In this excerpt from What it takes, Stephen Schwarzman explains how Blackstone developed it’s highly risk-averse and impersonal investing strategy. His system differs from that of Warren Buffett which I find highly interesting. Warren makes decisions on his own mostly, at Blackstone there is a process through which investing decisions have to go.
THERE ARE NO BRAVE, OLD PEOPLE IN FINANCE
As Blackstone was expanding, we hired a young banker from the corporate finance division at Drexel Burnham Lambert. He was smart and ambitious and soon after he arrived in 1989, he had a deal for us. Edgcomb, based in Philadelphia, bought raw steel and milled it into products for car, truck, and airplane manufacturers. This young partner had worked on a couple of Edgcomb deals at Drexel, so he knew the company, and its executives knew him. Now it was up for sale, and we got an exclusive first look at buying it.
An exclusive always warrants attention, and the deal looked promising. Edgcomb was making a lot of money. Its customer base was growing, and the company looked as if it could expand. They were asking around $330 million, which, based on our analysis, seemed like a decent price. I was ready to offer. Before I did, though, another of our new partners, David Stockman, came into my office spouting doom. David was a hybrid of Washington, DC, and Wall Street and had been director of the Office of Management and Budget under President Reagan. He had been with us less than a year, and had a fierce intellect, analyzed deals closely, and expressed his opinions without reservation.
“This Edgcomb thing is a disaster,” he said. “We absolutely cannot do it.”
“The other guy thinks it’s great,” I said.
“It’s not great,” David said. “It’s awful. The company is worthless and poorly managed. All of its profits are coming from the increase in steel prices. They’re one-time profits, and the basic business just has the illusion of profitability. It’s going to end up going bankrupt. If we leverage it the way we’re going to, we’re going to go bust ourselves. It’s a disaster in the making.”
I called Edgcomb’s champion and chief critic into my office to debate the investment, so I could hear them argue it out face-to-face and then make a decision. I sat there and listened to their pitches as if I were King Solomon. I thought the younger man got the better of it. He had worked with Edgcomb for years. He had an insider’s knowledge and could answer all the questions. Stockman was analyzing the deal as an outsider. He had a strong argument but didn’t have the same level of information. We thought we understood steel after our success with Transtar, the transportation business we had bought from USX. And somehow we thought we could now predict the commodity cycle, so I decided to go ahead. We made the offer, gathered money from investors, and closed the deal.
And right on cue, a few months after we closed, steel prices began to nosedive. Edgcomb’s inventory was now worth less than they had paid for it and dropping in value every day. The profits we anticipated, which were to pay our borrowing costs, never materialized. We couldn’t make our debt payments. Edgcomb was imploding, just as David Stockman predicted it would.
I got a phone call from the chief investment officer of Presidential Life, which had invested in our fund. He wanted to see me. I took a cab to his office in Nyack, on the Hudson above New York. He asked me to sit down and started screaming at me. Was I a complete incompetent or just stupid? What kind of imbecile would squander his money on something so worthless? How could he have given a dime to someone as inept as I was? As I sat there absorbing the punishment, I knew that he was right. We were losing their money because our analysis was flawed. I was the person who had made the decision. I don’t think I have been as ashamed as that in my life before or since. Even messing up those deal book numbers for Eric Gleacher as a first-year associate at Lehman didn’t compare. I wasn’t capable. I wasn’t competent. I was a disgrace.
I also wasn’t used to being yelled at. My mother and father never raised their voices. If we did something wrong, they let us know about it, but they never screamed or shouted. I felt tears welling up and my face turning red and hot. I had to force myself not to cry. I said I understood, and we would do better in the future. As I found my way to the parking lot, I vowed to myself, This is never, ever going to happen to me again.
Back in the office, I worked like a demon to make sure that even if Blackstone and our investors lost money on Edgcomb, our creditors—the banks we had borrowed from to fund part of the deal—didn’t lose a nickel. Edgcomb was just one deal in one fund. We would make other deals with the money from that fund and ensure that, overall, our investors did well. But our creditors lent us money deal by deal. If we failed to repay them even once, I feared, it would damage our reputation. Banks would lend us less money on stricter terms, making business harder.
We then examined our decision making. For all our entrepreneurial strengths, our drive, our ambition, our skills, and our work ethic, we still weren’t building Blackstone into a great organization. Failures are often the best teachers in any organization. You must not bury your failures but talk about them openly and analyze what went wrong so you can learn new rules for decision making. Failures can be enormous gifts, catalysts that change the course of any organization and make it successful in the future. Edgcomb’s failure showed that the change had to start with me and my approach to investing and evaluating potential investments.
