gso lenders of last resort 2013

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LENDERSof LAST

RESORTBY JULIE SEGAL

JUNE 2013 INSTITUTIONALINVESTOR.COM

GSO’s Bennett Goodman



UNDERBLACKSTONE’SOWNERSHIPCREDIT SPECIALISTGSO CAPITALHAS GROWNFIVEFOLD,EMERGING ASA TOP SOURCEOF FUNDINGFOR STRUGGLINGCOMPANIES.

PHOTOGRAPHS BYMATT FURMAN

Tripp Smith is happy

to leave the spotlight

to fellow GSO

co-founder Bennett

Goodman and

instead focus on

doing deals



GSO’s 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 Manhat-tan’s 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 Ostrover’s 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 Jersey–based homebuilder had become a target

for short-sellers; investors were betting billions of dollars in credit

default swaps that the company Hovnanian’s 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 you’re 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 Hovnanian’s liquidity prob-

lems. The company would sell its property inventory to a land bank

created by GSO in return for a $125 million 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 Ostrover’s Smoked Fish on New York’s

Lower East Side in the 1950s following a blackout; he couldn’t 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 you’ve been out in the

battlefield for seven years, being shot at constantly, you don’t 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

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 other Wall Street research firms changed their rating from a sellto a hold — GSO had been hoping for a buy — and Credit Suisse

refinanced Hovnanian’s 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 mar-

ket was underestimating our ability to succeed in a space — hous-

ing — 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 GSO’s 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 troubledcompanies like Hovnanian that couldn’t tap public markets or get

bank loans. The firm has financed well-known names like Chesa-

peake 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

$650 million of capital to smaller homebuilding companies like the

U.K.’s Miller Group and $888 million 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

York–based 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, it’s

harder for them to do that economically. As a consequence, banks

want to syndicate risk into the market — put together a road show

and talk to 200 investors. But they don’t 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

2008–’09 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, GSO’sthree founders, then working for Hamilton (Tony) James at DLJ,GSO co-founder Douglas Ostrover made the pitch to Hovnanian

ALTERNATIVES

“In the old days a bank mighthave been more willing tocommit its balance sheet for

long-standing clients. Becauseof the regulatory environment,it’s harder for them to do that.”— Bennett Goodman, GSO Capital Partners

A



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, includ-

ing energy exploration and homebuilding. If Drexel came up with

the junk bond and DLJ created the institutional leveraged-financemarket, 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 Buf-

fett 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 it’s the as-yet-unfinalized Volcker

rule that does the most damage to banks’ freedom, preventing themfrom 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 the Volcker rule, GSO and others

like it, with their ability to make commitments, have more market

power than ever,” says Brian O’Neil, chief investment officer of the

$9 billion-in-assets Robert Wood Johnson Foundation, the U.S.’s

largest philanthropic organization focused on public health and one

of GSO’s 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 prod-

uct, GSO has a host of competitors, including Apollo Group Man-agement; Ares Capital Corp. (an Apollo spin-out); Avenue Capital

Group; Carlyle Group; Goldman, Sachs & Co.; J.P. Morgan Asset

Management’s Highbridge Capital Management; KKR & Co.;

Oaktree Capital Management; and TPG 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. “It’s alter-

native credit growing up. It’s not the Wild West, not the personality-

driven 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 firm’s 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 they’ve found a way to extend credit to orga-

nizations 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 $1 billion toacquire GSO, which then had a $3.2 billion credit hedge fund,

$500 million in mezzanine investments and a $4.8 billion collateral-

ized loan obligation business. The deal wouldn’t have happened

without Goodman, Smith and Ostrover’s former boss, Tony James,who had joined Blackstone as president in 2002 after Credit Suisse

bought DLJ and who manages the firm’s 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 wide-

open white space for us? Credit jumped off the page.”

With $58 billion in assets under management and 235 employees,

GSO has grown fivefold under the Blackstone umbrella.Today it offers

$27 billion in alternative-investment funds, including the now $4 bil-

lion hedge fund, $8 billion in mezzanine funds — financing buyouts for

private equity — $8 billion in rescue lending and $7 billion in small-cap

direct lending. The firm’s long-only strategies include a $24 billion

CLO business, making GSO the largest institutional investor in lever-

aged loans, as well as closed-end and other funds. Goodman is quick

to credit the Blackstone brand for at least part of GSO’s success. “If

we were Schmeckle & Schmeckle or just stand-alone GSO, there’s no

way the board of Sony or some of these other companies would have

gone along with some no-name firm,” he explains.

