Stephen’s Posterous

Pete Peterson co-founded Blackstone Group LP. His proceeds from the sale of stock from the IPO was $1.85 billion.  Most of this money will go to Mr. Peterson's Peter G. Peterson Foundation.

Mr. Peterson, the author of prior books, like "On Borrowed Time: How the Growth in Entitlement Spending Threatens America's Future,"  decided to write a book, The Education of an American Dreamer, which was released on June 8, 2009.

Peter Lattman reviews the book in The Wall Street Journal and he calls the book, "an honest and winning account of an eventful life," with "self-deprecating wit."

Mr. Peterson attended Massachusetts Institute of Technology, Northwestern and the University of Chicago's business school. He worked at McCann-Erickson, Bell & Howell, and was President Richard Nixon's Secretary of Commerce. He later worked at Lehman Brothers for a decade before starting Blackstone in 1985.

Mr. Lattman says that Mr. Peterson spends much of the book talking about that went wrong in his life. Two of his marriages ended in divorce, and he wishes he spent more time with his five kids. Mr. Peterson blames his workaholic habits and emotional detachment. However, Mr. Peterson does celebrate his professional success.

One reviewer of the book on Amazon.com wrote:

If you're never picked up an autobiography before and even if you're not really interested in business and politics - try this book anyway. I doubt you will regret it. His life is very compelling and there are many lessons to be learned in The Education of an American Dreamer. If nothing else, you will appreciate the story of a true American dream, of pulling oneself up from meager beginnings to a position of influence and privilege.

Mr. Lattman ends by writing:

It sounds like good advice. In "The Education of an American Dreamer" Mr. Peterson comes off as the good guy who managed to extricate himself from fraught situations and forge ahead -- usually to great success. Dumb luck maybe but, as they say, you make your own luck in life.

The Education of an American Dreamer by Peter G. Peterson

Twelve, 375 pages, $34.99

It could be time for some new generally accepted buyout practices. The number of private equity firms that completed fundraising efforts in the first quarter fell by more than 70% from the first quarter last year. But a record number of them were out trying to raise money. This suggests competition for investors is fierce. They should push for lower fees and better governance.

Fund managers have good reason to raise money now. Most of them invested a lot of cash during the leverage boom, but the deals aren’t looking good. KKR’s publicly traded fund, KKR Private Equity Investors, has a market capitalisation of about $600m, down from $5bn when it first went public. The fund invested in several KKR-led buyouts in 2006 and 2007, including Alliance Boots, TXU, First Data, and HCA.

Buyout barons are looking for a chance to redeem themselves. Blackstone, for example, is in the midst of fundraising. With all kinds of asset prices now much lower, it may be a good time to buy companies. That’s certainly the view many buyout firm bosses have expressed.

But many investors have soured on private equity. Even some of the enthusiasts are cash-strapped, having taken losses on other investments. Private equity firms were seeking to raise nearly $890bn in funds in the first quarter. But funds with an aggregate of just $46bn closed, very modest even though fundraising usually continues over several quarters.

The result: demand for investors’ cash heavily exceeds supply. With their new-found negotiating power, investors could start with fees. Private equity fees are, generally, better tailored for investors than hedge fund fees. Management fees are slightly lower for large funds, often between 1% and 1.5%. And the carried interest or the portion of a fund’s profits the managers keep for themselves, often 20% is taken over a long period and can be clawed back if gains aren’t realised.

But the industry’s fees are still hefty, especially with many firms posting huge writedowns on funds invested in huge deals during the credit boom. Plus, management fees ballooned during the boom. What was meant to be a fee to keep the lights on now makes managers rich.

Not only that: private equity firms collect fees on the deals they do in addition to management fees and carried interest. A portion of these is credited back to investors. But a large part is often shared among the firms’ partners.

This raises a potential conflict of interest. Fund managers can get rich from these fees alone, encouraging buyout firms to do more deals - and bigger ones. But they add hardly anything to investors’ returns.

Investors should push for lower deal fees or even none at all. There’s a strong case that doing deals is what the management fees and carried interest are supposed to compensate. And since the fees come out of newly acquired, often highly-leveraged portfolio companies, investors might be better served in the long term by leaving the companies with that little bit of extra buffer against unexpected trouble.

Investors could also demand that buyout shops toughen up governance. They often have no say in fund management at all. In extreme cases, private equity investors have even agreed not to sue fund managers under any circumstances. This contrasts with a public company, for example, or even a mutual fund. In both cases, shareholders get to vote on important issues.

