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The Transtar triumph produced a warm afterglow. But it didn’t last long. Two misguided investments quickly ran off the tracks in 1989 and forced the young firm to rethink the way it vetted its investment options. The failures also established a harsh new unwritten rule: Slip up badly enough, just once, and you’re out. Everyone was on notice. Not even partners were exempt.
The first misfire was Wickes Companies, an unwieldy amalgam of three dozen disparate businesses that Blackstone took private for $2.6 billion in December 1988 in partnership with Wasserstein Perella, Blackstone’s rival as an M&A boutique and buyout shop. Conglomerates like Wickes, once stock market darlings, had fallen out of favor and were being ripped apart. David Stockman, Blackstone’s point man and strategist on Wickes, thought that Wickes would be worth more dismembered than intact.
Stockman was a relentless advocate for his own deals, bombarding his colleagues with minutiae—the actuarial details of pension plans, consumer vehicle preferences, or whatever other imaginative product of his research would be the key to making an investment successful. He became legendary inside and outside the firm for calculating and writing out voluminous spreadsheets by hand, often faxing the sheets of numbers to underlings at Blackstone who would type them into computer spreadsheets, as most other deal makers did from the outset. A banker who worked on one of Stockman’s deals remembers being dumbfounded as page after endless page of figures spat out of the fax machine during negotiations.
Stockman had cracked the Wickes nut, or so he thought. He plotted to break up the company, whittling it down to a single business: Collins & Aikman, a maker of textiles, carpeting, and wallpaper. Blackstone and Wasserstein Perella each sank $122 million into the buyout, which closed the same month as Transtar—the largest investment by Blackstone for the next seven years.
Things went awry almost from the start, in early 1989, when the U.S. economy started to soften. An early sign of trouble came that spring, when Wickes put Builders Emporium, then the largest home-improvement retail chain in California, up for sale. Blackstone expected it to fetch as much as $250 million, one former employee says. “But we ended up having to sell it over time for like $50 million.” Slowing auto sales also dug into the auto fabrics side of the business.
The buyers also soon discovered that Wickes’s former CEO Sandy Sigoloff—a corporate turnaround artist and notorious cost slasher nicknamed Ming the Merciless—had hacked away rather too exuberantly at Wickes’s managerial ranks. “ What we found was that Sigoloff was used to getting rid of whole layers of management for companies that were in trouble. But this company wasn’t in trouble,” says Schwarzman. “He fired a lot of people anyhow, so there was nobody around to do the work.” Nearly from the start, then, the company was a problem.
Far uglier and more damaging than Collins & Aikman, though, was Blackstone’s third investment, an ill-conceived $330 million LBO of Edgcomb Metals Company, a Tulsa steel distributor. In the space of just a few months, Edgcomb threatened to demolish Blackstone’s investors’ faith in the firm.
The Edgcomb acquisition was the brainchild of Steven Winograd, a thirty-one-year-old M&A prodigy Blackstone lured away from Drexel. At Drexel, Winograd had played a role in a $150 million, management-led LBO of Edgcomb in 1986 and later that year helped take the steel fabricator public, making a rich man of Edgcomb’s CEO, Michael Scharf, and huge profits for Texas’s Bass family and other backers of the buyout.
From the moment Winograd settled in at 345 Park Avenue, he pressed the idea of a second buyout of Edgcomb, whose stock had languished after it went public. Schwarzman quickly said yes. In May Blackstone negotiated a $330 million deal to take Edgcomb private for $8 a share, $2 above the IPO price of 1986. Like Transtar, the Edgcomb buyout was leveraged to the rafters, with Blackstone contributing just $23 million for a 65 percent equity stake. The buyout closed in June.
David Stockman opposed the deal. Since his arrival at Blackstone a year earlier, Stockman had carved out a role for himself as a devil’s advocate and doomsayer, and he argued fervently against the Edgcomb buyout. Stockman’s input didn’t win him many fans at headquarters. “ He had a habit of criticizing other people’s deals, particularly in the early years,” says one former Blackstone partner. “ Right or wrong, David was never in doubt,” says David Batten, another ex-partner. Stockman’s Cassandra act soon wore thin not only because it put him at loggerheads with his partners, but because he often was just wrong.
