JUNE 2013 INSTITUTIONALINVESTOR.

COM

GSOs Bennett Goodman

LENDERS
of LAST
RESORT
BY JULIE SEGAL

UNDER
BLACKSTONES
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

GSOs Douglas Ostrover

Ara Hovnanian, CEO of Hovnanian Enterprises, knew little about

GSO Capital Partners before the credit-oriented alternative asset
manager offered the struggling homebuilder a lifeline last year.
Douglas Ostrover, the O in GSO, invited him to lunch at Manhattans Core Club in July 2012, just as the U.S. housing market was
showing a few signs of life. The then-54-year-old CEO figured he
had little to lose by listening to Ostrovers pitch. His company had
been bleeding money for six years and had used up every penny of
its capacity to issue secured debt.With no bank willing to lend to it,
the Red Bank, New Jerseybased homebuilder had become a target
for short-sellers; investors were betting billions of dollars in credit
default swaps that the company Hovnanians father and three uncles
had founded in 1959 would go belly-up. Hovnanian, who had lived
through several real estate cycles, was shocked when Ostrover told
him the price of the five-year CDS contracts on Hovnanian implied a
93 percent probability of default. The market is saying youre going
bankrupt, Ostrover added.
GSO, which is owned by private equity giant Blackstone Group,
had spent six months digging into the finances of Hovnanian and
had been buying up its equity, secured debt and unsecured debt since
March. Ostrover, now 50, who helped build the leveraged-finance
business at investment bank Donaldson, Lufkin & Jenrette during
the 1990s, explained his idea for solving Hovnanians liquidity problems.The company would sell its property inventory to a land bank
created by GSO in return for a $125million cash infusion. Over time
GSO would sell the land back to the homebuilder. Ostrover asserted
that not only would the market react positively to the initial financing
but that the GSO-Blackstone brand would signal that there could
be more behind it. Look, the market hates your company, he told
Hovnanian. We love your company.
(Ostrover had his own hard-luck family bankruptcy story: His
grandfather had to shutter Ostrovers Smoked Fish on NewYorks
Lower East Side in the 1950s following a blackout; he couldnt pay
his creditors because his customers fish had rotted.)
Hovnanian, for his part, was not convinced that the market would
react as positively as Ostrover suggested. If youve been out in the
battlefield for seven years, being shot at constantly, you dont know
what to do if the bullets stop flying, he told Ostrover, who left the
lunch uncertain whether the CEO would agree to his plan.
It took a week before Hovnanian softened, but GSO got its deal.
Indeed, when Hovnanian announced the land banking deal on July
GSO co-founder Douglas Ostrover made the pitch to Hovnanian

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 otherWall Street research firms changed their rating from a sell
to a hold GSO had been hoping for a buy and Credit Suisse
refinanced Hovnanians 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
year since 2006 (see CEO Interview, page 48). Hovnanian was the
largest position in GSOs flagship hedge fund in 2012, and the firm
made 50 percent on its capital in six months.
GSO has provided much-needed credit to scores of troubled
companies like Hovnanian that couldnt tap public markets or get
bank loans. The firm has financed well-known names like Chesapeake Energy Corp., struggling with weak natural-gas prices and
controversy around its ex-CEO and needing capital to develop
lucrative energy projects, and Sony Corp. while also providing
$650million of capital to smaller homebuilding companies like the
U.K.s Miller Group and $888million to companies in Europe last
year, including Canberra Industries,Welcome Break and EMI Music
Publishing. As one of the largest creditors of MBIA and holders of
its equity, GSO had a big win last month when the Armonk, New
Yorkbased provider of municipal bond insurance finally settled a
dispute with Bank of America Corp. after years of wrangling over
troubled mortgage-backed securities.
In the old days a bank might have been more willing to commit its
balance sheet for long-standing clients, says Bennett Goodman, the
56-year-old G in GSO, who started his career at Drexel Burnham
Lambert in the 1980s. Because of the regulatory environment, its
harder for them to do that economically. As a consequence, banks

In the old days a bank might

have been more willing to
commit its balance sheet for
long-standing clients. Because
of the regulatory environment,
its harder for them to do that.
Bennett Goodman, GSO Capital Partners

