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To Wall Street, the deal was little short of revolutionary. In October 1978 a little-known investment firm, Kohlberg Kravis Roberts, struck an agreement to buy Houdaille Industries, an industrial pumps maker, in a $380 million leveraged buyout. Three hundred eighty million bucks! And a public company, no less! There had been small leveraged buyouts of privately held businesses for years, but no one had ever attempted anything that daring.
Steve Schwarzman, a thirty-one-year-old investment banker at Lehman Brothers Kuhn Loeb at the time, burned with curiosity to know how the deal worked. The buyers, he saw, were putting up little capital of their own and didn’t have to pledge any of their own collateral. The only security for the loans came from the company itself. How could they do this? He had to get his hands on the bond prospectus, which would provide a detailed blueprint of the deal’s mechanics. Schwarzman, a mergers and acquisitions specialist with a self-assured swagger and a gift for bringing in new deals, had been made a partner at Lehman Brothers that very month. He sensed that something new was afoot—a way to make fantastic profits and a new outlet for his talents, a new calling.
“ I read that prospectus, looked at the capital structure, and realized the returns that could be achieved,” he recalled years later. “I said to myself, ‘This is a gold mine.’ It was like a Rosetta stone for how to do leveraged buyouts.”
Schwarzman wasn’t alone in his epiphany. “ When Houdaille came along, it got everybody’s attention,” remembers Richard Beattie, a lawyer at Simpson Thacher & Bartlett who had represented KKR on many of its early deals. “Up until that point, people walked around and said, ‘What’s an LBO?’ All of a sudden this small outfit, three guys—Kohlberg and Kravis and Roberts—is making an offer for a public company. What’s that all about?”
The financial techniques behind Houdaille, which also underlay the private equity boom of the first decade of the twenty-first century, were first hatched in the back rooms of Wall Street in the late 1950s and 1960s. The concept of the leveraged buyout wasn’t the product of highbrow financial science or hocus-pocus. Anyone who has bought and sold a home with a mortgage can grasp the basic principle. Imagine you buy a house for $100,000 in cash and later sell it for $120,000. You’ve made a 20 percent profit. But if instead you had made just a $20,000 down payment and taken out a mortgage to cover the rest, the $40,000 you walk away with when you sell, after paying off the mortgage, would be twice what you invested—a 100 percent profit, before your interest costs.
Leveraged buyouts work on the same principle. But while homeowners have to pay their mortgage out of their salaries or other income, in an LBO the business pays for itself after the buyout firm puts down the equity (the down payment). It is the company, not the buyout firm, that borrows the money for a leveraged buyout, and hence buyout investors look for companies that produce enough cash to cover the interest on the debt needed to buy them and which also are likely to increase in value. To those outside Wall Street circles, the nearest analogy is an income property where the rent covers the mortgage, property taxes, and upkeep.
What’s more, companies that have gone through an LBO enjoy a generous tax break. Like any business, they can deduct the interest on their debt as a business expense. For most companies, interest deductions are a small percentage of earnings, but for a company that has loaded up on debt, the deduction can match or exceed its income, so that the company pays little or no corporate income tax. It amounts to a huge subsidy from the taxpayer for a particular form of corporate finance.
By the time Jerome Kohlberg Jr. and his new firm bought Houdaille, there was already a handful of similar boutiques that had raised money from investors to pursue LBOs. The Houdaille buyout put the financial world on notice that LBO firms were setting their sights higher. The jaw-dropping payoff a few years later from another buyout advertised to a wider world just how lucrative a leveraged buyout could be.
Gibson Greeting Cards Inc., which published greeting cards and owned the rights to the Garfield the Cat cartoon character, was an unloved subsidiary of RCA Corporation, the parent of the NBC television network, when a buyout shop called Wesray bought it in January 1982. Wesray, which was cofounded by former Nixon and Ford treasury secretary William E. Simon, paid $80 million, but Wesray and the card company’s management put up just $1 million of that and borrowed the rest. With so little equity, they didn’t have much to lose if the company failed but stood to make many times their money if they sold out at a higher price.
