A letter from Stephen Schwarzman, chairman and chief executive, regarding the proposed buyout of Blackstone Group
June 1, 2012
The Blackstone Group
345 Park Avenue
New York, NY 10154
Dear Shareholders:
I am, together with funds managed by our firm, pleased to propose to acquire, for a purchase price of $15 in cash per unit, all of the firm's outstanding common units, representing limited partners' interests in Blackstone Group L.P. (the "Group"). We are also offering to purchase the Chinese government's minority stake on the same terms. Our proposal provides a substantial premium to the current price for all of the Group's common unit holders. If this offer is accepted, Blackstone Group will delist from the New York Stock Exchange.
Conditions in our business have not been easy in the five years since we first issued securities on the NYSE. Many unit holders who bought into the initial public offering are now sitting on a large capital loss. Although we have made our share of mistakes, the substantial decline in the value of Blackstone's securities is largely a result of factors beyond our control.
Looking back over this difficult period, most of our problems can be ascribed to the following: deteriorating economic conditions, extraordinary convulsions in the credit markets, a worsening political and legal environment for the buyout industry, and the consequences of what is now commonly referred to as the "private equity bubble." I will briefly examine each of these issues.
1. The Macroeconomic Climate: When Blackstone came to the market in the summer of 2007, economic conditions were remarkably benign. Most economists now agree that the decision by Congress to impose punitive tariffs on Chinese imports during the first year of the new Clinton administration represented a turning point. Since that date in 2009, consumer price inflation has returned to levels not witnessed for two decades. Both nominal and real interest rates have soared as Asian savings ceased to be recycled into dollar-denominated assets. These developments have had a negative impact on the prices of all long-dated assets. Our real estate business in particular has been badly hit by the collapse of property prices.
Blackstone was prepared for a downturn. We had hedged against a rise in interest rates. Weak covenants on many of our loans and the increased use of payment-in-kind notes provided a respite for many of our portfolio companies when the hard times began. However, the severity of the recession of 2010, which was statistically a three-
standard-deviation event, was worse than our models had anticipated. Though we have experienced only a handful of bankruptcies among our companies, many of the survivors are currently valued by the market at less than what we paid for them.
2. The Credit Market Crisis: Convulsions in the credit markets have wreaked havoc in recent years. During the buyout boom, loans to finance LBOs were available in seemingly limitless quantities and risk premiums were low. This was largely a consequence of innovations in the credit markets.
In those days hedge funds had a great appetite for leveraged loans, which were bundled into securities, such as collateralized debt obligations. This market had never been tested by a recession. During the recent financial crisis, many credit hedge funds blew up. Since then, the rating agencies have become stricter in their ratings of CDOs. As a result, the market for securitizations has contracted. Furthermore, commercial banks have become wary of our industry after several experienced sizeable losses on their bridge loans to LBOs. Today credit is less available, and risk premiums on leveraged loans have risen -- permanently, I fear.
3. The Buyout Backlash: By early 2007, it was clear that the rapid growth of private equity was inciting a wave of public opposition in both the U.S. and Europe. That is why our industry established the Private Equity Council in Washington to explain our case. At the time, I personally expended much time and effort educating the media on this subject.
Our efforts were not entirely successful. Since 2007 two tax changes have hurt our industry's profitability. Several countries in Europe, including Germany, have followed Denmark's lead in removing the tax deductibility of interest payments for leveraged buyouts. Although the U.S. did not follow, the Internal Revenue Service has succeeded in forcing a change in the tax treatment of private equity's performance fees (known as the "carried interest"). Previously, the carried interest was taxed at the capital gains tax rate of 15 percent. Now that this loophole has been closed, these fees are taxed at the corporate rate. This tax change wiped nearly 20 percent off our 2008 earnings.