want to syndicate risk into the market put together a road show
and talk to 200 investors. But they dont want to commit their capital.
We, on the other hand, want to own the risk.
GSO founders Goodman, Ostrover and Tripp Smith have
emerged as lenders of last resort, filling the gaping financing void
left by banks and opportunistic hedge funds in the wake of the
200809 financial crisis.The firm follows in the footsteps of Drexel
and Michael Milken, who in the 1980s invented the junk bond
market for non-investment-grade companies. In the 1990s, GSOs
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 Buffett 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 its 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 theVolcker rule, GSO and others
like it, with their ability to make commitments, have more market
power than ever, says Brian ONeil, chief investment officer of the
$9billion-in-assets Robert Wood Johnson Foundation, the U.S.s
largest philanthropic organization focused on public health and one
of GSOs first investors.
Banks may no longer have the balance sheets, but big institutional
investors like sovereign wealth funds, endowments and pension
funds do. To be sure, Blackstone is not the only manager to have
smelled opportunity in the financing void. Depending on the product, GSO has a host of competitors, including Apollo Group Management; Ares Capital Corp. (an Apollo spin-out); Avenue Capital
Group; Carlyle Group; Goldman, Sachs & Co.; J.P. Morgan Asset
Managements Highbridge Capital Management; KKR & Co.;
Oaktree Capital Management; andTPG Capital.
James Coulter, co-founder of private equity firm TPG, says the
opportunity is much more attractive for managers and investors now
that banks which threw cheap money from depositors at troubled
companies financing problems and pocketed the profit are not
in the mix. There is a place for capital formation at market rates of
return and driven by problem solvers, explains Coulter. Its alternative credit growing up. Its not theWildWest, not the personalitydriven days of 20 years ago. And this is good for the economy. TPG
launched its own midmarket lender after the financial crisis and has
both competed and partnered with GSO.
Goodman, Smith and Ostrover founded GSO in 2005 to provide
capital to non-investment-grade cyclical companies that were going
through a tough patch but had tangible assets to put up as collateral
to protect the firms downside when it lent them money. GSO was an
early investor in the shale gas industry, which has been whipsawed by
volatile pricing and other events. They have a zealous approach to
protecting capital, and theyve found a way to extend credit to organizations that need it and structure it in a way that takes advantage
of the environment at the time, says Blackstone chairman, CEO
and co-founder Stephen Schwarzman.
In 2008, Blackstone, looking to diversify, paid $1billion to
acquire GSO, which then had a $3.2billion credit hedge fund,

Blackstone co-founder Stephen Schwarzman (left) and

president Hamilton (Tony) James wooed GSOs principals for
several years before buying their firm in January 2008

$500million in mezzanine investments and a $4.8billion collateralized loan obligation business. The deal wouldnt have happened
without Goodman, Smith and Ostrovers former boss,Tony James,
who had joined Blackstone as president in 2002 after Credit Suisse
bought DLJ and who manages the firms day-to-day operations.This
was more like a family reunion than an acquisition, says Schwarzman.
Credit to Steve, he really trusted me on this one, adds James,
who says Blackstone was looking for an area of asset management
with room to grow that would complement its existing private equity,
real estate and fund-of-hedge-funds businesses. What was a wideopen white space for us? Credit jumped off the page.
With $58billion in assets under management and 235 employees,
GSO has grown fivefold under the Blackstone umbrella.Today it offers
$27billion in alternative-investment funds, including the now $4billion hedge fund, $8billion in mezzanine funds financing buyouts for
private equity $8billion in rescue lending and $7billion in small-cap
direct lending. The firms long-only strategies include a $24billion
CLO business, making GSO the largest institutional investor in leveraged loans, as well as closed-end and other funds. Goodman is quick
to credit the Blackstone brand for at least part of GSOs success. If
we were Schmeckle & Schmeckle or just stand-alone GSO, theres no
way the board of Sony or some of these other companies would have
gone along with some no-name firm, he explains.
GSOs returns have been top quartile. According to external marketing documents, its hedge fund has delivered a net annualized return
of 13.6 percent since January 2010, compared with the HFRI Fund
Weighted Composites return of 4.6 percent for the same period.
(Though the hedge fund was launched in 2005, GSO has since
stripped out mezzanine and other investments into separate funds.)

tive credit mirrors tools that equity investors have had with private
equity, saysTPGs 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 couldnt
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 thats 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.

The firms mezzanine fund has one of the best records in the industry,
up an average of 19.9 percent a year net since inception in July 2007.
Rescue lending has returned an annualized 15.2 percent since inception in September 2009. The GSO team has been through the ups
and downs of numerous credit cycles, and theyre always worried and
trying to protect the downside, saysTimothyWalsh, chief investment
officer of the $74billion New Jersey Pension Fund, which has committed to $1.1billion in investments in five GSO funds.
Blackstones acquisition of GSO has been an undisputed winner.
GSO represents 26.6 percent of the firms $218billion in assets, on
par with its $59billion real estate business and larger than both its
private equity ($52billion) and Blackstone Alternative Asset Management hedge fund ($48billion) businesses. GSO represented 38.9
percent of Blackstones $629million of realized performance fees
earned in 2012 and 16 percent of the firms $2billion in economic
net income last year. In 2007, the peak for the firms performance
fees, private equity contributed the bulk of the total. Between 2005
and 2012, GSOs assets grew at a compounded annual rate of 29
percent. That makes GSO Blackstones fastest-growing business
in terms of both earnings and assets. Executives at two publicly
traded alternatives firms say they arent so much concerned about
Blackstone as a competitor in private equity but that theyve been
blindsided by GSOs growth. Though hurt by the financial crisis,
Blackstone and GSO have emerged as dominant players in its
aftermath. Since 2008, Blackstone has more than doubled its assets.
At the same time that GSO is capitalizing on the void left by banks,
it is also benefiting from historically low interest rates and unrelenting investor demand for credit investments.While non-investmentgrade companies need capital, investors need yield, and alternative
credit strategies like those offered by GSO provide a much-needed
boost to returns for bond portfolios. Now the emergence of alterna-

