Stephen A. Schwarzman, CEO and co-founder of The Blackstone Group, one of the world’s premier private equity firms, remembers the exact moment when he realized that private equity, which had occupied a sleepy corner of the capital markets for more than a decade, was changing.
“I’m doing my sit-ups and watching CNBC. Suddenly somebody starts talking about me on television ….The business has gone into a weird zone of visibility. For those of us who have done it for a long time, it’s strange,” said Schwarzman in a keynote address at the recent Wharton Private Equity and Venture Capital Conference, whose theme was “Exploring New Frontiers.” Schwarzman and two other keynote speakers — David A. Brandon, chairman and CEO of Domino’s Pizza, and Timothy Draper, the Silicon Valley venture capitalist — examined the recent explosion in private equity deals and discussed its impact on business and investors.
Schwarzman, who started Blackstone with Peter G. Peterson in 1985, rode the wave of the buyout binge that crested with the RJR-Nabisco leveraged buyout. The industry then entered a relatively quiet period during the Internet-driven IPO mania of the 1990s. Now private equity is back in a big way, and Schwarzman’s firm is one of the hottest players. Indeed, earlier this month, Blackstone beat out Vornado Realty Trust by offering $23 billion in cash plus $16 billion in assumed debt for Equity Office Properties Trust. The deal makes Blackstone owner of the biggest collection of office buildings in the country.
The Dating Game
Private equity has jumped from the backs of financial journals to the front pages of mainstream newspapers, noted Schwarzman. “What’s going on in private equity today is remarkable.” He recalled that for much of his career, he was one of a few specialists in private equity flying around the country hoping to get investors to put up $10 million. “Now people just come into our office and say, ‘I’d like to give you $200 million.'”
The sharp rise in private equity transactions is due to two major drivers: Availability of capital and a desire by corporate managers to escape the public markets, according to Schwarzman.
Private equity’s new-found popularity, he said, is due largely to outstanding returns. “There hasn’t been a better asset class over the last 30 years. The world has slowly caught on and asset allocations have changed. Now we have substantial flows coming into our business.” The size of today’s private equity buyouts are stunning, compared with prior deals, he added. “A $5 billion bid would have been unbelievable. For us to do a $36 billion offer — one that was accepted — is an out-of-body experience.”
Schwarzman noted that historically, strategic buyers operating in the same industry as a target acquisition were able to justify paying more than a financially oriented private equity firm. The strategic buyer could bring operational strength and synergies to the deal that would generate better returns. Indeed, Vornado Realty Trust, with private backers, has pulled together a rival $38 billion bid for Equity Office.
Now, however, private equity firms are better able to compete with strategic buyers, said Schwarzman. A flood of liquidity in world financial markets and low interest rates improve the returns for heavily leveraged financial bidders, such as The Blackstone Group. Meanwhile, banks are more willing to finance deals in which they take a lower percentage of the risk, and syndicate the rest to private investors. In addition, credit terms have eased. “In the old days there were restrictive covenants from banks…. We can borrow immense amounts from senior lenders. … It’s a wonderful [development] for us.”
Moving down the capital structure, he noted that high-yield, or so-called “junk debt,” is also drawing investors seeking outsized returns in a market where there has not been a major default in recent memory. All that capital needs somewhere to go. “It’s like dating,” he said. “You might want to go out, but you have to find somebody who wants to go out with you.”
Another fortuitous element of timing, he noted, is that public companies are now increasingly open to private equity advances. Sarbanes-Oxley and other regulatory and accounting rules are making some CEOs eager to work for private equity owners. Executives are also tired of the pressure to make quarterly numbers for the benefit of Wall Street analysts. “This is a transformation from 10 years ago when people in the buyout world were regarded as marginal, and becoming the CEO of a publicly traded company was an apogee moment.”
Boards and executives are so concerned with Sarbanes-Oxley and compliance that they take very little risk in running their companies. Board members now come to meetings with their own lawyers, Schwarzman said, adding that accounting changes limiting write-offs for extraordinary events, such as plant closings or layoffs, prevent corporate executives from taking steps to enhance their business for fear that their earnings will take a major hit. “We have a bit of a broken system right now and the solution for these frustrated managers is to sell their businesses to private equity.”
If today’s climate for private equity is so hospitable, what could cause clouds to form?
Schwarzman said that while the capital markets side of the equation is a happy accident for the sector, capital markets never stand still. Eventually, the interest rate spread will grow wider, reducing private equity’s ability to generate huge returns on leveraged investments. “Nobody knows when or why it will happen. But it’s hard to imagine it can get better than it is [today]. We’re at maximum advantage in all probability right around now.”
In the meantime, he suggested, private equity firms should do a better job of selling their story as job-creation vehicles to governments and the public who associate leveraged buyouts with massive cost-cutting and layoffs. He noted that German politicians have called private equity firms “locusts.” In the first year or two after a private equity transaction, firms typically do experience layoffs, he acknowledged, adding, however, that five years later more people are working for the company than when it was acquired.
Inevitably, when the cycle turns, strategic buyers will regain their advantage over buyout firms and some companies may default on junk bonds. However, most investors have enough of a cushion to preserve their equity and earn a respectable return even in a downturn, he suggested.
