Source: Bain &
Company
The Private
Equity industry has grown and morphed over the nearly seven decades of its
formal existence. From primarily Venture
Capital-related funds at the outset, to Buyout strategies (and a levered
sub-segment); Secondaries; Fund of Funds; Distressed, Infrastructure; and Real
Estate, private equity has typically taken on the dynamics of the macro
environment around it, reacting to interest rate levels, spreads and the tax
code to take advantage of conditions as they have presented themselves. In this note, we will look at the development
of the industry and its major sub-segments over time and also provide our
insight as to what we think the years ahead might look like.
Background
The current view
of what constitutes the private equity industry today most likely began to take
shape in the late 1940’s when organized, professional management firms with the
sole purpose of funding private companies were established. However, for decades before this, private market
transactions were not at all uncommon.
The first major U.S. transaction was the notable buyout of the Carnegie Steel Company in 1901 by J.P.
Morgan & Company for $480 million. After
the deal closed, J.P. Morgan famously quoted,
“Congratulations Mr. Carnegie, you are the richest man in the world”, a fact of
which Andrew Carnegie was supposedly embarrassed. At the time, the $480 million transaction
value equated to over 2% of US GDP.
Today, a similarly sized transaction would have to weigh in at nearly $355
billion.
Private
acquisition activity continued apace until the early 1930’s when the Glass
Steagal Act (technically the Banking Act of 1933) forced a separation of the
activities of commercial and investment banks and hampered the further
development of the US merchant banking industry. The act essentially left private acquisition
activity as the preserve of wealthy individuals and families.
After World War
II, what are widely considered the first two modern venture capital firms were
formed. In 1946, American Research and
Development Corporation was founded by Georges Doriot with the goal of
encouraging investment in businesses run by returning soldiers. In the same year, J.H. Whitney & Company
was founded by John Hay “Jock” Whitney to provide capital and services to small
and mid-market growth companies. Based
in New Canaan, CT, J.H. Whitney & Company is still in business today.
In 1958, the
Small Business Investment Act was passed which aided in the financing and
management of smaller enterprises.
Specifically, this act provided certain firms access to federal funds
which could be levered at a rate of 4:1 against privately raised investment monies. Though helpful, the industry still remained
on the fringes of most investors’ radar.
Beginning in the
1960’s and continuing through the 70’s, the foundation upon which today’s
industry is based was laid. In the
1960’s private equity activity was predominantly centered around venture
capital firms who focused on providing funding to start and expand companies,
many of whom were in technology-related fields.
It was also during this period that the current Limited Partnership
structure for private equity funds was introduced:
- Limited Partners putting up the
money
- General Partners identifying and
acquiring investments and running the day-to-day business
- A compensation structure comprised
of a management fee plus a percentage of the profits
In 1973, the National
Venture Capital Association was founded to serve as the industry’s trade
group. However, the stock market crash
of the time quickly put a damper on fund raising and it wasn’t until 1978 that asset
gathering normalized.
Buyouts are now the
largest segment within the private equity world, with the leveraged sub-segment
often commanding much of the attention. The
first generally acknowledged leveraged buyouts were the acquisitions of
Pan-Atlantic Steamship Company and Waterman Steamship Corporation in 1955 by
McLean Industries. McLean borrowed $42
million and raised $7 million through the issuance of preferred stock. Upon closure of the deal, McLean used $20
million of the target’s cash and assets to retire some of the borrowings. This deal became a blueprint for many of the
leveraged buyouts of the 1980’s and later.
In the mid-1960’s,
Henry Kravis, Jerome Kohlberg and George Roberts, then employees of Bear
Stearns, began targeting the acquisition of family businesses that were facing
succession issues. These companies were
generally too small to take public and their founders did not care to sell out
to competitors. It wasn’t until 1976
that Kohlberg, Kravis and Roberts left Bear Stearns to form what we know today
as KKR. About the same time (1974),
Thomas H. Lee founded a new investment firm bearing his name to focus on
acquiring more mature companies in leveraged buyouts. Both firms have gone on to great successes.
The passage of
the Employee Retirement Income Security Act of 1974 (ERISA) initially stunted
industry growth as corporate pension funds were prohibited from owning what were
deemed to be “risky” investments in private companies. Largely as a result, industry-wide fund
raising fell to $10 million in 1975. In
1978, restrictions were relaxed and fund raising climbed quickly from $39
million in 1977 to $570 million, solidifying private equity as an important
asset class with a significant following.
