The History of Private Equity & Venture Capital
Investors have been acquiring businesses and making minority investments in privately held companies since the dawn of the industrial revolution. However with a few exceptions, private equity in the first half of the 20th century was the domain of wealthy individuals and families.
Early History: 1946 – 1981
In 1946 the first two venture capital firms American Research and Development Corporation (ARDR) and J.H. Whitney & Company were founded. ARDC is credited with the first major venture capital success story when its 1957 investment of $70,000 in Digital Equipment Corporation (DEC) would be valued at over $355 million after the company's initial public offering in 1968 (representing a return of over 500 times on its investment and an annualized rate of return of 101%).
One of the first steps toward a professionally-managed venture capital industry was the passage of the Small Business Investment Act of 1958. The 1958 Act officially allowed the U.S. Small Business Administration (SBA) to license private "Small Business Investment Companies" (SBICs) to help the financing and management of the small entrepreneurial businesses in the United States.
During the 1960s and 1970s, venture capital firms focused their investment activity primarily on starting and expanding companies. More often than not, these companies were exploiting breakthroughs in electronic, medical or data-processing technology. As a result, venture capital came to be almost synonymous with technology finance.
It was also in the 1960s that the common form of private equity fund, still in use today, emerged. Private equity firms organized limited partnerships to hold investments in which the investment professionals served as general partner and the investors, who were passive limited partners, put up the capital.
Throughout the 1970s, a group of private equity firms, focused primarily on venture capital investments, would be founded that would become the model for later leveraged buyout and venture capital investment firms.
Venture capital played an instrumental role in developing many of the major technology companies of the 1980s. Some of the most notable venture capital investments were made in firms that include: Tandem Computers, Genentech, Apple Inc., Electronic Arts, Compaq, Federal Express and LSI Corporation.
- Arguably the first leveraged buyout may have been the purchase by Malcolm McLean's McLean Industries, Inc. of Pan-Atlantic Steamship Company in January 1955 and Waterman Steamship Corporation in May 1955
- The first major venture capital success story occurred in 1957, when an investment of $70,000 into Digital Equipment Corporation would end up being valued at over $355 million after the company’s IPO in 1968, providing a return of over 500 times the initial investment)
- Florida Foods Corporation was a developer of an innovative method for delivering nutrition to American soldiers which later came to be known as Minute Maid orange juice and was sold to The Coca-Cola Company in 1960.
The first Private Equity Boom: 1982 – 1993
The 80’s are perhaps more closely associated with the leveraged buyout than any decade before or since. For the first time, the public became aware of the ability of private equity to affect mainstream companies and "corporate raiders" and "hostile takeovers" entered the public consciousness. The decade would see one of the largest booms in private equity culminating in the 1989 leveraged buyout of RJR Nabisco.
In January 1982, former US Secretary of the Treasury William E. Simon, Ray Chambers and a group of investors, which would later come to be known as Wesray Capital Corporation, acquired Gibson Greetings, a producer of greeting cards. The purchase price for Gibson was $80 million, of which only $1 million was rumoured to have been contributed by the investors. By mid-1983, just sixteen months after the original deal, Gibson completed a $290 million IPO and Simon made approximately $66 million. The success of the Gibson Greetings investment attracted the attention of the wider media to the nascent boom in leveraged buyouts.
Because of the high leverage on many of the transactions of the 1980s, failed deals occurred regularly, however the promise of attractive returns on successful investments attracted more capital. With the increased leveraged buyout activity and investor interest, the mid-1980s saw a major proliferation of private equity firms. Among the major firms founded in this period were: Bain Capital, Chemical Venture Partners, Hellman & Friedman, Hicks & Haas, The Blackstone Group, Doughty Hanson, BC Partners, and The Carlyle Group.
Venture Capital in the 80’s
The public successes of the venture capital industry in the 1970s and early 1980s (e.g., DEC, Apple, Genentech) gave rise to a major proliferation of venture capital investment firms. From just a few dozen firms at the start of the decade, there were over 650 firms by the end of the 1980s, each searching for the next major "home run". While the number of firms multiplied, the capital managed by these firms increased only 11% from $28 billion to $31 billion over the course of the decade.
