Leon Black Loses to Carl Icahn as Apollo Sets New Credit Terms

In a private dining room at the Beverly Hills restaurant Spago, four dozen financiers gathered in April for a dinner put on by one of their own: Leon Black, head of private equity giant Apollo Global Management LLC.

As the group dined on Hong Kong-style loup de mer and filet mignon prepared with an Armagnac-peppercorn emulsion, Michael Milken, who worked with Black at junk-bond firm Drexel Burnham Lambert Inc. in the 1980s, praised him for using his deep knowledge of finance to survive the credit crisis, according to people who were there.

Black spent most of the last decade buying companies with billions of dollars in debt and selling them at a profit, Bloomberg Markets magazine reports in its August issue. The credit crisis hit as Black made several marquee deals. He bought Harrah’s Entertainment Inc., the world’s biggest casino operator, in a $30.7 billion takeover in January 2008, just as strapped, middle-class gamblers were shying away from the tables.

Black also bought Realogy Corp., the biggest broker of residential real estate, in April 2007, in the midst of the worst downturn in home sales since the Great Depression. By November 2008, both companies were on the verge of defaulting on the billions of dollars Apollo had borrowed to buy them.

That’s when Black went to work, tapping decades of experience in managing the finances of struggling companies and making use of loan covenants that gave him maximum flexibility. He did swaps, offering bondholders new notes in exchange for twice the amount of old ones.

‘Tough Stuff’

With the old debt trading for little more than a dime on the dollar, many investors were eager to make the trade, and Black cut his debt by half in some cases.

“They do the tough stuff, but sometimes the tough stuff is what you do to keep the company alive,” says Paul Schaye, founder of Chestnut Hill Partners, a New York-based company that helps private-equity investors find companies to buy. “That’s their skill set. It’s not always a friendly handshake.”

The tough line with bondholders helped Apollo return a profit for equity investors and keep Black’s reputation intact. In the 20 years since it was founded, the firm’s private-equity funds have invested $29.3 billion and increased that amount to $46.8 billion, including distributions.

Two funds started since 2005, the beginning of a buyout boom that went bust in 2007, have invested $15.3 billion and were up $2.2 billion, or 14 percent, as of Dec. 31.

Black, 58, a bear-sized New York native with a mop of gray hair, has been involved in contentious transactions ever since he started Apollo 20 years ago. Since the market crash, he’s had to fend off a series of lawsuits.

Icahn Sues

Huntsman Corp., a Salt Lake City-based chemical maker, sued Black and others for $3 billion in June 2008 after Apollo backed out of a deal to buy the company. Financier Carl Icahn, a Drexel client in the 1980s, sued Apollo in November 2008 over Black’s attempt to swap old Realogy bonds for new.

Investors are making new demands, too. In April, Joseph Dear, chief investment officer of the California Public Employees’ Retirement System, won a cut in the fees that Apollo charges to manage state pension fund money.

Calpers is a part owner of Apollo. It invested $600 million in the privately held firm in July 2007. The investment is a loser so far. Calpers marked the value of the stake down to $124.6 million after the credit crunch.

Investors who have grown leery of private-equity managers say that in the boom years, Black and others like him cared more about the size of deals than they did about the quality.

Good Marketing

“They are fabulous marketing people who, at one time, were excellent investors,” says Harold Bradley, CIO of the $1.7 billion Ewing Marion Kauffman Foundation in Kansas City, Missouri. Bradley, an investor in Apollo funds, says, “Private- equity firms became money raisers and asset gatherers, and the state pensions walked right into their arms.”

Black founded Apollo in 1990, along with Drexel alums Marc Rowan and Joshua Harris, as an investor in distressed debt and beaten-up companies. He created his image as a master of leveraged buyouts when his $3.4 billion Apollo Investment Fund V achieved an average annual rate of return of 78 percent for the three years ended in 2004, attracting more money from Calpers, an Apollo investor since 1995, and from the pension plans of the states of New York and South Carolina. He now oversees $54 billion.

Black’s most troubled investments were made with money from his $10.8 billion Fund VI -- augmented with billions of dollars in loans and bonds sold to investors.

Buying Low

Fund VI, which included Harrah’s and Realogy, ultimately recovered not because of its equity investments but because Black bought debt in companies Apollo owned when credit markets slumped. He profited when they rebounded last year.

The fund’s $919 million investment in Realogy was marked at $74 million at the end of last year, according to a letter sent to investors in March. Even so, Fund VI was up 7.6 percent on money the fund invested from the time it made its first investment in July 2006 to Dec. 31. The Standard & Poor’s 500 Index fell 12 percent in that period.