Other regulatory events late in the decade also supported the growth of
the industry, most notably the capital gains tax rate reductions of 1979
(39.875% to 28%) and 1981 (28% to 20%).
Boom and Bust Cycles – a more recent history
The Stars Align.
The First Big Boom (1982 – 1990)
Along with the capital
gains rate tax changes, 1981 saw the peaking of interest rates. Further fuel was thrown on the fire by investment
bank Drexel Burnham Lambert, which essentially created the Junk bond market,
allowing many middle market firms to borrow while bypassing the banks. The issuance of high yield debt climbed from
$1.5 billion in 1982 to $15 billion in 1984 and was almost entirely
underwritten by Drexel. Bank lending as
a percentage of corporate credit fell from just under 60% at the beginning of
the decade, to 15% by its end. Further
spurring the growth of leveraged buyouts was the Tax Reform Act of 1986 which
provided strong incentives for corporations to substitute debt for equity
financing (the curtailment of non-debt tax shields such as the investment tax
credit and depreciation allowances were two such incentives). And, as if this weren’t enough, the stock
market soared. Accordingly, the levered
portion of the private equity industry boomed with commitments climbing nearly
10-fold from $2.4 billion in 1980 to $21.9 billion in 1989. In total, it is estimated that more than 2,000
levered deals with a value in excess of $250 million were consummated. As volume increased, new, niche areas also began
to develop a following including secondary market purchases and
industry-specific funds.
The venture segment
saw numerous new firms enter the market, though capital managed by them grew only
slightly as this area was not buffeted as greatly by the favorable events in
the debt markets. Instead, the segment gradually
went through a shakeout with the best models rising to the top.
It should also be
noted that this decade coincided with the arrival of the “corporate raider” that
used many of the same financing structures as private equity firms, but typically
acted as hostile investors in public companies.
Michael Milken’s bankers at Drexel Burnham supported many of these hostile
investors through the funding of blind pools which enabled the transactions. Levered private equity funds were often
lumped in with the raiders – at least in the public’s eye.
At the time, public
companies being taken private accounted for about ½ of all transaction value
and large mature industries, like retail and manufacturing, made up the bulk of
transactions. Subsequent to the junk bond collapse, these public to private
deals fell to less than 10% of total value and middle market buyouts of
non-publicly traded firms accounted for the bulk of deals (the public to private
relationship currently stands at a more normalized level of approximately 46%
of deal value).
The LBO Bust (1990 – 1992)
As with any
boom, excesses appeared and a number of buyouts fell into bankruptcy, including
those of the Campeau Corporation. Campeau
was a Canadian Real Estate company which acquired Allied and Federated
department stores in the US in the late 1980’s and was one of the first, large
levered bankruptcies of the decade. By
1991, 26 of the 83 large deals completed between 1985 and 1989 had defaulted with
18 entering Chapter 11 bankruptcy proceedings.
LBO volume dropped by over 90% to under $10 billion. At the same time, Drexel Burnham Lambert was
tainted by the charge of insider trading against one of its managing directors,
Dennis Levine. Levine pled guilty and in
turn implicated one of his partners, Ivan Boesky. Boesky in turn, agreed to cooperate with the
SEC regarding his dealings with Michael Milken.
The SEC initiated an investigation of the firm which dragged on for more
than two years with Drexel finally pleading “no contest” to six felonies and
agreeing to pay a fine of $650 million.
During this time, junk bond activity slowed dramatically and funding
declined.
Venture Capital and Technology. The Second Boom (1993 – 2000)
Source:
National Venture Capital Association
Source:
Bain & Company
During the
second boom, both venture capital and levered investments experienced a
re-birth, with the former leading the way.
Private equity commitments overall climbed from roughly $20 billion in
1992 to $240 billion in 2000. Venture
commitments climbed from less than $5 billion to over $100 billion. The overall industry also managed to separate
itself from the taint associated with the 1980’s corporate raiders by
emphasizing the growth and development of acquired companies to the point where
such investors were often welcomed by managements (investments in capital
expenditures and management incentives became more common place during this
time). Risk was moderated as less
leverage was employed in the buyout sector (from 85% - 90% of purchase price in
the 1980’s to 20% to 40% in the 1990’s).
