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Transcript of Gso Lenders of Last Resort 2013
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LENDERSof LAST
RESORTBY JULIE SEGAL
JUNE 2013 INSTITUTIONALINVESTOR.COM
GSO’s Bennett Goodman
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UNDERBLACKSTONE’SOWNERSHIPCREDIT SPECIALISTGSO CAPITALHAS GROWNFIVEFOLD,EMERGING ASA TOP SOURCEOF FUNDINGFOR STRUGGLINGCOMPANIES.
PHOTOGRAPHS BYMATT FURMAN
Tripp Smith is happy
to leave the spotlight
to fellow GSO
co-founder Bennett
Goodman and
instead focus on
doing deals
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GSO’s Douglas Ostrover
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Ara Hovnanian, CEO of Hovnanian Enterprises, knew little about
GSO Capital Partners before the credit-oriented alternative asset
manager offered the struggling homebuilder a lifeline last year.
Douglas Ostrover, the “O” in GSO, invited him to lunch at Manhat-tan’s Core Club in July 2012, just as the U.S. housing market was
showing a few signs of life. The then-54-year-old CEO figured he
had little to lose by listening to Ostrover’s pitch. His company had
been bleeding money for six years and had used up every penny of
its capacity to issue secured debt. With no bank willing to lend to it,
the Red Bank, New Jersey–based homebuilder had become a target
for short-sellers; investors were betting billions of dollars in credit
default swaps that the company Hovnanian’s father and three uncles
had founded in 1959 would go belly-up. Hovnanian, who had lived
through several real estate cycles, was shocked when Ostrover told
him the price of the five-year CDS contracts on Hovnanian implied a
93 percent probability of default. “The market is saying you’re going
bankrupt,” Ostrover added.GSO, which is owned by private equity giant Blackstone Group,
had spent six months digging into the finances of Hovnanian and
had been buying up its equity, secured debt and unsecured debt since
March. Ostrover, now 50, who helped build the leveraged-finance
business at investment bank Donaldson, Lufkin & Jenrette during
the 1990s, explained his idea for solving Hovnanian’s liquidity prob-
lems. The company would sell its property inventory to a land bank
created by GSO in return for a $125 million cash infusion. Over time
GSO would sell the land back to the homebuilder. Ostrover asserted
that not only would the market react positively to the initial financing
but that the GSO-Blackstone brand would signal that there could
be more behind it. “Look, the market hates your company,” he told
Hovnanian. “We love your company.”
(Ostrover had his own hard-luck family bankruptcy story: His
grandfather had to shutter Ostrover’s Smoked Fish on New York’s
Lower East Side in the 1950s following a blackout; he couldn’t pay
his creditors because his customers’ fish had rotted.)
Hovnanian, for his part, was not convinced that the market would
react as positively as Ostrover suggested. “If you’ve been out in the
battlefield for seven years, being shot at constantly, you don’t know
what to do if the bullets stop flying,” he told Ostrover, who left the
lunch uncertain whether the CEO would agree to his plan.
It took a week before Hovnanian softened, but GSO got its deal.
Indeed, when Hovnanian announced the land banking deal on July
13, 2012, its stock rose, its senior secured debt traded up from 84 to
97 cents on the dollar, and the price of the CDS contracts collapsed.
Traders betting against the company lost money. The stock rose
170 percent between July 2012 and the end of the year. J.P. Morgan
and other Wall Street research firms changed their rating from a sellto a hold — GSO had been hoping for a buy — and Credit Suisse
refinanced Hovnanian’s high-cost debt that was coming due in 2016
and that the naysayers were sure would sink the company.
“They did their homework, and they were convinced that the mar-
ket was underestimating our ability to succeed in a space — hous-
ing — that they thought was recovering,” says Hovnanian. Eleven
months later the U.S. housing rebound is official and Hovnanian
Enterprises is flourishing, expecting 2013 to be its first profitable
year since 2006 (see CEO Interview, page 48). Hovnanian was the
largest position in GSO’s flagship hedge fund in 2012, and the firm
made 50 percent on its capital in six months.
GSO has provided much-needed credit to scores of troubledcompanies like Hovnanian that couldn’t tap public markets or get
bank loans. The firm has financed well-known names like Chesa-
peake Energy Corp., struggling with weak natural-gas prices and
controversy around its ex-CEO and needing capital to develop
lucrative energy projects, and Sony Corp. while also providing
$650 million of capital to smaller homebuilding companies like the
U.K.’s Miller Group and $888 million to companies in Europe last
year, including Canberra Industries,Welcome Break and EMI Music
Publishing. As one of the largest creditors of MBIA and holders of
its equity, GSO had a big win last month when the Armonk, New
York–based provider of municipal bond insurance finally settled a
dispute with Bank of America Corp. after years of wrangling over
troubled mortgage-backed securities.“In the old days a bank might have been more willing to commit its
balance sheet for long-standing clients,” says Bennett Goodman, the
56-year-old “G” in GSO, who started his career at Drexel Burnham
Lambert in the 1980s. “Because of the regulatory environment, it’s
harder for them to do that economically. As a consequence, banks
want to syndicate risk into the market — put together a road show
and talk to 200 investors. But they don’t want to commit their capital.
We, on the other hand, want to own the risk.”