“The world is off the edge of a precipice,” Black said at the annual Milken Institute Global Conference in Los Angeles in April, the occasion for the dinner. “What a difference a year makes.”

Black, a Shakespeare lover who endows a professorship on the playwright at his alma mater, Dartmouth College in Hanover, New Hampshire, may find that his winter of discontent isn’t quite over. Business remains tough for Apollo and the rest of the private-equity industry.

Deals Scarce

Buyout firms announced just 484 deals worldwide in 2009, less than a third of the 1,610 they announced in 2007, according to data compiled by Bloomberg. The total value of those deals tumbled 94 percent to $29.3 billion from $493.8 billion in 2007.

The biggest private-equity deal announced in 2010 as of mid-June was Silver Lake and Warburg Pincus LLC’s takeover of Interactive Data Corp., a provider of financial market data, for $3.4 billion. That was a trifle compared with the 2007 record- setting deal in which New York-based KKR & Co. and TPG Capital of Fort Worth, Texas, bought TXU Corp., Texas’s largest electric supplier, for $43.2 billion.

Some of the debt that funded such deals fell to pennies on the dollar in 2008 and 2009 as a wave of bankruptcies and near defaults hit many indebted companies.

Apollo and others offered deals to desperate investors in which they would swap their old bonds that were maturing soon for new ones with extended due dates, according to regulatory filings describing the swaps. They demanded a discount, too. An investor with $10 million of old bonds, for example, might be offered just $5 million of new ones.

Desperate Swaps

If the old bonds were trading at 20 cents on the dollar and the company faced default, swapping $1 of old bonds for 50 cents of new ones seemed to some investors like the better of two bad choices, unless they thought the bonds would rebound one day, an outcome that was difficult to see from the depths of the credit crisis.

Private-equity managers took advantage of covenants -- protections for investors written into bond agreements -- that allowed them to substitute new debt for old. In exchange for the liberal covenants, the buyers of the original debt got a higher yield. The new debt, though, often leapfrogged the old in the line for collecting proceeds from the sale of collateral -- whether factories, hotels or inventory -- should the companies fail.

‘Bad Covenants’

Apollo was the most aggressive swapper of all, says Adam Cohen, founder of New York-based Covenant Review LLC, a firm that reviews such protection and charges for its reports.

“Apollo takes first place for bad covenants and willingness to use them,” Cohen says. “We look at it in amazement, with grudging admiration.” Cohen says he wrote plenty of bond covenants as a lawyer at Los Angeles-based Latham & Watkins LLP.

Apollo had no comment on Cohen’s statement.

One Apollo-controlled company threatened by the 2008 crisis was Realogy, owner of real estate brands Century 21 and Coldwell Banker. Apollo bought the company in April 2007 for $8.75 billion, using $6.3 billion of debt. The company reported a loss of $1.9 billion in 2008 as sales of previously owned homes in the U.S. dropped 13 percent to 4.9 million units, according to the National Association of Realtors.

In November 2008, Realogy said in a regulatory filing that it was at risk of violating terms of its bank loans and offered to swap $1.1 billion of its bonds at a range of 36 cents to 50 cents on the dollar, looking to cut its debt by about $600 million.

Fraudulent Transfer

Icahn, a takeover artist who has made runs at Texaco Inc. and Time Warner Inc. during his 40 years in finance, wasn’t buying it. He owned a batch of Realogy bonds that were up for swap and sued Apollo in Delaware Chancery Court on Nov. 26, 2008, calling the swap a fraudulent transfer of assets because owners of the new bonds would be ahead in line for payment in the event Realogy went bankrupt.

Three weeks later, Judge Stephen Lamb ruled that the swap violated debt contracts. Realogy canceled the exchange.

Black then found another way to save Realogy from violating its debt agreements. He used a provision in the debt agreement that allowed the company to “add back” savings from cost cuts it made, most of which weren’t fully realized. The move added at least $100 million to the company’s earnings from the third quarter of 2008 to the fourth quarter of 2009, barely keeping the ratio of debt to earnings from breaching the levels that lenders require, according to a person familiar with the company.

Fee Cut

Just when Black was busy trying to save his companies, Calpers in January 2009 hired Dear, executive director of the Washington State Investment Board, as CIO. Dear has been a critic of the fees in private equity -- usually 1.5 percent of assets under management plus 20 percent of any gains.

The $210 billion pension fund has committed $4.2 billion to Apollo since 1995. In April, Black agreed to cut fees paid by Calpers by $125 million over five years.