But not this time. Edgcomb made its money buying raw steel, milling and shaping it, and selling it at a markup to auto factories, aircraft makers, and other users. Its profit margins, Stockman pointed out, were directly linked to steel prices, and if business turned down sharply, Edgcomb would find itself selling its steel inventory at a loss and its cash flow would vanish.
“I had them both in my office,” Schwarzman says of Stockman and Winograd. “Winograd argued that the company’s profits were of a repeat nature, and that it had very interesting expansion prospects. Stockman said it was a dangerous deal to do and it wasn’t worth the price. I could see both sides, and I voted with Winograd. It turned out to be a catastrophically wrong decision.”
Indeed, almost as soon as Blackstone completed the deal in June 1989, the same economic softening that had undermined the firm’s breakup plans for Wickes doomed Edgcomb, just as Stockman had predicted. The company was saddled with inventory that was worth less than it paid. The business situation turned very bad so quickly that Edgcomb had trouble making its first interest payment that summer, a humiliating state of affairs for Blackstone. Right out of the gate, the buyout was racing toward insolvency.
Schwarzman soon threw his energies into trying to rescue the deal. He cajoled Blackstone’s fund investors to stump up another $16 million of equity to try to keep the business afloat and worked tirelessly to ensure that the creditors didn’t lose a dime. If Edgcomb defaulted on its debt, it might irreparably taint the new buyout firm’s reputation in the credit markets. He was beside himself at that possibility and made his anxiety clear around the office.
In July 1990, Schwarzman arranged to sell the nearly bankrupt company to a subsidiary of France’s Usinor Sacilor SA, then the world’s largest steel company, at a steep discount to the original price. Edgcomb’s senior lenders were repaid, but there wasn’t enough money left to repay Blackstone. Its fund investors wound up losing $32.5 million of the $38.9 million they’d put into the deal.
That Schwarzman ultimately salvaged even one-sixth of the limited partners’ money was little short of miraculous in the circumstances, an ex-partner recalls. “ That’s where I saw Steve’s brilliance,” this person says. “That’s where I saw how good he was. He saw the problem and he worked doggedly to resuscitate the company.”
Many Blackstone fund investors viewed the entire affair less charitably. In a phone conversation, Shirley Jordan, the chief investment officer of Presidential Life Insurance, called Schwarzman “a complete idiot” and fumed, “I never should have given you a dime!” Schwarzman says he responded, “I may not be a complete idiot, but I certainly was on this transaction.” Other limited partners rendered similar judgments in less-barbed language.
Schwarzman may have taken responsibility in talking to outsiders, but internally he blamed Winograd and turned on him. He castigated him savagely for his deficient judgment and other supposed failings and fired him with a bazooka blast of invective. The brutal dismissal fueled anxiety among the rank and file and contributed to the firm’s reputation for being a difficult and even volatile place to work. Anything from misspelling a word in a legal document or failing to rustle up enough business could evoke Schwarzman’s ire. But Winograd’s experience sent the chilling message that losing money could be a capital offense.
In the early years, “there was an atmosphere where every deal on the principal, or LBO, side was do-or-die,” says former partner Howard Lipson, who logged eighteen years at Blackstone. “Like life or death.”
At the same time Schwarzman was wrestling with problems at Collins & Aikman and at Edgcomb, the firm faced a third major setback in 1989: an ill-timed detour into stock trading that took a generous bite out of the partnership’s own capital.
The new business was launched on a victorious note in December 1988, when Blackstone procured another $100 million from Nikko, the Japanese bank that had made a crucial early commitment to Blackstone’s first fund. This time the money would go not to the buyout fund, but to Blackstone itself. As with Wasserstein Perella’s headline-grabbing pact with Nomura six months earlier, Nikko was putting up $100 million for a 20 percent cut. But Schwarzman extracted sweeter terms from his Japanese backer than Bruce Wasserstein, his friendly rival and tennis partner, had.
