Dwight Scott had just a few days to save a $3.4 billion business.
It was late December 2014. Scott — president of credit manager GSO Capital Partners — was negotiating with Linn Energy, an oil and gas business whose stock had lost more than two-thirds of its value as the price of oil plummeted.
Scott and Linn Energy CFO Kolja Rockov were hammering out the final details of a term sheet for a complex loan deal, a structure dubbed a DrillCo, that hadn’t been tried before with financial investors. Rockov and Linn’s CEO had been in discussions with GSO — Blackstone Group’s credit manager — since Thanksgiving. But now they had only a few days before they needed to tell shareholders about the financing during the company’s earnings call.
Until the last few months of the year, Linn and other so-called upstream master limited partnerships — groups that look for fossil fuels, extract them, and handle production — were on a tear. Among upstream MLPs, Linn was the darling. The North American energy market was exploding with the development of hydraulic fracking drilling technology. But as it became easier to get fossil fuels out of the ground, supply ballooned and prices fell.
Rockov had to cut capital spending as the price of oil dropped, but it would be catastrophic for the company if the market thought growth would be kneecapped. That’s where GSO came in.
“There were really only two players — one being GSO — that you could talk to about something creative and untested like this, and who could write a very large check,” says Rockov.
“We had been messing around in the energy space long enough to know what kind of risk we were willing to take and what risks we weren’t. And they were willing to sign on a term sheet and trusted that we would get it done,” Scott says of Linn. But the lender didn’t know how long the downturn would last or whether Linn’s oil price hedges would protect it.
“Pure credit didn’t feel like a good place to be,” says Scott. After all, he and his colleagues are still fixed income investors, promising pensions, endowments, and other clients that they (probably) won’t lose their principal.
Pure credit felt too risky to GSO, but the other obvious financing option — equity — felt wrong to Linn. Rockov and his management team hated the idea of permanently selling off a stake at fire-sale prices and losing control to a private equity firm.
“This was a way to be invested in an asset directly so we were protected if in fact they got in trouble,” adds Scott. “And they didn’t have to cut their capital spending so much that it hurt the value of their business.”
In the end, GSO, Linn, and their bankers crafted a DrillCo: GSO would fund a portion of the company’s drilling costs in exchange for an ownership interest in the well. Once Linn hit a certain return hurdle, GSO’s interest in the well would drop dramatically. Linn could tell shareholders that it would still be developing the business even though it slashed costs.
On New Year’s Eve, GSO signed off on the deal. “We did something we almost never do,” Scott says. They hammered out the framework of a deal with a public company off of an informal term sheet.
It worked — briefly. The stock traded up to $14.
Linn went bust before GSO could fund its novel deal. But the asset manager had opened up a new market, and competitors noticed. GSO and other credit firms began creating other versions of DrillCos, where they provide drilling capital in exchange for an ownership stake in a well. “After we announced the deal, we received emails from bankers saying, ‘I was just at an industry conference where one of the panels was called ‘How Do We Do a GSO–Linn Style Deal?’” laughs Robert Horn, co-head of GSO’s energy platform.
Ralph Eads, vice chairman of investment bank Jefferies, sees the spread of DrillCos as inevitable. “You can’t keep a technology proprietary for long. There have been about 20 of these deals now. With anything new you need someone to go out there and be first,” Eads says. “DrillCos helped the industry out of the darkest days of the energy business.”
“It was classic GSO,” says Bennett Goodman, a co-founder of GSO. “There was a market disruption: The price of hydrocarbons collapsed, the banks withdrew from the business, and we emerged.” He talks about changing credit markets with the exuberance of a boy talking about new toys.
GSO was a dominant force in the massive restructuring of credit that started a decade ago, becoming a major lender to non-investment-grade companies that the banks could no longer finance with cheap money after 2008. Banks retreated to their traditional role as advisers to corporations, underwriting bonds for highly rated companies and riskless deals.
That left an enticing vacuum, and many firms eagerly and profitably stepped in, including Apollo Global Management, Ares Management, TPG Capital, KKR & Co., Bain Capital Credit, and scores of smaller credit shops. GSO capitalized on being early and being part of Blackstone, yet still independent. Now firms like Apollo and Ares have become formidable competitors in huge sectors like business development companies.
