Financial Markets (2008)

ECON 252 (2008) - Lecture 20 - Guest Lecture by Stephen Schwarzman

Chapter 1. Introduction: Stephen Schwarzman’s Profile [00:00:00]

Professor Robert Shiller: Well, I have the pleasure of introducing to you today Stephen Schwarzman, who has kindly agreed to lecture our class. Mr. Schwarzman graduated from Yale in 1969. He was at Davenport College. Do we have any Davenport people here? A few, not a lot. He graduated then from Harvard Business School in 1972. He worked for Lehman Brothers as — I don’t know if it was his first job, but one of his first jobs, and became Managing Director at Lehman Brothers at age thirty-one and he became head of their Global Mergers and Acquisitions team. In 1985, Mr. Schwarzman, with Peter Peterson, founded the Blackstone Group, which has become the lead manager of alternative assets.

In some sense, what he does and what David Swensen does, whom we had heard from earlier this semester, are similar. They’re both looking at unusual and different investment assets and they are both very successful in doing this. Mr. Schwarzman’s firm has had a return on private equity investments of 23% a year for the last — on average — for the last twenty years. This is a little bit in excess of David Swensen, but I think we have to put them both as remarkable investors. In the real estate group at Blackstone, they’ve had 30% a year for the last fifteen years and this is after fees. Blackstone Group has been very much in the news recently. It just came out that they are apparently going to be buying $12.5 billion dollars of leveraged loans from Citigroup at a steep discount. So, apparently they’ve seen a profit opportunity there or they’re supporting our economy from the ravages of the subprime crisis.

Also in the news, China has announced that it plans to buy $3 billion dollars stake in Blackstone Group as its first effort to diversify its $1.2 trillion dollars of foreign exchange reserves. So, the Blackstone Group was picked by the Chinese government as the most fitting place for it to put some of its reserves. With that, I will leave it to Mr. Schwarzman, who will speak for a while.

Chapter 2. In His Own Words: Early Discoveries in the Financial Market [00:03:00]

Mr. Stephen Schwarzman: Well, thank you very much for coming out on what’s a bit of dreary, slightly rainy morning. When I was an undergraduate, you wouldn’t have gotten much of an attendance; people would have been sleeping in. So, it’s awful nice of you to be here. There are some dramatic differences from when I was an undergraduate and you are. One of the first differences is that this course wouldn’t have existed because no one had an interest in finance at that time. It wasn’t a particularly interesting time. In the 1960s, the securities markets actually were regulated, commissions were fixed on the New York Stock Exchange; so, it was very difficult to find some way to compete. It was sort of rigged system, if you will, and it wasn’t open.

So, there was very little to no interest, really, in finance. There really wasn’t an SOM — School of Management — at Yale at that point. Business generally was utterly unfashionable. We were in the midst of the Vietnam War and business was sort of linked to the perception of that war because they supplied certain types of war materials and that was the most unfashionable thing that you could be involved with. So, there was a very anti-business, non-existent finance orientation at the school and, obviously, that’s changed in the society generally, with enormous differences. As a result of when I grew up, I didn’t even take an economics course at Yale. I frankly wasn’t much good with math; I stopped in the eleventh grade and I think calculus was, for me, that was way too much of a reach. So, I’m more in the add, subtract, multiply, and divide kind of category, which worked and still does quite well for me.

When I graduated, I was lucky enough to get a job at a firm that had just gone public. It was the first New York Stock Exchange firm that had just gone public; it was called Donaldson, Lufkin & Jenrette. Bill Donaldson actually founded the School of Management after he left DLJ. That was, because this is a financial markets course, that was quite interesting for me because I didn’t even know what common stock was when I graduated. Hopefully, you will have learned more in this course. I went to DLJ — I couldn’t read a financial statement, which is like going to a foreign country and not being able to speak the language; it was sort of hopeless.

One of the interesting experiences I had about — which really, now that I’m a little bit older and can look backwards on financial markets, it was my first visit to a company. DLJ basically was one of the first large institutional stock managers of pension fund assets and so forth and I was allowed to go and interview a company. I had never interviewed a company executive; I read their annual report and I went up to see this gentleman and I sat there. I figured out all the things I’d want to know so that I could figure out whether I should buy his stock or invest in his company. I went through my list of questions and he wouldn’t answer most of them. I found it a very frustrating experience.