The growth the industry enjoyed was hampered by sharply declining returns and certain venture firms began posting losses for the first time. The market for initial public offerings cooled in the mid-1980s before collapsing after the stock market crash in 1987 and foreign corporations, particularly from Japan and Korea, flooded early stage companies with capital. Many of the venture capital firms attempted to stay close to their areas of expertise in the technology industry by acquiring companies in the industry that had reached certain levels of maturity.
In 1989, Prime Computer was acquired in a $1.3 billion leveraged buyout by J.H. Whitney & Company in what would prove to be a disastrous transaction. Whitney's investment in Prime proved to be nearly a total loss with the bulk of the proceeds from the company's liquidation paid to the company's creditors.
Corporate raiders and hostile takeovers
Although buyout firms generally had different aims and methods, they were often lumped in with the "corporate raiders" who came on the scene in the 1980s. The raiders were best known for hostile bids—takeover attempts that were opposed by management. By contrast, private equity firms generally attempted to strike deals with boards and CEOs, though in many cases in the 1980s they allied with managements that were already under pressure from raiders. But both groups bought companies through leveraged buyouts; both relied heavily on junk bond financing; and under both types of owners in many cases major assets were sold, costs were slashed and employees were laid off. Hence, in the public mind, they were grouped together.
Management of many large publicly traded corporations reacted negatively to the threat of potential hostile takeover or corporate raid and pursued drastic defensive measures including poison pills, golden parachutes and increasing debt levels on the company's balance sheet.
One of the final major buyouts of the 1980s proved to be its most ambitious and marked both a high water mark and a sign of the beginning of the end of the boom that had begun nearly a decade earlier. In 1989, KKR closed on a $31.1 billion dollar takeover of RJR Nabisco. It was, at that time and for over 17 years, the largest leverage buyout in history. The event was chronicled in the book, Barbarians at the Gate: The Fall of RJR Nabisco.
By the end of the 1980s the excesses of the buyout market were beginning to show, with the bankruptcy of several large buyouts. Additionally, in response to the threat of unwelcome LBOs, certain companies adopted a number of techniques, such as the poison pill, to protect them against hostile takeovers by effectively self-destructing the company if it were to be taken over.
- A $31.1 billion dollar takeover of RJR Nabisco. It was, at that time and for over 17 years, the largest leverage buyout in history.
- Wesray Capital Corporation, acquisition of Gibson Greetings, a producer of greeting cards. The purchase price for Gibson was $80 million and by mid-1983, just sixteen months after the original deal, Gibson completed a $290 million IPO.
- In 1989, Prime Computer was acquired in a $1.3 billion leveraged buyout by J.H. Whitney & Company in what would prove to be a disastrous transaction. Whitney's investment in Prime proved to be nearly a total loss with the bulk of the proceeds from the company's liquidation paid to the company's creditors.
- In 1985 Revlon was acquired for $2.7 billion. The buyout would prove troubling, burdened by a heavy debt load. Revlon ended up selling four divisions: two were sold for $1 billion, its vision care division was sold for $574 million and its National Health Laboratories division was spun out to the public market in 1988.
The second Private Equity Boom: 1993-2003
Beginning roughly in 1992, three years after the RJR Nabisco buyout, and continuing through the end of the decade the private equity industry once again experienced a tremendous boom. After declining from 1990 through 1992, the private equity industry began to increase in size raising approximately $20.8 billion of investor commitments in 1992 and reaching a high water mark in 2000 of $305.7 billion, outpacing the growth of almost every other asset class.
As private equity re-emerged in the 1990s it began to earn a new degree of legitimacy and respectability. Although in the 1980s, many of the acquisitions made were unsolicited and unwelcome, private equity firms in the 1990s focused on making buyouts attractive propositions for management and shareholders.
The venture capital boom and the Internet Bubble: 1995–2000
Unlike the leveraged buyout industry, after total capital raised increased to $3 billion in 1983, growth in the venture capital industry remained limited through the 1980s and the first half of the 1990s increasing to just over $4 billion more than a decade later in 1994.
