Barbarians at the Gate: A Short History of Private Equity

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0:54Thanks for listening to A Long Time in Finance with Jonathan Ford and Neil Collins.

1:03So we've done quite a lot recently on what I would regard as quite jolly subjects like Greenshield stamps and the crimes of Robert Maxwell. So we thought it was time to look at something a little bit chewier, looking at one of the industries that has really changed the financial world in the last half century. Private equity from its beginnings in the middle of the century to the 7 trillion behemoth it is today. And it's interesting for two reasons. The first, after 40 years of declining interest rates, we're now perhaps in a genuinely persistent upcycle, especially in the West where governments are running very large budget deficits.

1:40And also a change in the political environment, which has moved from a very permissive one with globalization and low taxes to one where public opinion is much more jaded about the very rich, especially those who've made their pile from financial sectors. And who better to discuss these things with than that old friend of the show, Peter Morris, last while banker who sold junk bonds back in the day, I believe, and longtime analyst and thinker about the private equity sector. So welcome, Peter. Nice to be back. Well, I think where we should start is by looking at the origins of private equity, where the idea comes from, and what sort of turns it from a few wealthy people putting money into private businesses into the institutional industry that emerges?

2:21Is it all about KKR? And if so, where did they get their idea from? KKR would certainly claim to have been one of the founders in the late 70s. I think it has more to do with other things that were going on around them, such as deregulation and pension regulations. So there's a thing called ERISA, which plays a big part in this. It's 1978. ERISA basically allowed pension funds to, it brought in something called the prudent man rule. So instead of imposing very strict rules on what pension funds could do, it basically said you can do whatever a prudent man would do. So pension funds took that as a license to go off and do a lot of things, including private equity.

2:59It so happened that Henry Gravis and George Roberts and their former colleague, Jerry Kohlberg, had set themselves up in business in, I think, 1976. Obviously, the idea didn't come from nowhere. It sort of has a longer gestation period, I suppose. If you go back to the end of the Second World War, you find what are proto-private equity firms being set up to invest essentially in businesses being established by GIs who have come back from the Second World War and gone to university under the GI Bill, building their own companies up. So I think you're referring to things like Fairchild Semiconductor, so Silicon Valley, So the sort of venture capital end of it.

3:37So that would be the GIs that we're talking about. As well as that, I mean, the idea of buying a company using lots of debt is not something that was invented in either 1945 or 1976. It's been around for a long time. Sure. Success has many fathers, but this particular stream came from both the post-World War II GI funding. That's the venture capital that Jonathan was talking about. plus large investors looking for more exciting things to do with their money and pension funds being allowed to. Yeah, I was very struck when I was looking at the history of KKR, how they started off obviously working as bankers at Bear Stearns, which is where they did their earliest deals, which are kind of, I suppose, proto private equity deals, but because they're not done in a kind of fund structure, and we'll come on to that and why that's so important in setting these things up.

4:25They were kind of just things they did at Bear Stearns. And Bear Stearns, when one of them, a business splendidly called Cobblers Industries, went bust in the early 70s, they basically, their bosses said, what the hell are you doing? Wasting your time buying all this junk and losing us money. And they said, well, we're going to leave unless you set up a fund and do it, you know, like a proper, what would become a proper private equity firm. And some guy called Cy Lewis, who's the chief executive of Bear Stearns, said, I'm not going to waste my time on that sort of nonsense. You can bugger off.

4:58Which, judging by what happened subsequently, is rather a boo-boo by Cy Lewis, I would say. So generally, Cy Lewis and Bear Stearns were regarded as fairly smart. It's easy to laugh at them now. If you flip that round, the other way of looking at that is to say, with the benefit of hindsight, it may seem obvious that private equity was a thing to do and to get into. You know, Messers, KKNR, they genuinely were taking a risk on trying to do something that no one thought would work in the late 1970s. It might not have worked. They will say it worked because they were brilliant. Another way of looking at it is to say it worked because they happened to coincide with things like ERISA and declining interest rates and whatever.