Schwarzman also predicted that some of the provisions of Sarbanes-Oxley and other restrictive post-Enron reforms will be reworked, thereby encouraging companies to stick with the public markets. The New York Stock Exchange has lost 80% of the world market in equity offerings in four years, he noted. “That should be a bell-ringer for somebody in Washington.”
“Change Is Good”
Domino’s CEO David Brandon brought a different perspective to the conference, talking about his experience operating under private equity control and as the head of a publicly held company.
When the founder of Domino’s, Tom Monaghan, decided to retire in 1988, he sold the publicly traded Michigan fast-food company to a private equity team led by Bain Capital for $1 billion. Brandon, who had been chief executive of a Michigan marketing and sales promotion firm, was appointed chief executive a few months later. In 2004 the company went public, returning 400% to Bain’s investors.
Brandon recalled critics of the first deal complaining that Bain paid too much for Domino’s and saddled it with so much debt it would not be able to compete. He noted that some of the investment banks working on the company’s 2004 initial public offering were concerned about debt levels. Now private equity specialists sent to see him by some of those same firms are carrying deal books titled, Leverage is Good.
On his first day at Domino’s, Brandon told employees he had one message for them: “Change is good. If you like change, you’re going to like me. If you’re one who likes to talk about the good old days, then likely it ain’t going to work.” Brandon cut staff levels, closed facilities and reduced operating expenses. At the same time, he created an employee bonus program based on options before the company went public in order to build a sense of ownership. “Operations and results make all this possible,” he emphasized. “I’m an operator. I’m not a financial guy.” Strong operations, he said, open the door for financial mechanisms that can enhance the business all the more.
Brandon stressed the importance of working in partnership with private equity owners. “The ability to work with the sponsor company in a spirit of trust and fairness is what it’s all about.” Bain exhibited its faith in him when it allowed Brandon to make the call on when to go public, he said. “I believe management teams are the ones that have to pay back debt and take the company public. We are responsible. We can’t be reluctant partners.”
Brandon noted that he has now taken two companies public — one before Enron and one after. “This time around was dramatically different.” The process was harder and independent directors — he serves on three other boards — now have a “bunker mentality.” New committee structures, Sarbanes-Oxley and whopping fees paid to auditors all make for more “moving parts” in running a public company. “It’s changed how I allocate my time, but I don’t think that, in and of itself, is going to make every company run back and become private.”
Brandon recalled that after Domino’s went public, he was often asked whether it was difficult to meet Wall Street’s quarterly expectations. His response: “Have you ever looked at the expectations of those Bain guys? It wasn’t like I was with a bunch of wimps who didn’t care. They and their investors had thresholds. So whether I’m trying to … satisfy and impress Bain, or show results for public investors, to me it’s all kind of the same thing. It’s all about performance.”
Providing Solutions to the Toughest Problems
Timothy Draper, founder and managing director of the venture capital firm Draper Fisher Jurvetson, outlined some new ideas that private equity investors should be thinking about, and urged entrepreneurs to “change the world. That’s what it’s all about. If you see something wrong, or a little unusual, or something that makes you mad, go change it. Then change it for everybody else. You’ll become very wealthy and very successful.”
Draper pointed to some of the problems that entrepreneurs should take on: Energy, security, health care, traffic, pollution, war, poverty, education, roads, prisons and airport development. He said politicians, at best, help bring these problems to light; at worst, they create problems.
“Who solves problems?” he asked. “It’s business.”
He named some companies backed by his firm that are attempting to tackle entrenched problems with private-sector solutions — EnerNoc, which develops systems to conserve energy in commercial buildings; Lumena, a security company, and Konarka, which specializes in solar panels.
Business, he suggested, is better equipped to develop lasting solutions for society’s problems than government because it is perpetual, not limited by elections, terms of office, or political boundaries. With advances in telecommunications, national borders are fading away. As a result, governments are now forced to compete with one another to attract capital and develop promising businesses to generate jobs and economic growth.
Draper has worked with the governments of Singapore and the Ukraine, where officials are trying to ease the bureaucratic burden on corporations. “All countries are recognizing this needs to be done,” he said. “All except one.” He pointed to Sarbanes-Oxley and other post-Enron changes in the U.S. regulatory system as roadblocks to economic expansion.
Draper suggested that competitive governance could lead to an idealized world in which governments borrow the best from each other: Chile’s social security system, Russia’s system of science education, the United States’ religious freedoms and the Cayman Islands’ corporate structure.
The most successful entrepreneurs take on huge competitors, he noted, pointing to Hotmail, which took on the postal system; Skype, which confronted the telecom industry, and MySpace, which has changed the concept of community.
He listed some of the major advances of the past 100 years, including telephones, computers, cars, airplanes, penicillin, heart surgery, nanotechnology, search engines, and email. With advancing technology, the kind of change that required 120 years to take hold may now evolve in just 15 to 20 years. Future breakthroughs will emerge in fusion, space travel, wireless power distribution, desalinated water, 150-year life spans and cures for cancer and AIDS. “Keep in mind anything is possible,” Draper said. “When you shoot for something, shoot really high.”