LENDERS of LAST RESORT

JUNE 2013 INSTITUTIONALINVESTOR.COM

GSO’s Bennett Goodman

LENDERS of LAST RESORT BY JULIE SEGAL UNDER BLACKSTONE’S OWNERSHIP CREDIT SPECIALIST GSO CAPITAL HAS GROWN FIVEFOLD, EMERGING AS A TOP SOURCE OF FUNDING FOR STRUGGLING COMPANIES.

PHOTOGRAPHS BY MATT FURMAN

Tripp Smith is happy to leave the spotlight to fellow GSO co-founder Bennett Goodman and instead focus on doing deals GSO’s Douglas Ostrover ALTERNATIVES

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 sell to 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 market was underestimating our ability to succeed in a space — housing — 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 Ara Hovnanian, CEO of Hovnanian Enterprises, knew little about year since 2006 (see CEO Interview, page 48). Hovnanian was the AGSO Capital Partners before the credit-oriented alternative asset largest position in GSO’s flagship hedge fund in 2012, and the firm manager offered the struggling homebuilder a lifeline last year. made 50 percent on its capital in six months. Douglas Ostrover, the “O” in GSO, invited him to lunch at Manhat- GSO has provided much-needed credit to scores of troubled tan’s Core Club in July 2012, just as the U.S. housing market was companies like Hovnanian that couldn’t tap public markets or get showing a few signs of life. The then-54-year-old CEO figured he bank loans. The firm has financed well-known names like Chesa- had little to lose by listening to Ostrover’s pitch. His company had peake Energy Corp., struggling with weak natural-gas prices and been bleeding money for six years and had used up every penny of controversy around its ex-CEO and needing capital to develop its capacity to issue secured debt. With no bank willing to lend to it, lucrative energy projects, and Sony Corp. while also providing the Red Bank, New Jersey–based homebuilder had become a target $650 million of capital to smaller homebuilding companies like the for short-sellers; investors were betting billions of dollars in credit U.K.’s Miller Group and $888 million to companies in Europe last default swaps that the company Hovnanian’s father and three uncles year, including Canberra Industries, Welcome Break and EMI Music had founded in 1959 would go belly-up. Hovnanian, who had lived Publishing. As one of the largest creditors of MBIA and holders of through several real estate cycles, was shocked when Ostrover told its equity, GSO had a big win last month when the Armonk, New him the price of the five-year CDS contracts on Hovnanian implied a York–based provider of municipal bond insurance finally settled a 93 percent probability of default. “The market is saying you’re going dispute with Bank of America Corp. after years of wrangling over bankrupt,” Ostrover added. troubled mortgage-backed securities. GSO, which is owned by private equity giant Blackstone Group, “In the old days a bank might have been more willing to commit its had spent six months digging into the finances of Hovnanian and balance sheet for long-standing clients,” says Bennett Goodman, the had been buying up its equity, secured debt and unsecured debt since 56-year-old “G” in GSO, who started his career at Drexel Burnham March. Ostrover, now 50, who helped build the leveraged-finance Lambert in the 1980s. “Because of the regulatory environment, it’s business at investment bank Donaldson, Lufkin & Jenrette during harder for them to do that economically. As a consequence, banks the 1990s, explained his idea for solving Hovnanian’s liquidity problems. The company would sell its property inventory to a land bank created by GSO in return for a $125 million cash infusion. Over time “In the old days a bank might GSO would sell the land back to the homebuilder. Ostrover asserted have been more willing to that not only would the market react positively to the initial financing but that the GSO-Blackstone brand would signal that there could commit its balance sheet for be more behind it. “Look, the market hates your company,” he told long-standing clients. Because Hovnanian. “We love your company.” of the regulatory environment, (Ostrover had his own hard-luck family bankruptcy story: His it’s harder for them to do that.” grandfather had to shutter Ostrover’s Smoked Fish on New York’s — Bennett Goodman, GSO Capital Partners Lower East Side in the 1950s following a blackout; he couldn’t pay his creditors because his customers’ fish had rotted.) want to syndicate risk into the market — put together a road show Hovnanian, for his part, was not convinced that the market would and talk to 200 investors. But they don’t want to commit their capital. react as positively as Ostrover suggested. “If you’ve been out in the We, on the other hand, want to own the risk.” battlefield for seven years, being shot at constantly, you don’t know GSO founders Goodman, Ostrover and Tripp Smith have what to do if the bullets stop flying,” he told Ostrover, who left the emerged as lenders of last resort, filling the gaping financing void lunch uncertain whether the CEO would agree to his plan. left by banks and opportunistic hedge funds in the wake of the It took a week before Hovnanian softened, but GSO got its deal. 2008–’09 financial crisis. The firm follows in the footsteps of Drexel Indeed, when Hovnanian announced the land banking deal on July and Michael Milken, who in the 1980s invented the junk bond market for non-investment-grade companies. In the 1990s, GSO’s GSO co-founder Douglas Ostrover made the pitch to Hovnanian three founders, then working for Hamilton (Tony) James at DLJ, ALTERNATIVES

