292

A BRIEF HISTORY OF PRIVATE EQUITY¹

John Gilligan

Introduction

This chapter looks at some of the ups and downs of the private equity (PE) industry since the late 1980s. It examines the industry from a practitioner’s perspective. Prior to the foundation of CMBOR no comprehensive deal-level databases existed. Today there are competing commercial databases at the transaction, fund, and fund manager levels. This emergence of greater data availability, and the limitations of some of those data sources, explains why the timeline of academic research does not always align with the timeline of an industry practitioner. Those who work within the industry often undertake analysis that is unpublished but significantly pre-dates the peer-reviewed academic equivalents. The author of this chapter, for example, was diligently working through the investment cash flows of all of 3i’s portfolio by vintage in 1989, as no doubt many others were elsewhere, long before the data that enabled similar academic work to be undertaken.

While there have always been equity investments made outside the public markets (see Toms, Chapter 3 this volume), PE as we understand the term today, emerged in the 1980s from, broadly, two pre-existing pools of funds: venture capital and development capital. Venture capital provides equity capital to early and emerging businesses. Development capital provides equity capital to expand existing businesses. The term private equity was adopted from the late 1980s. Before then it was more common to hear institutions refer to themselves as venture capitalists in the UK and leveraged buyout firms in the US.

1960s and 1970s asset stripping

In the late 1960s and 1970s corporate raiders sought out companies with undervalued assets (Toms et al., 2016). They scoured the markets for businesses that had saleable assets that were greater in value than it would cost to buy the company. They then bought the businesses, often using debt secured on the assets of the target company. Prior to the transaction the banks would have no security, but immediately on gaining control, the purchaser would give the banks security for the acquisition finance. Having bought the company, they would then close all or part of the business down and sell the assets and any viable businesses at a profit. They repaid the debt and kept the excess. This generated very high returns on equity but also left the unsecured creditors and employees to suffer losses.

301970s ban on financial assistance

In the 1970s in most developed countries it became illegal to use the assets of a target company to offer security to a lender to a bidder for that company. Under the new laws a bidding company could not promise to give security on assets that it did not own; neither could a target company give any other financial assistance to help in the purchase of its own shares. This was specifically designed to stop the asset stripping that had been seen in the late 1960s and 1970s. The idea was to deter corporate raiders by dramatically reducing the availability of debt. You could still buy undervalued companies, but you had to use equity to do so. The financial assistance prohibition effectively made it a criminal offence to asset strip companies in most countries.

1980s relaxing regulation to facilitate the rescue of companies

An unintended consequence of the legislation was that it prevented the rescue of viable companies. In the recession of the 1970s and early 1980s many struggling conglomerates had viable subsidiaries that could be rescued as standalone businesses. However, these subsidiaries could not provide security to a purchaser’s bank, even if that bank was happy to lend money to help acquire and rescue a business.

To reverse this unintended prohibition, and to encourage the rescue of viable businesses, a change was made to the law in a number of countries. These changes allowed companies to give financial assistance under certain tightly controlled circumstances. In the UK it was provided in the Companies Act 1981.

The new law on financial assistance broadly required the directors to make a statutory declaration that, as far as they knew at the completion date of the transaction, the company would be solvent for the next 12 months. If they made the declaration knowing it to be untrue, it was a criminal offence.

This created a procedure whereby the company’s auditors reviewed the business plan and signed a report confirming broadly that, as far as they could tell at that time, it was reasonable for a director to say that the company looked as if it would be solvent for at least a year.

1980s first buyout boom

This legal change allowed leverage, or gearing, back into the buyout market. Following the change on financial assistance in most jurisdictions, the number of buyouts grew rapidly. Initially growth was seen in the US whereas in Europe the market was overwhelmingly dominated by the UK. By the mid-1980s, 3i, which at that time was jointly owned by the Bank of England and the major clearing banks, had an overwhelmingly strong position in the UK (Toms et al., 2016). Other early UK participants were subsidiaries of banks that had historically focused on development capital and other financial investors with a background in venture capital. These were the so-called “captive” investors.

