Bull Bear Report Aug 24 2010

PE Culture Shift: How Schwarzman and James Made It Work at Blackstone

By john e. morris

As private equity matures, employees across the industry are experiencing a profound shift in workplace culture. Founders are handing off power to a second generation of management. As a result, small, entrepreneurial businesses are seeking to transform themselves into institutions with staying power.

These moments can be treacherous for any company still run by founders whose personalities define their firms' cultures. The Blackstone Group, the largest private-equity firm, confronted these issues eight years ago, and its experience holds lessons both for managers and others who work at firms undergoing the institutionalization process.

In 2002, Blackstone's co-founder and CEO Stephen Schwarzman found himself stretched thin. Peter Peterson, who formed the firm with Schwarzman in 1985, was 76 and was playing only a peripheral role. Since 1997, Blackstone had doubled to 450 employees, added new businesses and expanded to Europe. Meanwhile, the core buyout business was down to just two seasoned dealmakers. For all intents and purposes, Schwarzman was Blackstone's management.

Two years earlier, Schwarzman had nearly lured Jimmy Lee, Chase Manhattan's ├╝ber-banker, to be his No. 2. In 2002, Schwarzman began talking to another candidate, Hamilton "Tony" James, who was widely credited with building the upstart Donaldson, Lufkin & Jenrette into a leading investment bank and private-equity shop in the 1990s.

It would be a risky proposition for both men. James knew full well that the track record of founder-entrepreneurs handing the reins to outsiders was dismal. Schwarzman, meanwhile, had to gauge the abilities of -- and his own compatibility with -- someone he had had only fleeting contacts with over the years. It was only after a series of long dinners at Schwarzman's Park Avenue apartment that summer that Schwarzman was convinced he could trust James, and James was persuaded that Schwarzman was serious about giving him latitude to manage as he saw fit. They also learned that they saw eye to eye on investing.

What emerged from those conversations was a clear mandate. At Blackstone, James was to oversee the entire firm on a day-to-day basis and reinvigorate the private equity and M&A advisory businesses. When he came on board in November 2002, James wasted no time putting his stamp on the firm.

Compared with DLJ and Credit Suisse First Boston, which absorbed DLJ in 2000, Blackstone was a small company. And it was managed by the seat of Schwarzman's pants.

"We had no standard operating procedures," as one partner later put it.

To utilize partners' time most productively, James required them to get clearance before they spent weeks scoping out target companies. To rectify Blackstone's reputation as a difficult place to work, he instituted "360 reviews" of partners, in which underlings and peers gave feedback. He also commissioned an exhaustive study of the firm's buyout investments that illuminated the patterns behind both successes and failures.

Inevitably, James's insertion as deputy to Schwarzman altered life for partners. There were no purges, but over the next three years, the three senior partners in the buyout group, the head of the real estate investment team and others left.

Some had been itching to start their own investment firms and took advantage of a good fundraising environment. Others sensed that their stars were fading. Partners, whose place within the firm had been defined largely by their relationships with Schwarzman, now found themselves in something that looked more like a conventional company with reporting lines, which ran through James.

Installing a gifted manager was essential at that stage of Blackstone's evolution, the departed partners are the first to say, and by any reckoning the hire was a success: Schwarzman and James forged a strong working relationship, Blackstone held its lead in assets under management and in 2007 it became the first major American private equity firm to go public -- a deal engineered by James.

For employees at other firms facing the same tests, there are several take-aways emerge from Blackstone's evolution.

1. No matter how adeptly an outsider is inserted into senior management, it alters the dynamics of an organization. The question is not whether it will change the firm, but in what ways and how to manage that.

2. James succeeded because his approach to investing jibed with Schwarzman's and because he and Schwarzman communicated honestly at the outset about their expectations and James's marching orders. How do the new and old leaders match up at your firm?

3. Perhaps most importantly, Schwarzman came to terms emotionally with the difficult process of ceding power over his creation. Had he not, the hand-off never would have worked.

-- John E. Morris and David Carey are co-authors of "King of Capital: The Remarkable Rise, Fall and Rise Again of Steve Schwarzman and Blackstone," which will be published by Crown in October.

Related Content: Private Equity Ushers in the Next Generation

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