My Review of William D. Cohan's "Money to Burn: The Unvarnished Truth about Leon Black........"

 

The Rise and Fall of Leon Black

       “Behind every great fortune there is a great crime.”

                                             Honoré de Balzac

Financial journalist and former investment banker William Cohan brings together the intertwined history of financier Leon Black and Apollo Global Management, the private equity firm he founded. The most formative event in Leon Black’s life was the suicide of his father Eli in 1975. The senior Black founded the 1960’s conglomerate United Brands which fell to hard times in the early 1970’s. It was Eli who convinced him to give up on his love of art history, which came from his mother and aunt, to go to Harvard Business School. Nevertheless, his knowledge of art and the big bucks he made enabled him to accumulate one of the largest private collections in the world whose value exceeds one billion dollars.

 

Black gets his start as a young associate at Michael Milken’s Drexel Burnham’s junk bond empire. By the mid-1980’s Milken became the “King of Wall Street” by first using high yield bonds to finance hitherto noncredit worthy smaller companies, especially in cable television (See: https://shulmaven.blogspot.com/2025/09/my-review-of-john-malones-born-to-be.html ) Black expanded the use of junk bonds to acquire established companies through the use of “highly confident letters” that sent shivers down the corporate establishment. It was that innovation that made Black’s reputation at Drexel.

 

However, Drexel and Milken were soon charged with securities law violations that brought down the firm and sent Milken to jail in 1990. Out of the wreckage Black formed Apollo. It was here where the great crime took place. Apollo received funding from France’s Credit Lyonnaise to acquire the junk bond portfolio of Executive Life Insurance that was in receivership in California. Executive Life was one of Drexel’s biggest clients and Black had intimate knowledge of its portfolio. As the junk market recovered Apollo made a fortune and its reputation. Although Apollo was never charged, Credit Lyonnaise was charged with violating state and Federal banking laws and ended up paying a $770 million fine.

 

Working hand and glove with Black in the early 1990’s Marc Rowan, now head of Apollo, and Josh Harris became key members of the firm. Although they were not exactly cofounders, Black gave them the title in the early 2000’s and made them billionaires. One of the keys to Cohan’s book is that Black, Rowan, and Harris talked freely to him. Thus, we get here inside views as to how Apollo grew from being primarily a private equity company to a leader in private credit. It was Rowan’s idea to establish a captive annuity company that would buy Apollo’s debt products. That company, Athene, has become a leader in the sale of annuities.

 

The advantage of having an insurance company to hold private debt is that it is not subject to the vagaries of short-term finance. It also has the benefit of being regulated by the generally understaffed state insurance departments. The risk here is that should private debt experience a wave of defaults the annuitants and the backup state insurance funds would be at risk.

 

After riding high for years, Leon Black got caught up in the Jeffrey Epstein sexual predator scandal. It was discovered that he paid Epstein a staggering $158 million fee for tax advice on his estate plan. To be sure Epstein found a way to correct a major mistake that Black’s white shoe law firm made, it hardly justifies the $158 million. Cohan goes into unsubstantiated reports of Black’s sexual proclivities, too much for my taste, but I guess it sells books and might explain the $158 million.

 

Then there is Black’s long time Russian paramour who claimed that Black sexually abused her. Black paid her off for years, but then she broke her nondisclosure agreement and the whole sordid mess became public. With that the Museum of Modern Art removed Black as its chairman but left him on the board. Why? Cohan suggests they want his art collection.

 

One of the great attributes of Cohan’s book is that he goes into great detail about the successful and failed deals that Apollo was involved in. Here his investment banking knowledge is crucial. Of particular note is the dispute with the Huntsman family of Utah and their eponymous chemical company. It was a knock down drag out fight that Huntsman won, but afterwards the relationship remained cordial.

 

Cohan makes all his leading players come alive. It becomes very clear that Black, Rowan, and Harris continue to have money to burn and they all show it. As a postscript Leon Black continues to ignore a congressional subpoena to discuss his involvement with Epstein.

My Review of Donald Chew Jr.'s "The Making of Modern Corporate Finance"

An Ode to Modern Financial Theory

As a former professor of finance, I read Donald Chew’s book with great interest. His book is a history of the development of modern financial theory from its early roots in John Burr Williams’ 1938 “Theory of Investment Value” to its beginning in the late 1950’s with the works of Miller and Modigliani on capital structure and dividend irrelevance. He made a mistake in attributing Myron Gordon’s model to Williams. 

