Controversy and the Future of Private Equity

In eighteen ninety eight, John Nuvine had a vision to underwrite municipal bonds that would propel American infrastructure into the twentieth century. More than one hundred and twenty five years later, that vision lives on. Today, Nuvine has grown into a leading global asset manager with expertise spanning public and private markets, still investing with a future in mind Nuine Invest like the Future is watching. Visit nouvine dot com slash future to learn more. Investing involves risk, principal loss is possible. He sounds like he was quite a strong believer in capitalism and in the profit motive Daris said almost like a Gordon Gecko character who believed that greed was good. I think he doesn't necessarily believe that it's greed that is good, but rather entrepreneurialism or what he thinks of as being that. He genuinely believes that what needs to happen to America's economy is it needs somebody to come along and really breathe life into it. someomebody in government compared them to Genghis Khan at one point, right? Yes, And I think that gives you both a sense of where he's coming from politically but also a sense of his character Today on the story of money, we're going to be delving into a story that connects Gordon Gecko with Garfield, The Cat I love it. I mean I was a teenager in the nineteen eighties and they are both icons of the nineteen eighties. Gordon Gecko famously said Greed is good, epitomising. the attitude of Wall Street in those days And Garfield, well, what can I say? He was a cartoon character famous for loving Lasagna. And believe it or not, that link is relevant But there's something else that links them beyond being born in the eighties. and that's the subject of today's episode And that is the business deal that launched the private equity industry. And I mean, let's be honest, it wasn't the first ever private equity deal out there, but the key point is that this was the deal that put private equity on the map And back then, in fact, it wasn't actually called private equity The keyword is the leverage buyout era of the nineteen eighties. And that's where Gordon Gecko comes in of course, because LBOs were all about borring up to the hilts, tons and tons of debt in order to gobble up a stodgy, inefficient company and then beating it into shape or breaking it up and selling it off for parts essentially. And obviously it's hugely relevant today because Private equity now controls a swath of the corporate world. It's one of the biggest alternative asset classes out there in the world. And that means it's still pertinent to ask just how much value this kind of more cutthroat bucaneering form of capitalism born in the nineteen eighties actually adds. Welcome to the story of Money from the Financial Times. I'm Robin Wigglesworth And I'm Gillian Tett, child of the eighties Okay, so Jillian, I promise we will get to Garfield soon enough, but first of all, we have something much more important to introduce, and that's our guest today, Hetty O'Brim. and Hetty is the author of a new book about private equity' influence on the world today. It's called The Asset Class, Killer Name. and Hetty is also a fantastic opinion and long read writer at The Guardian So He, thanks for being here today Thank you very much for having me. Now Heti, you work for Guardian, which is not usually a publication that delves into the finer details of financial structures. So tell us you know what made you want to write about private equity Well, I think that's part of the reason is that I kept finding private equity in places you just wouldn't expect it, whether that was in housing or in care homes or in our water system. And it just seemed as though after two thousand eight in particular, the industry had gone on this incredible spending spree buying up everyday services and so on. And it just made me really curious. I was wondering, what on earth is private equity and why has it grown seemingly so powerful But I think the more I looked into it, the more I realized that it goes back way beyond two thousand eight. and there is this fascinating story about this renege group of financiers in the late nineteen seventies and early eighties who really see themselves as involved in this kind of revolution that is going to breathe life into America's tired economy. and they believe that they've discovered this tool of kind of financial ingenuity that will do so and that will really revive entrepreneurialism And yet at the same time, now we're seeing all sorts of critiques directed at the industry. And so I think the sense in which it was trying to do something that perhaps it hadn't fully managed to achieve in the present day was just a contradiction that I found very interesting I can understand that. And today obviously we are going to be focused on one of those renegades, you mentioned, those early days, long before frankly the term private equity had even been invented And this renegade we're going to be focusing on is who you called sort of the father of private equity. And I think lots of listeners might think that there's somebody like you Colberg, Kravis, Henry Kravis, George Roberts, the founders of KKR. who did one of the first deals. Actually, we're going to be talking about former U.S. Treasury Secretary William E. Simon Can you tell us a bit about him Be he was kind of summed up this kind of more ideological bent that you mentioned, right? Yeah, and I think compared to some of the other private equity people that we know and have heard about. he's largely been forgotten from the history books, which I thought was really interesting. He is this polarizing, fascinating, quite abrasive figure. and he's born a year before the crash of nineteen twenty nine or maybe a couple of years before the crash. And so he comes of age during the New Deal He goes into the US Army and then he ends up going into finance. He works at Salomon Brothers, where he is a bond trader. He's an incredibly good bond trader seems to really suit his kind of binary approach to things. There's no gry in the bond business. It's all yes, no, buy sell. and he's very decisive as an individual. He sounds quite an unusual type of public servant then because Back in the nineteen sixties and seventies, the people who were serving in high office usually weren't coming from Wall Street as such. and yet He sounds like he was quite a strong believer in capitalism and in the profit motive. Darow said almost like a Gordon gecko character who believed that Greed was good Well, I think