Goldman, Sachs & Co.'s Richard Friedman remembers 1999 as a "surreal period" in private equity, a time when an industry built on leveraged buyouts of staid, cash-generating businesses fell prey to the allure of the tech-telecom revolution and the promise of untold riches to be had bankrolling startups ravenous for capital and whose only assets were their grandiose business dreams.
"The new applications and businesses leveraging off telecommunications were generating a lot of excitement," says Friedman, the longtime head of Goldman's private equity operation. "We were inundated with growth-capital opportunities. The pace of [the dealflow] was unprecedented in my career to that point."
Barons of buyouts on the past and future
Five private equity executives muse about the past decade
On financial bubbles:
"Every seven years or so, another bubble comes along, and everyone thinks they know when it is going to end and that they can get out before it's over. But they don't." -- David Rubenstein, co-founder, Carlyle Group
"The tech bubble was less than 10 years ago. Then you had the housing bubble and a debt bubble. That's three bubbles in a decade. You would have thought that people in one market would have learned lessons from the other markets." -- Lawrence Schloss, chairman and CEO, Diamond Castle Holdings LLC
On coping with the fallout:
"I think there will be far more fallout from this [latest] cycle [than from the tech-telecom bust]. It's impossible to predict today which firms will and won't [survive]. The key thing is how this generation of funds performs. If all you do is get your investors their money back, I don't think that will be a good enough story to get them to give you a lot of money for the next cycle. I think the burden is going to be on all of us to show performance out of this. A key determinant of [private equity's] future is whether or not all of the skills we claim to have really prove out." -- Richard Friedman, managing director and head of the principal investment area, Goldman, Sachs & Co.
"Everybody needs to go to confessional on this, but the continuum between those who need to go 100 times versus once is pretty wide. There was a set of folks who I think were a bit disarmed by the speed at which things were moving and got very active late in the cycle. If you rate firms along that continuum, I think that will tell a lot about who survives this cycle and who doesn't. There will be significant change in the number and kind of firms."
-- Mark Nunnelly, managing director, Bain Capital LLC
"The industry will wise up because the [LPs] have been burned. The LPs will consolidate who they give money to, so you'll have people leave the business." -- Schloss
"I think you'll see much more discipline on pricing for both equity and lending. ... You'll have longer holding periods in deals. You'll probably have somewhat lower rates of return, although I think they'll still be pretty good compared to the alternatives."
On why PE plunged into frothy markets:
"It's the self-induced competitive juices of people who come to an industry like this. If you're a shrinking violet, you don't tend to work in the private equity business."
"It's very hard for horses not to run, especially when the horses from the other stables are running." -- Schloss
"It's very, very hard to be inactive during these periods, because then to your investor base, it looks like you're not a factor." -- Friedman
On the lessons of the past decade:
"Many of us had the strongly held belief that regardless of the secular changes, the world is cyclical, so you need to be very careful late in an extended cycle to not fall into the trap of believing that secular changes will forever overwhelm the cycle. A corollary of that is it's one thing to take advantage of competitive financing; we all need to do that. But it's another to start buying at multiples that are above long-term normalized trading ranges because you have convinced yourself that the world is fundamentally different. If I had to point to the single biggest mistake made in this [most recent cycle], it was that." -- Scott Sperling, co-president, Thomas H. Lee Partners LP
"Private equity is not countercyclical. We are a captive of the markets. ... Mark-to-market accounting has really changed the way people perceive deals in the holding phase. Now, everyone is obsessed with quarterly numbers. ... Cash is king with your portfolio companies. When you have problems, those companies that have enormous cash are going to be the ones that survive. ... People have learned that private equity is not the cause of systemic risk, that we're not the cause of the system almost going down. ... Diversification is probably the name of the game going forward. You'll see all the meaningful private equity firms dramatically diversifying the businesses they're in." -- Rubenstein
"There was a lot of talk that we're in a new, globally integrated, lower-inflation, lower-interest-rate environment that had dampened labor and financing costs. A little bit of that was true, but we know in retrospect that a lot of it wasn't. So be skeptical of economic forecasts that say it's all different this time. And always remember that the ability to drive operating improvements in portfolio companies is what ultimately creates superior returns." -- Nunnelly
"Valuation does matter. ... Don't utilize excessive leverage, even if it's made available to you and even if it's cheap. Leverage needs to be maintained at levels you can finance and support." -- Friedman
On how PE's role has changed:
"The private equity industry became almost a parallel capital market to the public [equity] market, became an enormous source of liquidity for sales of assets and sales of corporations. ... Private equity's role now is not what it was from 2005 to 2007. It has diminished. How significant a role it plays in the future will depend on the availability and the cost of capital."
