluted Peterson’s and Schwarzman’s portions equally.

There were other strains, too, at the top of an organization that shed partners faster than a dog sheds hair. In 1992, just two years after Schwarzman recruited him from First Boston for the buyout team, David Batten quit for a high-profile position at Lazard Frères, and Joe Robert, whom Batten had recruited in 1991 to buy distressed real estate in a joint venture with Blackstone, defected to Goldman Sachs.

Blackstone gave him a chunk of HFS stock and free rein to run the business. As severance packages go, this one was a doozie, for HFS went public in 1992 and, over the next fifteen years, Silverman transformed it into Cendant Corporation, a franchising empire that controlled top brands such as the real estate brokerages Coldwell Banker and Century 21, Avis and Budget car rentals, Wyndham hotels, and the Travelport and Orbitz reservation systems.

Fink and Blackstone laid plans to raise outside capital through an IPO. At the time, Fink, Ralph Schlosstein, and other senior BFM managers jointly owned 45 percent of the business through a partnership while Blackstone Group and its partners owned another 35.3 percent. Fink and Schlosstein individually owned much of the rest.

Everyone involved in the deal was convinced that Six Flags could be turned around: Time Warner; Roger Altman, who had spotted the opportunity and recruited Bob Pittman, a cofounder of MTV and a media marketing guru, to manage Six Flags; Henry Silverman, the deal’s overseer; and Howard Lipson, who had helped Silverman vet the proposal. Stockman begged to differ.

Schwarzman set out to nurture new business lines more suited to a period of tumbling markets and a drought of leverage. In May 1991, he poached a six-member crew of debt-restructuring specialists from Chemical Bank led by Arthur Newman, an ace in the field. The move paid off quickly as assignments poured in from America West Airlines, R. H. Macy and Company, steelmaker LTV Corporation, and other bankrupt corporations needing advice on reorganizing their finances.

JMB had pioneered the kind of real estate private equity Schwarzman had in mind, buying properties on the cheap or in need of upgrading, and selling them a few years later. Schwarzman first contacted Schreiber for advice on whom he might hire, but after talking with other property investors and bankers, he called Schreiber back in the summer of 1992 and tried to woo Schreiber for the position.

“I told him I had no interest,” Schreiber says. Schreiber had promised his wife he wouldn’t go back to work full-time, he was sick of managing, and there was no way he was moving to New York.

“but at the last minute he changed his mind.” Sternlicht went on to form Starwood Capital, his own property investment firm. In his place, Schreiber in 1993 recruited Thomas Saylak

By this time, Schreiber’s group was flush with money, having stockpiled $330 million in commitments in 1994 for the real estate investment fund, and later in 1995 it joined up with the giant Ontario Teachers’ Pension Plan Board and pushed through a bailout plan for Cadillac Fairview that Schreiber had taken a hand in crafting. In exchange for injecting $200 million, the two acquired a combined 32 percent stake. Goldman Sachs, the largest creditor, swapped its bank loans for 22 percent. Two years later, Cadillac Fairview went public. The deleveraged company thrived, and when Blackstone later cashed out, it made a $73 million profit on its $65.5 million investment.

JMB had blazed the trail for real estate private equity long before Blackstone. But Blackstone was the first large corporate-LBO specialist in America to launch a real estate venture, and it was the only one that developed into a top-tier player.

LBO sponsors, in particular, were elated to be rid of the hassle of scraping together debt from multiple sources. But the new full-service banks siphoned off advisory work from boutique advisers such as Blackstone that didn’t lend or underwrite.

Hoffman, who cohead the firm’s M&A division, left in 2001 to advise the State of California on a financial crisis and later moved to Riverstone Holdings, a private equity firm that specializes in energy investments.

charging them a fee to screen hedge funds and spread their money across a variety funds, and had become a profit-making business in its own right. Called Blackstone Alternative Asset Management, BAAM for short, the unit would scuffle along under a series of overseers until the time Hill relinquished his M&A post and took charge of it in 2000. At BAAM, Hill would find his groove, and the business’s assets under management would soar in size.

branding what they did as “private equity.” British buyout firms, meanwhile, took to calling their deals “management buyouts” to highlight that the business would be run by familiar faces, though the managers seldom had a controlling stake.

“Private equity” had long been used for venture capital investments in start-ups and other young companies—an investment approach that was widely lauded as fueling innovation and growth. But now the phrase was appropriated for the more controversial process of buying companies with borrowed money.

IPOs are inherently risky, because the offering price can change up to the last minute, and the seller can rarely sell more than a small minority of its shares at the outset. By contrast, a negotiated sale offers certainty and nets more cash for the seller because it can off-load as much of its holding as it wants.

The spring and summer after the investment was made, production cuts and price hikes drove up UCAR’s earnings, and in August 1995 the owners moved to cash in by taking UCAR public. When Blackstone sold the last of its shares in April 1997 after a surge in the stock, it had bagged a walloping $675 million gain, 3.6 times its investment, and an average annual return of close to 200 percent.

Nearly all the 80 percent annualized return that Blackstone touted to investors was attributable to UCAR. It was a pattern that would recur with future funds: One or two great investments made at a trough in the business cycle could make a fund a huge success.

In an April 1998 interview with BusinessWeek, he drew the reporter’s attention to Blackstone’s complement of advisory, hedge fund, real estate, and buyout activities. By contrast, he said dismissively, KKR was a “one-trick pony.”

Blackstone had negotiated downside protection in the form of a put option that allowed it to sell its stake back to Loewen at a gain. But just when Prime Succession and Rose Hills were on the brink of insolvency, Loewen itself was teetering on the edge, succumbing to the industry’s general malaise and a huge court judgment. Loewen filed for bankruptcy in 1999, rending the put option worthless. Blackstone walked away $58 million poorer.

On top of all that, Blackstone bought many of them at the wrong time in the economic cycle. It wound up overpaying and piling on too much debt. It had stacked the deck against itself.