“Hands-off, eyes-on”

Virtually all early UK funds were generalist investors who had skills in financial engineering and transactions but had little hands-on management input. Investors monitored their investments, but the underlying philosophy was to passively back management to manage. At this stage of the industry it was quite rare for funds to have a formal board position in investee companies. It was more common to have observer rights rather than a formal board seat.

31Sources of deals

In the early incarnation of the PE market it was usually the management who sought to “do a buyout.” Buyouts were pretty much synonymous with MBOs, where a management team sought support to negotiate to acquire the business they ran. Deals came from three major sources: subsidiaries of larger companies, succession in family companies, and insolvency. There were very few public-to-private transactions (“P2P”s) in Europe in the first wave of buyouts.

In contrast the US saw more P2P activity, especially in larger businesses. This reflected both the amount of available funds in the US vs the rest of the world, and the technical requirements of the London Stock Exchange compared to the New York Stock Exchange. There was more money and it was easier to do P2Ps in the US.

Mid-1980s: new entrants

The returns earned by the early buyout investors, although somewhat opaque, were generally perceived to be very good. For example, a series of studies of 3i’s portfolio found that buyouts completed in 1986 had generated a gross IRR of 33.1% by 1992, compared to an overall portfolio IRR over the same period of 19.3%. This led to a growth in the funds committed by existing investors and to the emergence of new funds raised by groups of investors who wished to enter the market. In the UK many of these funds’ founder managers were from the relatively small pool of experienced investors; often they were ex-3i executives or accountants. In the US they tended to be from consultancy and investment banking backgrounds.

Taxation and limited liability partnerships

One of the practical issues in raising non-captive PE funds was to find a way to avoid double taxation that didn’t create other complex liabilities. Tax is paid by people, companies, and other organizations that have a “tax identity.” That is to say they are a discrete taxable thing. If the new funds were established as limited companies, they would have been taxable and then the shareholders would have been taxed again on their distributions.

However, many investors in the funds were exempt from paying some taxes, particularly capital gains tax. Therefore, the industry needed to find a structure that would protect the tax exemption of its investors. If it could not, the returns would be materially lower than directly investing elsewhere.

A solution in the UK was to use an old structure that had been developed to allow temporary partnerships with a limited lifetime, imaginatively known as the “limited life partnership.” A limited life partnership is a temporary arrangement and the partners are taxed individually, not collectively. Because of this it is described as being transparent for tax purposes. The tax authorities look straight through the partnership and tax each partner depending on their individual circumstances. One problem that arose with the structure was the fact that the managers and founders of the PE business could be deemed to be earning income, not capital gains. In the 1980s income tax and capital gains tax were taxed at the same rate. There were, however, allowances, called taper reliefs, that both protected individuals from being taxed for inflationary increases in value and also encouraged people to invest in building businesses. To protect those reliefs in both the UK and US it was formally agreed by the tax authorities that carried interest, the share in capital gains that goes to the fund manager, would be taxed as capital gain not income. This later became, and remains, controversial.

32In the US and elsewhere similar structural solutions were designed to facilitate creating tax transparent investment vehicles with a limited life. The availability of these structures was a key enabling factor (or impediment in the case of, for example, Australia) in the growth of independent PE funds.

1989: mega deals V1.0

In the US two factors enabled the market to expand rapidly: first, a market for subprime “junk” bonds was created. This enabled investors to issue high yield debt in the public market to fund acquisitions. Second, the early funds generated returns that were widely held to be outperforming the market. This led to ever larger equity funds being raised, capable of doing ever larger deals. The peak of the market was the iconic buyout of RJR Nabisco in 1988 for approximately $23bn.

Due to the relatively smaller size of the European funds, the capacity of the European buyout market was limited and in consequence many transactions were syndicated between equity investors. To put the scale of the industry into context, a large European buyout during this period was generally defined as one in excess of £10m; in the current market it might be defined as perhaps £0.5bn−£1bn or thereabouts. At the end of the 1980s, the largest deal in Europe was the 1989 Isosceles buyout of Gateway Supermarkets for £2.2bn.

Captives versus independents

By the end of the first wave of buyouts in the 1980s, the industry was characterized by a split between so-called “captive funds” that were owned by a large corporate parent and the independent firms that had taken the partnership form that we see as the commonest structure today, plus, in Europe, 3i.

