|History of private equity|
and venture capital
|(origins of modern private equity)|
|(leveraged buyout boom)|
|(leveraged buyout and the venture capital bubble)|
|(dot-com bubble to the credit crunch)|
Private equity in the 2000s represents one of the major growth periods in the history of private equity and venture capital. Within the broader private equity industry, two distinct sub-industries, leveraged buyouts and venture capital expanded along parallel and interrelated tracks.
The development of the private equity and venture capital asset classes evolved, from the middle of the 20th century, through a series of boom-and-bust business cycles. As the century ended, so, too, did the dot-com bubble and the tremendous growth in venture capital that had marked the previous five years. Following the collapse of the dot-com bubble, a new "Golden Age" of private equity ensued, as leveraged buyouts reach unparalleled size and private equity firms achieved new growth levels of scale and institutionalization, an example of which is found in The Blackstone Group's 2007 IPO.
The Nasdaq crash and technology slump that started in March 2000 affected virtually the entire venture capital industry as valuations for startup technology companies collapsed. Over the next two years, many venture firms had been forced to write off large proportions of their investments and many funds were significantly "under water", leaving the values of a fund's investments below the amount of capital invested. Venture capital investors sought to reduce the size of commitments they had made to venture capital funds and, in numerous instances, investors sought to unload existing commitments for cents on the dollar in the secondary market. By mid-2003, the venture capital industry had shrunk to about half of its 2001 capacity. Two years later, the PricewaterhouseCoopers MoneyTree Survey showed that total venture capital investments held steady at 2003 levels through the second quarter of 2005.
Although the post-boom years represent just a small fraction of the peak levels of venture investment reached in 2000, they still represent an increase over the levels of investment from 1980 through 1995. As a percentage of GDP, venture investment was 0.058 percent in 1994, peaked at 1.087 percent (nearly 19 times the 1994 level) in 2000, and ranged from 0.164 to 0.182 percent in 2003 and 2004. The revival of an Internet-driven environment (thanks to deals such as eBay's purchase of Skype, the News Corporation's purchase of MySpace.com, and the very successful Google.com and Salesforce.com IPOs) have helped to revive the venture capital environment. However, as a percentage of the overall private equity market, venture capital has still not reached its mid-1990s level, let alone its peak in 2000.
Meanwhile, as the venture sector collapsed, the activity in the leveraged buyout market also declined significantly. Leveraged buyout firms had invested heavily in the telecommunications sector from 1996 to 2000 and profited from the boom which suddenly fizzled in 2001. In that year at least 27 major telecommunications companies, (i.e., with $100 million of liabilities or greater) filed for bankruptcy protection. Telecommunications, which made up a large portion of the overall high yield universe of issuers, dragged down the entire high yield market. Overall corporate default rates surged to levels unseen since the 1990 market collapse rising to 6.3 percent of high yield issuance in 2000 and 8.9 percent of issuance in 2001. Default rates on junk bonds peaked at 10.7 percent in January 2002 according to Moody's. As a result, leveraged buyout activity ground to a halt. The major collapses of former high-fliers including WorldCom, Adelphia Communications, Global Crossing and Winstar Communications were among the most notable defaults in the market. In addition to the high rate of default, many investors lamented the low recovery rates achieved through restructuring or bankruptcy.
Among the most affected by the bursting of the internet and telecom bubbles were two of the largest and most active private equity firms of the 1990s: Tom Hicks' Hicks Muse Tate & Furst and Ted Forstmann's Forstmann Little & Company. These firms were often cited as the highest profile private equity casualties, having invested heavily in technology and telecommunications companies. Hicks Muse's reputation and market position were both damaged by the loss of over $1 billion from minority investments in six telecommunications and 13 Internet companies at the peak of the 1990s stock market bubble. Similarly, Forstmann suffered major losses from investments in McLeodUSA and XO Communications. Tom Hicks resigned from Hicks Muse at the end of 2004 and Forstmann Little was unable to raise a new fund. The treasure of the State of Connecticut, sued Forstmann Little to return the state's $96 million investment to that point and to cancel the commitment it made to take its total investment to $200 million. The humbling of these private equity titans could hardly have been predicted by their investors in the 1990s and forced fund investors to conduct due diligence on fund managers more carefully and include greater controls on investments in partnership agreements.
