As the year draws to a close, we tend to reflect upon where we’ve been. For Stephen A. Schwarzman, chairman, CEO, and co-founder of the Blackstone Group, one of those early painful lessons was the importance of establishing and following a rigorous process for assessing all the risks before making an investment.
That emerges from his new book, one of the best business titles of the year, and the talks he gave about it. What also emerges is a deal that went sour three decades ago, as he was starting his firm.
“We go from the premise that our first job, sort of like a doctor, is do no harm – and in the financial business that means don’t lose money,” Schwarzman said at a Reuters Newsmaker event for “What It Takes: Lessons in the Pursuit of Excellence.” He was interviewed at the Thomson Reuters building in New York before invited guests by Reuters editor-at-large Sir Harold Evans. Schwarzman in his book cited “don’t lose money” as the number one rule at Blackstone, acknowledging that saying that out loud sometimes prompts smirks.
Since before the release of the book, Schwarzman has granted a number of high-profile interviews with prominent media outlets and venues besides Reuters. The Wall Street Journal was first out of the gate with a feature titled “Stephen Schwarzman’s Lifelong Audacity.” Next the Economic Club of Washington, D.C. sponsored a live interview of Schwarzman by David Rubinstein, whose eponymous show on Bloomberg features peer-to-peer interviews and who is also co-founder and co-executive chairman of the Carlyle Group, a private equity firm.
On the day the book was released Schwarzman was the featured guest on CNBC’s early morning talk show Squawk Box. Schwarzman has also been interviewed live at high-profile events sponsored by the New York Times and the Washington Post.
Blackstone’s chairman, in his conversation with Evans, tied his passionate aversion to losing money, especially capital, in part, to losses from the firm’s third investment: a $330 million leveraged buyout in 1989 of Edgcomb Metals, a Tulsa steel distributor. The price per share was $8, four times the $2 share price of a 1986 LBO of Edgcomb by Drexel Burnham Lambert. “Based on our analysis, [it] seemed like a good price,” Schwarzman wrote in his book.
Schwarzman recalled that he was faced with a difference of opinion within Blackstone about whether or not Blackstone should pursue the Edgcomb LBO deal.
Advocating for the deal was the man who proposed it, a young mergers and acquisition whiz and partner at Blackstone that Schwarzman had lured away from Drexel Burnham Lambert. While Schwarzman does not reveal his name him in his book, he is identified as Steven Winograd in the 2010 book King of Capital, a detailed and lively history of Schwarzman and Blackstone by David Carey and John E. Morris.
Winograd had been part of the Drexel team that arranged the 1986 Edgcomb LBO and then worked on the company’s initial public offering underwritten by Drexel later the same year.
The man opposing the deal was David Stockman, former director of the Office of Management and Budget in the Reagan Administration, who had been hired as a partner a year earlier.
Schwarzman, whose prior experience was in M&A, was new to investing and was facing the firm’s first internal disagreement about an investment. The firm did not have an organized process for reviewing investments and assessing their risk, Schwarzman recalled at the Reuters event. “This was frightening. I didn’t know what to do. So I just sort of pretended I was King Solomon.” In other words, he decided he should bring both men into his office and hear out both sides and then hopefully make a wise and correct decision that did not involve cutting the baby in half.
With Edgcomb’s valuation rising sharply in recent years, Winograd saw blue skies ahead for earnings and impressed Schwarzman with his inside knowledge of the company. Stockman warned that rising earnings at Edgcomb were just gains in the value of inventory and not underlying operating profits. “When the price of steel goes down, the earnings are going to disappear and the company will go bankrupt. If we leverage it the way we want to, we’re going to go bust. It’s a disaster in the making,” Stockman told Schwarzman.
Schwarzman reasoned that because of his prior M&A work at Drexel, Winograd better understood Edgcomb. He decided to go ahead and green light the deal. Stockman did not respond to email queries to comment on the terms of the deal and its subsequent performance.
Shortly after the deal closed, steel prices fell. Blackstone was almost immediately struggling to make principal and interest payments to the creditors who lent them money for the deal. Each deal had its own creditors tied to that deal and not to Blackstone generally. So, Schwarzman had to scramble to find cash to meet those payments because the deal was not generating the income to do so. Presumably that meant Blackstone not only lost the $23 million it contributed to equity in the deal but had to take money from its own resources or borrow money to pay the company’s creditors.