Yield versus capital gain

Captive funds and 3i tended to be longer-term holders of an investment (compared to current structures) without any explicit exit policy. To compensate for this flexibility, they required a higher yield from their investments than the funds with an explicit exit horizon. Independent firms were generally structured as 10-year funds (as we see today) and therefore were more focused on generating capital gains with a defined exit policy and had lower yield requirements. There was therefore something of a trade-off of yield versus exit flexibility. Long-term investors charged higher interest rates on loans and had a need for an ongoing dividend yield. Those focused on exit would forgo the yield in the short term but have either penal rates to encourage sale after five to seven years, or an explicit agreement to pursue a sale before a given date.

Short-term or long-term investors?

Critics say that PE is short term, because closed-end funds have an explicit exit horizon of somewhere between three and seven years. Advocates say that PE investing is long term because the funds are usually at least 10-year commitments and have an option to extend for two more years in most cases. In a sense both are correct. To each individual company, 33PE can be (but doesn’t have to be) a short-term transition from one ownership to another (evidence on the longevity of PE-backed buyout transactions is presented by Jelic et al. in Chapter 27 this volume). Conversely to the fund managers and investors it is a very long-term commitment to the broad portfolio of illiquid investments.

As long as IRR is used as a measure of investment performance, the pressure to act quickly is intense. IRRs are very sensitive to time, especially when the returns are high.

1990s blow up and buyouts of captive funds

Following the impact of the recession of the early 1990s and high interest rates, many leveraged investments struggled or failed. Appetite to support in-house captive PE declined. This led many of the captive funds to be bought out from their parent companies by their partners. The symbolic importance of PE funds “doing their own buyouts” was a very common refrain heard during this period. In this limited sense the partners of many PE fund managers have taken the risks and earned the rewards of a manager in a buyout.

Virtually all these firms rebranded themselves as PE or buyout firms and abandoned any pretension to venture capital activities (Table 2.1).

Table 2.1      Selected UK PE firms and their predecessors

34It is important to understand that the buyouts of PE funds were buyouts of the fund management companies, not purchases of the portfolios of investments. In a typical transaction the parent would retain ownership of the existing portfolio and grant a management contract to the fund managers. The manager would then raise a new fund, often with the assistance of their former parent as a cornerstone investor, creating so-called semi-captives.

Double taxation, interest deductibility, and “loop holes”

There has been a long-running discussion about taxation and interest. It is argued that because interest costs are deductible against corporation tax, then debt is subsidized when compared to equity. The argument then goes on to state that this subsidy can account for the observed performance of highly leveraged firms. The argument is flawed in a number of serious ways.

First, not all interest is deductible in companies’ tax accounts. If loans are from connected parties (broadly shareholders) and are not on commercial terms, the interest is simply not deductible. This has been the case since the early 1990s and specifically targeted shareholder loans in PE.

Second, interest deductibility is not a subsidy any more than deducting the costs of stamps or chairs or telephones against tax is a subsidy. Taxation is levied on a company’s profits. For a trading company interest is a cost. For a bank it is a revenue. Bank’s profits are taxed and these include interest receivable from trading companies. Therefore, banks price the taxation of interest into the price of debt. Interest rates reflect the after tax returns required by banks. So, just as the Royal Mail, IKEA, or British Telecom are taxed on the profits of stamps, chairs, and phones, so banks are taxed on the profits from interest. There is absolutely no difference. If the costs of debt were not allowable, double taxation would result: taxing once in the profits of the borrowing company (by increasing its taxable profit by adding back interest) and then again in the profits of the lending company that receives the interest.

Avoiding double taxation is one of the key drivers of the complex structures that are seen in PE funds and individual deals. Of course there is no sharp distinction between legally minimizing double taxation and legally minimizing taxation generally. But it is important to understand that taxation is far from simple and straightforward, not because of incompetence or conspiracy on anyone’s part, but because it necessarily has to be complex to avoid creating loopholes and inequitable double taxation. Tax laws have consistently moved against PE funds since the late 1990s, becoming progressively tighter, not, as the public discourse might lead one to believe, becoming weaker.