IN THE 1980S, WALL STREET HAD A CLEAR PECKING

order. On top were three white-shoe firms: First Boston Corp., Goldman Sachs and Morgan Stanley.Thats 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,
Drexels CEO, passionately recounting how it financed entrepreneurs,
married capital to ideas and was profoundly transforming whole
industries.I fell for it hook, line and sinker, says Goodman.I love the
underdog.While his friends at Harvard including one he describes
as having had pinstripes on his diapers did summer internships at
Wall Streets toniest firms, Goodman took a job with Drexel.
There Milken was leading whats now called the democratization of capital-raising, providing funding to small and medium-size
companies that were starved for financing and whetting the appetites
of investors for distressed and troubled companies that showed
promise despite short-term woes. In the process, Drexel helped spark

The GSO team has been

through the ups and downs of
numerous credit cycles, and
theyre always worried and
trying to protect the downside.
Timothy Walsh, New Jersey Pension Fund

an unprecedented era of prosperity in the U.S. as companies likeTed

Turners Turner Broadcasting System, Craig McCaws McCaw
Cellular Communications and William McGowans MCI Communications Corp. rapidly expanded by using this newly available
source of capital. Junk bonds also fueled the leveraged buyouts of
the 1980s, when firms like KKR targeted companies that had once
turned deaf ears to shareholder demands.
After earning his MBA in 1984, the Miami-born Goodman took
a full-time job with Drexel in New York. He spent five years there,
toiling on ten to 12 deals a year all of them different in a culture
that rewarded Street smarts and a maniacal work ethic. Drexel was

ALTERNATIVES

a place where analysts spent days buried in

the dense financials of dicey companies.The
firm honed the skills needed to look at an
ugly financial situation and determine the
commercial viability of a financing for both
the companies and investors. In contrast to
the few traditional deals a year that a junior
banker at Goldman might work on, Goodman cut his teeth on such unusual transactions as KKRs investment in Union Texas
Petroleum Holdings in 1985 and Maxams
1986 takeover of Pacific Lumber Co. For
the latter he and Joshua Friedman, then
head of the capital markets group at Drexel,
came up with a term sheet for a zero-coupon
increasing-rate note whose complexity and
model they still laugh about.
In 1987 the Los Angelesbased Milken
called Goodman, who by this time focused on
LBOs, telling him he should move to Beverly
Hills and work for Friedman (who would
go on to co-found hedge fund firm Canyon
Capital Advisors). But after his wife, Meg,
refused to leave NewYork, Goodman quickly
set his sights on DLJ, a midsize investment
bank known for equity research and a certain
scrappiness and entrepreneurial culture.
Garrett Moran, who ran the high-yield bond
group at DLJ, says Goodman stalked him
for six months, wanting to pitch his idea for a
capital markets desk.
Goodman liberally quotes from his uncle,
Skip Bertman, a former head coach at Louisiana State University who has the best baseball
record in the National Collegiate Athletic
Association and who took an influential role
in Goodmans life after his father passed away
when he was five years old. Bertman, who
built an underdog team into a profitable legend for LSU, told Goodman that success took
three Hs: hard work (in an interview his
uncle calls that hustle), honesty and humility.
Hard work got him noticed at Drexel, as
well as a meeting with Moran. But Goodman
shunted humility aside at least temporarily
during his lunch with Moran.The 30-yearold newly minted Drexel vice president told
the DLJ executive, Im going to help build
this big business at DLJ, and youre going to
get rich and famous. Moran, who says he
instantly liked Goodman and the wealth of
experience he had gotten working on deals
inside the Drexel pressure cooker, hired him.
He might have been young, but it was like
a pro coming into an amateur team, adds
James, who then ran DLJs investment bank.