I went back to the office and by the time I got back to the office, Dick Jenrette, who was president of the firm, had gotten an enraged phone call from this executive and called me into his office. He said, geez you made this man very angry. I said, well how could I do that? I was just asking questions and he wasn’t answering them, so I just asked the question again. I couldn’t quite understand why he wasn’t answering me. He said, well you were asking him things that he’s not allowed to answer. I said, what do you mean? He said, well you were asking him for inside information. I said, well I don’t know what inside information is; I’m just asking the question that I need to know to know to answer whether to buy the stock or not. He said, well Steve, there are all these rules of what you can ask somebody. Then if he tells you, then he has to tell everybody in the world and that’s just too cumbersome, so that’s why he didn’t answer. I said, well if he didn’t answer, how in the world can you figure out what to do? I said, I’m not that smart; I need to have all relevant data and he’s the person who has it, so why won’t he give it to me?

It became pretty clear that I was doing the wrong thing for a living. In effect, that’s the dilemma for people who want to buy liquid securities. I decided very quickly this was a bad business, certainly a bad one for me — that I couldn’t figure out how I could win that game when somebody wouldn’t fully share openly everything they knew. I guess if you were like a sumo with a good fashion sense, that’s how you manage liquid securities and beat other people. It’s not just what you know, it’s a question of whether the rest of the world will buy into what you know and drive that security up. So, I basically retreated and went to Harvard Business School, where I figured maybe somebody will tell me how this game really works in a way that I can prosper in it. That was a good experience for me. They basically taught you — you’re undergraduates, so you don’t know what they’re teaching you at the school like that — so, I can explain it actually pretty clearly.

It’s basically — they’re teaching you that everything you do with a company has something else to do with that company, so that it’s an integrated system. If you are trying to develop a product for sale, it would be good to know whether somebody wants it. What happens, actually, in the real world, is that sometimes people just get an interesting idea and they’ll produce a product and nobody will want it. If you integrate all the different kinds of knowledge in the company so that you’re doing intelligent things — and I know this appears very elementary — you’ll have a better company. That’s sort of what they were teaching and after they taught that for two or three months, I sort of got it and thought about dropping out of school because it got a little repetitive, frankly. I was convinced by my friend, Dick Jenrette, who also thought about dropping out of Harvard Business School. In December, it gets very cold in Boston and really miserable — he was going to drop out and go and get a PhD in Economics. I was going to drop out and go back to the real world and he said that his staying on was a good thing and I should stay on, so I did.

What I’ve sort of done for a career is try and solve that problem of my initial meeting, where people will — I want people to tell me what’s really going on, so I can figure out whether what they’re saying makes sense or doesn’t make sense. You can do that in the private equity business, which was sort of our largest business, and you can do that in the real estate business because you’re allowed to get all that inside information, if you’re trying to buy a company with our rules and also the rules of other countries. If you sign a confidentiality agreement that you won’t use that information for any purpose other than buying the company and putting a price on it, then the shareholders get a chance to vote on whether they want the price that you give them. So, to me that was like an answer to my conundrum of how could we get all the information and then figure out what to do with it, including improving the company.

Chapter 3. Real Estate Assets Performance with Blackstone [00:12:36]

I’m sure you know something about private equity. If you read the general newspapers, I’ll tell you basically what it is. Well, all we do is we buy companies and that’s the simplest thing we do. We do a lot of other things, but let’s start with, we buy companies; we borrow money to buy those companies. Historically, it’s been about three dollars of debt for every one dollar of equity. We then improve those companies through a whole variety of sort of managerial actions and then those companies grow with the general economy. Let’s say — if they just grow at the regular rate of all companies, then if you’re leveraged three-to-one, you’re going to earn a much better return. If you take a company and can accelerate its growth so it’s growing faster because you’ve improved it and you have three-to-one leverage, you’ll get a way better return then any normal stock market kind of return. That’s sort of the model of what we do in that business.

As Professor Shiller was saying, we’ve compounded, after fees, at 23%; but before fees, because we charge a 20% part of the profits of the deal goes back to the general partners, which is us. We actually earned around 31%, which from you being in a course like this, you’d see that’s really pretty high compared to a stock market average over a period, which would be around 11%, in real estate, where we do the same kind of thing. But, real estate is an easier business because buildings don’t talk. Management of companies talk and you have to figure out what they’re saying. Companies are very complex — you have interesting competition, you have global competition — and it’s a complicated asset class.

Real estate is very simple. I mean there’s a — buildings don’t talk, so you can’t get misled by a building; they can’t tell you something; they don’t have a belief system. It’s just there; it’s on the corner; it’s in the middle of the block; and there are other buildings that are either getting built or planned. You can figure out what the supply/demand is for real estate in a much easier way. Because of that, our returns in real estate have been better because it’s an easier asset class and we’ve earned, after fees, 30% a year since we started and, before fees, close to 40%. This alternative asset class, if handled right, is really a much better way of earning money for investors as well as the general partner — let’s not forget us — than regular financial markets investing.

