Apollo Fueled by $9.6 Billion Profit on Debt Beats Peers
Joshua Harris, the marathon-running co-founder of Apollo Global Management LLC (APO), was in a hole.
The 2008 collapse of housewares retailer Linens ’n Things Inc. had wiped out most of Apollo’s $430 million investment. A global financial crisis threatened its leveraged buyouts of casino operator Harrah’s Entertainment Inc. and real estate broker Realogy Holdings Corp. (RLGY) A $360 million bet on the debt of a Rotterdam-based chemicals maker was losing money every day as the company spiraled toward default.
That’s when Harris, now 48, and his partners, including Leon Black, a fellow billionaire and veteran of junk-bond firm Drexel Burnham Lambert Inc., decided to dig deeper, Bloomberg Markets will report in its August issue. They accumulated even more debt of LyondellBasell Industries NV (LYB), the world’s largest manufacturer of polypropylene, before it filed for bankruptcy in January 2009.
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“We seek to buy when the world appears to be very, very cheap,” says Harris, an Apollo senior managing director, sitting in a 43rd-floor Manhattan office overlooking Central Park that’s adorned with Lucite tombstones, photos of himself at road races and an insignia of the Philadelphia 76ers basketball team, which he and a group of investors bought in 2011.
The Lyondell bet paid off. The $2 billion Apollo sank into the company, whose products are used to make tires and bathroom fixtures, has turned into a $9.6 billion paper profit, the biggest gain ever on a private-equity investment, according to data compiled by Bloomberg.
That eclipses the $7 billion that Henry Kravis’s KKR (KKR) & Co. reaped from the 1986 buyout of supermarket chain Safeway Inc. and a similar profit that a group led by financier J. Christopher Flowers reaped from the 2000 takeover of the predecessor to Tokyo-based Shinsei Bank Ltd.
The gain has propelled a turnaround in Apollo’s fortunes, boosted by a rally in asset values that has lifted returns across most classes of alternative investments. Private equity has rebounded from the lows of the financial crisis, generating a 15.2 percent average annual return during the three years ended Dec. 31, according to data compiled by Boston-based Cambridge Associates LLC.
Apollo, the third-largest U.S.-based private-equity firm, with $114 billion under management, has outshone its peers. The $10.1 billion Apollo Investment Fund VI LP, which had tumbled as much as 40 percent from its 2006 inception, according to a person with knowledge of the matter, had a 10 percent average annual net internal rate of return, or IRR, through March 31, regulatory filings show.
A $14.7 billion pool from 2008 known as Fund VII, which invested in LyondellBasell, posted a 28 percent annual average IRR through that date. At year-end, it ranked highest among 2008 megafunds, those with more than $4.3 billion in committed capital, according to London-based research firm Preqin Ltd.
Since Apollo’s founding in 1990, its private-equity funds have generated an average annual net IRR of 26 percent, according to filings. That’s better than the 19 percent since inception posted by KKR, the 18 percent by David Rubenstein’s Carlyle (CG) Group LP and the 15 percent by Stephen Schwarzman’s Blackstone (BX) Group LP.
Apollo’s stock rose 15 percent from the firm’s March 29, 2011, initial public offering through yesterday. From May 2, 2012, when Carlyle went public, the last big buyout firm to do so, Apollo’s shares soared 72 percent.
That compares with 49 percent for Blackstone, 31 percent for KKR and 10 percent for Carlyle. The Standard & Poor’s 500 Index (SPX) rose 12 percent in the period.
Apollo stoked its results by snapping up loans and bonds -- an unusual move in an industry famous for issuing debt, not buying it. For Apollo, such wagers have been an instrument of profit since the firm’s creation.
After the financial crisis hit, Apollo gathered billions of dollars of debt, including some in its own battered companies. Often the firm purchased debt from panicky lenders and bondholders before companies converted it to equity through bankruptcy or a negotiated restructuring. Before that, Apollo calculated what the value might be after a financial overhaul.
The strategy was central to Lyondell. Apollo also used it to transform a looming wipeout of an almost $1 billion bet on Realogy, acquired in 2007, into an 85 percent gain.
“They are great distressed-debt investors,” says Mark Epley, co-head of the private-equity-banking group at Nomura Holdings Inc., which has helped Apollo finance buyouts. “It’s in their DNA. They take a fundamental view on the downside, and if debt prices go down, they don’t get scared; they buy more. Most private-equity guys aren’t distressed investors at the end of the day. They don’t think in those terms.”