GSO founders Goodman, Ostrover and Tripp Smith have
emerged as lenders of last resort, filling the gaping financing void
left by banks and opportunistic hedge funds in the wake of the
2008–’09 financial crisis. The firm follows in the footsteps of Drexel
and Michael Milken, who in the 1980s invented the junk bond
market for non-investment-grade companies. In the 1990s, GSO’sthree founders, then working for Hamilton (Tony) James at DLJ,GSO co-founder Douglas Ostrover made the pitch to Hovnanian
ALTERNATIVES
“In the old days a bank mighthave been more willing tocommit its balance sheet for
long-standing clients. Becauseof the regulatory environment,it’s harder for them to do that.”— Bennett Goodman, GSO Capital Partners
A
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took up where Drexel left off, building that firm into the No. 1
leveraged-finance player, lending to blemished companies that were
in some of the fastest-growing sectors of the U.S. economy, includ-
ing energy exploration and homebuilding. If Drexel came up with
the junk bond and DLJ created the institutional leveraged-financemarket, GSO is again reinventing the concept of providing capital to
non-investment-grade companies — this time as an asset manager.
GSO — which Goodman jokingly refers to as “the Warren Buf-
fett of the dregs” — is at the center of a reshaped Wall Street, where
newly chastened banks are retreating to traditional roles as advisers
to corporations, underwriting bonds for only the most highly rated
companies and riskless deals. Since the financial crisis investment
banks have been deleveraging and governments around the world
have imposed stricter capital requirements on financial institutions,
as the U.S. is doing with the Dodd-Frank Wall Street Reform and
Consumer Protection Act. But it’s the as-yet-unfinalized Volcker
rule that does the most damage to banks’ freedom, preventing themfrom engaging in proprietary trading or lending their own capital in
speculative deals like the one to rescue Hovnanian.
“In the era of Dodd-Frank and the Volcker rule, GSO and others
like it, with their ability to make commitments, have more market
power than ever,” says Brian O’Neil, chief investment officer of the
$9 billion-in-assets Robert Wood Johnson Foundation, the U.S.’s
largest philanthropic organization focused on public health and one
of GSO’s first investors.
Banks may no longer have the balance sheets, but big institutional
investors like sovereign wealth funds, endowments and pension
funds do. To be sure, Blackstone is not the only manager to have
smelled opportunity in the financing void. Depending on the prod-
uct, GSO has a host of competitors, including Apollo Group Man-agement; Ares Capital Corp. (an Apollo spin-out); Avenue Capital
Group; Carlyle Group; Goldman, Sachs & Co.; J.P. Morgan Asset
Management’s Highbridge Capital Management; KKR & Co.;
Oaktree Capital Management; and TPG Capital.
James Coulter, co-founder of private equity firm TPG, says the
opportunity is much more attractive for managers and investors now
that banks — which threw cheap money from depositors at troubled
companies’ financing problems and pocketed the profit — are not
in the mix. “There is a place for capital formation at market rates of
return and driven by problem solvers,” explains Coulter. “It’s alter-
native credit growing up. It’s not the Wild West, not the personality-
driven days of 20 years ago. And this is good for the economy.” TPG
launched its own midmarket lender after the financial crisis and has
both competed and partnered with GSO.
Goodman, Smith and Ostrover founded GSO in 2005 to provide
capital to non-investment-grade cyclical companies that were going
through a tough patch but had tangible assets to put up as collateral
to protect the firm’s downside when it lent them money. GSO was an
early investor in the shale gas industry, which has been whipsawed by
volatile pricing and other events. “They have a zealous approach to
protecting capital, and they’ve found a way to extend credit to orga-
nizations that need it and structure it in a way that takes advantage
of the environment at the time,” says Blackstone chairman, CEO
and co-founder Stephen Schwarzman.
In 2008, Blackstone, looking to diversify, paid $1 billion toacquire GSO, which then had a $3.2 billion credit hedge fund,
$500 million in mezzanine investments and a $4.8 billion collateral-
ized loan obligation business. The deal wouldn’t have happened
without Goodman, Smith and Ostrover’s former boss, Tony James,who had joined Blackstone as president in 2002 after Credit Suisse
bought DLJ and who manages the firm’s day-to-day operations. “This
was more like a family reunion than an acquisition,” says Schwarzman.
“Credit to Steve, he really trusted me on this one,” adds James,
who says Blackstone was looking for an area of asset management
with room to grow that would complement its existing private equity,
real estate and fund-of-hedge-funds businesses. “What was a wide-
open white space for us? Credit jumped off the page.”
With $58 billion in assets under management and 235 employees,
GSO has grown fivefold under the Blackstone umbrella.Today it offers
$27 billion in alternative-investment funds, including the now $4 bil-
lion hedge fund, $8 billion in mezzanine funds — financing buyouts for
private equity — $8 billion in rescue lending and $7 billion in small-cap
direct lending. The firm’s long-only strategies include a $24 billion
CLO business, making GSO the largest institutional investor in lever-
aged loans, as well as closed-end and other funds. Goodman is quick
to credit the Blackstone brand for at least part of GSO’s success. “If
we were Schmeckle & Schmeckle or just stand-alone GSO, there’s no
way the board of Sony or some of these other companies would have
gone along with some no-name firm,” he explains.
GSO’s returns have been top quartile. According to external mar-
keting documents, its hedge fund has delivered a net annualized return
of 13.6 percent since January 2010, compared with the HFRI Fund
Weighted Composite’s return of 4.6 percent for the same period.
(Though the hedge fund was launched in 2005, GSO has sincestripped out mezzanine and other investments into separate funds.)
ALTERNATIVES
Blackstone co-founder Stephen Schwarzman (left) and
president Hamilton (Tony) James wooed GSO’s principals for
several years before buying their firm in January 2008
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The firm’s mezzanine fund has one of the best records in the industry,
up an average of 19.9 percent a year net since inception in July 2007.
