Game of Stones

Early in his life, it was clear that Stephen A. Schwarzman was destined for greatness. His professional career began early, folding handkerchiefs as a child for his father’s dry goods store in Pennsylvania.

As he transitioned into his teen years, his ambitious visions were on full display when he laid out his plans for transforming his father’s local business to a nationwide chain.

To Schwarzman’s surprise, his father shot down the idea and explained that the stable and comfortable life that his small business provided him with was worth more than the potential risks and headaches that came with nationwide expansion.

Schwarzman couldn’t disagree more.

Schwarzman was not only an exceptional student in high school whose academic record granted him admission into Yale, but he was also a phenomenal athlete, earning a track and field state championship.

At Yale, he joined the exclusive secret society Skull and Bones whose alums include both Bush Sr. & Jr., John Kerry, William Howard Taft, Percy Rockefeller, Henry Luce, and more.

After Yale, Schwarzman got an offer to join Donaldson, Lufkin, & Jenrette, an investment bank on Wall Street.

The starting salary for a new graduate was $10,000.

SCHWARZMAN: That is absolutely terrific. But there’s only one problem

DONALDSON: What’s that?

SCHWARZMAN: I need $10,500.

DONALDSON: I’m sorry, what do you mean?

SCHWARZMAN: I need $10,500 because I heard there’s another person graduating from Yale who’s making $10,000, and I want to be the highest-paid person in my class.

DONALDSON: I don’t care. I shouldn’t be paying you anything at all. It’s $10,000!

SCHWARZMAN: Then I won’t take the job.

DONALDSON: You won’t take the job?!

SCHWARZMAN: No, I need $10,500. It’s not a big deal to you, but it’s a really big deal to me.

DONALDSON: You’ve got to be kidding.

SCHWARZMAN: No, I’m not kidding.

DONALDSON: Let me think about it

( two days later )

DONALDSON: Okay. $10,500.

After Harvard Business School, Schwarzman began working at Lehman Brothers and quickly rose up the ranks, achieving partner status at just 35.

While most people would be satisfied with being a partner at a tier 1 bank, Schwarzman desired more — he wanted the head honcho title. More importantly, he seemed destined for it, as he was a close ally of the the chairman and CEO Pete Peterson.

The COO Lewis Glucksman was also vying for the top spot. Given his trading background, his vision of aggressive traders running the bank heavily contrasted Peterson and Schwarzman’s idea of leaning into investment banking more.

By promoting key traders to senior positions and convincing senior leadership that a focus on trading will lead to higher long-term growth, Glucksman was able to consolidate power and force Peterson to resign in 1983.

Schwarzman, a true competitor, was not going down without a fight. After Glucksman’s management style was perceived as divisive in addition to increasing trading losses, Schwarzman pulled a similar stunt to Glucksman and rallied discontent partners and executives who believed Lehman needed new leadership.

However, instead of Schwarzman wrestling away the title of CEO, he facilitated the sale of Lehman to American Express in 1984. It wasn’t long before he realized that the new culture established wasn’t for him and that he needed a fresh start.

After lengthy discussions with Peterson, they decided to enter the capital management business—but with a twist. Instead of following the diversification trend popular at the time, they would solely focus on an emerging sub-sector of finance: buyouts.

The timing seemed to be perfect.

Firstly, in the 1960s, corporate conglomerates went through a period of diversification in which they expanded into verticals outside of their main business focus. However, by the time the 1980s rolled around, many of them realized this was not an ideal strategy and began to divest the assets, providing a great environment for buyouts.

Also, the rise of junk bonds thanks to Michael Milken at Drexel Burnham Lambert provided investment firms with an alternative source of capital to execute their buyouts.

To Peterson and Schwarzman, the buyout business was a no-brainer. They named the company Blackstone, as “schwarz” means black in German, and petros (from Peterson) means stone in Greek.

After identifying their strategy, their next order of business was to raise capital, which should have theoretically been quite easy for them.

However, business isn’t theoretical—it’s practical.

And the practical truth was although the duo had an impressive joint resume, their actual investing track record was blank and this was enough to make potential investors nervous.

Their initial goal of raising $1B was looking less and less likely as time went on given the hundreds of letters they wrote to institutional investors were being ignored.

While trying to locate sources of capital, they instituted a consulting arm of the business to keep them afloat, earning a modest $50K from their first deal.

When all hope seemed lost, Prudential, the largest investor in the world at the time, was willing to take a chance on the firm. After just one meeting, the insurance company agreed to cut a $100 million check, giving the company instant credibility.

Schwarzman describes this as his “miracle moment.”

In the blink of an eye, raising capital morphed from impossible to simple. The firm raised $800 million, becoming the largest first-time fund in history.

Over the course of its history, Blackstone has executed a variety of notable deals, including Hilton Hotels ($14B profit), Freescale Semiconductor ($11B profit), Equity Office Properties ($7B profit), and more.

Unlike other investment firms, Blackstone didn’t blindly chase hot sectors or trends, as they generally stayed within the realm of hotels, tourism, chemicals, food, and real estate.

In Schwarzman’s eyes, the hottest sectors often saw institutional investors irrationally crowd into assets that overinflated its equity price. Because of this, he liked to invest in verticals that were more stable but could also benefit from emerging sectors.

For example, in the 1990s, he felt hesitant to invest directly in internet companies; instead, he deployed capital in cable television networks, as they could be used for internet data transmission. Not only did these companies receive a stimulating effect from the internet boom, but Blackstone was also one of the few firms that was relatively unaffected by the ensuing dot-com bubble.

Blackstone also established the trend of active management, as they aggressively cut costs, altered management structures, expanded into new business areas, and more to increase the value of their assets.

The Celanese deal embodies this approach perfectly: Blackstone took the German company private in 2004 for $3.8B and then proceeded to eliminate areas of bureaucracy, divest from unprofitable businesses, and relocate operations to regions with lower labor costs.

The following year, Blackstone helped the company go public, and by the time they exited the position in 2007, they had accumulated a profit of nearly $3B.

Another differentiation factor Blackstone tapped into was a co-ownership model that provided an innovative partnership style the finance world hadn’t seen before.

Instead of simply distributing shares to partners, the most exceptional individuals from either within or outside of the company could run a specialized company within Blackstone’s umbrella.

The company would be jointly owned by both these individuals and Blackstone to ensure not only an alignment of interests, but also to prevent the inevitable dilution effect that occurs when shares are simply doled out.

What Blackstone did not know at the time was that this concept would inadvertently create a monster.

But that’s a story for a different day.

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