I had fallen into a trap common to many organizations. When people have to pitch ideas, they tend to address the great man or woman sitting at the end of the table. If their idea is no good, the great man or woman rejects them. Regardless of the quality of their proposal, they leave the room with their heads down. A few weeks later, they go through the same routine with a new proposal and leave the room even more slowly than before to show what they think of the decision. The third time, they’re gritting their teeth. The fourth time, the person at the end of the table now feels bad. The proposers aren’t horrible employees, just not that good. But if that fourth idea is near-okay, the boss will end up green-lighting it just to keep everyone happy.
In my enthusiasm to give a new partner a shot with the Edgcomb deal, I had made myself and the firm vulnerable. I had succumbed to a good sales pitch. I learned later that one of the analysts on this new partner’s team had opposed the deal. He couldn’t see it ever working. But the partner had told him to keep his doubts to himself.
I should have been more wary of my emotions and more scrupulous with the facts. Deals aren’t all math. But there are a lot of objective criteria to consider, and I needed to do that at length, in peace, not with two people pushing their views, and me sitting there deciding between them.
Finance is full of people with charm and flip charts who talk so well and present so quickly you can’t keep up. So you have to stop that show. Decisions are much better made through systems designed to protect businesses and organizations than through individuals. We needed rules to depersonalize our investment process. It could never again rely on one person’s abilities, feelings, and vulnerabilities. We needed to review and tighten our process.
I had always been maniacal about not losing money, and the trauma of Edgcomb pushed me further. I began to think of investing as like playing basketball without a shot clock. As long as you had the ball, all you had to do to win was just keep passing, waiting until you were sure of making the shot. Other teams might lose patience and take those off-balance, low-percentage shots from behind the three-point line, the way we had done with Edgcomb. At Blackstone, I decided we would keep moving and passing until we could get the ball into the hands of our seven-foot center standing right underneath the basket. We would obsess about the downside of every potential deal until we were certain we could not miss.
We decided to involve all of our senior partners in our discussions of investments. We would never again allow one person single-handedly to green-light a deal. During my career, I had gotten things more right than wrong, but Edgcomb had shown that I was far from infallible. My colleagues had decades of experience. By working together, arguing and applying our collective wisdom to evaluate an investment’s risks, we hoped we could examine our deals more objectively.
Next, we insisted that anyone with a proposal would have to write a thorough memorandum and circulate it at least two days before any meeting so it could be carefully and logically evaluated. The two-day requirement would give readers time to mark up the memo, spot any holes, and refine their questions. No additions could be made to the memo at the meeting unless there was a significant subsequent development. We did not want extra sheets of paper going around the room.
The senior partners would sit on one side of the table and the internal team presenting a deal on the other. Around us would be the junior members of our teams, who were expected to watch, learn, and contribute.
These discussions had two fundamental rules. The first was that everyone had to speak, so that every investment decision was made collectively. The second was that our focus should be on the potential investment’s weaknesses. Everyone had to find problems that hadn’t been addressed. This process of constructive confrontation could be challenging for the presenter, but we designed it never to be personal. The “only criticism” rule liberated us to critique each other’s proposals without worrying that we might be hurting someone’s feelings.
The upside of the potential investment should be included as well, but that was not the focus of our early investment committee discussions.
Once this group dissection process concluded, whoever was running the deal now had a list of problems to address and questions to answer. What would happen to the company they were proposing we buy if a recession hit? Would its profits decline gently or plummet? Were the best managers likely to stick around following a buyout? Had we thought hard enough about the likely response from competitors? Or the effect on profitability if commodity prices collapsed, as they had after we bought Edgcomb? Did their financial model take account of all these eventualities? The presenter’s team would go back and find answers to our questions, and in doing so, they could implement fixes or figure out how to manage the downside, or they might uncover new risks, new probabilities of loss that they might never have seen before. And back they would come for another round of discussion. By the third round, we hoped, there would no longer be any nasty surprises lurking in the deal.
I also resolved that I would never talk to just the lead partner on any potential investment. If I had detailed questions, I would call the most junior person, the one working the spreadsheets and closest to the numbers. If I had done that on Edgcomb, I might have heard from the analyst who hated the deal. Breaking through the hierarchy would allow me to get to know the junior people at the firm and get a different read. The risk may not be obvious on paper, but it came through in the analysts’ tone of voice when I asked them, “Just walk me through this deal from your perspective.” You could hear if they liked it or felt anxious. Psychology would be one of my strengths as an investor. I didn’t need to remember each number in an analysis. I could watch and hear the people who knew the specifics and tell how they felt from their posture or tone of voice.
The final change we made to depersonalize and derisk our investment process was to encourage a greater sense of collective responsibility. Every partner on our investment committee needed to participate in assessing the risk factor of a proposed investment. In this way, the internal team presenting could not target the senior person at the table or lobby him or her for a positive decision. Everyone in attendance would share responsibility for whatever decision was made. And we made every decision in the same predictable manner.