he doesn't necessarily believe that it's greed that is good, but rather entrepreneurialism or what he thinks of as being that. I mean, greed is more of a byproduct perhaps, but I think he genuinely believes that what needs to happen to America's economy, which he thinks is really stuck in the doldrums is it needs somebody to come along and really breathe life into it And I think that when you think about where he was coming from, He really entered government, I think it was nineteen seventy four. It was under the Nixon administration. He was Treasury seecretary And during that period, Nixon's elected after Linda B Johnson, who is engaged in this huge G society programme of using the power of the federal government to address all of these kind of social ailments. and all of that is based on vast deficit spending And Simon looks at this and he thinks firstly as a conservative Catholic that The family, not the state should be really where people are turning to for help And secondly, that This is a vast programe of government overreach that is extending far too deeply into people's lives and is also involving the running up of huge amounts of public debt. And so there's a kind of irony in the sense that yes, he goes into government, but he also kind of despises government or at least government at that point in time. Somebody in government compared him to Genghes Khn at one point, right Yes, and I think that gives you both a sense of where he's coming from politically, but also a sense of his character. I do think he manages to alienate quite a few people on his journey. In your book, you make the case that there are a lot of key moments in his time from government that kind of really crystallize his conservative but extreme pro market beliefs What were those moments and why were they so formative for him Well, I think the first moment is actually some of the trips he makes to the USSR during his time as Treasury seecretary. He makes, I think two trips and he hangs out with Brezneev, who he thinks is actually a very nice, jovial guy and they have Sturge and caviar and vodka, and they seem to have a really good time. Sounds very convivial, yeah. It does sound very convivial And Simon gets back on his plane back to the US and he writes about this later and he says actually, what he'd seen during his time in Soviet Russia was this sense in which the Russian economy was entirely propped up by Western ingenuity and invention. So the Russians were buying caterpillar bulldozers, they were buying synthetic fur coats, buying factories that had been completely ready made and then they were importing those into Russia. and all of this stuff was coming from the West And so whilst this Russian economic situation entirely depended upon the West, what he feared was happening was that that Soviet approach to government, the sense of overreaching state planners, was migrating from Russia westwards. and it was a sort of sickness infecting both Western Europe, and eventually he feared it would infect America So that was onene of the first formative moments in his political journey. Another one was slightly later when he was made the energy czar during the oil crisis And this was a period of huge panic and unrest, and there was a real sense of actually society is almost falling apart here because everything in America depends upon fossil fuels And when he was put into that position There was a lot of political pressure to introduce a rationing program that would conserve fuel by rationing it out. And he was really opposed to that. He thought rationing was kind of akin to the type of government planning that he'd seen in Soviet Russia. And so he instead decided to try and cobble together this system of fuel allocation. that really didn't work. But to him, what he took away from that was that you cannot try and mimic the invisible hand of the market by using the levers of government. Essentially what we have then in the middle of the nineteen seventies is this nosed, no nonsense, free market idilologogue William E. Simmon who strongly believes that you need to have competition and the profit motive to drive efficiency and growth And he's a former financial trader, so he knows how markets work He has also been in the government during the nineteen seventies under both Nixon and Ford. And that's made him even more convinced his experience of being in government and then seeing the Soviet Union that you have to have free market forces to deliver growth So That's our key character. and then in nineteen seventy seven somethingomething critical happens The Republicans lose power, get kicked out brand new Democratic president comes in, Jimmy Carter So How does that unleash what happens next I mean, Simon is massively disillusioned by this. He was obviously hoping that Gerald Ford would win. And I think there's a sense in which Simon is almost ten years too early in terms of his political instincts because really later these take off during the Reagan administration, But Simon effectively takes a break from public service and he decides that he's really done with government. back to New Jersey, where he's from And he writes a book and that book becomes a bestseller, and that book is called A Time for Truth. It is a complete Deremiad of a book. It's actually very funny at points and extremely polemical Simon really didn't like writing, so he managed to find a ghost writer called Edith Efron, who was a good friend of Ane Rand to write the book for him. and it made a series of arguments about why government intervention was a bad idea and why there was this risk that America was drifting towards what resembled more of a Soviet or what he called social democratic model And I think then he decides partly because he's no longer in government, that he really wants to try and find a way of enacting his political instincts or principles in another sphere So he decides to go into business and at least look for ways within the kind of business realm that he can adopt some of these ideas and really enforce them and have a big effect And so he becomes president of the Olin Foundation, which is a think tank that is really working to roll back some of those New deal regulations and principles He also gets involved with the Heritage Foundation, which is a similar think tank. And by the time Reagan is vying for the Republican presidential nomination, it really looks as though Simon is going to play a huge role within the Reagan administration if Reagan gets elected. But actually, Reagan basically takes one look at what Simon