A Brief History of Private Equity
Updated: Dec 17, 2020
By Elena Sergeeva, King's Private Equity Club
Today private equity firms are known as financial giants worth billions of dollars and making astronomical deals. However, this was not always the case. The private equity firm we know today is mostly different from how it started. This financial sector has experienced one of the most drastic shifts in both its operations, position and significance in the capital markets since the 19th century.
Early European Private Equity Developments
Although the private equity market grew significantly faster and more robust in the U.S., its roots can be traced as far back as the late 18th century Great Britain. The primary features of private equity investment could be seen in the way entrepreneurs were seeking out wealthy individuals to finance their risky projects or ventures.
Generally, private equity plays a significant role in economic development, as it provides firms with the needed financial resources to promote innovation. In fact, this is what allowed the private equity industry to develop in Europe during the 19th century. During the industrial revolution, high amounts of capital were needed for innovation, and at that time, the primary capital providers were wealthy individuals, families and even first groups of institutional investors (i.e. groups of banks). However, due to the high probability of failures of these ventures, banks decided to separate the venture capital divisions into subsidiaries and detached them from their core business activities. This is precisely the way that Société Générale was formed in 1822.
Even though the private equity business in Europe had an earlier start, a lack of uniformity in the legal and tax features, as well as the great dispersion of investment cultures and traditions across Europe, all stifled growth of this industry. Hence, the current private equity firms we know today have only emerged relatively recently in Europe compared to the United States.
Early US Private Equity Developments
The United States has had a formidable history of private equity developments during the 20th century. In the U.S., the first venture capital practices stem back to the railroad and textile mills industries. During the 19th century, railroad companies, who could no longer seek wealthy private individuals for capital, were bailed out by major banks, who then restructured their operations and changed their management systems amongst other private equity practices we know today.
The venture capital scene during the 1920s- and 1930s was characterized as in early European private equity sector, by wealthy individual investors. They would invest their capital into emerging companies, such as Xerox and Eastern Airlines. However, that era of single private investors did not last long, as banks soon joined the investment game. From there, it was the regulatory changes that played a significant role in the growth of the private equity and venture capital sectors in the U.S.
The main developments of the venture capital business were underlined by the federal government interventions in wartime periods of U.S. history. During the first World War, Congress established the War Finance Corporation (WFC), that was responsible for providing, through the means of bank loans, capital to essential war industries. Then, in 1932 the government formed the Reconstruction Finance Corporation (RFC) that would lend money to businesses in order to alleviate the crisis posed by the Great Depression. During the Second World War, the government intervened again by creating the Smaller War Plants Corporation (SWPC) and had aimed to "encourage large financial institutions to make credit available to small enterprises".
Over the following years, other government bodies were established to provide capital for businesses; however, it was during the Korean War in the 1950s that one of the major entities that propelled the private equity industry forward was created. The SBIC (Small Business Investment Company) was responsible for regulating and helping provide the needed capital for privately owned and operated venture capital firms. In fact, at the time, a study conducted by the Federal Reserve outlined that the most significant barrier for small businesses lied in the lack of credit that would allow small firms to keep up with the technological progress.
Six years later, it is the Small Business Act of 1958 that allowed the licensed venture capital firms, also known as SBICs, to borrow at below-market interest rates if the borrowed capital was used towards entrepreneurial ventures. Consequently, the venture capital industry began to grow, and new independent venture capital firms began to make their appearances in the market. Such firms were more attractive to the investors as they were independent of the government, and thus, more flexible.
First US Private Equity Firm
The two earliest known venture capital firms, the American Research & Development Corporation (ARD) and the J.H Whitney & Company were both established in 1946. ARD was founded by Georges Doriot, while he was teaching at Harvard and who is to this day considered to be the "father of venture capitalism". What made ARD famous was their investment in Digital Equipment Corporation, established by two MIT engineers working on building a minicomputer. ARD bough Digital Equipment Corporation for a mere $70, 000 and sold it for nearly $38 million, when the company went public by IPO in 1970. This represented a colossal increase in capital and established ARD as a major player in the venture capital business.
On the other hand, J.H Whitney & Company became famous for their investment in an innovative way of delivering nutrition to the U.S. Army, also known as the "Minute Maid Orange Juice" initiative. Thus, what was known before as a small industry where high net individuals provided private financing developed into an organized, separate alternative asset class, driven by individuals such as Doriot, Whitney and Rockefeller.