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, including energy exploration and homebuilding. If Drexel came up with the junk bond and DLJ created the institutional leveraged-finance market, 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 them from 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 Blackstone co-founder Stephen Schwarzman (left) and of GSO’s first investors. president Hamilton (Tony) James wooed GSO’s principals for Banks may no longer have the balance sheets, but big institutional several years before buying their firm in January 2008 investors like sovereign wealth funds, endowments and pension funds do. To be sure, Blackstone is not the only manager to have $500 million in mezzanine investments and a $4.8 billion collateral- smelled opportunity in the financing void. Depending on the prod- ized loan obligation business. The deal wouldn’t have happened uct, GSO has a host of competitors, including Apollo Group Man- without Goodman, Smith and Ostrover’s former boss, Tony James, agement; Ares Capital Corp. (an Apollo spin-out); Avenue Capital who had joined Blackstone as president in 2002 after Credit Suisse Group; Carlyle Group; Goldman, Sachs & Co.; J.P. Morgan Asset bought DLJ and who manages the firm’s day-to-day operations. “This Management’s Highbridge Capital Management; KKR & Co.; was more like a family reunion than an acquisition,” says Schwarzman. Oaktree Capital Management; and TPG Capital. “Credit to Steve, he really trusted me on this one,” adds James, James Coulter, co-founder of private equity firm TPG, says the who says Blackstone was looking for an area of asset management opportunity is much more attractive for managers and investors now with room to grow that would complement its existing private equity, that banks — which threw cheap money from depositors at troubled real estate and fund-of-hedge-funds businesses. “What was a wide- companies’ financing problems and pocketed the profit — are not open white space for us? Credit jumped off the page.” in the mix. “There is a place for capital formation at market rates of With $58 billion in assets under management and 235 employees, return and driven by problem solvers,” explains Coulter. “It’s alter- GSO has grown fivefold under the Blackstone umbrella. Today it offers native credit growing up. It’s not the Wild West, not the personality- $27 billion in alternative-investment funds, including the now $4 bil- driven days of 20 years ago. And this is good for the economy.” TPG lion hedge fund, $8 billion in mezzanine funds — financing buyouts for launched its own midmarket lender after the financial crisis and has private equity — $8 billion in rescue lending and $7 billion in small-cap both competed and partnered with GSO. direct lending. The firm’s long-only strategies include a $24 billion Goodman, Smith and Ostrover founded GSO in 2005 to provide CLO business, making GSO the largest institutional investor in lever- capital to non-investment-grade cyclical companies that were going aged loans, as well as closed-end and other funds. Goodman is quick through a tough patch but had tangible assets to put up as collateral to credit the Blackstone brand for at least part of GSO’s success. “If to protect the firm’s downside when it lent them money. GSO was an we were Schmeckle & Schmeckle or just stand-alone GSO, there’s no early investor in the shale gas industry, which has been whipsawed by way the board of Sony or some of these other companies would have volatile pricing and other events. “They have a zealous approach to gone along with some no-name firm,” he explains. protecting capital, and they’ve found a way to extend credit to orga- GSO’s returns have been top quartile. According to external mar- nizations that need it and structure it in a way that takes advantage keting documents, its hedge fund has delivered a net annualized return of the environment at the time,” says Blackstone chairman, CEO of 13.6 percent since January 2010, compared with the HFRI Fund and co-founder Stephen Schwarzman. Weighted Composite’s return of 4.6 percent for the same period. In 2008, Blackstone, looking to diversify, paid $1 billion to (Though the hedge fund was launched in 2005, GSO has since acquire GSO, which then had a $3.2 billion credit hedge fund, stripped out mezzanine and other investments into separate funds.) 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 was constantly 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 1983 that 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, The firm’s mezzanine fund has one of the best records in the industry, married capital to ideas and was profoundly transforming whole up an average of 19.9 percent a year net since inception in July 2007. industries. “I fell for it hook, line and sinker,” says Goodman. “I love the Rescue lending has returned an annualized 15.2 percent since incep- underdog.” While his friends at Harvard — including one he describes tion in September 2009. “The GSO team has been through the ups as having had pinstripes on his diapers — did summer internships at and downs of numerous credit cycles, and they’re always worried and Wall Street’s toniest firms, Goodman took a job with Drexel. trying to protect the downside,” says Timothy Walsh, chief investment There Milken was leading what’s now called the democratiza- officer of the $74 billion New Jersey Pension Fund, which has com- tion of capital-raising, providing funding to small and medium-size mitted to $1.1 billion in investments in five GSO funds. companies that were starved for financing and whetting the appetites Blackstone’s acquisition of GSO has been an undisputed winner. of investors for distressed and troubled companies that showed GSO represents 26.6 