wants, which is control of levers of economic policy making normally answerable to the president. And he basically says I think this guy wants too much power. I'm not really willing to have a self appointed csar in charge of my economic policies. For Simon, that really is a red line. He's quite uncompromising, as I said, He really is quite black and white. And so again, he decides, right, well, if I can't do this in government, I'm going to try and do this in business. And that really is a key moment because that's when he starts to think about things that later become known as leveraged buyouts. So he decides not to go into administration because he can't get what he wants out of Reagan, but how does he kind of stumble almost into this kind of leveragage buyout industry, which I mean let's face it, it wasn't even an industry at the time, right? How did that happen No, and it's actually really kind of serendipitous for him. He's golfing in New Jersey and he has membership of a particular club where there's this other guy who also plays golf there called Ray Chambers. and Chambers is kind of the opposite of Simon. I mean, he's got a business background as an accountant. He used to work for Price Waterhouse And he had become very successful during the nineteen seventies because he had been involved with the nursing home business through a company called Metrocaare And it was during the seventies that there was a IPO for Metrocaare that left Chambers with quite a lot of money And rather than just retire, he'd actually had a second insight, which was that there were all of these Uvalued companies hanging around in the late nineteen seventies, many of which could support large amounts of debt on their balance sheet. and a kind of wily entrepreneur or somebody who was smart and realized that there was value to be tapped here could borrow against the value of those companies's assets and use that debt to finance their purchase, which is what looks a lot like a LBO And so Simon and him got talking And not only was a sense that I guess opposites attract in the sense that Simon could do the big picture stuff, the fundraising, the political networking chambers could do the detail stuff. there was also a sense from Simon that Chambers had really spotted something, but he was doing it on a scale that could be far, far bigger And Simon could see that actually you could apply this principle to much larger conglomerates, and that was where you could really start to have an effect So in terms of their skill set, it seems a bit like a match made in heaven And, you know, what was Simon hoping to get out of doing all this Well There's a number of things I think he was hoping to get out of it. One of them was personal. He did want to make money. Former bond trader, I'm assuming that was a large part of the motivation, especially after I worked in government service for a bit This was the era breed is good, wasn't it? you know? He also had seven children to say Oh wow. Yeah there was that as well. I've got three and they are a massive financial drain, I can show you, yes. Yeah. So when he went into government, he had put his fortune from Salomon Brothers, which was roughly five million dollars into a blind trust to avoid conflicts of interest. And when he left government, it had shrunk by about half. a sense in which he really needed to make that up and hopefully make more as well I think there was also he spotted effectively opportunity. that I think the post warar era was one in which this kind of managerial ation emerged as being the dominant way of doing business. and there was a sense in which these CEOs who were in charge of these vast corporations had embarked on these empire building projects, buying up subsidiaries and unrelated companies that they really didn't know much about and forming these quite large but quite shaky and quite bureaucratic conglomerates. And Simon compared these two watching a sumo wrestler compete in figure skating in the sense that many of these companies It's completely the opposite of an efficient, lean, mean machine And so I think he saw that that was a ripe opportunity, but also at the same time, there was, know those ideological principles he'd been trying to do something about for a number of years. And actually one of the things that he really wanted to do was to, as he saw it, really give some of these kind of enact managers a bit of a kicking and actually show them that it was entrepreneurs who should be in charge of the economy or at least you know private individuals who had a better sense of where value existed and weren't so complacent. weren't kind of dining out on the company credit card and having these various forms of corporate largesse Yeah, and probably not an entirely unfair critique in the eighties as well. So we're in nineteen eighty one now. Simon Chambers decided to set up a partnership. I love that they call it Wesray. so William E. Simon, Wes and Ray from Bray Chambers. So they have this partnership called Weesray. And can I just say by the way, I think Weesray is a dreadful name, but anyway, Hckty. I've heard worse in finance. I think we both have, haven't we Jillian Absolutely, yes. What did this gastly named Rly actually do? So yeah, the somewhat unimaginatively named Resly. was very much involved in small scale things at first. There was an oyster farm in Long Island There was a subsidiary of a far larger company that sold cans and matchsticks and that sort of thing. and there was a company, I think that rented musical instruments to children's schools or something. So these were not really partarticularly memorable or era defining deals, right? I mean, just to be upfront about this, this wasn't the first ever leverage buyout to take place. Yeah, I mean, I thought the one that I've always thought was the first one or generally considered, it just wasn't this high profile is KKR, which we've already mentioned, purchase of Hudle industries But it just was far less high profile than the one WesRay put together that we're going to be exploring, partly because just the one we're going to be digging into now was so insanely profitable, right So really kind of telegraph to the entire world financial potential of this new nascent embryonic LBO industry. It's not the first, but it's certainly the most the most significant in terms of the sheer amount of money that was made and therefore it became a touchstone, a way of almost a proof of concept for the LBO as a form because it showed that you could come away with an astronomic amount of money