In early 1988, Goodman started building

the capital markets business at DLJ under
Moran and James. At that time, Drexel had
a lock on the business.Take the highly confident letter, a piece of paper Drexel would
issue to the board of a company as a promise
that it would provide financing on deals.When
DLJ tried issuing its own highly confident letters, they meant nothing, as DLJ had a small
balance sheet. So the firm created the bridge
loan, not promising capital but intended to
tide the company over until it could obtain
permanent financing. On the strength of
that bridge loan business, we built ourselves
up into the leading firm, says James.
In September 1988 the Securities and
Exchange Commission sued Drexel for
insider trading and stock manipulation.The
following March, Milken was indicted for
racketeering and securities fraud. In February 1990, Drexel filed for bankruptcy; two
months later Milken pled guilty to lesser
charges, agreeing to pay a $600million fine
and serve ten years in jail. (The sentence was
later reduced to two years.)
With Drexel and Milken gone amid a
recession, many market watchers thought
high-yield financing would die. But although
mostWall Street firms pulled out of the highyield business, DLJ stayed in, doing some secondary trading and working with companies
that felt they had been abandoned.When the
markets rebounded in 1991, DLJ took over
as a leading player.
In 1992, Goodman hired Ostrover from
Grantchester Securities, the high-yield arm
of boutique investment bank Wasserstein
Perella & Co., to run DLJs sales and trading. Ostrover, who has a BA in economics
from the University of Pennsylvania and an
MBA from New York Universitys Leonard
N. Stern School of Business, was ranked the
No. 1 salesperson by a third-party consulting
firm, and Goodman and Moran decided to
steal him away the day the news came out.
While Goodman loves to talk, Ostrover has
to be pressed for details. He reveres his middleclass upbringing first in Queens, NewYork,
and later in Stamford, Connecticut and says
that when he was growing up he didnt know
anyone who worked onWall Street. Apologizing for the seeming hokeyness of it, he refers to
a black-and-white picture in his office of New
Yorks Orchard Street early in the past century,
with unpaved, muddy roads; pushcarts; and a
glimpse of Ostrovers Smoked Fish.

In 1993, Goodman hired Smith from

Salomon Smith Barney, where he worked on
restructurings. Smith had joined Salomon
from Drexel, leaving with a group during the
bankruptcy.Two years out of the University
of Notre Dame, he witnessed firsthand the
toll Drexels failure took on senior managers
whose wealth had been tied up in its stock.
Smith is the third generation in his Indianapolis Irish family to graduate from the Catholic
university; two of his four kids are currently
studying there.
Goodman and Ostrover joke that Smith
was responsible for DLJs success.The year he
joined, the firm became the No. 1 underwriter
for high-yield bonds, a distinction it would
keep for 12 years. Drexel had unwittingly
passed the high-yield baton to DLJ.Though
the three founders couldnt be more different,
theyve maintained their partnership without
a blip for 20 years. Goodman is the storyteller
of the group, Ostrover is Mr. Markets, and
Smith wants to stay out of the limelight and
just do deals.Though the three are equal partners at GSO, Smith and Ostrover often defer
to Goodman for the final word.
In 1995, Moran moved up to chief operating officer of fixed income, and Goodman
took over all of leveraged finance. DLJ used
its market position to keep reinvesting in the
firm, building a leveraged-loan capability
and creating a derivatives business and large
distressed unit.The group invented concepts
such as payment-in-kind toggle bonds, with
which an issuer can defer interest payments
in return for a larger coupon in the future,
and IPO carve-outs, whereby the parent
company sells stock of a subsidiary to the
public. In the late 1990s, Schwarzman, a
client of DLJs, asked Goodman to start a
credit business at Blackstone. It was the first
of many overtures Blackstones executives
would make to him.
It was DLJs limited balance sheet that
taught Goodman, Ostrover and Smith how
careful they had to be with their credit analysis and due diligence. There was little room
for error. You had to figure things out and
use your smarts instead of brute strength,
Smith, 47, says. By 1999, however, DLJ was
hamstrung by its small balance sheet and a
business that was primarily domestic. Competition from increasingly bigger banks was
fierce.The world had changed, and the firm
needed a partner.
Credit Suisse bought DLJ for $11.5bil-

lion in 2000 and combined the firm with its

New Yorkbased investment banking unit,
Credit Suisse First Boston. The big Swiss
bank wanted Goodmans leveraged-finance
business as well as DLJs merchant banking
and real estate groups. Though DLJ investment banking staffers left in droves after the
deal including James, though he stayed
two years as part of the merger agreement
Goodman, Smith and Ostrover flourished.
Even before James left CSFB, he and Goodman talked about going off on their own.After
James joined Blackstone, Goodman took over
CSFBs alternative capital division. Shortly
thereafter Ostrover assumed responsibility
for leveraged finance and Smith joined Goodman in the alternatives group.What the three
founders have built at GSO, they originally
planned for CSFB.
But in June 2004, John Mack, then CEO
of CSFB in the U.S., announced he was leaving; the Credit Suisse board had decided not
to renew his contract. It was a good time for
Goodman, Smith and Ostrover to start their
own firm. By that July the three partners
had launched GSO with 25 employees and
one hedge fund. The firm had purchased
a small CLO group, run by Daniel Smith,
from Royal Bank of Canada. Smith, who