percent of the firm’s $218 billion in assets, on promise despite short-term woes. In the process, Drexel helped spark 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 “The GSO team has been percent of Blackstone’s $629 million of realized performance fees through the ups and downs of 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 numerous credit cycles, and fees, private equity contributed the bulk of the total. Between 2005 they’re always worried and and 2012, GSO’s assets grew at a compounded annual rate of 29 trying to protect the downside.” percent. That makes GSO Blackstone’s fastest-growing business — Timothy Walsh, New Jersey Pension Fund in terms of both earnings and assets. Executives at two publicly traded alternatives firms say they aren’t so much concerned about an unprecedented era of prosperity in the U.S. as companies like Ted Blackstone as a competitor in private equity but that they’ve been Turner’s Turner Broadcasting System, Craig McCaw’s McCaw blindsided by GSO’s growth. Though hurt by the financial crisis, Cellular Communications and William McGowan’s MCI Com- Blackstone and GSO have emerged as dominant players in its munications Corp. rapidly expanded by using this newly available aftermath. Since 2008, Blackstone has more than doubled its assets. source of capital. Junk bonds also fueled the leveraged buyouts of At the same time that GSO is capitalizing on the void left by banks, the 1980s, when firms like KKR targeted companies that had once it is also benefiting from historically low interest rates and unrelent- turned deaf ears to shareholder demands. ing investor demand for credit investments. While non-investment- After earning his MBA in 1984, the Miami-born Goodman took grade companies need capital, investors need yield, and alternative a full-time job with Drexel in New York. He spent five years there, credit strategies like those offered by GSO provide a much-needed toiling on ten to 12 deals a year — all of them different — in a culture boost to returns for bond portfolios. “Now the emergence of alterna- that rewarded Street smarts and a maniacal work ethic. Drexel was ALTERNATIVES

a place where analysts spent days buried in In early 1988, Goodman started building In 1993, Goodman hired Smith from the dense financials of dicey companies. The the capital markets business at DLJ under Salomon Smith Barney, where he worked on firm honed the skills needed to look at an Moran and James. At that time, Drexel had restructurings. Smith had joined Salomon ugly financial situation and determine the a lock on the business. Take the “highly con- from Drexel, leaving with a group during the commercial viability of a financing for both fident letter,” a piece of paper Drexel would bankruptcy. Two years out of the University the companies and investors. In contrast to issue to the board of a company as a promise of Notre Dame, he witnessed firsthand the the few traditional deals a year that a junior that it would provide financing on deals.When toll Drexel’s failure took on senior managers banker at Goldman might work on, Good- DLJ tried issuing its own highly confident let- whose wealth had been tied up in its stock. man cut his teeth on such unusual transac- ters, they meant nothing, as DLJ had a small Smith is the third generation in his Indianapo- tions as KKR’s investment in Union Texas balance sheet. So the firm created the bridge lis Irish family to graduate from the Catholic Petroleum Holdings in 1985 and Maxam’s loan, not promising capital but intended to university; two of his four kids are currently 1986 takeover of Pacific Lumber Co. For tide the company over until it could obtain studying there. the latter he and Joshua Friedman, then permanent financing. “On the strength of Goodman and Ostrover joke that Smith head of the capital markets group at Drexel, that bridge loan business, we built ourselves was responsible for DLJ’s success. The year he came up with a term sheet for a zero-coupon up into the leading firm,” says James. joined, the firm became the No. 1 underwriter increasing-rate note whose complexity and In September 1988 the Securities and for high-yield bonds, a distinction it would model they still laugh about. Exchange Commission sued Drexel for keep for 12 years. Drexel had unwittingly In 1987 the Los Angeles–based Milken insider trading and stock manipulation. The passed the high-yield baton to DLJ. Though called Goodman, who by this time focused on following March, Milken was indicted for the three founders couldn’t be more different, LBOs, telling him he should move to Beverly racketeering and securities fraud. In Febru- they’ve maintained their partnership without Hills and work for Friedman (who would ary 1990, Drexel filed for bankruptcy; two a blip for 20 years. Goodman is the storyteller go on to co-found hedge fund firm Canyon months later Milken pled guilty to lesser of the group, Ostrover is Mr. Markets, and Capital Advisors). But after his wife, Meg, charges, agreeing to pay a $600 million fine Smith wants to stay out of the limelight and refused to leave NewYork, Goodman quickly and serve ten years in jail. (The sentence was just do deals. Though the three are equal part- set his sights on DLJ, a midsize investment later reduced to two years.) ners at GSO, Smith and Ostrover often defer bank known for equity research and a certain With Drexel and Milken gone amid a to Goodman for the final word. scrappiness and entrepreneurial culture. recession, many market watchers thought In 1995, Moran moved up to chief operat- Garrett Moran, who ran the high-yield bond high-yield financing would die. But although ing officer of fixed income, and