"Private equity got a real seat at the table. It became a major factor in all corporate financing. Also, for Wall Street, the biggest profits came not from servicing IBM or Hewlett-Packard or other Fortune 100 companies; it came from servicing hedge funds and private equity funds." -- Rubenstein
"PE accounts for a much bigger percentage of corporate ownership now. This involves everything from labor relations to climate change, a broad range of issues that PE hasn't historically had to deal with. There are new obligations that come along with this that we're working our way through." -- Sperling
"This is an industry that is still in its late adolescence, maybe just coming into adulthood. With this evolution, the kinds of deals and the kinds of expertise brought to bear has certainly reached more of an institutional quality."
"PE pushed the capacity limits of individual banks or syndicates to finance ever-larger deals, which led to the spread of synthetic buyers of debt, such as CDOs and credit hedge funds. The rest is history!" -- Schloss
On the best PE development in the past decade:
"The real focus of most of the major firms on adding value as a necessary element of their investing strategy."
"Seven percent, covenant-lite high-yield bonds."
"The acceptance by the financial community globally and by the investment community globally that PE is a permanent player in the investment world."
"Our industry has shown it can be a very good steward of companies, and that we drive value and growthful change." -- Nunnelly
On the worst PE development in the past decade:
"Seven percent, covenant-lite high-yield bonds."
"The availability of very cheap debt with few terms attached helped the private equity industry lose its focus. If the debt had been harder to obtain and you couldn't finance a $30 billion or $40 billion buyout, maybe some of these problems would have been avoided." -- Rubenstein
"Capital formation was really the worst and the best development. There was just too much capital committed to the industry."
"We need to do a much better job of telling our story as an industry. We have become, for a bunch of self-inflicted reasons, whipping boys in the midst of what is in the aggregate a very good story." -- Nunnelly
It would turn out that the riches were a mirage, the business plans were mostly seductive fictions and projections of telecom traffic and capacity needs were vastly overblown.
It wouldn't be the only period between then and now that private equity got caught up in a financial bubble. In fact, the history of private equity since The Deal first published in September 1999 can be summarized as two bubbles separated by about six years, the second of which was a golden age for the industry, a time of stupendous growth and profit. Each of the bubbles ended in ugliness and woe.
It's been a rollicking and painful ride. And though the nature and scope of the bubbles differed markedly, as did the downturns that came after, a couple of bedrock truths about private equity and its practitioners link the two wild up-and-down cycles: First, as David Rubenstein (pictured), co-founder of the Washington buyout giant Carlyle Group, points out, the industry is very much "a captive of the markets" and "not countercyclical." And second, the titans of private equity, or a significant portion of them, are just as prone as the Average Joe to get caught up in investment fads and fashions and to emulate the unenlightened, noncontrarian masses.
It may seem hard in retrospect to fathom why some big-name buyout players in the late 1990s were enthralled by pie-eyed visions of connectivity. But those visions had a mighty strong pull back then. Prices of profitable and mature businesses were on the high side, resulting in watered-down return expectations for conventional LBOs. The buyout industry had gotten envious of the stratospheric returns that venture capital types were scoring on smallish software and Internet bets. Even their own LPs, as well as younger partners, were goading the established firms to get hip to the action. Many of them did begin to dabble in small Web startups, but they really needed bigger targets to absorb the $50 million or more they preferred to sink into individual deals. The stage was set for a large-cap, high-returning, trailblazing deal to channel the industry's yearnings and trigger an outpouring of capital. That deal was Global Crossing Ltd.
Few deals have had the mesmerizing, even talismanic, impact that Global Crossing had. In the 1990s, only the extraordinarily successful initial public offering in 1995 of Netscape Communications Corp., the browser developer, which stoked investing in the Web, came close. A builder of fiber-optic telecom lines, Global Crossing opened for business in March 1997, raised $1.2 billion in debt and $400 million in equity, and went public in August 1998. Even though the company was burning through cash at a frightful rate, GCI's stock price shot the moon, and by mid-1999 Gary Winnick, the financier who had led the deal, was showing a $6.5 billion paper profit on what was a roughly $30 million investment.
To the graybeards of the private equity business, Winnick's feat did more than evoke awe, shock and envy. They interpreted it as a sign that traditional value metrics like cash generation and profitability were passé -- that the very logic of investing had been turned on its head.
The same week The Deal's first issue came out, one high-profile buyout executive told this reporter that his firm and several others had had the chance to invest in Global Crossing, and passed. "The deal made no sense. We couldn't get the numbers to work," he said. Amplifying their wonder was Winnick's lackluster investment record during his stint as a midlevel aide to junk bond king Michael Milken at Drexel Burnham Lambert.