“These were all medium-sized, cyclical businesses that we bought within two or three years of an economic top,”

He began his buying spree in April 1996 with a $30 million purchase of Bar Technologies, the former wire and rod division of Bethlehem Steel, and later annexed two much bigger businesses, Republic Engineering Steels and a steel-bar venture once owned by U.S. Steel and Japan’s Kobe Steel. When Bar Technologies merged with Republic in 1998, the businesses were in such rotten shape that one Wall Street wag likened the combination to “two garbage trucks in a collision.”

managers of the companies, who were unhappy at his persistent meddling and niggling. Stockman questioned the judgment of executives who knew their businesses far better than he. In August 1999, when Stockman was away on a two-week African vacation, Schwarzman decided to play detective. He personally hit the phones, calling executives at each of Stockman’s companies to find out about their relations with Stockman. From those soundings, “Steve came to the realization that David was a little out of control,”

in 1998. The world’s largest insurance company, American International Group, took a 7 percent stake in the firm, valuing Blackstone at $2.1 billion, and AIG promised to ante up $1.2 billion for Blackstone’s investment funds.

The VCs know that many of their companies will fizzle but hope that a few will be spectacularly successful. It is a scattershot approach, like tossing apple seeds and hoping a healthy tree or two will spring up. VCs make bets on which entrepreneur will achieve a technological breakthrough first, who can get to market fastest, and whose product will dominate its market—events whose likelihood defies precise projections.

To be a private equity investor, you need to be a kind of control freak—someone who can patiently map out all the scenarios, good and bad, first to make sure your company won’t go bust and, second, to see how it can be improved incrementally to lift its value. Buyout investing focuses on cash flow because banks won’t lend money, and bond buyers won’t buy bonds, unless they are confident a company will be able to pay

No amount of number crunching can predict if a new website will capture the public’s imagination or whether a biotech startup’s research will succeed in developing a drug to treat cancer. The payoff comes from seeding dozens of long shots.

The business then borrowed so that debt could replace some of Time Warner’s equity, allowing Time Warner to take out cash. As a bonus, because it no longer held a controlling stake, Time Warner no longer had to report the system’s debt on its own balance sheet, which was massively leveraged at the time.

walked away with $400 million—eight times its original investment—on TW Fanch-One, a bigger multiple of its investment than even UCAR had earned. It hauled in 5.5 times its money, or $747 million, on Bresnan.

Using Blackstone’s name was in his best interest, and he paid for it with equity.
********************************************************

Schwarzman recruited Robert Friedman, Blackstone’s lead outside lawyer at Simpson Thacher & Barlett, to join the buyout team to make sure “nothing dropped through the cracks.”

With some venture funds chalking up returns of 100, 200, and even 300 percent a year, the lure of venture investing proved irresistible, and pension funds and endowments began redirecting more money to investment funds that specialized in start-ups and other technology companies.

When Schwarzman hit the road in 1999 to raise money for Blackstone’s new mezzanine debt fund, which would lend money to midsized businesses, one potential investor who preferred venture funds just scoffed. “I make more money in a month than you make in a year in your mezz fund if things go well,”

Competing with the VCs wasn’t really an option, though. That took in-depth knowledge of tech industries ranging from semiconductors and software to websites and biotechs—sectors where private equity firms had little if any expertise and few contacts. Moreover, entrepreneurs flocked to the venture firms that had backed the most successful investments. Why would they come to Blackstone, which had no track record and was on the wrong coast? Buyout firms that tried to intrude on the Californian finance turf were likely to get only companies that had been rejected by the top VCs.

Many conventional phone companies and wireless and cable operators made money but needed additional capital. Many were large enough that private equity firms could put hundreds of millions of dollars to work at one company, which was nearly impossible with start-ups.

The Callahan deals, which together were worth $5.2 billion, would be the largest private equity investments to date in Europe and a dramatic debut for Blackstone.

Callahan and Colley planned $1 billion of capital spending the first year, in a race to get the new equipment in place. But the management team that had performed so ably in Spain struggled in Germany. Colley and other senior staff didn’t speak German and commuted from Britain and Spain, arriving Mondays and leaving Fridays.

There were delays getting the equipment and software running, so the revenue from new services that was supposed to help cover the ongoing upgrade costs didn’t materialize as planned. They also found they were hostage to Deutsche Telekom, which owned the conduits through which the cable wires ran. Callahan’s engineers had problems getting access, and they discovered the hard way that the phone company’s maps of cable paths didn’t always correspond to reality. When they installed their new equipment, they sometimes unwittingly blacked out whole neighborhoods.

The loss was most devastating for the new media and telecom fund, because the $159 million it had contributed from its kitty represented more than 70 percent of its invested capital to that point.

…plunking $2.5 billion—much of his funding—into just two companies, XO Communications and McLeodUSA, which were building phone, cable, and Internet networks to compete with the Bell phone companies. Forstmann Little lost it all when both had to be restructured in 2002.

state of Connecticut, which had invested in Forstmann’s fund, sued in February 2002, claiming the firm had breached its agreements with investors by putting so much of its capital into just two risky investments. Ted Forstmann found himself on the witness stand in 2004, where he was grilled publicly about the calamitous decisions. (In a quirky outcome, the jury found that the firm had violated its investment contract but awarded no damages.)

Hicks Muse Tate & Furst, the Texas firm that grew to be a major player in the later years of the nineties, well over $2 billion of its investors’ money was incinerated in eleven disastrous deals over three years (>50% loss).

When Tom Hicks tried to raise a new fund in 2000 to match his $4.1 billion pool of 1998, his investors balked. Most weren’t convinced the firm deserved a second chance, and in 2002 it had to settle for $1.6 billion.

Sixty-two major private equity–backed companies went bust in 2001, vaporizing $12 billion of equity by one tally. Another forty-six failed in the first half of 2002, wiping out a further $7.6 billion

which had audited both Enron and WorldCom, for destroying Enron documents, that only reinforced the growing suspicion that corporate financial statements meant nothing.