Buyout barons may justifiably resist giving investors the right to micromanage every deal. But since investors’ money is tied up for quite a long time, they should have some voice if they feel that their managers aren’t up to snuff.

Finally, private equity investors could ask for more freedom to trade their investments. Sure, they invest for the life of a fund. But if they find a buyer to take over part or all of their investment, that shouldn’t disadvantage a fund manager. Yet managers often have some say in such sales. Aside from this level of control seeming unwarranted, it can make a stake less liquid.

It may be no easy task to change practices that have become entrenched. So they may be hard to change. But investors with cash have something private equity managers badly need. They should seize the moment.

Source.

When a group of men who got rich by buying low and selling high want to make you their partner, hang on to your wallet. That bit of financial wisdom was amply demonstrated by the 97 per cent peak-to-trough drop in the common stock of Fortress Investment Group on its second anniversary as a public company last month.

Leverage cuts both ways, and its impact has been almost entirely bad for the alternative asset manager with the low point being a temporary halt to redemptions at its Drawbridge hedge fund late last year.

But investors looking over the detritus left by the financial crisis seem suddenly to realise that, having survived so far, Fortress is ideally suited to reap a future bonanza. They looked past a hefty net loss for the fourth quarter and bid Fortress’ shares up as much as 40 per cent on Monday upon hearing its optimism about participating in the first round of the term asset-backed securities loan facility,TALF.

Fortress is one of a handful of groups that retain the size and credibility to play a role in what may prove to be a high reward and relatively low-risk exercise. Fortress executives dub the coming period “the great liquidation”.

Meanwhile, much of the bleeding has stopped in Fortress’ existing business. About 82 per cent of its capital is long-term in nature with an average remaining life of 9.2 years, leaving plenty of time for mark-to-market losses to be reversed. With important debt renegotiations and redemptions mostly behind it, nasty surprises are unlikely.

Management’s optimism about the future of their hedge fund business may sound like bluster after huge outflows and no inflows recently, but it is not so implausible. If it can build new funds while using the taxpayer as a low-cost prime broker, new investors should be willing to let bygones be bygones.

Source.

Private equity company Blackstone Group CEO Stephen Schwarzman said on Tuesday, March 10, 2009, that up to 45 percent of the world's wealth has been destroyed by the global credit crisis.

"Between 40 and 45 percent of the world's wealth has been destroyed in little less than a year and a half," Schwarzman told an audience at the Japan Society. "This is absolutely unprecedented in our lifetime."

But the U.S. government is committed to the preservation of financial institutions, he said, and will do whatever it takes to restart the economy. U.S. Treasury Secretary Timothy Geithner plans to unfreeze credit markets through a new program that will combine public and private capital in a fund that would buy bank toxic assets of up to $1 trillion.

"In all likelihood, that will have the private sector buy troubled assets to clean the banks out in terms of providing leverage ... so that we can get more money back into the banking system," Schwarzman said.He expects the private sector to end up making "some good money doing that," but added there were complex issues on how to price toxic assets.

Mr. Schwarzman put part of the blame for the financial crisis to credit rating agencies.

"What's pretty clear is that, if you were looking for one culprit out of the many, many, many culprits, you have to point your finger at the rating agencies," he said. Rating companies have been the focus of intense criticism for their role in granting top "AAA" ratings for complex bonds that later plummeted in value, resulting in subsequent rating cuts, in many cases to junk status.

"Once you bought into ... the Triple A paper and it turned out to be paper that was in many situations going to end up defaulting, then you really had the makings of a global problem," he said. Mr. Schwarzman said problems were then exacerbated by mark-to- market accounting rules. Those rules ask banks and other financial institutions to price assets at a value related to how they would be sold in the open market.

Blackstone reported a quarterly loss in February 2009 after writing down the value of its portfolio and eliminated its fourth-quarter dividend. Asked where was a good place to invest, Schwarzman said it made sense to buy cyclical names, which are less exposed to the economic cycles.

Mr. Schwarzman said investors also may find value in debt products, including "senior layers of certain securitizations," where investors can see 15 percent to 20 percent returns, he said. Geographically, he said there were "pockets of strength" in China, which is committed to getting to an 8 percent growth level, and in India, where the economy is slowing but banks are in good shape.

Source.

Back in late September 2008, when David Bonderman lost $7bn on an investment in Washington Mutual bank made by a private equity consortium headed by his firm TPG, a senior executive at a rival house sent him a sympathetic note. Both the industry and the world needed a reminder that private equity was not infallible, he argued. Before that time, "we made it look too easy", this executive added.