Sixteen months later, after selling off Gibson Greeting’s real estate, Wesray and the management took the company public in a stock offering that valued it at $290 million. Without leverage (another term for debt), they would have made roughly three and a half times their money. But with the extraordinary ratio of debt in the original deal, Simon and his Wesray partner Raymond Chambers each made more than $65 million on their respective $330,000 investments—a two-hundred-fold profit. Their phenomenal gain instantly became legend. Weeks after, New York magazine and the New York Times were still dissecting Wesray’s coup.
Simon himself called his windfall a stroke of luck. Although Gibson Greeting’s operating profits shot up 50 percent between the buyout and the stock offering, Wesray couldn’t really claim credit. The improvement was just a function of timing. By early 1983 the economy was coming back after a long recession, giving the company a lift and pushing up the value of stocks. The payoff from Gibson was testament to the brute power of financial leverage to generate mind-boggling profits from small gains in value.
At Lehman, Steve Schwarzman looked on at the Gibson IPO in rapt amazement like everyone else. He couldn’t help but pay attention, because he had been RCA’s banker and adviser when it sold Gibson to Wesray in the first place and had told RCA the price was too cheap. The Houdaille and Gibson deals would mark the beginning of his lasting fascination with leveraged buyouts.
The Gibson deal also registered on the radar of Schwarzman’s boss, Lehman chairman and chief executive Peter G. Peterson. Virtually from the day he’d joined Lehman as vice-chairman in 1973, Peterson had hoped to coax the firm back into the merchant banking business—the traditional term for a bank investing its own money in buying and building businesses. In decades past, Lehman had been a power in merchant banking, having bought Trans World Airlines in 1934 and having bankrolled the start-ups of Great Western Financial, a California bank, Litton Industries, a technology and defense firm, and LIN Broadcasting, which owned a chain of TV stations, in the 1950s and 1960s. But by the time Peterson arrived, Lehman was in frail financial health and couldn’t risk its own money buying stakes in companies.
Much of what investment banks do, despite the term, involves no investing and requires little capital. While commercial and consumer banks take deposits and make loans and mortgages, investment bankers mainly sell services for a fee. They provide financial advice on mergers and acquisitions, or M&A, and help corporations raise money by selling stocks and bonds. They must have some capital to do the latter, because there is some risk they won’t be able to sell the securities they’ve contracted to buy from their clients, but the risk is usually small and for a short period, so they don’t tie up capital for long. Of the core components of investment banking, only trading—buying and selling stocks and bonds—requires large amounts of capital. Investment banks trade stocks and bonds not only for their customers, but also for their own account, taking big risks in the process. Rivers of securities flow daily through the trading desks of Wall Street banks. Most of these stakes are liquid, meaning that they can be sold quickly and the cash recycled, but if the market drops and the bank can’t sell its holdings quickly enough, it can book big losses. Hence banks need a cushion of capital to keep themselves solvent in down markets.
Merchant banking likewise is risky and requires large chunks of capital because the bank’s investment is usually tied up for years. The rewards can be enormous, but a bank must have capital to spare. When Peterson joined in 1973, Lehman had the most anemic balance sheet of any major investment bank, with less than $20 million of equity.
By the 1980s, though, Lehman had regained financial strength and Peterson and Schwarzman began to press the rest of management to consider merchant banking again. They even went so far as to line up a target, Stewart-Warner Corporation, a publicly traded maker of speedometers based in Chicago. They proposed that Lehman lead a leveraged buyout of the company, but Lehman’s executive committee, which Peterson chaired but didn’t control, shot down the plan. Some members worried that clients might view Lehman as a competitor if it started buying companies.
“It was a fairly ludicrous argument,” Peterson says.
“I couldn’t believe they turned this down,” says Schwarzman. “There was more money to be made in a deal like that than there was in a whole year of earnings for Lehman”—about $200 million at the time.