Going into 2001, it still had more than $1 billion left from its $4 billion 1997 fund, as well as nearly all of the communication fund’s $2 billion, and it was gearing up to raise a fourth generalist fund. Sooner or later it would have to deploy this money. It could wait until the credit markets recovered, or it could find alternatives to the classic leveraged buyout. The strategy that unfolded revealed a truth about private equity that is seldom observed by those outside the financial world: It is defined more by opportunism than by the conventional LBO.

In troubled times, however, it can pay to invest instead at other levels of a corporation’s capital structure, or to make unleveraged equity investments.

Relatively low-risk senior debt of a company may pay as much as 15 percent—not too far short of the 20-percent-plus returns buyout firms typically aim for.

Private equity firms pounced on the opportunity caused by the terrorist attacks, pouring money into the sector—KKR, Hellman & Friedman, TPG, and Warburg Pincus, to name just a few. Rather than invest in existing companies that still had big claims to work off, however, they set up new reinsurers with clean balance sheets that now would face little competition from existing, wounded companies.

Blackstone plowed $201 million into Axis Capital, a new reinsurer it formed with four other private equity firms. The next June it invested $268 million alongside the London buyout firm Candover Investments and others to form another new reinsurer, Aspen Insurance, around assets that a troubled London reinsurer, Wellington Re, was forced to sell. These were 100 percent equity investments in start-ups without leverage. In a crippled industry, they had the potential to match the returns Blackstone expected on LBOs in good times because the new players would be abnormally profitable.

We would not make an amazing return, by the nature of the industry, but you could make twenty-one or twenty-two or twenty-three percent a year for a few years.” Ultimately, Blackstone made a 30.2 percent annual return on Axis. Aspen might have matched that but it suffered big losses from Hurricane Katrina in 2005, so Blackstone ultimately earned only a 15 percent return.

Blackstone veered even further from its customary investment formulae, detouring into vulture debt investing, a treacherous new territory where it had ventured only a few times before

10 percent interest on its face value and it’s selling for 67 cents on the dollar because it might go into default, the buyer earns a 15 percent return on its investment; the effective interest rate is 50 percent higher than the nominal rate because of the discounted price.
“We’re value investors and we’re pretty agnostic as to where we appear in the capital structure,” Schwarzman says. “In 2002 it became pretty clear that subordinated debt in a whole variety of companies was a terrific place to be.”

Art Newman, the head of Blackstone’s restructuring advisers, was called in to help strategize. “These guys knew the assets very well, and I understood the bankruptcy process,”

In both cases, the underlying businesses were fundamentally sound. They simply carried too much debt, and that would be reduced in a restructuring.

“At that point, cable looked relatively well protected,” says Schwarzman. “Its systems were built out. Its systems were difficult to replicate.

mid-2003 when Blackstone began weighing a third big investment in distressed cable debt. This one would be equally risky but also held the promise of redemption, for the companies in question were the two Callahan systems

The Callahan Systems had simply run out of cash because they had spent too much too quickly to upgrade their networks and hadn’t signed up enough new customers to keep pace.

Blackstone approached one of the Baden-Württemberg system’s banks and arranged to buy a big slice of the company’s loans at a meager 19 euro cents on the euro and then bought more in the open market at deep discounts.

The restructuring cut the company’s debt to manageable levels and the business was soon back on its feet. By 2005 profits were rising and the company was able to borrow money to refinance its debt and pay a huge dividend to Blackstone and other shareholders. By the time Blackstone cashed out its last piece of the two companies in 2006, it had booked a profit of $381 million—three times what it had invested

“We had just raised this $2 billion fund” when the original Callahan deal foundered, Guffey says. “This was 15 percent of the fund and it looked like it would be zero. We were down eight to one in the seventh inning and we turned the game around.”

more than doubled the roughly $800 million it gambled on the distressed debt strategy.

They saw it as a growth play and calculated that the business would expand quickly enough that they could make LBO-level profits even without steep leverage.

Northrop Grumman, a defense contractor, was acquiring TRW’s parent company, another defense supplier, and needed to off-load the auto subsidiary as quickly as it could to pay down the loans for the main takeover. Blackstone was unwilling to invest more than $500 million of its own, so Neil Simpkins, a young partner who was leading the deal, persuaded Northrop to keep a 45 percent stake while Blackstone tried to recruit other investors after the deal closed. In effect, the seller was offering installment financing for its own asset. Northrop even loaned Blackstone some of the money to buy its 55 percent stake. Still, it was hard to line up the debt needed to cover the 4.6 Billion balance.

The buyers were consummate opportunists, taking advantage of the disarray in the markets and the economic problems of the corporate world for their own and their investors’ benefit. But the billions they invested at the bottom of the market supplied sellers with capital they needed to make it through the recession.

Between 1996 and 2000 it had doubled to 350 people.

Wall Street, and it had just raised a new mezzanine fund, which would make loans to midsized businesses. The real estate group was running swanky hotels in London and buying up office towers and warehouses in France and properties in Germany. The firm had finally opened a London office and now hoped to push into private equity across Europe, an expansion that would raise a host of new business, cultural, and legal issues.

2002 to sign up investors for its next fund, the $6 billion Blackstone Capital Partners IV. And so in mid-2002, two years after the go-around with Lee, Schwarzman set out again to see if he could find the right person.

When Schwarzman reached out to him in 2002, investors in DLJ’s $1 billion 1992 fund had earned an average annual return after DLJ’s fees of more than 70 percent—an astronomical rate of return to sustain over such a long period. That was roughly twice the very respectable 34 percent Blackstone’s 1993 fund had posted over the same span.

When Drexel Burnham Lambert imploded in 1990, James had swooped in to snare many of its top bankers, including Ken Moelis, an M&A star, and Bennett Goodman, a trader who helped DLJ build a high-yield debt group.

created position of chairman of global investment banking, where no one reported to him, and installed a new investment banking chief. James hadn’t actually been sacked, as so many bankers were in that period. It was, in the words of a DLJ colleague, “death with dignity.”

