Blackstone Risks Hedge Fund Returns as LBO Loans Fade

When Blackstone Group LP, the world's biggest buyout firm, was pursuing the takeover of the Weather Channel cable network earlier this month with General Electric Co. and Bain Capital LLC, Wall Street balked at providing financing.

So the New York-based company turned to GSO Capital Partners LP, the hedge-fund manager it acquired in March, to pull off the largest U.S. leveraged buyout this year.

Blackstone can't wait for banks, stuck with almost $100 billion of debt from earlier LBOs, to start lending again. Instead, it's pushing deeper into deal financing with GSO. The strategy may hurt the hedge-fund unit's returns -- some approaching 40 percent -- if slowing economies lead companies taken private by Blackstone to default on their debt.

``The question is: Do you lose your objectivity when you do something so close to home?'' said Paul Schaye, managing director of New York-based Chestnut Hill Partners, which helps LBO funds identify investments. ``The lines get blurred in terms of who's doing what and it raises questions as to what is truly arms-length.''

Blackstone spokesman Peter Rose declined to comment.

The $153.9 billion of announced buyouts this year is down more than 70 percent from the same point in 2007, according to data compiled by Bloomberg. Lenders and debt investors pulled out of the LBO market last August as losses mounted on subprime- mortgage securities.

Just prior to the meltdown, Blackstone agreed to purchase Hilton Hotels Corp. for $20 billion. Investment banks led by Bear Stearns Cos., Bank of America Corp. and Morgan Stanley arranged $21 billion of financing to acquire the Beverly Hills, California-based hotel chain.

A Different World

That deal wouldn't fly today, and the Weather Channel purchase, announced July 6 and valued at about $3.5 billion, might well have slipped away had it not been for the financing arranged by GSO and Sankaty Advisors LLC, Boston-based Bain's credit affiliate, said Mark Epley, global head of financial- sponsors coverage for Deutsche Bank AG in New York.

Deutsche Bank and GE Commercial Finance Ltd., a division of the Fairfield, Connecticut-based conglomerate, provided $1.22 billion of loans for the Weather Channel deal. GSO and Sankaty kicked in $610 million of riskier so-called mezzanine debt that matures in eight years.

``It's a great time to do financing'' because banks and investors are charging too much, said Daniel Fuss, manager of the $18 billion Loomis Sayles Bond Fund.

The GSO acquisition was engineered by Blackstone Chairman Stephen Schwarzman and President Tony James, a former colleague of GSO founder Bennett Goodman at investment bank Donaldson Lufkin & Jenrette. Blackstone agreed to pay as much as $930 million, assuming GSO hits certain financial targets.

DLJ Exiles

Blackstone must rely more on non-buyout businesses such as restructuring advice and hedge funds as private-equity fees plunge. Its hedge-fund unit, which also includes proprietary funds and funds-of-funds, rose to $56.6 billion in the first quarter, making it the firm's largest unit by assets. Blackstone, which oversees $113.5 billion, has lost 44 percent of market value since it went public at $31 a share in June 2007.

Blackstone rose 27 cents to $17.29 at 4 p.m. in New York Stock Exchange composite trading.

GSO was started in 2005 by the 51-year-old Goodman and DLJ colleagues Tripp Smith and Douglas Ostrover. When it was bought by Blackstone, it managed $10 billion in loans issued in buyouts and debt whose prices have fallen to distressed levels.

The firm, whose offices are down from Blackstone's headquarters on Manhattan's Park Avenue, operates funds under its own name. GSO plays up the Blackstone affiliation in marketing materials, including a presentation for a $1.5 billion mezzanine pool.

Bypassing Banks

GSO Capital Opportunities Fund LP fund has received a $100 million commitment from New Jersey's pension fund, according to a memorandum from the State Investment Council on the state's Web site. Mezzanine funds typically make loans to companies at higher rates than banks and buy their preferred stock.

In a presentation to the Indiana Public Employees' Retirement Fund in April, GSO said 14 investments made since 2005 have produced an internal rate of return of 38 percent.

James, 57, has said the GSO takeover was a byproduct of Blackstone's initial public offering, which gave the firm a currency to make acquisitions. It also gave James a chance to do deals while Wall Street licks its collective wounds.

``We're bypassing the banks,'' James said after a February panel discussion in Munich at the Super Return conference. ``There's still ultimately demand for this paper out there if you can go directly to the buyers.''

GSO Deals

GSO has financed the buyouts of companies including San Francisco-based Hellman & Friedman LLC's $1.76 billion purchase of Goodman Global Inc. in October. GSO and Farallon Capital Management LLC, a San Francisco-based hedge fund, committed to buy $500 million of high-yield debt from Goodman Global, a Houston-based maker of heating and cooling products.

In addition to loans, GSO is buying debt issued as part of leveraged buyouts, a business Blackstone was pursuing before the GSO purchase. Blackstone raised $1.3 billion to invest in distressed debt securities through a separate fund.

Such deals are especially attractive for buyout firms, which are snapping up LBO debt trading at less than 90 cents on the dollar in some cases. Since the debt often is associated with transactions researched by the firms' dealmakers, the distressed funds can make fast, informed decisions.

Distressed Debt

GSO bought loans backing the $17.9 billion takeover of Clear Channel Communications Inc. last week by Bain and Boston rival Thomas H. Lee Partners LLC for as little as 85 cents on the dollar, according to Standard & Poor's. Banks selling the debt, including Frankfurt-based Deutsche Bank and Credit Suisse Group of Zurich, loaned GSO the money to buy the LBO debt.

``This is a good price for the private-equity firm,'' said Matthew Wilcox, an analyst at KDP investment Advisors Inc. in Montpelier, Vermont. ``Its an absolute mess for the banks. It's tough for them to sell the debt at a lower price.''

Still, the strategy may increase Blackstone's risk if those companies falter because it means the firm and investors may hold both equity and debt in a single deal.

The number of companies with high-yield or high-risk debt that fail to make interest payments probably will triple within the next 12 months to 6.3 percent, according to Moody's Investors Service in New York. The pace of defaults would have been even faster were it not for loose loan covenants that allow many distressed issuers the ability to avoid defaulting.

Relying on GSO also may strain Blackstone's relationship with Wall Street. Investment banks earned $1 billion of fees in the first quarter of this year, down from $4.3 billion a year earlier, according to data compiled by New York-based research firm Freeman & Co. and Thomson Financial.

Blackstone paid less than $21 million, a decline of more than 90 percent, according to Freeman.

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Blackstone Risks Hedge Fund Returns as LBO Loans Fade