The two never gave up on the dream. Schwarzman would invite Dick Beattie, the lawyer for the Kohlberg Kravis buyout firm whose law firm was also Lehman’s primary outside counsel, to speak to Lehman bankers about the mechanics of buyouts. “Lurking in the background was the question, ‘Why can’t Lehman get into this?’ ” Beattie recalls.
All around them, banks like Goldman Sachs and Merrill Lynch were launching their own merchant banking divisions. For the time being, however, Peterson and Schwarzman would watch from the sidelines as the LBO wave set off by Houdaille and Gibson Greeting gathered force. They would have to be content plying their trade as M&A bankers, advising companies rather than leading their own investments.
Peterson’s path to Wall Street was unorthodox. He was no conventional banker. When he joined Lehman, he’d been a business leader and Nixon cabinet member who felt more at home debating economic policy, a consuming passion, than walking a trading floor. A consummate networker, Peterson had a clearly defined role when he came to the firm in 1973: to woo captains of industry as clients. The bank’s partners thought his many contacts from years in management and Washington would be invaluable to Lehman.
His rise up the corporate ladder had been swift. The son of Greek immigrants who ran a twenty-four-hour coffee shop in the railroad town of Kearney, Nebraska, Peterson graduated summa cum laude from Northwestern University and earned an MBA at night from the University of Chicago. He excelled in the corporate world as a young man, first in marketing. By his midtwenties, on the strength of his market research work, he was put in charge of the Chicago office of the McCann-Erickson advertising agency. His first big break came when he was befriended by Charles Percy, a neighbor and tennis partner who ran Bell & Howell, a home movie equipment company in Chicago. At Percy’s urging, Peterson joined Bell & Howell as its top marketing executive, and in 1961 at age thirty-four, he was elevated to president. In 1966, after Percy was elected to the U.S. Senate, Peterson took over as CEO.
Through an old Chicago contact, George Shultz (later treasury secretary and then secretary of state), Peterson landed a position in early 1971 as an adviser to President Richard Nixon on international economics. Though Peterson had allies in the White House, most notably Henry Kissinger, the powerful national security adviser and future secretary of state, he wasn’t temperamentally or intellectually suited to the brutal intramural fighting and stifling partisan atmosphere of the Nixon White House. He lacked the brawler’s gene. At one point Nixon’s chief of staff, H. R. Haldeman, offered Peterson an office in the West Wing of the White House, nearer the president. But the move would have displaced another official, Donald Rumsfeld (later George W. Bush’s defense secretary), who fought ferociously to preserve his favored spot. Peterson knew Rumsfeld from Chicago and didn’t want to pick a fight or bruise his friend’s ego, so he turned down Haldeman’s offer. Kissinger later told Peterson that it was the worst mistake he made in Washington.
Peterson soon found himself in the crosshairs of another headstrong figure: treasury secretary John Connally, the silver-maned, charismatic former Texas Democratic governor who was riding with President Kennedy when Kennedy was assassinated and took a bullet himself. Connally felt that Peterson’s role as an economics adviser intruded on Connally’s turf and conspired to squelch his influence.
A year after joining the White House staff, Peterson was named commerce secretary, which removed him from Connally’s bailiwick. In his new post, Peterson pulled off one splashy initiative, supervising talks that yielded a comprehensive trade pact with the Soviets. But he soon fell out of favor with Nixon and Haldeman, the president’s steely-eyed, brush-cut enforcer, in part because he loved to hobnob and swap opinions with pillars of the liberal and media establishments such as Washington Post publisher Katharine Graham, New York Times columnist James Reston, and Robert Kennedy’s widow, Ethel. The White House saw Peterson’s socializing as fraternizing with the enemy.
Nixon dumped Peterson after the 1972 presidential race, less than a year after naming him to the cabinet. Before leaving town, Peterson delivered a memorable parting gibe at a dinner party, joking that Haldeman had called him in to take a loyalty test. He flunked, he said, because “my calves are so fat that I couldn’t click my heels”—a tart quip that caused a stir after it turned up in the Washington Post .