“I didn’t want to meet him in a work setting. I wanted to really learn how his mind worked,” Schwarzman explains.

Over a long meal they traded experiences and their takes on the world. “I really had a great time because we could speak shorthand about just about anything in the financial world,” says Schwarzman. “Here’s a situation. How did you think that worked out? What do you think went wrong? What would you have done there? I think we both found out there was an enormous convergence of investment style and outcome, and conservatism.”

“They all said exactly the same thing. They said that Tony was brilliant, he was a workaholic, that he was a great investor, he was a natural leader, that the people who worked for him were incredibly loyal. He was a brilliant manager and that he had tremendous loyalty to the institution. And, at a personal level, he would never betray you—meaning me.

Schwarzman had never been afraid to bring in big personalities with their own ambitions and agendas. He had wooed Roger Altman, David Stockman, Larry Fink, and Tom Hill to Blackstone in the early years.

it was a huge leap of faith for Steve—to [trust] any outsider that he didn’t really know that well.”

I said, ‘You and I are only going to have one type of disagreement working together. You’re going to be interested in starting a lot of new businesses, some of which may not really be big enough to really affect us. That’s because you’re a better manager than I am. I prefer starting fewer things but having them be huge. But that’s a matter of taste. That will be a difference in the way we approach things. We’ll never disagree about deals or investments.’ ”

James agreed to join, lured in part by a major stake in the firm. (By the time of the IPO in 2007, he would hold 6.2 percent, slightly more than Peterson.) He agreed to finish the year at CSFB, but soon Schwarzman was pestering him for advice and help. “As soon as I accepted the job, Steve started calling, saying, ‘We’ve got this crisis. Can you come up and think about this?’ Or ‘We’re about to make this big investment’ or ‘We’ve got to pay people. You really should be a part of that process,’

partners, who had been free to pursue investment possibilities for weeks or even months without supervision, were required to submit an outline at the outset so management could decide if an opportunity was promising enough to warrant the partner’s time.

He also pressed partners to analyze the risks of deals more rigorously. Like their counterparts at other firms, Blackstone’s partners were accustomed to producing voluminous projections, often a hundred to one hundred and fifty pages, forecasting “every item of every division, down to how many Coca-Colas they’re buying in their conference rooms and the price of Coke,” as James puts it, to come up with the base case—the minimum projected financial performance. But he insisted that they take the analysis a step farther, factoring in more carefully the possibility of fluke events that could sink a company or turn the investment into a success—what economists dub optionality.

“All these unlikely things are one in ten, one in twenty, one in fifty, whatever they are, so you don’t put them in your base case because they’re very unlikely.” But they are hazards nonetheless. “The chance of any one of them happening is tiny, but the chance that none of them will happen is also tiny. You multiply it out and you find that there’s [say] a 55 per cent chance that one of them will happen, and it kills you.”

that it had little money at risk and the freak possibilities on the downside were few and the payoff from an unlikely event on the positive side of the ledger was huge—such as Paul Allen’s grabbing up Blackstone’s U.S. cable holdings in 1999 and 2000 at inflated prices—it was like a cheap call option.

He “wanted to judge people not just on their talent but on how you trained people, et cetera,”

He commissioned an exhaustive study of the firm’s past investments to find out exactly where and how the firm had made its money—and how it had lost it. The report contained some provocative conclusions.

It came as no surprise that the firm had profited mightily by timing the markets shrewdly—buying during troughs and selling at the peaks. It turned out, for instance, that partners had a tendency to overestimate the abilities of those managing the companies Blackstone bought. In deals where the partners in charge had rated management highly at the outset, returns tended to be disappointing. The results led the firm to turn to outside consultants and psychologists to evaluate executives at potential portfolio companies.

James also reexamined Blackstone’s relations with its bankers. He began tracking how much Blackstone paid to individual investment banks so it could see which bankers were bringing it deals, and which weren’t. the reputation the firm had gained for being a hard-nosed and difficult customer.

long voice mails for each other ten or twelve times on a typical day. Schwarzman could often be seen slouched comfortably in a chair in front of James’s desk. On the few occasions when people tried to go over him to Schwarzman, Schwarzman backed James.

as did the fact that Blackstone’s partners did not forfeit their share of the firm’s profits on past investments, as partners at many other buyout firms do once they depart. They could start new careers and continue to collect checks from Blackstone for years to come as investments from their time there were sold off.

teamed up with a group of Silicon Valley executives and investors and Bono, the lead singer of the rock group U2, to form Elevation Partners to invest in media, entertainment, and consumer companies. The next year Elevation raised $1.9 billion. In October 2005, Gallogly, who had mulled going out on his own in 1999, finally took the plunge, forming Centerbridge Partners with a veteran vulture investor. By the next year they had a $3.2 billion fund at their disposal.

“I recall Steve very early in that particular cycle [saying], ‘Look what’s going on! You’ve got to be buying,’ ” says Mario Giannini of Hamilton Lane, a firm that advises pension funds and others on private equity investments.

Timing is everything when you are borrowing to buy a cyclical company. The exit must be timed as deftly as the entry, however, because in a declining economy multiples can recede at the same time earnings are falling.

CELANESE

When Chu first began running the numbers on Celanese in 2001, the company was in a slump. With the economy ailing, demand was down for its key products: acetyl derivatives used in paints, drugs, and textiles; acetates for cigarette filters and apparel; plastics used in automobiles; farming chemicals and detergents; and food and beverage additives.

Celanese was also something of an orphan. Originally an American company, it had been acquired by the German chemical and drug maker Hoechst AG in 1987. When Hoechst agreed to merge with a French pharmaceutical company in 1999, it sold off Celanese via an IPO on the Frankfurt stock exchange. More than half Celanese’s operations and revenue were in the United States, however, and only 20 percent or so in Europe, so it was a German company in name only and never found much favor on the German market. Moreover, German stock valuations tended to be lower than those in the United States. The logical thing, it seemed, would be to shift Celanese’s main stock listing to New York. Chu figured that Celanese would trade for one multiple more there: five times cash flow, for example, if it traded for four times in Germany.

