The big idea and why it matters: Like the development of electric guitars, modern Private Equity (PE) firms are the result of a natural evolution. PE is a necessary part of capital markets, and tradeoffs are part of every transaction – not just PE transactions.
“Life is like riding a bicycle. To keep your balance, you must keep moving.” -Albert Einstein.
It starts small
Leo Fender didn’t set out to change music forever. According to this timeline, he tinkered with amplifiers and public address systems as early as 1928, after graduating high school, while running an amateur radio station. That led to opening a repair shop, where he was able to start building “homemade PA systems and musical instruments.” That, it seems, allowed him to find his passion, which was to focus full-time on building instruments. By 1950, The Fender Electric Instruments Company, based in Fullerton, CA, released a solid-body guitar that we’d eventually know as the Telecaster. And four years later, the most popular guitar in history – the Fender Stratocaster – was unleashed upon the world.
Now let’s make a quick transition over to Wikipedia and an entirely different company: In 1902 (seven years before Leo Fender was even born!), The Gibson “guitar” company was founded by Orville Gibson about eight years after he’d started making instruments. But, the original intent was to make mandolins and mandolin derivatives – hence, the original company was called the “Gibson Mandolin-Guitar Mfg. Co. Ltd.” That’s a mouthful, but I guess long names come as part of being based out of Kalamazoo, MI. That led to the invention of the archtop acoustic guitar (structurally similar to a violin) and being at “the forefront of innovation in acoustic guitars.” But, the game-changer was the release of its first solid-body electric guitar – the Les Paul – in 1952.
For those who missed jazz history class, Les Paul was a great guitarist of his day (often paired in a duo with his wife, Mary Ford). Still, he was also an inventor who is credited with inventing the solid-body electric guitar – an idea he tried to bring to Gibson as early as 1941. I was fortunate to meet Les at the Iridium Jazz Club in NYC in the early 2000s, where he still performed into his 90s. He was warm, lively, and hilarious, and I hope he’s resting very peacefully, considering the legacy he left.
Now let’s get into more of that legacy and what any of that has to do with Alts. Here we go!
What’s the big deal about solid-body electric guitars?
In short, they changed everything. Before the solid-body format, guitars were only hollow-body; like an acoustic guitar, the hollow-body helps naturally amplify the sound. Once magnetic pick-ups (the things you can see under the strings that “pick up” the sound) and electric amplifiers were invented, the hollow body amounted to unwanted noise.
Solid-body guitars were quiet enough to allow the sound of the strings to be cleanly amplified, so the new electric guitars and bass guitars could be heard in larger venues – keeping up with drums and vocals – and the increased production meant widespread availability. All of that changed the face of music forever! I also have to mention that the backbone of the entire situation was the general evolution of technology and the widespread availability of electricity.
Hollowood
If you have a favorite rock guitarist who isn’t Ted Nugent (known for his love of hollow bodies because they make more noise/feedback), the guitar they’re known for playing is almost certainly a solid-body design. And, if you ever want to get into a long conversation with a guitarist, just ask for their preference for “Strat, Tele, or Les Paul.”
[As an aside, hollow-body guitars, like this Gibson ES-335, are still very much “a thing,” but not nearly as popular as the guitars discussed above. And there is A LOT more to guitar history, so here’s a good link if you’d like to go down that rabbit hole and bring CF Martin, Doc Kauffman, Adolph Rickenbacker, and Teddy Bigsby into the story]
Alts, please?
The roots of private equity go much further back in history than those of the electric guitar. As this article reminds us, “The Massachusetts Bay Company was an early prototype of the private equity model, in that it pooled money to help fund the burgeoning British North American colonies. Settlers sent to the new American colonies helped build up the economy, while those who stayed in England helped fund the venture, hoping to find a return on their investment over time.” There were also other examples along the way, like banks buying out distressed railroads (using leverage to restructure them) or the JP Morgan acquisition of Carnegie Steel in 1901 to create “what was the largest company in the world at that time: United States Steel.”
While these are what we now consider “private equity” transactions, the modern concept of private equity didn’t need to be invented for people to “do private equity.” Instead, it has naturally existed as part of capital markets.