Peterson soon moved to New York, seeking a more lucrative living. Wooed by several Wall Street banks, he settled on Lehman, drawn to its long history in merchant banking. But two months after being recruited as a rainmaker and vice chairman, his role abruptly altered when an internal audit led to the horrifying discovery that the firm’s traders were sitting quietly on a multimillion-dollar unrealized loss. Securities on its books were now worth far less than Lehman had paid and Lehman was teetering on the edge of collapse. A shaken board fired Fred Ehrman, Lehman’s chairman, and turned to Peterson—the ex-CEO and cabinet member—to take charge, hoping he could lend his management know-how and his prestige to salvage the bank.
The man responsible for the trades that nearly sank the firm was its trading department chief, Lewis Glucksman, a portly bond trader known for his combustible temper, who walked the floor with shirt flaps flying, spewing cigar smoke. There were some, particularly on the banking side of the firm, who wanted Glucksman’s head over the losses. But Warren Hellman, an investment banker who took over as Lehman’s president shortly before Peterson was tapped as chairman and chief executive, thought Lehman needed Glucksman. The trader was the one who understood why Lehman had bought the securities and what went wrong. “ I argued that the guy who created the mess in the first place was in the best position to fix it,” Hellman says. Peterson concurred, believing, he says, that “everyone is entitled to one big mistake.” Glucksman made good on his second chance and, under Peterson, Lehman rebounded. In 1975 BusinessWeek put Peterson’s granite-jawed visage on its cover and heralded his achievement with the headline “Back from the Brink Comes Lehman Bros.”
Despite his role in righting the firm, Peterson never fit easily into Lehman’s bare-knuckled culture, particularly not with its traders. His cluelessness about the jargon, if not the substance, of trading and finance amazed his new partners. “ He kept calling basis points ‘basing points,’ ” says a former high-ranking Lehman banker. (A basis point is Wall Street parlance for one one-hundredth of a percentage point, a fractional difference that can translate into big gains and losses on large trades or loans. Thus, 100 basis points equals 1 percent of interest).
Peterson was appealing in many ways. He was honest and principled, and he could be an engaging conversationalist with a dry, often mordant, wit. He wasn’t obsessed with money, at least not by Wall Street’s fanatical norm. But with colleagues he was often aloof, imperious, and even pompous. In the office, he’d expect secretaries, aides, and even fellow partners to pick up after him. Rushing to the elevator on his way to a meeting, he would scribble notes to himself on a pad and toss them over his shoulder, expecting others to stoop down and gather them up for his later perusal.
At times, he seemed to inhabit his own world. He would arrive at meetings with yellow Post-it notes adorning his suit jacket, placed there by his secretary to remind him to attend some charity ball or to call a CEO the next morning. The off-in-the clouds quality carried over into his years at Blackstone, too. Howard Lipson, a longtime Blackstone partner, remembers seeing Peterson one blustery night sporting a bulky winter hat. Affixed to its crown was a note: “Pete—don’t forget your hat.” Lipson recalls, too, the terror and helplessness Peterson would express when his secretary stepped away and he was faced with having to answer his own phone. “Patty! Patty!” he’d yowl.
Peterson enjoyed the attention and ribbing that his absentmindedness provoked from others. In his conference room, he later showcased a plaque from the Council on Foreign Relations given in appreciation for, among other things, “his unending search for his briefcase.”
“This was endearing stuff,” says Lipson. “Some people said he was losing it, but Pete wasn’t that old. I think it was a sign he had many things going on in his mind.” David Batten, a Blackstone partner in the early 1990s who admires Peterson, has the same take: “ Pete was probably thinking great thoughts,” he says, alluding to the fact that Peterson often was preoccupied with big-picture policy issues. During his Lehman years, he was a trustee of the Brookings Institution, a well-known think tank, and occasionally served on ad hoc government advisory committees. Later, at Blackstone, he authored several essays and books on U.S. fiscal policy.