5:35It's worth just talking about how private equity becomes a proto-institutional product. And I think, is it fair to say that it is the establishment of this sort of structure where you have a fund with a limited partnership and basically the fee structure which emerges of the so-called two and 20? Maybe you can talk us through that very quickly. When KKRs of this world, when they started out, they were doing deals on a one by one basis. They were going to individual institutional investors on a deal by deal basis. and they were using very much non-mainstream lenders. So it really was kind of bootstrapping on a deal-by-deal basis.

6:16So you had deals like Gibson Greetings in 1982, where a firm called Wes Ray put in a million dollars and made$66 million. So returns like those on individual deals started to catch the attention of big institutional investors, meaning pension funds. And that led people like KKR to say, okay, if we're going to get these pension funds interested, it's in their interest, it's also in our interest to create these things called limited partnership funds, which became the kind of standard vehicle for doing this. The one other thing just about setting the scene is, to what extent is basically this industry ushered into being by the kind of general feeling at the end of the 70s that there's this terrific malaise, returns on equity in public companies are terribly low, taxes are too high.

7:07And essentially, there is a kind of reformist view that capital gains taxes should come down, entrepreneurship should be encouraged. Does that sort of drive it forward? It might have happened anyway. But I think the other thing that was happening about the time of ERISA was basically, we had Reagan, Thatcher, and the beginning of deregulation. And you're right, there was a sort of fantasy feeling going on, the feeling that the world needed to turn around. So there probably was a sense of there is a need to go and reinvent things. That is certainly what Michael Jensen and his co-author were writing in their academic papers, where they were writing very, very gloomy stuff saying the world has come to an end.

7:47So let's get on to the 80s, Niels Thurston to talk about R.J.R. Nabisco. And obviously, the industry kind of is created, and it goes through this very dramatic expansion. and one of the things is that private equity firms will seem to compete to do bigger and bigger deals, presumably partly for reasons of economies of scale. If you can get a$17 billion company, A, you don't have to do as many deals. And secondly, the competition becomes quite thin for that very large targets. But how does that come about? The returns have been good. The amount of debt that was available to them was growing exponentially.

8:26So this is Michael Milken and Drexel Burnham and all the banks. It's also worth remembering that the stock market was still recovering from the late 70s. So stock market performance in the 1970s was terrible. So even in the 1980s, you were recovering from a very low base. And there were a lot of large conglomerates around which were like RGR. RGR was not the only fat, lazy conglomerate around. They were sort of there for the taking. But they presumably thought that their biggest defence was the sheer size, because nothing like this has been attempted in the past. And it was a very large company.

9:03So what was it particularly? Was it a confluence of all those forces that you've just described, the recovering market, generally falling interest rates, possibly the likes of Michael Milken, who had found new sources of capital, which was available to do this sort of huge deal? So Henry Kravis, Michael Milken, the banks, their incentives lay in doing the biggest possible deal. So forget economies of scale. The bigger the deal, the bigger the fees. Quite apart from the 2 % plus 20 % carry that they were then going to get paid on this very large investment. I think I'm right in saying that most of the private equity deals up to that point had been essentially been agreed.

9:46And this was a hostile act. the RJR board fought it to the end because they realised that their sinecure was going to be taken away from them and they were damned if they were going to capitulate to these wretched jumped up bankers. Maybe it's worth just as an aside going into because I think the answer to Neil's question in part is the role played by people like Michael Milken. I mean you talked about the pension funds being able to buy riskier assets and equities and so forth, private equity. And similarly, at the same time, Michael Milken was persuading them to buy bonds in essentially risky companies.

10:29That clearly has a similar effect in terms of putting together with, you know, the private equity firms with their pile of equity, an enormous amount of debt, which allows them to chase larger companies. Sure. To be clear, at that point in the late 80s, the money Milken was raising was coming less from pension funds and more from something that sounds wrong. S &Ls, savings and loans. S &Ls. Okay, I take it all back. Yeah, the S &Ls, of course. Milken the milker, I think he was. But also, I think one of the reasons why he was able to persuade S &Ls to lend to hostile takeovers was because in the 80s, there was this extraordinary thing known as blind pools where someone like Jimmy Goldsmith would wander around Wall Street, buying stakes in companies using debt, and then trying to either blackmail them to sell him half their company for nothing, or trying to take them over.