Rescue lending has returned an annualized 15.2 percent since incep-
tion in September 2009. “The GSO team has been through the ups
and downs of numerous credit cycles, and they’re always worried andtrying to protect the downside,” saysTimothyWalsh, chief investment
officer of the $74 billion New Jersey Pension Fund, which has com-
mitted to $1.1 billion in investments in five GSO funds.
Blackstone’s acquisition of GSO has been an undisputed winner.
GSO represents 26.6 percent of the firm’s $218 billion in assets, on
par with its $59 billion real estate business and larger than both its
private equity ($52 billion) and Blackstone Alternative Asset Man-
agement hedge fund ($48 billion) businesses. GSO represented 38.9
percent of Blackstone’s $629 million of realized performance fees
earned in 2012 and 16 percent of the firm’s $2 billion in economic
net income last year. In 2007, the peak for the firm’s performance
fees, private equity contributed the bulk of the total. Between 2005
and 2012, GSO’s assets grew at a compounded annual rate of 29
percent. That makes GSO Blackstone’s fastest-growing business
in terms of both earnings and assets. Executives at two publicly
traded alternatives firms say they aren’t so much concerned about
Blackstone as a competitor in private equity but that they’ve been
blindsided by GSO’s growth. Though hurt by the financial crisis,
Blackstone and GSO have emerged as dominant players in its
aftermath. Since 2008, Blackstone has more than doubled its assets.
At the same time that GSO is capitalizing on the void left by banks,
it is also benefiting from historically low interest rates and unrelent-
ing investor demand for credit investments. While non-investment-
grade companies need capital, investors need yield, and alternative
credit strategies like those offered by GSO provide a much-neededboost to returns for bond portfolios. “Now the emergence of alterna-
tive credit mirrors tools that equity investors have had with private
equity,” says TPG’s Coulter.
The future looks bright for credit investing. Remnants of the
financial crisis continue to cast a shadow on markets, especially in
Europe. When Smith was pitching deals at Credit Suisse, he wasconstantly being undercut by in-country banks. “You couldn’t
hope to compete because the banks were so aggressive,” he says. As
a result, the high-yield and leveraged-loan markets never developed
in Europe to the extent they did in the U.S. But that’s starting to
change as European banks need to deleverage and raise capital and
companies desperately require funding. GSO is hoping to be a big
part of the transformation.
IN THE 1980S, WALL STREET HAD A CLEAR PECKING
order. On top were three white-shoe firms: First Boston Corp., Gold-
man Sachs and Morgan Stanley.That’s where you wanted to land a job
if you were a Harvard Business School student. The day in early 1983that the three firms sent recruiters to the campus, Bennett Goodman
was playing basketball; when the game went into overtime, he arrived
too late to get into the crowded blue-chip presentations.
The only opening that day was for Drexel, which was at the bottom
of the Wall Street pecking order even as it dominated the business of
financing non-investment-grade companies. Goodman had never
heard of the firm, but he distinctly remembers Frederick Joseph,
Drexel’s CEO, passionately recounting how it financed entrepreneurs,
married capital to ideas and was profoundly transforming whole
industries. “I fell for it hook, line and sinker,” says Goodman. “I love the
underdog.” While his friends at Harvard — including one he describes
as having had pinstripes on his diapers — did summer internships at
Wall Street’s toniest firms, Goodman took a job with Drexel.There Milken was leading what’s now called the democratiza-
tion of capital-raising, providing funding to small and medium-size
companies that were starved for financing and whetting the appetites
of investors for distressed and troubled companies that showed
promise despite short-term woes. In the process, Drexel helped spark
an unprecedented era of prosperity in the U.S. as companies like Ted
Turner’s Turner Broadcasting System, Craig McCaw’s McCaw
Cellular Communications and William McGowan’s MCI Com-
munications Corp. rapidly expanded by using this newly available
source of capital. Junk bonds also fueled the leveraged buyouts of
the 1980s, when firms like KKR targeted companies that had once
turned deaf ears to shareholder demands.
After earning his MBA in 1984, the Miami-born Goodman took
a full-time job with Drexel in New York. He spent five years there,
toiling on ten to 12 deals a year — all of them different — in a culturethat rewarded Street smarts and a maniacal work ethic. Drexel was
“The GSO team has beenthrough the ups and downs ofnumerous credit cycles, and
they’re always worried andtrying to protect the downside.”— Timothy Walsh, New Jersey Pension Fund
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a place where analysts spent days buried in
the dense financials of dicey companies. The
firm honed the skills needed to look at an
ugly financial situation and determine the
commercial viability of a financing for boththe companies and investors. In contrast to
the few traditional deals a year that a junior
banker at Goldman might work on, Good-
man cut his teeth on such unusual transac-
tions as KKR’s investment in Union Texas
Petroleum Holdings in 1985 and Maxam’s
1986 takeover of Pacific Lumber Co. For
the latter he and Joshua Friedman, then
head of the capital markets group at Drexel,
came up with a term sheet for a zero-coupon
increasing- rate note whose complexity and
model they still laugh about.In 1987 the Los Angeles–based Milken
called Goodman, who by this time focused on
LBOs, telling him he should move to Beverly
Hills and work for Friedman (who would
go on to co-found hedge fund firm Canyon
Capital Advisors). But after his wife, Meg,
refused to leave NewYork, Goodman quickly
set his sights on DLJ, a midsize investment
bank known for equity research and a certain
scrappiness and entrepreneurial culture.
