This is the second in a series of articles about the rise of leveraged finance and private equity firms. To read the first in the series, "The Rise of the Ridiculously Rich," click here.

A little-discussed group of financiers has recently assumed the mantle of Wall Street's most elite. From a standing start in the 1970s, this group's influence now permeates every corner of our economy. And along the way, its leaders have gotten rich -- ridiculously so. The co-founders of Kohlberg Kravis Roberts (NYSE: KKR) made $94 million each last year. The founder of Apollo Global Management (NYSE: APO) took home a cool $104 million. And The Blackstone Group's (NYSE: BX) chairman and CEO made a staggering $213.5 million.

In this three-part series, I track the history of the private equity industry, picking up here with the industry's growth and retrenchment throughout the 1990s and early 2000s.

Growth and retrenchment
While leveraged buyout firms continued to flourish during the 1990s and early 2000s, much like they did in the 1980s, they did so less conspicuously in a conscious effort to avoid re-entering the spotlight after the RJR Nabisco fiasco. It was during this period, for example, that the industry rebranded itself as "private equity," and some, like American Capital (Nasdaq: ACAS), decided to go public. It was also during this period that two additional financial innovations popped up to facilitate the industry's growth, much as junk bonds had in the 1980s.

The first innovation was the collateralized loan obligation, or CLO. The process of securitization had been a staple of the financial system since the 1980s. While banks continued to lend money as they always had, instead of keeping the loans on their books, they packaged them into securities, which were then sold to institutional investors looking for yield. These securities were originally only made up of things like residential mortgages and car loans -- that is, things that had physical collateral backing them up. As time went on, however, they expanded to include loans to corporations. Between 2004 and 2007, for instance, an estimated 60%-70% of all corporate loans were securitized into CLOs. This flooded the economy with credit and made it exceedingly easy for the private equity firms to finance their trade.

The second innovation worked in tandem with CLOs. In 1993, a small group of bankers at JPMorgan Chase (NYSE: JPM) were confronted with a problem. ExxonMobil, one of the bank's largest customers, needed a $5 billion credit line to payoff claims related to the Valdez oil tanker spill. While the bankers didn't doubt the oil company's willingness or ability to pay it back, they were reluctant to commit so much capital for so little yield, as Exxon's credit rating was outstanding. What they did, in turn, was create the world's first credit default swap. Much like an insurance policy, a CDS shifts the risk of loss from one party to another in exchange for a fee. In this case, JPMorgan's counterparty was the European Bank for Reconstruction and Development. If Exxon defaulted, then the EBRD would be on the hook to compensate JPMorgan for any loss. And if Exxon didn't default, then the EBRD would simply keep the fees and merrily move on down the road.

The golden age of private equity
To say that this was a paradigm change in the financial world wouldn't do it justice. Indeed, this small group of bankers believed that they had figured out how to eliminate credit risk from the financial industry. For the first time in history, banks would be able to make loans without carrying all, or perhaps even any, of the risk involved themselves. As recounted by the authors of King of Capital, a book tracing the rise of The Blackstone Group, the deluge of credit triggered by CLOs and CDSs was akin to a credit card without a limit for private equity firms.

In 2005, a trio of firms purchased the rental car company Hertz from Ford for $14 billion. In 2006, The Carlyle Group and Goldman Sachs took energy company Kinder Morgan private for $22 billion. Two months later, KKR led a $33 billion buyout of HCA Holdings, the private hospital chain founded by Dr. Thomas Frist, grandfather of former U.S. Senate majority leader Bill Frist. In 2007, The Blackstone Group paid $27 billion and $39 billion, respectively, for Hilton Hotels and Equity Office Partners, one of the largest commercial real estate companies in the U.S. Also that year, KKR and Goldman Sachs teamed up to orchestrate the largest leveraged buyout in history: the $45 billion purchase of TXU, the biggest provider of electricity and natural gas in Texas. And this is just to name a few of the better-known deals.

"Inevitably when people look back at this period, they will say this is the golden age for private equity because money is being made very readily," Carlyle's co-founder David Rubenstein told an audience at the beginning of 2006. And he wasn't kidding. That year, private equity firms initiated one of every five mergers globally and nearly one of every three in the U.S.

Perhaps nothing exemplified the riches this bestowed on the newly minted kings of capital more than the 2007 60th birthday party for Stephen Schwarzman, one of Blackstone's co-founders. Held at the exclusive and cavernous Park Avenue armory, which had been transformed into a large-scale replica of Schwarzman's Manhattan apartment, the scale of the purported $6 million bash stunned even jaded Wall Streeters. According to a record of the event in The New Yorker, replicas of Schwarzman's art collection were mounted on the walls, and plates of lobster, filet mignon, and baked Alaska were served in a faux-night-club setting with orchids and palm trees. The comedian Martin Short was the evening's MC, Patti LaBelle sang a song written specially for Schwarzman, and Rod Stewart sang a medley of his hits for a reported fee of a million dollars. Indeed, it was a scene straight out of The Great Gatsby.

To continue reading about the rise of leveraged finance and private equity firms, see part three of this series: "Is Private Equity Good for America?"

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