A Brief History of Private Equity Through Five Deals
On the 29th floor of Morgan Stanley's offices at 1221 Avenue of the Americas, after you stepped off the elevator and walked through reception, if you turned right, you passed lushly decorated offices whose occupants ascended in stature as you approached a gorgeous view of the Manhattan skyline. The hall ended at the corner office of the CEO of Morgan Stanley's fledgling private equity firm, Morgan Stanley Capital Partners (MSCP).
If you turned left, you came to a wall of cubicles, each packed with analysts who, despite how seriously they all took themselves, looked out of place wearing ill-fitting suits as though they had dressed up for "bring your kid to work day." I was one of those kids. And except for a brief tour on my first day, I'd never stepped foot in an office on the right side of the hall, it might as well have been the other side of the world.
But on this day, I'd been summoned by Vice President David Ramsay's assistant. She had said simply, "David wants to see you." After standing for ten minutes outside of David's office, David ushered me in and cut to the chase, "How would you like to go to Missouri?" It wasn't a question.
I went home and packed a bag. Little did I know, I was about to be a footnote in one of the most storied investments in the budding private equity industry, a $500 million venture investment in a hog farm called Premium Standard Farms (PSF) in Northern Missouri, run by a bunch of New York Wall Street guys. What could go wrong?
Private equity has a long and storied past. Here is a small snapshot into the history of private equity through the story of five deals:
● 1982: William Simon buys Gibson Greetings
● 1988: KKR buys RJR Nabisco
● 1994: Premium Standard Farms (PSF)
● 1996: Chainsaw Al, Sunbeam and the birth of Asurion
1982: William Simon buys Gibson Greetings
There is no specific date when private equity—as it is referred to today—started. But one of the first investments to garner Wall Street's attention and imagination was the acquisition of Gibson Greetings by William Simon, the former Treasury Secretary.
In the early 1980s, Gibson Greetings was a greeting card company with roughly $100 million of revenue. In 1982 William Simon made an offer to purchase Gibson Greetings from RCA Corporation for $80 million. The only issue was that William Simon didn't have $80 million. In fact, he had very little money at all. William’s ingenuity was that he recognized that if he paid a slightly higher interest rate, he could convince lenders to loan the money for much of the purchase price of Gibson Greetings using the company's own assets, brands, and cash flow as collateral for the loan. William borrowed $79 million of the $80 million purchase price and invested only $330,000 of his own money. At the time, this type of investment was referred to as a "bootstrapped" deal, the equivalent of buying a home today with little or no money down.
Just over one year later, William took Gibson Greetings public at a $290 million valuation, pocketing $66 million on his $330,000 investment, earning 200x his initial investment.
This investment caught the attention of several rising entrepreneurs on Wall Street, including Henry Kravis and George Roberts, Steve Schwartzman and David Rubenstein, who would later found KKR, Blackstone, and Carlyle, respectively.
Over the years, both the vernacular and the types of deals would evolve. Bootstrapped deals would evolve into hostile takeovers of public companies. The friendly or non-"hostile" deals were termed "leveraged buyouts." But "leverage" had negative connotations, so the industry became "management buyouts," and later just “buyouts.” And then eventually the industry term became "private equity," a generic term which, literally translated, means simply equity investments in private companies.
1988: KKR buys RJR Nabisco
If Gibson Greetings put "bootstrapped deals" on the radar of a handful of Wall Street entrepreneurs, it was the acquisition of RJR Nabisco which garnered the budding industry national attention.
In the early 1980s, corporations were not necessarily run for the benefit of the shareholders, and perhaps no company personified this disconnect more blatantly than RJR Nabisco. Run by CEO Ross Johnson, RJR had a fleet of jets, executive chefs, corporate spending accounts, and country club memberships for its club of senior executives. RJR was a public company with a market capitalization of $12 billion and a roster of world class brands including Winston and Salem cigarettes, Oreo cookies, Nilla Wafers, Ritz crackers, and Life Savers.