That world has been started very small. When we started it, the institutions had less than 1% of their assets. It was like infinitesimal in the private equity side of the business. It’s now up to about 4.5% and the returns are so much higher; you wonder why people don’t give us all their money on an asset allocation basis. I actually still wonder why they don’t since we put most of our money in that and we keep making more and more and outperforming. It just takes the rest of the world apparently the equivalent of your lifetime to sort of figure out exactly what they should be doing. I think the projections are that this should be growing at a lot faster rate going into the future and some institutions, like Yale, have private equity with around — I guess it’s around — 16%, 17%. It was up to 18% of their portfolio and that’s one of the reasons why Dave Swensen has done much better than regular money managers.

Chapter 4. Deconstructing the Subprime Crisis and “Jars of American SARS” [00:17:16]

Turning to a different subject — it’s a financial markets course and I thought it would be useful to talk to you a little bit about what’s really going on in the real world. Even though this course is being recorded and whatever you say about the current moment turns out to be right or wrong, but it’s just a current moment; it’s such a fascinating one. You all are, I guess, somewhere between eighteen and twenty-one years old, probably nineteen and twenty-one, so you don’t have the perspective to understand how really interesting and dangerous this current environment is. What’s happened is that through an abnormal issuance of something called subprime securities — nobody in this audience, certainly people watching, have probably owned a house. What happened was that in the late ’90s, the government in Washington passed a law to encourage more low-income people being able to buy houses and resulted, along with other factors, in an explosion of these types of loans.

In terms of loans — and Professor Shiller can correct me if I’m slightly off on this — but in the year 2002, of the total mortgage loans that were originated for houses, probably around 2-3% of them were subprime. These are for people who don’t have enough money to really pay normal principle or interest and expect their mortgage to be current — to not go into default. By 2006, this had exploded to 30% of all the mortgages that were issued that year. When you go from 2-3% to 30%, this is an almost out of body experience and to entice these people to take these loans they actually would tell somebody — in the olden days, when I was your age, to buy a house you had to put up 25% of the cost of the house. Sometimes, you’d have to put up 20% of the cost of the house and you can borrow 80%. The subprime loans — sometimes you only had to put up 3% of the cost of the house; sometimes you didn’t even have to put up anything. That makes it really affordable and then you didn’t have to pay any interest for two or three years. So, you put up nothing and you paid nothing, so this led to a stampede of people who wanted this.

What’s happening now is that the mortgage — the interest which no one — a lot of these mortgages didn’t have to pay now, two to three years later you have to pay it and a lot of the people who didn’t have the resources can’t pay the mortgages; those mortgages are defaulting. The issue that created all the problems in the financial system that you’re reading about in the front page is that these mortgages were pooled in a new security. Imagine just, sort of, a jar where somebody threw in a few thousand of these mortgages and then put the lid on it. They had these new securities and what they did is they said, well the first 83% of them must be really safe because mortgages basically hardly ever default. They rated those — the rating agencies, which tell people how secure something is, rated this as a “triple-A” security. In the world of finance, when you tell somebody that a security is triple-A — they get rated all the way from AAA’s down to CCC’s and CCC means something’s about to blow up; AAA means there’s no possible chance you’re ever going to lose your money.

Because 83% of this jar was rated AAA, people bought this all over the world as if it was a security that could never, ever, ever default. As you can see, these were basically mortgages made to low-income people who weren’t even paying, in some cases, interest on it and the chance that these were going to default was really sky high. Historians will go back and figure out why anybody would believe that these things could be AAA. They did and they were bought everywhere; so, these securities became like American SARS. They were exported throughout the world, creating enormous problems for individual institutions around the world. In the United States, they’ve created what will be hundreds of billions of dollars of losses for the financial institutions.

As part of Sarbanes-Oxley, which was a law passed after Enron and some other things, we’ve developed accounting procedures with something called — very technical — called FAS-157, which is called Fair Value Accounting. It means, before these defaults even happen, the fact that other people think they’re going to happen results in the securities being worth less and you have to take a loss based on that expected value. The financial institutions were losing all this money without the defaults even happening or people knowing how bad it would be. As a result of that those large losses, the financial market started losing confidence in some of the financial institutions and different asset classes in those financial institutions. Principally banks started trading in a really bad way.

People thought they were going to be forced to sell some of those and we had a variety of different asset classes, ranging from municipal bonds, basically changing their value. People said, I don’t want these anymore, there were hedge funds that owned those on leverage, so there were margin calls, which forced those securities to be sold, which made them worth even less. That got the banks even more nervous. That resulted in higher-rated securities being sold that were also unleveraged. What you had was panic selling of securities rolling through every element of the financial system as people desperately tried to get out of stuff before it would become worth less. This type of rapid de-leveraging resulted in downward valuations for all these securities — a lot of hedge funds going bankrupt. Anyone with leverage borrowing more than five to one to carry some very secure real securities, not subprime, but government-oriented securities — those institutions got into trouble. What we’ve had is basically melt in the financial markets, where the banks have been so severely impacted that they have stopped lending to certain whole asset classes, particularly leveraged lending, which we’re involved with, as well as other areas.

