Ahead of the Curve (24 page)

And the juicing opportunities just keep on coming. Now you have bought your company, which up until recently was quietly going about its business making lots of cash and avoiding taking on debt. You take the debt you incurred and dump it onto your acquisition. If possible, you then take even more debt and pay yourself a large management fee. If at all possible, this will equal or exceed the amount of cash you yourself put into the deal. Already you have recouped your investment. Piling debt onto some poor company carries the innocuous term “leveraging the balance sheet.”

For the acquired company, the horror show is just beginning. Your sole focus now is to generate cash to keep up those interest payments. Such discipline, your investors will keep telling you from their lavish offices in New York, is vital to success. It will result in a better-run, more profitable company that two or three years down the line can be sold at a huge profit. First, you strip your headquarters down to its bare essentials, removing any perks or visible signs of comfort. You gut your health plan and sack loyal employees so as to keep up with those crushing interest payments. Then along comes a team of consultants from your private equity investor, sharp-suited number crunchers booked into the local Four Seasons, who tell you to keep turning the ratchet. Those who do so, they promise, will be handsomely rewarded—this is known as “aligning the interests of management and investors.” But all it really means is forcing management to be loyal first and foremost to its equity holders—no matter that those equity holders plan to be in and out of their investment within a few years.

The humiliation is compounded when your company receives a bill from the private equity firm charging you for its consulting services. If you don’t have the money to pay, they might suggest, how about taking on some more debt? It’s cheap, after all. The government pays for a chunk of it by allowing you to charge interest as an expense. And it will enhance the returns on equity.

“But I’ve fired everyone I can fire!” the manager screams. “I’ve moved from our lovely old offices to this soul-wrecking office park. No one in my town talks to me anymore. I’ve outsourced everything humanly possible to China. There is nothing left but the trickle of cash, no life, no humanity, no higher purpose.”

“Mission accomplished. Time to sell,” says the man in rimless spectacles in his office overlooking Central Park.

Now the “improved” company is floated on the stock exchange. The private equity investor recouped his original investment months ago, perhaps even doubled it in fees and financial chicanery. And now he gets another bite. The market now regards the company as “turned around”— more efficient, trimmed of fat and waste, and ready to grow again. If the investor bought it for $1 billion and can sell it for $3 billion, the $2 billion is all his, plus, of course, his original equity investment. Even better, the tax rate on returns from private equity investment is lower than the standard corporate tax rate. Is it any wonder so many want to be in this business?

Private equity had created a form of accelerated capitalism that brings us back to the problem laid out by Milton Friedman and Charles Handy. The private equity model can serve investors very well, and in the best cases it can make companies much more efficient and valuable. But the drift of so much power into the hands of those who control the large private equity investment funds leaves companies and the communities where they exist prey to individuals who care for them only as economic machines. The social role of companies is diminished. The private equity investors can retire to their apartments in Manhattan trusting in the capitalist machine to make everything right but without having to deal with the day-to-day consequences of their actions. It is very different from when a factory owner has to face his workers every day. The fact that so many Harvard MBAs have succeeded in private equity and so many more want to go into it makes the issue pertinent. Where are the leaders and difference-makers in private equity? What conscience do they bring to their work? What balance do they see in their roles as economic and social actors?

Two giants of private equity came to campus to speak within a few days of each other and were rapturously received. The first was David Rubenstein, who cofounded the Carlyle Group in 1987. Since then, Carlyle had invested more than $50 billion of its investors’ money in companies around the world. The second speaker was Steve Schwarzman, founder and CEO of the Blackstone Group and probably the man most of my class would one day like to be.

Rubenstein looked like any other Wall Street elder statesman, in a blue pinstriped suit and owlish tortoiseshell glasses. But the moment he spoke, he revealed a droll, self-deprecating wit. The difference between corporate leaders and those who start their own businesses, I had observed, was startling. The latter come across as so much smarter and independent-minded, so much less prone to platitudes, so much more comfortable in their own skins. There seems to be an anarchic streak in anyone who has taken a real risk in his life. And even when it has to burn its way through a pinstriped suit, it shows.