If he sometimes seemed oblivious to underlings, he was assiduous in cultivating celebrities in the media, the arts, and government—Barbara Walters, David Rockefeller, Henry Kissinger, Mike Nichols, and Diane Sawyer, among others—and was relentless in his name-dropping.
Far outweighing his shortcomings was his feat of managing Lehman through a decade of prosperity. This was no small achievement at an institution racked by vicious rivalries. Since the death in 1969 of its longtime dominant leader, Bobbie Lehman, who’d kept a lid on internal clashes, Lehman had devolved into a snake pit. Partners plotted to one-up each other and to capture more bonus money. One Lehman partner was rumored to have coaxed another into selling him his stock in a mining company when the first partner knew, which the seller did not, that the company was about to strike a rich new lode. In a case of double-dealing that enraged Peterson when it came to light, a high-ranking partner, James Glanville, urged one of his clients to make a hostile bid for a company that other Lehman partners were advising on how to defend against hostile bids.
The warfare was over the top even by Wall Street’s dog-eat-dog standards. Robert Rubin, a Goldman Sachs partner who went on to be treasury secretary in the Clinton administration, told Lehman president Hellman that their two firms had equally talented partners. The difference, Rubin said, was that the partners at Goldman understood that their real competition came from beyond the walls of the firm. Lehman’s partners seemed to believe that their chief competition came from inside.
The Lehman infighting amazed outsiders. “ I don’t understand why all of you at Lehman Brothers hate each other,” Bruce Wasserstein, one of the top investment bankers of the time, once said to Schwarzman and another Lehman partner. “I get along with both of you.”
“If you were at Lehman Brothers, we’d hate you, too,” Schwarzman replied.
The bitterest schism was between Glucksman’s traders and the investment bankers. The traders viewed the bankers as pinstriped and manicured blue bloods; the bankers saw the traders as hard-edged and low bred. Peterson tried to bridge the divide. A key bone of contention was pay. Before Peterson arrived, employees were kept in the dark on how bonuses and promotions were decided. The partners at the top decreed who got what and awarded themselves the lion’s share of the annual bonus pool regardless of their contributions. Peterson established a new compensation system, inspired in part by Bell & Howell’s, that tied bonuses to performance. He limited his own bonuses and instituted peer reviews. Yet even this meritocratic approach failed to quell the storm of complaints over pay that invariably erupted every year at bonus season. Exacerbating matters was the fact that each of the trading and advisory businesses had its ups and downs, and whichever group was having the stronger year inevitably felt it deserved the greater share of Lehman’s profits. The partners’ brattishness and greed ate at Peterson, whose efforts to unify and tame Lehman flopped.
Peterson had allies within Lehman, mostly bankers, but few of the firm’s three dozen partners were his steadfast friends. He was closest to Hellman and George Ball, a former undersecretary of state in the Kennedy and Johnson administrations. Of the younger partners, he took a liking to Roger Altman, a skilled “relationship” banker in Peterson’s mold, whom Peterson named one of three coheads of investment banking at Lehman. Peterson was also drawn to Schwarzman, who in the early 1980s chaired Lehman’s M&A committee within investment banking. Schwarzman wasn’t the bank’s only M&A luminary. In any given year, a half-dozen other Lehman bankers might generate more fees, but he mixed easily with CEOs, and his incisive instincts and his virtuosity as a deal maker set him apart.
Those qualities were prized by Peterson, and over the years, the two developed a kind of tag-team approach to courting clients. Peterson would angle for a chief executive’s attention, then Schwarzman would reel him in with his tactical inventiveness and command of detail, figuring out how to sell stocks or bonds to finance an acquisition or identifying which companies might want to buy a subsidiary the CEO wanted to sell and how to sell it for the highest price.
“ I guess I was thought of as a kind of wise man who would sit down with the CEO in a context of mutual respect,” says Peterson. “I think most would agree that I produced a good deal of new advisory business. But it’s one thing to produce it, and it’s another to implement it, to carry most of the load. I experimented with various people in that role, and Steve was simply one of the very best. It was a very complementary and productive relationship.”