Today, nobody could say that private equity needs any further reminders of how vulnerable both their investments and their own fortunes have become. The public vehicles set up by a few of the larger houses most clearly depict the carnage. The value of investments in the Amsterdam listed unit of Kohlberg Kravis Roberts dropped 47.5 per cent last year, while the private equity investments of Blackstone were worth 30 per cent less.

In Europe, Candover this week cut the valuation of its portfolio by half, writing down a third of its investments to zero, including Gala Coral, the UK's biggest bingo group, and Ferretti, an ailing Italian yachtmaker. The rival Permira wrote down its portfolio by 36 per cent, valuing five companies at zero.

Terra Firma, run by financier Guy Hands, has taken an impairment provision for half its €2.6bn ($3.3bn, £2.3bn) investment in EMI, the music group that was one of the final buy-outs of the credit boom, as it wrote down its entire portfolio by 45 per cent.

A growing number of companies owned by private equity are filing for bankruptcy protection as demand weakens, cash flows diminish and their debt burdens weigh them down. In the US, Apollo Management's Linens n Things was one of the first. It has been followed by Aleris, a TPG-owned aluminium company, and KKR's Masonite International in the last few weeks.

Where did it all go wrong? And does this blood-letting mean the era of private equity, which grew by using a sliver of its own investors' cash and bucketloads of cheap bank debt to acquire some of the world's biggest companies, is over?

At stake for the wider financial world is not only a stream of revenues that could help sustain the west's battered banks, private equity generated more than $47bn in fees for investment banks from 2005 to 2007, but also the ability of entrepreneurs and families to sell their companies.

For years, private equity bosses, once dubbed the "masters of the universe," boasted of their consistent record in generating outsized annual returns of above 30 per cent for investors including pension funds, insurers, educational endowments and rich families. But with stock markets down 20 per cent since the start of the year and the recession eating into earnings, analysts doubt private equity portfolios have seen the last of the writedowns.

Executives argue that the writedowns taken in today's valuations are meaningless, because they intend to hold their companies for years, even though new mark-to-market accounting rules force them to be valued if they were being sold now.

Some point out that compared with public markets' fall of more than 60 per cent from their peak, most private equity portfolios are still outperforming. Dominique Senequier, chief executive of Axa Private Equity, which manages more than $20bn (£14bn, €16bn), says: "There are some signs that private equity groups have overpaid but the track record up to now is much better than the overall stock market."

Yet at least to some extent, the industry is suffering from problems that are self-inflicted. Buy-out groups seemed wrapped up in their own hubris, as smooth economic growth, easy bank financing, and rising stock markets convinced them that everything they touched turned to gold.

Bankers say practitioners rushed their analysis of bid targets and relied too heavily on due diligence data provided by the vendor's investment banking advisers. Simon Walker, head of the British Private Equity and Venture Capital Association, acknowledges that the industry became lazy during the credit boom.

By taking on so much debt, private equity also exposed itself to the flip side of leverage, which magnifies returns on the way up, but also multiplies losses on the way down. If a company is bought with £100m of equity and sold for £200m, investors double their money. Yet if the deal is funded with £20m of equity and £80m of debt, with the interest paid from the company's cash flow, the investor makes a sixfold return. But if it is sold for only £80m, the equity is wiped out.

Mario Levis, professor of finance at London's Cass Business School, asks: "Why did private equity use so much debt? They were carried away by the circumstances like everyone else."

Philip Dunne, partner at A.T. Kearney, the consultancy, says that when competition for deals increased in the second half of this decade, private equity groups changed strategy. They stopped looking for reasons to pay less for a company and started seeking hidden gems that could justify a higher price and more debt.

Private equity invested a total of $1,637bn in 2005-07, at the peak of the bubble, more than half its total investment staked since 1995, according to Dealogic, the research group. That underlines how much is riding on those boomtime deals.

Sceptics such as Jon Moulton, founder of Alchemy Partners in the UK, say that as the senior debt on most of the world's big leveraged buy-outs is trading at discounts of 40 to 80 per cent below full value, the equity in these deals must be worthless. But most buy-out bosses say debt prices do not reflect corporate fundamentals as much as a scarcity of buyers in the market which has driven debt to absurdly cheap levels.