Deals completed during this period tended to be smaller and financed less with high yield debt than in other periods. Private equity firms had to cobble together financing made up of bank loans and mezzanine debt, often with higher equity contributions than had been seen. Private equity firms benefited from the lower valuation multiples. As a result, despite the relatively limited activity, those funds that invested during the adverse market conditions delivered attractive returns to investors. Meanwhile, in Europe LBO activity began to increase as the market continued to mature. In 2001, for the first time, European buyout activity exceeded US activity with $44 billion of deals completed in Europe as compared with just $10.7 billion of deals completed in the US. This was a function of the fact that just six LBOs in excess of $500 million were completed in 2001, against 27 in 2000.
As investors sought to reduce their exposure to the private equity asset class, an area of private equity that was increasingly active in these years was the nascent secondary market for private equity interests. Secondary transaction volume increased from historical levels of two or three percent of private equity commitments to five percent of the addressable market in the early years of the new decade. Many of the largest financial institutions (e.g., Deutsche Bank, Abbey National, UBS AG) sold portfolios of direct investments and “pay-to-play” funds portfolios that were typically used as a means to gain entry to lucrative leveraged finance and mergers and acquisitions assignments but had created hundreds of millions of dollars of losses. Some of the most notable (publicly disclosed) secondary transactions, completed by financial institutions during this period, include:
As 2002 ended and 2003 began, the private equity sector, had spent the previous two and a half years reeling from major losses in telecommunications and technology companies and had been severely constrained by tight credit markets. As 2003 got underway, private equity began a five-year resurgence that would ultimately result in the completion of 13 of the 15 largest leveraged buyout transactions in history, unprecedented levels of investment activity and investor commitments and a major expansion and maturation of the leading private equity firms.
The combination of decreasing interest rates, loosening lending standards and regulatory changes for publicly traded companies would set the stage for the largest boom private equity had seen. The Sarbanes Oxley legislation, officially the Public Company Accounting Reform and Investor Protection Act, passed in 2002, in the wake of corporate scandals at Enron, WorldCom, Tyco, Adelphia, Peregrine Systems and Global Crossing, Qwest Communications International, among others, would create a new regime of rules and regulations for publicly traded corporations. In addition to the existing focus on short term earnings rather than long term value creation, many public company executives lamented the extra cost and bureaucracy associated with Sarbanes-Oxley compliance. For the first time, many large corporations saw private equity ownership as potentially more attractive than remaining public. Sarbanes-Oxley would have the opposite effect on the venture capital industry. The increased compliance costs would make it nearly impossible for venture capitalists to bring young companies to the public markets and dramatically reduced the opportunities for exits via IPO. Instead, venture capitalists have been forced increasingly to rely on sales to strategic buyers for an exit of their investment.
Interest rates, which began a major series of decreases in 2002 would reduce the cost of borrowing and increase the ability of private equity firms to finance large acquisitions. Lower interest rates would encourage investors to return to relatively dormant high-yield debt and leveraged loan markets, making debt more readily available to finance buyouts. Additionally, alternative investments also became increasingly important as investors sought yield despite increases in risk. This search for higher yielding investments would fuel larger funds and in turn larger deals, never thought possible, became reality.
Certain buyouts were completed in 2001 and early 2002, particularly in Europe where financing was more readily available. In 2001, for example, BT Group agreed to sell its international yellow pages directories business (Yell Group) to Apax Partners and Hicks, Muse, Tate & Furst for £2.14 billion (approximately $3.5 billion at the time), making it then the largest non-corporate LBO in European history. Yell later bought US directories publisher McLeodUSA for about $600 million, and floated on London's FTSE in 2003.