of profit So I think that's what makes it really, really significant. And in terms of the actual just the sheer coverage that it generated, was on the front of New York magazine. timees covet it Everywhere was, everyveryone and every media outlet seemed to be talking about this at the time. So it really cut through Okay, so you've created a lot of narrative suspense here. Yeah. It's nineteen eighty two and Wesre is about to do this iconic deal which made history, as he said, what was it? You wouldn't think it would be iconic given that it was for a greeting cards company, which doesn't really seem to be one of the kind of industries of the future when we think about, you know capitalist ingenuity. It was for a company called Gibson Greeting Cards, which was a Greeting Cards company based out of Cincinnati. It had been manufacturing Greeting cards for many, many years Crucially, it was sitting on some very valuable intellectual property, which was Garfield the Cat. It owned the rights to Garfield the Cat. a very popular hartoon feline, as we all know And it was also one of the textbook types of forms of value hidden within a conglomerate that Simon had been looking for, Simon in Chambers Gibson was owned by a radio Corporation of America and they had bought the company without necessarily realizing the true value of the asset that they were sitting on and now they were looking to Unload it. And there was a sense in which it hadn't been fully optimized and there was value to be had here if you knew where to look. So they weren't just massive Garfield fans, essentially. That's not why they went for Gobbson No, I mean, they may have been, but that's yeah, I guess that's not the main reason. So Tell us exactly what happened. I mean, how did this deal all come together whether without the cat. So RCA sets this purchase price for about eighty million dollars. and Wesray buys a company by investing just one million dollars of equity. that is made up of Chambers and Simon each put in, I think around three hundred thirty thousand dollars and the rest comes from Wesroay's other partner and employees. And so they have basically bought the company using just a million dollars. How did they do this? They borrowed seventy nine million and also sold off some of the company's real estate assets to finance the transaction I don't think this has ever been done before that point in terms of buying a company for that little, injecting so little of your own capital into a deal and Simon does looads of fundraising. There is, as I mentioned, this piece in New York magazine after the deal goes through that says the deal is wrought as if by the hand of Uncle Sam because Simon relies heavily upon his contacts in the US. government to open doors, but also from his time as Salomon brothers. So he's really the kind of hustling. fundraiser and Chambers is doing the accounting and the detail And there is a moment when it looks like the deal's not going to go through when General Electric, which is one of the lenders for that seventy nine million wants to pull out. and Simon says if he was still working at Salam and Brothers, he'd chuck you out of a window or something along I'm paraphrasing, but it's something like that and Chambers manages to talk him down from his perch. And so the deal completes. That's what happens and actually during the time before they then take the company public, very little changes. Why do they even try and structure an LBO in the first place? Why didn't they just go and buy it in the normal way There's lot of benefits for doing it this way. First of all, if it fails, then Gibson, not them, are responsible for paying off that seventy nine million of debt. So they will only lose three hundred thirty thousand dollars each Also, there's the fact that the interest payments on all of that debt reduce their taxable profits, which means that more money gets rerouted to them as kind of capitalist disruptters rather than the government tax manen making it more profitable for them as a deal And there's also the fees that they can charge the company for the privilege of being owned by them. And Simon is quite open about this. He says we charge the company fees and then some, again, I'm paraphrasing. It basically meant that they got the company for free by covering their initial three hundred thirty thousand purchase equity that they had invested, they managed to recoup that by charging the company fees while they owned it. So there are a number of reasons why this just looks like an incredible opportunity and it really is hard to overstate just how revolutionary that was, this had not been done before at this scale Yeah. I mean, this is kind of it's not even just LBO. it's like LBO maxing almost to use the modern vernacular where you you're borrowing basically almost all the money and the tiny little sliver of equity you're putting in actually is covered by the fees almost instantly that the company itself is paying you Sounds incredible. but how did the deal play out? How did I'm guessing State me out' like bandits, right Yeah, I think you could say that. I mean, I think the thing that was really interesting to me while I was looking into this was I was trying to understand, well what had they done during this period of ownership? because they take it public roughly eighteen months after the deal first closes And the typical private equity narrative is that you instill kind of operational improvements, you basically turn a company around and you create value in a way that was't in a way that it didn't previously exist One of the things that I found striking about this deal was that actually very little changed in the company. The management structure still looked pretty much the same. There hadn't been any dramatic kind of operational changes that had occurred during their period of ownership And actually, Simon himself was pretty open about this. He was just lucky. They bought it when there was a downturn. The markets then recovered, they sold it eightighty months later And they effectively had borrowed when interest rates were low, and they had seen a massive opportunity and the timing had paid off. And so when the IPO happens eighteen months afterwards after the deal closes Its value has soared to something like two hundred and ninety million dollars up from the purchase price of eighty million do. So for each dollar they invest, they make something like a two hundred dollars return on that investment I would have loved to be involved in this. It just sounds like so fabulously