11:29And the reason he was able to do this was because Milken would basically raise bonds where there was no purpose. It was just, we'll give$200 million to Jimmy Goldsmith, assuming that he'll make a good use of it. So underwriting standards were obviously pretty mad in the 1980s. Sure. So come back to RJR, because at the end of the 80s, you have this wave of hostile takeover. You mentioned the enormous transaction fees that KKR would have received for taking over that business, a$25 billion deal, which even now is enormous. So then it was absolutely huge. On top of which they got their management fee and their share of the profits.

12:08But of course, the profits weren't as great as they anticipated, because they essentially walked right into the 1990 recession. And what will become a recurrent problem in private equity, which is booms followed by sudden sharp and unpleasant busts, where essentially bankers get very rattled and it becomes very hard to sell the company off because the stock market is down. But did they make any money out of the deal? I believe the returns on RGR were very poor. And when you only put in 5 % of the money, I think their equity investment was around 5 % of the deal. To make a very small positive return, which I think is what they made, shows you it was a pretty close run thing.

12:52It's like the Battle of Waterloo. It's, of course, the real winnings, as you said earlier, are in the fees. I don't think much has changed in that department. One aspect of private equity, which I think we should just address before we get on to the fascinating subject of IRRs, is their capacity for reinvention. Because it seems to me, if you look at the history of the private equity industry, it's crazy booms followed by, as I said, sharp busts. And then the industry kind of wriggles its way around the kind of problem which has emerged from the boom. And so in the 1990s, I guess, the fix is the product of the boom itself.

13:32It's lots of people left with participations they don't want. So they create a secondary market in private equity for funds which are going to pick up the debris from the last boom. And then I suppose you get the dot-com boom, which produces this enormous wave of deals in telecoms, which then blows up in 2002. Right. Part of it was picking up the pieces, the wreckage of what had gone wrong in the late 1980s. And it's worth saying that many firms are very proud to say that they make their best returns when everyone else is flat on their back, which also means taking advantage of lenders. So in other words, they're making money out of lenders making a loss.

14:11Somebody else might say sweeping up the debris after the party and finding a few hidden gems in it. So that's one thing that was going on in the 90s. And then, as you say, Jonathan, there was the whole TMT ludicrousness, which the private equity firms got into without ever really knowing what they were doing. So that was most of the 90s. And then we had the dot-com boom. And then we get to the 2000s. The dot-com boom didn't really lend itself to private equity because there wasn't sufficient cash flow. No, but telecoms companies did. Things like Global Crossing and WorldCom and things like that.

14:48Well, they were basically financed by private equity. And I think there was a year 2002 when something like 25 telecoms companies around the world went fast in one go. Yes. And Neil is right. I mean, the private equity firms certainly were not equipped to do it because it wasn't their expertise. And there was one famous case whose name I forget where a, I think the state of Connecticut pension fund sued one of the largest private equity firms for the money that they lost on the TNT deal, telecoms deal. It's a firm called Forceman Little, and they were sued for 125 million losses, saying that they had been negligent.

15:23And they'd given Forceman Little a lot of money to go and invest. And they suddenly realized they didn't want to give it to them after all. So they sued them to get out of the contract. They settled, but they wanted 125 million. They ended up settling for 15 million. So obviously Forceman Little's contract was slightly more cunningly written than they hoped. But that brings us back to the question of the pension funds, who have clearly been huge players in this industry. I mean, why, as Neil has said, are they able to do such enormous deals? And in the 2000s, they do them again, only a few years after all the telecoms companies go bust.