The late 1990s were a boom time for the venture capital, as firms on Sand Hill Road in Menlo Park and Silicon Valley benefited from a huge surge of interest in the nascent Internet and other computer technologies. Initial public offerings of stock for technology and other growth companies were in abundance and venture firms were reaping large windfalls. Among the highest profile technology companies with venture capital backing were Amazon.com, America Online, E-bay, Intuit, Macromedia, Netscape, Sun Microsystems and Yahoo!
The bursting of the Internet Bubble and the private equity crash: 2000 - 2003
The Nasdaq crash and technology slump that started in March 2000 shook virtually the entire venture capital industry as valuations for start-up technology companies collapsed. Over the next two years, many venture firms had been forced to write-off large proportions of their investments and many funds were significantly "under water". By mid-2003, the venture capital industry had shrivelled to about half its 2001 capacity.
Although the post-boom years represent just a small fraction of the peak levels of venture investment reached in 2000, they still represent an increase over the levels of investment from 1980 through 1995.
Stagnation in the LBO market
Meanwhile, as the venture sector collapsed, the activity in the leveraged buyout market also declined significantly. Leveraged buyout firms had invested heavily in the telecommunications sector from 1996 to 2000 and profited from the boom which suddenly fizzled in 2001. In that year at least 27 major telecommunications companies, (i.e., with $100 million of liabilities or greater) filed for bankruptcy protection.
Deals completed during this period tended to be smaller and financed less with high yield debt than in other periods. Private equity firms had to cobble together financing made up of bank loans and mezzanine debt, often with higher equity contributions than had been seen. Private equity firms benefited from the lower valuation multiples. As a result, despite the relatively limited activity, those funds that invested during the adverse market conditions delivered attractive returns to investors.
Meanwhile, in Europe LBO activity began to increase as the market continued to mature. In 2001, for the first time, European buyout activity exceeded US activity with $44 billion of deals completed in Europe as compared with just $10.7 billion of deals completed in the US.
- Thomas H. Lee Partners acquisition of Snapple Beverages, in 1992, is often described as the deal that marked the resurrection of the leveraged buyout after several dormant years. Only eight months after buying the company, Lee took Snapple Beverages public and in 1994, only two years after the original acquisition, Lee sold the company to Quaker Oats for $1.7 billion.
- In 1993 the Texas Pacific Group acquired Continental Airlines. The plan included bringing in a new management team, improving aircraft utilization and focusing on lucrative routes. By 1998, Texas Pacific Group had generated an annual internal rate of return of 55% on its investment.
- In 1998, after 38 years of ownership, Domino's Pizza founder Tom Monaghan announced his retirement and sold 93 percent of the company to Bain Capital, Inc. for about $1 billion and ceased being involved in day-to-day operations of the company.
The third private equity boom and the Golden Age of Private Equity: 2003 – 2007
As 2003 got underway, private equity began a five year resurgence that would ultimately result in the completion of 13 of the 15 largest leveraged buyout transactions in history, unprecedented levels of investment activity.
The combination of decreasing interest rates, loosening lending standards and regulatory changes for publicly traded companies would set the stage for the largest boom private equity had seen. The Sarbanes Oxley legislation, officially the Public Company Accounting Reform and Investor Protection Act, passed in 2002, in the wake of corporate scandals such as Enron. In addition to the existing focus on short term earnings rather than long term value creation, many public company executives lamented the extra cost and bureaucracy associated with Sarbanes-Oxley compliance.
For the first time, many large corporations saw private equity ownership as potentially more attractive then remaining public. Sarbanes-Oxley would have the opposite effect on the venture capital industry. The increased compliance costs would make it nearly impossible for venture capitalists to bring young companies to the public markets and dramatically reduced the opportunities for exits via IPO.
Resurgence of the large buyout
By 2004 and 2005, major buyouts were once again becoming common and market observers were stunned by the leverage levels and financing terms obtained by financial sponsors in their buyouts. Some of the notable buyouts of this period include: Dollarama (2004), Toys "R" Us (2004),The Hertz Corporation (2005), Metro-Goldwyn-Mayer (2005) and SunGard (2005).
Age of the mega-buyout
As 2005 ended and 2006 began, new "largest buyout" records were set and surpassed several times with nine of the top ten buyouts at the end of 2007 having been announced in an 18-month window from the beginning of 2006 through the middle of 2007.