It started small
As this overview of How Private Equity Was Born recounts – using Jerome Kohlberg, Henry Kravis, and George Roberts as an example – they “started small, doing debt-financed buyouts of family-owned companies in the 1960s and 1970s” before ultimately founding the official PE firm, KKR, in 1976. And, as with most things in life, a smaller version of something led to a larger version of that same thing. In this case, it was deals, and those deals soon would become bigger – MUCH bigger.
Barbarians at the gate
Suppose you’re familiar with the book Barbarians at the Gate: The Fall of RJR Nabisco. In that case, you already know that private equity transactions – specifically hostile takeovers and Leveraged Buyouts (LBOs) – erupted in the 1980s. Kravis and KKR are some of the lead characters of that epic (worth the 592-page read). Like electricity in our guitar history, there were factors in the background that played an essential role in PE’s roaring ‘80s. As this article astutely points out, there had been a shareholder revolution brewing for quite some time, at least partly due to the thought leadership of Harvard Business School professor Michael Jensen; he argued for paying managers in equity (better alignment of interest) and using a lot of debt (to force greater discipline of unprofitable pieces of the business).
If a CEO is paid primarily in stock, then it’s probably not a wild extrapolation to think there’s an incentive for that CEO to inflate the stock price like never before (and potentially even reason to obscure anything that could cause a price decline). That would surely make an LBO seem like a great idea, as – if properly executed – it could help to increase one’s net worth quite rapidly.
Still, a lot of fundraising was needed to light the fuse…
PE’s solid-body guitar
Even if one knew how to take over a company and successfully execute a leveraged buyout transaction (which is basically buying a company using a lot of borrowed money), it required access to huge sums of Other People’s Money (someone should make a movie 😊), sometimes very quickly. Enter Michael Milken and Drexel Burnham Lambert. Milken’s development of the junk bond, which we know more innocently as “high yield bonds” today, and his team’s ability to raise capital quickly, is a non-insignificant part of what spurred the LBO storm of the 1980s.
A natural progression
There’s a lot of finger-pointing at private equity. Case in point: a client recently sent me a newsletter entitled “Everything is Worse Because of Private Equity.” Unless that newsletter is called “Dripping with Hyperbole,” then it’s easily dismissible as clickbait. Even if PE were somehow ALL bad, how could it affect “everything?”
Were the 2000+ LBOs of the 1980s indicative of “overdoing it?” I’m sure the case could be made. Were they all good? Certainly not. Were they all, however, bad? I’d bet my life they were not. PE and PE firms have continued their evolution over the years. If they had zero utility for society, I’m also willing to bet the phenomenon would have disappeared by now. Private businesses need to be able to raise capital, grow, and change, which is the same for public companies.
And, let’s not forget that “private equity” involves much more than just LBOs. Are we also saying that Venture Capital – which is responsible for an incredible amount of technological advancement, millions of jobs, and who knows how much cumulative GDP – is ALL bad? It’s utter nonsense, and I’m sorry for wasting the time it took you to read that question.
Nail in the coffin
Unless you go out and pool money together to buy private companies yourself (or lend money to them in private loans, as is the case in direct lending/private credit), you need an experienced team to do it for you. And if you did do this yourself, you would still be “doing” private equity, but you’d be the PE firm! As we learned in its origin story, PE is natural, and there is simply no reasonable case for why it shouldn’t exist. Shut all PE firms down, and something will fill the capital needs that private companies have; even if you don’t call it private equity, it will just be private equity by another name.
Instead of my ranting, if you want to listen to what a thoughtful defense of PE is, this Capital Record podcast episode from David Bahnsen is a great place to start.
Full circle
After filing for bankruptcy, “in November 2018, [the Gibson Guitar company] was acquired by a group of investors led by private equity firm Kohlberg Kravis Roberts.” So, if nothing else, we can at least thank KKR and Private Equity for saving one of music’s most iconic and culturally significant brands.
Until next time, this is the end of alt.Blend.
Thanks for reading,
Steve