After getting caught up in buyout fever at the market peak and straying from its contrarian roots by paying high prices for a handful of star-crossed deals, Apollo is focused again on buying on the cheap.
The firm has blunted the damage of boom-era wagers such as the one on Harrah’s, now Caesars Entertainment Corp. (CZR), while targeting newer deals that fit its signature pattern of bottom-fishing for assets it considers sound. Its latest acquisitions, including this year’s purchase, with co-investor Metropoulos & Co., of Twinkies and other snack brands from bankrupt Hostess Brands Inc., are textbook Apollo deals.
Apollo’s debt bloodlines run deep. In the 1980s, Black worked with Michael Milken at Drexel, which bankrolled many of that era’s leveraged buyouts and corporate takeovers. When the firm went out of business in 1990 after a securities-fraud scandal, Black teamed with Drexel colleagues Marc Rowan and Harris to form Apollo, with financial backing from Paris-based Credit Lyonnais SA.
Black, 61, the oldest of the founders and Apollo’s chairman and chief executive officer, is a linebacker-size Shakespeare devotee and art collector. He’s worth $6.8 billion, according to the Bloomberg Billionaires Index, and last year paid $120 million for Edvard Munch’s 1895 The Scream, a record for a work sold at auction. Black and Rowan, who bought a $26 million Fifth Avenue co-op apartment this year, declined to be interviewed.
Apollo’s first big deal involved the 1991 purchase of junk bonds, mostly Drexel creations, from Executive Life Insurance Co., an insolvent California insurer. Apollo reaped several times its $3 billion investment by selling the securities and the equity it took when the companies were restructured, according to a person with knowledge of the matter. The payoff cemented the firm’s bona fides as an investor in the loans and bonds of distressed companies and set the tone for the future.
Even after going public and branching into other investment lines, Apollo strengthened its underpinnings in debt investing.
Its credit unit, started in 2004, held $63.5 billion as of March 31, or 56 percent of Apollo’s managed assets, according to company filings. Another division, real estate, managed $9.4 billion -- about half in debt securities and the rest in equities. In private equity, with managed assets of $39.2 billion, Apollo’s investors have granted it freedom to invest more in distressed deals than in leveraged buyouts, depending on market conditions and where opportunities lie.
About 40 percent of Apollo’s private-equity bets have involved distressed targets -- what Harris calls “buying good companies with bad balance sheets.”
Many of its non-distressed deals involve carve-outs, or buyouts of brands, product lines and divisions parent companies no longer want to own. These include Apollo’s $7.15 billion purchase in 2012 of El Paso Corp.’s oil and gas exploration and production operations and its $2.4 billion purchase this year of McGraw-Hill Cos.’ textbook and education unit.
In any Apollo deal, the paramount rule is to pay a low cash-flow multiple, Harris says. That’s less of a concern for buyout firms seeking gains mainly by cutting costs, adding cash flow and wielding leverage to boost returns.
“The single biggest determinant of investment return is the purchase price,” Harris says. “When you get in at the right price, you have the wind at your back. Distressed deals are one way to do that.” With carve-outs, he says, “we trade complexity and aggravation for rate of return.”
LyondellBasell, which wasn’t a carve-out, brought plenty of aggravation. The company was created by Len Blavatnik, a Ukrainian-born American citizen who built a fortune in oil, media and real estate valued at $15.8 billion, according to the Bloomberg Billionaires Index. He merged Dutch chemicals maker Basell NV, which he bought in 2005, and Houston-based Lyondell Chemical Co., an oil refiner and producer of ethylene and propylene oxide.
The deal forged a company with $34 billion in sales; 15,000 employees; more than two dozen plants in the U.S., Europe, Argentina and Australia; and $22 billion of debt.
Credit markets had started to unravel by the time the merger was completed in December 2007, and Citigroup Inc., the deal’s main lender, couldn’t sell LyondellBasell’s senior debt to investors. Stuck with $43 billion of loans it had made to finance corporate buyouts, Citigroup agreed in April 2008 to sell about $12 billion of them to TPG Capital, Apollo and Blackstone for at least 10 percent off face value.