profitable. Probably wouldn't be a journalist,. A two hundred times return in eighteen months sounds pretty incredible, right? Yeah, that is It is fascinating that they didn't really sort of do anything because like you say, that is such a core part of the narrative back in those days and obviously today that you know private equity with the right incentives, the right management team a more hard headed approach to capital allocation, they'll turn you know Coal into diamonds And then this case, it was just basically luck And also a few of the Gibson's competitors went bankrupt in those eighteen months, right That was another factor, I think, that helped to explain why it became so astronomically profitable I also liked the fact that Simon was quite open about this. I think at one point he said later on, this deal has been poured over by business professors But actually it's very unlikely to be repeated because it was mainly luck and I think there's something kind of refreshingly honest about that And yet the reality is that when Wall Street saw what had happened and a two hundred times return had just been reated in eighteen months. In eighteen months. Yeah. So you know, the reality is that you know there's never an idea on Wall Street that other people don't want to replicate if it works and makes money. And so unsurprisingly, contrary to what William Simon said, we're about to see a dramatic boom in Cobbycat LBOs And that didn't just lead to specific deals, it began to change the wider business culture on Wall Street, it paved the way for the explosion in private equity we're living with today also, of course, it sparked a lot of controversy. So We'll be coming back to that after the break. The future of fixed income investing will continue to blur the lines between public and private markets. NuVven's credit platform was built to navigate the shifting landscape, channneeling capital toward the businesses, infrastructure and energy solutions that are shaping tomorrow's economy, all while aiming to deliver the resilience and returns that portfolios seek today Nuine. Invest like the future is watching. Visit nouveine. com slash future to learn more. Investing involves risk, principal loss as possible. And we are back. So it's nineteen eighty three. News of this Gibson Greeting cards deals success is spread across Wall Street like wildfire made William Summon quite rich actually very, very, very rich, without very much work either on his end And it seems everyone is now looking for ways to replicate this success No surprise there. but This deal isn't the only reason why the LBO industry is about to explode It just so happens that the excitement about a two hundred times return was colliding with some other bigger structural factors influenced how people regarded it as well Hetty, explained to us why the bigger political economy context mattered so much I think it's really important to understand this. I think what happens after the Second World War is that there is this period of American supremacy with a lot of the companies that emergeed from that period really dominating the economy. But then towards the nineteen seventies, you get the European and Japanese markets had been somewhat sleepy after the Second World War, actually roaring back to life after factories are rebuilt from bomb damage and so on And there is a sense in which a lot of these managerial corporations had dominated the period after the Second World War in the US are now coming under competition from other places. At the same time, there is this point about the financing that I found really interesting when I was doing this research, which is that a lot of the banks prior to the LBO wave taking off were lending to countries like Mexico and Brazil. And when the Latin American debt crisis sparked in the early nineteen eighties banks had built up these massive syndicated lending teams that basically had nowhere to lend that money to. And so they basically just changed course, steered the ship in another direction, and started lending to LBOs. At the same time, there is a really important bit of government regulation that really changes the game and leads to a massive influx of capital into this industry. And that's with the Securities and Exchange Commission that starts to allow private funds which have previously faced strict limits on the amount of money that they're able to raise from investors to raise more money from a greater number of investors And so that means that you're also seeing much more capital flooding into this industry. So I think those three factors really come together to help explain why this really takes off when it does. Yeah, because I looked up the numbers here. and in nineteen eighty one, before these rules had been introduced, alBO funds raised two hundred fifty million dollars, which was real money back then, but not Massive But by nineteen eighty seven, they'd raised fourteen point six billion dollars So clearly in you st it's a massive change And there is one more component here, right? And it happens to be about one of the people I find the most fascinating pretty much in financial history, Michael Milken So Mike Milkin, for the people that don't know him, in the nineteen eighties, he sat inside an investment bank called Drexel Burnham Lambert and he became known as the Junk Bondb King And he wasn't just frankly the king of the junk Bong market He was its creator, its godfather. He really kind of conjured it up almost, not quite out of thin air, but not far from it Junk bonds. They are essentially bonds issued by companies that are not rated investment grade by one of the big credit rating agencies. And anything below tririple B is essentially considered junk or below investment grade Essentially it's the way the credit rating agency says, you know they'd be dragons I'd love to hear how Mike Milkin and his junk bong machinery fits into this story because that was also another big factor that came in and powered this phenomenon, right Absolutely. And I think Milkin is totally fascinating, but also he has this one major insight. I he's firstly totally obsessed with bonds. He knows absolutely everything you can do. All good people are obsessed with bonds, Heetie. It's just a fact of life. And he basically has this insight which he picks up during his time at Wharton where he's studying finance He realizes that actually a lot of these lower rated bonds from companies that have either fallen on hard times or don't really have an established reputation or are the types of things that Wall