The costs of credit have gone up, sort of, 3%, 4%, which doesn’t sound like much to you, but it actually in the overall system is a lot. What that’s resulted in is a financial crisis. It’s resulted in the Federal Reserve, who’s the ultimate protector of the system, very quickly lowering interest rates — agreeing to lend huge amounts of money to the banking system because banks are now not even lending money to each other. They’re sufficiently scared about what’s going on and the Federal Reserve is saying, well everybody can come to me and I’ll lend you all money to keep you liquid, so this whole system doesn’t stop. As it impacts regular people is when the financial institutions go into a crisis like this and stop lending or reduce their lending of money. There’s less money for regular people to borrow to go about their lives and businesses to get. As that starts happening, an economy will slow down and go into a recession and that’s what’s happening in the United States.

Chapter 5. A Recession in the Aftermath: A New Financial World [00:26:53]

For those of you who are graduating this year, your prospect of getting a job will be less than the people who graduated last year and the people who graduated the year before had a much better deal than the ones that were graduating last year. This is a problem that’s a pretty pervasive one and it will probably take longer to get out of this recession than other ones that we’ve had. The implications of financial markets, which may sound like just sort of a dry academic course — this will also effect the outcome of presidential elections among other things because you’ll see that from what the presidential candidates started talking about nine months ago, which was a lot of foreign policy, war in Iraq, which we’d be doing a better variety of those issues. You’ll see that by the time this election occurs, that the focus will be much more and perhaps dominantly so on the economy, on people defaulting and being thrown out of their houses, on what’s happening to the economy generally.

It’s going to hit other things, such as trade and the country being more populist, more protectionist, which also has negative implications because the United States right now is the largest debtor nation in the world. Ten years ago, we were the largest creditor, and when you’re the largest debtor, that means you have to borrow money all the time from people in the outside world. If we become more protectionist and outsiders basically say, look these Americans are starting to not have an open world; I’m worried that maybe I won’t be able to get my money back or they don’t really want me to be part of their world, then there’s the potential that they will invest less with us, which again will raise our cost of borrowing in financial markets, whether they’re for Treasuries or other types of things, which will have the effect of again slowing our economy.

You all are about to enter the world in a very, very, very interesting time. The problems with our financial institutions are perhaps the greatest that we’ve had since the 1930s, in the era of the Great Depression, which is when my dad was sort of a young man and he grew up in the 1930s. Anyone who did would tell you, that was just a disastrous economic time because those financial institutions — as opposed to struggling the way ours are and ours will ultimately be fine — those financial institutions collapsed because they didn’t have the kind of safeguards that the system has basically put into our system, currently. We learned from the 1930s how to avoid a complete collapse of the financial institutions. This is a trying time for the system and the Federal Reserve is doing a really excellent job at sort of guaranteeing it.

If you read about the recent Bear Stearns crisis, which was front page of literally every newspaper in the world, where the Federal Reserve stepped in and basically provided sufficient guarantees and credit support so that this one institution wouldn’t go bankrupt. There were — it’s a brokerage firm. Brokerage firms are not regulated by the Federal Reserve and they don’t have access to the borrowings of the Federal Reserve to protect them, which is — they’re sort of outside the system. The reason why the Federal Reserve went and did that is that the large brokerage firms, which don’t have the same kind of regulation or the same kind of ultimate lender, literally have trillions and trillions of dollars of counter-party risk — sort of guarantees that they’ve given that they’ll do something. If they go bankrupt, they can’t do it and that leaves the system vulnerable to people expecting performance on things like credit default swaps and things that are too technical to actually explain to you at the moment.

But, there are so many trillions of dollars of those obligations that if they get into trouble — this isn’t just like a subprime mortgage; these are in the trillions. Just credit default swaps are about forty-five trillion dollars and the subprime mortgage losses will only be a few hundred billion dollars. The Fed was basically going in and saying, we can’t take this risk to our overall system. That’s one reason why the stock market has gotten better because the prospect of a collapse of the system has been really reduced.

I wasn’t trying to depress you on an early morning. The American system is enormously resilient and there will be solutions that happen over time that will deal with this. The impact of financial markets, which is your course — I’m just a visitor — is really driving the whole overall economy and is affecting the global economy. The countries in Asia — China, India, and in particular those large ones — will obviously sustain lower growth rates as a result of this financial markets problem here in the United States. You’re seeing the U.K. having already slowed down and this will probably, as it has historically, roll into continental Europe and result in the whole world growing slower, higher unemployment and people being adversely affected.

