o understand the explosion of buyouts in 2006 and 2007 and the unprecedented quantity of capital and power amassed by big private equity rms in that era, one must understand what happened several years earlier.
The year 2003 proved to be an economic in ection point, and Celanese, Nalco, and TRW were harbingers of a gush of pro ts to come. Other private equity rms, too, were able to cash out of investments as the economy and markets turned up, and the gains they showered on their investors in 2004 and 2005 ensured that the next round of buyout funds would attract far larger sums than the last. Together with the availability of credit on an unparalleled scale, the stage was set for a wave of LBOs that would mesmerize the business world across the United States and Europe.
The mood shift was abrupt. Between March 2003, when Blackstone kicked o its new $6.9 billion fund by investing in TRW Automotive, and the end of that year, American stocks rose nearly 40 percent, and investors became hungry again for IPOs. But their tastes had changed since the tech bubble ended in 2000. This time investors wanted no part of visionary dotcoms with no revenues or pro ts. They were perfectly content, thank you, to invest in mundane businesses provided that they produced steady income—precisely the kind of companies buyout firms tended to buy.
Blackstone raced to take advantage of the situation. In May 2002, when the IPO market rst opened brie y, it pulled o an IPO of Premcor, the oil re ner David Stockman had bought in 1997. A couple of years earlier Premcor had looked like it would be a money loser for Blackstone. After a supply glut drove down oil prices in 1997 and 1998, the company began leaking cash. Then, in 2000, it was indicted for environmental violations. But by 2002 oil prices were up, the company was on the mend, and Stockman’s original premise for the investment—that Premcor would bene t from a chronic shortage of re ning capacity in the United States—had been borne out. Premcor went public at a price two and a half times what Blackstone had paid, and the rm made six times its money selling down its stake as the
stock rose in the following years.
After demand for IPOs became more sustained in late 2003, Blackstone prepped six more of its companies to go public. Centennial Communications, a Caribbean cell phone operator it backed in 1999, held its IPO in November 2003. Then Centerplate, Inc., a catering company Blackstone had bought from KKR eight years earlier, followed by Aspen Insurance, the reinsurer Blackstone had helped set up after 9/11. That December, Foundation Coal went public, just ve months after Blackstone had bought the American mining company from a German utility. Nalco and Celanese rounded out the IPO list. In none of these cases did Blackstone cash out even half of its holding, but the IPOs began the process of locking in pro ts and set the stage for it to take its gains over time by selling shares.
Taking companies public wasn’t the only way to cash in on the market turnabout. There was also the dividend recapitalization—leveraging up the company more to pay a dividend. Together, the surging economy and the resuscitated credit markets made those the pro t-taking methods of choice in many cases. 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 ows 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 ow gure they had when they nanced the deal originally. That money could then be paid out to the company’s owners.
But the takings were even larger than that because bankers had grown more generous as the debt markets improved. With a given annual cash ow, you could now borrow much more than you could in 2002. The high-yield bond market reopened in 2003 and 2004 and quickly matched its peaks in 1997 and 1998, sending interest rates tumbling as money cascaded in. A company issuing junk bonds at the beginning of 2003 had to o er 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 they originally had invested.
Presto! An instant return. 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, with debt at six times Nalco’s cash ow going in, but within a week of the deal’s closing in November 2003, Blackstone and its coinvestors, Apollo and Goldman Sachs Capital Partners, were peppered with calls from bankers o ering to lend Nalco even more money. “This was a wake-up call, evidence to me that something new was unfolding,” says one investor in the deal. “Between the time that we signed the Nalco deal in the summer and the time it closed in November, the availability, pricing, and structure of this kind of credit had undergone a big change for the positive in the market.”
The recaps were an irresistible move for buyout rms, 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.
To the uninitiated, the recaps could look like nancial gymnastics. In fact, they were a tried-and-true move in the private equity playbook, and if the new debt simply re ected a healthier business with better prospects, or lower interest rates, there was nothing nefarious about the practice. It was no di erent from owning an apartment building where rents and the property’s value had risen sharply. There would be nothing irresponsible about re nancing the building to take out equity if the increases looked permanent or mortgage rates had fallen.
Still, there had never before been a spate of recaps like this. Buyout rms big and small sucked $86 billion of cash out of their companies this way between 2004 and 2007—money that largely owed straight back to their limited partners.
The recaps were in part a necessity at rst, because it was still hard for private equity rms to nd buyers for their holdings. Corporations had pursued so many misguided acquisitions in the late nineties that they were slow to resume buying once the recession ended. Merger activity didn’t match its 1999 and 2000 heights again until 2007.
To compensate for the lack of corporate buyers, private equity rms also created their own M&A market, buying companies from one another in what are known as secondary buyouts.