bankruptcy lawyer who had been with DLJ

since 1999 and worked on some of the most
complex distressed deals, such as financing
Level 3 Communications and Qwest Communications, joined GSO at the start. He now
manages its hedge fund. A month after its
launch, GSO hired Donald (Dwight) Scott,
who ran the energy practice at DLJ before
joining El Paso Corp. in 2000. Houstonbased Scott oversees GSOs energy group.
In 2007, Merrill Lynch & Co. took a
minority stake in GSO and the firm had its
first closing for a new mezzanine fund. But
its deals remained small, providing funding
for companies like Pacific Lumber and Caff
Nero, a U.K. coffeehouse chain. Though
it was satisfying to be on their own, Goodman, Ostrover and Smith were used to being
No.1 and having a big firm behind them. But
things were changing, and they would get
their chance soon.
WHEN ASKED ABOUT HIS DECISION
to switch from the sell side to the buy side,
Goodman says his only regret is that he
didnt make the move ten years earlier.
Though he loved working on Wall Street,
particularly at DLJ, Goodman wanted to
spend all his time investing.At a bank youre

Blackstone allowed us to take our

business from being three years old
to ten overnight.
Douglas Ostrover, GSO

had been co-head of high-yield group among

other positions at Van Kampen Investments,
now runs GSOs customized credit strategies, including CLOs, closed-end funds and
Franklin Square Capital Partners, its smallcap direct lending group.
On day one Credit Suisse gave the firm
more than $500million to manage a big
part of the approximately $3billion it had
raised from outside investors, including the
Bass brothers, Blackstone, Cornell University, K2 Advisors, MetLife, Notre Dame and
Quellos Group (now owned by BlackRock).
GSOs hedge fund invested in public securities, mezzanine debt and distressed debt and
provided some rescue lending for companies
going through liquidity problems.
Fully 80 percent of GSOs senior management team is from DLJ. Jason New, a onetime

working for anonymous shareholders, trying to make as much money as you can, he
explains. Its amorphous, and you dont
know the people. Its a different kind of satisfaction walking into the CIOs office for the
Bass brothers.
A deal between Blackstone and GSO, however, wasnt a no-brainer. Private equity investors are by nature optimistic and swaggering,
thinking every deal is a potential blockbuster.
Blackstones offices on Park Avenue are nothing short of glitzy, with unobstructed views
of the NewYork skyline and floors connected
by grand staircases with polished metal banisters. No one has represented Blackstones
opulence more than its billionaire co-founder
Schwarzman, who in 2000 reportedly paid
$37million for a 34-room triplex on Park
Avenue and has owned vacation properties in

the Hamptons; Jamaica; Palm Beach, Florida;

and Saint-Tropez.
Credit investors, on the other hand, are
pessimists, aware that the upside of their
investments is limited, evaluating everything
that can go wrong in an effort to protect their
principal. Credit geeks Goodman, Ostrover
and Smith nonetheless went to Blackstones
extravagant road show at New Yorks Pierre
hotel in the spring of 2007, the first time
that granular detail about the private equity
firm was available to the public.The trio had
remained close to James after he left DLJ for
Blackstone, and they knew he was interested
in striking some type of deal. During the road
show, Blackstone disclosed its numbers, showing heft in private equity, real estate and funds
of hedge funds, but credit was an afterthought,
amounting to only about $5billion in assets.At
the same time, Blackstone had relationships
with almost every major institutional investor
in the world, a group that had, on average,
$200million in assets invested with the firm.
GSOs investors, by contrast, had a paltry
$22million invested with Goodman, Ostrover
and Smith. GSO was also overly dependent
on Merrill Lynch and Credit Suisse, both of
which were starting to feel pressure in the early
days of the subprime crisis.
Any deal would hinge on James, who was
revered by GSOs three founders.That summer James approached Goodman the
fourth time Blackstone had tried to entice
him into a deal and stated the obvious:
In credit were not where we want to be.We
want to buy you.
After six months of negotiations, Goodman and his partners said yes. Although
they enjoyed being their own bosses, they
missed the prestige, and the deals, that came
with being part of a big organization. With
Blackstone they would get scale, a brand,
idea-sharing with the firms deal makers
and access to new and larger clients. Smith,
who calls himself Mr. Process, was the least
enthusiastic about the tie-up, concerned
that they were trading away their autonomy.
But the $1billion price tag the proceeds
of which the partners rolled over into GSO
funds and the potential to take advantage
of what they thought would be a huge shift on
Wall Street helped alleviate their concerns.
Blackstone allowed us to take our business from being three years old to ten overnight, Ostrover says.
GSO and Blackstone announced the deal

