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Those magnificent men and their fee machine

Date: Saturday, June 23, 2007
Author: Boyd Erman, The Globe and Mail

Buyout expert Onex is looking to get bigger - but not too big, as it branches out with new funds

The initial public offering of Blackstone Group, the 13th-largest IPO ever, could not have come at a better time for Onex Corp. Investors are gaga over Blackstone, giving the firm a market value bigger than Bank of Montreal's, because of the massive fees it generates running hedge funds, buyout funds, real estate funds, almost any kind of fund. It's a money machine, and it's a model Gerry Schwartz and his team at Onex are out to copy.

Onex, known for its buyout expertise, is set to branch into real estate funds and hedge funds, changing the face of the firm and creating the "machinery" to earn billions in fees.

"People are starting to recognize the value of the machinery," says Mr. Schwartz, Onex's founder and controlling shareholder. "It wasn't until Blackstone and Fortress went public in the U.S. that people really understood that."

How valuable is that machinery?

Blackstone is on pace to earn more than $1-billion (U.S.) in fees this year, running its mix that caters to big investors such as pension plans that are trying to spread their risks beyond just standard stocks and bonds.

So-called "alternative asset managers" like Blackstone, Fortress and Canada's Brookfield Asset Management Inc. rake in the money by charging backers hefty fees to manage their money. Some critics say the fees, which include a flat management fee and a big share of any profits, are too high, but judging by the amount of money pouring into alternative asset classes such as buyout funds and hedge funds, investors don't mind.

Private Equity Intelligence, a London-based firm that tracks the business, estimates that pension plans, university endowments and other institutions anted up almost $100-billion last year for new real estate funds, and will pour $85-billion into hedge funds in the next year.

Onex, with about $9-billion of assets under management, is nowhere near the size of Blackstone, but with the new funds coming in to tap some of those dollars from investors, the fees are set to soar.

Mr. Schwartz argues that investors haven't fully caught on to just how much money the new Onex can make once the transformation he plans is complete. Yet, the new Onex almost wasn't to be.

Debates are always heated at Onex, where every Monday the firm's deal makers and Mr. Schwartz argue the merits of transactions and strategies.

In person in the firm's anachronistic offices, where old-fashioned sliding-sash windows open only onto the sheet glass of the modern skyscraper's facade, or by phone from the road anywhere in the world, the team members take turns dissecting transactions.

One dissenting voice is enough to raise serious doubt. Two naysayers and an idea is all but left for dead.

Many debates five years ago centred on a strategic switch that had the potential for huge rewards, but came burdened with a risk to the firm's culture. Should Onex, instead of largely investing its own money in takeovers, begin to raise large private equity funds from other investors such as pension plans?

The solo approach had paid big dividends: The firm was successful, and Onex didn't have anybody but shareholders looking over its shoulder.

On the downside, when Onex didn't have enough money of its own for a takeover it had to go hunting for partners, a time-consuming process.

Bringing in money from outside investors such as pension funds for a billion-dollar-plus buyout fund would mean cash instantly on tap, enabling the firm to move fast on bigger deals. And the fees for running such funds could be massive, tens of millions of dollars a year even for a relatively small fund.

But doubters highlighted a risk: Rather than patiently searching for the perfect takeover, the lure of the management fees could put pressure on Onex to make deals quickly, putting money to work fast so the firm could raise more from backers and generate yet more management fees. Quantity of deals could become more important than quality. The pure deal-making ethos that had driven the firm could be compromised.

"We were worried," Mr. Schwartz now acknowledges, sitting in a conference room with the blue sprawl of Lake Ontario behind him.

But it was the way the private equity world was headed, and proponents at the firm argued that Onex could manage the risk. Compensation schemes could be reworked to link bonuses to the successful and profitable completion of deals, not just to finding takeover targets. The firm would invest big chunks of its own money in buyouts, as would individual partners, to ensure that nobody was tempted to cut corners on returns.

It was decided. Onex would raise its first big buyout fund, and begin in earnest to build what Mr. Schwartz calls "the machinery" that today fuels profits, and soaring executive pay, at firms like Onex and Blackstone.