GSO’s returns have been top quartile. According to external mar-

keting documents, its hedge fund has delivered a net annualized return

of 13.6 percent since January 2010, compared with the HFRI Fund

Weighted Composite’s return of 4.6 percent for the same period.

(Though the hedge fund was launched in 2005, GSO has sincestripped out mezzanine and other investments into separate funds.)

ALTERNATIVES

Blackstone co-founder Stephen Schwarzman (left) and

president Hamilton (Tony) James wooed GSO’s principals for

several years before buying their firm in January 2008



The firm’s 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 incep-

tion in September 2009. “The GSO team has been through the ups

and downs of numerous credit cycles, and they’re always worried andtrying to protect the downside,” saysTimothyWalsh, chief investment

officer of the $74 billion New Jersey Pension Fund, which has com-

mitted to $1.1 billion in investments in five GSO funds.

Blackstone’s acquisition of GSO has been an undisputed winner.

GSO represents 26.6 percent of the firm’s $218 billion in assets, on

par with its $59 billion real estate business and larger than both its

private equity ($52 billion) and Blackstone Alternative Asset Man-

agement hedge fund ($48 billion) businesses. GSO represented 38.9

percent of Blackstone’s $629 million of realized performance fees

earned in 2012 and 16 percent of the firm’s $2 billion in economic

net income last year. In 2007, the peak for the firm’s performance

fees, private equity contributed the bulk of the total. Between 2005

and 2012, GSO’s assets grew at a compounded annual rate of 29

percent. That makes GSO Blackstone’s fastest-growing business

in terms of both earnings and assets. Executives at two publicly

traded alternatives firms say they aren’t so much concerned about

Blackstone as a competitor in private equity but that they’ve been

blindsided by GSO’s 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 unrelent-

ing investor demand for credit investments. While non-investment-

grade companies need capital, investors need yield, and alternative

credit strategies like those offered by GSO provide a much-neededboost to returns for bond portfolios. “Now the emergence of alterna-

tive credit mirrors tools that equity investors have had with private

equity,” says TPG’s 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 wasconstantly being undercut by in-country banks. “You couldn’t

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 that’s 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.

IN THE 1980S, WALL STREET HAD A CLEAR PECKING

order. On top were three white-shoe firms: First Boston Corp., Gold-

man Sachs and Morgan Stanley.That’s where you wanted to land a job

if you were a Harvard Business School student. The day in early 1983that 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,

Drexel’s 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 Street’s toniest firms, Goodman took a job with Drexel.There Milken was leading what’s now called the democratiza-

tion 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

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

Turner’s Turner Broadcasting System, Craig McCaw’s McCaw

Cellular Communications and William McGowan’s MCI Com-

munications 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 culturethat rewarded Street smarts and a maniacal work ethic. Drexel was

“The GSO team has beenthrough the ups and downs ofnumerous credit cycles, and

they’re always worried andtrying to protect the downside.”— Timothy Walsh, New Jersey Pension Fund



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 boththe companies and investors. In contrast to

the few traditional deals a year that a junior

banker at Goldman might work on, Good-

man cut his teeth on such unusual transac-

tions as KKR’s investment in Union Texas

Petroleum Holdings in 1985 and Maxam’s

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 Angeles–based 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 acapital markets desk.

Goodman liberally quotes from his uncle,

Skip Bertman, a former head coach at Louisi-

ana State University who has the best baseball

record in the National Collegiate Athletic

Association and who took an influential role

in Goodman’s life after his father passed away

when he was five years old. Bertman, who

built an underdog team into a profitable leg-

end for LSU, told Goodman that success took

three “H”s: 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-year-

old newly minted Drexel vice president told

the DLJ executive, “I’m going to help build

this big business at DLJ, and you’re 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 DLJ’s 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 con-

fident letter,” a piece of paper Drexel wouldissue to the board of a company as a promise

that it would provide financing on deals.When

DLJ tried issuing its own highly confident let-

ters, 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 forinsider trading and stock manipulation. The

following March, Milken was indicted for

racketeering and securities fraud. In Febru-

ary 1990, Drexel filed for bankruptcy; two

months later Milken pled guilty to lesser

charges, agreeing to pay a $600 million 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

most Wall Street firms pulled out of the high-

yield business, DLJ stayed in, doing some sec-ondary 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 DLJ’s sales and trad-

ing. Ostrover, who has a BA in economics

from the University of Pennsylvania and an

MBA from New York University’s Leonard

N. Stern School of Business, was ranked theNo. 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 middle-

class upbringing — first in Queens, NewYork,

and later in Stamford, Connecticut — and says

that when he was growing up he didn’t know

anyone who worked on Wall Street. Apologiz-

ing for the seeming hokeyness of it, he refers to

a black-and-white picture in his office of New

York’s Orchard Street early in the past century,

with unpaved, muddy roads; pushcarts; and aglimpse of Ostrover’s 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 Universityof Notre Dame, he witnessed firsthand the

toll Drexel’s failure took on senior managers

whose wealth had been tied up in its stock.