Goodman group at DLJ, says Goodman stalked him most Wall Street firms pulled out of the high- took over all of leveraged finance. DLJ used for six months, wanting to pitch his idea for a yield business, DLJ stayed in, doing some sec- its market position to keep reinvesting in the capital markets desk. ondary trading and working with companies firm, building a leveraged-loan capability Goodman liberally quotes from his uncle, that felt they had been abandoned. When the and creating a derivatives business and large Skip Bertman, a former head coach at Louisi- markets rebounded in 1991, DLJ took over distressed unit. The group invented concepts ana State University who has the best baseball as a leading player. such as payment-in-kind toggle bonds, with record in the National Collegiate Athletic In 1992, Goodman hired Ostrover from which an issuer can defer interest payments Association and who took an influential role Grantchester Securities, the high-yield arm in return for a larger coupon in the future, in Goodman’s life after his father passed away of boutique investment bank Wasserstein and IPO carve-outs, whereby the parent when he was five years old. Bertman, who Perella & Co., to run DLJ’s sales and trad- company sells stock of a subsidiary to the built an underdog team into a profitable leg- ing. Ostrover, who has a BA in economics public. In the late 1990s, Schwarzman, a end for LSU, told Goodman that success took from the University of Pennsylvania and an client of DLJ’s, asked Goodman to start a three “H”s: hard work (in an interview his MBA from New York University’s Leonard credit business at Blackstone. It was the first uncle calls that hustle), honesty and humility. N. Stern School of Business, was ranked the of many overtures Blackstone’s executives Hard work got him noticed at Drexel, as No. 1 salesperson by a third-party consulting would make to him. well as a meeting with Moran. But Goodman firm, and Goodman and Moran decided to It was DLJ’s limited balance sheet that shunted humility aside — at least temporarily steal him away the day the news came out. taught Goodman, Ostrover and Smith how — during his lunch with Moran. The 30-year- While Goodman loves to talk, Ostrover has careful they had to be with their credit analy- old newly minted Drexel vice president told to be pressed for details. He reveres his middle- sis and due diligence. There was little room the DLJ executive, “I’m going to help build class upbringing — first in Queens, NewYork, for error. “You had to figure things out and this big business at DLJ, and you’re going to and later in Stamford, Connecticut — and says use your smarts instead of brute strength,” get rich and famous.” Moran, who says he that when he was growing up he didn’t know Smith, 47, says. By 1999, however, DLJ was instantly liked Goodman and the wealth of anyone who worked on Wall Street. Apologiz- hamstrung by its small balance sheet and a experience he had gotten working on deals ing for the seeming hokeyness of it, he refers to business that was primarily domestic. Com- inside the Drexel pressure cooker, hired him. a black-and-white picture in his office of New petition from increasingly bigger banks was “He might have been young, but it was like York’s Orchard Street early in the past century, fierce. The world had changed, and the firm a pro coming into an amateur team,” adds with unpaved, muddy roads; pushcarts; and a needed a partner. James, who then ran DLJ’s investment bank. glimpse of Ostrover’s Smoked Fish. Credit Suisse bought DLJ for $11.5 billion in 2000 and combined the firm with its bankruptcy lawyer who had been with DLJ the Hamptons; Jamaica; Palm Beach, Florida; New York–based investment banking unit, since 1999 and worked on some of the most and Saint-Tropez. Credit Suisse First Boston. The big Swiss complex distressed deals, such as financing Credit investors, on the other hand, are bank wanted Goodman’s leveraged-finance Level 3 Communications and Qwest Com- pessimists, aware that the upside of their business as well as DLJ’s merchant banking munications, joined GSO at the start. He now investments is limited, evaluating everything and real estate groups. Though DLJ invest- manages its hedge fund. A month after its that can go wrong in an effort to protect their ment banking staffers left in droves after the launch, GSO hired Donald (Dwight) Scott, principal. Credit geeks Goodman, Ostrover deal — including James, though he stayed who ran the energy practice at DLJ before and Smith nonetheless went to Blackstone’s two years as part of the merger agreement — joining El Paso Corp. in 2000. Houston- extravagant road show at New York’s Pierre Goodman, Smith and Ostrover flourished. based Scott oversees GSO’s energy group. hotel in the spring of 2007, the first time Even before James left CSFB, he and Good- In 2007, Merrill Lynch & Co. took a that granular detail about the private equity man talked about going off on their own. After minority stake in GSO and the firm had its firm was available to the public. The trio had James joined Blackstone, Goodman took over first closing for a new mezzanine fund. But remained close to James after he left DLJ for CSFB’s alternative capital division. Shortly its deals remained small, providing funding Blackstone, and they knew he was interested thereafter Ostrover assumed responsibility for companies like Pacific Lumber and Caffè in striking some type of deal. During the road for leveraged finance and Smith joined Good- Nero, a U.K. coffeehouse chain. Though show, Blackstone disclosed its numbers, show- man in the alternatives group. What the three it was satisfying to be on their own, Good- ing