16:00And the question is, why are they such suckers for this industry? And are the returns they're getting really vastly superior to what they could get from something else. For a while, the returns were quite good for some of the investors. When was that? In the 80s? So certainly in the 70s and the 80s, they were certainly strong. One of the problems is the way people measure the returns is this financial measure called the internal rate of return, which has the merit of being mathematically accurate and the disadvantage of being economically meaningless under many circumstances. You can get a high IRR, then you understand that all you get is your money back.

16:42And the two are mathematically explained to you as a rather tragic investor. This investment has done jolly well, but you haven't. You may need to just give a very, very simplified explanation of what an IRR is after that tantalising example from Neil. Okay. So technically, the internal rate of return is the percentage rate that reduces a series of cash flows to a net present value of zero, which doesn't mean much. So in real English, what it means is it's a mathematically correct way of calculating a discount rate. Bad news from the point of view of real investors. There are some particular nuances to the way it works, which means it's easy to manipulate.

17:24So to give you an example, I believe KKR's current public filings with the SEC report that its private equity funds have made over their full lifetime, they've made an internal rate of return of call it 25%. That's in a publicly filed SEC document. So almost certainly, I'm quite happy that the 25 % number is correct. But let's do a real world check. If you were a pension fund that invested a million dollars in KKR's first fund in 1976, and if you had really earned a 25 % return on that investment over the next 40 years since then, you would now own the entire world. You would own the world. It's mathematically correct, but really, really seriously misleading in economics.

18:11The other flaw in it, which I came across when looking at hedge funds, was that, And of course, the way that people will look at this is they do a mathematical average over the years. But comparing the$20 million of deals that produced 150 % IRR in the 1970s to the $47 billion that produced a much smaller one, if you don't money weight it, you end up with a completely meaningless number. But you said the returns were declining over time. On what basis are you measuring those and how badly have they declined? Analysis of private equity returns is very tricky because the data has only gradually become available because they're allowed to keep it effectively secret.

18:55There are better ways of measuring returns. So academics tend to use a measure called the PME, private market equivalent. And what that broadly shows is that academic consensus was that in terms of net returns, After fees. Correct. The net returns are plus or minus 1 % or 2 % compared to the stock market. Much the same. Not much different to what? Quoted market returns. Ah, right. Which I'm afraid brings me to my understanding of the motivation of these pension funds, which is it's far less trouble to have big chunks of interest in these funds rather than trying to do your own stock picking. which, as everybody knows, is bloody difficult to do.

19:41If the promoters of these schemes are schmoozing you and telling you how wonderful their IRR is, and they're taking you to glamorous places to explain all this, the poor old pension fund manager, I suspect, just falls for this because it's a much easier life. And after all, it's not his money. Correct. What economists would call an agency problem. Is there any possibility, do you think, that that is changing? The startling thing is that the academics and the establishment, going back to Michael Jensen, who proclaimed private equity as the answer to the corporate world's problems, they seem to have failed to recognise that pension funds have an other people's money problem.

20:26As far as I know, regulators have yet to understand that. One potential solution is to shine a light on what's going on. So one of the problems with private equity is it is so private. In less polite terms, it's extremely secret. If your own incentives, financial incentives aren't linked to it, it's just a question of you want to be doing what everyone else is doing. It's the herd instinct. But there is another aspect which people have looked at, and I'd be interested in your thoughts on this, which is private equity has a very odd thing, which is it looks from the returns published by these private equity funds as they go through their existence.

21:03that everything is not very volatile at all, even though they're largely investing in medium-sized companies and gearing them up. So you would imagine that their prices would be zipping up and down or values would be zipping up and down. They never go anywhere. And this suppression of volatility, which must to some extent be artificial, is basically fantastic for pension funds because it means they don't have a sudden panic where their values all drop in one year, they've got something which they can just rely on. What you're describing is sometimes referred to as volatility washing, putting your money into an unquoted fund, which is not very seriously marked to market is a way of reducing volatility, which is a good thing.