How financial markets work, how they’re impacted, and what would have happened if these subprime mortgages wouldn’t have been allowed to have been made from a regulatory point of view, and what would have happened if they were, instead of being rated AAA, they would have been rated single B. Hardly anybody would have bought them and that would have controlled the expansion and the risk to the financial system. Historians will look back on it and real people, not that historians aren’t, but real practitioners will try and solve this problem by having different types of regulation so that you can’t get into this kind of risk posture. In any case, why don’t we take some questions. That’s an opening and we can talk about anything you’d like to.

Chapter 6. Questions: Successes and Setbacks [00:34:49]

Dare to be great? Yes?

Student: I’m sort of curious; maybe you can sort of take us through one that went great in your opinion and one that went very poorly.

Mr. Stephen Schwarzman: The question was, can I take you through a good deal and a bad deal? I assume private equity or —

Student: Yes.

Mr. Stephen Schwarzman: …to show you how this works. Well, a good deal — those are always more fun by the way — a good deal was really our first deal. It was a company called U.S. Steel Corporation, which is sort of a big one. It was attacked by a corporate raider named Carl Icahn, who I think you have some familiarity with, being a prior speaker. The corporation didn’t want to be taken over, so they were trying to marshal cash to fight him off. The way they chose to fight him off was by buying their own stock at a higher price to give their shareholders the equivalent of a really big dividend, but doing it by buying their stock, which gave them capital gains treatment; so, they needed to get a bunch of money. The way they thought about getting some money was to sell one of their big assets; the asset they chose to sell was their railroads and barge lines and ore boats on the Great Lakes.

To make steel, for those of you who have never done it, it’s a lot like cooking. You need a variety of different ingredients and the ingredients, instead of just being carried into your house in a shopping bag, come in on a railroad because they’re iron ore, and coke, and all these really heavy things. I guess around 1880-1890 a fellow named Andrew Carnegie, who owned U.S. Steel — it was then called Carnegie Steel — built all these railroads to bring this stuff in. U.S. Steel wanted to sell it and they didn’t want to lose control of it because they felt if that was a lifeline artery into their steel plants, where it brought in 100% of the raw materials to make steel and took out about 85-90% of the finished product because steel is really heavy. So, you just can’t carry it out and put it on a truck, necessarily — goes out by railroad also.

Because this was an artery that went right into the company, if we started overcharging for the railroad, they were worried that we would bankrupt the steel companies, we’d siphon off all the profit. We did a partnership deal where we owned 51% of the railroads, in effect; they owned 49% and we — let me show you how excessive finance can get. I believe the deal was somewhere around 600 million dollars — 700 million dollars in 1988-89, so that’s a lot more money today. We borrowed almost all the money; I think we put up fifteen or twenty million dollars, so the leverage was huge.

The business wasn’t particularly a growth business; it was pretty stable. We bought it in the middle of strike, so part of the art of what we did was guessing whether U.S. Steel would come back to the same production level that they were before. Our guess/analysis was correct and every year the profits from that company would be worth more than the amount of money that we invested in the equity. So, we ended up making twenty-four times our money in that deal in twelve years. In our world, not the academic world, if you make twenty-four times your money in twelve years, this is regarded as a success; so, that was a good one.

Now, a bad one shows you a little bit about the volatility and danger of the currency markets. We, in 1998, bought — it might have been 1997 or 1998 — controlled the second biggest cellular phone company in Argentina, which was an interesting place to be. I’m sure you all have one of these if you don’t have something more elegant and some other sort of personal device like one of these that can get email or it can — you can talk on it. You can almost set it up as a disco; you can do almost anything with it. We bought this company for eight times cash flow, which is not real high for a company that’s growing very rapidly in what was called an emerging markets country.

This particular country had its currency indexed to the dollar, so it was almost like investing in the United States because, what could go wrong? A rapidly growing country invested in dollars. We borrowed dollars to buy this company because in Argentina you couldn’t borrow money for a long time. One of the great things about the United States’ financial markets is that you can borrow debt for long periods of time. This looked to be a very low-risk, rapidly growing situation, where we were hopeful we were going to make four to five times our money. There was only one problem that — Argentina the country collapsed. I mean, literally collapsed. The linkage, which is called a peg to the dollar, turned out to be a most unfortunate thing and the emerging markets — this is when you started with the Russian financial crisis and this crisis. Then you had an Asian financial crisis; it rolled through the whole world with currencies rapidly changing their values — all kinds of countries at risk of collapse. It got to Argentina and the whole economy pulverized; it was like a depression. They got off their linkage to the dollar; their currency became close to worth nothing; and then we had to pay debt back in dollars with earnings in Argentina, which were worth nothing. We lost every cent — every dollar we invested in that investment — and even as we were going bankrupt, it was still a good company.

