How Private Equity Was Born
Private equity, now a major presence in the US economic landscape, has been booming since the 2008 financial crisis. Its roots lie in the rise of the corporation at the turn of the century and the shareholder revolution of the 1980s.
Stephen Schwarzman, CEO of Blackstone, talks to David Rubenstein (R), co-CEO of the Carlyle Group, during an interview at an Economic Club of Washington luncheon in Washington, DC, on September 15, 2015. (Andrew Harrer / Bloomberg via Getty Images)
You’ve always got to start somewhere, so I think I’ll start as the nineteenth century was turning into the twentieth. As the scale and technical complexity of production increased, the previously existing world of businesses that were run either as sole proprietorships or small partnerships were inadequate to the task. They gave way to what would become the large, professionally managed corporation, many of which were assembled from smaller pieces by the likes of J. P. Morgan. Morgan hated competition as a destructive force, and while his preference for private monopolies controlled by the likes of him is not our social ideal, neither should we romanticize the old world of small competitive firms.
In his book on the Morgans (which I reviewed long ago, here), Vincent Carosso quotes an unnamed socialist observing on J. P.’s death: “We grieve that he could not live longer, to further organize the productive forces of the world, because he proved in practice what we hold in theory, that competition is not essential to trade and development.” Competition has never been a socialist virtue.
These new large firms were marked by what later would be called the separation of ownership from control. The official owners were outside investors, stockholders, who could sell those shares to other investors if they liked but they had little influence over corporate policy. That was set by an increasingly professionalized caste of formally trained managers. The first US business school, University of Pennsylvania’s Wharton, was founded in 1881, and over the next couple of decades others sprang to life, including Harvard’s in 1908. The professionals’ victory wasn’t complete; financial operators still played a big role in what we call today corporate governance — how firms are run and for whom.
But with the crash of 1929, the financial operators who’d manipulated and cheated their way through the Roaring Twenties were beaten back, their freedom to maneuver greatly hobbled first by shame (and a few prison sentences) and then by the regulatory reforms of the 1930s. Legal scholars and economists began reflecting on what it meant that shareholders were now mostly millions of dispersed individuals — concentrated among the affluent, of course, but incapable of communicating with each other about the companies they owned — and managers were largely free to run their firms. Sure, dissatisfied shareholders could sell their stock, but they had no leverage over their hired managerial hands.
That began to change in the 1970s, when, at the same time, institutional investors like pension funds replaced individuals as stockholders and corporate performance deteriorated with the stagflation of the 1970s. In the early post–World War II decades, profits, dividends, and share prices rose more or less reliably; that was no longer true.
The major financial markets, stocks and bonds, had one of their most miserable decades in history. And these institutional stock owners were roused to action, led by the buyout artists who would become the commanders of the shareholder revolution. Their organizing revolutionary doctrine was that getting profits up, and therefore stock prices, was the only point of business enterprise; all notions of responsibility and stakeholdership should be junked in favor of pure profit maximization.
The Shareholder Revolution
The roots of modern private equity (PE) were in the early post–World War II years, but things didn’t really get rolling for a few more decades. In the lead were the trio Jerome Kohlberg, Henry Kravis, and George Roberts (Henry’s cousin), who were working at the investment firm Bear Stearns in the mid-1960s. They started small, doing debt-financed buyouts of family-owned companies in the 1960s and 1970s. The trio founded their own eponymous firm, Kohlberg Kravis Roberts (KKR), in 1976; many others soon followed. KKR would become one of the giants of PE. Kohlberg died in 2015; Kravis and Roberts are no longer running the show but still serve as coexecutive chairs.
At first the buyout deals engineered by KKR and its early colleagues were small and financially sensible, but as the Roaring Eighties really got roaring, the deals and the loans that financed them got bigger. The archetypal deal of the decade was called a leveraged buyout, or LBO (which inspired the name for the newsletter I ran from 1986 to 2013). LBOs involved borrowing lots of money to take over companies, cutting costs sharply, and then offloading the property a few years later by going public again or selling it to someone else, like another buyout boutique or to the public by a stock offering.