Publicly traded private equity
Although there had previously been certain instances of publicly traded private equity vehicles, the convergence of private equity and the public equity markets attracted significantly greater attention when several of the largest private equity firms pursued various options through the public markets.
In May 2006, Kohlberg Kravis Roberts raised $5 billion in an initial public offering for a new permanent investment vehicle. KKR raised more than three times what it had expected at the outset as many of the investors in KPE were hedge funds seeking exposure to private equity but could not make long term commitments to private equity funds.
On March 22, 2007, after nine months of secret preparations, the Blackstone Group filed with the SEC to raise $4 billion in an initial public offering. On June 21, Blackstone sold a 12.3% stake in its ownership to the public for $4.13 billion in the largest U.S. IPO since 2002.
Meanwhile, other private equity investors were seeking to realize a portion of the value locked into their firms. In September 2007, the Carlyle Group sold a 7.5% interest in its management company to Mubadala Development Company, for $1.35 billion, which valued Carlyle at approximately $20 billion. Similarly, in January 2008, Silver Lake Partners sold a 9.9% stake in its management company to the California Public Employees' Retirement System for $275 million.
Secondary market and the evolution of the private equity asset class
In the wake of the collapse of the equity markets in 2000, many investors in private equity sought an early exit from their outstanding commitments. Beginning in 2004 and extending through 2007, the secondary market transformed into a more efficient market in which assets for the first time traded at or above their estimated fair values and liquidity increased dramatically. During these years, the secondary market transitioned from a niche sub-category in which the majority of sellers were distressed to an active market with ample supply of assets and numerous market participants. By 2006 active portfolio management had become far more common in the increasingly developed secondary market and an increasing number of investors had begun to pursue secondary sales to rebalance their private equity portfolios.
- The Carlyle Group, Welsh, Carson, Anderson & Stowe, along with other private investors, led a $7.5 billion buyout of QwestDex. The buyout was the third largest corporate buyout since 1989. QwestDex's purchase occurred in two stages: a $2.75 billion acquisition of assets known as Dex Media East in November 2002 and a $4.30 billion acquisition of assets known as Dex Media West in 2003. R. H. Donnelley Corporation then acquired Dex Media in 2006.
- Private equity firms KKR, TPG Capital, and Goldman Sachs Capital Partners purchased TXU in 2007. Energy Future Holdings (TXU) can boast the largest amount ever paid in a private equity deal, a staggering $44.37 billion.
- After the gaming conglomerate Harrah’s Entertainment acquired the Caesar's Entertainment corporation in 2005, shares jumped, but that didn't deter Apollo and TPG from forming Hamlet Holdings and taking Harrah's private in 2008. The deal was valued at $27.4 billion.
The Credit Crunch and post-modern private equity: 2007-2008
In July 2007, turmoil that had been affecting the mortgage markets spilled over into the leveraged finance and high-yield debt markets. Uncertain market conditions led to a significant widening of yield spreads, which coupled with the typical summer slowdown led to many companies and investment banks to put their plans to issue debt on hold until the autumn.
By the end of September, the full extent of the credit situation became obvious as major lenders including Citigroup and UBS AG announced major writedowns due to credit losses. The leveraged finance markets came to a near standstill.
Additionally, the credit crunch has prompted buyout firms to pursue a new group of transactions in order to deploy their massive investment funds. These transactions have included Private Investment in Public Equity (or PIPE) transactions as well as purchases of debt in existing leveraged buyout transactions.
According to investors and fund managers, the consensus among industry members in late 2009 was that private equity firms will need to become more like asset managers, offering buyouts as just part of their portfolio, or else focus tightly on specific sectors in order to prosper. The industry must also become better in adding value by turning businesses around rather than pure financial engineering.
Private Equity in 2010
Private equity firms invested nearly 90% more capital in 2010 than they did in 2009. Overall, private equity firms invested around $225 billion in 3,380 transactions, compared to $119 billion in 2,818 deals for 2009. Nearly half of the 2010 dollars went to North and South American companies. Europe placed second with a 35.5% market share, followed by Asia-Pacific (excluding Japan) with a 12.5% stake. 2010 saw activity in the private equity backed buyout market recovering to reach the kind of levels not seen since the onset of the financial crisis.