Lenders disagree. "By issuing so much bank debt with shorter maturities [for their companies] instead of longer-dated high-yield bonds, private equity firms are in a race against the clock," says Stephen Kaplan, a founding principal and head of private equity at Oaktree Capital, which buys debt at a discount. "Unless private equity firms are prepared to write big cheques, there will be the greatest transfer of ownership from equity owners to creditors in history."

Already, cash-strapped investors are putting much less money into the industry. One European adviser to secondary investors in private equity says: "Very, very few investors are planning to make new investments this year. Everybody is in a wait-and-see mode, everything is frozen."

Faced with these pressures, what is the industry to do? "Private equity firms will spend 70 per cent of their time shoring up their investments, 20 per cent of their time shoring up their investor base, 5 per cent trying to raise new money and 5 per cent trying to do new deals," says David Rubenstein, co-founder of Carlyle.

Keeping the companies they own alive through a brutal slowdown is, as Mr Rubenstein implies, practically a full-time job. Firms are attempting to restructure the debt in those companies, buying the debt of their deals either because it is cheap or to have a seat at the table when the companies hit the wall and control goes to the creditors. As Gerry Grimstone, chairman of Candover, puts it: "The whole industry is almost going into suspense for the time being."

Indeed, as bank debt has dried up and lenders have become partly state-owned, private equity deals have dwindled. So far this year, there have been 147 buy-outs together worth $18.2bn, down two-thirds from the 470 deals worth $43.6bn in the same period last year, according to Dealogic.

The industry has two main cushions on which it can rely. First, the barriers to exit are high. When private equity groups raise money from investors, it is in the form of cast-iron commitments, lasting at least 10 years, allowing them to hold companies through tough times and wait until conditions are right for a sale. Second, of its $2,500bn of assets under management, about $1,000bn is "dry powder", or uncalled commitments from investors, according to Prequin, a research group.

Buy-out groups themselves have about $472bn of the dry powder, with the remainder held by venture capital, real estate and other groups such as investors in distressed debt.

But investors say groups that invested heavily in the most highly indebted buy-outs at the top of the market will struggle to raise new funds. This is the kiss of death for a private equity group, as without fresh capital to invest, its only option is to go into run-off, slowly selling off existing assets to return cash to investors. Moreover, cash-strapped investors are pressing private equity groups to refrain from calling in commitments to fund new deals.

Two years ago, firms had the upper hand in dealing with their investors. No longer. Instead, at conference calls Steve Schwarzman at Blackstone and Mr Rubenstein of Carlyle are begging their investors not to default on commitments, and are informally making a market for investors to opt out.

Since the credit crunch began, groups have been diversifying away from buy-outs into distressed debt, minority stakes, infrastructure and bank bail-outs. Now, many are shrinking. Some including TPG, Candover and Permira are giving back some of the money they had raised.

Many are cutting staff and closing offices. "Smaller funds will mean lower fees and smaller profits and that can only mean fewer people employed in private equity and lower pay for those who remain," says Mr Hands at Terra Firma.

The industry's last shake-out, following the dotcom bubble, claimed only two big victims: Hicks, Muse, Tate & Furst and Forstmann Little. This time the victims are likely to be more numerous, warns Maarten Vervoort, a partner at Alpinvest, one of Europe's biggest investors in private equity.

While some "will not be able to raise new funding, others will disappear with infighting between partners, Mr Vervoort predicts, adding: "In 2001 it was a mild breeze, something refreshing, but now we are in the ice age."

Source.

Blackstone’s fourth-quarter earnings show the day of reckoning for buyout firms is nigh. Its abysmal results and plummeting asset values reflect the industry’s woes. But Blackstone’s diverse business strategy may make it better positioned than its rivals to ride out the storm. Still, that bodes ill for other buyout shops.

Blackstone’s earnings make for grim reading. It wrote down its real estate investments by a whopping 30%, and its private equity investments by 20% in the quarter. Blackstone also stopped paying out on its traded units, and posted negative economic net income – the private equity firm’s preferred earnings metric. More writedowns are probably on the way. Blackstone officials, during its earnings call, even had to field a question about liquidating its funds, reflecting just how concerned shareholders are about its prospects.

Though Blackstone assured analysts that liquidation was unlikely, president Tony James said that things would get worse before they got better. Buyout investors are scared, don’t have an appetite to invest more money and many are having liquidity problems, he said. Blackstone also may face further writedowns – several of its investments are teetering.

