How Have Private Markets Evolved Over the Years?

In the last two chapters, we saw how venture capital evolved. Though the alternative investment markets are now branching out to accommodate other private assets, private equity is probably the most prominent aspect of private markets worldwide. In fact, it was likely the first form of private capital ever raised in the history of private markets.

During those times, raising private capital meant helping firms in distress or initiating buyout proceedings to buy loss-making entities. So, where did it all begin? In this chapter, let us study the history of private equity and understand how different it was compared to modern-day private equity investments.

The journey of private equity is as much a story of economic evolution as it is of visionary foresight. It begins in the aftermath of World War II, a time when the United States was ripe with technological innovation and entrepreneurial spirit. People were buoyed with a renewed vigour in life and optimism was in the air.

This period marked the birth of venture capital as we know it. It began with Georges Doriot. This Harvard professor, aka the “father of venture capital”, founded the American Research and Development Corporation (ARDC) in 1946.

This is the tale of a $70,000 bet that turned into a fortune.

ARDC and Georges Doriot were not looking for companies to invest in. No, their search was more innate — they were looking for a future that was yet to be written.

Enter DEC and two engineers with a dream.

Ken Olsen and Harland Anderson were two engineers from the Massachusetts Institute of Technology. They had a dream that was as bold as it was simple: to make computers smaller, more interactive, and accessible to everyone. In the 1940s, the era of bulky mainframes and huge systems, this idea was nothing short of revolutionary!

When Doriot and ARDC came across DEC, they saw more than just a startup; they saw a glimpse of the future. With a leap of faith, ARDC invested $70,000 in DEC. This wasn’t just money; it was a ticket to a journey into the unknown. In return, ARDC got a 70% stake in DEC, which was then valued at a mere $100,000.

The years rolled by, and DEC’s vision turned into tangible, groundbreaking products. By the time DEC went public in 1968, ARDC’s initial investment had transformed into a golden egg. And when ARDC finally sold its last shares in DEC in the late 1970s, that $70,000 had ballooned to about $355 million – a return that was as staggering as it was unprecedented.

This wasn’t just a windfall; it was a signal to the world. It showed that investing in technology startups could yield returns beyond imagination. It laid the foundation for the venture capital industry.

As the success stories of early ventures like DEC became legendary, the appetite for private equity grew. The 1970s and 1980s saw the formalisation of the industry with the establishment of firms dedicated to private equity transactions, including names like KKR (Kohlberg Kravis Roberts) and Bain Capital. These firms began to specialise in a variety of investment strategies, including leveraged buyouts (LBOs), which would come to dominate the industry’s headlines.

At its core, private equity is about investing in potential. It’s about being on the lookout for companies with a spark of potential ready to ignite. Broadly, we can divide private equity into two main types — growth equity and leveraged buyouts (LBOs).

Growth Equity

Think of growth equity investors as the catalysts for mature companies on the brink of their next growth spurt. They stand in the space between venture capital and traditional buyout deals. These firms have passed the tumultuous startup phase and are now profitable entities yearning to stretch their legs further.

Growth equity investors step in not just with a wallet but with a roadmap, guiding these companies to scale up, break into new markets, or innovate with new acquisitions. Their approach is collaborative, preferring to join hands with existing owners rather than taking over, ensuring a partnership geared towards mutual growth.

Leveraged Buyouts (LBOs)

At the other end of the spectrum are LBOs, where private equity firms use leverage to acquire controlling interests in companies. They spot companies with solid foundations but perhaps outdated designs. With a combination of their own funds and borrowed capital, they acquire these companies, aiming to do more than just a lick of paint. Their goal is to remodel from the inside out, making operations sleeker and more efficient.

Moving into the 1980s, the narrative of private equity took a dramatic turn with the advent of Leveraged Buyouts.

One of the earliest examples of an LBO was the acquisition of Houdaille Industries in 1979. The deal was orchestrated by KKR and it showcased the potential of leveraging debt to acquire companies and improve their operations and profitability.

It was based on a simple premise — borrow from other sources to buy the company. Then use the company’s future revenue to repay the debt. It’s the same principle when you buy an apartment and rent it out to cover the mortgage. This model of buyout became a blueprint for a number of transactions in the following decades.

Another example was RJR Nabisco’s acquisition by KKR in 1989. At a staggering $25 billion, it was not just a financial manoeuvre but a strategic overhaul. Through comprehensive restructuring and tactical shifts, KKR managed to vastly increase RJR Nabisco’s value.

The 1990s saw a flurry of major mergers in the financial sector. Sanford Weill’s Travelers Insurance acquired companies like Smith Barney and Salomon Brothers. The ultimate goal, however, was Citicorp. Weill managed to close this $83 billion deal in 1998 after discussions with Citicorp’s CEO John Reed.

It aimed to create a financial “supermarket,” merging banking, insurance, and securities underwriting within one entity. But the merged company, with its 100 million customers in 100 countries, created a fact on the ground that was difficult for Congress to ignore.

The merger faced regulatory challenges due to Depression-era laws that separated banking and insurance. However, the sheer scale of the deal combined with the involvement of influential figures like former Treasury Secretary Robert Rubin, who joined Citigroup, spearheaded legislative change. The Glass-Steagall Act was revised to facilitate future financial mergers!

In 1979, the world of private equity was hit with a game-changer. The government altered the Employee Retirement Income Security Act (ERISA), allowing pension funds to invest in private equity.

It was a small adjustment — a slight tweak to the “prudent man rule”. It provided more flexibility for pension funds to include alternative investments in their portfolio. However, in terms of the effect, that was anything but small. It opened up the floodgates for institutional capital and increased the scope of the playing field exponentially.

Source: https://www.federalreserve.gov/pubs/staffstudies/1990-99/ss168.pdf

The influx of pension fund money into private equity transformed the landscape, enabling larger and more ambitious transactions. It also marked the beginning of private equity’s integration into the broader financial ecosystem, as institutional investors became key players in funding private equity ventures.

As the new millennium unfolded, private equity ventured into uncharted territories, eyeing the vibrant potential of emerging markets. This wasn’t just about spreading the map wider; it was about tapping into the dynamic growth and modernisation pulsing through these regions.

With hefty war chests, private equity firms sought out the promise of Asia, Latin America, Africa, and Eastern Europe. The allure of emerging markets lay in their high-growth economies, burgeoning middle classes, and often undercapitalised companies hungry for investment. Countries in Asia, Latin America, Africa, and Eastern Europe became focal points for PE firms seeking higher returns and new growth avenues.

While the expansion into emerging markets offers substantial rewards, it also comes with its share of risks and challenges. Political instability, currency fluctuations, and regulatory changes can pose significant risks to PE investments.

Looking ahead, the role of private equity in emerging markets is poised to evolve further. As the global economy recovers from the pandemic, the focus on sustainable and socially responsible investments is expected to increase. Private equity, with its ability to drive significant economic transformations, will continue to be a key player in shaping the future of emerging markets.