Street's old guard might treat with sort of slight derision and wear rubber gloves when dealing with them You can actually make a lot of money by trading in these junk bonds because at certain points in an economic cycle, the return on those can be better than they would be for her grade bond or higher grade companies. And so He is dealing with something that has previously been stigmatized and he sees his role as much more actually than just a bond salesman. He is really thinking of his work as something like reviving this spirit of American entrepreneurialism. So it's a similar kind of ethos to that shared by Simon findinding out that he printed off this map of the US and put pinpoints on it for his children to see all of the different companies that his junk bonds had financed. So that was everything from film studios on the west coast to a nursery chain to a number of casinos actually in Las Vegas. And I kind of wonder what Las Vegas would have looked like if it hadn't have been for Michael Milkon. Well, CNN as well. CNN was financed entirely by junk bonds. so Ted Turnay was something Obviously Ted Turner recently passed away in maybe as a bit of a bondood. I was almost disappointed to see the lack of mentions of Mike Milkin's role in birthing CNN in all the obiteraries for Ted Turner Yes, yeah. And I think he Mike Milkin didn't initially really foresee just how pivotal junk bonds would become for takeovers or for what became known as leverage buyout. In fact, He hadn't thought that this was going to be necessarily their use, but what they provided was a vast new pool of capital that allowed outsiders to basically approach large companies that they would have never previously been able to dream of taking over And junk bonds were a weapon to finance those transactions. I think it would have been 's pretty much impossible to imagine an Lbo wave taking off in the way that it did without Mike Milkin and his junk bonds So in many ways, it was a kind of insurgency, a use of asymmetric power to use a term that's very popular today and took a lot of people by surprise. and it's worth pointing out as he said, that William Simons was driven by not just a desire to make money, but also this quite evangelical desire to proclaim the value of free markets right across America But Even back then there was starting to be controversy and As the LBO market boomed, back in december the fifth, nineteen eighty five The FT published an article that was entitled How Mr. Simon opened the floodgates talks about how the Gibson Greeting deal took Wallterre by storm. It mentions a stat The number of LBOs jumped from one hundred and sixty four in nineteen eighty two T to two hundred and fifty in just two years in nineteen eighty four. So you have this astonishing stat. off course, on the face of it looks really good, Do doesn't it, Robin? Well, yes, but The other interesting thing about this article is that it also brings up a lot of questions from critics. and there were critics at the time and there weren't of labour union officials from companies being dismembered. They're from the Wall Street elite that are also a little bit concerned about this phenomenon There's a quote here from a senior partner at the investment bank Lazard U Hetty and Jyen, we all know who he is, but it's Felix Rowaton who the FT describes as one of the most respected Wall Street bankers, but really frrankie leegend on Wall Street. He told our reporters at the time and I'm going to dig out the exact quote here First, it bets the company on a combination of continued growth and lower debt rates with no margin for error It substitutes debt for permanent capital which is exactly the opposite of what our national investment objective ought to be. And that's a direct quote from Felix Rowatin So I mean Hetty I'd love to hear why you think this practice Although it was embraced by people like Milkin and Simon, was so controversial and at least part of Wall Street's O guard. Yeah, and I think this is really fascinating actually, because it's very easy to find critics of private equity in the places one would expect, labour unions and so on. But actually even today you still get criticisms coming from people who you would think of as being the kind of arch defenders and believers in capitalism And Felix Wotin is one of those or was one of those And I think it really comes back to that point that Gillian made. this is a group of renegade insurrectionary outsiders who are tearing up effectively what remains of the post war consensus in terms of America's corporations. There was another quote that I came across from Felix Rowaton and he described that large corporations can be treated like artichokes and simply torn apart And so I think it's that comes back to that question of power. Wh holds power now on Wall Street? and it's looking as though power is tilting away from the old guard, the people like Felix Rowerton who came of age during this particular moment and had this idea of national investment objectives, which is something that kind of belongs also to that period of government intervention in the New Deal and it's tilting towards people who are these Financial outsiders were previously, and are now managing to take over corporations and in some cases tear them apart like artichokes But the difference is though, it wasn't just about The old guard, the incumbents hating a bunch of disruptive newcomers who are threaten their power. There were also much bigger philosophical questions at the same time, like does this type of wheing and dealing create a very short term vision of capitalism, which is potentially bad for the economy overall And if you are structuring this to assume that interest rates will always be low and growth will continue Is that creating a bunch of risks for the future? And what's fascinating is that those two questions are incredibly important right now Given that we just had a period of ultra low rates and reasonable growth and given there's real concern about short termism in a wider sense Yeah. And I think these questions have continued to stalk the LBO and then private equity industry to this day. In terms of the research that I was doing, I couldn't see that the industry had ever really managed to match its nineteen eighties high point in the sense of its ability to create value and returns and these operational improvements that it injected into some companies because when you look at the academic literature, there is a real sense that actually the early LBOs did kind of do what they said they did on the