Beyond that, Celanese looked ripe for cost cutting. “We believed there were significant costs that could be taken off Celanese because Celanese was the [product] of a number of acquisitions and mergers,”

Twice Chu approached Celanese and twice he was rebuffed, first in 2001 and again in 2002. In May 2003 he came back a third time, this time allied with General Electric, the American industrial and financial conglomerate. They proposed to merge Celanese’s plastics businesses—about a quarter of the total business—into GE’s global plastics division, leaving the rest of Celanese for Blackstone.

To keep up the momentum after GE bailed, he did an end run around management, appealing to Celanese’s biggest shareholder, the Kuwait Petroleum Corporation, which owned 29 percent. The Kuwaitis signaled to management that they supported a buyout, and the process got back on track.

Like most LBOs, Blackstone’s purchase would take place via a new holding company, which would borrow money to buy the operating business and use profits from that to cover the cost of the debt.

Blackstone needed about $850 million of cash (75% debt also) to close the deal, but that would amount to 13 percent of Blackstone’s new fund—far more than it was willing to risk on any single investment. Chu had assumed he would be able to bring in other buyout firms to take smaller stakes but soon found that he was alone in his conviction that the chemicals market was turning up. All six of the competitors he approached turned him down. “A lot of them thought the cycle would get worse before it got better and told us, ‘You guys overpaid,’ ” Chu recounts. Ultimately he lined up $206 million from Blackstone investors, which invested directly in Celanese in addition to their investments through Blackstone’s fund.

the lenders for the buyout, agreed to buy $200 million of preferred shares—a cross between equity and debt—to fill the remaining hole.

There was still one more hurdle: getting the shareholders to agree. The Kuwaitis had committed to sell their 29 percent, but other shareholders were free to refuse the 32.50 offer, and German takeover rules gave them a perverse incentive to do so.

In the United States and many other European countries, once a buyer gets 90–95 percent of the shares of a company, it can force the remaining shareholders to sell out at the price the other shareholders accepted.

Because of the holdout right in Germany, Chu found himself playing a multibillion-euro game of chicken with the hedge funds and mutual funds that owned most of Celanese’s stock.

“We had run up something like $25 million in expenses, which was no small matter. Steve said, ‘Chinh, how is it going?’ I’d say, ‘Steve, I’m on the phone negotiating with everybody. I don’t know how it’s going!’ ”

Schwarzman returned again with only minutes to spare till the 6:00 P.M. deadline. “We were 15 percent short. At six o’clock, Steve asked me, ‘What is the official tally?’ At that point, we were 1.5 percent short

A few stragglers stuck it out and ultimately got 67 per share. Holding out pays off. Blackstone didn’t wait for the last of the holdouts before setting about to reshape the company. That began as soon as it won control in April 2004.

The move to Dallas saved $42 million a year. Retooling at the North American plants sped up production and allowed more jobs cuts, saving another $81 million annually. Celanese also off-loaded a money-losing business that made glasslike plastics and sold its stake in an unprofitable fuel-cell venture, two drains on profits. It saved another $27 million annually by shifting most of its production of acetate fibers used in cigarette filters to China, where cigarette sales were rising and labor is cheaper.

Celanese’s bureaucracy at the time also would have thwarted the changes, adds Weidman, who remained on as CEO long after Blackstone exited Celanese.

Two months after the dividend, in November, Celanese filed papers for an IPO to go public and in January 2005, only eight and a half months after Blackstone won control of the company, Celanese went public again on the New York Stock Exchange. As Chu had predicted, American investors valued the company more highly: at 6.4 times cash flow, or 1.4 “turns” more than Blackstone had paid. Celanese raised close to $1 billion in common and preferred stock, $803 million of which went to Blackstone and its coinvestors, on top of the dividend they received earlier. Blackstone and the coinvestors had now collected $700 million in profit on their $612 million investment, and they still owned most of Celanese.

By the time they sold the last of their Celanese shares in May 2007, raked in a $2.9 billion profit on Celanese—almost five times their money

Those enhancements rather than the economy were responsible for roughly half the increase in the company’s cash flow from 2003 to 2006… flow, which never dipped below $800 million in 2008–2009, double its level in the 2001–2002 recession.

Even relisting in the United States—the ploy that at first glance looks like a financial sleight of hand—benefited the company.

Premcor went public at a price two and a half times what Blackstone had paid, and the firm made six times its money selling down its stake as the stock rose in the following years.

In none of these five 2003 cases did Blackstone cash out even half of its holding, but the IPOs began the process of locking in profits and set the stage for it to take its gains over time by selling shares.

Suppose a company had been acquired for $1 billion with relatively little leverage in 2002, when credit markets were tight, and it had debt of just $500 million. If the improving economy had pushed cash flows up 20 percent, the company could now borrow an additional $100 million (20 percent of $500 million) assuming its bankers applied the same debt–to–cash flow figure they had when they financed the deal originally. That money could then be paid out to the company’s owners.

A company issuing junk bonds at the beginning of 2003 had to offer an interest rate 8 percentage points over the rate on U.S. treasury bills. By December 2003 that spread had narrowed to just 4 percentage points. With their interest costs falling, companies could shoulder more debt and replace their old debt with new, cheaper loans and bonds. Thus the hypothetical company above might well be able to take on, say, $200 million of additional debt, paying back its owners 40 percent of the $500 million

And the recapitalization might not even increase the company’s interest costs.

That’s what happened with Nalco. The buyout was quite highly leveraged from the start.. The recaps were an irresistible move for buyout firms, because they allowed them to earn back part of their investment quickly, without the drawn-out process of an auction or an IPO, and the faster they returned money to their investors, the higher their annual rates of return.

It was no different from owning an apartment building where rents and the property’s value had risen sharply. There would be nothing irresponsible about refinancing the building to take out equity if the increases looked permanent or mortgage rates had fallen.