Still, there’s a bit of a silver lining. James said Blackstone realized the market was peaking in 2006, and reined in its investments somewhat – though that didn’t stop the firm from going public the following year. It is also raising a new fund and it has other businesses, like its GSO hedge fund, that give it a degree of diversification.

Firms that focus solely on buyouts may suffer more pain. And Blackstone hasn’t had any big blow ups – yet – unlike, say, TPG’s $1.3bn Washington Mutual deal or Cerberus’s auto investments. Blackstone may survive private equity’s day of reckoning, but the outlook is less certain for others.

Source.

The Financial Times is suing Blackstone Group for multiple use of a single online subscription, alleging the private-equity firm shared a username and password to avoid paying for multiple accounts.

The suit, filed in federal court in Manhattan, says a “senior” Blackstone employee distributed login information for one account to other employees. That account accessed thousands of individual articles from February 2006 to June 2008. The suit describes the use as “massive” and “far more than an individual would normally access.”

A person familiar with the situation says employees in Blackstone’s London office passed around the account information. Once aware of the situation, this person says, Blackstone began settlement negotiations with the Financial Times. Blackstone “was very surprised by the filing of the suit,” this person says. Financial Times publisher Pearson PLC declined to comment.

Online subscriptions to the financial newspaper cost $179 to $299 features are available only through an online premium subscription, including the widely read Lex column. Alan Mutter, an independent media consultant, said media executives are more determined than ever to monetize digital content.

Mr. Mutter also said this problem predates the Internet. For example, decades ago people would photocopy expensive trade publications.  Only one million of the roughly 7.1 million monthly unique users on FT.com are registered, according to the suit. The site gets 72 million page views each month.

Source. Subscribe to FT.com.

On the 18th floor of American International Group Inc.’s headquarters in Manhattan, Blackstone Group LP executives regularly gather to carve up what was once the world’s largest insurer. The battered giant is unloading more than two dozen businesses worth about $60 billion to repay the government after its bailout last year.

Blackstone, the No. 1 leveraged-buyout firm, has a seat at the table, but not as a buyer. The company that orchestrated the then record $34 billion acquisition of Equity Office Properties Trust in 2007 is now playing a more modest role -- as an adviser to AIG as it sheds units from auto insurance to aircraft leasing.

Blackstone is searching for profits in acquisition and restructuring advising and distressed debt as LBO dealmaking enters its gravest crisis in its 40-year history. After buyout firms helped inflate the credit bubble, its obliteration has crippled the global financial system and spurred a spate of bankruptcies at companies owned by the industry’s most-hallowed names. Buyout firms themselves may be next to go. As many as 40 of the biggest 100 companies may collapse by 2011 as their debt- strapped assets default, according to a 2008 report by Boston Consulting Group Inc., which didn’t identify the firms in its study.

“These guys had a sense they could do no wrong,” says Paul Schaye, managing partner of New York-based Chestnut Hill Partners, which helps firms find deals. “They were the new masters of the universe. Now they’re going through a very sobering experience. They have to figure out how to survive this environment.”

Blackstone founder Stephen Schwarzman, the son of a dry goods store owner in Philadelphia, was swagger personified. He owns five trophy homes in Manhattan, East Hampton, Florida, the South of France and Jamaica.

For his 60th-birthday party in February 2007, Schwarzman had the Park Avenue Armory in Manhattan redecorated to resemble part of his 35-room Upper East Side apartment, complete with a replica of a painting of himself by Andrew Festing. The guest list of 500 was stacked with notables, including Donald Trump and JPMorgan Chase & Co. head Jamie Dimon. Rod Stewart entertained them for a $1 million fee.

Four months later, Schwarzman crowned the era of megadeals with his own initial public offering. In June, he pocketed $684 million from his industry’s second IPO just three months before the stock market began its historic collapse. Now Schwarzman and his rivals -- Henry Kravis of KKR & Co. and David Rubenstein of Carlyle Group -- are trying to endure the hangover from their binge. Buyout firms went on a record-breaking shopping spree in 2006-07, saddling themselves with $1.5 trillion in assets that they intended to sell at a profit. Since then, they haven’t been able to find buyers for their companies, depriving them of their main source of income: the 20 percent fee they reap from a profitable sale.

After last year’s bankruptcies of Apollo Global Management LLC’s Linens ‘n Things Inc. and Carlyle’s Hawaiian Telcom Communications Inc., private equity shops face a flood of defaults that may eventually sink them too.