ALTERNATIVES

in January 2008. In addition to strengthening their firms credit business, Schwarzman

and James saw benefits for its private equity
operation. Having a better understanding
of credit markets, having a better idea of
how we could finance a creative idea, would
make us better in private equity, says James.
GSO was very synergistic and complemented our other businesses well.
The honeymoon was over quickly,
though. As 2008 wore on and the credit
crisis gathered steam, GSO started putting
money to work. In August the group put
up $1billion in equity to buy a portfolio of
busted bridge loans from Deutsche Bank,
with the German bank providing 3-to-1
leverage. The approximately $4billion
portfolio was distributed across GSOs
own funds as well as Blackstones private
equity portfolios.The next month Lehman
Brothers Holdings filed for bankruptcy
and all hell broke loose. Loan prices
dropped 30 points, obliterating almost the
entire investment at least on paper.The
Deutsche Bank portfolio was marked to
about 5 cents on the dollar for the quarter
ended March 31, 2009. GSO had partnered with TPG to buy a $2billion portfolio of bridge loans from Citigroup. That
also plummeted in value.
As it turned out, GSO had done thorough credit analysis and structured the
debt appropriately, and it made 1.5 times its
investment in two years, with every company
paying off its debts. Writing something
down to zero is not your proudest moment,

ucts to managing 27.The breadth and scale

of its funds allow it to offer a range of solutions to companies, including rescue financing and senior secured bank loans. At the
same time, the platform gives it a lot of different eyes into potential investments. GSO has
a view on about 1,000 companies through its
CLO business, garnering leads that can be
passed on to the hedge fund or other vehicles.
Investments can also be shared.The Hovnanian deal was originated through the hedge
fund but later expanded to include the rescue
financing fund. We stand on this very busy
street corner and see all this activity, says
customized credit strategies partner Daniel
Smith. Under Blackstone, GSO has the heft
to write big enough checks to fully finance a
solution, reducing a companys need to find
additional capital elsewhere.
GSOs flagship hedge fund takes an activist
or event-driven approach to credit. News
team looks for companies going through
some sort of upheaval, such as a covenant
breach, debt maturation, regulatory change,
bankruptcy or a legal dispute like MBIAs
battle with BofA. But unlike activist equity
managers or loan-to-own credit funds, GSO
doesnt seek to change management unless
something goes wrong and it has no choice. It
wants to stay off the front pages of newspapers.
The firm, which has a competitive advantage by doing most of its own loan originations and investing in companies that are
No.1 or 2 in their markets, looks at about
1,000 deals every year and completes fewer
than 5 percent of those. Every Monday the

Its really hard for some people to be

aggressive in times of disruption, because
you have to do your work beforehand.
Tripp Smith, GSO

Goodman says. But by the end of 2009, the

firm had $24billion in assets.
After the market bottomed in 2009,
GSO launched its first rescue lending fund,
which closed at $3.3billion. The next year
it acquired nine CLOs from Allied Capital
Corp., and a year later it bought Harbourmaster Capital Management, a $10billion
European leveraged-loan manager, and four
CLOs from Allied Irish Bank.
In its five years in the Blackstone fold,
GSO has gone from having two fund prod-

investment staff meets to go over ideas and

review the pipeline. GSO now has offices in
NewYork, London, Dublin and Houston.
GSO and Blackstone actively share information. Ryan Mollett, a 34-year-old managing partner who joined News group from
BlackRock in 2011, wrote a paper late that
year asserting that the housing market had
bottomed. Blackstones real estate group
saw similar evidence, and BAAM expected
mortgage improvement based on results
from its underlying hedge funds. As a result

of the cumulative research among the different Blackstone groups, private equity
bought $220million of nonperforming residential loans, the real estate team purchased
$1.4billion of single-family homes to lease,
and GSO invested in Hovnanian. At its peak,
GSO had $475million in hedge fund exposure to homebuilders and related industries
and put out $600 million in financing across
private market vehicles.
The Capital Solutions Fund GSOs
rescue lending vehicle is an object lesson
in the maturation of alternative credit. In the
old days highly cyclical companies in trouble
could sell control to a competitor, a private
equity firm or a hedge fund firm that took a
loan-to-own strategy. In all cases the company
would likely be giving up control at the bottom of the market. In contrast, GSO will take
a minority stake, a seat on the board and a
debtlike investment that pays a big doubledigit coupon, but it will let management retain
control.We decided that the banking system
is a mess globally, so lets raise some money to
lend to more troubled private companies that
cant tap the markets and dont have access to
the banks, says Ostrover.
Part of GSOs success comes from leaving
some money on the table. Goodman states
the obvious: No company does business
with us because were such nice guys, though
we like to think we are. They do it because
they cant get the capital otherwise. And
many companies say GSO doesnt scrape
every penny out of a deal. I dont feel like
Im going to get my throat ripped out when
I call GSO, says one CEO who has done
multiple deals with the company.
GSO LIKES A LITTLE, BUT NOT TOO
much, market misery.Well before the downgrade of the U.S.s credit rating in August
2011, GSO was busy preparing for the possibility that markets would freeze up if the
rating agencies made good on their threats. It
was keeping up-to-date in its credit work on
certain companies and identifying potential
situations for investment. Its really hard
for some people to be aggressive in times of
disruption because you have to do your work
beforehand, says partner Smith.
GSO put about $5billion of capital to
work as the markets slid after the downgrade.
For its drawdown funds alone, it committed
$3billion to 26 companies. Its investments
included City Ventures, a private home-