Early secondary transactions

The existing portfolio of these businesses was often sold in a separate transaction to a new type of PE investor: a secondary fund. These secondaries involving an entire fund are not to be confused with secondary buyouts involving a particular portfolio company. The early secondary deals often involved selling underperforming assets at a discount. In some cases particular circumstances created large secondary transactions. When RBS successfully bid for Nat West Bank in 2000, the PE management division of Nat West was sold to its management, becoming Bridgepoint, and its portfolio was separately sold to Coller Capital Partners, an independent fund manager with an early focus on these secondary deals.

35In recent years, secondary transactions have grown in importance and frequency and they are reshaping the way that the PE market operates.

Hands-on investors and sector specialization

Back in the mainstream deal market, competition for transactions increased and the need to generate value in individual investments increased. This led to a variety of strategies aimed at increasing the success rate and the value of each success to funds. Investors generally became much more active in the management of each individual investment. Many investors began to focus on specific industries and sectors to gain an advantage over the generalist investors. Today most firms have a sector bias and an active investment style.

Deal initiation, proprietary deal flow, and the death of the MBO

As the market became more competitive, funds became increasingly proactive in initiating transactions rather than passively responding to management teams and their advisers. It became common for PE funds (and advisers) to actively seek out management teams where there was a perception that a buyout could occur. The holy grail of PE deal flow became so-called proprietary deal flow: potential transactions the fund owned in some sense and was therefore able to negotiate free from the threat of competition.

This ultimately led to a sharp fall in the number of pure management led MBOs. They were replaced by either institutionally led deals (IBOs) or transactions led by external management (MBIs) or some blend of the two.

Globalization and the growth of global mega-funds

In the late 1990s and after the turn of the century the market began to bifurcate: the largest PE funds became increasingly international in their outlook, while in the mid-market the businesses became more focused on specific sectors or types of business. The trend in globalization led to a huge growth in the number of non-UK investors based in London seeking UK and European transactions.

The largest PE funds, particularly but not exclusively in the US, increasingly diversified away from pure PE. Many opened debt funds, infrastructure funds, and a wide array of other alternative asset funds. They effectively morphed from pure PE into multi-asset managers.

2005–2007: boom

The prolonged period of economic growth with low inflation from the mid-1990s to the 2008 financial crisis was characterized by: ever larger funds, larger deals, greater complexity in structures, greater leverage, and an explosion in the size of PE as a global industry. It was still a poorly understood, little reported industry and operated from a number of unregulated jurisdictions, often for entirely innocuous reasons to do with the availability of easy to use legal structures and confidentiality concerns about the identity of the investors in the fund. As PE funds competed for investment mandates, making public who the investors in a fund were was inviting competitors to approach funders when that commitment was expiring.

The debt markets also metamorphosed, and banks that had previously held loans on their own balance sheets, sold them into the wholesale market. They ceased to earn the majority 36of their income from net interest payments and became fee-earning businesses that parceled up loans to be sold on to other financial institutions.

Innovation in the debt markets led to the emergence of markets in new forms of derivatives. Most of these instruments were designed to allow risk to be traded. This has always been one of the functions of derivatives, but when they were stripped from their underlying loans, they became tradable assets creating some perverse, unintended incentives.

New businesses emerged that mimicked the use of leverage seen in PE financial structures in individual investments but without certain controls that operate in the traditional fund structures: they created leveraged funds to make leveraged investments, doubling up the risks and apparent rewards. This was at the heart of the so-called Icelandic model that was most widely associated with the highly acquisitive Baugur group.

2007–2008: bust

By 2007 the wholesale debt markets were opaque and poorly understood by most. There was an implicit assumption that there was an available appetite for debt in the global market that was effectively infinite or unlimited. This allowed banking institutions to fund themselves using facilities that were renewed continuously in the highly liquid debt markets. When the default rates on US mortgages turned out to be higher than expected, it was unclear who was holding the associated risk. In the absence of any clear information about who was going to be making losses, banks and institutions started to hold on to all the cash that was available to them and reduced or stopped lending to the wholesale markets. This meant that wholesale credit dried up and banks reliant on renewing facilities were unable to refinance and became insolvent. Initially smaller banks struggled and failed, but as the scale of the confusion spread, the world’s largest institutions turned to governments to provide capital and guarantees. In the case of Lehman Brothers, the US government declined to rescue them and the investment bank failed.