Schwarzman was more than just a deal broker. In some cases, he was integrally involved in restructuring a business, as he was with International Harvester, a farm equipment and truck maker, in the 1970s. Harvester’s CEO, Archie McArdle, originally phoned Peterson, with whom he had served on the board of General Foods, and told Peterson he wanted Lehman to replace Morgan Stanley as his company’s investment bank. Harvester was at death’s door at the time, bleeding cash and unable to borrow. Peterson dispatched Schwarzman to help McArdle perform triage, and over the following months Schwarzman and a brigade of his colleagues strategized and found buyers for a passel of Harvester assets, raising the cash the company desperately needed.
Similarly, Peterson landed Bendix Corporation as a client shortly before a new CEO, William Agee, came on board there in 1976. Agee wanted to remake the engineering and manufacturing company by buying high-growth, high-tech businesses and selling many slower-growing businesses. Peterson handed the assignment off to Schwarzman, who became Agee’s trusted consigliere, advising him what to buy and to sell, and then executing the deals. “Bill was a prolific deal-oriented person. I would talk to him every day, including weekends,” Schwarzman says.
Peterson and Schwarzman made an odd couple. Apart from the twenty-one-year gap in their ages, the six-foot Peterson towered over the five-foot-six Schwarzman, and Peterson’s dark Mediterranean coloring contrasted with Schwarzman’s fair complexion and baby blue eyes. While Peterson could be remote and preoccupied, Schwarzman was jaunty, down-to-earth, always engaged and taking the measure of those around him. Whereas Peterson instinctively shied away from confrontation, Schwarzman could get in people’s faces when he needed to. Their lives had followed different paths, too, until they intersected at Lehman. Schwarzman’s family had owned a large dry goods store in Philadelphia and he had grown up comfortably middle-class in the suburbs—“two cars and one house,” as he puts it—whereas Peterson was the small-town boy of very modest means from the American heartland.
While Peterson adored the role of distinguished elder statesman, Schwarzman had a brasher way and a flair for self-promotion. That shone through in a fawning profile in the New York Times Magazine in January 1980 shortly after Schwarzman had added several M&A feathers to his cap, advising RCA on its $1.4 billion acquisition of CIT Financial Corporation and Tropicana Products’ $488 million sale to Beatrice Foods. The Times proclaimed him “probably” the hottest of a “new generation of younger investment bankers,” extolling his aggressiveness, imaginativeness, thoroughness, and “infectious vitality that make other people like to work with him.” Peterson and Martin Lipton, a powerful M&A lawyer, sang his praises.
“Normally chief executives are reticent working with someone that age, but he is being sought out by major clients,” Peterson told the Times . Schwarzman, Lipton said, possessed a rare “instinct that puts him in the right place at the right time.” (Schwarzman offered little insight into his own drive, other than saying, “I’m an implementer” and “I have a tremendous need to succeed.”) At a company outing that spring, colleagues presented him a copy of the story set against a framed mirror—so he could see his own image reflected back when he gazed at it. Not everyone at the firm responded to Schwarzman’s vanity with amusement, though. As one Lehman alumnus puts it, “He was appreciated by some, not loved by all.”
The Times feature may have been hyperbolic, but it was on the mark about Schwarzman’s abilities. “ He had a pretty good ego, but Steve was inherently a great deal guy,” says Hellman, Lehman’s president in the mid-1970s. “Steve had a God-given ability to look at a transaction and make something out of it that others of us would miss,” says Hellman, who is not close to Schwarzman. Hellman goes so far as to compare Schwarzman to Felix Rohatyn of Lazard Frères, the most accomplished merger banker of the 1960s and 1970s who gained wide praise, too, for orchestrating a restructuring of New York City’s debt in 1975 that spared the city from bankruptcy.