Chew writes in a very breezy style by referring to Michael Jensen as Mike and Stewart Myers as Stu. From his post as an editor of Stern Stewart’s “The Journal of Applied Corporate Finance,” he got to know most of the major players in academic finance. I too met many of the academics he discusses, and indeed I was an early adopter of Brealey and Myers textbook he highly praises in my corporate finance class during the 1982-83 academic year. I also met, on several occasions, his mentor, Joel Stern.

Chew makes the case that earnings per share don’t count, but rather it is the ability of a corporation to earn a return above the cost of capital with return measured as net operating profit after taxes. It is with this insight that Stern Stewart pioneered the concept of economic value added. (EVA) Indeed, instead of using earnings to value a corporation, value can be defined as the present value of the cash flow associated with existing assets plus the present value of future growth opportunities. Hence, Amazon for example, can trade at values divorced from current earnings.

However, he oversells his point that earning per share doesn’t count. Corporate management and analysts continue to stress earnings per share and woe to the company that misses its quarterly earning estimates.  In the short run earnings seem to count a great deal.

He also oversells private equity. To be sure private equity posted extraordinary returns in its first twenty years starting in the 1980’s. Since then, returns have eroded, and their risks have been underrated. Put simply, the industry is guilty of what Cliff Asness of AQR, calls “volatility washing.”

This book is of interest to readers who are interested in how modern financial theory evolved and it is helpful in understanding what forces drive stock prices in long run.

 

CalPERS: On the Way to Becoming the World's Largest Hedge Fund

The Financial Times reported today that the nearly $400 billion CalPERS pension fund will start employing leverage up to 20% of the fund's assets. (https://www.ft.com/topics/organisations/California_Public_Employees'_Retirement_System, paywall) Ben Meng, the chief investment officer, outlined his view that leverage was required to achieve its 7% required return in a Wall Street Journal op-ed. The leverage would be used to finance illiquid private equity, yield curve arbitrage (On the old Salomon Brothers trading floor that trade trade was described as the "widow-maker".) and purchase equity futures.

All of these moves can rightly be characterized as risky hedge fund trades. Then why is is a public pension plan doing this? Simply put Meng does not believe that the fund's normal asset allocation can deliver the 7% required return needed to fund its liabilities which is exacerbated by a 71% funding level for the nearly two million beneficiaries of the plan. Instead of lowering the required rate of return assumption which would require politically unpalatable moves to increase contributions from employees and governmental sponsors, CalPERS is betting the ranch on a series of risky trades. What can go wrong? 

Ten years ago I posted a blog entitled "An Uneasy Look at Leverage." (https://shulmaven.blogspot.com/2010/03/uneasy-look-at-leverage.html) I argued there that pension funds were fooling themselves by not by not fully consolidating the debt associated with private equity and leveraged real estate investments. For example today CalPERS has about $70 billion of investments in private equity and real estate. If that were likely leveraged at say 3:1, then a fully consolidated balance sheet would show an additional $210 billion of assets on the books an a concomitant $210 billion of debt. Thus CalPERS is already leveraged with about one-third of its assets supported by debt. ($400 bil. of assets plus $210 bil. grossing up private assets yields a total balance sheet of $610 bil. funded in part with $210 bil. in debt.) 

Although Meng rightly argues that CalPERS is a perpetual organization, it lives in a series of short-run environments. So if interest rates increase, credit spreads widen and the economy enters a sustained downturn, will a future board had courage to stay the course? Further in a downturn leveraged investments suffer severe bankruptcy risk, from which there is minimal recovery. I would also note that in 1999, near the market peak, the New Jersey pension fund made a leveraged bet on ever rising equity values that did not turn all that well.

To sum up, I believe that CalPERS is engaging in a very dangerous strategy that should give its beneficiaries and the California Legislature great pause. 

The Dice are Rolling in Mall Land

Last May we wrote "Thus if private equity or sovereign wealth funds don't come in soon to scoop up the apparent bargain, the Street, as I argued, is way off." (https://shulmaven.blogspot.com/2017/05/a-new-look-at-mall-reit-valuations-part.html) Of a sudden, after a long period of sustained discounts to Street estimates of net asset value the dice are starting to roll in Mall Land. First Brookfield Property Partners offered to take in the 64% of GGP that it doesn't already own with a  cash and stock offer valued at $23/share. To be sure the offer was well above the $19/share the stock was trading at, but still well below the $28/share of value ascribed by the Street. As of this writing GGP is trading about 3% above the Brookfield offer price.

