July 2009

Private equity investing can be traced back to the industrial revolution when merchant banks in Europe and later, the U.S., financed industrial projects and the building of the Transcontinental Railroad.

When J. Pierpont Morgan bought Andrew Carnegie’s American Steel Company in 1901, it marked one of the earliest known major corporate buyouts. J.P. Morgan would later finance railroads and other industrial ventures.

Private equity in the early part of the 20th century was largely practiced by wealthy individuals and families such as the Vanderbilts, Whitneys, Rockefellers and Warburgs. Laurance Rockefeller helped finance the creation of Eastern Airlines and his family developed vast holdings in a variety of companies and real estate.

The period after World War II was characterized by relatively modest volumes of private equity investment. In the 1960s, private equity firms organized into the structure that is common today, limited partnerships, in which investment professionals serve as general partners and the investors, as passive limited partners, provide the capital. Firms began using the now familiar “2 and 20″ compensation structure, with limited partners paying an annual management fee of up to 2 percent and 20 percent of profits to the general partners.

In the late 1970s and 1980s, the industry experienced the first of three boom cycles. Financier Michael Milken popularized the use of high yield debt (also known as junk bonds) in corporate finance and mergers and acquisitions. This fueled a boom in leverage buyouts and hostile takeovers.

Milken’s network of high-yield bond buyers enabled him to raise large sums of money which provided the fuel for entrepreneurs such as John Malone’s Tele-Communications Inc., Ted Turner’s budding 24-hour TV network, Turner Broadcasting, cellphone pioneer Craig McCaw, and casino entrepreneur Steve Wynn.

By some estimates, there were more than 2,000 leveraged buyouts during this period. Other well-known corporate raiders during the 1980s included Carl Icahn, Victor Posner, Nelson Peltz, Robert M. Bass, T. Boone Pickens, Harold Clark Simmons, Kirk Kerkorian, Sir James Goldsmith, Saul Steinberg and Asher Edelman.

Milken’s money-raising ability also facilitated the activities of leveraged buyout (LBO) firms such as Kohlberg Kravis Roberts. Led by three former Bear Stearns executives, KKR targeted successful family-owned businesses founded after World War II that were facing succession challenges.

Many of these buyouts would sell off pieces of the company to pay off the debt load. Thus, leveraged buyouts came to symbolize “ruthless capitalism” prompting a backlash in the media and Oliver Stone’s famous movie, Wall Street. The era culminated in the massive $31.1 billion dollar takeover of RJR Nabisco by KKR, which was later popularized by the book, Barbarians at the Gate. The junk bond industry collapsed later in the decade in part due to Milken’s 1989 indictment and 1990 guilty plea to multiple charges that he violated US securities laws.

The industry enjoyed another boom cycle from 1992 to 2000 with the emergence of more institutionalized private equity firms and the high tech frenzy among telecommunications and Internet companies. This cycle ended with the Dot-com crash of 2002.

When the dust settled from that crisis, historically low interest rates geared to jump-starting the economy spawned a wave of leveraged buyouts from 2003 through 2007. It led to the completion of 13 of the 15 largest leveraged buyouts in history, a major expansion in private equity activity, and the growth of massive, institutional-sized private equity firms such as The Blackstone Group and the Carlyle Group.

Sarbanes Oxley legislation, passed in the wake of the corporate accounting scandals at Enron, Worldcom, Tyco, Global Crossing and other companies also added an extra layer of cost and complexity to publicly-traded companies. Thus, many top executives saw private equity ownership as more attractive than remaining public.

Leveraged buyouts were back, only this time private equity executives rebranded themselves as pursuers of corporate efficiency and of “adding value” to underperforming companies. Major buyouts were once again common from 2004 through 2006 due to widely available credit at unprecedented levels of leverage.

By 2007, however, the crisis that affected the mortgage market spilled over into the world of leveraged finance. By mid year, there was a clear slowdown in high yield and leverage loan markets with far fewer issuers. Uncertain market conditions continued to put a damper on investment, with many firms withdrew from or renegotiated deals completed at the top of the market. The LBO market ground to a halt..

The credit crunch has prompted private equity firms to either sit tight on their investments or pursue other ways of deploying their funds. This includes Private Investments in Public Equity (PIPE) transactions.

In addition, several of the largest private equity firms have pursued opportunities through the public markets. In 2006, Kohlberg Kravis Roberts raised $5 billion in an initial public offering for a new permanent investment vehicle (KKR Private Equity Investors or KPE). The Blackstone Group completed its first major IPO of a private equity firm in June 2007. These public offerings allow investors who would otherwise be unable to invest in a traditional private equity limited partnership to gain exposure to a portfolio of private equity investments.

According to the Wharton School of Business and their 2009 Wharton Private Equity & Venture Capital Conference, Private equity firms will face unprecedented challenges in the next few years. Deals that once required only 15% in equity will require upwards of 35 to 40 percent or more. In addition, many private equity firms face a “wall” of refinancings that are due in 2012 which may challenge the survival of both the portfolio companies and many established private equity firms.

Next time, we’ll look at a brief history of the venture capital industry.

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