examples of carried interest calculations can be found in Chapter 16. Fund Formation.
A Look Back at the Last 45 Years
By T. Bondurant French, Executive Chairman, Adams Street Partners
In reflecting on the changes in the private equity industry over the last 45 years, fundraising trends were one of the first things that stood out. Looking at fundraising data for the private equity industry, I was a little taken aback to see that 1960 through 1983 were barely visible on my bar graph, compared to the funds being raised today. In 1972, $225 million was raised for venture funds in the US; buyout funds didn’t exist and Kleiner Perkins was a first time fund. Venture fundraising bottomed in 1975 at $60 million.
By 1979, the economy was better, capital gains tax rates had been lowered from 50 % to 28 %, venture-backed companies were bounding (Intel, Microsoft, Apple, and Genentech), and $800 million was raised for venture funds. In the early 1980s, venture funding really took off on the back of excellent returns and a rising stock market. In 1983, $3.7 billion was raised and for the first time the term “mega fund” was used.
It is hard to imagine today, but we had no real data to evaluate the managers with and there were very few realized deals. Almost everyone was a first time fund and there were virtually no formal standards in place. Benchmarks, quartile rankings, written valuation guidelines, and placement agents did not exist. Neither did industry conferences and newsletters, with the exceptions of the National Venture Capital Association’s annual meeting and the Venture Capital Journal. The fax machine hadn’t yet been invented, but a new venture-backed company, Federal Express, helped us with overnight documents.
Back then, fundraising was exceptionally difficult. Most pension consultants did not follow or cover the asset class. We spent a lot of time doing educational presentations for trustees and their consultants at offsite retreats, board meetings and pension conferences. During the 1980s, our hard work finally began to pay off. As we had actual data going back to 1972, we became pension funds’ source of information on expected returns, standard deviations and correlation coefficients for the private equity “asset class.” The new term “asset class” implied a transition from a niche activity to something that was becoming institutional. We took the lead in establishing the first industry performance benchmarks, chaired the committee that established the private equity valuation guidelines, and worked with the CFA Institute to establish the guidelines for private equity performance reporting.
Throughout the 1970s and for most of the 1980s, we had lived in a US and venture-centric world. Now, the buyout business was emerging as a new practice within the world of private equity. Pioneered by KKR, CD&R and a handful of other firms, the use of leverage to buy and manage a company was a new idea. The development of the high yield bond market, led by Michael Milken of Drexel Burnham Lambert, made this practically possible on a much wider scale than previously thought. Heretofore, “junk bonds” were formerly high grade bonds of companies that got into trouble and were in or likely to be in default. The idea of a new issue “junk bond” was a new concept.
In 1980 only $180 million was raised for buyout funds in the US. This grew to $2.7 billion in three years, and $13.9 billion by 1987. As with many things in the financial and investment markets, this was a good idea carried to an extreme, culminating in the takeover of RJR Nabisco in 1989 by KKR (as told in a book and a movie, both called Barbarians at the Gate).
During the second half of the 1980s, managers in Europe and Asia began to adopt “American style” venture capital and buyout practices. Many of these managers made fundraising trips to the US as, relatively speaking, there were more willing investors there. Along with pension funds and endowments, nearly all of the private equity funds of funds were based in the US.
By 1990, the US was in a recession and a savings and loan crisis. Buyout fundraising dropped dramatically, with only $6 billion raised in 1991. Fortunately, lessons were learned by all parties and the buyout business grew steadily and more rationally throughout the 1990s. What were originally highly leveraged transactions morphed over time to become today’s private equity industry, which provides a variety of equity capital, including growth capital, to a broad range of industries and businesses.
By the mid-1990s, the globalization of the private equity market was on the horizon. A number of venture and private equity managers were becoming established in emerging markets. By the mid-2000s, institutional investors were interested in global exposures enhancing their diversification and return potential by accessing rapidly growing economies. Significant money was raised by Asian general partners, particularly in China. Fast forward to today, the private equity industry has expanded to nearly every corner of the globe.
While many things about the private equity industry have changed over the last 45 years, several things remain the same. Private equity remains a people business and, at Adams Street, we understand that the people we invest with are of paramount importance. Spending time with them is an important part of developing real relationships based on trust and mutual respect. Nothing has changed in that regard and these relationships are a critical part of our investment process. The characteristics of successful private equity firms are the same today as they were decades ago. It takes mutual respect, independent thinking, and an optimal mix of experience and energy. At the heart of all enduring firms are good investors who have time to work with their companies, an international awareness and network, and a differentiated deal flow edge.
I am very proud of what the private equity industry does. We generate above average returns for our investors while also providing capital to finance business growth. This financing cuts across a wide spectrum of company stages, industries, and geographies. The end result is greater growth in job creation, wealth, and GDP than would otherwise be possible.
CLOSING
PE as an asset class continues to grow and evolve, both in developed and emerging markets. Business operators the world over – from entrepreneurs looking for start-up funding, to SME business owners with global ambitions, to management teams interested in buying out a corporate division – often find the right partner in PE funds to invest in their ambitions. As a result, PE is deeply entrenched in the economic model and will remain an important driver of business transformation globally.
KEY LEARNING POINTS
● PE is a simple business – buy a stake in a company (minority or majority), improve the business and sell it after a (limited) holding period.
● The preferred method employed by PE firms is to raise and invest individual funds, which they manage on behalf of investors (LPs). PE funds are typically structured as closed-end limited partnerships that require investors to commit capital for a period of 10 years or more.
● PE funds differ from traditional asset classes due to their illiquidity and the unpredictable cash flows generated from their investments.
● Both the fee structure and profit sharing arrangements in PE ensure alignment of interest; incentives change as the funds mature.
RELEVANT CASE SUDIES
from Private Equity in Action – Case Studies from Developed and Emerging Markets
Case #1: Beroni Group: Managing GP−LP Relationships
Case #3: Pro-invest Group: How to Launch a Private Equity Real Estate Fund
Case #6: Adara Venture Partners: Building a Venture Capital Firm
REFERENCES AND ADDITIONAL READING
Gompers P., Kaplan S. and Mukharlyamov V. (2015)