Garrett Moran, who ran the high-yield bond
group at DLJ, says Goodman stalked him
for six months, wanting to pitch his idea for acapital markets desk.
Goodman liberally quotes from his uncle,
Skip Bertman, a former head coach at Louisi-
ana State University who has the best baseball
record in the National Collegiate Athletic
Association and who took an influential role
in Goodman’s life after his father passed away
when he was five years old. Bertman, who
built an underdog team into a profitable leg-
end for LSU, told Goodman that success took
three “H”s: hard work (in an interview his
uncle calls that hustle), honesty and humility.
Hard work got him noticed at Drexel, as
well as a meeting with Moran. But Goodman
shunted humility aside — at least temporarily
— during his lunch with Moran. The 30-year-
old newly minted Drexel vice president told
the DLJ executive, “I’m going to help build
this big business at DLJ, and you’re going to
get rich and famous.” Moran, who says he
instantly liked Goodman and the wealth of
experience he had gotten working on deals
inside the Drexel pressure cooker, hired him.
“He might have been young, but it was like
a pro coming into an amateur team,” adds James, who then ran DLJ’s investment bank.
In early 1988, Goodman started building
the capital markets business at DLJ under
Moran and James. At that time, Drexel had
a lock on the business. Take the “highly con-
fident letter,” a piece of paper Drexel wouldissue to the board of a company as a promise
that it would provide financing on deals.When
DLJ tried issuing its own highly confident let-
ters, they meant nothing, as DLJ had a small
balance sheet. So the firm created the bridge
loan, not promising capital but intended to
tide the company over until it could obtain
permanent financing. “On the strength of
that bridge loan business, we built ourselves
up into the leading firm,” says James.
In September 1988 the Securities and
Exchange Commission sued Drexel forinsider trading and stock manipulation. The
following March, Milken was indicted for
racketeering and securities fraud. In Febru-
ary 1990, Drexel filed for bankruptcy; two
months later Milken pled guilty to lesser
charges, agreeing to pay a $600 million fine
and serve ten years in jail. (The sentence was
later reduced to two years.)
With Drexel and Milken gone amid a
recession, many market watchers thought
high-yield financing would die. But although
most Wall Street firms pulled out of the high-
yield business, DLJ stayed in, doing some sec-ondary trading and working with companies
that felt they had been abandoned. When the
markets rebounded in 1991, DLJ took over
as a leading player.
In 1992, Goodman hired Ostrover from
Grantchester Securities, the high-yield arm
of boutique investment bank Wasserstein
Perella & Co., to run DLJ’s sales and trad-
ing. Ostrover, who has a BA in economics
from the University of Pennsylvania and an
MBA from New York University’s Leonard
N. Stern School of Business, was ranked theNo. 1 salesperson by a third-party consulting
firm, and Goodman and Moran decided to
steal him away the day the news came out.
While Goodman loves to talk, Ostrover has
to be pressed for details. He reveres his middle-
class upbringing — first in Queens, NewYork,
and later in Stamford, Connecticut — and says
that when he was growing up he didn’t know
anyone who worked on Wall Street. Apologiz-
ing for the seeming hokeyness of it, he refers to
a black-and-white picture in his office of New
York’s Orchard Street early in the past century,
with unpaved, muddy roads; pushcarts; and aglimpse of Ostrover’s Smoked Fish.
In 1993, Goodman hired Smith from
Salomon Smith Barney, where he worked on
restructurings. Smith had joined Salomon
from Drexel, leaving with a group during the
bankruptcy. Two years out of the Universityof Notre Dame, he witnessed firsthand the
toll Drexel’s failure took on senior managers
whose wealth had been tied up in its stock.
Smith is the third generation in his Indianapo-
lis Irish family to graduate from the Catholic
university; two of his four kids are currently
studying there.
Goodman and Ostrover joke that Smith
was responsible for DLJ’s success.The year he
joined, the firm became the No. 1 underwriter
for high-yield bonds, a distinction it would
keep for 12 years. Drexel had unwittinglypassed the high-yield baton to DLJ. Though
the three founders couldn’t be more different,
they’ve maintained their partnership without
a blip for 20 years. Goodman is the storyteller
of the group, Ostrover is Mr. Markets, and
Smith wants to stay out of the limelight and
just do deals. Though the three are equal part-
ners at GSO, Smith and Ostrover often defer
to Goodman for the final word.
In 1995, Moran moved up to chief operat-
ing officer of fixed income, and Goodman
took over all of leveraged finance. DLJ used
its market position to keep reinvesting in thefirm, building a leveraged-loan capability
and creating a derivatives business and large
distressed unit.The group invented concepts
such as payment-in-kind toggle bonds, with
which an issuer can defer interest payments
in return for a larger coupon in the future,
and IPO carve-outs, whereby the parent
company sells stock of a subsidiary to the
public. In the late 1990s, Schwarzman, a
client of DLJ’s, asked Goodman to start a
credit business at Blackstone. It was the first
of many overtures Blackstone’s executives
would make to him.
It was DLJ’s limited balance sheet that
taught Goodman, Ostrover and Smith how
careful they had to be with their credit analy-
sis and due diligence. There was little room
for error. “You had to figure things out and
use your smarts instead of brute strength,”
Smith, 47, says. By 1999, however, DLJ was
hamstrung by its small balance sheet and a
business that was primarily domestic. Com-
petition from increasingly bigger banks was
fierce. The world had changed, and the firm
needed a partner.Credit Suisse bought DLJ for $11.5 bil-
ALTERNATIVES
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lion in 2000 and combined the firm with its
New York–based investment banking unit,
Credit Suisse First Boston. The big Swiss
bank wanted Goodman’s leveraged-finance
business as well as DLJ’s merchant bankingand real estate groups. Though DLJ invest-
ment banking staffers left in droves after the
deal — including James, though he stayed
two years as part of the merger agreement —
Goodman, Smith and Ostrover flourished.