Just over a year after the LBO, Blackstone unloaded Edgcomb at a fire-sale price to a subsidiary of Usinor Sacilor S.A., a large state-owned French steel company that was expanding its operations in Europe and the United States. Under the terms of the deal, Blackstone had to retain a huge piece of the risk by buying all of Edgcomb’s $100 million in debt, according to a New York Times report July 18, 1990.
When the deal was complete, Blackstone investors lost a combined $32.5 million on their $38.9 million or 84% of their investment, according to “King of Capital.” To the extent Blackstone was unable to unload the Edgcomb debt in a timely manner, it would have faced future additional losses when Edgcomb went bankrupt two years later in 1992.
Schwarzman, while not publishing a tally of all the losses from the Edgcomb LBO, described it as a “catastrophically wrong decision” in “King of Capital.” A back-of-the-envelope calculation suggests Blackstone’s potential exposure to losses was approaching $150 million. By comparison, the firm had raised $810 million for its launch in 1987.
As one might expect, the investors in the Edgcomb deal were extremely unhappy about how it turned out, especially Presidential Life of Nyack, New York. Schwarzman says the company’s chief investment officer (who he does not identify by name) called him and said he wanted to see him in his office. Schwarzman obliged and made the trip to see him. “I sat in front of his desk in a wooden chair and he just started screaming,” Schwarzman recalled.
It was perhaps not so much the invective leveled at him as it was the yelling that Schwarzman found so painful and disturbing. “In my family nobody ever raised their voice. It was the way I was raised. And here somebody was screaming. The way I heard it – it was amplified,” he said at the Reuters event. “I started feeling my face get red and hot. I realized I was going to start crying. I was so ashamed that we were losing money because this was a person who trusted us.”
Schwarzman was determined not to let the situation deteriorate further. “I was sort of sitting there thinking I just can’t cry. You’ve got to suck this up,” he recalled. He composed himself and then told the CIO, “I understand and we will do better in the future.”
It seemed like an eternity until the meeting was over. “In the back of the taxi riding back to my office, I said this is never going to happen to me again – never!” he recalled.
Schwarzman then decided that no one person should ever be the sole person to make an investment decision at Blackstone and that there should be a robust and intensive risk assessment. “You start out by looking at every conceivable way that you can get into trouble by owning something. And we do it with a group of us, not one really smart person,” Schwarzman said at the Reuters event. People participating in the process would ask basic questions: “If something goes wrong how wrong can it go? And can that affect your preservation of capital?”
If there is more than one thing that can go wrong, you go another step, Schwarzman explained. “You take all those things that can go wrong, debate them, and then you figure out what the correlation is between those bad things.”
Schwarzman says that Blackstone’s risk assessment process has shown its mettle over time. There have been 700 control investments made across the firm over the years with no liquidations and only one bankruptcy filing, “only one-tenth of one percent” of all the firm’s deals, Schwarzman said on the company’s third quarter earnings call in October. He told investors he was “incredibly proud” of Blackstone’s record of positive contributions to communities, claiming that the private equity companies in which Blackstone invested have added over 100,000 jobs over the last 15 years.
The single bankruptcy Schwarzman noted is likely the one in a 1998 buyout deal when Blackstone and funeral industry giant Loewen Group bought Prime Succession and Rose Hill, both on the brink of insolvency. A year later Loewen itself went bankrupt leaving Blackstone with all the losses on the acquisitions. The Loewen deal was one of several Stockman deals at the time that performed poorly, according to “King of Capital.”
Why did Schwarzman write the book? Schwarzman says it was to share 25 of the lessons he has learned to help others succeed by avoiding similar pitfalls.
Given the considerable notice and positive coverage Schwarzman has achieved with the book, one can also view it as shaping how history will view him, says Montieth Illingworth, chief executive officer at Montieth & Company, a public relations and communications firm that advises private equity firms (but not Blackstone). “Look. If you’re in the last five years of your career, you should write a book to define your legacy and don’t wait for someone else to define it for you,” Illingworth says. Furthermore, “Schwarzman is in a category of about half a dozen people on Wall Street you want to hear from.”
Illingworth argues that Schwarzman understands that when you put together a deal you have to also ask if you are creating value for the economy and not just for the partners in the private equity firm. “I think Schwarzman gets that. I think a number of private equity firms do,” he says.