tin. There were more companies, large conglomerates that were sitting on these undervalued assets Right. That's fascinating because in some ways, the story of financial innovation is about somedbody having a good idea which works well and often has real merit in the first few deals, And then because it works, everyone copies it and clones it and takes it to extremes and applies it in areas where it shouldn't really be applied. and things go horribly wrong. I mean, that was the story of cred derivatives story of LBOs and the story of so much else, good ideas then go bad. So just to recap for our listeners, LBO's you know go through this massive frothy hyday of the nineteen eighties driven by the evangelizing zeal William Simon who believes in free markets and the fact you had this fairly specific set of historical circumstances coming together ped the way. It produces big returns for investors Some of those bloated conglomerates do become more efficient. But Zen It starts to go wrong. because at the end of the nineteen eighties, as I'm sure many of our audience might remember, Michael Milkin, the father of the junk Bnd world is indicted for racketeering, securities fraud and insider trading And his firm, Drexel Burnham Lambert collapses. So how does the LBO industry respond? What happens next, Eddie? Well, I think there is this real sense in which the narrative around LBOs needs to change. And one of the things that Drexel does is at Prince's t shirt saying junk bonds keep America fit. and despite his best attempts kind of rebranding junk bonds there really is a failure to do so. And so instead of LBOs, there's a new language that emerges around this time. A lot of these firms start to instead use the term private equity. This sounds more respectable. It sounds more sophisticated. It's private, which always sounds fancy and impressive And you have to look at that partly as a response to the fact that the capital that is flooding into this industry is now coming from pension funds and sources that expect a certain level of responsibility and stewardship and long termism. And when you look at the narrative that surrounds the industry today, First of all, you have the fact that private equity firms, many of them have morphed into these vast asset managers. and second of all, you have the fact that those asset managers now talk about things like really taking care of retirees across the country and doing things that sort of really ensure that your average firefighter or unionized nurse can afford to retire. And it's a just completely different narrative to that that surrounded the LBOs of the nineteen eighties Yeah. And obviously junk bonds also became high yield bonds, Or as Mike Milkon like to call them high performance bonds apparently. And what actually happens to William Simon? I mean, this really fascinating character who had seven kids worked in the government and was an evangelist for free market capitalism in a very black and white way Does he end up getting what he would regard as his just rewards? Well, he does appear on the Forbes Rich list. He manages to build himself a very beautiful boat called Freedom. both a boat and a philosophy, as he puts it, he has a number of Holmes, he has a very, very nice life by all accounts However, he ends up deciding to invest in the kind of Pacific Bin and he basically makes a series of quite seemingly ill timed or badly conceived deals that means that he is eventually removed from the Forbes Rich list. And it seems as though towards his later life, His reputation as this wily deal maker who spotted all of this value and did these incredible things with LBOs. actuallyctually his reputation is somewhat tarnished, I think, by his later investments. And there is a really interesting article I came across from the nineteen nineties in the Wall Street Journal about his decision to do a lot more charitable fundraising, but also talked about the fact that he had lost quite a lot of money and that he had effectively perhaps fallen outward chambers and that perhaps chambers had been the one really behind a lot of the more successful deals, and Simon had provided the face of Wes Ray, but not so much the deal making acumen. In many ways, again, that's quite a common pattern in financial history that someone has a brilliant success And rather than just stopping and celebrating it feels you motivated to try it again and again and it goes wrong and you often do end up with seemingly successful teams later falling out with each other But u What actually happened to LBOs? Be you would have thought that A this explosive boom that when it turned sour, the whole idea would have died whether you call it private equity, whether you call it LBOs They didn't just go away and die quietly, did they No, it's astronomic in its size and scale and reach today, the modern private equity industry. and it also has found its way into various locations where you would least expect to find it in kind of low return, low risk sectors such as care homes and water and this sort of thing that you feel as though its model of creative destruction isn't particularly well suited to those sectors But I also one of the things I was really interested in was this sense in which it's never quite matched up to its nineteen eighties heyday in terms of operational improvements or returns. And there was a really interesting study I came across which studied three hundred seventeen LBOs between ninety five and two thousand and it found little evidence of operating improvements. And instead, the main change that had happened to these firms before and after the LBO was a change to their capital structure. So a sustained increase in financial leverage. So put simply LBOs led to an awful lot of debt, but not necessarily the operational improvements or value creation that they claim to be doing. So when you think about value creation, you think about something that didn't previously exist and you think about ingenuity and entrepreneurship and all of the things that in favor of. All the good stuff basically. All the good stuff. And then when you look at the fact that a lot of LBO's have simply led to a sustained increase in financial leverage, you can't help but wonder this looks more like a way of gaming tax systems than it does a way of creating value Of course the irony all this is that you've also ending up with these vast private equity companies that in some ways are actually looking a bit like the kind of bloated bureaucratic Establishment firms that the LBO pioneers back in the nineteen