The cuts apply only to accounts created specifically for Calpers, according to a letter Apollo sent to investors. About half of the pension fund’s money is invested in Apollo funds open to all investors, in which fees will remain the same. Calpers paid Apollo a total of $38.6 million in fees in 2009.

Apollo’s rich returns to Calpers took a dip during the credit crisis. Apollo VII, the firm’s newest fund, bought portfolios of bank loans and other debt securities from banks including Citigroup Inc. in early 2008 for 87 cents on the dollar, according to a letter that Apollo sent to investors.

Comeback

Prices of such securities tanked to as little as 55 cents by March 2009, forcing Apollo to post $707 million to its brokers in a margin call, according to an Apollo letter to investors, before prices rebounded.

Some investors bailed, selling stakes in the fund for as little as 20 cents on the dollar in early 2009, according to a person familiar with the transaction. Since then, the fund has made a comeback and was up 29 percent as of Dec. 31.

Apollo’s dealings with Calpers have also been roiled by the buyout firm’s payments to Alfred Villalobos, a member of the pension fund’s board from 1992 to 1995. After leaving, Villalobos started working as a placement agent, representing investment firms eager to manage Calpers money.

Apollo paid Villalobos at least $38 million for work on eight deals from 2005 through 2008, according to a complaint filed against Villalobos by California Attorney General Jerry Brown on May 5.

Agent Fatigue

Placement agents such as Villalobos have seen their credibility challenged. New York-based Quadrangle Group LLC, the private equity firm co-founded by Steven Rattner, agreed in April to pay $12 million to settle investigations by the Securities and Exchange Commission and the New York state attorney general’s office.

The agencies were investigating $1.1 million in payments that Quadrangle made to Hank Morris, a former political consultant, in return for help getting investments from the New York pension system.

Quadrangle neither admitted nor denied guilt.

Rattner in February 2009 joined the administration of President Barack Obama to manage its investment in U.S. auto companies and wasn’t a party to the settlement. He has denied wrongdoing.

(Until this year, Quadrangle handled the finances of New York Mayor Michael Bloomberg, who is the majority owner of Bloomberg LP, parent of Bloomberg News.)

$13.2 Million in 2007

Villalobos was paid $13.2 million by Apollo in 2007 for securing the $600 million, 10 percent investment by Calpers in Apollo’s private management company, according to disclosure documents from Apollo that Calpers released.

Brown alleges that Villalobos defrauded Calpers by not disclosing the fees he was paid by Apollo and other investment firms and broke California law by failing to disclose gifts he gave to Calpers executives. Villalobos, through his lawyers, has denied the allegations.

Brown’s complaint says, among other things, that in May 2007, Villalobos took Leon Shahinian, the Calpers investment officer in charge of private equity, to New York from California in a rented private jet -- price: $53,000 -- to attend a fundraiser in honor of Black at the Museum of Modern Art. Shahinian sat at a table with guests of Black’s wife, Debra Ressler Black, a producer of such Broadway plays as Dirty Rotten Scoundrels and The History Boys.

The Lap of Luxury

Villalobos and Shahinian shared a two-bedroom suite at the Mandarin Oriental hotel that cost $9,552.90 for two nights, says Brown, who is the Democratic candidate for governor of California. Apollo reimbursed Villalobos at least $63,000 for their trip, according to the suit.

Apollo paid Shahinian’s expenses because he attended a meeting with Apollo executives while he was in New York, according to people familiar with the matter.

Two weeks later, Villalobos faxed Shahinian a term sheet for the equity investment in Apollo, Brown says. Six weeks after that, on July 13, Calpers agreed to buy the $600 million stake.

“We will continue to cooperate fully with all regulatory agencies investigating this matter,” Apollo spokesman Charles V. Zehren told Bloomberg News on May 6. “We believe that we, at all times, have handled our placement-agent relationships in an appropriate manner.”

A Family Affair

Debra Black has family ties to Calpers. Two of her brothers, Richard and Antony Ressler, also manage the pension fund’s money, and both hired Villalobos to help win the investments, according to disclosure forms released by Calpers.

Richard’s Los Angeles real estate company, CIM Group LP, hired Villalobos in 1998. CIM paid Villalobos $9.6 million for his work, according to disclosure forms made public by Calpers.

Antony’s firm, Ares Management LLC, an Apollo spinoff in Los Angeles, paid Villalobos $1 million in five installments, starting in 2002, after Villalobos helped land a $100 million investment.

Debra Black and her brothers declined to comment.