The buyers could cherry-pick loans, and Apollo was drawn to a $1.8 billion chunk of LyondellBasell debt, for which it paid 80 cents on the dollar, or more than $1.4 billion. It put up $360 million, with Citigroup financing the rest, according to a person with knowledge of the matter. Harris, who had shepherded other successful chemicals deals, expected Apollo would recoup the full principal value plus interest, the person says.
It didn’t look that way at first. The economy slumped after the September 2008 bankruptcy of Lehman Brothers Holdings Inc., clobbering LyondellBasell as global demand fell for its products. Earnings before interest, taxes, depreciation and amortization, or Ebitda, dropped to about $2 billion in 2008 from almost $5 billion in 2007, taking the value of loans down with it. As the price of LyondellBasell debt fell to 70 cents on the dollar -- then 60 cents, 40 cents and eventually below 20 cents -- Harris and his team kept buying more of it.
By January 2009, LyondellBasell couldn’t pay its bills and filed for bankruptcy. Apollo kicked in $600 million of a $3.2 billion debtor-in-possession loan, a type of financing to keep the business running. Well into that year, Apollo kept buying more debt. All told, it amassed more than $3 billion in face value of LyondellBasell’s senior loans at an average cost of 50 cents to 60 cents on the dollar, the person says.
Executives at two private-equity firms say they watched in amazement as Apollo loaded up on LyondellBasell debt, even as it was reeling from losses on Realogy, Caesars and other buyouts. The two people, who asked not to be named because they didn’t want to openly criticize a competitor, say Apollo was betting the house.
Harris says talk of excessive risk-taking is ill-informed.
“When people hear the phrase distressed debt, they think risk,” he says. “But we generally are buying secured, senior bank debt at the top of the capital structure.”
At its core, Apollo’s wager was on the economy. Harris and his team estimated, based on the impact of past slumps on the chemicals industry, that LyondellBasell’s Ebitda might fall 25 percent at most, the person with knowledge of the matter says.
The actual drop came as a shock. Still, they hewed to their view that LyondellBasell would recover. They figured customers were depleting inventory to generate cash and that, as long as the economy didn’t go into a tailspin, the cutbacks wouldn’t last, the person says.
Harris was vindicated. Ebitda rose to $4.1 billion in 2010 and reached $5.7 billion last year. In LyondellBasell’s April 2010 reorganization, Apollo traded in its debt for equity and bought additional shares to bring its stake to 29 percent.
The bankruptcy benefited Apollo and other creditors by enabling the chemicals maker to avoid almost $5 billion in fines the U.S. Environmental Protection Agency sought to collect from the company to cover cleanup costs for allegedly polluting an 80-mile (130-kilometer) stretch of Michigan’s Kalamazoo River and at other toxic-waste sites. LyondellBasell settled with the EPA for $250 million.
Since LyondellBasell exited bankruptcy, its stock has climbed 196 percent. Apollo, which began to sell its stake in September, has reaped $5.5 billion from share sales and received $1.53 billion in dividends. Including the value of its unsold shares, the firm’s $2 billion investment has increased almost sixfold in value. That gain excludes Apollo’s $600 million debtor-in-possession loan, which it recouped with interest.
“The guys who grumble are the ones who didn’t do it,” says Marc Lasry, the billionaire co-founder of New York-based Avenue Capital Group LLC, which also bought LyondellBasell debt. “Apollo knew the company well. They didn’t panic when the market went down. Their thesis was that the market overreacted, and their thesis turned out to be true.”
Harris portrays the bet this way: “Put simply, we bought into LyondellBasell at six times cash flow, and that’s where it trades today. We’ve ridden the cash flow from $5 billion down to $2 billion and back up to $6 billion.”
Realogy was another roller coaster. Apollo bought the residential real estate brokerage, which owns Century 21 Real Estate, Coldwell Banker and Sotheby’s International Realty, in an $8.3 billion going-private transaction in April 2007. Affiliates of Apollo and Realogy’s management put up $2 billion of equity, including $920 million from the firm’s Fund VI, and loaded the company, based in Parsippany, New Jersey, with $6.3 billion of debt.
Then the bottom fell out of the housing market. From 2006 to 2009, Ebitda tumbled by almost half, and Apollo’s stake was on the way to being wiped out.