heft in private equity, real estate and funds founders have built at GSO, they originally man, Ostrover and Smith were used to being of hedge funds, but credit was an afterthought, planned for CSFB. No. 1 and having a big firm behind them. But amounting to only about $5 billion in assets. At But in June 2004, John Mack, then CEO things were changing, and they would get the same time, Blackstone had relationships of CSFB in the U.S., announced he was leav- their chance soon. with almost every major institutional investor ing; the Credit Suisse board had decided not in the world, a group that had, on average, to renew his contract. It was a good time for WHEN ASKED ABOUT HIS DECISION $200 million in assets invested with the firm. Goodman, Smith and Ostrover to start their to switch from the sell side to the buy side, GSO’s investors, by contrast, had a paltry own firm. By that July the three partners Goodman says his only regret is that he $22 million invested with Goodman, Ostrover had launched GSO with 25 employees and didn’t make the move ten years earlier. and Smith. GSO was also overly dependent one hedge fund. The firm had purchased Though he loved working on Wall Street, on Merrill Lynch and Credit Suisse, both of a small CLO group, run by Daniel Smith, particularly at DLJ, Goodman wanted to which were starting to feel pressure in the early from Royal Bank of Canada. Smith, who spend all his time investing. “At a bank you’re days of the subprime crisis. Any deal would hinge on James, who was revered by GSO’s three founders. That sum- “Blackstone allowed us to take our mer James approached Goodman — the business from being three years old fourth time Blackstone had tried to entice to ten overnight.” him into a deal — and stated the obvious: — Douglas Ostrover, GSO “In credit we’re not where we want to be. We want to buy you.” After six months of negotiations, Good- had been co-head of high-yield group among working for anonymous shareholders, try- man and his partners said yes. Although other positions at Van Kampen Investments, ing to make as much money as you can,” he they enjoyed being their own bosses, they now runs GSO’s customized credit strate- explains. “It’s amorphous, and you don’t missed the prestige, and the deals, that came gies, including CLOs, closed-end funds and know the people. It’s a different kind of sat- with being part of a big organization. With Franklin Square Capital Partners, its small- isfaction walking into the CIO’s office for the Blackstone they would get scale, a brand, cap direct lending group. Bass brothers.” idea-sharing with the firm’s deal makers On day one Credit Suisse gave the firm A deal between Blackstone and GSO, how- and access to new and larger clients. Smith, more than $500 million to manage — a big ever, wasn’t a no-brainer. Private equity inves- who calls himself Mr. Process, was the least part of the approximately $3 billion it had tors are by nature optimistic and swaggering, enthusiastic about the tie-up, concerned raised from outside investors, including the thinking every deal is a potential blockbuster. that they were trading away their autonomy. Bass brothers, Blackstone, Cornell Univer- Blackstone’s offices on Park Avenue are noth- But the $1 billion price tag — the proceeds sity, K2 Advisors, MetLife, Notre Dame and ing short of glitzy, with unobstructed views of which the partners rolled over into GSO Quellos Group (now owned by BlackRock). of the NewYork skyline and floors connected funds — and the potential to take advantage GSO’s hedge fund invested in public securi- by grand staircases with polished metal ban- of what they thought would be a huge shift on ties, mezzanine debt and distressed debt and isters. No one has represented Blackstone’s Wall Street helped alleviate their concerns. provided some rescue lending for companies opulence more than its billionaire co-founder “Blackstone allowed us to take our busi- going through liquidity problems. Schwarzman, who in 2000 reportedly paid ness from being three years old to ten over- Fully 80 percent of GSO’s senior manage- $37 million for a 34-room triplex on Park night,” Ostrover says. ment team is from DLJ. Jason New, a onetime Avenue and has owned vacation properties in GSO and Blackstone announced the deal ALTERNATIVES

in January 2008. In addition to strengthen- ucts to managing 27. The breadth and scale of the cumulative research among the dif- ing their firm’s credit business, Schwarzman of its funds allow it to offer a range of solu- ferent Blackstone groups, private equity and James saw benefits for its private equity tions to companies, including rescue financ- bought $220 million of nonperforming resi- operation. “Having a better understanding ing and senior secured bank loans. At the dential loans, the real estate team purchased of credit markets, having a better idea of same time, the platform gives it a lot of differ- $1.4 billion of single-family homes to lease, how we could finance a creative idea, would ent eyes into potential investments. GSO has and GSO invested in Hovnanian. At its peak, make us better in private equity,” says James. a view on about 1,000 companies through its GSO had $475 million in hedge fund expo- “GSO was very synergistic and comple- CLO business, garnering leads that can be sure to homebuilders and related industries mented our other businesses well.” passed on to the hedge fund or other vehicles. and put out $600 million in financing across The honeymoon was over quickly, Investments can also be shared. The Hovna- private market vehicles. though. As 2008 wore on and the credit nian deal was originated through the hedge The Capital Solutions Fund — GSO’s crisis gathered steam, GSO started putting fund but later expanded to include the rescue rescue lending vehicle — is an object lesson money to work. In August the group put financing fund. “We stand on this very busy in the maturation of alternative credit. In the up $1 billion in equity to buy a portfolio of street corner and see all this activity,” says old days highly cyclical companies in trouble busted bridge loans from Deutsche Bank, customized credit strategies partner Daniel could sell control to a competitor, a private with the German bank providing 3-to-1 Smith. Under Blackstone, GSO has the heft equity firm or a hedge fund firm that took a leverage. The approximately $4 billion to write big enough checks to fully finance a loan-to-own strategy. In all cases the company portfolio was distributed across GSO’s solution, reducing a company’s need to find would likely be giving up control at the bot- own funds as well as Blackstone’s private additional capital elsewhere. tom of the market. In contrast, GSO will take equity portfolios. The next month Lehman GSO’s flagship hedge fund takes an activist a minority stake, a seat on the board and a Brothers Holdings filed for bankruptcy or event-driven approach to credit. New’s debtlike investment that pays a big double- and all hell broke loose. Loan prices team looks for companies going through digit coupon, but it will let management retain dropped 30 points, obliterating almost the some sort of upheaval, such as a covenant control. “We decided that the banking system entire investment — at least on paper. The breach, debt maturation, regulatory change, is a mess globally, so let’s raise some money to Deutsche Bank portfolio was marked to bankruptcy or a legal dispute like MBIA’s lend to more troubled private companies that about 5 cents on the dollar for the quarter battle with BofA. But unlike activist equity can’t tap the markets and don’t have access to ended March 31, 2009. GSO had part- managers or “loan-to-own” credit funds, GSO the banks,” says Ostrover. nered with TPG to buy a $2 billion port- doesn’t seek to change management unless Part of GSO’s success comes from leaving folio of bridge loans from Citigroup. That something goes wrong and it has no choice. It some money on the table. Goodman states also plummeted in value. wants to stay off the front pages of newspapers. the obvious: “No company does business As it turned out, GSO had done thor- The firm, which has a competitive advan- with us because we’re such nice guys, though ough credit analysis and structured the tage by doing most of its own loan origina- we like to think we are. They do it because debt appropriately, and it made 1.5 times its tions and investing in companies that are they can’t get the capital otherwise.” And investment in two years, with every company No. 1 or 2 in their markets, looks at about many companies say GSO doesn’t scrape paying off its debts. “Writing something 1,000 deals every year and completes fewer every penny out of a deal. “I don’t feel like down to zero is not your proudest moment,” than 5 percent of those. Every Monday the I’m going to get my throat ripped out when I call GSO,” says one CEO who has done multiple deals with the company. “It’s really hard for some people to be aggressive in times of disruption, because GSO LIKES A LITTLE, BUT NOT TOO much, market misery. Well before the down- you have to do your work beforehand.” grade of the U.S.’s credit rating in August — Tripp Smith, GSO 2011, GSO was busy preparing for the pos- sibility that markets would freeze up if the Goodman says. But by the end of 2009, the investment staff meets to go over ideas and rating agencies made good on their threats. It firm had $24 billion in assets. review the pipeline. GSO now has offices in was keeping up-to-date in its credit work on After the market bottomed in 2009, NewYork, London, Dublin and Houston. certain companies and identifying potential GSO launched its first rescue lending fund, GSO and Blackstone actively share infor- situations for investment. “It’s really hard which closed at $3.3 billion. The next year mation. Ryan Mollett, a 34-year-old manag- for some people to be aggressive in times of it acquired nine CLOs from Allied Capital ing partner who joined New’s group from disruption because you have to do your work Corp., and a year later it bought Harbour- BlackRock in 2011, wrote a paper late that beforehand,” says partner Smith. master Capital Management, a $10 billion year asserting that the housing market had GSO put about $5 billion of capital to European leveraged-loan manager, and four bottomed. Blackstone’s real estate group work as the markets slid after the downgrade. CLOs from Allied Irish Bank. saw similar evidence, and BAAM expected For its drawdown funds alone, it committed In its five years in the Blackstone fold, mortgage improvement based on results $3 billion to 26 companies. Its investments GSO has gone from having two fund prod- from its underlying hedge funds. As a result included City Ventures, a private homebuilder in Orange County, California, now their call prices, and new issuance of cove- ETF, the first of its kind. planning to go public; EMI Music Publish- nant-lite leveraged loans in 2012 surpassed Europe currently offers GSO the great- ing; Energy Alloys, a global provider of oil the levels seen during the credit craze in the est opportunities. But, as Smith says, it’s field metals; Spain’s Giant Cement Holding; middle of the past decade. “When the high- also a great place to lose money. The high- and the U.K.’s Miller Group. yield market trades at highs, we put out yield and leveraged-loan markets