Even before James left CSFB, he and Good-
man talked about going off on their own. After
James joined Blackstone, Goodman took over
CSFB’s alternative capital division. Shortly
thereafter Ostrover assumed responsibility
for leveraged finance and Smith joined Good-
man in the alternatives group. What the threefounders have built at GSO, they originally
planned for CSFB.
But in June 2004, John Mack, then CEO
of CSFB in the U.S., announced he was leav-
ing; the Credit Suisse board had decided not
to renew his contract. It was a good time for
Goodman, Smith and Ostrover to start their
own firm. By that July the three partners
had launched GSO with 25 employees and
one hedge fund. The firm had purchased
a small CLO group, run by Daniel Smith,
from Royal Bank of Canada. Smith, who
had been co-head of high-yield group among
other positions at Van Kampen Investments,
now runs GSO’s customized credit strate-
gies, including CLOs, closed-end funds and
Franklin Square Capital Partners, its small-
cap direct lending group.
On day one Credit Suisse gave the firm
more than $500 million to manage — a big
part of the approximately $3 billion it had
raised from outside investors, including the
Bass brothers, Blackstone, Cornell Univer-
sity, K2 Advisors, MetLife, Notre Dame and
Quellos Group (now owned by BlackRock).
GSO’s hedge fund invested in public securi-
ties, mezzanine debt and distressed debt and
provided some rescue lending for companies
going through liquidity problems.
Fully 80 percent of GSO’s senior manage-ment team is from DLJ. Jason New, a onetime
bankruptcy lawyer who had been with DLJ
since 1999 and worked on some of the most
complex distressed deals, such as financing
Level 3 Communications and Qwest Com-
munications, joined GSO at the start. He nowmanages its hedge fund. A month after its
launch, GSO hired Donald (Dwight) Scott,
who ran the energy practice at DLJ before
joining El Paso Corp. in 2000. Houston-
based Scott oversees GSO’s energy group.
In 2007, Merrill Lynch & Co. took a
minority stake in GSO and the firm had its
first closing for a new mezzanine fund. But
its deals remained small, providing funding
for companies like Pacific Lumber and Caffè
Nero, a U.K. coffeehouse chain. Though
it was satisfying to be on their own, Good-man, Ostrover and Smith were used to being
No. 1 and having a big firm behind them. But
things were changing, and they would get
their chance soon.
WHEN ASKED ABOUT HIS DECISION
to switch from the sell side to the buy side,
Goodman says his only regret is that he
didn’t make the move ten years earlier.
Though he loved working on Wall Street,
particularly at DLJ, Goodman wanted to
spend all his time investing. “At a bank you’re
working for anonymous shareholders, try-
ing to make as much money as you can,” he
explains. “It’s amorphous, and you don’t
know the people. It’s a different kind of sat-
isfaction walking into the CIO’s office for the
Bass brothers.”
A deal between Blackstone and GSO, how-
ever, wasn’t a no-brainer. Private equity inves-
tors are by nature optimistic and swaggering,
thinking every deal is a potential blockbuster.
Blackstone’s offices on Park Avenue are noth-
ing short of glitzy, with unobstructed views
of the NewYork skyline and floors connected
by grand staircases with polished metal ban-
isters. No one has represented Blackstone’s
opulence more than its billionaire co-founder
Schwarzman, who in 2000 reportedly paid
$37 million for a 34-room triplex on ParkAvenue and has owned vacation properties in
the Hamptons; Jamaica; Palm Beach, Florida;
and Saint-Tropez.
Credit investors, on the other hand, are
pessimists, aware that the upside of their
investments is limited, evaluating everythingthat can go wrong in an effort to protect their
principal. Credit geeks Goodman, Ostrover
and Smith nonetheless went to Blackstone’s
extravagant road show at New York’s Pierre
hotel in the spring of 2007, the first time
that granular detail about the private equity
firm was available to the public. The trio had
remained close to James after he left DLJ for
Blackstone, and they knew he was interested
in striking some type of deal. During the road
show, Blackstone disclosed its numbers, show-
ing heft in private equity, real estate and fundsof hedge funds, but credit was an afterthought,
amounting to only about $5 billion in assets. At
the same time, Blackstone had relationships
with almost every major institutional investor
in the world, a group that had, on average,
$200 million in assets invested with the firm.
GSO’s investors, by contrast, had a paltry
$22 million invested with Goodman, Ostrover
and Smith. GSO was also overly dependent
on Merrill Lynch and Credit Suisse, both of
which were starting to feel pressure in the early
days of the subprime crisis.
Any deal would hinge on James, who wasrevered by GSO’s three founders. That sum-
mer James approached Goodman — the
fourth time Blackstone had tried to entice
him into a deal — and stated the obvious:
“In credit we’re not where we want to be. We
want to buy you.”
After six months of negotiations, Good-
man and his partners said yes. Although
they enjoyed being their own bosses, they
missed the prestige, and the deals, that came
with being part of a big organization. With
Blackstone they would get scale, a brand,idea-sharing with the firm’s deal makers
and access to new and larger clients. Smith,
who calls himself Mr. Process, was the least
enthusiastic about the tie-up, concerned
that they were trading away their autonomy.