builder in Orange County, California, now

planning to go public; EMI Music Publishing; Energy Alloys, a global provider of oil
field metals; Spains Giant Cement Holding;
and the U.K.s Miller Group.
The firm financed Sonys deal to buy EMI,
giving the Japanese electronics maker access
to a music catalog that included more than
200 songs by the Beatles.When Sony was trying to buy EMI in the fall of 2011, it couldnt
consolidate all the debt onto its balance sheet
without getting downgraded. Sony went to
every bank it knew, including those in Japan,
but couldnt get a $500million bridge loan.
The company initially approached Blackstones private equity group for a $500million
infusion of equity, but it wanted a controlling
stake and Sony wasnt about to do that. Blackstone referred Sony to GSO, which crafted a
deal of mezzanine debt and equity warrants
in the company.
Many investors are quite cautious when
evaluating entertainment deals especially
institutions, says Rob Wiesenthal, then
Sonys CFO and now chief operating officer of Warner Music Group. But the GSO
team immediately understood the annuitylike cash flow streams of music publishing
and how much less volatile it is than recorded
music and less subject to the decline of physical recorded media.
Wiesenthal adds that GSO was flexible
enough to let billionaire David Geffen, also
an investor, participate in the transaction
late in the game. David Geffen is the Warren Buffett of the entertainment industry,
and they understood the value of that to the
deal, he explains. Many investors wouldnt
know how to approach that.
GSO also bought the debt of Clear
Channel Communications, a privateequity-owned media company, and led
a $1.25billion preferred stock deal for
Chesapeake Energy so that company could
develop natural-gas production from shale
in eastern Ohio.
Current market conditions are setting
the stage for a lot of future opportunities for
GSO. Annual high-yield issuance is more
than double what it was in 2006 and 2007,
61 percent of bonds are trading at or above

their call prices, and new issuance of covenant-lite leveraged loans in 2012 surpassed
the levels seen during the credit craze in the
middle of the past decade. When the highyield market trades at highs, we put out
less capital, says Ostrover. As the market
comes down, we put out a lot. Lets face it,
if a company can tap the public markets,
they will, and theyll get a much better deal.
The GSO team is confident that the bright
future investors are anticipating will lose its
luster sooner or later, whether its because of
inaction in Washington or rumblings from

ETF, the first of its kind.

Europe currently offers GSO the greatest opportunities. But, as Smith says, its
also a great place to lose money. The highyield and leveraged-loan markets never
developed there like they did in the U.S.
Instead, banks dominated the leveragedfinance markets, with few institutional
buyers such as high-yield mutual funds. In
the U.S. banks provide about 30 percent of
lending, with capital markets and investors
providing the remainder. In Europe 70 to
75 percent of lending is done by banks. But

In the era of Dodd-Frank and the

Volcker rule, GSO and others like it have
more market power than ever.
Brian ONeil, Robert Wood Johnson Foundation

North Korea, Israel or Iran. All those covenant-lite loans will be great opportunities for
GSO to step in at some point. In the meantime, it has cut back the pace of investments
and is going after only the most compelling
ones, in industry sectors including shipping,
metals and mining, and natural gas.
GSO has $8billion in dry powder to put
to work when rates eventually rise and investors inevitably sell at least some of the bonds
theyve bought in recent years. In fact, the
firm is preparing to be a buyer when rates rise
and long-only mutual fund managers have
to sell bonds to meet investor redemptions.
Amid the froth GSO is now doing its preparatory work for the next crisis.Though investors
seem to have set their concerns aside, GSO
maintains that Europe poses the same risks to
the global economy it always did and that rates
must rise sometime in the next four years.
Patience is the key, says Smith, adding
that GSOs funds and compensation are
structured in such a way that staffers dont
have to feel compelled to put money to work
in deals that dont make sense.The group has
products that do better in different market
environments, such as its closed-end funds
and a new exchange-traded fund it recently
launched with State Street Global Advisors.
GSO is actively managing the leveraged-loan

that is likely to change as banks shed assets

to deleverage and companies need capital.
Smith calls Europe a huge opportunity
maybe a little like what Milken saw in the
1980s and DLJ in the 90s.
But things are changing much more slowly
in Europe than they did in the U.S. Every
European country has its own business climate, union rules and regulatory system, and
bankruptcy law isnt always clear enough for
a manager like GSO to get the assurance it
needs to invest in a troubled company. Even
so, GSO has 31 investment professionals in
London, and they are doing more deals now
than the firm is doing in the U.S.
Nearly five full years after the worst of
the financial crisis, the real estate market
is finally on the mend, investors are wondering if homebuilders stocks have rallied
too far, and the outlines of the new order of
Wall Street are coming into sharper focus.
The defanged banks are receding into the
background and making peace with new
regulations designed to emasculate their
balance sheets.The new power brokers in the
financial industry are money managers and
investors like GSO, which control real assets.
There is a wealth transfer going on from
banks shareholders to the investors in our
funds, says Goodman.

