1.2 How the industry grew

Private equity did not appear fully formed. It grew over several decades, from a handful of specialist firms into an industry that owns companies in almost every sector and country. Today's largest managers run many funds across several asset classes and employ thousands of people.

Knowing how the industry grew helps you make sense of the words and structures you will meet in your job. It explains why buyouts use so much debt, why funds are set up as they are, and why so many different strategies now sit under the "private equity" label. This lesson tells the story in broad strokes, by decade rather than by firm.

Early roots: venture capital and the first buyouts

Investing private money in private companies is very old. Wealthy families have always backed new businesses. But organized private equity, with professional managers investing other people's money, is a modern development.

In the 1940s, one of the first organized venture capital firms was founded in the United States. Venture capital is investment in young companies with high growth potential. The aim was to back new technology businesses with money from institutions rather than just rich individuals. Venture investing grew slowly over the following decades.

In the 1970s, a small number of firms began to specialize in a different idea: buying whole, established companies using a large amount of borrowed money. This is a leveraged buyout (LBO). Leverage means using debt to pay for part of an investment. Because the debt is repaid from the company's own cash flows, the buyer needs less of its own money, and any gain in the company's value is spread over a smaller equity stake. Lesson 3.2 shows how this works with numbers.

Over time, both venture and buyout firms settled on the structure you met in Lesson 1.1: a limited partnership, with the firm as general partner and investors as limited partners, investing for a fixed term. That structure is still the standard today.

The 1980s: the buyout boom

Leveraged buyouts grew rapidly in the 1980s. A key driver was the high-yield bond market. High-yield bonds, also called junk bonds, are bonds issued by companies with low credit ratings. They pay higher interest to make up for the higher risk that the company cannot repay. They gave buyout firms a way to borrow large sums, which let them buy much bigger companies than before.

Late in the decade, a wave of very large buyouts drew wide public attention. Some were bitterly contested takeover battles. Critics argued that buyout firms loaded companies with too much debt and cut jobs to repay it. Supporters argued that the discipline of debt and a concentrated owner made companies run better. Both arguments are still heard today.

The decade ended badly for some deals. Several heavily indebted companies struggled to meet their payments, and the high-yield market went through a difficult period. The lesson for the industry was that leverage magnifies losses as well as gains.

The 1990s and 2000s: professionalization and growth

Through the 1990s and 2000s, private equity became a mainstream part of institutional investing. Several changes came together:

• More investors. Pension funds, endowments, insurers and later sovereign wealth funds (state-owned investment funds) set aside a regular share of their portfolios for private equity.
• More professional firms. Firms built larger teams and more formal processes for finding deals, doing due diligence and reporting to investors.
• A focus on operations. Returns relied less on debt alone. Firms hired former executives and consultants to improve how their companies were run.
• Global spread. Private equity grew in Europe and later in Asia and other regions.
• Specialization. Firms began to focus on particular company sizes, sectors or strategies.

The years before 2008 saw another wave of very large buyouts, helped by cheap and plentiful debt. Then the 2008 financial crisis struck. Lending dried up, company earnings fell, and new buyouts slowed sharply. Some companies bought at the peak struggled. But the industry recovered in the years that followed, and fundraising and deal activity grew again through the 2010s.

Why investors kept allocating

Despite the setbacks, investors kept coming back. Their reasons fall into a few groups.

• Return potential. Investors hoped private equity would earn more than listed shares over the long run, partly as a reward for illiquidity. Results vary widely between managers, so choosing the right manager matters a great deal.
• A fit with long-term liabilities. A pension fund pays benefits for decades. It does not need all its money back next year, so it can accept having capital locked up for ten years.
• Access to different companies. Many companies are privately owned, and in some markets companies stay private for longer before listing. Private equity gives investors a way to own them.
• Alignment of interests. Carried interest and the GP's own commitment to the fund tie the manager's pay to investors' results.
• Diversification. Private equity adds different companies and different sources of return to a portfolio. (Because the investments are valued only periodically, their reported values move less than listed shares, which can make them look less risky than they are.)

How the model spread beyond buyouts

As the industry matured, the private equity model spread in several directions.

A continuation fund is a new vehicle set up by a GP to buy one or more companies from an older fund it manages. Existing LPs can choose to sell their share and receive cash, or roll their interest into the new vehicle. New investors provide the money for those who sell. This lets a GP keep owning a company it likes beyond the old fund's life.

Wider access for individuals raises its own questions. Private equity is illiquid, and funds for individuals must deal with investors who may want their money back sooner. You will see these issues debated in the industry press.

Key terms

• Venture capital: Investment in young companies with high growth potential.
• Leveraged buyout (LBO): The purchase of a company using a large amount of borrowed money.
• Leverage: Using debt to pay for part of an investment, which magnifies both gains and losses.
• High-yield (junk) bond: A bond issued by a company with a low credit rating, paying higher interest for higher risk.
• Limited partnership: The legal structure most private equity funds use, with a general partner and limited partners.
• Sovereign wealth fund: A state-owned fund that invests a country's surplus wealth.
• GP-led secondary: A transaction organized by the manager in which fund assets or interests change hands, often through a continuation fund.
• Continuation fund: A new vehicle set up by a GP to buy companies from an older fund it manages.

Key takeaways

• Organized venture capital began in the 1940s; leveraged buyouts developed from the 1970s.
• Buyouts boomed in the 1980s on high-yield bond financing, and the decade showed that leverage magnifies losses too.
• The industry professionalized and spread worldwide through the 1990s and 2000s, slowed sharply in 2008, then recovered.
• Long-term investors allocate to private equity for return potential, a fit with long liabilities and access to private companies.
• Large managers have diversified into other private markets, and secondaries and access for individuals have grown.