"People who were maybe 10 years older than I was at the time were staring at [deals like Global Crossing] and not really understanding them," Goldman's Friedman says. "They felt a little lost, like they were the ones out of sync."
Soon enough, however, the private equity establishment embraced the new order, some more enthusiastically than others. "There was a suspension of disbelief that was moving from the general public equity market into the private equity market," says Scott Sperling, co-president of the Boston private equity firm Thomas H. Lee Partners LP.
While major firms like Kohlberg Kravis Roberts & Co. and Carlyle tested the waters, others dived in head-first. Hicks, Muse, Tate & Furst, an industry heavyweight, sank $1.6 billion into an assortment of telecom and Internet deals in 1999 and 2000. Ted Forstmann, known for his soapbox rants on the evils of junk bonds and overaggressive financing, bet a total of $2.7 billion -- much of his firm's capital base -- on two telecoms, McLeodUSA Inc. and XO Communications Inc. Other players pumped billions more into extravagantly costly network buildouts and local telecom and Internet service suppliers. The capital structures of many of them defied reason: a slab of equity topped by a tower of debt, often billions of dollars high. In most cases the revenues couldn't cover the operating costs, let alone service the debt. But Tom Hicks, Forstmann and others fervently believed that startups' cash flows would surge as the information revolution took hold and that the debt would pose no problem.
Their belief was misplaced. Not that long after the short heyday of telecom investing began, it flamed out, and the faithful experienced what one investor describes as "the 'Oh, shit!' moment" when "everybody asked, 'How did this happen?' " In early 2000, the high-tech-flavored Nasdaq stock index began a decline that would cost it three-fourths of its value. By late 2001, in the wake of the Sept. 11 attacks, the broader economy was in a deepening funk that plunged a good number of old-style, brick-and-mortar businesses saddled with LBO debt into bankruptcy.
But private equity's most spectacular flops came in telecom. As banks and investors picked up and fled the sector, whose revenues were in retreat, the telecoms' massive superstructures of debt pancaked, pulverizing the equity beneath. More than $20 billion that private equity had bet on such deals was vaporized, and the pain was widely felt.
But two giants of the trade wound up the biggest losers, stripped of an asset required to survive: their credibility as investors. Hicks, who in 1999 had raised what was then the second-biggest LBO fund on record, at $4.1 billion, and who had only recently emerged as an industry star, and Forstmann, the buyout business' respected second banana, who had built an enviable record laboring in the shadow of industry kingpin Henry Kravis, would lose their status as frontline players.
Forstmann's foray into telecom effectively killed his career.
And Winnick? He managed to escape most of the mayhem he'd helped create. By the time Global Crossing went bust in January 2002, the man who more than anyone had inspired telecom madness had racked up several hundred million dollars in winnings from the deal by dumping much of his stock early.
The bursting of the tech bubble and the economic slump that ensued had a purgative effect on private equity and the deal market. As invariably occurs in a down cycle, a dearth of leverage and falling earnings drove down deal values. The buyout market recalibrated itself, and buyout firms regrouped.
The down times didn't last long. The expunging of excess and froth and a quick rebound in the economy set the stage for what would become the most colossal and frenzied round of dealmaking and profit taking the buyout industry has ever seen.
As of late 2002, deal prices were alluringly low, and elite buyout shops like Blackstone Group LP, KKR, Goldman and Thomas H. Lee Partners all had recently raised $5 billion to $6.5 billion equity funds and were poised to attack.
This time, the fuel that would ignite dealmaking and give rise to the next financial bubble wasn't anything as airy as the hype of the high-tech boom. It was debt, oceans of debt. Until the time the debt bubble burst, a seemingly boundless supply of leverage would help propel private equity to a new level of prosperity and greatly extend its power and reach.
One early sign that something extraordinary was brewing in the debt world came in late 2003. By then, the buyout market was revving back up, and it was now possible to finance a $4.2 billion deal, which is what Blackstone, Apollo Management LP and Goldman paid for Nalco Co., a chemicals producer, that November. The deal, richly priced at 7.8 times Ebitda, was financed with $1 billion of equity and $3.2 billion of debt -- equivalent to 6 times Ebitda.
Less than a week after the deal closed, Nalco's sponsors were being lobbied by various banks eager to lend the company even more to pay the sponsors a hefty dividend. "This was a wake-up call, evidence to me that something new was unfolding," says one Nalco investor. "Between the time that we signed the Nalco deal, in the summer, and the time it closed in November, the availability, pricing and structure of this kind of credit had undergone a big change for the positive in the market."