Secondary buyouts were usually not too baffling if you delved into the financials of the companies. Both mattress makers had steadily improved and expanded their businesses over the years under their successive private equity owners. They had consolidated smaller companies and launched new products, their businesses got a lift from a slow but steady increase in the number of bedrooms in the average American home, and they had expanded overseas. Their cash flows were predictable enough that they could be highly leveraged, generating gains for their owners from even relatively small improvements.

From 1991, when Merrill Lynch bought Simmons, to 2007 its annual cash flow rocketed more than sixfold, from $24 million to $158 million. Even though Sealy’s growth wasn’t as steady, its cash flow tripled over the same stretch

managers who make money for their clients attract more capital over time. With bucket loads of profits coming in and extraordinary rates of return, Blackstone and other private equity firms with good records were assured of raising gargantuan investment pools

The typical pension fund still kept half or more of its money in ordinary stocks, and a large slice in bonds, but pension managers increasingly were adhering to an economic model known as modern portfolio theory. This taught that overall returns could be maximized by layering in small amounts of nontraditional, high-returning assets such as buyout, venture, and hedge funds and real estate.

Contrary to the common admonition, in the case of private equity, past investment performance is a good predictor of future performance. There was a welter of mediocre private equity firms that didn’t outrun the public stock

If a buyout firm could put more debt on the company so that any gain in the company’s value was magnified in the value of its stock, companies began to ask themselves, why couldn’t we do the same to give our public shareholders a higher return on their shares? In some cases, hedge funds and other activist investors urged companies to perform their own dividend recaps, borrowing more money to pay a dividend or to buy in some of their shares.

The sheer magnitude of the funds and the deals had another side effect on the business, one that troubled some investors. The fixed 1.5 percent to 2 percent management fees the firms charged their investors, and the transaction fees they tacked on when they bought or sold a company, had grown so large in absolute dollar terms that they had become a wellhead of income at large private equity houses, rather than just a way of ensuring that some money was coming in the door in tough times. By mid-decade, firms like Blackstone and KKR were deriving roughly a third of their revenue from the fixed fees rather than from investment profits,

As long as a BDC pays out almost all of its income each year to shareholders, it is exempt from most corporate taxes.

Leon Black’s Apollo Management moved first, filing papers in February 2004 to raise $575 million for a new entity, Apollo Investment Corporation. Apollo Investment would not buy control of companies the way that a conventional buyout fund would. Instead, it would be a mezzanine lender, making loans to small and midsized companies. Mezzanine debt—the type of debt that insurance companies provided for LBOs in the early days of the business—is subordinated to senior debt such as bank loans, so the interest rates are higher, and mezzanine lenders usually demand a slice of equity in their customers as well, so they can share in the profits if the customers’ stocks take off.

Apollo, like other buyout firms, already had legions of analysts studying industries and potential target companies, and its knowledge of the debt markets was deep. Here was a way to capitalize on that expertise and collect management fees and profits on ever larger amounts of capital. The parent Apollo’s cut was similar to an LBO fund’s, a 2 percent management fee based on the total assets and up to 20 percent of the profits after investors had received a certain minimum.

Road shows consumed an enormous amount of time—time that the Leon Blacks and Steve Schwarzmans would rather have spent doing deals and raking in profits than justifying themselves. Original capital in perpetuity and could raise new capital at any time by selling additional shares to the public, a process that could be handled by bankers and lawyers without senior management having to press the flesh.

The BDC wasn’t a perfect substitute, but the prospect of permanent capital raised on the public markets was irresistible.

Within a month, more than a dozen were in the works from private equity firms like Thomas H. Lee Partners and Ares Capital Management and banks. It was “the pack moving and Wall Street was pushing, and there was no downside,”

that would invest directly in companies alongside KKR and also would invest indirectly as a limited partner in KKR’s buyout funds. This was the private equity manager’s dream, the Holy Grail—true permanent capital raised in the public markets, obviating the need for laborious fund-raising campaigns and broadening the class of investors sponsors could tap.

When KKR Private Equity Investors went public on May 3, 2006, it raised a whopping $5 billion.

TRONOX

He figured the chemical industry was near a crest and that if business slacked off, the company wouldn’t be able to handle such a huge debt load. If earnings fell back to what one might expect at the midpoint in the business cycle instead of the peak, he reckoned, Tronox’s debt could suddenly equate to fourteen times cash flow—a perilous level.

“The debt [offered] on that deal was twice what I thought the company was worth,” Chu says.

At least as important, the private equity firms offered executives equity stakes that potentially could make them much richer than they could ever hope to become collecting stock options in a public company. “Sign me up!” CEOs said.

The run-up in prices was startling. In 2004 the average large company that went through a buyout was priced at 7.4 times its cash flow. By 2007, the average had shot up to 9.8 times. But it wasn’t that buyout firms were cutting larger equity checks. Most of that rise in multiples consisted of debt, as banks promised bigger loans and larger bond packages for a given sum of cash flow. With the same amount of equity, a buyout firm could afford to buy a much more expensive company in 2007 than in 2004.

PIKs. A popular type of bond in the Drexel era, they paid interest not with cash but with more bonds. In other words, the company could take on more debt instead of paying cash to its creditors. In an added, company-friendly feature, these notes had a “toggle”: Freescale could pay in cash or with more notes as it wished. If sales plunged, Freescale could exercise the PIK option to conserve cash.

We knew we were buying nearer the semiconductor peak than the trough, so we built a capital structure with no covenants, long maturities, tons of liquidity. We said, it’s going to be a wild ride, but the long-term trends for the industry were positive as electronics permeate everything.

The banks were offering us ten times debt to cash flow,” says James. “No company can support that kind of debt.

A beguiling proposition began to take shape in his head. If people like Kaplan would now buy buildings at a cap rate of 4, Gray could afford to pay a godfatherly price for EOP and sell off a third or so of its assets, leaving Blackstone owning the balance for a song. In effect, Blackstone would buy wholesale and sell retail.