never The firm financed Sony’s deal to buy EMI, less capital,” says Ostrover. “As the market developed there like they did in the U.S. giving the Japanese electronics maker access comes down, we put out a lot. Let’s face it, Instead, banks dominated the leveraged- to a music catalog that included more than if a company can tap the public markets, finance markets, with few institutional 200 songs by the Beatles. When Sony was try- they will, and they’ll get a much better deal.” buyers such as high-yield mutual funds. In ing to buy EMI in the fall of 2011, it couldn’t The GSO team is confident that the bright the U.S. banks provide about 30 percent of consolidate all the debt onto its balance sheet future investors are anticipating will lose its lending, with capital markets and investors without getting downgraded. Sony went to luster sooner or later, whether it’s because of providing the remainder. In Europe 70 to every bank it knew, including those in Japan, inaction in Washington or rumblings from 75 percent of lending is done by banks. But but couldn’t get a $500 million bridge loan. The company initially approached Black- stone’s private equity group for a $500 million “In the era of Dodd-Frank and the infusion of equity, but it wanted a controlling Volcker rule, GSO and others like it have stake and Sony wasn’t about to do that. Black- stone referred Sony to GSO, which crafted a more market power than ever.” — Brian O’Neil, Robert Wood Johnson Foundation deal of mezzanine debt and equity warrants in the company. “Many investors are quite cautious when North Korea, Israel or Iran. All those cove- that is likely to change as banks shed assets evaluating entertainment deals — especially nant-lite loans will be great opportunities for to deleverage and companies need capital. institutions,” says Rob Wiesenthal, then GSO to step in at some point. In the mean- Smith calls Europe a huge opportunity — Sony’s CFO and now chief operating offi- time, it has cut back the pace of investments maybe a little like what Milken saw in the cer of Warner Music Group. “But the GSO and is going after only the most compelling 1980s and DLJ in the ’90s. team immediately understood the annuity- ones, in industry sectors including shipping, But things are changing much more slowly like cash flow streams of music publishing metals and mining, and natural gas. in Europe than they did in the U.S. Every and how much less volatile it is than recorded GSO has $8 billion in dry powder to put European country has its own business cli- music and less subject to the decline of physi- to work when rates eventually rise and inves- mate, union rules and regulatory system, and cal recorded media.” tors inevitably sell at least some of the bonds bankruptcy law isn’t always clear enough for Wiesenthal adds that GSO was flexible they’ve bought in recent years. In fact, the a manager like GSO to get the assurance it enough to let billionaire David Geffen, also firm is preparing to be a buyer when rates rise needs to invest in a troubled company. Even an investor, participate in the transaction and long-only mutual fund managers have so, GSO has 31 investment professionals in late in the game. “David Geffen is the War- to sell bonds to meet investor redemptions. London, and they are doing more deals now ren Buffett of the entertainment industry, Amid the froth GSO is now doing its prepara- than the firm is doing in the U.S. and they understood the value of that to the tory work for the next crisis. Though investors Nearly five full years after the worst of deal,” he explains. “Many investors wouldn’t seem to have set their concerns aside, GSO the financial crisis, the real estate market know how to approach that.” maintains that Europe poses the same risks to is finally on the mend, investors are won- GSO also bought the debt of Clear the global economy it always did and that rates dering if homebuilders’ stocks have rallied Channel Communications, a private- must rise sometime in the next four years. too far, and the outlines of the new order of equity-owned media company, and led Patience is the key, says Smith, adding Wall Street are coming into sharper focus. a $1.25 billion preferred stock deal for that GSO’s funds and compensation are The defanged banks are receding into the Chesapeake Energy so that company could structured in such a way that staffers don’t background and making peace with new develop natural-gas production from shale have to feel compelled to put money to work regulations designed to emasculate their in eastern Ohio. in deals that don’t make sense. The group has balance sheets. The new power brokers in the Current market conditions are setting products that do better in different market financial industry are money managers and the stage for a lot of future opportunities for environments, such as its closed-end funds investors like GSO, which control real assets. GSO. Annual high-yield issuance is more and a new exchange-traded fund it recently “There is a wealth transfer going on from than double what it was in 2006 and 2007, launched with State Street Global Advisors. banks’ shareholders to the investors in our 61 percent of bonds are trading at or above GSO is actively managing the leveraged-loan funds,” says Goodman. • • FEATURES JUNE 2013