But the $1 billion price tag — the proceeds
of which the partners rolled over into GSO
funds — and the potential to take advantage
of what they thought would be a huge shift on
Wall Street helped alleviate their concerns.
“Blackstone allowed us to take our busi-
ness from being three years old to ten over-
night,” Ostrover says.GSO and Blackstone announced the deal
“Blackstone allowed us to take our business from being three years oldto ten overnight.”— Douglas Ostrover, GSO
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in January 2008. In addition to strengthen-
ing their firm’s credit business, Schwarzman
and James saw benefits for its private equity
operation. “Having a better understanding
of credit markets, having a better idea ofhow we could finance a creative idea, would
make us better in private equity,” says James.
“GSO was very synergistic and comple-
mented our other businesses well.”
The honeymoon was over quickly,
though. As 2008 wore on and the credit
crisis gathered steam, GSO started putting
money to work. In August the group put
up $1 billion in equity to buy a portfolio of
busted bridge loans from Deutsche Bank,
with the German bank providing 3-to-1
leverage. The approximately $4 billionportfolio was distributed across GSO’s
own funds as well as Blackstone’s private
equity portfolios. The next month Lehman
Brothers Holdings filed for bankruptcy
and all hell broke loose. Loan prices
dropped 30 points, obliterating almost the
entire investment — at least on paper. The
Deutsche Bank portfolio was marked to
about 5 cents on the dollar for the quarter
ended March 31, 2009. GSO had part-
nered with TPG to buy a $2 billion port-
folio of bridge loans from Citigroup. That
also plummeted in value.As it turned out, GSO had done thor-
ough credit analysis and structured the
debt appropriately, and it made 1.5 times its
investment in two years, with every company
paying off its debts. “Writing something
down to zero is not your proudest moment,”
Goodman says. But by the end of 2009, the
firm had $24 billion in assets.
After the market bottomed in 2009,
GSO launched its first rescue lending fund,
which closed at $3.3 billion. The next year
it acquired nine CLOs from Allied Capital
Corp., and a year later it bought Harbour-
master Capital Management, a $10 billion
European leveraged-loan manager, and four
CLOs from Allied Irish Bank.
In its five years in the Blackstone fold,GSO has gone from having two fund prod-
ucts to managing 27. The breadth and scale
of its funds allow it to offer a range of solu-
tions to companies, including rescue financ-
ing and senior secured bank loans. At the
same time, the platform gives it a lot of differ-ent eyes into potential investments. GSO has
a view on about 1,000 companies through its
CLO business, garnering leads that can be
passed on to the hedge fund or other vehicles.
Investments can also be shared. The Hovna-
nian deal was originated through the hedge
fund but later expanded to include the rescue
financing fund. “We stand on this very busy
street corner and see all this activity,” says
customized credit strategies partner Daniel
Smith. Under Blackstone, GSO has the heft
to write big enough checks to fully finance asolution, reducing a company’s need to find
additional capital elsewhere.
GSO’s flagship hedge fund takes an activist
or event-driven approach to credit. New’s
team looks for companies going through
some sort of upheaval, such as a covenant
breach, debt maturation, regulatory change,
bankruptcy or a legal dispute like MBIA’s
battle with BofA. But unlike activist equity
managers or “loan-to-own” credit funds, GSO
doesn’t seek to change management unless
something goes wrong and it has no choice. It
wants to stay off the front pages of newspapers.The firm, which has a competitive advan-
tage by doing most of its own loan origina-
tions and investing in companies that are
No. 1 or 2 in their markets, looks at about
1,000 deals every year and completes fewer
than 5 percent of those. Every Monday the
investment staff meets to go over ideas and
review the pipeline. GSO now has offices in
NewYork, London, Dublin and Houston.
GSO and Blackstone actively share infor-
mation. Ryan Mollett, a 34-year-old manag-
ing partner who joined New’s group from
BlackRock in 2011, wrote a paper late that
year asserting that the housing market had
bottomed. Blackstone’s real estate group
saw similar evidence, and BAAM expected
mortgage improvement based on resultsfrom its underlying hedge funds. As a result
of the cumulative research among the dif-
ferent Blackstone groups, private equity
bought $220 million of nonperforming resi-
dential loans, the real estate team purchased
$1.4 billion of single-family homes to lease,and GSO invested in Hovnanian. At its peak,
GSO had $475 million in hedge fund expo-
sure to homebuilders and related industries
and put out $600 million in financing across
private market vehicles.
The Capital Solutions Fund — GSO’s
rescue lending vehicle — is an object lesson
in the maturation of alternative credit. In the
old days highly cyclical companies in trouble
could sell control to a competitor, a private
equity firm or a hedge fund firm that took a
loan-to-own strategy. In all cases the companywould likely be giving up control at the bot-
tom of the market. In contrast, GSO will take
a minority stake, a seat on the board and a
debtlike investment that pays a big double-
digit coupon, but it will let management retain
control. “We decided that the banking system
is a mess globally, so let’s raise some money to
lend to more troubled private companies that
can’t tap the markets and don’t have access to
the banks,” says Ostrover.
Part of GSO’s success comes from leaving
some money on the table. Goodman states
the obvious: “No company does businesswith us because we’re such nice guys, though
we like to think we are. They do it because
they can’t get the capital otherwise.” And
many companies say GSO doesn’t scrape
every penny out of a deal. “I don’t feel like
I’m going to get my throat ripped out when
I call GSO,” says one CEO who has done
multiple deals with the company.