“ After Bruce did that deal,” Schwarzman says, “I went back to Nikko and said I wanted another $100 million, like he got, but I wanted it in the form of a joint venture with our advisory business.” He knew how avidly Nikko and other Japanese brokers wanted a piece of the M&A banking business, and he and Nikko both knew that allying with a well-connected American firm was the quickest way to obtain it. Nikko resisted at first but eventually acceded to his terms: Instead of taking a straight 20 percent ownership interest in the Blackstone partnership and all its operations, as Nomura had in Wasserstein Perella, the Japanese accepted a 20 percent share of the net earnings of Blackstone’s M&A advisory business over the next seven years. In addition, Nikko would receive 20 percent of any returns Blackstone earned investing the $100 million. In 1995, if either party chose not to extend the investment, Blackstone would repay the $100 million along with any returns Nikko was still due.
For Nikko the deal had loads of promise. Mergers had rebounded smartly from the brief lull after the 1987 stock market fall, and in 1988 M&A was Blackstone’s main fee engine, yielding close to $29 million in income. Japanese corporations and banks were snapping up American businesses and real estate, and Blackstone advised on two of the biggest such deals that year: Sony’s purchase of CBS Records and Bridgestone Corporation’s purchase of Firestone Tire and Rubber Company. Nikko had visions of trading on Peterson’s ties to Japanese managers to capture a bigger share of the cross-border merger market.
Conceivably Blackstone could have used Nikko’s money to fund expansion and hire top-tier talent, or tucked it away as a rainy-day reserve. But Schwarzman wasn’t eager to embark on a hiring spree and was thinking more short term. Soon after Nikko wired Blackstone the money in early 1989, he hit on a moneymaking formula that would throw off hefty dividends to Blackstone and his partners as well as to Nikko. (By this time, the burdensome M&A fee-sharing arrangement with Shearson had expired and only Nikko and the buyout fund’s investors shared in Blackstone’s M&A fees. What’s more, Nikko’s cut was of M&A earnings after expenses, including the payments to fund investors.)
Schwarzman decided to sink half of Nikko’s money into risk arbitrage, or trading in stocks of takeover targets. Arbitrageurs—arbs for short—bet on the likelihood and timing of takeovers and mergers that have been announced but not yet completed. Typically, a target’s stock will sell for less than the offer price to reflect the risk that the deal may not go through and the fact that, even if the deal is completed, the shareholder can’t collect until sometime in the future. If something goes wrong with a deal, the target’s stock can plummet, but in spite of the risk, many big brokerages wagered tens of millions of dollars on takeover stocks and earned a pile of profits in the eighties with the explosion of takeover activity.
That March Schwarzman lured a seasoned arb, Brian McVeigh, along with his team from Drexel. McVeigh’s résumé was blemished. Smith Barney and Harris Upham and Company had dumped him and his crew after they suffered massive losses in the October 1987 stock market crash. Overall, though, his record sparkled. From February 1983 to September 1987 at Smith Barney and then from May 1988 to March 1989 at Drexel, McVeigh’s arbitrage funds had returned on average 39 percent a year. Blackstone formed a joint venture with McVeigh along the lines of the one it had formed with Larry Fink for the fixed-income investment affiliate. McVeigh and his group were allotted a 50 percent interest in Blackstone Capital Arbitrage and were handed custody of about $50 million of Nikko’s money and were told to go at it.
Blackstone couldn’t have picked a worse moment to ramp up in arbitrage. The economy was just beginning to slow, putting the brakes on takeovers, and by October 1989 LBOs and most takeover activity had screeched to a halt. The death knell for the M&A boom was the unexpected collapse of a $6.8 billion, employee-led buyout of UAL Inc., the parent of United Airlines, that October. McVeigh’s group, which had amassed a large position in UAL’s stock, lost a bundle when the airline’s shares plunged from a high of $294 to less than $130. Many other of his holdings nose-dived, as well. The arb unit took an 8 percent loss.
