What’s Behind Blackstone’s Investment Success?

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As the largest private equity firm in the world, the Blackstone Group understands firsthand what it takes to keep a big company nimble.

“Our biggest challenge is, how do we keep expanding and [still] keep the firm intimate and flexible and responsive?” Stephen Schwarzman, chief executive, chairman and co-founder of Blackstone, told an audience of University of Pennsylvania students recently. On stage at Penn’s Annenberg Center, he discussed the progression of his long career and the key factors responsible for his remarkable success. The moderator was his long-time friend, Howard Marks, now co-chairman of Oaktree Capital Management.

Schwarzman, who established Blackstone in 1985, began his Wall Street career at Lehman Brothers in 1972. In those days, “it was a completely different world than we have now,” he recalled. “It was great because we didn’t have what we have now — that is to say, specialists. Now everybody is a specialist at something. We were all generalists; so if you were in corporate finance, you did literally every type of activity, from rating agency presentations, to private placements, to equity offerings, debt offerings, mergers — anything that somebody needed, you did it. That was a really important element of my career. Because you sort of knew something about everything. In that way, you could sense trends, changes and so forth.”

Although the path of least resistance after Lehman would have been to start another investment bank, Schwarzman didn’t go there. Instead, he went into investment management. “We tried to figure out, ‘What could we do that everybody else in the world wasn’t doing?’ That’s an important way to think; not just trying to do better at what everybody else is doing,” he said.

The strategic plan that arose was, first of all, to enter the corporate advisory business, which is what Schwarzman had been in, and where he knew a lot of people. Going into the advisory business meant that no capital was required. “It’s always good to not need capital because then you don’t have to dilute your ownership. So we did that.”

The second piece of the strategic plan was to go into what was then called ‘leveraged buyouts.’ “A lot of my friends were the young people who were starting the other firms at that time,” such as KKR & Co. and the now defunct Forstmann, Little & Co., Schwarzman said. Those people had trouble getting anybody to represent them because “they were very small companies that had leveraged structures; it all seemed risky. Because I knew them, I took them on as clients.”

“We must have sent out 500 letters that said, ‘we’re in business; let us represent you.’ But nobody hired us. This was a very depressing moment.”

A major deal that attracted Schwarzman’s attention was the $380 million buyout of Houdaille Industries by Kohlberg Kravis Roberts that laid out the whole structure of leveraged buyouts (LBOs), which were “then kind of a secretive type of thing,” he recalled. “You looked at it and it was an amazing way to make money — just amazing. I knew I wanted to do that. I tried to get Lehman to start that, and we actually got a deal but it was turned down by the management committee [at Lehman], which is one reason they ended up broke. They weren’t always great decision makers, in my view.”

A third foundation of the strategy took advantage of the fact that the financial sector was going through an “amazing consolidation after May Day 1975 [when the SEC deregulated the brokerage industry, ushering in lower trading fees]. Commissions had basically been fixed, for, I guess, 200 years, and this led to a lot of different popcorn stands that were highly inefficient cost structures. These companies started combining, and it became very clear that there was going to be a massive increase in the size of firms.” How dramatic was that consolidation? Schwarzman said when he joined Lehman, “We had about 550 people but 25 years later, we had 30,000.”

The consequences of that consolidation were significant. “When I was at Lehman, I knew everybody by sight, a lot of people by name. But when you have a firm that has 30,000 people, it is a veritable impossibility. I thought that, strategically, there were a lot of people who liked to be in smaller-sized organizations and what we should do is to recruit those people when we saw an amazing opportunity — a market shift, something unusual happening. And that people who were ‘10s’ [highest-rated] on a scale of 10 [in terms of their capabilities], would be available simply because they didn’t want to work for these ever-consolidating big firms” that had become impersonal.  “We could strengthen these businesses and have them generate intellectual capital, which we could use to make the business stronger.”

So Schwarzman laid out his plan, and waited for the phone to ring. Only, it did not ring. “We must have sent out 500 letters that said ‘We’re in business; let us represent you,’ but nobody hired us. This was a very depressing moment.” After waiting two weeks, they called prospects again, and “got lucky. Squibb, the pharma company, hired us for $50,000.” It was a modest but important step for Blackstone, which currently has more than $340 billion in assets under management. Looking back on his progress, Schwarzman said, “That sounds like a good trip, but the journey is always much rougher people imagine. But the strategic plan of the firm never changed. It is still a great plan, and we’re still executing on it.”

