When the U.S. economy entered a recession in the late 80s, financing disappeared putting an end to the big ticket buyout takeovers of that era. And although there was certainly a shakeout in the buyout industry, it does survive. Eventually the economy begins to recover and financing return, and new firms begin to emerge as major players on the scene, not just supporting actors to KKR.
But this time things are different. Banks are still scarred by the giant failures of years past and impose stricter lending standards. Gone are the days of 95% financing. Now banks are requiring 20-30% of equity be put up for buyout deals. This has a couple of implications – deal sizes shrink but BO firms also have to rethink how they make money because they can no longer rely as much on leverage to amplify returns. They begin to focus on creating real value through operational improvements and revenue growth rather than cost cutting and selling assets.
It turns out to be a great time to invest and their new approach is making investors attractive returns (though nothing like the 80’s) and the industry is steadily growing.
But as successful as these new private equity firms were, they were quickly trumped by a new era of technology investing.
In 1995, Netscape goes public and generates tremendous returns for the Venture Capital firms that backed the company.
The dot.com era had begun. Investors quickly turned their attention to Venture Capital firms that promised to invest in companies that would change the world and deliver phenomenal returns.
Venture Capital couldn’t be more different from than Private Equity.
First, VC is primarily on the West Coast, or also known as the best coast.
Second, VCs also have an informal dress code but depending on the type of jeans and hoodie it could be just as expensive as a suit (ha!)
Third, and most importantly, the biggest difference is in terms of investment strategy. Venture Capital firms investments are high risk/high potential return. They invest in unproven businesses, with new technology, and little of no revenue to speak of. Without revenue, they don’t use debt so leverage.
In a typical VC fund most investments will not make money, so the winner must be phenomenally successfully to overcome these loses. VCs also take a minority stake so they do not have as much control over the outcome of these investments.
By contrast, buyout investors are control freaks – they literally take control of the companies they buy and drive specific plans to increase the value of those companies. Unlike venture these are established companies with earnings and cash flow, which is really important because leverage is key to the strategy, and banks won’t lend money unless they are confident a company will be able to pay its creditors. These types of investments also have more predictable outcomes, which means less risk. So unlike the venture funds, buyout funds will have more winners than losers, but the potential payoffs aren’t as massive.
So by the time we get to the late 90’s the boring buyout guys are kind of watching from the sidelines as VC funds are getting all the love from investors. They hate this but they couldn’t compete. And some tried but it didn’t turn out well.
But all good things come to an end and early 2000, the dot.com bubble bursts. The crash was so catastrophic for tech companies and their investors that VC industry and it’s another 10 years before the industry starts to produce attractive returns.
That’s not to say that great companies didn’t come out of this era or later. Take Google or Facebook for instance. It’s just that success was concentrated in a very limited number of companies, and they weren’t in your VC portfolio you did not do well.
Join us for the next episode where we’ll discuss the subsequent events that shaped the next private equity market cycle in the 2000s and where that leaves us today.