Driving much of the deal activity was the new found interest in the
internet, which drove a frenzy in start-ups and in some cases created new
riches overnight. The vast majority of venture deals were completed in the
Technology Software and Services space, setting the stage for the subsequent
bust.
Source:
National Venture Capital Association
What Goes Up, Must Come Down. The Internet Bubble Bursts (2000 – 2003)
As a large
percentage of the “dot.com” investments were premised solely on the unlimited
potential of the internet rather than a solid business model, many ran into
cash flow issues and the dominoes were set in motion, leading to a large number
of write-offs across technology and telecom-related investments. By mid-2003, private equity fund raising was
at less than half the peak level.
Leveraged buyout firms collapsed with a number of high profile shake-outs
including Hick Muse Tate & Furst and Forstmann Little & Company.
The bust ended
up forcing a greater level of due diligence upon investors and resulted in more
controls being placed on investment partnerships. Bank loans again became a more prevalent form
of deal financing.
Driven by surging
primary market volumes and regulations that increased capital set asides, many banks
and insurers made strategic decisions to exit from in-house private equity
operations. Secondary market transactions
(where one fund buys the private investments of another) grew from under 3% of
commitments to over 5% of the total, joining venture and buyouts as a viable segment
in the private equity world.
Thank You Messrs. Greenspan and Bernanke. The Third Boom (2003 – 2008)
In the aftermath of
the internet bust, seeds were also planted for the industry’s revival. Lower policy rates and a relaxation of
lending standards set the stage for some of the largest private equity transactions
to date. Unlike the boom of the late
1980’s which was fueled by the junk bond market, this boom benefited from the
growth of syndicated bank debt – more than 50% of the LBO’s funded in 2006 were
funded by bank loans. The syndication process
itself resulted in market imbalances which then contributed to the subsequent
bust. First, as the loans did not remain
on the originating bank’s books, there was the likelihood that the diligence
conducted in making the loans was relaxed. Second, a
number of the deals were funded with debt that had weak covenants
(“cov-lite”). Further, regulatory
changes (the imposition of Sarbanes Oxley), helped the buyout industry convince
public companies that life as a private firm might be preferable while the same
legislation hurt the IPO dreams of many venture firms. As a result, more of the venture deals ended
up being done with strategic buyers (a purchaser in the same industry as the
company) and secondary volumes grew, comprising over 20% of total transaction
value. The “Greenspan Put”, as it came
to be known, convinced industry players and investors that the environment
would not change and overall risk taking appetite increased. Funding volume hit a peak of just under $700
billion in both 2007 & 2008.
Source:
Bain & Company
A Different Kind of Exit
Toward the end
of the third boom, an exit of sorts was seen by some of the larger private
equity firms, though not in the usual context of selling portfolio firms. In 2007 the Blackstone group filed for an IPO with the SEC and proceeded
with a sale to the public (12.3% stake).
In the same year, the Carlyle Group also sold an interest in the
management company (7.5% interest). In
January of 2008, Silver Lake Partners followed suit with a 9.9% sale of its
management company to CalPERS. To the
cynical, this might seem like a backdoor way to raise liquidity for partners at
a time when the size of their investments limited strategic sales and when the
weakening market environment limited the IPO door. It was promoted by the sellers as a way to
spread the riches of private equity to a wider audience of investors.
Yet Another Bubble Bursts
Low interest
rates, no-money down mortgages and new residential mortgage financing vehicles
led to an unprecedented run in the US housing market from the early part of the
decade and into 2007. As this bubble
inevitably burst, its repercussions were felt world-wide. From the failure of a Bear Stearns hedge fund
during the summer of 2007 to the failure of Lehman Brothers a year later, the
credit markets froze and spreads widened to record levels. Globally, stock markets fell by more than 40%
and as might be expected, the leveraged finance markets came to a standstill,
with deal activity troughing at $134 billion in 2008. Only the Distressed and Turnaround funds saw notable
increases in fund raising in 2007 and 2008.
