Yet, although there were pools of private money in existence between the turn of the century and through the 1950s, these were primarily invested in startups, much like today's venture capital firms. The notion of a private buyout of an established public company remained foreign to most investors until 1958, when President Dwight D. Eisenhower signed the Small Business Act of 1958. That provided government loans to private venture capital firms, allowing them to leverage their own holdings to make bigger loans to startups--the first real leveraged purchases.
Soon, other companies started playing with the idea of leverage. Kohlberg Kravis Roberts & Co. made the first modern leveraged buyout in 1964 through the purchase of the Orkin Exterminating Co. Others followed, but the trend quickly died by the early 1970s. For one, the government raised capital gains taxes, making it more difficult for KKR and other nascent firms to attract capital. Pension funds were restricted by Congress in 1974 from making "risky" investments--and that included private equity funds.
The 1980s: Greed is Good
These trends started reversing themselves in the 1980s, when Congress relaxed both pension fund restrictions and capital gains taxes. Money flowed back into private equity funds, and some of the best known firms were founded--Bain Capital in 1984, The Blackstone Group in 1985 and The Carlyle Group in 1987.
Carl Icahn made a name for himself as a corporate raider with his LBO of TWA Airlines in 1985, and KKR raised private equity's visibility to a new high with the $31.4 billion acquisition of RJR Nabisco in 1988.
This was a time of growing pains for private equity as well as intense success. Many firms realized that they couldn't act in a bubble, as KKR found out with a ton of negative publicity surrounding the RJR Nabisco deal. Tom Wolfe's Bonfire of the Vanities gave all of Wall Street a black eye, and Gordon Gecko's "Greed is good" mantra from Wall Street was pinned on private equity firms as a whole. By the time the 1990-1991 recession took hold, private equity firms resumed a low profile, waiting for the next boom.
The 1990s--The Tech Boom
The tech boom of the 1990s was a unique time for private equity. Stock prices soared, even for companies that had no business being publicly traded, let alone having a rising stock price. It became inordinately difficult for a private equity firm to create value through the traditional buyout method.
But at the same time, venture capital was on the rise, fueling a surge of new companies. As one venture capitalist put it at the time, "Look, I'll throw $1 million at 10 different companies. If one company succeeds, that'll bring me $50 million. So it's worth it in the end." So the major private equity firms shifted gears and participated in the boom through startup funding. LBOs still occurred, but at far less impressive levels than in the 1980s.
The 2000s--A Maturing Industry
The dot-com bust of 2000-2001 brought the markets back to reality and unearthed new opportunities for private equity firms. Some firms swept in to buy good companies on the cheap, waiting for the bust mentality to pass before returning them to market. Others simply enjoyed the fire sale, and bought technology and patents for resale, dismantling the failed companies in the process.
By 2003, the market had returned to a bull cycle, but with some notable changes. Congress had enacted the Sarbanes-Oxley Act, which tightened regulations on public companies and what they could say and do. The new bull market was very much focused on companies "hitting their numbers" instead of long-term investment in new business. Those pressures combined to make private buyouts seem attractive to potential target companies.
Furthermore, the rise of hedge funds created a great deal of wealth that needed new homes, and broadened the number of potential investors in private equity. Soon, newly wealthy individuals, hedge funds and major Wall Street institutions were all piling into private equity, and the firms enjoyed even more success, leveraging their newfound capital into major multibillion-dollar deals. The record RJR Nabisco buyout was eclipsed twice in 2007 alone.
The Summer of 2007
Early on, 2007 was shaping up to be a remarkable year for private equity firms. Private investors LBO'ed the nation's largest utility, TXU Corp., in a record $44.3 billion private buyout that had the heads of Blackstone and KKR gladhanding members of the Texas Legislature in what many saw as a symbol for private equity's increasing clout.
Then, in the summer, the whole private equity wave came crashing down. And it wasn't even the firms' fault. LBOs became the latest victim of the housing and mortgage crisis.