The impact on the PE market was abrupt and precipitous. Banks needed to hold cash rather than to generate lending. Deal volumes, which are reliant on leverage, collapsed. The largest deals were the worst affected.

Those who had used debt within their fund structures rapidly faced insolvency as there was a mismatch between the dates they were expecting to realize their investments and the date that their borrowings were repayable.

LP and GP unfunded commitments

If an individual investor in a PE fund cannot fund its commitments to the fund, it faces very harsh penalties. There is therefore a very strong incentive to ensure that commitments are funded. When institutions started to fail, some of their commitments to PE funds were exposed to the risk of being unfunded. HBOS was, for example, a major investor in the UK mid-market PE funds. To avoid crystalizing losses on these exposures there was a flurry of secondary transactions including unfunded commitments. This gave a significant boost to the secondary market for PE funds.

In the case of Candover, one of the largest UK PE funds, it had a particular structure that caused the fund to cease to make new investments. Other funds who had partners that could not fund their commitments had to renegotiate or scale back their funds.

The restructuring of the industry was significant but largely unreported at the time. Importantly it had limited impact on the prospects of the underlying businesses that were in PE portfolios.

372009–2012: hangover

The aftermath of the financial crisis showed both the strengths and weaknesses in the PE model. On the positive side of the balance, the traditional “10+2” (10-year fund with a possible 2-year extension) fund generally did not have any debt and therefore could not become insolvent and did not fail; it was bankrupt remote. Neither could it spread risk through financial markets because the whole risk fell on its partners. This is an important and little publicized fact: PE fund structures in a limited way stopped the creation of systemic risk (Gilligan & Wright, 2014).

However, perverse situations arose between fund managers and their partners. Many funds had raised billions of dollars prior to the crash on the assumption that leverage would be available to support deals. They found themselves charging fees on capital that would be unlikely to be deployed. Investors were understandably unhappy.

The period of extremely low interest rates that followed the crisis prevented the feared collapse of many companies with high levels of borrowings, including buyouts and other PE investments. Had the recession been accompanied by high interest rates, the failure rate would certainly have been materially higher, in all types of business.

2012–2016: recovery

The PE industry adjusts slowly to any crisis. Some funds went into terminal decline, unable to raise new funds and managing out their portfolios motivated by a mix of maintaining fee income and hoping for carried interest to move into positive territories. Others who fared better sought to take advantage of downward pressure on asset prices to buy at the bottom of the cycle, hoping to profit on the upturn.

New organizational models with operating partners and in-house consultancies emerged that embedded active management methodologies into a fund’s organization, moving ever further away from the old model of passively backing incumbent management to buy the businesses they run.

Today

As we write a 30th anniversary book of CMBOR, the industry continues to mature, morph, and consolidate. Global PE firms have been created based in both the US and Europe. These started in large buyouts, but global mid-market firms are emerging, in this case mainly led by the US.

If a Martian were to land in the financial markets today, many firms that we know as PE investors would look more like diversified fund managers with a taste for long-term illiquid assets, but with a range of other asset classes in the mix. The simple alignment model of backing managers to buy their companies and paying the deal leaders on success has largely disappeared in these emerging financial behemoths. Multiple fees have replaced carried interest as the primary source of the incentives in some large PE firms.

Returns and the level of analysis

Returns can be calculated at the level of the individual firm invested in, at the fund level, or at the level of the investors and fund managers.

At the firm level, the evidence is extensive and well researched (Kaplan & Schaor, 2005; Wright et al., 2009; Wilson et al., 2012; Harris et al., 2014). There is a wider array of 38outcomes than in the broad population of companies. PE investment increases the variance of returns, which is unsurprising as gearing or leverage is so-called because it amplifies returns. In addition to increasing the variance, there is also incomplete but strong evidence that PE investment increases the average return. The evidence on risks is not globally available, but in the massive piece of research on the question in the UK undertaken at CMBOR, there was no evidence that failure rates were systematically higher in PE-backed companies (see Wilson, Chapter 28 this volume). So, at the company level, the tentative conclusion is higher returns, more variation in returns, but not higher failures.