Management initially endeavored to partner with an investor to take RJR private, but, in doing so, they ignited a massive bidding war for the company. Nearly all major Wall Street firms bid, including Merrill Lynch, Morgan Stanley, Goldman Sachs, Solomon Brothers, First Boston, Forstmann Little, Shearson Lehman Hutton, and KKR. KKR emerged as the winning bidder valuing RJR at more than $25 billion. KKR financed the purchase with roughly $22 billion in debt and $3.5 billion of equity, investing a whopping 63% of its $5.5 billion fund in this single deal.
The RJR deal was troubled nearly from the start. The towering debt load forced RJR to invest nearly all its free cash flow in debt service rather than investing in the company’s brands. In order to service this debt, the company sold off many of its brands including Del Monte, Nabisco's UK operations, and even a 20% stake they held in ESPN.
KKR wouldn't exit its RJR position for another 15 years. They would ultimately lose $730 million of their $3.5 billion investment. Notwithstanding the poor outcome, the deal would put KKR, and the entire private equity industry, on the map and usher in a new era of buyouts. The deal also put public company management teams on notice. The message was, “run your companies for the benefit of shareholders, or you will find yourself out of a job.” Public companies adopted much better corporate governance as a result.
While KKR demonstrated incredible aptitude in the innovative financing of the RJR buyout, it would be years before the budding buyout industry leaders would focus on becoming experts in helping companies improve operationally post-buyout.
1994: Premium Standard Farms (PSF)
Six years after KKR's ill-fated RJR purchase, as a first-year analyst at Morgan Stanley’s new private equity fund, I read the transcript of a speech by the fund’s CEO describing the firm’s $500 million greenfield hog farm investment. He said, “This investment will usher in a new era of private equity. We are using our capital to create and build companies, not just finance the purchase of them.”
As I started my drive from Kansas City to Princeton, Missouri, those words echoed in my mind. On the 2.5 hour drive to the pig farm, I passed very few houses, buildings, or other cars. As I neared Princeton, the Premium Standard Farms headquarters emerged on the empty horizon much as I imagine the Taj Mahal emerges in the middle of the desert. Like the Taj Mahal, the PSF headquarters had gold trim and a running waterfall. Half a billion dollars goes pretty far in farm country.
Wall Street writers debated, was Morgan Stanley brilliant, catalyzing—as my CEO promised—a new form of private equity? Or was Morgan Stanley delusional, building a $500 million hog farm in the middle of nowhere? I would find out more quickly than I imagined.
My first task was to work with Kevin Becker, a brilliant Morgan Stanley alum and recently appointed CFO. Given there were no hotels within 30 miles of the town, I camped out in Kevin’s basement for my six month tenure. Our job was to determine why the company didn’t seem to be performing according to projections. To a hammer, every problem is a nail. My only useful business skill at this time was my ability to input numbers in my Lotus spreadsheet. I reduced the 30+ page Morgan Stanley PSF financial model to a single page.
The answers jumped off the page. The company was missing nearly every assumption; the birth rates, growth rates and operational expenses we had projected weren’t even close. And the most unfortunate assumption in the model was hog prices. Over a period of two years since the investment, hog prices fell from roughly $.50 per pound to a low of $.10. In a business with high fixed costs and $400 million of high cost debt, an 80% reduction in revenue due to falling commodity prices crushed the company.
Morgan Stanley was right about the attractive economics of raising pigs and ultimately, they were right about the long-term increase in pork demand. But they failed to put in place a management team who could execute on the plan. Inconsistently missing projections, the management team lost the confidence of the board. When hog prices fell, Morgan Stanley panicked. They handed PSF over to the banks via a bankruptcy process in 1996, creating a 100% loss on Morgan Stanley’s investment.
Two years after the bankruptcy, hog prices rebounded from $.10 per pound to $.60 per pound. PSF went from zero earnings in its trough to earning over $200 million only two years later. The company was sold to Smithfield shortly after, yielding a windfall for the bond holders.
Morgan Stanley’s idea was ahead of its time. “We are going to use private equity to help build companies.” This ultimately would be the model employed by many of the most successful private equity firms. But Morgan Stanley would soon learn that businesses don’t live in Lotus. Results are created by exceptional management teams who, with investors’ support, are able to take a long term approach to building their company. Morgan Stanley had neither exceptional management nor a long term horizon, and thus they never realized their vision.
