The Hidden Beauty Of Bonds While you were watching the stock market, a little-known bond house called BlackRock grew into one of the biggest players on Wall Street.
By Andy Serwer Reporter Associate Julia Boorstin

(FORTUNE Magazine) – The slide in interest rates over the past decade made for boom times in the bond market, but who noticed? Everything's relative, after all, and there wasn't much glamour in a 6% Treasury bond yield when the Nasdaq was delivering an 86% return to investors, as it did in 1999.

But with once highflying stocks now in the hangar, bonds suddenly look (dare we say it?) sexy. Last year the benchmark Lehman aggregate bond index was up 11.6%, outperforming the S&P 500 (down 9.1%) for the first time since 1990--that's a spread of more than 20 percentage points, for those of you without a calculator. As for this year, well, would you care to place a bet?

Even so, most investors probably couldn't name the top-dog bond houses. Ever hear of Pimco? Wamco? How about BlackRock--perhaps the greatest success story on Wall Street in the past half-decade? Just opening its doors when George Bush the elder took office, BlackRock today has over $200 billion under management as George Bush the younger begins his term.

The first thing to know about BlackRock is that yes, there is also a Wall Street firm called Blackstone, and yes, the two companies are connected, but we'll get to that in a minute. The second thing to know is that BlackRock is the creation of a man named Larry Fink. Larry who? Fink, 48, may just be the heaviest hitter on Wall Street you've never heard of. His peers say he possesses one of the sharpest minds on the Street. "A very talented, smart guy with a twinkle in his eye" is how Merrill Lynch CEO Dave Komansky describes him. Meaning that Fink is talented not the way, say, Yo-Yo Ma is, but rather extremely able when it comes to understanding the vagaries of the capital markets.

Born and raised in L.A., Larry Fink didn't begin his working life with any great promise. "My parents thought my older brother Steve was the smart one," Fink says. "I went to work in my dad's shoe store." He also went to UCLA undergrad and UCLA business school, landing on Wall Street, in First Boston's training program, in 1976.

Unlike Fink's mom and dad, the Pooh-Bahs at First Boston saw Fink as a bright young guy, and he quickly moved up the ranks. He migrated to the firm's fixed-income trading department and focused on a then obscure niche, mortgage-backed securities (MBS). It was a business ripe for a boom. S&Ls were hot to offload mortgages to Wall Streeters like Fink who would package those loans into exotic new securities. By the early 1980s Fink had built First Boston's MBS business into a juggernaut generating over $100 million in revenues a year--huge money at the time. Barely 30 years old, Fink had become a bona fide Wall Street whiz kid. (Fink's chief rival in the MBS biz was Salomon Brothers' Lewis Ranieri, a cigar-chomping, larger-than-life character made famous in Michael Lewis' book Liar's Poker.)

As the bull market picked up steam, Fink's business became a moneymaking machine. In 1985 it made $230 million. In the first quarter of 1986 alone, Fink pulled in $130 million. But then, smack! A sudden decline in interest rates knocked Fink to the canvas. In the second quarter of '86, he lost $100 million. "We took too much risk. I should have been fired," he says. Suddenly First Boston's California golden boy wasn't looking so aureate. Fink was chastised, and his confidence was shot. "I never wanted to leave First Boston," he says. "But I couldn't forgive them for meting out more pain for my mistakes than joy for all my good performance."

For months Fink pondered his future. Two basic thoughts emerged. First, he realized that the brainpower of those who sold bonds vastly exceeded the brainpower of those who bought them. What if, Fink asked himself, he left the sell side of Wall Street and set up shop on the buy side? As one of the Street's most sophisticated players, wouldn't he have a huge advantage over other buyers? And second, losing money was no fun. Managing and avoiding risk would be paramount.

Those ideas would become, later on, the basic ingredients of BlackRock's secret, its value added in the bond business. BlackRock runs huge portfolios of bonds for companies and pension funds. It lets customers choose the level of risk they are comfortable assuming, and then it sets out to exceed, or at least match, the return that corresponds to that risk level. There are two ways to make money in the bond business. One is by guessing which way interest rates are going, which is inevitably a loser's game, and the other is sweating the details. BlackRock avoids the former and tries to excel at the latter. Assembling and managing a bond portfolio is tricky stuff. There are thousands of constantly shifting variables--spreads between types of bonds, prepayment trends, etc.--that must be monitored. Fink figured that to succeed he needed to rely on cutting-edge analytical tools (read: computer power). Today BlackRock's tools are so advanced that other companies, such as Freddie Mac, pay the firm to help analyze their portfolios. Fink also has teams that comb through each client's portfolio, checking over and over for mistakes and unanticipated risk. Say a particular customer can't have a certain type of bond in its portfolio. Blink! A little message flashes on a computer screen. Avoiding a million tiny mistakes like that adds up to big money. "It's like National League baseball," says Fink's partner Ralph Schlosstein. "Singles and doubles and very little long ball."