The buyout backlash worsened during the recession, which was accompanied by bankruptcies at several high-profile LBOs. Senate hearings into the private equity industry scrutinized the dismal performance of many buyout funds, especially the 2006 and 2007 vintages. Fees charged by private equity firms were also widely criticized following the losses experienced by many pension funds. As a result, public pension plans have been forbidden by federal law from making any further buyout investments. This has been a serious blow because public pensions accounted for about 40 percent of Blackstone's investor base.
4. The "Private Equity Bubble": The entire buyout industry, including Blackstone, must accept its share of responsibility for our current woes. At the time of our IPO, returns from buyouts had been excellent, largely because both corporate valuations and profits had been rising in tandem for several years.
In hindsight, it's clear that we became overconfident. Too much private equity money was chasing too few opportunities. We found it difficult to resist the urge to raise ever-larger funds. And we put that money to work too quickly. In the takeover frenzy, many private equity firms were overstretched. There was a collective loss of investment discipline. Too many businesses were bought at large premiums when profits were near a cyclical peak. Given the fees on offer and the ease with which assets could be flipped only months after acquiring them, our behavior was understandable.
Not only have corporate valuations substantially declined, exiting from LBOs has also become more difficult. Blackstone's own success in rapidly cashing out of its $39 billion investment in Equity Office Properties back in early 2007 encouraged others to pursue even bigger targets. Since the IPO market has been closed in recent years, many private equity firms have been stuck with their megacap acquisitions.
When competition heated up during the "bubble" period, private equity firms were also driven to buy more-cyclical businesses. To boost returns, we piled too much debt onto them. Had macroeconomic conditions remained favorable, these investments would have proved extremely profitable. That has not been the case.
Finally, I would like to comment briefly on Blackstone's own performance over the past five years. Although our recent investment record is disappointing by historical standards, Blackstone has retained its position among the top quartile of private equity firms. We have also experienced fewer bankruptcies pro rata than our competitors.
Our losses reflect an accounting quirk. At the time of our flotation, we moved to a "fair value" method of accounting for future performance fees. This allowed us to report as profit our anticipated future carried interest when we acquired a company. The intention was to reduce the volatility of Blackstone's reported profits. However, our expectations turned out to be optimistic, and we have been required to make adjustments in the past few years. It is important to understand that the large negative "carry" in our reported profits is not a cash item and has no economic significance.
In recent years Blackstone has substantially outperformed the Dow Jones Private Equity index, which comprises about a dozen frms, including Apollo Investment Corp., Carlyle Group and TPG, as well as a number of listed buyout funds. Nevertheless, we believe the market substantially undervalues our business. At the time of our IPO, Blackstone was valued at nearly 50 percent of assets under management. Today it commands a small premium to traditional investment firms.
Although the private equity industry will never again be as profitable as it was a few years back, I believe opportunities remain. But our historical business model of "leverage and flip" no longer works. As Cerberus Capital Management has shown with its successful investment in Chrysler, private equity can add value. At Blackstone we intend to roll up our sleeves and work harder in the future.
However, we now view the stock market listing as a distraction. Although we have eschewed providing guidance to analysts, the quarterly Wall Street reviews have hampered our ability to take a long-term view with our investments. Activist investors have demanded that we change the status of our listed "units" to normal shares, with voting and other traditional rights accorded to shareholders.
This is not acceptable to us. Nor are the demands for management change from them and our Chinese minority partners. Instead, my partners and I, along with several Blackstone funds, are offering to purchase all the Group's outstanding common units. Although the offer is 50 percent below the flotation price, it represents a substantial premium to where the securities have traded lately.
Of course, no binding obligation on the part of the undersigned or the Group shall arise with respect to the proposal or any transaction unless and until a definitive agreement satisfactory to us and recommended by the Special Committee and approved by the Board of Directors is executed and delivered.
We look forward to discussing our proposal with you further in the near future.
Very truly yours,
Stephen Schwarzman
Edward Chancellor, an editor at Breakingviews.com, is the author of Devil Take the Hindmost, a history of financial speculation.
