Alan Greenspan thinks private equity is the investment vehicle of the 21st century. Newt Gingrich and Rick Perry think they are "looters" practicing predatory capitalism. Both arguments oversimplify some very complex issues and miss the point.
Thanks to a contribution from a casino billionaire to a super-PAC supporting presidential candidate Newt Gingrich, the private equity business has moved from obscurity to center stage in the nation's economic conversation.
But private equity investors are not always the magicians their mouthpieces would have us believe. Take a look at Sears Holdings, bought by hedge fund manager Eddie Lampert, whom the redoubtable Jim Cramer once called the next Warren Buffett. Though he controls Sears through a hedge fund, Lampert runs it much like a private equity operation, leaving a sliver of shares public for investors to buy and observers to watch. Since reaching $180 a share, Sears recently traded below $40.
Private equity sprung up as a cottage industry in the post-World War II era at the same time as the venture capital business. Both industries evolved in a parallel fashion, though venture capital enjoyed more success in the 1950s and 1960s, financing a number of companies like Intel that would lead the economic boom that emerged in Silicon Valley by the 1970s.
While venture capital attracted major institutional investors in that era, private equity operated largely in the wilderness. A typical transaction might involve a retired CEO who had long had his eye on an orphan subsidiary of a quasi-competitor in an adjacent market.
As the parent focused on his primary business units and ignored the marginally profitable red-haired stepchild, the retired CEO saw potential. Given that the target division wasn't earning a lot of money, it could often be bought for a song, allowing its parent to redeploy the proceeds into its most profitable businesses, while the retired CEO got a chance to make his vision come true. I recall seeing one such individual buy a publishing company for $800,000 in 1982 and sell it for $40 million in 1986.
During the 1970s, the few bright spots of the U.S. stock market were the high-tech Nasdaq market and the energy business. Indeed, many academic studies have concluded that almost the entire so-called "small-cap outperformance premium" since 1926 can be attributed largely to an eight- or nine-year period between 1975 and 1983.
While companies like Wang Laboratories, Digital Equipment, Evers & Sutherland and Computervision were the darlings of a depressed Wall Street-where are they now-many companies were languishing with mid-single-digit, price-to-earnings multiples. More than a few concerns that had been hot IPOs in the 1960s went private, although the SEC cracked down on what it perceived as abuses of investors and stiffened the requirements.
At this time, the private equity business moved from behind the scenes into the mainstream. Firms like Kohlberg Kravis & Roberts, Forstmann & Little, Wesray Capital and a raft of others raised money from big institutions, often state pension funds. With the public equity market in the doldrums, they could often negotiate very advantageous deals and as soon as they strung together impressive track records, bankers and junk bond lenders were lining up to finance them.
Most of the acquired businesses were far from glamorous; some were bloated and scelerotic. But given the calcified state of large swaths of American industry in the late 1970s and early 1980s, it didn't take a lot of re-engineering to start generating strong cash flows, the financial stat that became private equity's mantra.
Former Treasury Secretary and Salomon Brothers partner William Simon of Wesray made a killing on Gibson Greetings Cards and told his story widely in the press. "I don't know why more people aren't doing this," he said in more than one interview.
Soon more people were-and not just on Wall Street. By 1984, Hellman Friedman was up and running in San Francisco and Bain Capital took off in Boston.
As the number of players expanded in the private equity game, the stock market kept rising. Corporate raiders were taking hostile takeovers to the big time, and they often looked to private equity to unload unwanted divisions following an acquisition to recoup a big part of their upfront investment.
With their war chests overflowing, private equity firms were confronted with what was once the unthinkable-launching their own hostile takeovers. Some like Ted Forstmann were outspoken in their rejection of this strategy. His argument was that a buyer wouldn't know what the real assets and liabilities of the target company were and, in any case, it was an unseemly, ungentlemanly way to do business.
Ethics aside, multiples and competition kept rising. Most technology stocks were left on the sidelines in the 1980s, except for a few companies like Microsoft that never took venture capital and only went public to gain a currency to attract star programmers. So more than a few VC players started migrating into the private equity space.
Everything came to a head with the RJR Nabisco transaction in 1988 and 1989. By then, several private equity players were engaged in hostile takeovers, forced to put their bulging funds to work. Prices and leverage was higher and many inefficient industries had been raked over and restructured, leaving buyers with less upside.
As the pickings grew slimmer and slimmer, acquirers sought to maintain their impressive rates of return by adding leverage. If they leveraged a company 9-to-1 and its value rose 10%, they doubled their return on investment. This tactic also raised the odds of default, and by that point bankruptcies and restructurings like Revco, RJR Nabisco and Federated Department Stores were piling up. Battles between dealmakers and bondholders got nasty.
Ironically, some of the VC firms abandoned technology investing for private equity and managed to do so just before another tech boom in Silicon Valley took off.
Returns for investors in the private equity space in recent years have failed to match the spectacular results some firms earned in the industry's early days. Faced with global competition, American business had no choice but to up its game. Increasingly efficient financial markets create fewer opportunities for financial buyers to "steal" companies.
Newt Gingrich's tale of Bain investing $30 million in a company, borrowing more than $100 million to pay itself a $180 million dividend, and then defaulting on the loans and firing all the employees after shutting the company is more the exception than the rule. A firm that does a few deals like that eventually finds it difficult to get financing. But stories of retailers and others unable to purchase sufficient inventories to fill their shelves or to rapidly change business tactics in response to shifting market conditions are quite common. The result likely could be underperformance, not bankruptcy, unless the leverage is out of whack.
Mitt Romney's real misfortune may have been to make his money in a relatively obscure, misunderstood sector of financial services that can easily be confused with the corporate raiders of the 1980s who were playing a different game in the same space. There are still a few spectacular winners and losers-Harrah's and Sears comes to mind as two of the latter. But the game has changed.
Today, private equity firms, like hedge funds, typically earn the bulk of their returns on fees and carried interest, not investment performance. As for Alan Greenspan, if he still believes private equity is the vehicle of the 21st Century, I would bet he has indulged in too much of Henry Kravis's champagne and caviar.