Blackstone took offices, closets, and other space that didn’t make money and created two hundred new rooms at the four buildings, upgraded the decor, and hired new chefs to create a buzz around the establishments before selling the company in 2003.

Drawing on the firm’s buyout know-how, they had shifted from buying individual buildings to acquiring whole real estate companies.

“That’s when our business took a step forward,” Gray explains. “It’s like when you’re turning a lock and all the tumblers all fall into place. We went from buying individual buildings to a business that was much more scalable.”

most publicly owned office companies managed their buildings to keep them full so they could maintain steady dividends and didn’t hold out for the highest possible rents, which might create temporary vacancies.

Before it acquired Trizec in October 2006, Blackstone had lined up buyers for thirteen of Trizec’s buildings, which it sold for $2.1 billion, earning an instant $300 million gain over its purchase price for the whole company.

“Sam’s a trader,” Sesler explains. “He’s never going to give you his exact number.”

Leventhal’s view was that, in the best markets, where it was hard to build new offices, you would make money over the long run if you bought buildings below their replacement cost, because prices had a natural tendency to rise where the supply couldn’t expand much.

Financing the EOP deal proved to be a cinch. It took Blackstone just five days to round up $29.5 billion in debt financing from Bear Stearns, Bank of America, and Goldman Sachs.

In addition to the debt, the banks agreed to invest several billion dollars in equity

Like Zell, Roth had started off down-market, raising money to develop strip malls in New Jersey, and had cut his teeth early on distressed property. He won control of Vornado through a proxy contest in 1980, when the company was an air-conditioner maker and retailer, shut its stores, and then rented out the space. In 1992, he and other creditors of the ailing Alexander’s department store in New York forced the company into bankruptcy. Vornado kept Alexander’s prime property next to Bloomingdale’s department store on New York’s Upper East Side, which Roth later developed into the headquarters for Bloomberg LP

Vornado’s $38 billion offer, though, was 40 percent in stock. Moreover it was nonbinding, and Vornado had not yet lined up debt financing, as Blackstone had when it signed its deal. To make matters worse, Vornado demanded that EOP sell off assets Vornado didn’t want before the deal closed.

ringing off the hooks. Everyone in the commercial property business was clamoring to pry loose a piece of EOP. Gray and Frank Cohen were caught off guard shortly after the deal was announced when they had lunch with a property mogul who unexpectedly began to quiz them about what they would sell. None of the men had notepaper. They had to summon a waiter and borrow his order pad to jot down a list of the cities.

Harry Macklowe, a New York office baron, who offered to buy most of EOP’s New York buildings for $6.6 billion, a cap rate of between 3 and 3.5. That was equivalent to a cash-flow multiple of 29 to 33—well into nosebleed territory. Macklowe would have to pay more than 3.5 percent interest on the loans to buy the buildings, so he was guaranteed to lose money at least in the short run. It made sense only if he could sharply boost the rents he collected

provided EOP would increase the breakup fee to $700 million, or 3 percent of EOP’s market capitalization. Breakup fees are normally 1-2%

“We talked about putting the firm’s reputation at risk in so big a deal,” Gray said. “If we had overpaid and the deal had gone spectacularly badly, we could have really hurt a franchise that took twenty years to build.”

in the pipeline. The biggest piece was already done: Macklowe’s $6.6 billion deal for most of EOP’s New York portfolio closed with the main buyout. A $6.4 billion sale of the Washington and Seattle holdings to Beacon Capital—the company headed by Alan Leventhal, whose theories of replacement value had inspired Gray—was nearly in the bag. But EOP emerged from the buyout with $32 billion in debt and the $3.5 billion of equity bridge financing, and knowing how torrid the market was, Gray sensed he had only a small window to sell off what he didn’t want to get those numbers down.

With the benefit of leverage, Blackstone’s $3.5 billion equity investment was worth about $7 billion when the sales were complete. It had doubled its money on paper simply by breaking up EOP.

KKR’s deals had made Kravis an A-list celebrity in the eighties, and with his second wife, the fashion designer Caroline Roehm, on his arm, he had gained entrée to New York’s elite social circles. He had worked the charity circuit for decades and his third wife, Marie-Josée Drouin, a Canadian economist and TV personality, made a name for herself hosting dinner parties sprinkled with intellectuals.

$70 billion in assets under management and was in the best niches of the alternative asset management business. It collected both its steady 1.5 percent management fee plus 20 percent of the profits on its biggest funds, buyouts and real estate, and the investors in those committed their money for up to ten years

An IPO would make sense only if the price were right, but there was no way James and Schwarzman were going to open up Blackstone’s books to Morgan Stanley—not even to Porat, whom James had known for twenty years and had once tried to recruit to DLJ. No one outside the firm—not even rank-and-file Blackstone partners—knew what the firm as a whole made. And Morgan Stanley was a competitor in private equity, real estate investing, and merger advice. James’s solution was to give Morgan Stanley some theoretical numbers. “We told them they would be disguised” but representative of the business, James explains. “Then we created a fictional set of numbers that reflected trends, mix, and margins but did not give absolute levels.”

Blackstone was organized as a partnership and partnerships generally don’t pay corporate taxes. Instead, their partners pay income tax on their respective shares of the partnership’s profits.

While its partners spent their days trying to devise ways to sell the assets Blackstone owned at a profit, they had no way of capturing the value in the business they had built.

if one of them died, his estate was entitled to receive income from the firm only for five to seven years; he could not pass on his stake in the firm to heirs, let alone sell it. Allowing the public to buy in would provide a route for Peterson to cash out

It would give the firm “acquisition currency”—stock with which it could buy other businesses and lure talent. With stock it could afford to add much larger new businesses than it could if it had to pay in cash or with an illiquid ownership stake in Blackstone.

James devised an end run around the difficulty. Partners would keep their stakes in most existing investments, and the public company would own only the profits on the most recent investments and those made after the IPO. This bypassed the need to predict the success of older investments, but there was a catch: The firm would have few if any investment profits in the first few years after the IPO, as it would take time for current investments to ripen and be harvested.

