Filling a Need: Unraveling the History and Growth of the Private Equity Industry
(0:54) Uncover the ideas that gave birth to the first private equity firms, laying the groundwork for an industry that would reshape the business landscape.
(5:37) Challenge the prevailing stigma personified by 1980s Wall Street movies, to explore how the industry has and continues to evolve.
(10:05) Highlight the shifting focus of private equity towards the people involved and the value they can create, from investors to management teams.
(13:18) Touch on the importance of being the best in private equity, engaging the right third party resources to help.
(15:20) Revisit the current state of PE and predict where it's going.
Welcome to the Karma School of Business Podcast. Today we're going to talk about the history of the modern age of private equity. This episode is brought to you today by BluWave. I'm Sean Mooney, BluWave's founder and CEO. BluWave is the go-to expert of those with expertise. BluWave connects proactive business builders, including more than 500 of the world's leading private equity firms to the very best service providers for their critical variable on-point and on-time business needs.
The private equity industry ultimately traces its roots back hundreds, if not thousands of years in the annals of commerce. All throughout time, there have been benefactors with capital who have supported founders who had skills and concepts in exchange for a percentage of the economics of the business. For the purposes of this episode, we're going to focus on the modern-day private equity industry, which functionally started in the '70s and really began taking shape in the '80s, '90s, and 2000s. Like many things, the private equity industry was created out of need, want, and solving a problem.
Prior to PE becoming what private equity is today, in the '70s and even '80s, if you were a business owner and needed capital to grow or diversify your wealth, you really had limited options. You could borrow money from a bank, which typically involved only a limited amount of money based upon a discounted percentage of the value of a business's working capital and its property, plant, and equipment. You could go public, but that was only for the select few that became large enough to be a public company. If you were on the West Coast and starting up, you could maybe find a venture capitalist, but this was really only if you were in the earlier stages of development, were in technology and were growing quickly. Your only other option was to sell your company to a competitor or a conglomerate that wanted to be in a bunch of businesses. This was a very finite option and typically meant that their life's work was then going to be consumed and integrated into a much bigger company and the founder's picture on the wall was going to be quickly put in a storage room.
So in the '70s, people like Jerome Kohlberg, Henry Kravis, and George Roberts of KKR fame and Thomas H. Lee of Thomas H. Lee Partners fame, they had an epiphany. More or less, they understood a few things. One, they observed that entrepreneurs over time inevitably got more conservative running their businesses as their businesses got bigger and the entrepreneurs and owners had more to lose. As a result, the performance of businesses often declined over time. For those of you who watch sports, it's like playing prevent defense all of a sudden and you immediately know that the score is going to start getting really, really close and the performance of the team is going to be slowing because they play not to win, but play not to lose. Number two, business owners' only options at the time to take meaningful capital off the table were limited and almost binary, a lot of bank debt or selling to another company, so the weight of having a lot to lose really couldn't be relieved. They had all their wealth trapped in illiquid securities of a private company.
Lastly, these pioneers realized that people could use debt and equity to buy things like houses and cars, so why couldn't they do the same thing to buy a company? And then they realized if they could figure out how to finance a company with other people's money and their own, they could solve the business owner's problems in multiple ways. First, they could create another option for a business owner to sell their business beyond outright acquisitions by a competitor or going public. Second, and as importantly, they could enable the business owner to take some money off the table. This would not only help business owners from a diversification perspective, but also would help the business owner get back to their old, higher risk-taking selves and free them from this loss aversion psychology and get back to throttling down on growth for the business.
With this in mind, the founders of the PE industry knew that if they could do this, they would then unleash a whole new level of growth in the companies that they invested. They could work together with the founders to professionalize the business where it needed it most, and then the PE firms could then call in their investment banking friends when it was time to sell the business and could sell the company in an efficient, more professional M&A process, which would ultimately create a host of win-wins. The PE firm professionals would benefit from the value created, the PE firm investors who backed the company with the capital that they had would get a healthy return, and the entrepreneurs would benefit from a second bite of the apple, and in many ways, they'd probably make more money on the second sale than the first, and as a result, the modern age of the private equity industry was born.