We then found out that hedge funds Starboard Value and Third Point have taken a position in Macerich causing its stock to rise from the mid-50s to the mid-60s, still below the $73 valuation estimated by the Street. Further Elliott Management, a $30 billion hedge fund, has taken a position in Taubman that elevated its stock price from the high 40s to the mid-50s again well below the $85 Street valuation. Remember the hedge funds are intermediaries and are ultimately looking for a final buyer like Brookfield to take them out. If no final buyer appears they will find themselves with dead money positions that will be sold back to the market.

Sitting on the sidelines watching and waiting are David Simon of Simon Property Group, the largest mall owner and Jonathan Gray of Blackstone, the largest private equity firm in the real estate arena. How they respond could very well be despositive as to how the price discovery process works out.

My guess is that the potential buyers of mall companies and/or mall assets are looking for what they perceive to be a bargain and with the Street still estimating mall cap rates in the 4-5% range, they will not find a bargain at those prices. Simply put the bid-offer spread is too wide, and as result I do not foresee transactions at anywhere close to the offer side of the market. But again, as we noted in May, time will tell.

The Hard Political Truth about Carried Interest

Liberal Democrats have wailed for years about the ability of hedge funds and private equity partners to convert ordinary income into capital gains. They are the villains of the piece. However the use of carried interest is far broader than in canyons of Wall Street and the leafy suburb of Greenwich.

Two key Democratic constituencies also water at the trough of carried interest. They are the venture capitalists of Silicon Valley and the arts community of Hollywood/Broadway. How do you think start-ups get financed? Answer: Venture Capital Partnerships. The same goes for Broadway productions and more than a few movies.

So next time the issue comes up you should look to the money bags of Silicon Valley and Hollywood to ante up. We will see if the Democrats will gore their own oxen.

An Uneasy Look at Leverage

Reprinted by permsion from REIT Wrap Special Report, March 2, 2010

By David Shulman*


Every REIT CEO and CFO should tattoo on their foreheads the following inscription, “Mike Kirby is right.” Mike Kirby is, of course, Director of Research at Green Street Advisors. He has been a voice in the wilderness calling for REITs to deleverage their balance sheets on the easy to understand grounds that higher leverage is statistically associated with lower long term shareholder returns and that unleveraged commercial real estate, which declined by 30% (likely an under-estimate of the true decline) in the early 1990s and 40% from 2007-2009, simply cannot afford to have leverage ratio in excess of 50% of gross value. Two crashes in 20 years are a bit much for an “asset class” heralded by the pension consultants as “safe.” By the way my UCLA dissertation written in 1975 found no gains to leverage for the few REITS that were in existence from 1963-74.

Moreover there really isn’t any support in financial theory for REITs to be leveraged. Kirby rightly notes the famous leverage indifference theorem of Miller and Modigliani which states that in a world of no personal and corporate taxation there are no gains to be had by leveraging up the balance sheet and in fact there is the risk of the enterprise bearing the costs of bankruptcy. As General Growth is showing us, those costs can be quite substantial.

The real “advantage” from leverage comes from the tax deductibility of interest at the entity level which REITs don’t have. To be sure interest payments at the REIT level can shield income from taxation at the personal level when it is paid out as a dividend, but to the extent that REITs are owned by tax exempt institutions that advantage goes away. Put simply REITs at best receive minimal benefits from leverage, but all of its costs.

If all of what I am saying is true, why do REITs leverage up? My own answer is that leverage has been in the DNA of every real estate professional ever since the first developers in the ancient city of Ur came on the scene. Besides, leverage is made for long-lived assets with relatively stable income streams. That is why institutions usually like to finance income producing real estate, but just because there is a willing lender doesn’t necessarily mean there should is a willing borrower. Nevertheless there are willing borrowers because the empire builder that resides in every real estate professional cannot just say “No” to the crack dealers of Wall Street.