“The big fear for private equity is that the default rates go to an extraordinary level,” says Roy Smith, a former Goldman, Sachs & Co. partner who now teaches at New York University. “The worst outcome is that we have such a high level of default that it makes the whole buyout scene a wasteland. This is part of the biggest bubble to burst in our history.”

Schwarzman, now 61, doesn’t buy the doom and gloom. Along with Peter G. Peterson, he left Lehman Brothers in 1984 and built Blackstone into a company with $116 billion under management. Last year, the firm posted its first quarterly losses in the first and third periods, spurring it to cut 70 jobs, or 7 percent of its workers, mostly in private equity. Its stock plunged 84 percent to $5.10 today from its $31 IPO price.

With his company sputtering, Schwarzman made public appearances in New York, Dubai and Quebec City in a seven-week span starting in August to try to persuade investors that good times were just around the corner.

“We’ll find a bottom, and we’ll be buying on the way up,” Schwarzman said in a speech at the Super Return Middle East conference of investors and buyout firms in Dubai in October. “Trying to catch falling knives is not what we do. The best returns in private equity have come in a period like the one we’re just entering. This is an absolute wonderful time.”

Investors, who are taking a beating in private equity funds worldwide, disagree. Investments in buyout funds fell by about 60 percent to $43 billion in the fourth quarter compared with a year earlier, according to Dow Jones Private Equity Analyst, an industry newsletter. Blackstone last year reduced the target for its sixth buyout fund to $15 billion by the end of 2009 from $20 billion.

“There’s a lot yet to go wrong,” says Bill Atwood, executive director of the Illinois State Board of Investment, an investor in Blackstone and other private equity firms. “It’s going to take all they can do to manage their existing problems.”

Blackstone leveraged cheap credit more than most firms during the boom. The extra yield over Treasuries that investors demanded to own high-risk debt hit an all-time low of 2.41 percentage points in June 2007, according to Merrill Lynch & Co. data. Schwarzman’s firm was involved in 30 announced private equity acquisitions worth $145 billion in 2006-07, a torrid spurt capped by its $34 billion purchase of Equity Office Properties. The deal sparkled as the biggest LBO ever -- but for only two weeks. KKR surpassed it with a $43.2 billion purchase of electricity producer TXU Corp. in February 2007.

One month later, Blackstone filed to go public, heightening the frenzy over private equity. Fortress Investment Group LLC had beaten Blackstone to the money trough, raising $634.3 million on Feb. 8. Blackstone President Tony James, who was hired from Credit Suisse Group in 2002, took the lead in managing the firm’s expansion prior to its IPO.

Blackstone’s 200-plus-page prospectus provided the first in- depth look into the firm. Its net income rose 71 percent to $2.27 billion in 2006 from a year earlier. During its history, returns to investors were also impressive: 23 percent annually from private equity funds, 29 percent from real estate investments and 12 percent from its funds of hedge funds.

With the Standard & Poor’s 500 Index over 1,500 in June 2007, Blackstone went public at the top of the market. The shares jumped 13 percent on the first day of trading, raising $4.75 billion for Blackstone. The IPO made Schwarzman one of the world’s richest men, with his stake worth $8.76 billion at the stock’s peak. The value plunged to $1.19 billion.

Only a few months after the IPO, dealmaking began to seize up. In July, two Bear Stearns Cos. hedge funds devoted to subprime mortgages exploded, signaling the bursting of the credit bubble. Kravis, 65, waited too long: KKR had filed to go public the same month that the hedge funds collapsed and has yet to list its shares. By September, credit for LBOs almost evaporated.

“It’s a massive shift for the industry because people are scared to death of leverage,” says Brad Alford, who runs Atlanta-based Alpha Capital Management LLC, which helps clients choose funds to invest in. “They’ve never seen an environment where there was absolutely no credit.” Flush with cash from the IPO, Blackstone found a way to exploit the crisis it helped create. In early 2008, as Wall Street firms began their bloodletting with thousands of job cuts, Blackstone bought GSO Capital Partners LP to acquire loans used for LBOs that banks were selling at deep discounts.

The New York-based hedge fund firm, which Blackstone bought for $932 million, was founded by Bennett Goodman, a friend and former colleague of James’s at Credit Suisse. In its hedge funds and funds of funds, Blackstone managed $59 billion as of September. The GSO Special Situations Fund was up by less than 1 percent compared with a 15 percent decline in Lehman’s high-yield index through the third quarter of 2008, Blackstone told investors. Its funds of hedge funds were down about 14 percent for the year, the firm said.