Smith is the third generation in his Indianapo-

lis 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 DLJ’s 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 unwittinglypassed the high-yield baton to DLJ. Though

the three founders couldn’t be more different,

they’ve 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 part-

ners at GSO, Smith and Ostrover often defer

to Goodman for the final word.

In 1995, Moran moved up to chief operat-

ing officer of fixed income, and Goodman

took over all of leveraged finance. DLJ used

its market position to keep reinvesting in thefirm, 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 DLJ’s, asked Goodman to start a

credit business at Blackstone. It was the first

of many overtures Blackstone’s executives

would make to him.

It was DLJ’s limited balance sheet that

taught Goodman, Ostrover and Smith how

careful they had to be with their credit analy-

sis 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. Com-

petition from increasingly bigger banks was

fierce. The world had changed, and the firm

needed a partner.Credit Suisse bought DLJ for $11.5 bil-

ALTERNATIVES



lion in 2000 and combined the firm with its

New York–based investment banking unit,

Credit Suisse First Boston. The big Swiss

bank wanted Goodman’s leveraged-finance

business as well as DLJ’s merchant bankingand real estate groups. Though DLJ invest-

ment 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 Good-

man talked about going off on their own. After

James joined Blackstone, Goodman took over

CSFB’s alternative capital division. Shortly

thereafter Ostrover assumed responsibility

for leveraged finance and Smith joined Good-

man in the alternatives group. What the threefounders 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 leav-

ing; 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

had been co-head of high-yield group among

other positions at Van Kampen Investments,

now runs GSO’s customized credit strate-

gies, including CLOs, closed-end funds and

Franklin Square Capital Partners, its small-

cap direct lending group.

On day one Credit Suisse gave the firm

more than $500 million to manage — a big

part of the approximately $3 billion it had

raised from outside investors, including the

Bass brothers, Blackstone, Cornell Univer-

sity, K2 Advisors, MetLife, Notre Dame and

Quellos Group (now owned by BlackRock).

GSO’s hedge fund invested in public securi-

ties, mezzanine debt and distressed debt and

provided some rescue lending for companies

going through liquidity problems.

Fully 80 percent of GSO’s senior manage-ment team is from DLJ. Jason New, a onetime

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 Com-

munications, joined GSO at the start. He nowmanages 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. Houston-

based Scott oversees GSO’s 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 Caffè

Nero, a U.K. coffeehouse chain. Though

it was satisfying to be on their own, Good-man, 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

didn’t 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 you’re

working for anonymous shareholders, try-

ing to make as much money as you can,” he

explains. “It’s amorphous, and you don’t

know the people. It’s a different kind of sat-

isfaction walking into the CIO’s office for the

Bass brothers.”

A deal between Blackstone and GSO, how-

ever, wasn’t a no-brainer. Private equity inves-

tors are by nature optimistic and swaggering,

thinking every deal is a potential blockbuster.

Blackstone’s offices on Park Avenue are noth-

ing short of glitzy, with unobstructed views

of the NewYork skyline and floors connected

by grand staircases with polished metal ban-

isters. No one has represented Blackstone’s

opulence more than its billionaire co-founder

Schwarzman, who in 2000 reportedly paid

$37 million for a 34-room triplex on ParkAvenue 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 everythingthat can go wrong in an effort to protect their

principal. Credit geeks Goodman, Ostrover

and Smith nonetheless went to Blackstone’s

extravagant road show at New York’s 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, show-

ing heft in private equity, real estate and fundsof hedge funds, but credit was an afterthought,

amounting to only about $5 billion in assets. At

the same time, Blackstone had relationships

with almost every major institutional investor

in the world, a group that had, on average,

$200 million in assets invested with the firm.

GSO’s investors, by contrast, had a paltry

$22 million 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 wasrevered by GSO’s three founders. That sum-

mer James approached Goodman — the

fourth time Blackstone had tried to entice

him into a deal — and stated the obvious:

“In credit we’re not where we want to be. We

want to buy you.”