JUNE 2013

Blackstone co-founder
Stephen Schwarzman

MATT FURMAN

FEATURES

Blackstones Stephen
Schwarzman on
Not Wasting a
Serious Crisis

loans in the world, GSO gives us a unique look into whats going
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
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 industry basis, but geographically. We dont need an economist to tell
us whats happening in the world. We see it.

Following the 2008 financial crisis,

Blackstone Group chairman and CEO
Stephen Schwarzman used the acquisition
of GSO Capital to diversify the alternative
asset management firms businesses and
help more than double its assets.

GSO has a very different opportunity going forward because of the smaller role banks are taking in lending to
distressed businesses. Tell us about that.
The regulatory environment has become more restrictive and
difficult for many financial institutions. And Europe in particular
now is having all kinds of problems. But its very difficult for
Europe to put their problems fully to bed. It will take a period
of years to do that even as the European banking system still
needs significant repair. While thats going on, the ability of certain borrowers to obtain credit has been inhibited, which creates
opportunities for firms like GSO.

By Julie Segal

n November 2008, just weeks after Lehman Brothers Holdings

filed for bankruptcy and the U.S. government was forced to
bail out insurance giant American International Group,
incomingWhite House Chief of Staff Rahm Emanuel famously told
a reporter that you never want to let a serious crisis to go to waste.
Five years after the worst financial crisis since the Depression, it seems that Blackstone Group co-founder, chairman and
CEO Stephen Schwarzman took that advice to heart. Blackstone
Group has been one of the biggest winners in the wake of the
crisis, doubling its assets under management from $90 billion to
$218 billion during the past five years. Much of that growth has
come from the 2008 acquisition of credit manager GSO Capital Partners, run by three partners who had turned Donaldson,
Lufkin & Jenrette (later Credit Suisse) into the No. 1 underwriter
of high-yield debt on Wall Street. GSO gave Blackstone access to
investment strategies that would do well as the economy fell off
the cliff. Since the acquisition, GSOs assets have grown fivefold
and rival those of Blackstones real estate and private equity businesses. Senior Writer Julie Segal spoke to Schwarzman recently
about the GSO acquisition, the advantage that U.S. financial
services firms now have in Europe, and the expanded role that
money managers are playing as the banks contract.
GSO has obviously been a successful acquisition for Blackstone. How did you see it fitting into the organization?
When we started the firm in 1985 we decided to be in three
lines of business. The first and second were the M&A advisory
business and private equity. The third part of our strategy, which
were still executing on, is to go after new businesses that had to
meet a few criteria. First, it has to be a great business with terrific
expansion potential. We dont want a lot of little businesses; we
want to be in relatively few complementary ones where we can
be the global leader. Second, we want people who are 10s on
a scale of 1 to 10. Third, the business has to make our existing
businesses stronger by bringing intellectual capital to the table
that we didnt have.
GSO fit those criteria. GSO produces intellectual capital that
can be used throughout Blackstone and GSO leverages information, where appropriate, that comes out of our real estate, private equity and other groups. As the largest investor in leveraged

Do you think regulators will get involved in overseeing this

type of activity?
Firms like ours avoided trouble during the financial crisis by
being prudent with our investors money. We have to compete for
our money on the open market without the benefit of federal or
sovereign guarantees. People deposit their money with banks because they feel their money is protected not just by the financial
institution itself, but by government as well. We dont have that.
We havent seen restrictions because we are operating without
any lender of last resort standing behind us and we dont have
the same kind of central role in the financial system.
In many ways, it seems that Blackstone is stronger now
than before the crisis.
In some areas we have fewer competitors, so its good. But
the overall system has really been challenged. As you can see
in Europe, when you have very tough regulations and you have
a shrinking banking system, its very difficult to get economic
growth. Virtually anyone would tell you that. How do you grow
if you cant get money? A negative growth environment creates
other political problems. Its complex, of course.
What are the implications for Blackstone?
One of the advantages that we have is that the American financial institutions are in much better shape than the European
ones. What youre starting to see is a normal pattern where firms
like ours go to non-U.S. locations and our banks tend to follow.
We can get financing where domestic people cant. It provides a
competitive advantage for which we have to thank [former Treasury secretary] Tim Geithner for doing a good job putting the
U.S. banking system in a better position with the stress tests and
capital raising.
Now the U.S. banking system is under-lent. Look at the
massive amounts of cash on corporate balance sheets. Banks
wouldnt lend in 2008-2009, so corporations essentially created
their own banks, doing debt deals and keeping the proceeds on
their balance sheet. That money had no purpose other than giving corporations a reason not to call their bank. Thats good for
us, whose job it is to buy companies, buy real estate and do other
types of investments. So, its actually turned out to be not so bad,
as they say.

Reprinted from the June 2013 issue of Institutional Investor Magazine. Copyright 2013 by Institutional Investor Magazine. All rights reserved.
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