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A Brief History of Private Equity

Private equity is, in the most simplistic terms, equity held in a private business. PE firms are run by general partners (also referred to as called sponsors), who invest money raised from investors who work together for a limited amount of time and thus are called “limited partners”.

Private equity firms are sometimes referred to as “buyout firms.”  This is so for a few reasons.  First, the term is descriptive.  Unlike venture capital firms, which do not typically buy entire companies, PE firms usually buy entire companies or, at least, controlling interests.  Second, the term is actually shorthand for “leveraged buyout firm;” most PE buyouts involve a PE firm putting up only a portion of the capital required to purchase a target, with the remainder coming in the form of a loan from a bank that is secured by the assets of the acquisition target (the company being purchased).

LBOs established themselves on Wall Street, and in the lexicon of financial terminology, in the late 1970s and 1980s when investment bankers, like notably high-profile financier Michael Milken, created them as a method of leveraging a company with debt equity and equity capital in order to buy it. Among the most notorious LBOs of that period—although not connected to Milken—was the $25 billion RJR Nabisco buyout in 1988.    In many ways, today’s PE firm is yesterday’s LBO firm. Private equity

Once purchased, the target company is usually one of many owned, or at least controlled, by the PE firm and, thus, is typically referred to as a “portfolio company” of the firm.

One point of clarification:  above, we speak of a private equity “firm.”  We were intentionally imprecise in order to more clearly present the concept we were explaining.  One must delineate between a private equity firm and a private equity fund.  The ‘sponsor’ is the PE firm and the firm is often the general partner of several (or many) individual PE funds.  A limited partner (i.e. an individual accredited investor who decides to invest money with the PE firm) does so by investing in a specific PE fund raised by the PE firm.  So, by example, a PE firm could have, say, four distinct funds of which it is the general partner and manager.  Each fund will have its own limited partners (though any particular limited partner may choose to invest in multiple funds) and its own portfolio companies.  Limited partners are not limited to individual accredited investors.  Rather, many funds count banks, insurance companies, pension funds, and other large entities among their investors.

Taking a step back, the practice of people pooling their money together to purchase controlling stakes a private company is not a new concept; although, as the Wall Street Journal points out in its excellent article on this subject, “[w]hile the private-equity firm is new, its methods—venture capital, growth capital, distressed situations, leveraged buyouts and others—are as old as capitalism itself.”  In fact, the Massachusetts Bay Company was such an early prototype of the private equity model – the pooling of money to help fund the burgeoning British North American colonies.  Settlers sent to the new American colonies helped build up the economy while those who stayed in England helped fund the venture, hoping to find a return on their investment over time.

A few hundred years later, railroads, struggling to find funding when simply turning to wealthy families stopped working, were bailed out by major banks who bought controlling interests, restructured business operations, inserted new management and helped eliminate corruption and deceit.  These are all present day components of private equity’s modus operandi.

When JP Morgan & Company bought out the floundering Carnegie Steel for $480 million, in 1901, it created what became (then) the largest company in the world – United States Steel. history of Private equity

So.  Why is private equity private?  As discussed above, it tends to invest in private companies.  But this is not the answer, since one private equity strategy involves taking publicly owned targets off the public market, or taking them “private”.  Private equity is private because it raises money in such a way (i.e. from accredited investors ) that allows it to avoid having to make any public offering.

The private equity firm of today, it is generally agreed, traces its origin back to American Research and Development Corporation, founded in 1946.  As explained in their chapter, Characteristics of the Private Equity Arena in the book Private Equity, History, Governance, and Operations (Wiley Finance, 2008), however, the industry had forerunners in the form of U.S. governmental institutions which were created to address needs brought on by the two world wars and the intervening Great Depression.

According to PEI Media, “[a]s recently as the 1970s, it was hard to count more than a few dozen private equity firms … located in the United States.  Now there are private equity firms both miniscule and enormous in all the developed countries of the world and in most of the emerging markets.”  This development, as also explained in Characteristics of the Private Equity Arena, was in part a function of:  (a) the U.S. stock market’s slump of the 1970s turning; (b) clarifications in 1978 to the 1974 enactment of ERISA, which was extremely detrimental to the industry until the clarification; and (c) subsequent reductions of the maximum capital gains tax rate.

The golden age of the LBO came in the late 1980s when players like KKR and Michael Milken engineered large leveraged buyouts.  Since then, as superior returns encouraged more investment in the asset class and as the number of funds proliferated as a natural consequence of fund managers leaving one firm to found a new one, the industry continued to grow into what it is today.  A good example of this can be seen by looking at the legendary PE firm, Golder Thoma & Co.

Established in 1980 by Stanley Golder and Carl Thoma, Golder Thoma & Co. originated the “consolidation” or “buy and build” investment strategy, which sought to combine the best of venture investing with the best of leveraged buyouts by investing in a “platform” business (an acquisition in a new area of business intended to be a ‘platform’ from which to add other business onto, to build something new) in a fragmented industry and then working with management to transform it into a larger and more profitable business through internal growth and a series of strategic, industry consolidating acquisitions.

Stanley Golder and Carl Thoma and worked together at First Chicago Corp. before founding Golder Thoma & Co.  Looking at one branch of the genealogy, Golder Thoma & Co. eventually split into Thoma Bravo and GTCR.  Looking at a different branch, John Canning took Stanley Golder’s place at First Chicago Corp. and Canning ultimately left to form Madison Dearborn.  These three firms are among the largest and most prominent PE firms currently in existence.

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About Judy Radler Cohen

Judy Radler Cohen is a financial editor and investigative reporter. Since 2007, she has worked with business publications and websites, including Global Finance magazine, eFinancialCareers.com and Wantedtech.com. Judy spent over a decade as editor of Mergers & Acquisitions Report where she managed weekly production, generated story ideas about all facets of capital markets and investigated/wrote…

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