At the fund level returns are usually measured as IRRs and multiples of funds invested. This makes perfect sense for a fund that draws down as it needs to and repays when it can. If you calculate fund IRRs and values per dollar invested, you generally find that PE funds perform favorably when compared with public markets (and most other similar measures).

At the investor level there is, however, an issue (Long, 2008). PE funds require their investors to be ready at short notice to provide large amounts of cash. Therefore, if you invest in a PE fund you need to manage your treasury function in a way that ensures you can pay your share when needed (Meads, 2016). PE funds therefore benefit from not having to manage the treasury function themselves. If they drew down all the cash committed by investors and put it in their own treasury function, the IRR received by the investors would be much lower, reflecting the early cash investment and the lower return earned before the funds are invested. In effect, PE funds receive guarantees of funding that not only do they not pay for, but for which they charge fees to the guarantors over the life of the guarantee.

To address this anomaly, a number of methods of varying complexity have been developed to make PE fund performance comparable with other fund types. These adjustments work on a variation of the idea that when assessing a PE fund’s contribution to a broader portfolio, a fund manager needs to include the opportunity cost of the capital that is set aside to fund capital draw downs. Once these calculations are made, the clear outperformance of funds disappears. What this suggests is that while PE funds do create significant value, much of that value is appropriated by the fund managers once the whole commitment is considered.

This recognition has led to pressure on fees and carried interest and led to the re-emergence of co-investment.

Co-investment

Co-investment has increased in recent years and is when a fund investor (an LP) invests further monies in a transaction alongside the PE fund on the same terms as the fund. The advantage to the co-investor is that they don’t pay fees or carried interest on the portion directly invested outside the fund. This is presented in many different ways in the industry, but the economics are very clear. Co-investing reduces the cost of investing in PE funds. At the extreme, the investors could shrink fund sizes and increase co-investment sizes such that the industry reverts to LPs having on-balance sheet direct investing facilitated by small fund managers rewarded by performance. Alternatively, the so-called Canadian model may prevail. A number of Canadian pension funds have started to direct invest rather than investing in funds.

Conclusions

First we had small groups of people doing deals on behalf of their parent companies paid by bonuses based on capital gains. These grew too big for their parents who sold them off 39to buyouts. Freed of their parent company’s capital constraints, the PE industry grew rapidly propelled by the rumors and glimpses of returns that seemed to outperform other fund types systematically. As more data and research was completed, the question became much more nuanced and larger investors started to assert themselves. PE being full of imaginative people has ridden these waves and metamorphosed from a small niche activity to a vast global industry supporting many thousands both within the industry and within the many thousands of businesses that it invests in.

There are always new structures emerging to tweak the PE model. However, as long as PE funds remain long term, ungeared, active investors in unquoted companies, the industry is performing a valuable service to the economy that no other sector has been capable of doing. Whether the rewards of that service are equitably shared, is an open question.

Note

  1    This chapter was adapted by the author with additional material from J Gilligan and M Wright. Private equity demystified. ICAEW 2014.

References

Gilligan, J., & Wright, M. 2014. Private equity demystified. 3rd edition. London: ICAEW.

Harris, R. S., Jenkinson, T., & Kaplan, S. 2014. Private equity performance: What do we know? The Journal of Finance, 69: 1851–1882.

Kaplan, S. N., & Schaor, A. 2005. Private equity performance: Returns, persistence, and capital flows. The Journal of Finance, 60: 1791–1823.

Long, A. M. 2008. The common mathematical foundation of ACG’s ICM and AICM and the K&S PME. Unpublished. Available at: www.j-curve.com/research/files/ACG%20ICM%20vs%20PME%20Jan%202008.pdf.

Meads, C. M. N. 2016. Cash management strategies for private equity investors. Alternative Investment Analyst Review, 31–42.

Toms, S., Wilson, N., & Wright, M. 2016. The evolution of private equity: Corporate restructuring in the UK, c.1945–2010. Business History, 57: 736–768.

Wilson, N., Wright, M., Siegel, D., & Scholes, L. 2012. Private equity portfolio company performance during the global recession. Journal of Corporate Finance, 12: 193–205.

Wright, M., Gilligan, J., & Amess, K. 2009. The economic impact of private equity: What we know and what we would like to know. Venture Capital, 11: 1–21.