The entrepreneurs who came to campus—from hedge fund pioneers such as Richard Perry; to Barry Diller, the media baron and founder of IAC; to Paul Orfalea, the founder of Kinko’s—seemed to be both enamored of their own skills and hard work and appreciative of the luck it had taken for them to succeed. Despite being dogged, competitive Darwinian types, they were more understanding of the world and its insanity, somehow more forgiving. They reminded me of generals who had experienced war, while all the corporate stiffs and consultants and lawyers and bankers were like the politicians who sent men into battle, with no grasp of the consequences.

I mention all this in the context of Rubenstein because he was so unexpected. It was easy to spot the entrepreneur when he arrived wearing a fleece pullover and jeans, and drinking coffee from a recyclable cup. But Rubenstein had never shaken the sartorial habits and manner of the Washington lawyer he once was. Within a few years of leaving law school, Rubenstein was working for candidate, and then president, Jimmy Carter. “When I started working for him in the 1976 campaign, he had a thirty-three-point advantage in the polls. By the time of the election, I’d turned the vote into a cliffhanger.” Once in the White House, Rubenstein said he would stay later than everyone else to make sure his memos were at the top of Carter’s in-box when he arrived in the Oval Office the next morning. His diligence, however, couldn’t do anything to save the Carter administration as it battled a deep economic slump. After leaving politics, Rubenstein practiced law for a while until he spied a far greater financial opportunity.

Most industries have their creation myths, from Alexander Graham Bell and the telephone to Larry Page and Sergey Brin building the prototype for Google in the Stanford computer department. The private equity industry was fathered by an intemperate old banker and former Treasury secretary, William Simon. In 1982, Simon and a partner, Raymond Chambers, purchased the Gibson Greetings Card Company from RCA. The price was $81 million. Simon and Chambers put in $1 million in cash, borrowed $53 million, and paid for the rest through a scheme whereby Gibson sold much of its property and then leased it back. This was a case of extreme leverage, but Simon knew what he was doing. RCA was keen to unload the company in order to concentrate on its other businesses. The stock market was about to emerge from a prolonged slump. And there were efficiencies to be wrung out of Gibson. A mere eighteen months later, Simon and Chambers floated Gibson on the stock market with an IPO (initial public offering), raising $290 million. Simon had turned his personal investment of $330,000 into a holding worth $70 million.

Returns like that never go unnoticed. Rubenstein was soon scrambling to raise money and, more important, to find companies to buy. Carlyle’s specialty has been finding value in difficult situations, often using high-ranking political connections to lubricate deals. When he spoke to us everyone was obsessed with India and China, but Carlyle was already scouting out virgin territory in Africa.

The reason Rubenstein had come to Harvard, however, was not to titillate business school students with talk of extraordinary returns. He had funded a building at the Kennedy School of Government and had crossed the river to offer us some advice on building careers that straddled business and government. When it comes to business and government, he believed “you can have your cake and eat it.” There were two ways to do this. Either you started in government very young and then moved into business, or you made lots of money and then went into government. The useful thing about private equity, Rubenstein said, is “that you are highly compensated if you are reasonably successful. And even if you’re not that good, you’ll probably still make a fair amount of money, and with money comes freedom.” And with freedom, he added, came the opportunity to do interesting things.

To his credit Rubenstein seemed generally unfazed by the industry that had made him so rich. Government, he said, had a far greater impact on the lives of others. “I had way too much of an impact at the age of twenty-seven.” In answer to the inevitable question about what qualities he sought in a job candidate, he said, “a reasonable degree of intelligence, a strong work ethic, the ability to get along with others, a desire to build something important, the ability to keep one’s ego in check.” His most important piece of career advice, though, was even simpler: “be a principal or a decision maker, not a service provider.” Principals make all the money. They can turn the cell phones off on weekends. They are the ones for whom everyone else runs around. They possess the grail: control over their time.