GSO’s founders — Goodman (the “G”), Tripp Smith (the “S”), and Doug Ostrover (the “O”) — had a long history in junk bonds and institutional leveraged finance dating back to Drexel Burnham Lambert in the 1980s. In the 1990s, the three worked for Tony James, who would move to Blackstone and spearhead the acquisition of GSO. The trio built Donaldson, Lufkin & Jenrette’s leveraged finance business. They left banking, where they were paid to structure deals, and jumped the fence to asset management. In 2005, they founded GSO.
In 2008, before the financial crisis struck, Blackstone bought GSO for diversification. It wanted a product that would be appealing to investors in a downturn.
By early 2012, GSO was five times larger than it was when Blackstone bought it and it was the private equity firm’s fastest-growing business in terms of assets. Even so, GSO was still in its early days. “When you start a credit business, no one understands exactly what you’re doing at first. GSO and, say, Highbridge [Capital Management] don’t do all the same things, but the market doesn’t know that at first,” says Scott. “It takes three to four years for people to know what GSO is calling on them for, and what to call on GSO for.”
Blackstone’s credit division, including GSO, had inflows of almost $30 billion last year and now has $24.2 billion to be invested, or dry powder. Credit represents about a quarter of Blackstone’s total assets of $512 billion and $99.7 billion of the firm’s total fee-earning assets of $353 billion. GSO closed on $4.4 billion for its direct lending funds, launched ten collateralized loan obligations for a record $6.4 billion, and raised $2.4 billion for energy strategies in 2018. Last April, GSO did a final close on its third rescue financing fund. The fund, which reached $7.5 billion in size, was oversubscribed.
In the first five or so years after the crisis, regulators were the ones in charge of reordering Wall Street and laying the foundations for the emergence of the buy side to dominate lending. Regulators deliberately moved the risk of credit from banks to what they viewed as a systemically safer home: asset managers and their long-term investor clients.
But over the last five years, regulators for the most part have stepped back and let the markets evolve organically. With super-low interest rates driving investors away from investment-grade corporate and government bonds, firms like GSO took the lead in transforming the fundamental business of lending, inventing new higher-yielding products and even making over whole industries, like insurance. Insurance companies once invested only a tiny slice of their portfolios in assets like private credit. GSO wants insurers and others to change that habit.
With $132 billion in assets — up from $10 billion when Blackstone bought it and about $65 billion six years ago — GSO is now testing the bounds of its creativity. Energy and DrillCos are just one piece of GSO’s exploding alternative credit business. The company lends money to blemished, over-leveraged, hard-to-understand companies in troubled sectors of the economy. It has had to flex its muscles to put this massive amount of money to work profitably. It’s now the second-largest credit manager in the world and reshaping markets.
“The return you get in private credit today is not by buying some liquid bond,” says Jon Gray, who became president and chief operating officer of Blackstone in February of last year, taking over from Tony James. “It’s by creating that fixed income instrument. The ability to originate, in both the U.S. and Europe, is a huge advantage for GSO.” One GSO investor says Gray’s point about creating an instrument from scratch is an important one that often gets lost. Originators — which find opportunities and set deal terms — have serious power: the power to protect themselves and their investors.
Although many pensions, endowments, and other institutions prefer small managers in equities, most say that size helps in the credit world. “Scale in credit is a different animal,” argues one investor. Only a handful of asset managers can write checks big enough to close certain transactions without the company having to bring in another lender. With its heft, GSO sees pretty much every deal in the market and has deep analysis on thousands of non-investment-grade companies through its CLOs and is able to tap into the knowledge of Blackstone’s real estate, private equity, and other investment teams. According to Scott, GSO’s president, “You can be a niche $2.5 billion credit manager and do very specific things like lending money for pharma royalties. But for large sovereign wealth funds, a $50 million investment doesn’t do a bit of good.”
Amid the growth at GSO and the spectacular amount of money they’ve made, two of its founders left. Ostrover departed in 2015 to found direct lending firm Owl Rock, and Smith left last year, likewise planning to launch his own shop. Their departures suggest a credit market that has permanently evolved: Alternative, or nonbank, credit is no longer so alternative.