The LBO movement’s principal mode of funding was junk bonds, high-interest rate debt most famously associated with the rogue brokerage Drexel Burnham Lambert, run from an X-shaped desk in Beverly Hills by Michael Milken, who later went to jail for securities fraud. Milken assembled a coterie of buyout artists armed with money he could raise in an instant from his investors’ circle and for a decade they wilded their way across the corporate landscape.
The decade saw over two thousand LBOs worth over $250 billion. Many of them were hostile takeovers, meaning unwelcome by management. It was quite an episode of intraclass warfare, as stodgy old-line CEOs were attacked by takeover artists and displaced. Along with KKR and the gang, raiders like Boone Pickens and Carl Icahn became household names, at least in households that got the Wall Street Journal home delivered.
There was a theory behind all the turmoil. Its chief proponent was Michael Jensen, a professor at the Harvard Business School, who wrote a series of papers arguing that corporate management was wasting money that should instead be going to shareholders, who in Jensen’s worldview were paramount for undisclosed reasons, on things like perks and employment.
The ideal, he argued, was a world in which “alternative managerial teams compete for the rights to manage corporate resources.” Corporations should not be stable institutions, but instead exist in a state of capitalist permanent revolution. Managers, Jensen argued, should be paid principally in stock, so they’d think and act like shareholders, instead of being paid fixed salaries. And, he further counseled, loading up firms with debt would serve as an excellent disciplinary device: having to cover the interest bill would force the closure or sale of weaker divisions and cost-cutting in the survivors.
The mania is usually said to have kicked off with the 1982 buyout of Gibson Greeting Cards, a deal led by former Treasury secretary and political reactionary William Simon. The investors kicked in about a million dollars of a total purchase price of $80 million. Less than a year and a half later, Gibson went public by floating $290 million in stock. Simon personally made $60 million. This success inspired many imitations. The mania peaked with KKR’s 1989 buyout of RJR Nabisco, universally seen as a debacle. The company was sold off piece by piece and ceased to exist a decade later; two thousand workers lost their jobs.
RJR’s fall was the emblematic end to the Roaring Eighties. Hundreds of firms found themselves unable to service their debts. Bankruptcies replaced buyouts in the headlines and Drexel got put out of business by the government. But the turmoil had a lasting effect on class relations. The challenge of servicing large debts meant firms had to hammer away at costs, and for most, their major cost is labor. Wage-cutting and mass layoffs hammered working-class living standards and self-confidence. For the dwindling number of workers with unions, concessions became the norm, and workers were often grateful to have a job at all. That deferential reflex persisted for decades and may only now be lifting.
Private Equity Goes Straight
At the top, the shareholder revolution transformed executive pay: Jensen’s dream of having CEOs paid in stock was realized, and the antagonism that characterized financial market–executive relations in the 1980s was resolved, largely on finance’s terms. PE began reviving from the early 1990s hangover, newly respectable, no longer associated with unsavory takeover artists and felonious investment bankers, and CEOs, their hearts with the stock price, often welcomed takeover offers.
PE entered another winter in the early 2000s, after the collapse of the late 1990s tech bubble, only to rise again. Deals got huge once again, and big PE firms like Blackstone, TPG, and Carlyle were all over them. An innovation in the period was PE firms going public by selling stock, notably Blackstone in early 2007. (At the time, I wrote in the Nation that the timing suggested that the great bubble of that decade was about to pop — those Blackstone guys are clever; the great financial crisis was underway just months later.) Blackstone was careful to keep all the voting rights for itself and took first cut of profits. A number of other PE firms followed; it was like free money.
The early 1990s were time of relative calm, financially. The economy was in what some on Wall Street called a “contained depression,” which they thought was a good thing since it meant the Fed would keep interest rates low and credit easy. That marked the onset of a change in the politics of money and credit. The hard money Wall Street of the late 1970s and early 1980s, when Fed chair Paul Volcker drove up interest rates towards 20 percent to break inflation, was giving way to a Wall Street that loved a generous Fed, since it raised asset values and made it easy to borrow.