After six months of negotiations, Good-

man 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 firm’s 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 $1 billion 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 busi-

ness from being three years old to ten over-

night,” Ostrover says.GSO and Blackstone announced the deal

“Blackstone allowed us to take our business from being three years oldto ten overnight.”— Douglas Ostrover, GSO



in January 2008. In addition to strengthen-

ing their firm’s credit business, Schwarzman

and James saw benefits for its private equity

operation. “Having a better understanding

of credit markets, having a better idea ofhow we could finance a creative idea, would

make us better in private equity,” says James.

“GSO was very synergistic and comple-

mented 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 $1 billion in equity to buy a portfolio of

busted bridge loans from Deutsche Bank,

with the German bank providing 3-to-1

leverage. The approximately $4 billionportfolio was distributed across GSO’s

own funds as well as Blackstone’s 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 part-

nered with TPG to buy a $2 billion port-

folio of bridge loans from Citigroup. That

also plummeted in value.As it turned out, GSO had done thor-

ough 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,”

Goodman says. But by the end of 2009, the

firm had $24 billion in assets.

After the market bottomed in 2009,

GSO launched its first rescue lending fund,

which closed at $3.3 billion. The next year

it acquired nine CLOs from Allied Capital

Corp., and a year later it bought Harbour-

master Capital Management, a $10 billion

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-

ucts to managing 27. The breadth and scale

of its funds allow it to offer a range of solu-

tions to companies, including rescue financ-

ing and senior secured bank loans. At the

same time, the platform gives it a lot of differ-ent 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 Hovna-

nian 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 asolution, reducing a company’s need to find

additional capital elsewhere.

GSO’s flagship hedge fund takes an activist

or event-driven approach to credit. New’s

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 MBIA’s

battle with BofA. But unlike activist equity

managers or “loan-to-own” credit funds, GSO

doesn’t 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 advan-

tage by doing most of its own loan origina-

tions 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

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 infor-

mation. Ryan Mollett, a 34-year-old manag-

ing partner who joined New’s group from

BlackRock in 2011, wrote a paper late that

year asserting that the housing market had

bottomed. Blackstone’s real estate group

saw similar evidence, and BAAM expected

mortgage improvement based on resultsfrom its underlying hedge funds. As a result

of the cumulative research among the dif-

ferent Blackstone groups, private equity

bought $220 million of nonperforming resi-

dential loans, the real estate team purchased

$1.4 billion of single-family homes to lease,and GSO invested in Hovnanian. At its peak,

GSO had $475 million in hedge fund expo-

sure to homebuilders and related industries

and put out $600 million in financing across

private market vehicles.

The Capital Solutions Fund — GSO’s

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 companywould likely be giving up control at the bot-

tom of the market. In contrast, GSO will take

a minority stake, a seat on the board and a

debtlike investment that pays a big double-

digit coupon, but it will let management retain

control. “We decided that the banking system

is a mess globally, so let’s raise some money to

lend to more troubled private companies that

can’t tap the markets and don’t have access to

the banks,” says Ostrover.

Part of GSO’s success comes from leaving

some money on the table. Goodman states

the obvious: “No company does businesswith us because we’re such nice guys, though

we like to think we are. They do it because

they can’t get the capital otherwise.” And

many companies say GSO doesn’t scrape

every penny out of a deal. “I don’t feel like

I’m 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 down-

grade of the U.S.’s credit rating in August

2011, GSO was busy preparing for the pos-

sibility 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. “It’s 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 $5 billion of capital to

work as the markets slid after the downgrade.

For its drawdown funds alone, it committed

$3 billion to 26 companies. Its investmentsincluded City Ventures, a private home-

“It’s really hard for some people to beaggressive in times of disruption, becauseyou have to do your work beforehand.”— Tripp Smith, GSO

ALTERNATIVES



builder in Orange County, California, now

planning to go public; EMI Music Publish-

ing; Energy Alloys, a global provider of oil

field metals; Spain’s Giant Cement Holding;

and the U.K.’s Miller Group.The firm financed Sony’s 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 try-

ing to buy EMI in the fall of 2011, it couldn’t

consolidate all the debt onto its balance sheet

without getting downgraded. Sony went to

every bank it knew, including those in Japan,

but couldn’t get a $500 million bridge loan.