So if theory says “No”, and the evidence says “No”, but existing practice obviously says “Yes” to leverage, where do we end up? What the market might be saying, to state the obvious, is that low leverage is benign and high leverage is malignant. Thus the degree of leverage a REIT takes on should not jeopardize the firm under stress conditions. The questions are where do you draw the line and what is the right measure for leverage.

First we have to dismiss the most widely used measure of leverage, debt/gross asset value. Why? Debt/gross asset value is a poor measure because it is very cap rate dependent. For example, at the height of the recent boom many REITs thought themselves to be conservatively financed with a 60% debt ratio. However when cap rates moved from say 6% to 9% the debt ratio exploded to 90%. In order to avoid the spot cap rate problem a more appropriate ratio to use would be debt/EBITDA which takes into account the ability to service the debt including amortization independent of fluctuating cap rates. Furthermore this metric has the advantage of being widely used in the corporate bond market.

I would argue that 5X EBITDA is the appropriate leverage metric for most REITs. Indeed a ratio of 5X EBITDA gives a great deal of credit for the stability of real estate cash flows. Remember the typical investment grade industrial corporation normally does not exceed 3X EBITDA.

Let’s assume that a REIT owns 10 buildings of equal value and it historically trades at around 12X EBITDA. In the old days a prudent owner would have mortgaged seven of the buildings at 60% and kept three unencumbered for both safety and opportunistic purposes. In this example the leverage ratio for all 10 buildings would be 42% (70% X 60%) or 5X EBITDA (42% X 12).

I would, therefore, argue that 5X EBITDA is a normalized maximum level for leverage for most REITs. If you want to quibble, as long as apartments have access to lower rate Freddie and Fannie financing at 70% of value, you could certainly make a case for 6X EBITDA for apartment REITs. Conversely for the operationally cyclical hotel REITs, debt should not exceed 3X EBITDA. Needless to say that with most REITs trading in excess of 7X EBITDA, the deleveraging process that began last April still has a long way to go.

Where do pension funds come in? It is no secret that many large pension funds and endowments with leveraged real estate investments got clobbered in the recent downturn. In my view it was an inevitability brought on by a complete misperception of risk. Put bluntly leveraged real estate is different from unleveraged real estate. It is much riskier. The higher risk can be categorized in two ways.

First whenever a pension fund engages in a leveraged transaction, it is, in effect, shorting it own bond portfolio. How so? All a pension fund has to do to understand this concept is to “gross-up” its leveraged asset and fully consolidate it on its books. For example take a hypothetical pension fund with the following asset allocation: $600 million equities, $300 million bonds and $100 million leveraged real estate/private equity.

In this example a $100 million real estate/private equity investment with $300 million of debt on it would be booked as a $400 million asset with a concomitant $300 million liability. In reality by booking only the equity, the pension fund is under-stating its investment in real estate and over-stating its investment in fixed income securities as the real estate debt cancels out the bond assets. Distilled down the pension fund portfolio is holding $600 million in equities and $400 million in real estate/private equity -- not exactly what you would call a “conservative” asset allocation. When looked at this way is not a surprise that a seemingly small allocation to real estate had such a drastic effect on pension fund performance.

If you prefer a different approach, the second way to look at leveraged real estate in a portfolio is to view it as a warrant. People tend to forget that in the original options pricing paper by Black and Scholes common equity was viewed as an option to buy back the firm from its bondholders. When leverage is low this notion is of minimal significance, but when leverage is high it becomes very obvious and it is this insight that theoretically underpins much of what goes on in capital structure arbitrage.

If a pension plan fully understood that its leveraged real estate investments were really long term options (warrants) and classified them as such they would have had a far better understanding of the risks embedded in their portfolios. It, therefore follows that, leveraged real estate certainly does not belong in the plain vanilla real estate bucket.

There is, of course, an agency argument for high leverage in REITs and private equity. Briefly stated leverage is required to increase the return on equity that is so necessary to compensate the best talent. That certainly was the argument from 2004-2007. However, many of the most talented real estate professionals crashed and burned with everyone else in 2008. It seems to me that the agency argument is better suited for bull markets than bear markets. All told, then, the evidence suggests that less leverage is preferable to more.

*David Shulman was formerly the Senior REIT Analyst at Lehman Brothers. He is now affiliated with Baruch College, the University of Wisconsin and the UCLA Anderson Forecast. He can be contacted at david.shulman@baruch.cuny.edu.