Marked by the two-stage buyout of Dex Media at the end of 2002 and 2003; large multibillion-dollar U.S. buyouts could once again obtain significant high-yield debt financing, and larger transactions could be completed. The Carlyle Group, Welsh, Carson, Anderson & Stowe, and other private investors, led a $7.5 billion buyout of QwestDex, marking the third largest corporate buyout since 1989. QwestDex's purchase occurred in two stages: a $2.75 billion acquisition of assets known as Dex Media East, in November 2002, and a $4.30 billion acquisition of assets known as Dex Media West, in 2003. R. H. Donnelley Corporation acquired Dex Media in 2006. Larger buyouts followed, signaling a resurgence in private equity, including Burger King by Bain Capital; Jefferson Smurfit by Madison Dearborn; Houghton Mifflin by Bain Capital, The Blackstone Group and Thomas H. Lee Partners; and TRW Automotive by Blackstone.
In 2006, USA Today reported retrospectively on the revival of private equity:
By 2004 and 2005, major buyouts were once again becoming common and market observers were stunned by the leverage levels and financing terms obtained by financial sponsors in their buyouts. Some of the notable buyouts of this period include:
As 2005 ended and 2006 began, new "largest buyout" records were set and surpassed several times with nine of the top ten buyouts at the end of 2007 having been announced in an 18-month window from the beginning of 2006 through the middle of 2007. Additionally, the buyout boom was not limited to the United States as industrialized countries in Europe and the Asia-Pacific region also saw new records set. In 2006, private equity firms bought 654 U.S. companies for $375 billion, representing 18 times the level of transactions closed in 2003. Additionally, U.S. based private equity firms raised $215.4 billion in investor commitments to 322 funds, surpassing the previous record set in 2000 by 22 percent and 33 percent higher than the 2005 fundraising total. However, venture capital funds, which were responsible for much of the fundraising volume in 2000 (the height of the dot-com bubble), raised only $25.1 billion in 2006, a two percent decline from 2005 and a significant decline from its peak. The following year, despite the onset of turmoil in the credit markets in the summer, saw yet another record year of fundraising with $302 billion of investor commitments to 415 funds.
Although there had previously been certain instances of publicly traded private equity vehicles, the convergence of private equity and the public equity markets attracted significantly greater attention when several of the largest private equity firms pursued various options through the public markets. Taking private equity firms and private equity funds public appeared an unusual move since private equity funds often buy public companies listed on exchange and then take them private. Private equity firms are rarely subject to the quarterly reporting requirements of the public markets and tout this independence to prospective sellers as a key advantage of going private. Nevertheless, there are fundamentally two separate opportunities that private equity firms pursued in the public markets. These options involved a public listing of either:
In May 2006, Kohlberg Kravis Roberts raised $5 billion in an initial public offering for a new permanent investment vehicle (KKR Private Equity Investors or KPE) listing it on the Euronext exchange in Amsterdam (ENXTAM: KPE). KKR raised more than three times what it had expected at the outset as many of the investors in KPE were hedge funds seeking exposure to private equity but could not make long-term commitments to private equity funds. Because private equity had been booming in the preceding years, the proposition of investing in a KKR fund appeared attractive to certain investors. However, KPE's first-day performance was lackluster, trading down 1.7 percent and trading volume was limited. Initially, a handful of other private equity firms and hedge funds had planned to follow KKR's lead but shelved those plans when KPE's performance continued to falter after its IPO. KPE's stock declined from an IPO price of €25 per share to €18.16, a 27 percent decline, at the end of 2007, and a low of €11.45, a 54.2 percent decline, per share in Q1 2008. KPE disclosed in May 2008 that it had completed approximately $300 million of secondary sales of selected limited partnership interests in and undrawn commitments to certain KKR-managed funds in order to generate liquidity and repay borrowings.
On March 22, 2007, The Blackstone Group filed with the SEC to raise $4 billion in an initial public offering. On June 21, Blackstone traded a 12.3 percent stake in its ownership for $4.13 billion in the largest U.S. IPO since 2002. Traded on the New York Stock Exchange under the ticker symbol BX, Blackstone priced at $31 per share on June 22, 2007.