The company initially approached Black-

stone’s private equity group for a $500 million

infusion of equity, but it wanted a controllingstake and Sony wasn’t about to do that. Black-

stone 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

Sony’s CFO and now chief operating offi-

cer of Warner Music Group. “But the GSO

team immediately understood the annuity-

like cash flow streams of music publishing

and how much less volatile it is than recorded

music and less subject to the decline of physi-cal 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 War-

ren Buffett of the entertainment industry,

and they understood the value of that to the

deal,” he explains. “Many investors wouldn’t

know how to approach that.”

GSO also bought the debt of Clear

Channel Communications, a private-

equity-owned media company, and led

a $1.25 billion 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 cove-

nant-lite leveraged loans in 2012 surpassed

the levels seen during the credit craze in the

middle of the past decade. “When the high-

yield market trades at highs, we put outless capital,” says Ostrover. “As the market

comes down, we put out a lot. Let’s face it,

if a company can tap the public markets,

they will, and they’ll 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 it’s because of

inaction in Washington or rumblings from

North Korea, Israel or Iran. All those cove-

nant-lite loans will be great opportunities for

GSO to step in at some point. In the mean-

time, 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 $8 billion in dry powder to put

to work when rates eventually rise and inves-tors inevitably sell at least some of the bonds

they’ve 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 prepara-

tory 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, addingthat GSO’s funds and compensation are

structured in such a way that staffers don’t

have to feel compelled to put money to work

in deals that don’t 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

ETF, the first of its kind.

Europe currently offers GSO the great-

est opportunities. But, as Smith says, it’s

also a great place to lose money. The high-

yield and leveraged-loan markets neverdeveloped there like they did in the U.S.

Instead, banks dominated the leveraged-

finance 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

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 cli-

mate, union rules and regulatory system, andbankruptcy law isn’t 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 won-

dering 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. • •

“In the era of Dodd-Frank and the

Volcker rule, GSO and others like it havemore market power than ever.”— Brian O’Neil, Robert Wood Johnson Foundation



FEATURES JUNE 2013

Blackstone co-founder

Stephen Schwarzman

M A T T F U

R M A N



In 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 Depres-

sion, 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 Capi-

tal Partners, run by three partners who had turned Donaldson,

Lufkin & Jenrette (later Credit Suisse) into the No. 1 underwriterof 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, GSO’s assets have grown fivefold

and rival those of Blackstone’s real estate and private equity busi-

nesses. 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 Black-

stone. 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 advisorybusiness and private equity. The third part of our strategy, which

we’re 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 don’t 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 didn’t have.

GSO fit those criteria. GSO produces intellectual capital that

can be used throughout Blackstone and GSO leverages informa-

tion, where appropriate, that comes out of our real estate, pri-

vate equity and other groups. As the largest investor in leveraged

loans in the world, GSO gives us a unique look into what’s 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 intel-

lectual capital and insights across all four of our major investing

businesses and our advisory business. And not just on an indus-

try basis, but geographically. We don’t need an economist to tell

us what’s happening in the world. We see it.

GSO has a very different opportunity going forward be-

cause 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 it’s 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 that’s going on, the ability of cer-

tain borrowers to obtain credit has been inhibited, which creates

opportunities for firms like GSO.

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 be-

cause they feel their money is protected not just by the financial

institution itself , but by government as well. We don’t have that.

We haven’t seen restrictions because we are operating without

any “lender of last resort” standing behind us and we don’t 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 it’s 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, it’s very difficult to get economic

growth. Virtually anyone would tell you that. How do you grow

if you can’t get money? A negative growth environment creates

other political problems. It’s complex, of course.

What are the implications for Blackstone?

One of the advantages that we have is that the American fi-

nancial institutions are in much better shape than the European

ones. What you’re 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 can’t. It provides acompetitive advantage for which we have to thank [former Trea-

sury 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

wouldn’t 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 giv-

ing corporations a reason not to call their bank. That’s good for

us, whose job it is to buy companies, buy real estate and do other

types of investments. So, it’s actually turned out to be not so bad,

as they say.

Blackstone’s StephenSchwarzman onNot Wasting aSerious Crisis

Following the 2008 financial crisis,

Blackstone Group chairman and CEO

Stephen Schwarzman used the acquisition

of GSO Capital to diversify the alternative

asset management firm’s businesses and

help more than double its assets.

By Julie Segal

R p i t d f th J 2013 i f I tit ti l I t M i C p i ht 2013 b I tit ti l I t M i All i ht d

gso lenders of last resort 2013

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