21:46It's also worth remembering where the volatility comes from. Private equity is simply equity plus leverage. The key point is the leverage. If you're a pension fund, my understanding would be that in most jurisdictions, pension funds face quite tight limits on the amount of leverage they can use directly. The easiest way to increase your risk is to take on some leverage. If I'm a pension fund, I normally face quite tight limits on being able to do that directly. I know my friend Henry Kravis offers me a way to get leveraged exposure to equity, but in an indirect way, which basically means I'm doing an end run around the regulations.

22:25And by the way, that is also what causes the volatility, which then gets washed because the funds are not really marked to market. Yeah, it's a variant on what caused the bond crisis in the UK under Liz Truss. All the pension funds were desperately trying to juice the returns they were getting from gilts. And of course, they only learned later that the risk was far greater than they thought. You talked about your comparison between stock market returns and private equity firms. You obviously said on a net basis. And one of the reasons why they are no better is that fees for private equity transactions remain very high.

23:09You still have the world in which people talk about the 2 % and 20%, the 2 % management fee and the 20 % carry or profit share. Economic theory would suggest in a world where this industry has gone from peanuts in the 1970s to being 7 trillion and 30 % of the US economy, that those fees would have been commoditized and fallen. But why hasn't that happened? I suspect they have been being eroded, but they are still very high. As of 10 years ago, one of the largest private equity investors, which is a Californian pension fund, stated in public that they estimated the average annual all-in cost, including everything, was about 7 % per annum.

23:52Bloody hell! 7%. So do you think that the promoters of these funds have got the client's interests at heart? No less than anyone else in financial markets. I think that's a no. 7 % seems rather a large slice of the pudding, I have to say. That's in 10 years you've got the lot. Let's suppose for the sake of argument that the net returns are now not very far from the stock market. If the fees are still very high, so even if the fees of all-in fees have fallen to 5 % from 10%, what that means is the gross returns are still very high. So what's wrong with that picture? So what's wrong with that picture is private equity are not as good as they say they are and not as good as they think they are.

24:38So private equity has a great weakness for numbers which are mathematically accurate, but economically very misleading. So if you talk to people in private equity, they will often start producing lots of numbers and charts that illustrate something that they call the value creation bridge. And what they do with the valuation bridge is they show here's where our returns come from. And what this shows is that 90 % of our returns come from running companies better. And they produce lots of numbers and charts that show because it's a valuation bridge and the numbers add up. And it seems to show that 90 % of the returns come from running companies better.

25:16It took me 10 or 15 years to finally sit down and take a look at this model correctly. And sure enough, it turns out if you think about it in a more sensible way, the value creation bridge is mathematically correct, like the internal rate of return. Economically, it's grossly misleading. What it does is it systematically understates the impact of leverage and it overstates the impact of the private equity firm. It's a variation on where are the customers' yachts, I think. Well, there's probably a calculation for that. They probably exist in some spreadsheet somewhere. But we've already heard that they are robbing from their widows and orphans of the pension funds.

25:56Disgraceful. But one of the critiques of private equity is that it's actually harmful to businesses to be run at a relatively high level of leverage, because obviously leverage levels have moved around over time and depend on interest rates and all the rest of it. Is there evidence that it is actually harmful in terms of the industrial or economic sort of sinews of the nation? So that's a complicated question. And I'm afraid the answer is yes and no. So I do think they perform a useful function within reason and if they're structured correctly. When it comes to debt, I have strong feelings. So there is absolutely no reason for private equity firms to use high levels of debt except to juice their returns.

26:40So Jonathan, you and I have talked before about this notion of the quote unquote discipline of debt. The official private equity doctrine says debt is not a bad thing. It's a good thing because it helps us run companies in a more disciplined way. I'm afraid that's just simply rubbish. Private equity firms already have a very strong incentive to run firms in a very efficient way. It's called two and 20. But Neil's point, I suppose, was about trust, was the people who bought and leveraged their holdings of guilt, notionally a very stable security, basically didn't perceive the risk that would happen if their calculations suddenly were upturned by some exogenous event.