Blackstone co-founder Stephen Schwarzman MATT FURMAN MATT loans in the world, GSO gives us a unique look into what’s going Blackstone’s Stephen 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 Schwarzman on secret sauce at Blackstone is that we can create and harvest intellectual capital and insights across all four of our major investing businesses and our advisory business. And not just on an indus- Not Wasting a try basis, but geographically. We don’t need an economist to tell Serious Crisis us what’s happening in the world. We see it. GSO has a very different opportunity going forward be- Following the 2008 financial crisis, cause of the smaller role banks are taking in lending to distressed businesses. Tell us about that. Blackstone Group chairman and CEO The regulatory environment has become more restrictive and Stephen Schwarzman used the acquisition difficult for many financial institutions. And Europe in particular now is having all kinds of problems. But it’s very difficult for of GSO Capital to diversify the alternative Europe to put their problems fully to bed. It will take a period asset management firm’s businesses and of years to do that even as the European banking system still needs significant repair. While that’s going on, the ability of cer- help more than double its assets. tain borrowers to obtain credit has been inhibited, which creates opportunities for firms like GSO. By Julie Segal Do you think regulators will get involved in overseeing this n November 2008, just weeks after Lehman Brothers Holdings type of activity? filed for bankruptcy and the U.S. government was forced to Firms like ours avoided trouble during the financial crisis by Ibail out insurance giant American International Group, being prudent with our investors’ money. We have to compete for incoming White House Chief of Staff Rahm Emanuel famously told our money on the open market without the benefit of federal or a reporter that “you never want to let a serious crisis to go to waste.” sovereign guarantees. People deposit their money with banks be- Five years after the worst financial crisis since the Depres- cause they feel their money is protected not just by the financial sion, it seems that Blackstone Group co-founder, chairman and institution itself, but by government as well. We don’t have that. CEO Stephen Schwarzman took that advice to heart. Blackstone We haven’t seen restrictions because we are operating without Group has been one of the biggest winners in the wake of the any “lender of last resort” standing behind us and we don’t have crisis, doubling its assets under management from $90 billion to the same kind of central role in the financial system. $218 billion during the past five years. Much of that growth has come from the 2008 acquisition of credit manager GSO Capi- In many ways, it seems that Blackstone is stronger now tal Partners, run by three partners who had turned Donaldson, than before the crisis. Lufkin & Jenrette (later Credit Suisse) into the No. 1 underwriter In some areas we have fewer competitors, so it’s good. But of high-yield debt on Wall Street. GSO gave Blackstone access to the overall system has really been challenged. As you can see investment strategies that would do well as the economy fell off in Europe, when you have very tough regulations and you have the cliff. Since the acquisition, GSO’s assets have grown fivefold a shrinking banking system, it’s very difficult to get economic and rival those of Blackstone’s real estate and private equity busi- growth. Virtually anyone would tell you that. How do you grow nesses. Senior Writer Julie Segal spoke to Schwarzman recently if you can’t get money? A negative growth environment creates about the GSO acquisition, the advantage that U.S. financial other political problems. It’s complex, of course. services firms now have in Europe, and the expanded role that money managers are playing as the banks contract. What are the implications for Blackstone? One of the advantages that we have is that the American fi- GSO has obviously been a successful acquisition for Black- nancial institutions are in much better shape than the European stone. How did you see it fitting into the organization? ones. What you’re starting to see is a normal pattern where firms When we started the firm in 1985 we decided to be in three like ours go to non-U.S. locations and our banks tend to follow. lines of business. The first and second were the M&A advisory We can get financing where domestic people can’t. It provides a business and private equity. The third part of our strategy, which competitive advantage for which we have to thank [former Trea- we’re still executing on, is to go after new businesses that had to sury secretary] Tim Geithner for doing a good job putting the meet a few criteria. First, it has to be a great business with terrific U.S. banking system in a better position with the stress tests and expansion potential. We don’t want a lot of little businesses; we capital raising. want to be in relatively few complementary ones where we can Now the U.S. banking system is under-lent. Look at the be the global leader. Second, we want people who are 10s on massive amounts of cash on corporate balance sheets. Banks a scale of 1 to 10. Third, the business has to make our existing wouldn’t lend in 2008-2009, so corporations essentially created businesses stronger by bringing intellectual capital to the table their own banks, doing debt deals and keeping the proceeds on that we didn’t have. their balance sheet. That money had no purpose other than giv- GSO fit those criteria. GSO produces intellectual capital that ing corporations a reason not to call their bank. That’s good for can be used throughout Blackstone and GSO leverages informa- us, whose job it is to buy companies, buy real estate and do other tion, where appropriate, that comes out of our real estate, pri- types of investments. So, it’s actually turned out to be not so bad, vate equity and other groups. As the largest investor in leveraged as they say.