Alfred M. Mthimkhulu
He was nostalgic. His mind hovered over the October days of 1978: “I read the prospectus, looked at the capital structure and realised the returns could be achieved. I said to myself, ‘This is a gold mine’”. In 2007, he listed his private equity firm, Blackstone. In their book, ‘King of Capital: the remarkable rise, fall, and rise again of Steve Schwartzman and Blackstone’, David Carey and John Morris share a story not just of a man and his business but of private equity as a sector and an asset class.
Steve Schwartzman and his former boss at Lehman Brothers, Peter Peterson, started Blackstone in 1985 and in 2020 it was ranked by some as the world’s largest. Reports suggest that in the past 5 years it raised $96 billion to invest in other businesses.
It perhaps started when Steve spotted a gold mine in the prospectus. The prospectus detailed how a small little-known firm, Kohlberg, Kravis and Roberts (KKR), was buying stock exchange-listed Houdaille Industries for $380 million.
He studied the deal — pricing, financing, forecasts, everything. He wanted it, not this one already under the bridge but the next, and the next, and the next.
Steve and Peterson tried to do such deals at Lehman but colleagues deemed them too risky. The duo helplessly watched as others creamed it. In 1982 for instance, buy-out firm Wesray bought Gibson Greeting Cards Inc. for $80 million.
The three Wesray partners put in only $1 million towards the deal, i.e., $330 000 each. The rest was borrowed and Gibson’s assets were collateral.
They sold Gibson’s real estate to pay off some of the debt and 16 months later listed it at a market valuation of $290 million. Each partner was up $65 million on $330 000 equity, not bad for 16 months’ work.
There was a coup at Lehman in 1983. Peterson left. Immediately after, Lehman’s future hung by a thread after heavy trading losses. Steve stepped-up.
Unauthorised, he approached Peter Cohen, CEO of Shearson, a large brokerage. “Buy us,” he proposed. Shearson did. Years later, Shearson spun-off Lehman.
Thanks to him, Lehman was safe but he wanted out. Peterson was setting up a buyout firm and Steve was the anointed partner. They were called buyout firms because they bought sluggish businesses (like Lehman by Shearson), turned them around and sold them (again, like Lehman).
In return for offering Lehman on a platter, Steve asked Shearson to waiver restraint of trade for him so that he could join Peterson. Shearson agreed, but reneged after the deal. How could they release him and stop others?
Eventually, they let him go on condition that the start-up split 50:50 with Lehman all its advisory income for three years.
The duo put down $400,000 each as equity, got office space, hired a secretary, got two desks and a used conference table. Blackstone was open for business. Their plan was to generate advisory fees to cover overheads while raising capital for a buyout fund.
As in their past, Peterson, a former advisor to President Nixon and thereafter Secretary of Commerce would open doors and Steve follow to close deals but this time around, it did not work. They had no brand. It took a year to get their first advisory deal which paid $50 000.
By then, their equity was $213,000. They kept going.
Their target was a $1 billion fund on which they would, as practice, charge fees of 1,5 percent per annum. They would also take 20 percent of profits on the final sale of businesses they would have invested in — though that cash-flow would kick-in in five or so years’ time.
Fund raising began in 1986. “The problem was that a lot of pension fund managers had financial advisers, and the first question they asked us was, “what is your track record?”
“Well, we didn’t have one. They had to accept us on faith, nothing more.
“It is one of the toughest things I have ever been involved in” reflected Peterson. Months later, all they had was a pledge of $25 million from New York Life Insurance Company.
Over a year later, things changed at a lunch with Prudential Insurance Chief Investment Officer. He had done business with Peterson before and his mentor was Peterson’s friend.
“I’m going to put $100 million in your fund, and we would like to be lead investors.”
Conditions were stiff. Blackstone would only get the 20 percent terminal profits when all investors had been paid a compounded annual return of 9 percent and all investors would get a quarter of Blackstone advisory fees meaning Steve and Peterson would be sweating for 25 percent of own fees since Lehman took 50 percent.
In April 1987, Peterson had a scheduled talk with politicians and business leaders in Tokyo. Steve joined him.
They set up meetings with investors. Nikko Securities committed $100 million. They left Japan with $175 million and found many in the US impatiently waiting.
“Where the hell have you been?” Jack Welch CEO of GE asked Peterson “I know you and Steve have started this business, and I haven’t heard from you.”
Peterson told him GE had turned them down.
“You should have called me directly.” They got $35 million from GE. General Motors Pension Fund threw in $100 million. It was happening, finally.
On Friday 15 October 1987, they decided to stop. They closed the fund with $635 million.
On Monday, the stock market crashed. Lucky or smart?
They would raise more capital in years to come ploughing it all in businesses to boost efficiencies and extract optimal returns. Somehow, during slumps when markets tanked, they often held cash. Lucky or smart?
On 22 July 2007 as the global financial crisis loomed, Blackstone listed at $31, closing at $38. It would dip like others during the crisis but still towers above almost all of its kind.
Why should we care about all this? We can note the role institutional investors (pension funds, insurance companies etc.) play in providing risk capital to industry. We can note that it is in fact debt that private equity firms inject in acquired businesses. Debt limits the borrowers’ degrees of freedom; it is cheaper than equity; it is tax deductible; and unlike equity it must be paid back.
We can note that the arrangement between the private equity firm, the investors and management of the acquired business has a ‘sale-by date’ upon which all go their separate way.
We would be right in concluding that the arrangement instils urgency among participants to meet their independent yet mutually reinforcing goal of earning highest possible returns within set time-frames. Such returns can only be earned when fundamentals of a business are fixed and fixed expeditiously. Could the private equity institutional arrangement be what we are missing?
As we jot down these observations, we should, as we part, perhaps consider how the Victoria Falls Securities Exchange could facilitate the emergence of such growth-focused arrangements and, in so-facilitating, deepen the entire domestic financial system.