1996: Chainsaw Al, Sunbeam and the birth of Asurion
In 1996, the same year as the PSF bankruptcy, two noteworthy new deals were launched, one to great fanfare, and another in near complete anonymity.
When Al Dunlap, nicknamed “Chainsaw Al”, took over as CEO of public consumer goods conglomerate Sunbeam, the share price rose immediately by 49%. Chainsaw Al had famously made over $100 million as CEO of Scott Paper by slashing expenses, divesting assets, and shrinking debt in order to sell the company at a big gain, all in the course of a single year. Chainsaw Al’s hammer was cutting costs, and he swung that hammer hard, cutting Sunbeam’s employees in half (from 12,000 to 6,000) in the first year alone. But Dunlap and Sunbeam shareholders learned that you can’t cut your way to greatness. Amidst high leverage, flailing brands, and an accounting scandal, Sunbeam declared bankruptcy in 2001, whipping out more than $3.2 billion of shareholder value over Dunlap’s tenure. Dunlap’s chainsaw reign mercifully came to a crashing stop.
The second of the two ventures started when two young Stanford GSB case writers and former graduates, Kevin Taweel and Jim Ellis, quietly and unceremoniously raised $4 million of equity from friends, family, and business school professors to purchase a small roadside assistance company in based in Houston, Texas, called Road Rescue.
Kevin and Jim were young and hungry former students of Irv Grousbeck, a Stanford professor and successful entrepreneur in his own right, who also invested in and became a board member of their company. Among other things, Irv taught his students to build their company for the long term, hiring world class people well ahead of the company’s current requirements, “Hire by looking through the windshield, not the rear view mirror,” was one of Irv’s philosophies. Kevin and Jim followed this playbook well. They built a world class management team that included several heavy hitters from outside the industry.
Road Rescue contracted with mobile phone carriers to provide roadside assistance to those carriers’ customers. As mobile phone usage exploded, RR rode the tailwind and subsequently purchased a small mobile phone insurance service company serving the same carriers.
Kevin and Jim renamed the new company Asurion and continued to invest significantly in their management team, hiring well ahead of the curve and continuing to infuse their young company with incredibly talented executives from outside the budding industry.
Twenty five years later, Asurion is the largest mobile phone insurance carrier in the world with over $10 billion of revenue. At the last price at which Asurion’s shares traded in 2020, initial investors received more than a 7,000x return on their initial investment. If you could have invested in Road Rescue or in the Amazon IPO, which took place several months after Road Rescue was formed, you would have made more money investing in Road Rescue.
Kevin and Jim approached their business as though they were going to own it for the long term. They invested in talent and capabilities, and they built a durable business with a fantastic reputation. Though they were acquisitive at times, they viewed themselves more in the company building business than in the deal business. They quietly built one of the largest private companies in the world.
I have been in the private equity industry now for 27 years. I worked at four large private equity funds before founding Alpine Investors in 2001. I have invested in over 300 private companies, including as a minority investor in search funds, as a fundless sponsor, and as a majority investor at Alpine.
Private equity has evolved significantly over the last 27 years. Today, the industry means many things to different people. There are over 5,500 private equity funds worldwide, and the industry gets more competitive every year. Competition, demanding investors, and a range of other forces conspire to entice investors to sell their best companies early for big gains, or to try for quick wins, typically through excessive leverage as was the case with RJR or through cost cutting akin to Al Dunlap.
But we have learned at Alpine, that there is one strategy that will work in any and all economic environments. It is the strategy Morgan Stanley tried with its investment in PSF and which Kevin and Jim successfully employed at Asurion. And that strategy is to hire incredible people and build great companies for the long term.
This strategy takes time and patience. Cutting expenses yields immediate and quantifiable results, which is why it is so enticing. Conversely, hiring exceptional people, the activity I believe to be the single best leading indicator of success, immediately shows up negatively on a company’s financial statements and most of its KPIs. And such a strategy doesn’t work at all if your holding period is short, or if you are highly leveraged.
But if, like Irv Grousbeck, Kevin Taweel, and Jim Ellis, you recognize that great companies are built over years, and even decades, and you adopt the mentality that the best investment a business can make is investing in its people, you will have an investment strategy that will work in nearly every market.
Sources
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