Calpers bought its 2007 stake in Apollo just as Black made a star-crossed deal. The day before, Apollo had announced an agreement to buy Huntsman for $6.5 billion in cash and $4 billion in assumed debt, planning to merge it with Hexion Specialty Chemicals Inc., a Columbus, Ohio, company that Apollo owned.

Apollo backed out of the deal 11 months later, on June 18, 2008, after the slowing economy cut Huntsman’s earnings. Huntsman sued Apollo and Black five days later, saying Black had worked secretly to scuttle the purchase so that Apollo could pay a lower price. Apollo denied the charges.

A 3-Day Meeting

Huntsman Chairman Jon Huntsman and Black met for three days in December 2008 and reached a settlement under which Apollo paid Huntsman Corp. $750 million in cash and bought $250 million of the company’s bonds.

The settlement with Huntsman was simple compared with the elaborate bond swaps that Black used to salvage other deals. The most important rescue was of Las Vegas-based Harrah’s. Apollo bought the company with TPG in January 2008.

Harrah’s, which has 52 resorts worldwide, reported a $47.8 million loss in the fourth quarter of 2007. The losses swelled in 2008 as payments loomed on its $24.5 billion of debt.

In July 2008, Covenant Review’s Cohen wrote a four-page report saying that Black might offer bondholders a swap. Harrah’s did so in November of that year, announcing an offer to trade old bonds for new ones that matured as many as five years later. Taking the deal meant that some bondholders would get less than 50 cents on the dollar for their paper, according to the swap offer.

Old Notes for New

Bondholders could have refused, yet many took it. Harrah’s debt was selling at 20 cents on the dollar in secondary markets, and the company had reported four quarters of losses. In December 2008, Harrah’s swapped old notes with a face value of $2.2 billion for new ones worth $1.06 billion.

Cohen published a report on the swap on Nov. 19, 2008, in which he predicted another one. That came in April 2009. Harrah’s this time swapped notes with a face value of $5.5 billion for new debt valued at $3.6 billion -- roughly a 33 percent haircut. When the two exchanges were done, Harrah’s had cut its debt total by $3 billion, according to regulatory filings.

Harrah’s CEO Gary Loveman, a former professor at Harvard Business School, says the exchanges were fair.

“You could either hold the security you had until maturity or you could trade them for a different security -- your call,” Loveman said in a December interview. “A lot of people traded, but not all did. I think everyone is much happier today than they were back in the dark days of the crisis.”

Drexel Shop

Black and a group of other former Drexel executives formed Apollo in 1990, after the firm went out of business and Milken went to prison for securities fraud.

Apollo’s first big deal left a pile of lawsuits. Apollo bought high-yield debt owned by Los Angeles-based Executive Life Insurance Co. When the junk-bond market crashed, Executive Life became insolvent. Black and Apollo raised money from Paris-based bank Credit Lyonnais SA and bought the portfolio for 50 cents on the dollar, according to Apollo.

The deal ended up in the courtroom in 1998, when a whistle- blower claimed that what was left of Executive Life’s insurance unit -- not the junk bonds -- was secretly controlled by Credit Lyonnais. The bank was owned by the French government at the time, and it was a violation of California law for an insurance company doing business there to be foreign owned. Lyonnais was later purchased by Credit Agricole SA.

$770 Million Fine

France paid $770 million in fines when the case was settled in 2004. By that time, Apollo was no longer part of the litigation.

Apollo prospered in the boom years of 2003 through 2007, as low interest rates and a big appetite for risk among bond investors helped buyout firms do huge deals. Apollo announced 21 takeovers in 2007 worth a total of $23 billion. They ranged from Noranda Aluminum Inc. of Toronto to Oceania Cruises Inc. of Miami.

Then the credit crisis hit, and Black had to fall back on his abilities as an investor in distressed debt. He bought bonds of companies in Apollo’s portfolio as they tumbled. As of Dec. 31, Black’s $10 billion Fund VI, the one that originally purchased Harrah’s and Realogy, had paid $1.6 billion for debt issued by Apollo companies, according to a March letter to investors.

Those bonds doubled in value to $2.8 billion, driving Fund VI’s rebound and helping Black eke out a small gain.

Black’s next move: He has registered for a $50 million initial public offering in Apollo Global Management. For all the drama of the past three years, Black will likely find investors who, like Milken, admire the Apollo founder’s survival skills.

-- With assistance from Beth Jinks and Jason Kelly in New York. Editors: Michael Serrill, Vince Bielski.

To contact the reporters on this story: Anthony Effinger in Portland, Oregon, at aeffinger@bloomberg.net; Cristina Alesci in New York at Calesci2@bloomberg.net.

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