Mr. Schwartz estimates that machinery is now worth about $2.5-billion. That's the value of the annual fees and the performance bonuses Onex and its top managers can earn on its three current funds, assuming the firm can maintain its long-term batting average of a 29-per-cent return a year on investments since the firm's founding in 1983.

Add the hedge fund, the real estate fund and another buyout fund that could get rolling in the next year, and those fee numbers could get a lot bigger.

The way the firm is set up, 40 per cent of the performance bonuses, known as "carry," go to Onex itself. The rest goes to Mr. Schwartz and his management team for finding the deals.

But it's those very fee numbers that have some in the buyout business concerned that the industry could be headed for a fall. The lure of fees and the availability of capital from investors is pushing some asset managers to create ever bigger funds, but before they can do so they have to put to work the money they already have.

Private Equity Intelligence reckons that $300-billion of new capital could flood into the buyout industry in the near future, on top of the $1.5-trillion that's already there, creating a pool of money 1 times bigger than Canada's annual economic output, all looking for takeovers.

Critics say that with so much money afoot and the fees so huge, some buyout firms are lowering their standards, and the higher returns that have made private equity and hedge funds so attractive to investors could vanish. The worst-case scenario could be massive deals gone sour, rocking confidence in the stock market and the economy, all because buyout firms could not resist the temptation to make deals too quickly.

It's not happening at Onex, Mr. Schwartz argues.

"It could. It could. And it has at some firms, but it doesn't here," he says. "It's very important for us to maintain our record because it makes it so easy to raise money, and if we blow it, it's 24 years down the drain. So there's no inclination here to shovel money out in order to get another fund raised."

One way to fight that temptation is to stay relatively small. Onex expects to raise $6-billion for its next buyout fund -- a fraction of what investors would be willing to give the firm, says Andrew Sheiner, one of the managing directors. By comparison, Blackstone is raising a $20-billion buyout fund and a $10-billion real estate fund that will both set world records for size.

"We think it's smart to keep the fund size reasonable," Mr. Schwartz says. "And if we need more money we will raise another fund, rather than having a much larger fund which would put some of the pressure on us to just get money invested."

Staying small may help the Onex team hang on to one of the most cherished parts of its reputation - that of a bunch of very rich cheapskates. Not necessarily when it comes to lifestyle, but certainly when it comes to takeovers.

It's a perception the Onex crowd courts, pointing out often that the firm has a history of paying less than many rivals in the buyout business, a game that revolves around finding firms to take over and then ways to increase their value.

It's a business that is a whole lot easier if you don't pay much in the first place, but with billions a day pouring into private equity funds that are all scouring the globe for acquisitions, cheap deals are harder and harder to come by.

The result of that pickiness and parsimony has been consistency - only two major losses in 150 takeovers by Onex.

It also means that the list of companies Onex has looked at and hasn't bought - Chrysler and Air Canada's maintenance and overhaul arm are among the more recent examples - is perhaps longer than the list of companies it has purchased. Lately, buyouts include the health care imaging arm of Eastman Kodak for $2.6-billion (Canadian), half of business jet maker Hawker Beechcraft in a deal valued at $3.8-billion and Spirit AeroSystems from Boeing Co. for $1.1-billion.

"We get a few transactions done, and we miss a lot," says Mr. Schwartz, giving no inkling that fact bothers him. "This year has been a great year for winning silver medals."

Perhaps the firm's highest-profile target right now is BCE Inc. Onex is a minority player in a bid led by the Canada Pension Plan Investment Board and Kohlberg Kravis Roberts & Co., joining the group as a late entrant.

"Whoever buys it needs to have a substantial amount of Canadian ownership and by adding us into the group, it not only added to the Canadian equity but if we're fortunate enough to be the winning bid we'll add to the sense of Canadian control over the business," says Mr. Schwartz, who started his career at a New York investment bank with Henry Kravis, who went on to found KKR.

Mr. Schwartz, rarely loquacious, declines to say more about the firm's participation in the bidding for BCE, or the team's plans for the company if the CPP-led group emerges as the winner.

Until this week, many handicapping the race were betting that Onex's team would come out on top. But now, with Telus Corp. considering a bid and having the advantage of synergies, BCE too may end up being a silver medal for Onex.

But there will always be another deal. Onex is shown the book on almost every company that comes up for sale in North America, especially in its main focuses of health care, outsourcing and aerospace, investment bankers say.