As we all know, capital's agile when opportunities present. The private equity industry was no different. As the early successes drew more capital and talent and more attention from those early days, the flywheel of private equity started spinning, but not too quickly and not too smoothly at first. In the 1980s, cornerstone PE firms like the Blackstone Group, Bain, Carlisle, Hellman & Friedman were also founded and a number of other PE firms as more and more really talented groups entered the fray. While these titans of private equity firms started in the 1980s and the 1970s, and they've ultimately left an indelible mark on the modern-day industry and have evolved into great creators of value for a whole host of stakeholders, not everything was fantastic for the perceived reputation of PE overall during its early days.
So like anything in its infancy, there was learning lessons and a maturation curve. Perhaps the eighties for a whole variety of reasons should be described as quote, unquote "too much of a good thing." In the 1980s, if you believe Gordon Gecko from the movie Wall Street, greed was good. Yuppyism rules. Cocaine was rampant. Talk to anyone about The Royalton from the 1980s in Midtown Manhattan. The use of debt in business was off the charts. An infamous financier named Michael Milken and his bond department at Drexel Burnham Lambert unleashed a product casually called quote, unquote "junk bonds," otherwise known as high-yield debt. During this time in the '80s, it was not unheard of to have debt to EBITDA multiple surpassing 10 times, and debt accounting for more than 80% of the capital used to fund a buyout, sometimes much higher. As a comparison, according to PitchBook, the average debt to EBITDA multiples last year in 2022 was 5.9 times, and debt accounted for only 50.8% of the capital structure in PE.
While modern-day PE has pulled in the reins quite a bit on their use of debt, to put things in perspective today, an average person can still acquire a home with 80% or more debt, and they could buy a car with a hundred percent debt, so in many ways, the private equity industry still suffers from this perceptions of movies with Michael Douglas and Charlie Sheen made in the 1980s about Wall Street at that time. A large amount has changed in PE and New York City, by the way, in the 35 years since that movie was made.
Which begs the question, what led the PE industry to change and evolve? The answer is Economics 101. Anytime great opportunities exist, talent and capital will find a way to the opportunity. So as we left the excess and the hangover of the 1980s and enter the more tapered and some might say more cynical Gen X-fueled 1990s, debt usage may have been pulled in, but equity flowed in a big way into the PE market. Over time, tens and hundreds of PE firms became thousands of PE firms. PitchBook shows more than 5,000 PE firms exist in the United States today, owning close to 20,000 companies. There's close to 800 billion of capital looking to be put to work in new investments in private equity. Over time, these forces of supply and demand have been impacting private equity with more and more capital, chasing a relatively flatter supply of companies looking for investment. As a result, purchase prices have generally risen over time while returns have gone down.
As an anecdote, when I was entering private equity in the late '90s, our financial models would estimate that we would get an IRR, otherwise known as an eternal rate of return, ranging from 30 to 45% per year over a five-year period. When I started in the industry, I said to myself, "Wow, I wish I was 10 years older. The founders of this industry are going to crush it." When I left the PE industry in 2016 to start BluWave, my model said we would earn 20 to 25% per year over a five-year period. Both of these are really good in almost any way you look at it, but when looking at one relative to the other, you couldn't help but have envy. Any way you cut it, they were both better than any alternative place to put your money, so the industry continues to grow even today.
As another anecdote, when I first ended the PE industry, we would have direct conversations with business owners who would line up for our capital and we could pick the best of the bunch. When I left in 2016, it was not uncommon for our firm and pretty much every other to be one of more than 150 PE firms that an investment banker would share the opportunity with and would battle it out to win the company. Talk about daunting.
One might ask, "Did the private equity industry just sit there and let the gravity of Economics 101 do its work?" The answer to that question lies in understanding the persona of the people who enter and work in the industry. People who enter the PE industry are clearly smart, but there's a lot of smart people in this world, and I'm guessing the quants at hedge funds and PhDs in academia pound for pound have more wattage. The differentiating factor in PE is the level of tenacity and grit and business creativity of the people.
