Macaskill on markets: Hovnanian highlights Blackstone’s risky business

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By:
Jon Macaskill
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Blackstone-owned GSO Capital’s provision of financing for building firm Hovnanian, on condition that it defaults on debt in order to trigger a payout on default swaps, highlights the reputational risks for investors as they supplant banks in setting the agenda for the credit markets.

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The trade could cause conflict not just with bank dealers and rival investors who worry that engineering the exercise of default swaps could undermine the functioning of the derivatives markets that are used to hedge and measure credit exposure, but also within the Blackstone group.

A separate unit of Blackstone owns a stake in a hedge fund called Solus Alternative Asset Management that launched a legal battle to prevent the GSO Capital trade for Hovnanian from closing.

That bid by Solus was rejected by a court on January 29, removing the main obstacle to success for the deal.

The trade by GSO will therefore cause economic harm to another unit of Blackstone if it is completed as planned. 

The financing package was put together for struggling New Jersey homebuilding firm Hovnanian and approved by the corporate in January. 

Traders led by Ryan Mollett, a GSO Capital distressed debt manager in New York, structured a refinancing for Hovnanian that includes issuance of a new bond with a 5% coupon that is well below the market rate for the struggling building firm. 

A planned failure to pay interest on some existing debt would trigger the exercise of default swaps on Hovnanian, with the low-coupon bond becoming the cheapest to deliver for swap purposes as it will be priced well below par. 

A lawyer for Solus described the deal as: “A bribe of off-market financing in exchange for an agreement to have a sham payment default by Hovnanian to deliver economic default to GSO.”

Blackstone retains a passive ownership stake of 10% to 15% in Solus, purchased in 2015, so there will be some cost to the hedge fund solutions group within the firm from a trade engineered by its credit arm GSO.

GSO holds default swap protection of around $330 million on Hovnanian while Solus sold protection of around $260 million. Solus would not lose the entire amount in a default swap exercise – perhaps 50% if the cheapest-to-deliver bond trades around 50 – but it has also incurred legal costs in fighting GSO, including hiring former International Swaps and Derivatives Association chief executive Robert Pickel as an expert witness at a rate of $900 an hour. 

Nominal loss

Assuming that the GSO trade does not tip Solus – a roughly $6 billion hedge fund – towards outright failure, and taking the minority holding in the fund into account, it could be argued that Blackstone’s hedge fund solutions group will be harmed by no more than a nominal $20 million of losses. This would be much less than the likely gain from successful completion of the trade by GSO Capital. 

A Blackstone insider says that there are walls dividing the relevant business lines, with the implication that this should not cause internal conflict. It is nevertheless easy to envision tension between business heads at a time when there is growing speculation over the details of succession planning to Blackstone co-founder and chief executive Stephen Schwarzman and whether the firm will react to recent US tax cuts by transforming from a partnership structure. 

Bennett Goodman co-founded GSO with Tripp Smith and Doug Ostrover (to make GSO) after the three men worked together at DLJ and then Credit Suisse. GSO was founded in 2005 and sold to Blackstone in 2008 for $1 billion. Ostrover left GSO in 2015. Smith remains in place, but Goodman has a higher profile and is the only GSO manager to sit on the Blackstone board. 

The GSO founders joined Blackstone 10 years ago at the invitation of Tony James, president of the firm and number two to Schwarzman. James was once their boss at DLJ and convinced Schwarzman to make a big push into credit to diversify Blackstone from its origins as a private equity and real estate investor.

GSO now has $99 billion of assets under management, which is roughly 10 times more than when it was bought by Blackstone, and is more than 25% of the firm-wide total assets of $387 billion, according to its last quarterly results.

James is expected to retire when Schwarzman finally agrees to hand over the reins at Blackstone, but Goodman is not viewed as a potential successor. 

Jon Gray, head of the real estate division that is Blackstone’s biggest and most profitable part, is generally seen as the heir apparent. Joe Baratta, who runs the private equity business that is now number two in assets and economic income, is the most likely alternative choice.

Tension

The buccaneering Hovnanian CDS trade by Goodman’s GSO group could cause tension with the new head of the fourth-largest division within Blackstone, however. 

The hedge fund solutions group at Blackstone was set up and run for many years by Tom Hill, one of Schwarzman’s longest-standing allies. Hill recently stepped aside to a role as vice-chairman, allowing John McCormick to take over as president and chief executive of a group that bills itself as the world’s largest discretionary investor in hedge funds, with $74 billion of assets.

McCormick is a lawyer and consultant by background; he does not have the same depth of direct experience in managing big investment stakes as the other top officials at Blackstone. 

McCormick could be forgiven for taking the controversy over the Hovnanian trade personally, given that it came just as he was taking over the reins of the hedge fund group from his old manager Hill. 

Mollett, the trader who came up with the cunning Hovnanian CDS exercise plan, left GSO Capital in January to take up a position as global head of distressed debt at Angelo Gordon. 

Michael Gordon, chief executive of the $27 billion investment firm, appeared impressed by 39-year-old Mollett’s ability to outfox his competitors, describing him as a “seasoned and talented distressed investor (with) significant experience executing on highly complex situations.”

Mollett’s convenient departure may help to calm any tension within Blackstone between GSO Capital and the hedge fund solutions group, but it leaves unanswered questions for the firm.

Apart from the issue of how to manage conflicts of interest within a growing investment group, there is also the question of how Blackstone hopes to be perceived externally. 

Schwarzman recently attended Davos to support the agenda of his friend Donald Trump but was instead forced to defend the Hovnanian CDS trade as a move to help a struggling corporate that only caused a problem for a hedge fund.

That glosses over the potential impact GSO’s trade might have on the functioning of the credit derivatives markets, if it contributes to diminished liquidity, and whether the deal will eventually be seen as short-term greedy, rather than long-term greedy. 

After all, a large credit investor like GSO needs hedging tools and a degree of counterparty trust in order to prosper. And if Blackstone does decide to make important changes to its corporate structure due to tax changes, it won’t necessarily want a reputation as an unusually sneaky investor just as it is courting potential new shareholders.