“Two to three years ago, there were still people saying that the banks would eventually come back to compete. But the people who saw the financial crisis unfold didn’t want that to happen,” says a former fixed income executive. “While there are hundreds of managers out there, a few big firms have essentially replaced the banks and they are technically offering the same product — credit. But without banking regulations, the product doesn’t look anything like it once did. Not only is a long-term investor a better home for this kind of lending, the products have gotten a much-needed makeover.”
At the same time, investors’ appetite for yield has become insatiable, the executive adds. “Given the prolonged period of low interest rates, pensions, insurance companies, and others need a fixed-income type of return that they can’t get in corporates [company-issued bonds] and the government markets like they used to, so there’s almost an endless amount of capital flowing to firms like GSO,” the former executive explains.
GSO, in turn, is pushing hard into new areas and working closer with natural allies within Blackstone. It’s building products for retail investors — a virtually untapped market for private credit — through Blackstone’s new private wealth management group, which represents about 13 percent of the parent firm’s assets. GSO is working more closely with other Blackstone businesses such as Blackstone Alternative Asset Management, the hedge fund group, to do co-investments, like a recent Westinghouse deal. In 2017, GSO together with other hedge funds initially purchased claims that South Carolina utilities had against Westinghouse Electric Co., which failed to finish a nuclear power plant in the state. GSO and the other funds were able to smooth the way to a bankruptcy resolution and an eventual sale of Westinghouse to Brookfield Business Partners.
Blackstone and GSO are also getting into insurance, a $30 trillion market. Although Apollo Global Management has been phenomenally successful with its strategy that included creating Athene, an insurance company, GSO is taking a different approach to enter the business, including securitizing fund products.
GSO has taken a bold approach to business development companies (BDCs), vehicles akin to retail mutual funds that invest primarily in private loans to small and mid-market companies. The firm ended its six-year BDC subadvisory relationship with FS Investments so it could go solo and have full control of the product, even if that meant starting over. Unlike its rivals, GSO is taking the novel step of working closely with companies it lends to, including offering them services once only available to Blackstone’s prized private equity portfolio companies, such as access to CEO conferences. The industry is closely watching GSO’s BDC to see if it trades well once it goes public. GSO thinks that if it invests higher up the capital structure and creates a simple, straightforward story for investors, the BDC will trade at a premium to net asset value. The BDC may also attract significant interest from mutual funds and other institutions, a trend that has been forecast for years but has not yet materialized in force.
When asked about challenges ahead, Goodman says, “We’re a big place. We need scale and we have to reinvent ourselves. We can’t do what we did yesterday — our competitors are too smart. The nature of capitalism is that if you generate excessive returns, it will not last forever.”
So far, investors can’t argue with GSO’s returns. Its strategies are in the top quartile across the board. Since inception, GSO has returned 11.5 percent annually net of fees in distressed credit, 15.5 percent in mezzanine, 18.5 percent in energy, 14.2 percent in direct lending, 11 percent in opportunistic, and 14.8 percent in structured credit. It has delivered 10.8 percent annually in European direct lending, a relatively new business. More importantly, GSO has preserved principal. Of the $50 billion it has invested in private-debt-oriented strategies since 2007, GSO has lost only 0.7 percent of principal.
If success came easy in the U.S., the same hasn’t been true in Europe for GSO. The credit firm’s efforts to replicate its capabilities in Europe have finally gained some steam after a number of slow years. But strategically, GSO believes the region has enormous potential.
Even after the financial crisis, European companies were still getting financing from commercial banks. But they’d been starved for capital as European regulators caught up with their U.S. counterparts to rein in bank lending. Mike Whitman moved to London in 2007 when GSO was still unknown and became co-head of the European business. He saw companies hamstrung without access to creative financing.
A GSO executive met the CEO of IBA Molecular, a small European nuclear medicine company, in 2016, shortly before a giant in the U.S market — Mallinckrodt Pharmaceuticals — announced plans to spin off a division that competed with IBA.
IBA saw opportunity: Acquire the Mallinckrodt business and create a multinational company that could diagnose illnesses early, saving money for desperate healthcare systems. The problem was that the Mallinckrodt division was five times its size, and IBA’s private equity owner, CapVest, couldn’t fund the takeover.