As we have added new businesses to Blackstone and ventured into new markets, we apply this same process to all our investment decisions. Everyone contributes to the discussion. Risk is systematically broken down and understood. Debate is full and robust. The same small groups of people, who know each other well, go over each investment applying the same rigorous standards. This unified approach to investing has become the backbone of the Blackstone way.
For all that was going on at Blackstone in its early years, the rest of my life didn’t stop. Ellen and I divorced in 1991, but we continued to raise our children, Zibby and Teddy, together. It had been a painful decision to separate. Before we did, I remember going to see my internist, Dr. Harvey Klein, for a checkup. Physically I was fine, but at the end of our meeting, Harvey asked me how I was doing. I told him I was under a lot of stress at work, and I couldn’t make a decision on my marriage. I was unhappy but frightened by the prospect of divorce. Harvey jotted down a telephone number and handed it to me.
Dr. Byram Karasu is a psychiatrist who spent twenty-three years as department chair at the Albert Einstein College of Medicine in New York. He is the author of nineteen books; runs a small, private practice in Manhattan; and is regularly called on for his opinions in Washington. When I stepped into his office for the first time, I made it clear that I wasn’t there for therapy. I just couldn’t make my mind up about divorce. He asked me what was holding me up. Four fears, I told him: the fear of losing my relationship with my children, the prospect of signing away half of what I had worked so hard to make, the fear of losing half my friends, and terror at having to date again.
Four reasonable anxieties, Byram said, but all ultimately unjustified. My children were well past the imprinting stage of childhood, when divorce might traumatize them. If I wanted a good relationship with them and worked on it, they would want the same. As for my money, yes, it would be a big check to have to write, but if it cleared the way for a new chapter in my life, I would soon forget about it. The friends we had made as a couple would likely split fifty-fifty, and that was just a fact of life. And as for dating? As a wealthy, single man in Manhattan, I wouldn’t be short of options.
Byram was warm, thoughtful, insightful, experienced, and convincing. His advice changed the direction of my life in the most positive way. I have been to see him once or twice a week ever since to talk about work mostly, and he always thinks with that same objective clarity he showed me at that first meeting. He understands my brain, the intensity with which I experience and respond to the world. He helps me test my intuitions and strip away the psychological, social, emotional, and intellectual filters that can obscure the truth.
Byram was also right about my divorce clearing the way for a new chapter in my personal life. My friends were kind enough to set up dates for me, and one was with a recently divorced attorney, Christine Hearst, who had a job lined up and her boxes packed to move to Palo Alto. Not the most promising setup. We were both busy, and Christine was already thinking about her new life on the West Coast. But my friends were insistent that I meet her, and I had promised I would try.
I thought our first date was great. She thought it was weird. She was expecting me to pick her up, but I was working late and we were going to a party close to my office, so I sent a car over to get her instead. She looked surprised when I finally did get in the car. I glanced over and said, “Hi, I’m Steve.” And then proceeded to flip down the visor mirror and run an electric shaver over my face. We went from a book party at Rockefeller Center to see George Michael perform at the new Sony Plaza building on Madison Avenue to a dinner party with friends. Debbie Bancroft, the mutual friend who introduced us, called me the next morning to ask how the date went.
“Great,” I told her. I liked Christine and we had done all these exciting things. Christine, though gregarious, is a private person. She had told Debbie she felt like an accessory as we went from place to place, socializing with lots of people I knew and she didn’t. She had had a miserable time. The date was so busy that we never had a proper chance to talk at all. Debbie told me I was to call Christine, apologize, and invite her out for a quiet evening at a restaurant, someplace where we could actually get to know each other. I did as she suggested, and our next date was a long dinner at an Italian restaurant on First Avenue. I had such a good time that by the end of the dinner, I had my trusty calendar out. Christine looked surprised as I ran through various dates and tried to schedule when we might meet again. She wasn’t used to anyone in finance as precise as I can be.
“We can do this thing fast or slow,” I said. “I prefer fast.”
Thankfully, I didn’t put her off. Once we started dating, one of her first orders of business was to bring some order to my bachelor habits. I was living in an apartment at 950 Fifth Avenue with my son, Teddy, and had hired a chef, Chang. Night after night we’d have those familiar father–teenage son conversations over dinner. “How was school?” “Fine.”
The first time Christine came over, she went into my kitchen and opened the fridge. It was more than I ever did. There she found box upon box of Stouffer’s ready meals all stacked up. For two years, Chang had been heating them up and serving them to me and my son, and we hadn’t even noticed.
A couple of years later, after Christine and I were married, I wanted to hire a chef. Christine has many skills, but none of them include meal prep. And everyone who knows me knows that after a long day’s work, I like a proper dinner. So we put out an ad and were particularly impressed by a résumé from a chef called Hymie. We invited him for an interview, and Christine recognized him the moment she opened the door. It was Chang! He had simply changed his name and hoped we might have forgotten the bad Stouffer years. That’s New York for you.