As Blackstone and other private equity firms move into distressed debt, they must still confront the nightmare scenario that begins with defaults. In May, Linens ‘n Things, the retail chain that Apollo and other investors bought for $1.3 billion in 2006, filed for bankruptcy. Mervyn’s, a department store chain that Cerberus Capital Partners LP, Sun Capital Partners Inc. and other investors purchased for $1.65 billion in 2004, went down in July.

For 2008, about one quarter of the 86 S&P-rated companies that defaulted on debt were private equity backed, according to the Private Equity Council, an industry lobbying and research group.  More crackups are on the way. The Boston Consulting Group study, which examined the credit spreads of 328 unidentified companies owned by private equity firms, said as many as 50 percent of them may default by 2011. The spate of bankruptcies may cause more lenders and investors to lose confidence in buyout firms, forcing many of them to shutter their doors.

“The biggest impact of the perfect storm will be on the private equity firms themselves,” the study says. “There are no precedents for the current situation, given the potential number of defaults, the structure of the debt and the difficulties faced by today’s equity owners.” Buyout firms are now having to micromanage their hoard of companies.

“We’ve gone through every company’s plan to make sure they have adequate credit lines and told them to tighten expenses,” says Rubenstein, 59, co-founder of Carlyle. “Almost every private equity firm is doing the same sort of thing.” In October 2008, Schwarzman met with about 40 chief executive officers from his companies to deliver a warning. The bosses gathered for a day at the Waldorf-Astoria Hotel, a 77- year-old Manhattan landmark that Blackstone bought in 2007 as part of its $20 billion acquisition of Hilton Hotels Corp.

“At the CEO summit, we told them to redo their recession plans,” James, 58, said on a conference call after the meeting. “We told them to go back to the drawing board for a much more severe recession.”

Freescale Semiconductor Inc., the chipmaker that Blackstone and other firms bought for $17.6 billion in 2006, is hemorrhaging money. It’s burdened with $8.1 billion in debt from the LBO. Now the combination of debt payments and a drop in chip sales as demand for cell phones and electronics wanes leaves Freescale with little margin for error. The Austin, Texas-based company, which said sales would fall 10 percent in the fourth quarter, is rushing to sell its cell-phone-chip business.

“The cell phone transaction is critical to Freescale being able to cut costs in line with sales declines in 2009,” says Jason Pompeii, an analyst in Chicago with Fitch Ratings. Freescale spokesman Mitch Haws says the company has doubled its cash position to $1.4 billion since the LBO and is set to grow once the credit crisis abates. With an almost dead market for IPOs -- they fell 70 percent in 2008 from the prior year -- buyout firms can’t unload even their strongest companies. That means endowments and pension funds, after pouring into private equity pools during the boom, aren’t receiving payments.

“The distributions stopped abruptly, and a lot of investors are in a real bind,” says David De Weese, a New York-based general partner at Paul Capital Partners, which has $6.6 billion of assets under management, including funds devoted to secondary investments. “There’s just no capital coming out.”

Investors such as Harvard University are taking losses, and other schools are selling their future commitments to funds on a secondary market at discounts as high as 50 percent. In 2009, investors may dump as much as $130 billion in commitments, De Weese says.  Harvard’s $28.8 billion endowment decreased 22 percent in the first four months of fiscal 2009, even before accounting for losses from private equity and real estate. That put the endowment, the largest of any U.S. university, on course for its worst performance in at least four decades.

Blackstone’s only profitable business is its advisory and restructuring unit. It’s exploiting the turmoil among banks that have posted losses of $797 billion stemming from the subprime mortgage meltdown and have cut 253,000 jobs.  In 2008, Schwarzman added 20 bankers from Lehman Brothers and other wounded firms to his 131-strong unit, the firm’s smallest. Ivan Brockman, who was co-head of West Coast technology investment at Citigroup Inc., joined Blackstone to run a new Silicon Valley outpost in Menlo Park, California.

John Studzinski, who heads the advisory group after joining Blackstone from HSBC Holdings Plc, has nabbed marquee clients. The firm advised Procter & Gamble Co. on the $4.5 billion sale of its Folgers coffee unit to J.M. Smucker Co. and worked with Microsoft Corp. on its proposed takeover of Yahoo! Inc.  In all, Blackstone earned fees from clients on 18 deals worth $12.3 billion last year, according to data compiled by Bloomberg. The group’s profit almost tripled to $61.1 million in the third quarter of 2008 compared with a year earlier.

