For the past few weeks, we have been discussing Leveraged Buyouts and the types of LBO risks. Now that we have completed our discussion about that, it is time to move on to The Private Equity Market.
The next series of articles will continue the discussion of going-private transactions. We will first focus on the role of private equity firms and the role they played.
Over the past quarter of a century, private equity firms have played a huge role in the takeover market. It has been proven that these firms were able to attract large amounts of capital. Not only that, but these firms have proven to pursue takeovers in an extremely aggressive manner.
History of the Private Equity and Lbo Business
If you think about it, it wasn’t so long ago when the modern private equity business started. It is not that old, as of yet. However, we also have had highly leveraged transactions for a while now, which means using large amounts of debt to purchase businesses is not a novel concept.
In a previous article, we have discussed how Henry Ford managed to do a highly leveraged transaction to help him regain control of his company back in 1919. As you might have guessed, this was years and years before the term “leveraged buyouts” and “private equity” even became a thing in the world of finance.
It was noted that the first leveraged buyout did not take place until 1955 when McLean Industries acquired both the Pan-American Steamship Company and the Waterman Steamship Company. At the time, Malcolm McLean, who runs McLean Industries financed these acquisitions. He got the money from the proceeds of the sale of McLean Trucking, his previous trucking company.
McLean Trucking
McLean Trucking was sold because the current regulations at that time strictly prohibit a trucking company from owning a steamship company. It had to choose between his old company or owning a new one.
Not all of the funds to acquire Pan-American Steamship Company and the Waterman Steamship Company were from McLean’s own pockets, though. He also had bank debt and the issuance of preferred stock.
Amazingly enough, McLean was also able to use the cash and assets of the companies he targeted to help pay down the buyout debt. It truly was a great example.
Fast forward to the 1960s and 70s, other dealmakers studied and learned from this very example. Many started their own investment firms and then did similar types of buyouts.
This included many dealmakers with high profiles such as Victor Posner of DWG Corporation and Warren Buffet (Berkshire Hathaway) used similar leveraged financing structures. A few years later, many followed their footsteps. This includes Mesa Petroleum’s Boone Pickens and Reliance Insurance’s Saul Steinberg, to name a few.
That’s when leveraged deals started. Even bankers at Bear Stearns started to do it. Some banks like Henry Kravis and Jerome Kohlberg even left the bank to start their own firm (KKR) or the Kravis and Roberts firm.
The KKR firm formalized the model of the LBO firm. It is a business model that later became known as private equity. As expected, KKR’s success has attracted many competitors. This has led to a segment of the financial services industry that we recognize today as the private equity market.
The Private Equity Market
The mergers and acquisition boom that occurred during the year 2003-2007 has been fueled substantially by private equity firms. The subprime crisis fallout has caused a decline in the private equity market but rebounded steadily as the recovery took hold.
So what is the private equity market, exactly? It is a collection of funds that have raised capital by soliciting investments from a variety of large investors. The funds are then invested in equity positions in companies.
Now, when the said investments acquire a hundred percent of the outstanding equity of a public company. Then it is referred to as a going-private transaction. On the other hand, if or when the equity is acquired by using some of the investment capital of the private equity fund. These deals are called a leveraged buyout or an LBO. It’s also the same with borrowed funds.
These deals are very common investments for private equity funds. It is so common, in fact, that these funds are now more often referred to as LBO funds.
Not only that, but these private equity funds may also be used for other investments. This includes providing venture capital to nascent businesses. Oftentimes, funds that are raised for this purpose are referred to as venture capital funds.
These investments might not necessarily use the borrowed fund, and exclusively use the fund’s capital. However, having such an equity investment may allow the target company to have improved access to debt markets. This is, of course, after it secures the equity investment from the private equity fund.
Fund as a Majority Position
Moreover, the fund might also take a minority or a majority position in the company. Most of the time, venture capital investments may also contain incentives. This includes, but is not limited to stock options.
Now, these incentives may enable the investor who assumes the risk to enjoy greater profits if the business turns out to be successful. However, it is also important to keep in mind that there are a lot of differences between private equity funds and venture capital funds. These differences are paramount and should always be considered.
Another important quality of private equity funds is that it seeks out investments that are undervalued. For instance, these could be whole companies that are not trading at values commensurate with what the fund managers think is possible. Or, it could also be divisions of companies that want to sell the units due to a change in strategy. It may also be a need for cash. We will discuss the various sources of income that private equity firms earn a little later in the next series of articles.
In the meantime, we hope that this article has helped you learn about the history of the private equity and leveraged buyout business.
© Image credits to Steve Johnson