The solution was a new accounting rule, Financial Accounting Standard 159, which allowed firms in some circumstances to book income based on projections of future profits. Each quarter, Blackstone would appraise each investment in its portfolio, based on cash flows and values for similar businesses, and using complex financial models, it would calculate the present value of the carried interest—its 20 percent of the profit—that it was likely to collect down the road.

Then there was Onex Corporation in Canada, but like 3i, it invested heavily in its own funds, so that buying its shares amounted to taking a stake in an investment fund whose profits and value could oscillate, rather than a piece of a fund manager, whose income and value tended to be more steady.

“Steve and I both instinctively felt that the public markets are inherently flighty,”

Once again doing much of the math himself, James came up with a new scheme in which partners would exchange their shares of the profits on past investments for more equity in the new entity—the tricky swap he had tried to avoid originally. Ultimately the firm used a formula based on the average multiple of its money it had earned on its investments historically.

First, its companies can deduct the interest on their debt, which gives them an advantage over companies that finance themselves with a higher portion of equity. Second, because most of the money that the partners in private equity firms make takes the form of carried interest—their 20 percent share of any investment gains—most of their income is taxed as capital gains. Instead of paying the top rate in the United States of 35 percent for high earners, buyout executives paid the 15 percent capital gains rate on most of their income.

“I want war—not a series of skirmishes,” he was quoted as saying. “I always think about what will kill off the other bidder.… I didn’t get to be successful by letting people hurt Blackstone or me.”

“He found every single provision that could justifiably be utilized, and he worked with some very smart tax lawyers,”

Tax work can be especially lucrative because the savings can be huge. And since clients don’t want extra scrutiny of their taxes, the strategies often remain under the radar.

Mr. Epstein started providing Mr. Black with tax and estate-planning advice around 1997 and began serving as a director of Mr. Black’s family foundation. Over time, Mr. Epstein earned millions in fees advising Mr. Black.

A $10 million investment Mr. Epstein made in Highbridge in 1999 turned into roughly $29 million, the people said. He also pitched tax strategies to managers of the firm, said someone familiar with those discussions.

Mr. Epstein long spoke of having other sources of income, including a currency-trading business that earned tens of millions of dollars, according to a person familiar with the matter.

The firm’s lobbyists were assuring them that no bill was likely to pass soon, so they decided to press on.

Peterson walked away with $1.92 billion and Schwarzman collected $684 million. James, who had been at Blackstone less than five years, pocketed $191 million. Tom Hill, Blackstone’s vice-chairman and manager of the hedge fund arm, got $22.9 million and Mike Puglisi, the CFO, $13.8 million. The other fifty-five partners received $1.74 billion

In the months that followed, as the price of oil, a key raw material, soared and the economy began to slow, the offer looked like a dreadful miscalculation on Apollo’s part, and Hexion sued to get out of the deal, arguing that the merged Hexion–Huntsman would be insolvent because it would carry so much new debt at a time when profits were falling. Huntsman countersued.

Unfortunately for Apollo, Huntsman had negotiated a nearly airtight agreement, which specifically provided that the merger couldn’t be called off because of industry-wide problems, and the judge who heard the dispute came down hard on the buyout firm. He ruled that Apollo and Hexion had deliberately breached the agreement and that, consequently, the legal damages would not be limited to the $325 million breakup fee. Facing billions in potential liability, Apollo and Hexion paid $1 billion to Huntsman to settle the case.

But because buyouts are structured legally so that neither the fund nor the private equity firm that manages it is liable for the portfolio company’s debt, providing a guarantee was problematic.

The company’s auditors took the BCE deal off life support when they said they might not be able to certify the company’s solvency, as required. That saved the buyers—the Ontario Teachers’ Pension Plan, Providence Equity Partners, Madison Dearborn Partners, and Merrill Lynch’s private equity fund—from what might have turned into the biggest private equity blunder ever.

Cerberus, the vulture debt firm that morphed into a major private equity investor, suffered the most catastrophic and public losses. Cerberus led a consortium that bought 51 percent of General Motors’ finance arm, GMAC, in 2006, at a time when GMAC’s mortgage lending operation was throwing off $1 billion in profits annually, much of it from subprime lending. Soon that business began to hemorrhage hundreds of millions and nearly brought down the whole company. Then auto sales collapsed. In 2009 GMAC took a government bailout that reduced Cerberus to a 15 percent voting position.

Even Cerberus’s investors were kept in the dark: It refused to share financial information when it raised the $7 billion in equity for the deal and told potential backers they would not receive regular financial reports even after they invested. “It was a blind-faith request—trust us,” says one investor who was approached but turned down the chance to join in.

to invest directly in companies alongside firms like Cerberus and Blackstone, because they then would not have to hand over 20 percent of the profits to the buyout firm as they would if they invested through a fund.

They were too early. When the crisis deepened, much of their bailout capital was lost. MBIA’s stock slid from $31 to barely $2 from $67.

A year before the Blackstone takeover, Hilton had purchased its sister company, Hilton International, which owned the rights to the Hilton brand overseas. The namesake brand hadn’t been fully exploited abroad, and the American company’s lower-cost, limited-service brands such as Doubletree, Hilton Garden Inn, and Embassy Suites hadn’t been licensed at all overseas. As a result, there was room to expand the business at the same time costs were being trimmed. Under Blackstone, the company franchised fifty thousand new rooms a year in 2008 and 2009, in places like Turkey, southern Italy, and Asia, which lifted cash flow sharply.

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.

KKR served notice in 2007 that it was setting up its own securities arm to sell shares and bonds. In part, this was a bid to service its own companies, cutting banks out of the loop and generating underwriting fees for itself, but KKR aims to be more than an in-house service unit. By 2010, it had participated in more than fifteen offerings, including floating bonds for Britain’s leading sports franchise, the Manchester United soccer team, in which KKR had no stake.