Ralph Schlosstein, another Lehman banker from that era, recalls Schwarzman’s bold and crafty approach when he advised the railroad CSX Corporation on the sale of two daily newspapers in Florida in November 1982. After initial bids came in, Morris Communications, a small Augusta, Georgia, media outfit, had blown away the other bidders with a $200 million offer versus $135 million from Cox Communications and $100 million from Gannett Company. Another banker might have given Cox and Gannett a shot at topping Morris, but with the disparity in the offers it was unlikely Morris would budge.
Not that CSX would have been displeased. The newspapers generated only about $6 million in operating income, so $200 million was an extraordinarily good price. “CSX was saying, ‘Sign them up!’ ” says Schlosstein, who worked on the sale with Schwarzman. Schwarzman instead advised CSX to hold off. Zeroing in on the fact that Morris had a major bank backing its bid, he reckoned Morris could be induced to pay more. Rather than reveal the bids, he kept the amounts under wraps and proceeded to arrange a second round of sealed bids. He hoped to convince Morris that Cox and Gannett were hot on its heels. The stratagem worked, as Morris hiked its offer by $15 million.
“That was $15 million Steve got for CSX that nobody else, including CSX, had the guts to do,” says Schlosstein. Today sealed-bid auctions for companies are the norm, but then they were exceedingly rare. “ We made it up as we went along,” says Schwarzman, who credits himself with pioneering the idea.
As the economy emerged from a grueling recession in the early 1980s, Lehman’s banking business took off and its traders racked up bigger and bigger profits playing the markets. But instead of fostering peace at the firm, Lehman’s prosperity brought the long-simmering friction between its bankers and traders to a boil as the traders felt they were shortchanged by the bank’s compensation system.
At first Peterson didn’t recognize how deep the traders’ indignation ran. He sensed that Glucksman, who had been elevated to president in 1981, was restless in that role and thought Glucksman deserved a promotion, and in May 1983 he anointed him co-CEO. But that didn’t placate Glucksman, who had long resented operating in Peterson’s shadow and wanted the title all to himself. Six weeks later Glucksman organized a putsch with the backing of key partners. “ He had a corner on the trading area” and his traders had earned a bundle the previous quarter, Peterson says. “I guess he felt it was the right time to strike.” Figuring the internal warfare might ease if he stepped aside, Peterson acquiesced, agreeing to step down as co-CEO in October and to quit as chairman at the end of 1983.
It was a humiliating ending, but Peterson never was one to push back when shoved. Schwarzman and other Lehman partners told him that if it came to a vote, he would win. But Peterson felt “that such a victory would be both hollow and Pyrrhic,” Peterson later wrote. “Lew would take some of his best traders, leaving the firm seriously damaged.”
Some of Peterson’s friends believe his cerebral flights and preoccupations may have contributed to his downfall, by desensitizing him to the firm’s Machiavellian internal politics. For whatever reasons, former colleagues say he was largely oblivious to—and perhaps in denial about—the coup Glucksman was hatching against him until the moment the trader confronted him in July that year and insisted that Peterson bow out. Peterson owns up to being “naïve” and “too trusting.”
That summer, after his ouster, Peterson withdrew for a time to his summer house in East Hampton, Long Island. Schwarzman and most of his fellow bankers labored on amid the rancor. But in the spring of 1984, Glucksman’s traders suffered another enormous bout of losses and Lehman’s partners found themselves on the verge of financial ruin, just as they had a decade earlier. Glucksman lost his grip on power and the partners were bitterly divided over whether to sell the firm or tough it out. If they didn’t sell, there was a very real risk the firm would fail and their stakes in the bank—then worth millions each—would be worthless.