In finance, bad things can happen to nice people and even when you think things through, you can have some really bad outcomes. We’ve had — obviously, if you have very high returns, you have wonderful stories — many more wonderful stories than the bad ones. We bought a chemical company called Celanese in about 2003, right after the recession was lifting. It was a company in Germany, but it had only 10% of its activities in Germany. It had about 60% of them in the United States, so it was really a U.S. company masquerading as a German company. The price-earnings multiples of German chemical companies were very low. The price-earnings of American companies were much higher.

Not being entirely dim-witted, what we did was we changed the location of the company — the headquarters — from Germany to the United States. They also, for some reason that we didn’t completely understand, had three headquarters operations going — two in the United States, one in Germany. We closed two of those three; we invested a lot more money in expansion as we were coming out of a recession; we leveraged the company pretty highly; and we made, I guess it was, about six times our money in two years owning Celanese, which is on the New York Stock Exchange now. It’s a lovely company, wonderful company. There are many stories of that type, where we invest more money, move things around, borrow a lot of money, catch fundamentals as they’re going up. The good stories are really a lot of fun; we enjoy those and so do our investors.

Chapter 7. Personal Lessons and Insights from the Financial World [00:44:54]

Those are — I gave you two winners and one loser instead one and one because, in our real estate business, we’ve probably, just to give you perspective, we’ve only lost money on two situations in our history out of about 160 investments. The number of good stories to bad stories — I mean, this isn’t like Las Vegas where you end up as a net loser or it’s a lot of luck. Every time you do one of these things, you have a team of people working on it, some of whom are in their early 40s, who are usually partners. Then, each one of the firms scales down in some kind of hierarchy, where you have managing directors, and vice presidents, and associates, and analysts.

The folks like yourself tend to get hired at firms like ours as analysts, which means you do statistical work. I guess they’re called now models on a computer, which give us an idea that if any of the variables affecting these deals change, how will it affect the overall earnings of the company, or cash flow of the company, or our ability to service the debt of that company. Then we can figure out, from doing that, what price we’d want to pay for the company, how much debt we could safely put on it so that the business doesn’t get in trouble. Now, this analyst program that firms like ours have and people all over Wall Street have is like a huge industry for people your age. This didn’t exist when I was in college and I’m actually not that old compared to you. I sort of think I’m almost the same age, a little older, but it’s amazing having people like yourselves. I mean, in two years you could be in my conference room with all the rest of the team talking about a live deal and putting in your two cents — a perception whether you think something’s a little more risky.

What we do at our firm, whenever we’re considering something, we always go around the table and ask everybody. So, we’re not trying to intimidate anybody, but we figure that if somebody your age has been working on something and knows the numbers sort of cold, you’ll have some views. It’s always fun, particularly for me, to ask because that’s how you start the process of learning. Finance is a business that is an apprentice business. It’s sort of like going back to the Middle Ages where they had guilds and you’d learn your business by apprenticing with somebody else who’s already done it. There’s a base level of knowledge that you have to have in finance before you can be creative. The only way you get that is by working with other people who’ve already done it and are doing it. People take enormous care when working with folks like yourself in terms of making sure you get the right answer or not.

What I’d say, which is different in the real world — as a visitor from the real world to you in the academic world — one of the real differences is, in the real world there is only one grade for every project, which is the equivalent of a course, and that is an A grade. The definition of an A isn’t the same as in academics. In academics, you can get an A — and I don’t know what Yale’s current grading curve is now — you can get A sometimes with a ninety, you can get an A with a ninety-two, you can get an A with ninety-three; that’s sort of pretty good — that’s an A. In our world, an A is a hundred. This was shocking to me because I wasn’t a one hundred kind of person.

My first project that I did — just to give you an idea of the real need for excellence and perfection in what we do — is I was assigned a project. I worked on it really hard; I wrote something up that was like a term paper, which normally you only get to do one a year. In the real world, you get to do them every two to three weeks. I submitted this thing to a gentleman named Herman Kahn, who was a partner at Lehman Brothers — an older partner at the time when I was doing it. I sent it down to him and he was waiting for this project and I got a phone call about three hours later. It sort of went like this: “This is Herman Kahn calling, is this Steve Schwarzman?” I said, “Yes it is, Mr. Kahn.” He said, “I got your paper; there’s a typo on page forty-three.” Bang. That is the only thing I ever heard from Herman Kahn. A slammed phone because a comma was in the wrong place on this piece of work and I had really struggled.