Where it began
Ever since the dot-com crash and subsequent recession of 2000-2002, investors disillusioned with high-flying stocks started investing in tangible assets, mostly real estate. By 2004, the condo-flipping craze was in full swing. Prices had soared considerably in just three to four years--three-fold in places like Los Angeles, Las Vegas and Miami. The national banking system helped fuel the craze with mortgages supported by historically low interest rates and relatively easy terms.
But in June 2004, the Federal Reserve started raising interest rates, which went from 1 percent at the start of 2004 to 5.25 percent in July of 2006, where they remained. Yet housing prices continued to climb as speculators jumped in and out of house purchases. That left the average homeowner struggling to afford a home. In response, mortgage lenders started pushing unusual mortgage products--everything from 50-year mortgages to interest-only, adjustable-rate loans. And because home prices had been on such a strong trajectory, many banks relaxed their lending requirements for "subprime" mortgages--loans to high-risk, poor-credit borrowers. The reasoning was that even these borrowers could refinance once their home prices appreciated substantially.
The irrational exuberance in housing started falling apart in spring and summer 2006, when prices leveled off and luxury homebuilders, responsible for half-filled communities of McMansions around the country, started lowering the profit forecasts. Housing prices evened out, then started falling in the majority of cities around the country. And all of those adjustable-rate mortgages began adjusting higher. Without the expected jump in home value, many borrowers, especially those with subprime mortgages, couldn't refinance and were stuck with payments they could no longer afford.
The effect of all of the late payments, loan defaults and home foreclosures wasn't limited to mortgage brokers and banks. Many mortgage lenders packaged their loans into mortgage-backed securities--bonds backed by the expected inflow of payments from borrowers as well as the value of the homes mortgaged. But with borrowers defaulting and home prices falling, the value of these bonds dried up. And the big banks and hedge funds holding this paper found themselves hit hard. Bear Stearns had to close two billion-dollar hedge funds in June because of the hit these bonds took, and Goldman Sachs spent $2 billion of its own money in August to prop up another fund.
And, of course, both hedge funds and major banks were hit not only with depreciating mortgage-backed securities, but also a severe correction in the equity markets and bond yields that finally normalized after nearly two years of inversion.
The result of all of this was a general tightening of credit. Nearly all major investment banks nearly all had mortgage-backed investments, and those with consumer arms also felt the pinch from mortgage defaults. Hedge funds, the other major source of leverage, faced the bond and equity problems, along with increased redemptions from worried investors.
The effects were seen as early as June, as Cerberus Capital Partners had difficulty borrowing the $12 billion needed to buy the Chrysler Group. It got the financing, but at less beneficial terms than it had thought. And it's unlikely that the new ownership will find underwriters to help lever Chrysler's dwindling assets for investor payoffs, let alone the capital the struggling automaker needs to keep making cars.
The lack of credit for buyouts has hurt other deals. The Home Depot Inc., once considered a prime buyout candidate itself, ended up accepting $8.5 billion to sell off its HD Supply wholesale/contractor chain to private equity buyers--the original bid was $10.5 billion. That's less money Home Depot can use for stock buybacks and dividends, further pressuring stocks and, potentially, prompting banks and hedge funds to decrease cash output.
As of the end of August 2007, there were 51 private equity deals pending, including TXU's and other notables: a consortium's $27.3 billion deal for Alltel Corp., KKR's $27 billion offer for First Data Corp. and Blackstone's $26.7 billion bid for Hilton Hotels. There is, of course, no way these deals can get done without borrowing. And if the private equity firms can't get the money on terms to their liking, they'll walk away.
"We can't borrow at unreasonable rates, but at the same time, we don't want to see too many deals fall through," says one insider at a top-three firm, who didn't want his name to be used. "If you see a bunch of us drop these megadeals, the people who have given us money are going to be really disappointed, and they're not going to give us any more. So even fewer deals will get done. It's probably the touchiest situation we've faced as an industry."
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