By the middle of the decade, the old LBO movement was reborn as private equity. PE stumbled some during the Great Recession following the 2008 financial crisis, and then boomed, as the Fed (led by PE alum — Carlyle specifically — Jay Powell) printed money in large quantities, stumbled briefly during the COVID spill, and then soared along with everything from bitcoin to Nikes. Higher rates and tighter financial conditions have slowed it down over the last year or two, but these guys do have a habit of shrugging off adversity.
Private Equity’s World
Today, a typical private equity firm is managed by a smallish staff that uses money contributed by institutional investors like pension funds and university endowments to buy up whole companies. They’re a worldwide phenomenon, but their spiritual home is in the United States, as is the bulk of their money. Typically, they run the firms they own for a few years, cutting costs and rearranging their components, and then sell them, either to the public in a stock offering or to another private equity firm. Also typically, PE operators load the firms they own up with debt to pay themselves fees and dividends. These are not meant to be long-term relationships. The idea is to contribute as little as possible, extract as much as possible, and “exit” (the term of art) a few years later.
And those fees! The typical structure is two and twenty, short for 2 percent of assets under management plus 20 percent of the profits. Since that could never be enough, they add to the take with whatever they can extract from their portfolio companies, as they are called. Top executives’ pay is very tax-favored; attempts to remove that break have always collapsed. When Barack Obama suggested repealing it in 2010, Blackstone head Stephen Schwarzman likened the suggestion to Hitler’s invasion of Poland in 1939.
PE has become a major presence in the US economic landscape. According to the industry’s trade association, the American Investment Council, twelve million people work at thirty-two thousand PE-owned companies, about 8 percent of the total workforce.
PE’s appeal for outside investors is that the vehicles supposedly offer higher returns than the public stock markets, but the evidence for that proposition is shaky. In fact, it’s hard to argue, when taking risk into account, that the high fees produce better returns than what’s offered by a Vanguard index fund with fees close to zero.
Some of the big names in the field include Blackstone, the Carlyle Group (Washington, DC–based, unusually, and with deep associations with the federal government and the national security state in particular), TPG Inc., Silver Lake, and Bain (what made Mitt Romney rich). Let’s take a quick look at Blackstone.
Blackstone, founded in 1985 by Peter Peterson (now dead) and Stephen Schwarzman (now #34 on the Bloomberg Billionaires Index, worth, if you can call it that, $38 billion) has been the biggest player in private equity for most recent years. It sometimes loses the top spot to KKR, as it did last year, but it’s back on top now. (Along with PE, they also have real estate and hedge fund divisions.)
It has a trillion dollars under management, about a third of it in the private equity division. Just 250 people work in the PE segment, which works out to $1.2 billion of capital to allocate per employee. (KKR has about two thousand employees.) New investments over the year ending in June were about $29 billion, and proceeds from sales of companies came to $24 billion, numbers taken together that suggest a lot of turnover. For top management, the game is very lucrative; last year, Schwarzman’s pay was one and a quarter billion.
Among the two hundred companies it owns, who all together have half a million employees: Emerson Climate Technologies, Ancestry.com, Bumble, and Reese Witherspoon’s Hello Sunshine. A fuller list than appears on their web landing page would include some recognizable names, but they’re mostly not headliners. A trip through KKR’s holdings leaves a similar impression.
Over the last couple of decades, PE has left a pile of corporate corpses in its wake, with some of its highest-profile victims in retail. Many shopping mall stalwarts who’ve disappeared over the last decade or two — most notoriously, Toys”R”Us — were driven under by PE’s depredations. You could argue that the decline of brick-and-mortar retail meant these stores were doomed anyway, but it’s not clear why vulture investors should drink their last drops of blood rather than the workers. PE firms are very active in the nursing home sector, which were already dominated by thin staffing and low wages. PE means thinner and lower. Dentistry chains are another popular target; there, they’re encouraging pointless root canals to boost the cash flow.