GSO LIKES A LITTLE, BUT NOT TOO
much, market misery. Well before the down-
grade of the U.S.’s credit rating in August
2011, GSO was busy preparing for the pos-
sibility that markets would freeze up if the
rating agencies made good on their threats. It
was keeping up-to-date in its credit work on
certain companies and identifying potential
situations for investment. “It’s really hard
for some people to be aggressive in times of
disruption because you have to do your work
beforehand,” says partner Smith.
GSO put about $5 billion of capital to
work as the markets slid after the downgrade.
For its drawdown funds alone, it committed
$3 billion to 26 companies. Its investmentsincluded City Ventures, a private home-
“It’s really hard for some people to beaggressive in times of disruption, becauseyou have to do your work beforehand.”— Tripp Smith, GSO
ALTERNATIVES
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builder in Orange County, California, now
planning to go public; EMI Music Publish-
ing; Energy Alloys, a global provider of oil
field metals; Spain’s Giant Cement Holding;
and the U.K.’s Miller Group.The firm financed Sony’s deal to buy EMI,
giving the Japanese electronics maker access
to a music catalog that included more than
200 songs by the Beatles. When Sony was try-
ing to buy EMI in the fall of 2011, it couldn’t
consolidate all the debt onto its balance sheet
without getting downgraded. Sony went to
every bank it knew, including those in Japan,
but couldn’t get a $500 million bridge loan.
The company initially approached Black-
stone’s private equity group for a $500 million
infusion of equity, but it wanted a controllingstake and Sony wasn’t about to do that. Black-
stone referred Sony to GSO, which crafted a
deal of mezzanine debt and equity warrants
in the company.
“Many investors are quite cautious when
evaluating entertainment deals — especially
institutions,” says Rob Wiesenthal, then
Sony’s CFO and now chief operating offi-
cer of Warner Music Group. “But the GSO
team immediately understood the annuity-
like cash flow streams of music publishing
and how much less volatile it is than recorded
music and less subject to the decline of physi-cal recorded media.”
Wiesenthal adds that GSO was flexible
enough to let billionaire David Geffen, also
an investor, participate in the transaction
late in the game. “David Geffen is the War-
ren Buffett of the entertainment industry,
and they understood the value of that to the
deal,” he explains. “Many investors wouldn’t
know how to approach that.”
GSO also bought the debt of Clear
Channel Communications, a private-
equity-owned media company, and led
a $1.25 billion preferred stock deal for
Chesapeake Energy so that company could
develop natural-gas production from shale
in eastern Ohio.
Current market conditions are setting
the stage for a lot of future opportunities for
GSO. Annual high-yield issuance is more
than double what it was in 2006 and 2007,
61 percent of bonds are trading at or above
their call prices, and new issuance of cove-
nant-lite leveraged loans in 2012 surpassed
the levels seen during the credit craze in the
middle of the past decade. “When the high-
yield market trades at highs, we put outless capital,” says Ostrover. “As the market
comes down, we put out a lot. Let’s face it,
if a company can tap the public markets,
they will, and they’ll get a much better deal.”
The GSO team is confident that the bright
future investors are anticipating will lose its
luster sooner or later, whether it’s because of
inaction in Washington or rumblings from
North Korea, Israel or Iran. All those cove-
nant-lite loans will be great opportunities for
GSO to step in at some point. In the mean-
time, it has cut back the pace of investments
and is going after only the most compelling
ones, in industry sectors including shipping,
metals and mining, and natural gas.
GSO has $8 billion in dry powder to put
to work when rates eventually rise and inves-tors inevitably sell at least some of the bonds
they’ve bought in recent years. In fact, the
firm is preparing to be a buyer when rates rise
and long-only mutual fund managers have
to sell bonds to meet investor redemptions.
Amid the froth GSO is now doing its prepara-
tory work for the next crisis. Though investors
seem to have set their concerns aside, GSO
maintains that Europe poses the same risks to
the global economy it always did and that rates
must rise sometime in the next four years.
Patience is the key, says Smith, addingthat GSO’s funds and compensation are
structured in such a way that staffers don’t
have to feel compelled to put money to work
in deals that don’t make sense.The group has
products that do better in different market
environments, such as its closed-end funds
and a new exchange-traded fund it recently
launched with State Street Global Advisors.
GSO is actively managing the leveraged-loan
ETF, the first of its kind.
Europe currently offers GSO the great-
est opportunities. But, as Smith says, it’s
also a great place to lose money. The high-
yield and leveraged-loan markets neverdeveloped there like they did in the U.S.
Instead, banks dominated the leveraged-
finance markets, with few institutional
buyers such as high-yield mutual funds. In
the U.S. banks provide about 30 percent of
lending, with capital markets and investors
providing the remainder. In Europe 70 to
75 percent of lending is done by banks. But
that is likely to change as banks shed assets
to deleverage and companies need capital.
Smith calls Europe a huge opportunity —
maybe a little like what Milken saw in the
1980s and DLJ in the ’90s.
But things are changing much more slowly
in Europe than they did in the U.S. Every
European country has its own business cli-
mate, union rules and regulatory system, andbankruptcy law isn’t always clear enough for
a manager like GSO to get the assurance it
needs to invest in a troubled company. Even
so, GSO has 31 investment professionals in
London, and they are doing more deals now
than the firm is doing in the U.S.
Nearly five full years after the worst of
the financial crisis, the real estate market
is finally on the mend, investors are won-
dering if homebuilders’ stocks have rallied
too far, and the outlines of the new order of
Wall Street are coming into sharper focus.The defanged banks are receding into the
background and making peace with new
regulations designed to emasculate their
balance sheets. The new power brokers in the
financial industry are money managers and
investors like GSO, which control real assets.