An adroit maneuver turned the bet around. Apollo started rounding up Realogy’s unsecured bonds in early 2009, building a $1.34 billion position at a cost of about $500 million. Hedge-fund manager Paulson & Co. also bought junior debt. By 2010, the two had amassed bonds with a face value of $1.83 billion, or 59 percent of Realogy’s unsecured paper, according to a regulatory filing. In January 2011, they arranged to trade in the bonds for $1.83 billion of newly minted notes convertible into equity.
In October 2012, amid signs of a housing rebound, Apollo and Paulson converted their bonds into stock and took Realogy public. The shares rose 27 percent the first day they traded, closing at $34.20. In April, Fund VI sold about half of its stake in a stock offering for $1.2 billion, lowering its holding to 24.3 million shares with a current market value of $1.1 billion and turning a potential loss into an 85 percent partly realized gain.
The debt play, Harris says, gave Realogy “enough runway to outlive the cycle.”
Beyond buying debt in some of its portfolio companies, Apollo has reconfigured balance sheets. It was among the first private-equity firms, along with TPG, its co-investor in Caesars, to coax lenders and bondholders to stretch maturities and trade in old debt for lesser amounts of new, more-senior debt. The debt swaps, which some debt-laden companies owned by private-equity firms undertook during the financial crisis, became known as coercive exchanges because they penalized bondholders who didn’t go along.
Laying the groundwork for many of Apollo’s debt moves are concessions exacted from lenders at the time of its buyouts, according to bankers with knowledge of the deals. Apollo often insists on covenants that give it latitude to boost debt to finance add-on acquisitions and award itself dividends. It cuts lenders it relies on for financing fewer breaks than private-equity competitors do, the bankers say.
Harris says the firm plays tough on terms to safeguard its investments and investors.
“The reality is that we are good fiduciaries for our funds,” he says. “When things get tough and we have to defend our companies, we’ll do that vigorously.”
Apollo’s $30.7 billion buyout of Harrah’s, its largest ever, remains the biggest drag on Fund VI’s performance. Gambling centers hurt by the recession, including Las Vegas and Atlantic City, New Jersey, continue to struggle, and the company has no presence in the fast-growing gaming mecca of Macau, China. Cash flow barely covers interest costs, says Peggy Holloway, an analyst at Moody’s Investors Service.
Apollo’s $1.34 billion wager had tumbled in value to about $444 million as of yesterday.
In Apollo’s view, its biggest blunder was straying from the discipline of buying low, according to a person familiar with the firm’s thinking. Apollo has revamped its valuation guidelines for deals in the wake of the experience and won’t pay a multiple of almost 10 times Ebitda again, as it did when it bought Harrah’s, the person says.
Caesars aside, most of Fund VI’s bigger stakes have fared well, according to a marketing document for a $12 billion fund the firm is raising. Berry Plastics Group Inc. (BERY), cable company Charter Communications Inc., Noranda Aluminum Holding Corp. and food retailer Sprouts Farmers Markets LLC (SFM) each have produced average annual net IRRs of at least 24 percent. Noranda’s IRR tops 500 percent.
Amid a recent surge in debt and equity markets, Apollo announced 11 investments in 2012 with a combined enterprise value of at least $13.8 billion, according to data compiled by Bloomberg. Mostly, though, it has benefited by selling as the stock market hit new highs.
Last year, Apollo sold Hughes Telematics Inc., a maker of wireless systems for cars, and movie theater operator AMC Entertainment Inc. It extracted dividends from four holdings and reduced stakes in three other companies. It held four IPOs. This year, Apollo was among investors that sold a 27 percent stake in Charter Communications to John Malone’s Liberty Media Corp. for $2.62 billion. In April, it reaped a fourfold profit by selling distributor Metals USA Holdings Corp. to Reliance Steel & Aluminum Co. for $1.24 billion.
“We think it’s a fabulous environment to be selling,” Black said in April at the Milken Institute Global Conference in Beverly Hills, California. “We’re selling everything that’s not nailed down, and if it is nailed down, we’re refinancing it.” Apollo returned $16.1 billion to investors in its private-equity funds in 2011 and 2012 and handed back $3.4 billion more in the first quarter of this year, according to filings.
The current ebullience has Harris dreaming of future opportunities.
“There’s froth in the market, and I don’t think it will end well, though not as badly as in 2008,” he says of efforts by central banks around the world to keep interest rates low. “When rates rise, you’re going to see valuations re-price, and things will get more treacherous.”
Apollo will be in its element.
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