That’s all I got — an angry man and a slammed phone and I basically said, what kind of crazy world am I in? What is this about? What I learned is that any piece of work that you did that wasn’t completely correct, you got a version of Herman Kahn in your face. Different people did it different ways, but this was a radically different world — the real world in finance — than I was used to.

I was a major here in something that doesn’t exist, I’m sure, anymore — a creature of the 1960s called Culture and Behavior. What we did is we had an interdisciplinary major with — in psychology, sociology, biology, and anthropology. In other words, we studied how people thought and why they thought that way. I thought that was a pretty neat thing to be doing. We had professors from each of those disciplines; we had two seminars a week; we had eight students in the major and we had four professors working with us all the time. So, I was used to a little softer, more loveable world than finance. So, finance for me was shocking — that people would have to have everything correct all the time.

At your level, what you’ll be doing — that’s sort of what it is, there’s no alternative. People are nice, they’ll help you get there, but there’s no, absolutely no flexibility in terms of getting perfect scores. Now, once you do that — I’m giving you a little career advice here — you do that for about two years or three years and then after that you can start being more creative and finance can be a really creative, interesting, problem-solving business, where it’s global — it’s fun. I mean, in my last two weeks, where have I been? Let’s see, certainly in New Haven now; I was in Bahrain, Kuwait, Saudi Arabia, Abu Dhabi, Dubai, Cambodia, Korea, Ireland and Germany. It’s actually really interesting and you meet people all over the world; you get to see how they think about issues — how their financial systems and their economies work. During that trip, I met heads of countries, heads of financial institutions.

You’re trying to figure out really the most complex stuff in the world, which is how all these systems work and how they interact. Ultimately, what you will do in an individual situation is based upon this immense flow of knowledge and data and cultural differences. I missed China and India on this trip, but we get them on other trips and it’s really — finance done appropriately is a wonderful lifetime learning, ever changing, exciting kind of business. It’s not like, sort of, selling socks to a department store; this is a really fascinating business — it never stays the same. You have so many different people in so many different countries making so many different kinds of decisions that you, as one decision maker in that enormously complicated matrix — the chance that you’re going to get it right is only because you’re absorbing as much information as you can from every place and trying to thread the needle to make a correct decision.

It’s a lot of fun, so any of you who go from this course into being a practitioner, which is sort of what I am in the real world — it happens to have historically been quite financially rewarding, which I guess is like a — I used to think that was a really good thing, until the U.S. is reevaluating exactly what it thinks about success. But, it’s basically a good thing and it’s fascinating and I would encourage you if you have an interest in it to pursue it.

Chapter 8. Questions: Dealing with Failure and the Future of Investing and Private Equity [00:55:44]

Yes?

Student: [Inaudible]

Mr. Stephen Schwarzman: Can you speak up a little?

Student: [Inaudible] profitable and my second question for you is from where and what kinds of classes do you see the next return for [inaudible]?

Mr. Stephen Schwarzman: Okay, it was a question about carried interest being taxed at a lower rate and the next question is what asset class do we think is going to have really high returns over the next five years. On the carried interest question, this is something that has been pretty well, sort of, surfaced. There are a bunch of arguments from different sides of the political spectrum on this. Folks like ourselves, who have had carried interest taxed at capital gains rates since the 1930s, are sort of wondering where the whole discussion is coming from. In other words, this has been going on for longer than I’ve been alive — that this has been a capital gains treatment item.

The way carried interest works is, we get a 20% share of the profits of any investment over some type of hurdle rate, which is a minimum return. In our case, usually it’s around 8%. To get this carried interest, we have to invest significant monies in our funds, which is totally unlike normal compensation. Most people — to get — some people in the government want to characterize this as normal compensation, ordinary income; people who get ordinary income just work and they get it. They normally don’t invest millions of dollars for the opportunity to get their salary. We also have to — if we don’t make a certain minimum return and we’ve gotten some of this carried interest, by the time a whole fund’s over, we have to pay the carried interest back. Most people who earn ordinary income don’t pay back their income after they’ve gotten it.

Carried interest basically comes out of splitting the profits from a partnership, where it’s sort of quite normal for a working partner to get more of a deal than just a passive investor. Whether it’s somebody just in a family — somebody who works in the business and somebody else in the family puts up the money to buy part of the business. Usually, the person working in the business gets more. So, we sort of look at this as sort of an issue that’s now in the political world and it will be solved in that world. We don’t have much of a say in that, but I would say that the, sort of, characterization of this is being something as sort of an odd thing. It’s really been going on for eighty years, so I don’t quite understand exactly why it’s officially odd now and it hasn’t been for all that time period.