The secondary buyouts of the mattress makers Simmons Company and Sealy Corporation within months of each other in the winter of 2003 to 2004 advertised the strange tendency of some companies to be handed o
repeatedly from one private equity rm to another. When Thomas H. Lee Partners bought Simmons from Fenway Partners for $1.1 billion, it was Simmons’s fth consecutive buyout over seventeen years. A few months later KKR bought Sealy from Bain Capital and Charlesbank Capital Partners for
$1.5 billion and became Sealy’s fourth private equity owner in fifteen years.
Again, it looked peculiar to outsiders. It called to mind Milo Minderbinder, the wheeling-and-dealing mess o cer in Catch-22 who made a pro t buying eggs from himself at 7 cents apiece and selling them for 5 cents. Were they just playing a financial shell game among themselves?
Secondary buyouts were usually not too ba ing if you delved into the nancials 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 ows were predictable enough that they could be highly leveraged, generating gains for their owners from even relatively small improvements.
But the mattress company ips illustrated the risks of overleveraging companies. Two of the previous seven buyouts of the companies had ended badly: Simmons and Sealy had each defaulted once when their owners overpaid and loaded the companies up with too much debt. (Simmons would go bankrupt in 2009 for the same reason, and Sealy would later need a huge shot of additional equity from KKR to stay alive.)
Nevertheless, Simmons’s three other prior buyouts had been very profitable, largely because of its superlative nancial performance: From 1991, when Merrill Lynch bought Simmons, to 2007 its annual cash ow rocketed more than sixfold, from $24 million to $158 million. Even though Sealy’s growth wasn’t as steady, its cash ow tripled over the same stretch, and the cumulative increase in both companies’ value over nearly two decades was remarkable. Given the expansion of the mattress businesses and the aggregate pro ts made by private equity rms from them over time, it wasn’t surprising that when the companies were put up for sale, the buyers turned out to be other private equity firms.
With all the IPOs, recaps, and secondary buyouts, private equity rms and
their investors were awash in incoming cash that they funneled right back into new investments. In 2001, the nadir of the market cycle, Blackstone’s buyout funds managed to pay out just $146 million to its limited partners. In 2004, it returned $2.7 billion, then $4.2 billion in 2005, and another $4.7 billion in 2006—testimony to the heady combination of a rising market and leverage. Competitors were cutting even larger checks. Carlyle touted in a press release that it had paid out $5.3 billion in 2004 and KKR returned $7 billion that year. Carlyle paid out another $7 billion in 2005. For four or ve years private equity became self-sustaining, as investors recycled the distributions immediately back into new buyout funds. The sums matched up almost perfectly.
It wasn’t just the raw totals that were astonishing. The rates of return on buyout funds shot to the sky because rms were able to earn back their investments and begin taking pro ts so quickly. If you double your money in ve years, your uncompounded annual rate of return is 20 percent, but if you double it in two years, it jumps to 50 percent. The economic turnaround was a godsend for everyone in the business, but Blackstone outpaced its big rivals.
By the end of 2005 the rm’s fourth fund, which it began investing in early 2003, had earned an annual return of more than 70 percent after Blackstone’s share of the pro ts was taken out, about two and a half times the 20 percent annual rise in the stock market over that period. Funds raised by rivals such as Apollo, KKR, and TPG around the same time as Blackstone’s also outperformed the stock market, but not by nearly as much. Their returns were about 40 percent, and returns on most other buyout funds of the early decade were below that, so Blackstone stood out in the crowd.
Blackstone’s 2002 fund sustained its lead among the biggest buyout funds, generating roughly a 40 percent annual return through the end of 2008, or two or three times the returns on competitors’ funds raised at the bottom of the business cycle in 2001 to 2003. That performance was the payo from Schwarzman’s and James’s gut feeling in 2002 that things were bottoming out then and from Chinh Chu’s two knockout deals: Celanese and Nalco. As Blackstone geared up to raise its next fund, its returns gave it a competitive edge.
It’s a law of nance and human nature that investment managers who make money for their clients attract more capital over time. With bucket loads of pro ts coming in and extraordinary rates of return, Blackstone and other private equity rms with good records were assured of raising
gargantuan investment pools the next time they hit the fund-raising trail.
Another factor magni ed the e ect: the quotas big pension funds and other investors set for private equity.
The mix of institutions investing in buyout funds looked very di erent in the 2000s from what it had when Peterson and Schwarzman rst went rapping on doors in 1986 and 1987. Back then they called rst on insurance companies and Japanese banks and brokerage houses. Only at the end did they raise money from two corporate pension funds, General Motors’ and General Electric’s. By the late 1990s, banks and insurers together were providing only 15 percent or so of the money in buyout and venture funds, and state and local government pension funds had emerged as the leading backers of buyouts, furnishing roughly half the investment capital. 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. Although they were riskier and illiquid (the investor’s money was tied up longer), adding these so-called alternative assets diversi ed a pension portfolio so that the overall risks were no greater, the theory held.