“The problems at all the major banks and securities firms are causing widespread cutbacks, distraction and personnel defections,” James told investors on a conference call in November. “This turmoil at our major competitors is clearly benefiting our advisory business.”  Blackstone wants to follow the rise of Perella Weinberg Partners, a boutique firm started by former Morgan Stanley banker Joseph Perella in 2006. It jumped to 19th in M&A advising in 2008 from 27th the previous year.

Without lending operations, small outfits are winning more business by avoiding conflicts. Clients don’t have to worry that their adviser is also lending money to one of their competitors or a buyer. Along with Blackstone, JPMorgan was working with AIG until it quit in December because it wanted to maintain relationships with potential buyers of AIG units.

“We’re interested in providing advice where there’s not a potential conflict,” Schwarzman said in an interview in Dubai. “There’s an opportunity to build that business with refugees from the financial crisis.”  Blackstone’s investment banking fortunes may diminish after Wall Street banks stop bleeding. While Citigroup plans to break itself up and Bank of America Corp. gets a second round of government loans, Goldman Sachs, JPMorgan and Morgan Stanley may earn a profit in the first quarter, according to analysts.

“Once it all plays out, you’re going to see the banks regaining their traditional role,” says Elizabeth Nowicki, a law professor who studies M&A at Tulane University in New Orleans. “It remains to be seen whether the private equity guys will continue to like that business.”  Schwarzman lives for the headline-grabbing buyout. Yet Blackstone’s latest move -- the December purchase of tiny Underwater Adventures Aquarium LLC in Minnesota for an undisclosed sum -- suggests the days of the $20 billion Hilton deal may be over for years to come.

The biggest of Blackstone’s 17 acquisitions in 2008 -- $3.5 billion for the Weather Channel -- may be the dealmaking model of the future, at least in the near term. Bain Capital Partners LP, NBC Universal Inc. and Blackstone had to pony up about half of the purchase price in cash instead of the 20 or 30 percent they provided during frothier times. With the extra yield over Treasuries for high-risk debt reaching as high as 18 percentage points in December, the buyers took only $1.22 billion in loans from Deutsche Bank AG and GE Commercial Finance Ltd. The buyout firms had to fund the rest themselves: Blackstone’s GSO and Bain’s credit arm, Sankaty Advisors LLC, kicked in $610 million.

Without leverage, buyout firm profits now depend on acquiring companies at very low prices. “Instead of turbocharging returns on leverage, they’re going to have to rely on better prices,” says Robert Profusek, a partner at Jones Day in New York, who oversees the law firm’s M&A practice. “The valuations are the opportunities for returns.”

While Schwarzman masterfully timed the top of the market in 2007, buying companies at the bottom will prove tricky. Blackstone has never faced a recession like today’s. Unlike the eight-month U.S. contraction in 2001, which was caused by the bursting of the dot-com bubble, the current downturn is global -- encompassing banking, manufacturing, retailing and housing -- and longer lasting.

“When managers want to talk optimistically, they will say, ‘The best vintage years for LBOs were the recession years,’” says Colin Blaydon, director of the Center for Private Equity and Entrepreneurship at Dartmouth College’s Tuck School of Business.

“When valuations come down, if you have the capital, that is a period where you do well. What you didn’t have in those cases was a really deep and multifaceted recession that’s going to last a while.” Schwarzman’s dealmaking prowess elevated his stature outside the confines of the business world. The billionaire’s donations to groups like the New York City Ballet put him in the company of Hollywood stars and the political elite.

In early 2008, he announced his biggest gift ever: $100 million to the New York Public Library. Its venerable Beaux Arts building on Fifth Avenue, famous for the large lions that guard the entrance, will be renamed after him. As chairman of the Kennedy Center for the Performing Arts, a group to which he gave $10 million, Schwarzman dined with honorees Roger Daltrey of The Who and actor Morgan Freeman at the State Department with then Secretary of State Condoleezza Rice in December. He later made a television appearance at the awards ceremony and sat with former President George W. Bush during the event.

“He’s going to do everything he can to make Blackstone work because his reputation is on the line,” NYU’s Smith says. “That’s as important as his pocketbook.”  With analysts forecasting more losses for Blackstone in the first quarter, Schwarzman faces his toughest test in four decades on Wall Street.

“I believe that Blackstone itself will make some of its best investments these next few years,” Schwarzman said on a conference call in November. The unflagging dealmaker will have to prosper in a changed world where credit is as scarce as company turnarounds.

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