Whitman knew the IBA deal was complicated. But the group had done three “minnow swallows whale” transactions in Europe and thought he could pull off a fourth. He also knew Blackstone’s brand would help assure Mallinckrodt’s board that GSO would make good on its commitment, even as it waited for the complicated carve-out to finish. GSO invested more than $500 million in senior secured debt to pull this off.
Yet Whitman is cautious. “The institutional non-investment-grade debt market in Europe is in its teenage years,” he says. “It’s got a similar feel to GSO in the early days in New York. There will be setbacks. We’re maniacally focused on the fact that it’s not a market share business. This is about results and maintaining discipline across market cycles.”
In Europe and globally, being part of Blackstone is increasingly valuable.
GSO is leveraging Blackstone’s muscle to push the bounds of credit, particularly in its direct-lending BDC business. Its clients can use a group purchasing program that David Calhoun, who had been second to Jeff Immelt at General Electric Co. and CEO of Nielsen when it went public, put in place for the 200 or so companies in Blackstone’s private equity portfolio. Calhoun has leveraged the volume of business that comes through its companies to get discounts on everything from health insurance to airfare and hotels. This isn’t an institutional Costco that carries discounted paper clips. Calhoun says companies get a meaningful earnings bump by using the program. Blackstone — buying on behalf of scores of companies — is one of FedEx Corp.’s top five customers, behind Amazon.com.
Unlike private equity, credit shops don’t get involved in a company’s operations — that’s one of the benefits of borrowing money versus selling a stake. But standing idly by isn’t in the Blackstone playbook. Its roots are in private equity, after all. “Applying strategic and operational intervention is part of the core DNA that Blackstone private equity applies to its portfolio companies," Goodman explains. "As a passive investor, GSO tries to extend those core competencies through access to our group purchasing organization, CEO leadership conferences, a cross-selling initiative, talent management program, etc., all of which are designed to help our portfolio companies enhance their franchise value and improve earnings.”
Such perks allow GSO to win deals without having the lowest pricing or slackest terms. “Eighty percent of our deals have covenants,” Goodman says. “Unlike other BDC competitors, we’re not trying to compete on price or cov-lite deals.” Access to Blackstone’s group purchasing program has resulted in an average 6.5 percent increase in EBITDA for direct-lending clients that enrolled in it, according to the co-founder.
One of the risks in direct lending is spending a long time finding a great small company — which takes as long as landing a big deal — and then borrowers quickly refinancing with another lender. Deal terms that protect GSO from this risk are incredibly valuable, says Brad Marshall, who heads direct lending. “We can pick good companies and not get refinanced out after a short period of time,” he says, adding that GSO’s activist perks make its call protections more legitimate. “If we’re going to spend all this time to help make your company better, we don’t want to be penalized by getting called out early because of strong performance.”
GSO is using a number of tactics to quickly attract assets, particularly from institutions like mutual funds, to the BDC that it believes will help the vehicle trade well once it goes public, which is the ultimate goal. First, it charges among the industry’s lowest fees, tackling a major criticism of the products, one that has turned off many institutions. GSO’s BDC charges a 0.75 percent management fee now and plans to charge 1 percent after going public. Performance fees are 17.5 percent, somewhat below the striking current standard of 20 percent. Assets are all investing in senior secured debt, a deliberate decision to differentiate itself from competitors exposed to junior debt and other securities. Lower fees amount to 50 to 100 basis points of additional return for investors, Marshall says.
GSO is aiming for a higher return on equity so the BDC trades at a premium to its net asset value. With market volatility returning in December, BDCs with big exposure to junior debt and equity traded down significantly. BDCs with senior debt were down, but they still traded at a premium to net asset value. GSO claims the market is getting more sophisticated with investors gravitating to BDCs with higher-quality portfolios.
Already, the BDC is half retail money, half institutional.
One investor says the way GSO has its hands in the markets these days reminds him of the founders’ early days at Drexel Burnham Lambert, when the firm invented the bridge loan to get a toehold in the junk bond market after Drexel went bankrupt. GSO is no longer a scrappy upstart like Drexel was at the time, but he says it’s stuck in his mind as he’s thought about the firm’s growth.