To personalize things, PE people are the classic try-hards. They do everything they can to get ribbons and metals. If you knew me in high school, you'd say, "Oh, there's a PE person in the making." They were often good athletes, but probably not the MVP best. They were capable interacting with people, but probably not the coolest in the crowd, and if I were to truly personalize things, the quote, unquote "they" were really good at getting turned down during high school for invitations to homecoming dances and the like, but they would always bounce back and work harder and figure out a way to land on their feet, and they usually did.
So in the 2000s, the smart and tenacious lot of PE investors realized that if they were going to overcome the pool of supply and demand, they were going to have to create more value. The PE firms then took action. They progressively operationalized their businesses to not only understand how to identify elements of value and place numbers around that, but also how to directly create value in places where no one else thought it could occur.
In gen one of this operational era of PE that began in the early 2000s, the private equity firm started by adding their previous CEOs who were successful in their PortCos because to their teams as their operational experts. Then over time, they added a lot of them. Today, a number of PE firms still find great success with this approach. Then some PE firms said, "Rather than maybe adding CEO-type people, we're going to add functional level experts in their portfolio operations, support teams across sales and operations and finance and technology, et cetera." Others added former consultants who could help their PortCos strategically and then manage a wide array of projects. All of the above were and are using also the best third parties that they could find as force multipliers and accelerants. A popular line about private equity is that if you've seen one PE firm, you've seen one PE firm. One approach is not better than the other. It just reflects different strategic tilts to creating value.
The one thing that is common about each approach is that the game of PE has evolved from primarily being able to do confirmatory due diligence and trust but verify that the seller of a company was being truthful and then coming up with a number that worked for the seller and then almost fully delegating value creation to the PortCo management team to optimize the company to a business that really involved not only trusting but verifying but also preforming value creation plans regarding what a company could or should be before they even buy it, integrating that perspective into the valuation, reaching an agreement with the seller, and then afterwards partnering with the management team to transform the company.
It was this shift in the evolution of private equity after 2010 that got me really thinking about BluWave and ultimately led to the idea. Every day while I was in PE, I felt this extreme pressure for us to be good at everything because we had little room for error and we had to pay such high prices that we needed to transform a company versus optimize it if we ever going to make an interesting return. I was with a great specialized PE firm. We had operational executives and deal team members and we were doing everything right, but we and every other PE firm I knew had to work with a village of best-in-class third-party groups and people to help us not only expertly perform confirmatory due diligence, but pre-inform our value creation plans and transform this company into something it was originally never intended to be and do this all in three to five years. It's like exhausting, but it had to be done, and we were going to figure out a way how to be successful.
But there was no way we could know everyone we needed to know who were the best at everything, in large part because every company assessed and every company we invest in was different, so the needs were different. So as a result, we'd have very expensive people and very capable people who would google problem and industry and call friends saying, "Do you know somebody who does this?" I realized that a business concept involving marketplaces, networks, and data and analytics could solve this problem if done well and BluWave was born. Another story for another time.
But today, BluWave is used not only by the deal teams in PE, but also by each of the forms of operations teams within the PE firms as a way of expertly force multiplying value creation and improving outcomes by bringing in the exact PE grade resources they need for each initiative. It's kind of interesting how it's evolved because today it's not only for PE firms and PortCos who are using this machine we've built, but also public companies and independent companies. Even the service providers in our network use us, and last and least, or first and... And also, we use ourselves on ourselves almost every week because it's really this true accelerant to value creation.
So let's finish off with the current state of PE and where it's going. Today the business of PE is looking more and more like a business. The PE firms have sales, which is bringing in deal flow using truly expert business development professionals. The firms have operations and its value creation team. They have finance, as they always did with their CFOs. What's growing more recently in PE is the internal HR area. The fastest-growing functional area in the PE firms themselves is human capital. PE firms now know that they have to transform a company. To transform a company, they need a wide array of new and additional skill sets, so heads of human capital are being brought in to help them hire droves and droves of highly capable people.