27:21Surely, if you run businesses with a high level of leverage, all you're doing is exposing them more to the kind of downturns that are an inevitable part of the cycle, and mean that more of those businesses will basically be unable to invest in their future growth because something will go wrong, something unexpected happens, and they just don't have the resilience to ride it out. Correct. But you're assuming that when that happens, the business just disappears and you lose all your money. There is a quaint belief in some quarters that if you put too much debt on a company and then it goes bust, the lenders have priority and they take the company and you lose all your money.

28:04That's not the way it works in bankruptcy nowadays. This brings us on to limited liability. So limited liability has been around for whatever it is, nearly 170 years, longer even than us. What it does is it gives the people who own companies a free option, meaning if the company goes bust, they can walk away. What that does is it basically creates an incentive to use as much risk as possible, because if things go wrong, it's the taxpayer's problem. If things go well, you make out like a bandit. What's going on here is, I think there is some unconscious level, there's a calculation that says we should maximize the leverage, because although it will cause some damage at the margin at some of the companies that we own, and at certain points, all the same, we are smart enough, and it actually creates additional opportunities for us to sweep up the wreckage from other companies.

28:55But in the end, across the cycle, we do okay. And the fact that private equity is still here after 40 years, having gone through some very bad down cycles, suggests that over leveraging companies, yeah, it causes some problems for individual companies at particular points in time, doesn't seem to have damaged the private equity industry too much. If you're using mostly other people's capital, and you have a tax break because the interest is offsetable against your tax bill, that gives you a pretty good competitive advantage, I'd say. Why aren't we all in this business? Because it's such a wonderful license to print money, and so much easier than actually trying to make money from the stock exchange, or even worse, trying to run a business in conventional terms.

29:42I think we've described an industry that has evolved, and as you say, kind of flourished with periodic downturns. It's changed its spots over time. It's gone into different areas. Where do you think we are now? Do you see this continuing to just expand gently over time? How big can it get? So there must be a limit to how big it can get simply because of the size of overall capital markets. My long-term view would be over time, what will go on happening is what's happening at the moment, which is public and private markets are converging. So it used to be that private equity consisted only of these 10-year limited partnership funds.

30:21Over time, that has gradually evolved to the point where private equity firms now make investments in quoted companies. There are these things called continuation funds, where they take companies out of the 10-year funds and go on owning them forever. We've got things called evergreen funds now, which go on forever. So I think over time, the public and private markets are going to converge. One of the interesting things will be whether the fees converge. So I think there has been downward pressure on private equity fees. I suspect that will probably continue over time. There's no reason for it to shrink unless the investors change their behaviour.

30:58I was going to say, what about the decline of the defined benefit pension scheme, which seems to me to be the loyal foot soldier in this whole operation? What happens when they go away? I mean, the main defined benefit pension plans we're talking about are US public plans. And as far as I'm aware, there's no sign of them going away. But the key thing that's going on at the moment at a very rapid pace is sometimes called in equally ugly terms, the democratization of private equity. And I've also recently seen it called the retailization of private equity. So that's an unfortunate word. Basically, private equity is desperate to be able to raise money from individual investors, which until now it's been forbidden from doing.

31:40So it's been limited to sophisticated investors. That will be a big source of new money for them. People will continue to tell their readers or viewers or whatever not to go near it, and people will continue to fall for it, I'm afraid. And that is just the way life is. I don't know. I'm more hopeful than actually it will. Hopeful meaning you think it will decline. I'm with the second version of Michael Jensen, the man who said everyone should be paid an enormous salary to incentivize them. These guys from private equity latched onto that. It seems to me that there is at least a vague recognition in the listed sector, although it's a bit weak, that sometimes these incentives are not delivering quite what was expected.

32:23I think it would be great if basically this model was, the fees came right down. But Neil has now infected me with his cosmic gloom. So I imagine nothing will change. I think one optimist out of three is probably a decent ratio. I know. No plus. No plus. That was Long Time in Finance with Jonathan Ford and Neil Collins. Production and editing by Nick Hilton. please rate and review it on your podcast app.