Schwarzman’s reaction was quick and severe. Ten months after McVeigh had arrived at Blackstone, he and his team were axed, Blackstone Capital Arbitrage was shuttered, and the $46 million that remained of the original $50 million was stowed away in the very safest kind of securities: certificates of deposit.
Blackstone wasn’t the only firm with heavy arbitrage losses in October. Nor was it alone in firing traders or bolting the arbitrage business. Some of Wall Street’s best-known arbs lost their jobs in the winter of 1989 when the takeover market evaporated. But it’s safe to say that few received a tongue-lashing on their way out the door like the one Schwarzman gave McVeigh. As Schwarzman saw it, McVeigh, like Winograd, had made an avoidable blunder that cost the partnership dearly. Few sins were worse in Schwarzman’s world.
Winograd and McVeigh were just the first of many partners and lesser employees hired and jettisoned from 1989 to 1991. Hotshot investment bankers the firm had lured away from First Boston, Shearson, and Morgan Stanley came and went in less than a year, let go for failing to rustle up deals and revenue in a down market. The best-known casualty was Richard Ravitch, a business executive and public official renowned for revitalizing New York City’s derelict subway system in the mid-1980s, when he was chairman of New York’s Metropolitan Transportation Authority. Like Felix Rohatyn, who had helped New York City stave off bankruptcy in the 1970s, Ravitch was a local legend with a dazzling résumé. (In 2009 he was named the state’s lieutenant governor, one of the few nonpoliticians ever to be offered the post.)
But his talents didn’t translate well to Blackstone’s deal-driven, pressure-cooker culture. “ He was a terrific manager. He was not a great deal guy,” says a former Blackstone partner.
Not all who left were summarily executed. Some who fell from grace were eased out quietly or quit. Others were exiled from the thirty-first floor, where Schwarzman and Peterson held court, to humbler quarters one floor below before getting the ax. The move to the thirtieth floor was brutally symbolic. Ringed by partners’ offices, the upper floor was the seat of activity and power, whereas the sparsely populated lower floor was home to accounting and payroll and a place to warehouse documents. After a few had been kicked downstairs, the thirtieth floor came to be seen as a departure lounge for those about to be sent packing, a death row for the condemned. Junior staff members jokingly dubbed the space the Aloha Suite.
“ Steve was a very tough boss,” says Henry Silverman, the former CEO of the travel and real estate conglomerate Cendant Corporation and a billionaire financier, who was a Blackstone partner from early 1990 to late 1991. “At one point I was in my office, working on a deal with the team, and Steve walked in and shook his finger at us and said, ‘Remember, I don’t like to lose money!’ I heard that many times from him over the years. He needed to remind us that he wasn’t among the minority who likes to lose money.”
Beyond the message Winograd’s summary termination sent to others at the firm, Edgcomb had another lasting and more beneficial repercussion. Realizing that a second costly stumble could do lasting harm to Blackstone, or perhaps even consign it to an early grave, Schwarzman decided that the firm’s process for vetting investments needed to be formalized. From then on, partners would have to submit a researched and tightly reasoned proposal that would be shared with all other partners. Schwarzman would remain the final arbiter, but henceforth there would be a full airing of every deal’s possible pitfalls before he decided whether to go forward.
“I didn’t want people lobbying me at my desk or whispering to me in a corridor. Every deal would get vetted in front of the entire partnership, and not just once,” Schwarzman says. “It would be the job of the partners to poke holes and lay out the risks, without anyone getting huffy or defensive. It wasn’t a personal attack. People had to realize it wasn’t their deal being criticized; it was the firm’s deal, and the process was to protect the firm. Had we not had Edgcomb, people might still be lining up at my door.”
Though the new procedures didn’t immunize Blackstone from making bad investments, Schwarzman is convinced they cut down their frequency. The more formalized review process also made the decision to invest a collective one. This insulated individual partners from blame—and from Schwarzman’s wrath—if deals went sour.