Steve Schwarzman grew up in the suburbs of Philadelphia, where his father ran a dry goods store. He attended Yale as an undergraduate, where he was elected to the Skull and Bones society the year after George W. Bush. Both men later attended Harvard Business School. After obtaining his MBA, Schwarzman headed to Wall Street, where he rose to be head of the mergers department at Lehman Brothers. In the mid-1980s, the firm was ripped apart by competing factions, and Schwarzman left with his fellow banker, Pete Peterson, to set up Blackstone. While many financiers shy away from publicity, Schwarzman courted it. He lived in a palatial apartment on Park Avenue, attended society events, and reveled in his status.

He came back to HBS to be interviewed by Charlie Rose for PBS. Sitting in his pinstriped suit—his shoulders hunched, his head poking out of the white collar of his striped shirt like a turtle’s, looking as if it might disappear down into his torso at any minute—he clasped his hands in front of him. His features conveyed a sneaky playfulness, as if he had planted a whoopee cushion somewhere and was waiting for it to go off.

As a young man, he said, he went to visit his fellow Skull and Bones man Averell Harriman, a railroad heir who became a prominent diplomat. “I came from a normal, middle-class sort of upbringing,” he said, speaking softly, making his points with slight, tidy hand gestures. “I was looking for role models. It was a political time, and Harriman was handling the Paris peace talks. He asked me, ‘Young man, are you independently wealthy?’ I said no. ‘Well, that will make a great difference in your life. If my father weren’t E. H. Harriman, chairman of the U.S. Pacific Railroad, you wouldn’t be sitting here talking to me.’ He basically said you really ought to go and make some money.” It was a version of Rubenstein’s claim that with money came freedom and the opportunity to do more interesting things. If you wanted to have footmen and beautiful paintings and smart people to lunch, you needed money. If you wanted to cruise down Park Avenue in a limousine surrounded by the chatter of deal-making and the thunder of power crashing in great waves around you, only money would get you there. Once cushioned by your great fortune, you could then devote yourself to pursuits such as politics and diplomacy, the work of statesmen.

When Schwarzman started Blackstone, he suffered the agonies of anyone going their own way in business. “You have to really like pain and suffering,” he said. “Just because you start and make an announcement and assume they’ll come, they don’t come. Even if you sell, they don’t buy. Nine out of ten businesses that are started fail. If that’s the statistic, you know it’s not working for you. So to get from zero to some element of significant success, defined by yourself, you have to be exceptionally resilient.”

It took him until his nineteenth meeting to find anyone who would invest money in Blackstone. It was the head of an insurance company’s investment fund, who pledged him $100 million over a tuna sandwich. Since then, Blackstone had invested more than $80 billion of investors’ money. “When you do things in life that have a good feeling,” Schwarzman says, “they tend to work out well, rather than having a great strategic plan.” The trick, of course, is actually trusting that good feeling in the face of a barrage of artfully constructed PowerPoint slides explaining why you’re crazy.

Asked to explain his business, Schwarzman said, “We raise large amounts of money . . . and then we buy companies. Then we borrow three dollars for every dollar of equity in the deal.” He compared the search for companies to buy to dating. A lot of different factors lead to success. Part of it is figuring out how fast a company can grow and what can be done to assist that growth. And then there is the financing. How much debt could be loaded onto the company? How far could the operations be squeezed? To understand all of this, Schwarzman said, you need a combination of sharp analytical skills and a keen instinct for what will and won’t work, where you are in an economic cycle and, as he put it, “what’s gonna get you into trouble.” He compared his business to basketball, where the skill is not just repeatedly putting the ball in the hoop from one point on the court but, rather, being able to score from all over the court, being guarded by different people of different sizes and skills. Then, of course, there’s hard work, empathy, and “having a sense of where the world is going next.”