But we're getting ahead of the story. Having stewed at First Boston for more than a year, Fink left the firm in 1988 and joined the Blackstone Group. He set up shop as Blackstone's asset management business. Fink and his team owned 60% of their business, while Blackstone owned 40%. Blackstone was then a newly created LBO group run by Peter G. Peterson, Richard Nixon's former Commerce Secretary and onetime CEO of Lehman Brothers, along with his partner Steve Schwarzman. Roger Altman, a former Treasury Department official, became Blackstone's third partner. And Fink would be the fourth. Joining Fink from Lehman Brothers was Ralph Schlosstein, a former aide to Stuart Eisenstadt in the Carter White House, as well as a handful of other professionals, all of whom are still with the firm. "Larry and Ralph are very complementary," says Peterson, who dines with Fink several times a year. (It's the Four Seasons if Peterson is picking, San Pietro when it's Fink's call.) A banker close to Blackstone agrees: "Fink is a classic type-A guy. He has to know about everything: bonds, wine, music. He's a trader. Everything's quantifiable. He yells. Schlosstein is a really nice guy. A class act."

Fink's little business at Blackstone took off. By 1991, he had $9 billion under management and had pulled in investments from Chrysler and, most important, GE's pension fund. Fink's closed-end bond funds were a hit. In spite of this success, or because of it, Fink's relationship with the Blackstone grandees became strained. The asset managers had succeeded wildly, and the Blackstone partners were delighted with the 30%-plus returns--so delighted that they opposed issuing more shares, as that would dilute their stake. That was a problem because Fink felt he needed more equity to dangle in front of prospective hires.

There was little middle ground, and stories of Fink warring with Schwarzman--who's no pushover--made their way into the business press. Then came 1994, a horrible year for bonds. Even though Fink's business now had $19 billion under management, some of his partners grew alarmed, putting additional pressure on Fink to cut a deal. Peterson and Schwarzman finally relented. Get us a fair price, they said, and we'll set you free.

Fink's business already had its own name: BlackRock. "We didn't really think 'Fink & Schlosstein' would cut it," Fink says with a grin. "We wanted a name that linked us to Blackstone. It was like when the government split up the house of Morgan. Pete liked that."

Fink began the usual series of dates with top management of interested buyers. The winner was PNC, the Pittsburgh super-regional bank. PNC in fact had an asset management business, and the bank assured Fink that the boys from the 'burgh wouldn't interfere. And so PNC agreed to buy BlackRock for $240 million.

The bond market recovered, and BlackRock rocked on. From 1994 to 1999, assets under management rocketed from $24 billion to $165 billion. Some growth came from folding in PNC business, but the bulk of it was BlackRock's winning new business from the likes of Ford and the California State Teachers' Retirement System. BlackRock's operating margin climbed above 30%.

But once again Fink needed more equity to build his business. The solution this time: an IPO. The bank was amenable. BlackRock offered 14% of the company to the public at $14 a share on Oct. 1, 1999. PNC retained 70%, while Fink, Schlosstein, and the team owned the remaining 16%. Today BLK trades at around $40. Think about that for a minute. Over the past couple of years, hundreds of dot-coms went public in the teens, then soared to triple digits, and are now trading in single digits. Yet during the same time frame, this decidedly unsexy asset manager is up almost threefold.

If BlackRock makes its money hitting singles and doubles, the company has been nothing short of a grand-slam home run for its parent, PNC. Leaving aside the earnings that BlackRock has produced for the bank--which more than justifies the investment--its 70% stake is now worth $1.68 billion. Not a bad return for a $240 million investment made seven years ago.

Still, the bond business is hardly a guaranteed moneymaker. Just recently the Asian contagion, the ruble crisis, Long Term Capital, the high-wire junk-bond market, and the California energy crisis have given traders fits. The risks are real, and Fink & Co. know they can never eliminate them; the best they can do is obsess over them. BlackRock has shown that it can weather some pretty ugly conditions. "I don't see any reason why BlackRock's best years aren't in front of it," says Blackstone's Schwarzman.

Which might make sense if you consider that Fink has yet to fully stretch his wings. Remember, Fink escaped from his father's shoe store. He broke free from First Boston. He pried himself loose from Blackstone. But now PNC lords over him. To say that he is champing at the bit under PNC may be an overstatement, but not by much. The problem is, Fink has done such a great job, why would the bank ever let BlackRock go? As one of Wall Street's savviest traders, Fink knows better than anyone that success has a price and freedom a cost.

REPORTER ASSOCIATE Julia Boorstin

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