Not everything is as easy as offering a good discount. Longtime client Hovnanian Enterprises is a highly leveraged homebuilder that has languished despite a strong real estate market. In 2012, GSO provided financing after Hovnanian had been losing money for six years and had used up its capacity to issue debt. At the time, with no bank willing to lend to it, the New Jersey–based homebuilder had become a target for short sellers; investors were betting billions of dollars in credit default swaps that the company would go bankrupt. The price of the five-year CDS contracts on Hovnanian implied a 93 percent probability of default.
Fast forward to 2018. In a now-infamous trade, GSO used the CDS market to provide rescue financing for Hovnanian that needed capital for maturities. GSO did what’s called a manufactured default: The company missed bond payments to trigger a payout on the swaps, which was then used to provide capital to the company. GSO had a combination of a trigger, a manufactured default, and newly issued securities as a deliverable. But the transaction caught the attention of the market and regulators. The Commodity Futures Trading Commission, for one, issued a harsh statement about abusing the CDS market.
But the trade was complicated: Hovnanian’s securities didn’t trade in a distressed way because GSO had provided the company with capital and bought it time. With the transaction open and because the controversy was creating more risk for GSO, the firm ended up settling. Earlier this month, a working group of the International Swaps and Derivatives Association said it would work to halt the practice. The industry’s main trade group issued a proposal outlining a new definition of “failure to pay” events that would result in payouts. These defaults would have to be tied to legitimate financial stress, rather than being another way to raise capital.
“The HOV trade at its core is GSO providing rescue financing to a distressed company that we had a long, long relationship with,” says Scott. “That got lost in the story. But that’s in part because we solved the problem by giving it capital to meet upcoming maturities and therefore buying them a longer runway.”
The CDS trade raised issues for some investors, who have said privately that they didn’t expect a credit manager like GSO to be so mercenary: manufacturing a bond default to raise funds.
What counts as mercenary is up for debate. The non-investment-grade bond and financing that sprung from it over the years has long fueled some of the most vibrant sectors of the U.S. economy, including telecommunications companies that led to the internet and online commerce. But leveraged finance also fueled cuts and restructurings that pension funds might not like to explain to their beneficiaries, though they’re happy to reap the rewards. The same happens in private equity all the time. But investors say they expect that from the start. Credit mangers might need to explain themselves better.
A former chief investment officer of a sovereign wealth fund says he viewed the maneuver no different than many of the tactics in distressed investing, private equity, and private debt. “Every one of the distressed funds involve workouts, restructurings. We viewed it as fair game. There are always some unseemly aspects.”
GSO will face a market downturn. On one hand, the firm hopes to exploit such a situation by providing liquidity to stressed markets and becoming companies’ lender of last resort. On the other hand, the strength of its own deals will be tested.
To GSO, the credit markets are not homogenous. “Unlike others who are waiting for markets to change, and because we manage so many different strategies, last year was among the most active investment periods we ever had,” says Scott. “We did some large deals, but we also jumped on some one-off transactions that had unique drivers,” such as Fidelity & Guaranty Life’s buyout for Blackstone’s insurance business, which wasn’t an LBO in the traditional sense. GSO deployed $7.6 billion in 2018, according to filings.
Scott says that if there is a blip in the market, GSO is ready. The firm put a lot of money to work during bearish periods like early 2016, which was a commodity-driven correction, and the summer of 2011, which was mostly influenced by the U.S. downgrade.
David Posnick, chief investment officer of GSO’s rescue financing business, says the firm gets involved to manage outcomes. “Our business is not a ‘buy it, sit and watch it, do nothing, and wait for some good outcome.’ It’s active, particularly in capital solutions. We’re actively investing and reacting to what is happening,” he says.
As GSO has done more creative deals, like the DrillCos, its capital is also becoming an alternative to private equity. Instead of giving up control to PE, companies can get temporary financing from GSO. Small and midsize corporations might not have pursued certain M&A deals had they known there were other options, in Whitman’s view. “They weren’t aware that this alternative capital existed. They assumed that if they wanted to pursue this kind of financing, they would have to give up control. Not everyone wants to give up control,” he says.
Of course, Blackstone’s core business is still private equity. Stephen Schwarzman isn’t likely to let GSO make too much of a dent in that.