The firm prefers to find its own transactions, hunting far and wide for listless assets hidden in big parent companies that can be peeled out and energized, or small companies that can be snapped up and built into big ones.

The planned hedge fund, in addition to broadening Onex's appeal to investors and generating new fees, is also expected to turn up new buyout targets.

"It would look at buying shares in a business the way we look at buying a business," Mr. Schwartz explains. "We think that in addition to being an excellent asset category it also will generate ideas for us for our leveraged buyout business."

Mr. Schwartz, from his perch 49 floors above Toronto, sees little on the horizon that could derail the deal-making binge.

"It's a very good time in private equity," he says. "Low interest rates, huge liquidity. The only negative is there are a lot of very expensive things that have been sold."

The Onex team argues that the buyout industry is a boon to the economy.

"I think the private equity has brought a lot to the North American and world business markets," Mr. Schwartz says. "More discipline about utilizing assets. More discipline about focus on growth."

While some commentators point to a recent increase in interest rates as a possible roadblock for buyout firms, because it will make the loans to finance transactions more costly, the Onex head is unconvinced. He argues that there is so much money in the hands of lenders that they won't be able to charge much for loans.

"There is enormous liquidity in the market and that liquidity keeps interest rates down," he says. "Even though the government may raise interest rates a little bit to keep inflation down, there's still enormous liquidity."

But if it should happen that rates rise and the buyout economy goes sour, Onex has a plan for that, too: a fund to invest in distressed debt. The idea has been kicking around Onex for years, but the economy has been so good there are few investment opportunities.

"It's on ice at the moment, but it's something we'll keep on looking at," Mr. Schwartz says.

And what of Onex? Where will it be in five years? Mr. Schwartz ticks off his goals, key among them getting bigger while still maintaining Onex's culture.

"More people. More transactions. Larger amounts of capital. Identical philosophy," Mr. Schwartz says.

And what of Mr. Schwartz, who at 65 is trim and stylish, sporting a narrow tie of the latest fashion. Where will he be? Doing deals at the helm of a much bigger, more profitable Onex, he says.

"I've got a long time. I've got a long time. I've got 25 to 30 years of this. Maybe longer."


Onex compared


(OCX on TSX)

Specialties: Buyouts and private equity

Market capitalization: $4.7-billion (Canadian)

Assets under management: $9-billion (U.S.)



(BAM/A on TSX)

Specialties: Real estate, infrastructure, lending

Market capitalization:$24.6-billion (Canadian)

Assets under management: $70-billion (U.S.)




Specialties: Hedge funds, private equity funds

Market capitalization: $9.9-billion (U.S.)

Assets under management: $36-billion (U.S.)



(BX on NYSE)

Specialties: Buyout funds, real estate, private equity

Market capitalization: $38.4-billion (U.S.)

Assets under management: $88.4-billion (U.S.)

The deals


Onex so far has 'had a great year for winning silver medals,' jokes Gerry Schwartz, alluding to the fact that with prices for assets rising, Onex is getting outbid in some auctions. But the company has also had its share of golds. Here's a look at some of the big hits and misses of late.


Gold medals (Recent deals that Onex made)


Spirit AeroSystems

In 2005, Onex bought aircraft factories from Boeing Co. for $1.1-billion. The firm cut costs, added customers and took Spirit public last year. The company now has a market value of $5-billion (U.S.).


Hawker Beechcraft

In March, Onex teamed with the private equity arm of Goldman Sachs to buy the maker of business jets in a deal valued at $3.8-billion (Canadian), with an eye to increasing market share in a growing business.


Carestream Health

This spring, Onex finished the $2.6-billion acquisition of Eastman Kodak's medical imaging arm, betting that Carestream will thrive as doctors and dentists switch from film to electronic imaging.


Silver (Deals Onex missed)



Onex teamed up with Canadian auto parts maker Magna International Inc. to bid for troubled auto maker Chrysler, but owner DaimlerChrysler AG instead chose Cerberus Capital Management as the winning bidder. Onex and Magna have never disclosed their proposal.


Qantas Airways Ltd.

Onex was part of a consortium of private equity firms bidding for Australia's dominant airline, but shareholders held out for more money and the proposal fell short.