BluWave's internal data clearly reflects this trend. In 2018, only 17% of projects were related to human capital. In the fourth quarter of 2022, 45% of the projects brought to us by private equity firms were related to human capital. While PE heads of human capital were initially brought in to build and enhance their PortCo teams, they've also figured out that they can really help their internal PE firm teams improve as well, so there's a whole renaissance in terms of just how humanity is managed within PE firms themselves. This is a rapidly growing function in PE that's making huge headway, but it's nascent. There are all sorts of emergent trends underway. People are figuring out how to most effectively use these great new resources and skills that they have.
To help understand this better, we recently partnered with Entromy and TalentScape to survey a large swath of the PE human capital world to understand these trends better and how and why this functional area is evolving in private equity. If you're interested, you can visit our website at bluwave.net, B-L-U-W-A-V-E, if you'd like to request a copy of the report. The private equity industry has and is constantly evolving to not only keep up with but also stay ahead of the times. It's continuing to do so today.
So what's up next? We're going to see continued development of these existing operation teams that will occur for sure with individual PE firms taking different approaches to enact their unique strategies, but new incremental elements are also emerging beyond the lookout for chief marketing officers who will be tasked with communicating the differentiation of the respective firms. As the capital under management today in PE is becoming more and more commoditized, having money isn't different, it's how they build value that is. You're also going to see more and more chief data scientists or head of analytics as the PE firms embrace the data analytics and the AI revolution that's underway.
Hopefully, this gives you a good high-level sense for where the PE industry came from, why and how it's evolved, and a bit about where it's going. The private equity industry has turned into a major economic engine for the global economy. Today it's not the 1980s movie that many still have dated notions of. It creates a tremendous amount of value for business owners, PE fund investors, including pension funds, university endowments, and a wide array of others, and has turned into a huge job creator across the United States, Canada, and the world.
The reason why is, in many ways selfish, because the way the private equity firms prevail and defy the gravity of supply and demand and declining returns is by creating value that in turn drives growth development and fertilizes and grows lots and lots of jobs. In this somewhat selfish desire to generate their own livings, which is fair and satisfying their own customers who are their limited partners like universities and pension funds, there's altruism in it, though, and that happens to be good for places where private equity brings its capital.
The PE industry is kind of a conundrum because it hasn't done a good job of explaining itself. The answer as to why is largely found in the name of the first word in private equity, which is private. The people in the private equity industry, by and large believe that discretion is the better part of valor, and if they keep their head down and do good work, they'll get credit for doing a good job. The private equity industry, admittedly, is perhaps not as glamorous as other industries, and for some, it's easier to beat up the reputation of the relatively geeky try-hards, like I'd say my former self, but I'd say still my current self, let's be honest.
But at the end of the day, coming from someone who spent most of my professional life in the industry and now serves hundreds of PE firms, I can tell you that the vast majority of the professionals in the industry just want to do good things with good people and drive a successful outcome for their stakeholders. The PE industry by no means is and has been perfect over its history. As with most things, though, the private equity industry has come a long way, and it still has a long way to go. Today, the PE industry continues to offer the best risk-adjusted returns to investors versus pretty much every asset class. This comes with a lot of hard work, tenacity, grit, creativity, and innovation. The evolution of PE will continue to be a journey. It's not a destination, so we're going to have lots to talk about as it continues to grow and develop in the days ahead.
That's all for today. If helpful, we'll continue to do special episodes like this to share more about the whys, the hows, and whats of PE. Let us know what you'd like to hear about and we'll do our best to put it together for you. For more information, go to bluwave.net/podcast. Please continue to look for us anywhere you find your favorite podcast, including Apple, Google, and Spotify. We truly appreciate your support. If you like what you hear, please continue to subscribe, review, and share. In the meantime, let us know what we can do to support your success. Onward.
BluWave Founder & CEO Sean Mooney hosts the Private Equity Karma School of Business Podcast. BluWave is the business builders’ network for private equity grade due diligence and value creation needs.
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