Once synonymous with Wall Street excess, private equity has cleaned up its act and is the largest asset class in private markets today.
The 1989 leveraged buyout (LBO) of RJR Nabisco was, at the time, the biggest corporate takeover in US history. It remains the most notorious.
LBOs, which use significant amounts of debt (or leverage) to reduce the overall cost of financing, are a cornerstone of private equity, a form of capital invested in mature businesses with a view to rejuvenating them and generating hefty returns when they are sold.
RJR Nabisco was one of the largest companies in the USA, but by the summer of 1988, its stock was stagnating. When its CEO tried to take the food and tobacco conglomerate private, just about every private equity player on Wall Street recognised an opportunity and a ferocious bidding war ensued.
Kohlberg Kravis & Roberts (KKR) was the eventual winner. But the firm's hostile tactics and aggressive financial engineering - RJR Nabisco was saddled with USD 25 billion of debt - attracted plenty of criticism.
Indeed, the deal, which is famously chronicled in "Barbarians at the Gate" (perhaps the best-selling business book ever), dealt LBOs and private equity in general a major reputational blow.
Private equity, however, has deep roots in the constantly evolving story of American capitalism. Its origins lie in the late 19th century, when wealthy families and individuals financed railroads and invested in industrial companies using similar private structures.
J. Pierpont Morgan's 1901 acquisition of the Carnegie Steel Company to help create US Steel, which he paid for by issuing bonds backed by gold, may qualify as the first big buyout in a contemporary sense. While the Vanderbilts, Whitneys, Rockefellers, Warburgs, and others pioneered venture (known then as development) capital investments using their personal wealth.
After World War Two, legislative and regulatory developments, especially the 1958 Small Business Investment Act, expanded the funding pools for growth-oriented businesses. Institutional investors became more involved, and both private equity and venture capital (today largely associated with investment in high-risk startups) started to emerge in their modern forms.
For private equity, LBOs proved pivotal.
The 1955 purchase of the Pan-Atlantic Steamship Company and Waterman Steamship Corporation by McLean Industries Inc is said to have been the first textbook LBO. But it was the 1982 buyout of Gibson Greetings that really put LBOs and private equity on the map.
A group of investors led by former US Secretary of the Treasury William Simon paid USD 80 million for the greeting cards company (although they were rumoured to have contributed only USD 1 million themselves). Just 16 months later, after Gibson completed a USD 290 million IPO, Simon walked away with some USD 66 million.
Meanwhile, at Bear Stearns, corporate financiers Jerome Kohlberg Jr., Henry Kravis, and his cousin George Roberts, had also been generating healthy returns by investing in (usually family-owned) businesses whose owners were looking for attractive exit opportunities but were too small to go public.
They began in the 1960s with so-called bootstrap deals, a form of self-financing at the owner's expense, but soon moved on to leveraged buyouts. In 1976, the trio left Bear Stearns to found the eponymous KKR, kicking off the 1980s LBO boom that culminated in the infamous buyout of RJR Nabisco.
What happened next demonstrates private equity's astonishing staying power. KKR lost an estimated USD 700 million on RJR Nabisco. And the simultaneous collapse of the high-yield or "junk" bond market that had fuelled so many of the decade's LBOs seemed to signal game over.
In 1990, a year after junk bond king Michael Milken went to prison for securities fraud, his firm, Drexel Burnham Lambert, Wall Street's leading issuer of high-yield debt, filed for bankruptcy.
Yet remarkably, by the beginning of this century, a combination of falling interest rates, looser lending standards, and regulatory changes set the stage for an even bigger private equity boom.
It culminated in 2006, after "largest buyout" records had been set and surpassed several times, with a whopping USD 302 billion of investor commitments to 415 private equity funds.
Then, suddenly, the era of "mega-buyouts" came to an abrupt end.
The turmoil in mortgage markets that initiated the 2008 global financial crisis spilled over into the broader debt markets. Lending standards and regulation tightened again in both the USA and Europe.
In addition, with more institutional investors in the market, compensation terms changed for both private equity fund managers and general partners. Several of the biggest players, including KKR, converted from partnerships to more transparent public corporations.
The upshot: lower fees, lower profits, and thus less risky and more responsible investment behaviour. Private equity, in short, was growing up.
In recent times, private equity has largely shed its image as the preserve of debt-addicted corporate raiders and become a mature industry, characterised by longer hold times and more diverse investors.
Deals are still, of course, subject to a range of risks. What's more, since interest rates started rising, other forms of private capital - notably private debt and private infrastructure - have outperformed both private equity and venture capital. The success of private equity investments increasingly depends on managers' ability to drive operational efficiencies in the businesses they buy.
Nevertheless, as a means of enhancing returns and deepening diversification, private equity's attractions remain undimmed. With growing numbers of investors looking to deploy capital in new and different ways, its story is plainly far from over.