Source:
Probitas Partners
A Slow and Steady Recovery
It wasn’t until after
more than a year of unprecedented intervention by US and other western central banks
that confidence was secured and funding activity picked up. From a trough of $296 billion in 2010, funding
rose slowly to reach $461 billion in 2013 (2014 activity through August is on a
similar pace).
Source:
Bain & Company
The Present
The private
equity industry is led by buyout strategies which comprised 37% of the capital
raised last year. Tangible asset
strategies (Real Estate, Infrastructure and Natural Resources) made up an
additional 31% of the total, while distressed, venture capital and other
strategies comprised the remaining commitments.
Source:
Preqin Global Private Equity Report 2014
The Future
While nothing is
ever certain, the history of private equity has shown how the industry attempts
to take advantage of (or is effected by) the tax, regulatory, interest rate and
stock market environments. Given our
reading of the tea leaves, we think the following factors will drive and shape
the industry in the decade ahead:
- Increased regulatory and operational
scrutiny
- Diminished interest in hedge funds
- Greater demand for private equity in
the alternatives space
- A battle between mega-firms and
smaller, boutique style managers for investor monies
- A headwind for buyout and other private
equity strategies employing leverage
Increased regulatory and operational scrutiny
is a near certainty. Following on the heels
of the financial crisis, investors have stretched in search of new
opportunities as interest rates and spreads fell to historic lows. Perhaps because of this, alternative asset
categories have become more prevalent and regulators, accordingly, don’t want
to drop the ball again. The following
areas will be under watch in the private equity realm:
- Expense allocation between the funds
of a given manager
- The asset valuation policies of these
funds
- The co-investment policies of the
manager
- Fee transparency
- Form PF and marketing material scrutiny
- An increased push by investors to
outsource (and upgrade) manager operational capabilities
On balance, increased
scrutiny should bode well for the growth of the industry. While it will increase the costs of doing
business, greater oversight will also allow investors not currently in the
segment to feel more comfortable about future commitments. At the same time, many service firms
specializing in providing non-investment services such as Fund Administration
and Compliance Outsourcing will help limit smaller managers’ cost increases
while providing them with best in class services.
A diminished interest in Hedge Funds
is quite possible. Following a number of
years of less than stellar results and a well-publicized decision by CalPERS,
the largest public fund in the United States, and PFZW, the $150 billion Dutch Healthcare system, to divest from the category, we put
a high probability on the following:
- The potential for “follow on” moves
(away from hedge funds) by smaller plan sponsors
- A move away from the higher
expenses associated with fund of fund programs and toward direct placement by
those committed to the category, a continuation of a trend that is already
underway
- An opportunity for other
alternative categories such as Private Equity to gain share
The fact that we are likely to be in a low return
environment for traditional asset classes (see our
white paper, “Forecasting Return
Expectations”) and investors have already taken on more risk in the quest
for return, means many are now more likely
to consider investing in what may be “new” asset classes to them. With private equity allocations across large
plans currently at 7% of assets, there is still room for the segment to gain
share. Also, given the generally
fulfilled return expectations to date, private equity would seem to be a
natural fit for many.
Source:
Bain & Company, Cambridge Associates
However, within the industry, where investors focus is
still up in the air.
We are currently seeing different behaviors by investors in terms of the
size of manager with whom they have comfort.
- The State of Wisconsin as well as Colorado
Fire & Police have explicitly announced an intention to invest more with
smaller managers where they feel interests are better aligned and where more opportunity to add alpha is possible
- Los Angeles County ERS is also “looking
at smaller managers”
- CalPERS and the State of Michigan have
already increased allocations with mega-firms citing the ease of oversight when
managing large pools of capital
Ultimately,
performance will likely determine which preference becomes dominant, though
both are likely to co-exist for the near term.
Finally, given today’s
historically low level of interest rates and credit spreads, along with the
increased use of leverage in recent transactions, it will be more difficult for strategies dependent upon leverage to do
as well in the future as they have in the recent past. In fact valuation levels are approaching the
last cycle’s peak.
Source:
Bain & Company, S&P Capital IQ
Conclusion
At the end of
the day the future looks bright for most areas within the private equity
space. Investors are underweight the
asset class, private equity has historically met investor expectations and it is
looked upon favorably by current investors.
With a low return environment for traditional asset classes a high
probability, new sources of return will continue to be sought by plan sponsors. Private equity has every reason to be high on
most lists.