eighties lik to attack. I mean, that's a tremendous irony, isn't it? And I think that's one of the great ironies that looms over this story. There was a quote from the former CEO, was it of Revlon, which was a company, a cosmetics firm that was targeted in an early LBO. And he said, I'm paraphrasing. When one of these kind of financial outsiders takes over, they realize that they quite like getting their suits tailored in London and they quite like their French chefs and they quite like to there was a sense in which the outsiders become the elite, and that's just a kind of story that repeats itself throughout history. But also I think there are a lot of criticisms now coming from people who would think of themselves as being in favour of capitalism, that this really doesn't look like entrepreneurialism or value creation and some of these huge asset managers have become instead much more focused on chasing fees and expanding the assets under management and also finding new sources of new influxces of capital from which they can charge those fees too. So I think that's sort of an undermining of the principle of the early LBO Yes. I mean, I know lots of quite libertarian hedge fund managers who I think essentially the modern private equity industry is pretty much an accounting gimmick. And these are not people who think that you know companies should not be you shouldn't be able to buy them and turn them around. They just think that as it actually functions today mododern private equity. has become yeah a bloated conglomerate in its south, essentially Yeah, and this was something that came up again and again with interviews in interviews of people who you would think that they would, you know sort of be in favor of something like private equity and yet actually were completely opposed to it because of those very reasons. because actually it resembles yeah, the conglomerates of old But also it's really struggling to do its job or at least the job it's set out to do, which is create those generate those returns. And there was something, I mean, Robin's written about this in terms of the, I think it was in the six years before two twenty twenty four. The industry took in one point five trillion more dollars from investors and it actually created in returns, which is just the kind of statistic that you find I think was fascinating actually. And to what degree was this a kind of made in America phenomenon I mean As you say, it was driven by William Simon's belief The country was under threat from socialism and communism. they had to fight back And of course, America's always had a much more bucaneering risk taking profit seeking mentality, arguably than much of Europe. Was this it a Miden America phenomen? Absolutely. I think when you look at where Simon and others were coming from, there was a real sense in which they were reacting to the Well, the government programms of the New Deal in the sense in which the government had vastly expanded and that there were these new forms of regulation that emerged during that period that they wanted to roll back. So I'm very curious. I mean, William Simon is not around today. He in fact died in two thousand But I wonder if he had been alive today, what would do he have made of how the industry has developed? Yeah, it's a really good question I think he probably wouldn't necessarily think that it was at all had anything to do with the kind of entrepreneurial spirit that he hoped to inject into the American economy. As we've discussed, it doesn't really seem to be doing that But at the same time, he didn't do that much to improve Gibson greetings. So perhaps he would have thought this was actually a fabulous way of making money. and if you get rich, then so be it. But I suspect he probably would think that yeah, it really doesn't resemble the type of ideological commitment to entrepreneurialism that he had. Of course, the counter argument would be that when Adam Smith first developed his vision, of what might be called capitalism in a sense of free market competition driving growth and innovation His only vision of companies in those days were family owned firms where the owners were the managers as well and you had an elision of interest between owners and managers which of course, you don't have on Wall Street today in the form of public companies And one of the reasons why things have gone wrong sometimes in the past is the owners of the companies can't see what's happening inside the company and don't feel They have real skin in the game in terms of ownership So some people would argue that private equity is better that way because at least the owners and the managers tend to be more or less the same people And that's the classic argument in favor of private equity is that it can better align the misalignment of interest between those owners and managers And when you look at its use of debt, it was supposed to historically provide a kind of rod for executives backs so that those managers would no longer be able to spend lavishly on their clay pigeon shooting retreats and expensive and pointless computer equipment and would instead have to be focused on creating that kind of what we now know as shareholder value But I think that there is also a kind of largeest now within private equity industry, as we've kind of discussed. and I'm not sure that that argument really holds up, particularly in terms of the use of debt as a way of delivering that alignment. And I think there's never really been sufficient empirical evidence that that discipline of debt really works in the way that the private equity industry has historically argued that it would Well, I must say one conclusion I take away from all this is that Hegel, the great German philosopher, was correct When he said that history moves through pendulum swings of reaction and counter reactions or as he said, thesis and antithesis And the very fact you had this era of corporate management after World War II Basically what paved the way for a reaction was this outburst of world entrepreneurial creative destruction after that Of course, we're now living today with a counter reaction the other direction But Robyin, I know you've got thoughts on this. Well, I mean I think especially at that point of the heeti raise around debt, I think is fascinating just because U the rhetoric, the theory behind it was that debt was a disciplining tool kept companies lean and mean. I worry that really it's more of a systemic increase in corporate debt that makes the entire corporate world That's everybody really