Late 20th Century Development in The Private Equity Industry
The 1960s in the private equity industry were characterized by bull IPO markets. The large venture firms such as ARD were now able to reap significant benefits and had lucrative exit opportunities. It is also at the same time that the Leverage Buyout industry, first introduced by Michael Porter, started to get more prominent. During this early phase of the LBO industry, such transactions were referred to as "bootstrap" transactions. In fact, this revolutionary idea was first put into practice in 1964, when Kohlberg Karkis Roberts & Co bought Orkin Exterminating Company in such a way.
Nevertheless, this boom was short-lived and was quickly followed by an industry slump in the 1970s. The following decade was one of the toughest for the private equity industry. The IPOs no longer provided the significant returns they did earlier, and in 1974 a series of regulation tightenings for pension funds stopped managers from investing capital into "high-risk" investments". Overall in 1975, the entire venture capital industry only managed to raise $10 million.
The 1980s, however, could be referred to as the first golden age of private equity. In 1978, the ERISA announced the Prudent Man Rule, which explicitly permitted investments in private equity. Coupled with two cuts on capital gains tax rate, (first from 49.5% to 28% and then to 20%), and greater availability of debt, the buyout industry experienced one of the larger growths in history. The vast investment in venture capital and buyout backed enterprises produced some the companies we know today including Fed Ex, Apple Computer and Intel. In the following years, the industry continued to experience substantial growth. During that time, the LBO model was quickly becoming a standard and preferred instrument for many venture capital firms and led to the establishment of significant players such as Bain Capital, Blackstone Group, Carlyle and ABRY Partners within the industry.
Early 21st Century Developments in The Private Equity Industry
The Private Equity scene of the 21st century can be characterized by a series of booms and busts cycles. During the mid-1990s and 2000s, the financial world experienced the Dot Com Boom. During this time, venture capital fundraising surpassed many of the other asset classes, as it provided vast amounts of capital to tech start-ups. Overall, venture capital funds increased from only $12 billion in 1995 to $111 billion in 2000. Although the buyout sector also experienced significant growth, these sectors only grew from $26 billion to $72 billion in the same time frame.
Unfortunately, history shows that after every boom comes a bust. It is in March 2000 that the dot com bubble crashed, leading the private equity and venture capital industries into a substantial downturn. While in the year 2000, a venture fund could average 200% in net annual returns, in the following year on average such funds would lose up to 40% of their capital. Thus, as fundraising decreased, the private equity industry went into a sharp decline.
Four years after the crash, interest rates were lowered and lending standards loosened, which ultimately led to a second boom in the financial industry. This time, however, it was the buyout industry that experienced the highest growth. In 2004, the buyout industry raised circa $53 billion, while the next year they managed to raise up to $130 billion. In fact, this industry boom was not solely concentrated in the United States but was a worldwide phenomenon, Europe and the Asia-Pacific regions also experienced the boom. By 2007, the credit markets were liquid and fund sizes, return, and distributions were reaching record highs. This spectacular growth continued until the 2008 financial crises, whereupon uncertainty in the markets eventually curbed investments in alternative assets and private equity and consequently led to a buyout bust.
Private Equity Firms Today
The 2010s were mainly described as a positive environment for both investment and growth. The markets were flooded with capital and secondary markets were on the rise. This surplus of money, coupled with high amounts of leverage available led to more private equity deals. In fact, such trends continue to persist in the industry today. According to data compiled by Preqin, there is currently $2.44 trillion in capital waiting to be spent on LBO and real assets. The data surrounding the value of LBO deals also supports this theory. In the first half of 2019, the aggregate value of leveraged buyout deals was estimated at $256 billion, which is one of the largest half values in history.
Another trend in the current private equity industry is the "buy-and-build" strategy, where a fund purchases an established company and then uses it to buy smaller enterprises and merges them together to increase sales and value. Moreover, more interest is being paid to the middle market, which is not surprising as it comprises of over 200 000 businesses compared to only a few thousand in the "big business".
To conclude, private equity has a long and tumultuous history. Starting out as venture capital and aided by government interventions in the United States during both World Wars, this niche investment has grown to be one of the most lucrative alternative investments, which keeps attracting many despite its risks.
"Private Equity: History, Governance, and Operations" by Cendowski, Harry et al.
"The history of private equity market. The story based on usa, great britain, germany and poland cases" by Ilona Falat – Kilijanska
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