“There is a wealth transfer going on from
banks’ shareholders to the investors in our
funds,” says Goodman. • •
“In the era of Dodd-Frank and the
Volcker rule, GSO and others like it havemore market power than ever.”— Brian O’Neil, Robert Wood Johnson Foundation
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FEATURES JUNE 2013
Blackstone co-founder
Stephen Schwarzman
M A T T F U
R M A N
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In November 2008, just weeks after Lehman Brothers Holdings
filed for bankruptcy and the U.S. government was forced to
bail out insurance giant American International Group,
incomingWhite House Chief of Staff Rahm Emanuel famously told
a reporter that “you never want to let a serious crisis to go to waste.”
Five years after the worst financial crisis since the Depres-
sion, it seems that Blackstone Group co-founder, chairman and
CEO Stephen Schwarzman took that advice to heart. Blackstone
Group has been one of the biggest winners in the wake of the
crisis, doubling its assets under management from $90 billion to
$218 billion during the past five years. Much of that growth has
come from the 2008 acquisition of credit manager GSO Capi-
tal Partners, run by three partners who had turned Donaldson,
Lufkin & Jenrette (later Credit Suisse) into the No. 1 underwriterof high-yield debt on Wall Street. GSO gave Blackstone access to
investment strategies that would do well as the economy fell off
the cliff. Since the acquisition, GSO’s assets have grown fivefold
and rival those of Blackstone’s real estate and private equity busi-
nesses. Senior Writer Julie Segal spoke to Schwarzman recently
about the GSO acquisition, the advantage that U.S. financial
services firms now have in Europe, and the expanded role that
money managers are playing as the banks contract.
GSO has obviously been a successful acquisition for Black-
stone. How did you see it fitting into the organization?
When we started the firm in 1985 we decided to be in three
lines of business. The first and second were the M&A advisorybusiness and private equity. The third part of our strategy, which
we’re still executing on, is to go after new businesses that had to
meet a few criteria. First, it has to be a great business with terrific
expansion potential. We don’t want a lot of little businesses; we
want to be in relatively few complementary ones where we can
be the global leader. Second, we want people who are 10s on
a scale of 1 to 10. Third, the business has to make our existing
businesses stronger by bringing intellectual capital to the table
that we didn’t have.
GSO fit those criteria. GSO produces intellectual capital that
can be used throughout Blackstone and GSO leverages informa-
tion, where appropriate, that comes out of our real estate, pri-
vate equity and other groups. As the largest investor in leveraged
loans in the world, GSO gives us a unique look into what’s going
on in the credit markets. And Blackstone gives GSO access to
a lot of deals that they might not otherwise see. So, part of the
secret sauce at Blackstone is that we can create and harvest intel-
lectual capital and insights across all four of our major investing
businesses and our advisory business. And not just on an indus-
try basis, but geographically. We don’t need an economist to tell
us what’s happening in the world. We see it.
GSO has a very different opportunity going forward be-
cause of the smaller role banks are taking in lending to
distressed businesses. Tell us about that.
The regulatory environment has become more restrictive and
difficult for many financial institutions. And Europe in particular
now is having all kinds of problems. But it’s very difficult for
Europe to put their problems fully to bed. It will take a period
of years to do that even as the European banking system still
needs significant repair. While that’s going on, the ability of cer-
tain borrowers to obtain credit has been inhibited, which creates
opportunities for firms like GSO.
Do you think regulators will get involved in overseeing this
type of activity?
Firms like ours avoided trouble during the financial crisis by
being prudent with our investors’ money. We have to compete for
our money on the open market without the benefit of federal or
sovereign guarantees. People deposit their money with banks be-
cause they feel their money is protected not just by the financial
institution itself , but by government as well. We don’t have that.
We haven’t seen restrictions because we are operating without
any “lender of last resort” standing behind us and we don’t have
the same kind of central role in the financial system.
In many ways, it seems that Blackstone is stronger now
than before the crisis.
In some areas we have fewer competitors, so it’s good. But
the overall system has really been challenged. As you can see
in Europe, when you have very tough regulations and you have
a shrinking banking system, it’s very difficult to get economic
growth. Virtually anyone would tell you that. How do you grow
if you can’t get money? A negative growth environment creates
other political problems. It’s complex, of course.
What are the implications for Blackstone?
One of the advantages that we have is that the American fi-
nancial institutions are in much better shape than the European
ones. What you’re starting to see is a normal pattern where firms
like ours go to non-U.S. locations and our banks tend to follow.
We can get financing where domestic people can’t. It provides acompetitive advantage for which we have to thank [former Trea-
sury secretary] Tim Geithner for doing a good job putting the
U.S. banking system in a better position with the stress tests and
capital raising.
Now the U.S. banking system is under-lent. Look at the
massive amounts of cash on corporate balance sheets. Banks
wouldn’t lend in 2008-2009, so corporations essentially created
their own banks, doing debt deals and keeping the proceeds on
their balance sheet. That money had no purpose other than giv-
ing corporations a reason not to call their bank. That’s good for
us, whose job it is to buy companies, buy real estate and do other
types of investments. So, it’s actually turned out to be not so bad,
as they say.
Blackstone’s StephenSchwarzman onNot Wasting aSerious Crisis
Following the 2008 financial crisis,
Blackstone Group chairman and CEO
Stephen Schwarzman used the acquisition
of GSO Capital to diversify the alternative
asset management firm’s businesses and
help more than double its assets.
By Julie Segal
R p i t d f th J 2013 i f I tit ti l I t M i C p i ht 2013 b I tit ti l I t M i All i ht d