The second part of that question is — I’ll ask it a different way than it was asked, which is, what’s going to be the best performing asset class over the next five years? I think that was more or less what you were asking. It’s always hard to tell exactly what that will be, but typically you have to have a view of the world and I think our view of the world is that the economies of the developed countries are going to get hurt over the next year or so. It ought to drive down asset values of a variety of types and there should be a great opportunity out about, sort of, a year to start buying companies and other types of assets at what should prove to be a bottom. Then, if you can leverage those assets, as the economy keeps getting better, you’ll make really great returns.

The last time this set of circumstances presented themselves was 2002, after the recession in 2001, which went into 2002. We were the biggest purchaser of companies in the world in 2003 and 2004 and, as a result of that, the fund that we used to buy those companies earned about 51% after fees, which for those who keep score of these things is really quite extraordinary. We think that kind of cycle is going to repeat itself. We would think that the private equity business — you’re seeing now, we’ve just involved with a deal that Professor Shiller mentioned — it was in the newspaper this week, I guess — where we were buying assets from Citibank — loans at discounts. There will be opportunities in the debt area over the next year or so that also ought to be very good. Yes?

Student: How do you feel about and how do you deal with failures in investments, like your Argentina investment? And how do you think that in the future?

Mr. Stephen Schwarzman: The question is, how do we deal with failure like our Argentinean investment? The second part of that was?

Student: How do you think the private equity will evolve in the future?

Mr. Stephen Schwarzman: How do we think private equity will evolve in the future? How do we deal with failure? I really hate failure. I mean it’s deep, it’s visceral; I really can’t stand it. Because I feel so passionately about that, the people who work at our firm, all of whom I’ve been involved hiring, understand how I feel about failure and so we don’t have a lot of people around who like failing either. One, because they don’t want to disappoint me, but two, because I don’t hire people who don’t feel the same; this is like a passion not to fail. When we fail it’s a major, major, major event. This is not a normal thing.

What we do when we fail is we spend enormous time thinking through, what did we do wrong; what should we have seen; are our processes good; did we misidentify a variable that got us or did we identify it and didn’t evaluate how bad that can be — we got that wrong. Or did we just simply have bad luck where there are three or four bad things that could happen and they all happened, like in a very rapid period of time? Failure is a — how you manage failure is very important and some people manage failure by making pretend it didn’t happen. They just go about their jobs and people don’t pay attention — well we lost money on that one. I don’t believe in that. I like to learn. Sometimes, you learn more from your failures than you do from your successes. We actually changed the way we made decisions at the whole firm after a very early failure that we had had and changed our whole investment process; that one failure created most of our successes.

Failure — when you make a lot of decisions — I used to think we could make no mistakes. That’s what I always try and do, but if you’re very active in making decisions — I think about this stuff so much that we probably get about 90 to 93% of our decisions correct, maybe a tiny bit higher; but, that means we’ve failed a lot, so there’s 7% failure. Sometimes we get 95% right, but we’re still making 5% failure across the firm. So, we’re always struggling to improve and get that down to almost nothing. So, failure is a really important element in learning. It’s like bad dating. You date somebody, it doesn’t work out; that’s the way, by the way, most dating is — it doesn’t work out. Works out for a while, then it doesn’t work out. So, all of you would probably think about, what did I learn from this? Why did I get involved with this person? Was this a good thing on balance or not a good thing? Am I going to repeat this mistake in the future? What did I learn? That’s what we all do in our own lives and we do it in our commercial life as well.

Second part of that question was the evolution on private equity. Private equity is an enduring asset class because it basically makes really great returns. It attracts very talented people. It reallocates capital around the globe. It goes where there’s opportunity and it improves companies by investing more capital in these businesses. So, there’s an enduring place for private equity. Right now, there’s a capital crunch and there’s not much money available to borrow except on smaller deals. That circumstance happened briefly in 2002, it happened in 1990-91, happened in 1987, happened in 1982, happened in 1975; so, it happens. When it happens, everybody always says, oh my goodness this business is going away and so forth; that never ends up occurring because capital always comes back.

The evolution of the business will have a few super-bracket kind of firms, like ourselves, who keep attracting more and more capital, who are investing globally, who have people all over the world. The future for these kinds of businesses, I think, is pretty good — quite good. You have smaller firms that are in individual countries, sometimes segmented by an area of concentration. You’ll have a healthcare group and some of those businesses will do well; some will wither. You have smaller firms that do smaller kinds of deals; there’s always a place for that. So, I think that private equity tends to grow in step functions, as a function of how much money institutions have to put in the class. When stock markets go down and institutions generally have less money, they put less money in the class. When the markets get better, they put more money, so it’s not a straight line of growth; it’s a little wavy like that and I think that will continue. I think we’re done. Sorry to intercept your question.

[end of transcript]

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