Giant pensions such as California’s state employee and teachers funds, CalPERS and CalSTRS, led the way, sprinkling billions of their bene ciaries’
money across alternative assets in the 1990s, setting percentage targets for each subclass of assets. By the beginning of the new century, CalSTRS and CalPERS were allocating 5 percent and 6 percent, respectively, to the category that included buyout and venture funds—$13.6 billion between them—and they bumped the amounts up every few years. In 2003 the targets were lifted to 7 percent and 8 percent, shifting an extra $4.6 billion from other types of investments. Both California plans were major Blackstone investors, and they set a precedent with their large allocations that others copied. Between 2003 and 2008, state pension funds overall raised their private equity allocations by a third, from 4.2 percent to 5.6 percent. After the tech bubble burst in 2000, the great bulk of the money earmarked for alternatives went to LBO funds rather than venture capital.
Along with the rising quotas, the total assets of the pension funds were swelling as the population aged and the stock market roared back, so that
year by year a given quota, whether 5 percent or 8 percent, equated to an ever-larger absolute amount. The formulas mandated that the pension managers pump billions and billions more into the next generation of buyout funds.
The stepped-up quotas made it possible for Blackstone partners such as Bret Pearlman and Mark Gallogly to strike out on their own and quickly raise multibillion-dollar funds, even though they had no independent investment record. In the main, though, the money owed disproportionately to a handful of elite rms like Blackstone that had long outshone the stock market and their competitors. 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 rms that didn’t outrun the public stock market by a su cient margin to justify the risk or the illiquidity of investing in their funds, and some even fell short of public stocks’ returns. But those whose pro ts landed them in the top quarter of the rankings tended to stay there year in, year out, and investors clamored to gain entry to their funds. As a consequence, the top ten rms controlled 30 percent of the industry’s capital in 1998 and held that position for the next decade.
The planets were all aligned in private equity’s favor, and the forces converged to produce a fund-raising frenzy in 2005 and 2006. From the low ebb in 2002, fund-raising quadrupled by 2005. Blackstone’s record $6.9 billion fund was soon eclipsed when Carlyle closed a pair of new funds in March 2005 totaling $10 billion. The next month Goldman Sachs Capital Partners, an arm of the investment bank that raises money from outside investors as well as from the bank itself, rounded up $8.5 billion. That August, Warburg Pincus raised $8 billion, and Apollo was closing in on $10 billion. Across the Atlantic, Permira and Apax Partners, two British buyout rms with strong records, raised funds of more than $14 billion apiece. Soon KKR, TPG, and Blackstone vied to top those, laying plans to raise funds surpassing $15 billion. (Blackstone eventually would close on a record $21.7 billion in 2007.) The industry wasn’t as concentrated as it had been in the eighties, when KKR single-handedly dominated the eld and was behind most of the largest deals of the decade, but the dozen-odd rms that were able to raise megafunds enjoyed a hegemony, because they controlled so much buyout capital and they alone could compete for the new megadeals.
The breathtaking sums pouring in changed the business in several ways.
With such large war chests, the top buyout rms would not be content to buy a $500 million company here and a $1 billion company there. It would simply take too long and involve too much work to invest their money at that rate. They would have to nd bigger targets, and now the debt markets allowed them to finance deals on a much grander scale.
Private equity had enjoyed a revival in the late 1990s, but it was nothing like this. In the previous decade, merger activity was dominated by huge corporate takeovers, with buyouts accounting for merely 3 percent to 4 percent of all mergers most years, measured by total dollar value. That figure, though, began to tick upward in the 2000s. Even with nancing hard to come by, private equity led 10 percent of all takeovers worldwide in 2002, a level achieved only once before, in 1988, when the buyout numbers were skewed by the mammoth RJR Nabisco deal.
Private equity’s share kept ascending even after corporations began pursuing mergers again. By 2004 it hit 13 percent in the United States and 16 percent in Europe, and it would rise past 20 percent before the cycle was over. With plenty of cheap debt at its disposal, private equity became a potent force in the markets and the economy. The mere prospect of becoming a buyout target could lift the price of a stock that was otherwise languishing, and corporations began to rethink their own capital structures. If a buyout rm could put more debt on the company so that any gain in the company’s value was magni ed 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 e ect on the business, one that troubled some investors. The xed 1.5 percent to 2 percent management fees the rms 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, rms like Blackstone and KKR were deriving roughly a third of their revenue from the xed fees rather than from investment pro ts, enough to make the rms’
partners exceedingly rich regardless of the fate of their investments. Cynics began to wonder if the partners’ cushy income was undercutting their