“This depersonalizes decision-making, because if … everyone is attacking you all the time, then no one is attacking you.”

Blackstone’s System for Success

As for Blackstone’s successful track record, Oaktree’s Marks noted wryly that the dearth of investment errors took away opportunities for his own firm to profit from them. “Our portfolios over the years have been a litany of private equity firms’ mistakes, but Blackstone is under-represented” among them. Oaktree’s main business is investing in distressed debt, which “primarily attempts to take advantage of the mistakes of others and of private equity firms. But Steve has not done his part to give us investment opportunities.”

Why has Blackstone made so few mistakes? Schwarzman traced the origins of his investment philosophy back to the fact that he “can’t stand” the idea of losing money. “It is just something that goes to the core of the person,” he said. “If you start out delivering newspapers, and shoveling snow and doing all the stuff you do in suburban Philadelphia to make money” as a young man, then “you don’t want to go backwards.”

Still, in the early days, “we didn’t have an investment process,” Schwarzman said. To his deep regret, one of his early customers lost $32 million, and he vowed that he was never going to let that happen again. “This is the risk of starting a business when you don’t know what you are doing, other than having great enthusiasm.” Embarrassed, Schwarzman and his colleagues set up an “amazing system,” which they still use today.

“They actually don’t understand how people behave. And so, it’s not distributed risk assessment”

A key to Blackstone’s investment success is a system that takes emotions out of proposing and vetting investment ideas. “If you are in any business where people are looking for approval of their proposal, if you don’t approve their proposal, they’ll think you don’t like them. You don’t value them.” So Blackstone set up a process to remove any emotional blowback by insisting that dissent should be backed by analysis. It consisted of “pretty rigid rules for anything that we are going to buy or invest in. There has to be written analysis of that, and it has to identify all the risk factors, with the objective of deciding how you could lose money — and it could never happen.”

Next, he related, “I realized that if one person was criticizing the deal, then the person who brought the deal and was leading the team wouldn’t like that person; and they would try to retaliate in some way, which stops everyone from being objective about the investment if it’s not such a good investment. So I insisted that everyone around the table speak, and they could only speak about analytic weaknesses in the deal and risks in the deal. So this is all geared to not losing money.”

The goal of the system is this: “This depersonalizes decision-making, because if everyone is following through” and addressing these issues in detail, “and everyone is attacking you all the time, then no one is attacking you.” By the time the analysis is complete, “the responsibility for that investment no longer resides with that team of people. It’s all the people at the table who own that.” If anything goes wrong, later on, the common feeling is, “We got it wrong. That way, people are very comfortable going forward. And the chance that we lose money is really de minimis.”

“We are in the no-secrets business. Everybody is expected to pay attention and learn.”

Where Other Firms Fail

Why don’t other organizations undertake a similar process? Schwarzman explained, “They fall down in a lot of ways. First, they put somebody in charge of risk; that’s a person. … They believe in delegating this to someone who is setting this up as a profit center. Worse, they actually don’t understand how people behave. And so, it’s not distributed risk assessment.”

What is Blackstone’s greatest challenge in managing internal corporate relationships? “The key is that nobody wants to work in a big, impersonal place. Who would want to do that? That’s not fun. That’s one of the reasons why people start new businesses,” Schwarzman said. The firm’s challenge is to keep growing while maintaining intimacy, flexibility and responsiveness. Although Blackstone has become a global corporation, “Technology has solved this for us. We have offices all over the world.”

Every Monday, “each of our business lines — private equity, real estate, credit, hedge funds — meets as a group” through video conferencing. “We first look at what is going on in the world — any changes in the companies that we own that we can see as a trend. We go over [our investments all over] the world. Everybody is in that room, and anybody can talk. And anybody can ask questions about what we are doing,” Schwarzman said.

“We are in the no-secrets business. Everybody is expected to pay attention and learn. For younger people, this is like having a master class. As the older people in the group start asking questions about things — say, about tactics or industries or what’s going on — this is actually a lot of fun. Everybody likes being included. Nobody likes to be subordinated. This way, people learn about cycles. They learn about where we are in the cycle — whether it’s the U.S. economy, whether it’s the global economy, by industry and, ultimately, by asset class.”

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