Indeed, what lay behind it was a rapid and voluminous growth in the leveraged finance pool as money flooded in from unfamiliar sources. Banks were starting to marshal capital from hedge funds and foreign banks and then channeling it to structured finance vehicles called collateralized loan obligations, or CLOs, which scarfed up LBO loans as deals were confected. These vehicles, through the magic of internal leverage, paid CLO investors liberal returns well above the interest rates of the underlying loans.
This arrangement delighted the banks, because they could arrange very large loan packages for private equity clients at very cheap rates, earning huge deal fees, and immediately hand off the loans to CLOs without having to underwrite them. CLO investors were pleased to pocket ample returns on seemingly safe, senior debt. And buyout sponsors couldn't believe their luck in being able to draw on a vast reserve of low-cost financing. As the market gathered steam, banks began to strip away covenant protections and liens from loan packages to top-drawer buyout sponsors. For the first time in memory, LBO financing had few or no strings.
The endless supply of low-cost, no-strings leverage did more than touch off a boom in LBOs. It also lit a fire under corporate asset values, and buyout sponsors took advantage by selling off swaths of their holdings for enormous profits. By mid-decade, Blackstone, KKR and other top firms boasted annualized returns of 40% to 80% on their latest funds. As the big firms turned over billions in sale proceeds to their LPs, the LPs returned the favor by plowing their winnings right back into a new crop of record-sized private equity funds. The giants vied among themselves to land the biggest. Carlyle raised $10 billion in a pair of funds in 2005, only to be surpassed by TPG Capital ($15.4 billion), Goldman ($20 billion) and Blackstone ($21.7 billion). KKR, long the king of the trade, generated $17.6 billion.
Having topped off their war chests and able to tap cheap debt at will, the big guns of the industry embarked on a record-setting campaign of conquest. LBOs of $10 billion, $20 billion and $30 billion proliferated. In 2006 Bain Capital LLC, KKR and Merrill Lynch Global Private Equity set a size record, exceeding the mark KKR set in 1989 with its $31.3 billion LBO of RJR Nabisco, with a $33 billion purchase of hospital chain HCA Inc. In February 2007, Blackstone broke that record with a $39 billion take-private of Equity Office Properties Trust but soon was one-upped by TPG, KKR and Goldman's $45 billion purchase of TXU Corp., now called Energy Future Holdings Corp., a Texas utility.
The frenzied, debt-propelled buying jag produced any number of firsts and prodigious statistics. From 2004 to 2007 the number of mega-LBOs priced at $5 billion and up topped four dozen. The megadeals were capitalized with about $240 billion of equity, 40% of the equity capital that private equity firms deployed in those years, according to McKinsey & Co. The quantity of debt that enabled those deals easily surpassed $600 billion.
For the first time, major corporations wholeheartedly came to regard private equity as a preferred buyer when disposing of divisions or selling themselves. The buyout industry's share of the U.S. M&A market, which for years had hovered at around 5%, soared to 26% in 2006. A key reason was the industry's ultra-low borrowing costs, which drove down its cost of capital to the point that -- another first -- private equity could outbid strategic buyers in corporate auctions. At the same time, CEOs of public companies came to embrace the opportunity to escape the spotlight, the regulatory rigors of Sarbanes-Oxley and the chance to win a jackpot by participating in an LBO.
Also over the past few years, many elite firms expanded their territorial reach overseas, entered new businesses such as M&A advisory and credit and infrastructure funds and morphed into diversified alternative investment houses managing tens of billions of dollars in investors' assets. In short, private equity became a pillar of the capital markets, its power and legitimacy cemented by another first: the IPOs of two leading players, Fortress Investment Group LLC in February 2007 and Blackstone that June. Blackstone ended its first day of trading with a $38 billion market value, a figure inviting comparison with the $89 billion market value of the mightiest investment bank, Goldman Sachs.
What followed requires little elaboration. The fallout of the financial crisis that began shortly after Blackstone's public offering and of the worst economic slump since the Great Depression dominates today's news.
The toll on private equity has been steep. Virtually every buyout firm has had one or more of its companies go belly-up and is struggling to keep other debt-freighted holdings from doing the same. All have suffered severe paper losses across their portfolios. Especially problematic are megadeals done at the peak of the market. Even if the economy comes back strongly, many of those deals may lose money because of the stratospheric, debt-propelled multiples that sponsors often paid.
Even as the downturn has cost the private equity industry clout and credibility, it may cost specific sponsors rather more. Though previous down markets have forced slews of poor performers from the business, the body count this time could be great.
"There will be a significant change in the number and kind of firms," predicts Mark Nunnelly, a managing partner at Bain Capital in Boston.
Private equity won't die. At some point, perhaps in two or three years, the LBO market will be back in force, though likely not with the feverish intensity of 2005-'07. At some point, too, yet another speculative bubble will form. And when it does, you can bet private equity will be squarely in the middle of it.