Less than two weeks after The Blackstone Group IPO, rival firm Kohlberg Kravis Roberts filed with the SEC in July 2007 to raise $1.25 billion by selling an ownership interest in its management company. KKR had previously listed its KKR Private Equity Investors (KPE) private equity fund vehicle in 2006. The onset of the credit crunch and the shutdown of the IPO market would dampen the prospects of obtaining a valuation that would be attractive to KKR and the flotation was repeatedly postponed.
Meanwhile, other private equity investors were seeking to realize a portion of the value locked into their firms. In September 2007, the Carlyle Group sold a 7.5 percent interest in its management company to Mubadala Development Company, which is owned by the Abu Dhabi Investment Authority (ADIA) for $1.35 billion, which valued Carlyle at approximately $20 billion. Similarly, in January 2008, Silver Lake Partners sold a 9.9 percent stake in its management company to the California Public Employees' Retirement System (CalPERS) for $275 million.
Additionally, Apollo Global Management completed a private placement of shares in its management company in July 2007. By pursuing a private placement rather than a public offering, Apollo would be able to avoid much of the public scrutiny applied to Blackstone and KKR.  In April 2008, Apollo filed with the SEC to permit some holders of its privately traded stock to sell their shares on the New York Stock Exchange. In April 2004, Apollo raised $930 million for a listed business development company, Apollo Investment Corporation (NASDAQ: AINV), to invest primarily in middle-market companies in the form of mezzanine debt and senior secured loans, as well as by making direct equity investments in companies. The company also invests in the securities of public companies.
Historically, in the United States, there had been a group of publicly traded private equity firms that were registered as business development companies (BDCs) under the Investment Company Act of 1940. Typically, BDCs are structured similar to real estate investment trusts (REITs) in that the BDC structure reduces or eliminates corporate income tax. In return, REITs are required to distribute 90 percent of their income, which may be taxable to its investors. As of the end of 2007, among the largest BDCs (by market value, excluding Apollo Investment Corp, discussed earlier) are: American Capital Strategies (NASDAQ:ACAS), Allied Capital Corp (NASDAQ:ALD), Ares Capital Corporation (NASDAQ:ARCC), Gladstone Investment Corp (NASDAQ:GAIN) and Kohlberg Capital Corp (NASDAQ:KCAP).
In the wake of the collapse of the equity markets in 2000, many investors in private equity sought an early exit from their outstanding commitments. The surge in activity in the secondary market, which had previously been a relatively small niche of the private equity industry, prompted new entrants to the market, however the market was still characterized by limited liquidity and distressed prices with private equity funds trading at significant discounts to fair value.
Beginning in 2004 and extending through 2007, the secondary market transformed into a more efficient market in which assets for the first time traded at or above their estimated fair values and liquidity increased dramatically. During these years, the secondary market transitioned from a niche sub-category in which the majority of sellers were distressed to an active market with ample supply of assets and numerous market participants. By 2006 active portfolio management had become far more common in the increasingly developed secondary market and an increasing number of investors had begun to pursue secondary sales to rebalance their private equity portfolios. The continued evolution of the private equity secondary market reflected the maturation and evolution of the larger private equity industry. Among the most notable publicly disclosed secondary transactions (it is estimated that over two-thirds of secondary market activity is never disclosed publicly):
In July 2007, turmoil that had been affecting the mortgage markets, spilled over into the leveraged finance and high-yield debt markets. The markets had been highly robust during the first six months of 2007, with highly issuer friendly developments including PIK and PIK Toggle (interest is "Payable In Kind") and covenant light debt widely available to finance large leveraged buyouts. July and August saw a notable slowdown in issuance levels in the high yield and leveraged loan markets with only few issuers accessing the market. Uncertain market conditions led to a significant widening of yield spreads, which coupled with the typical summer slowdown led to many companies and investment banks to put their plans to issue debt on hold until the autumn. However, the expected rebound in the market after Labor Day 2007 did not materialize and the lack of market confidence prevented deals from pricing. By the end of September, the full extent of the credit situation became obvious as major lenders including Citigroup and UBS AG announced major writedowns due to credit losses. The leveraged finance markets came to a near standstill. As a result of the sudden change in the market, buyers would begin to withdraw from or renegotiate the deals completed at the top of the market:
The credit crunch prompted buyout firms to pursue a new group of transactions in order to deploy their massive investment funds, including Private Investment in Public Equity (PIPE) transactions, as well as purchases of debt in existing leveraged buyout transactions. Some of the most notable of these transactions completed in the depths of the credit crunch include:
Carlyle group featured prominently in Michael Moore's 2003 film Fahrenheit 9-11. The film suggested that The Carlyle Group exerted tremendous influence on U.S. government policy and contracts through their relationship with the president's father, George H. W. Bush, a former senior adviser to the Carlyle Group. Additionally, Moore cited relationships with the Bin Laden family. The movie quotes author Dan Briody claiming that the Carlyle Group "gained" from September 11 because it owned United Defense, a military contractor, although the firm's $11 billion Crusader artillery rocket system developed for the U.S. Army is one of the few weapons systems canceled by the Bush administration.
Over the next few years, attention intensified on private equity as the size of transactions and profile of the companies increased. The attention would increase significantly following a series of events involving The Blackstone Group: the firm's initial public offering and the birthday celebration of its CEO. The Wall Street Journal observing Blackstone's Steve Schwarzman's 60th birthday celebration in February 2007 described the event as follows:
The Armory's entrance hung with banners painted to replicate Mr. Schwarzman's sprawling Park Avenue apartment. A brass band and children clad in military uniforms ushered in guests. A huge portrait of Mr. Schwarzman, which usually hangs in his living room, was shipped in for the occasion. The affair was emceed by comedian Martin Short. Rod Stewart performed. Composer Marvin Hamlisch did a number from "A Chorus Line." Singer Patti LaBelle led the Abyssinian Baptist Church choir in a tune about Mr. Schwarzman. Attendees included Colin Powell and New York Mayor Michael Bloomberg. The menu included lobster, baked Alaska and a 2004 Louis Jadot Chassagne Montrachet, among other fine wines.
Schwarzman received a severe backlash from both critics of the private equity industry and fellow investors in private equity. The lavish event which reminded many of the excesses of notorious executives including Bernie Ebbers (WorldCom) and Dennis Kozlowski (Tyco International). David Rubenstein, the founder of The Carlyle Group remarked, "We have all wanted to be private – at least until now. When Steve Schwarzman's biography with all the dollar signs is posted on the web site none of us will like the furor that results – and that's even if you like Rod Stewart."
Rubenstein's fears would be confirmed when in 2007, the Service Employees International Union launched a campaign against private equity firms, specifically the largest buyout firms through public events, protests as well as leafleting and web campaigns. A number of leading private equity executives were targeted by the union members however the SEIU's campaign was not nearly as effective at slowing the buyout boom as the credit crunch of 2007 and 2008 would ultimately prove to be.
In 2008, the SEIU would shift part of its focus from attacking private equity firms directly toward the highlighting the role of sovereign wealth funds in private equity. The SEIU pushed legislation in California that would disallow investments by state agencies (particularly CalPERS and CalSTRS) in firms with ties to certain sovereign wealth funds. Additionally, the SEIU has attempted to criticize the treatment of taxation of carried interest. The SEIU, and other critics, point out that many wealthy private equity investors pay taxes at lower rates (because the majority of their income is derived from carried interest, payments received from the profits on a private equity fund's investments) than many of the rank and file employees of a private equity firm's portfolio companies. In 2009, the Canadian regulatory bodies set up rigorous regulation for dealers in exempt (non-publicly traded) securities. Exempt-market dealers sell securities that are exempt from prospectus requirements and must register with the Ontario Securities Commission.