It was Schwarzman who ultimately forced the hand of Lehman’s board of directors. The board had been trying to keep the bank’s problems quiet so as not to panic customers and employees while it sounded out potential buyers. In a remarkable piece of freelancing, Schwarzman—who was not on the board and was not authorized to act for the board—took matters into his own hands. On a Saturday morning in March 1984 in East Hampton, he showed up unannounced on the doorstep of his friend and neighbor Peter A. Cohen, the CEO of Shearson, the big brokerage house then owned by American Express. “I want you to buy Lehman Brothers,” Schwarzman cheerily greeted Cohen. Within days, Cohen formally approached Lehman, and on May 11, 1984, Lehman agreed to be taken over for $360 million. The merger gave Shearson, a retail brokerage with a meager investment banking business, a major foothold in more lucrative, prestigious work, and it staved off financial disaster for Lehman’s partners. (Years later Lehman was spun off and became an independent public company again.)
It meant salvation for the worried Lehman bankers and traders, but the deal came with strings attached. Shearson insisted that most Lehman partners sign noncompete agreements barring them from working for other Wall Street firms for three years if they left. Handcuffs, in effect. What Shearson was buying was Lehman’s talent, after all, and if it didn’t lock in the partners, it could be left with a hollow shell.
Schwarzman had no interest in soldiering on at Shearson, however. He yearned to join Peterson, who was laying plans to start an investment business with Eli Jacobs, a venture capitalist Peterson had recently come to know, and they wanted Schwarzman to join them as the third partner. As Schwarzman saw it, he’d plucked and dressed Lehman and served it to Cohen on a platter, and he felt that Cohen owed him a favor. Accordingly, he asked Cohen during the merger talks if he would exempt him from the noncompete requirement. Cohen agreed.
“ The other [Lehman] partners were infuriated” when they got wind of Schwarzman’s demand, says a former top partner. “Why did Steve Schwarzman deserve a special arrangement?” Facing a revolt that could quash the merger, Cohen backpedaled and eventually prevailed upon Schwarzman to sign the noncompete. ( Asked why Schwarzman thought Shearson would cut him a uniquely advantageous deal, one person who knows him replies, “Because he’s Steve?”)
Schwarzman desperately resented Shearson’s manacles and felt he’d been wronged. In the months after Shearson absorbed Lehman, he groused endlessly and sulked, according to former colleagues. For his part, Peterson still wanted Schwarzman to join him, and by now he needed him even more because he and Jacobs had fallen out. Peterson now says Jacobs never was his first choice as a partner. “ Steve and I were highly complementary,” he says. “I’d wanted Steve all along, but I couldn’t get him.” Peterson had to get him sprung from Shearson.
Eventually, Peterson and his lawyer, Dick Beattie—the same lawyer who had represented Lehman and Kohlberg Kravis—met with Cohen’s emissaries at the Links Club, a refuge of the city’s power elite on Manhattan’s Upper East Side, to try to spring their man. It was going to cost Schwarzman and Peterson dearly, because Cohen did not want to lose more Lehman bankers. “ It was a brutal process,” says Peterson. “They were afraid of setting a precedent.”
Shearson had drawn up a long list of Lehman’s corporate clients, including those Peterson and Schwarzman had advised and some they hadn’t, and demanded that Schwarzman and Peterson agree to cede half of any fees they earned from those clients at their new firm for the next three years. They could have their own firm, but they would start off indentured to Shearson. It was a painful agreement, because M&A advisory fees would be the new firm’s only source of revenue until it got its other businesses up and running. But Schwarzman didn’t have any good legal argument against Shearson, so he and Peterson buckled to the demand.
In Schwarzman’s mind, Cohen had betrayed him, and friends and associates say he still bears a deep grudge toward Cohen, both for making him sign the noncompete in the beginning when Cohen had agreed to make an exception, and later for demanding such a steep price to let Schwarzman out. “ Steve doesn’t forget,” says one longtime friend. “If he thinks he’s been crossed unfairly, he’ll look to get even.”
Peterson isn’t much more forgiving about the episode. “The idea of giving those characters half the fees when they broke their word seemed egregious. But we couldn’t get Steve out on any other basis.”
They had survived the debacle of Lehman and now would have to labor under Shearson’s onerous conditions, but at last the two were free to set out on their own as M&A advisers and to pursue the mission they had to put on hold for so many years: doing LBOs.