The Rise of the Ridiculously Rich

The tectonic plates of power are always in motion on Wall Street. Over the last 40 years, we've witnessed the rise and fall of corporate conglomerates, junk bonds, credit securities, derivatives, hedge funds, venture capital funds, and a host of other fads that I've probably overlooked or perhaps never even heard of. Yet through all of this, one insular group of financiers has lingered contently in the background, revealing itself only intermittently and reluctantly due to fear that its profligate ways might insight public outcry and legislative backlash.

Although I'm sorry to report that it isn't the Bilderberg Group or the Trilateral Commission or even the Council on Foreign Relations, rest assured that its members have a presence on all three. Unlike these famously secretive organizations, this group hides in plain sight. If you've stayed at a Hilton hotel, shopped at a Safeway, bought coffee at Dunkin' Donuts or a teddy bear at Toys R Us, eaten an Oreo cookie, or slept on a Simmons mattress at various points over the last 30 years, then you've helped to line their pockets. Known euphemistically as private equity firms, it's not an exaggeration to say that this group's collective influence now radiates into every conceivable corner of our economy. They are truly Wall Street's newest elites.

What follows is a three-part series on one highly influential group that's only lately come into public view. In this first column, I identify the deals that brought leveraged finance into Wall Street's vernacular, and the financial innovation that contributed to the industry's early growth. In the second column, I cover the growth, relabeling, and retrenchment of private equity firms like Kohlberg Kravis Roberts (NYSE: KKR  ) , Blackstone Group (NYSE: BX  ) , Apollo Global Management (NYSE: APO  ) , and American Capital (Nasdaq: ACAS  ) . And in the final column, I conclude with a discussion about whether private equity is good for America.

What in the world is leveraged finance?
As much of the country focused on the events in Iran in 1978, a different sort of revolution was under way on Wall Street. In October of that year, a little-known investment firm called Kohlberg Kravis Roberts had masterminded the purchase of Houdaille Industries, a $380 million publically traded industrial pumps maker, in exchange for an investment of only $1 million. While the financial techniques underlying the deal were developed in the 1950s and 1960s, they had never been used for something so daring. To buy a $380 million public company for only $1 million was simply unheard of at the time.

A leveraged buyout, or LBO, can best be analogized to a home mortgage. Suppose you buy a house for $100,000 cash and later sell it for $120,000. The return on your investment would be 20%, certainly nothing to shake a stick at. However, now suppose that you put only $20,000 cash down and finance the rest with a $80,000 mortgage. In this case, your return would be 100%, as it took only $20,000 in cash to produce a $20,000 profit.

If Houdaille put LBOs on the map, then the 1982 Gibson Greeting Cards deal was the X that marked the spot. At the time, the company was an unloved subsidiary of RCA Corporation, an electronics and media conglomerate. When the LBO firm Wesray expressed interest in its greeting card business, RCA was only too happy to oblige. RCA agreed to sell the subsidiary for $80 million, of which Wesray fronted $1 million. Sixteen months later, after disposing of its real estate assets, Wesray took Gibson Greeting Cards public in an initial stock offering that valued it at $290 million. The payday for Wesray's partners was epic. In return for individual investments of $330,000, each of them walked away with a cool $65 million.

High times and misdemeanors
Lured by the prospect of newfound riches, the LBO industry expanded prodigiously throughout the 1980s. There was Forstmann Little & Co., whose founder was later linked romantically to both Princess Diana and Padma Laksmi, the host of the TV show Top Chef. Bain Capital opened its doors in 1984, led at the time by Mitt Romney. Blackstone Group hung its shingle out in 1985 after the co-founders, one of whom had been President Nixon's commerce secretary, defected from the upper echelons of Lehman Brothers. Carlyle Group joined the mix when five well-known Washingtonians teamed up in 1987. And in 1990, Apollo Global Management sprung from the wreckage of Drexel Burnham Lambert's scandal-ridden collapse.

However, nothing fueled the industry's rise more than the creation and proliferation of junk bonds, the brainchild of a little-known investment banker based in Beverly Hills. Until Michael Milken came along, corporate bonds were the exclusive preserve of blue chip companies, the sort with impeccable credit that had never failed to make bondholders whole. Milken's insight was that less creditworthy companies should also be able to issue bonds so long as they compensate investors with higher yield. After lobbying institutional investors for years, Milken prevailed. By 1983, his investment bank Drexel Burnham Lambert was issuing nearly $5 billion in junk bonds a year -- though this was to grow by many orders of magnitude as the decade progressed.

The application of junk bonds to the LBO trade solved one of the industry's biggest problems. The capital structure of a typical LBO deal has three tranches. The first and largest is composed of a secured loan from a commercial bank like JPMorgan Chase or Citigroup. The second is the equity tranche. In the Houdaille deal, this was KKR's $1 million investment. And in between these two is what's known as mezzanine financing. This is generally unsecured credit provided by an institutional investor like an insurance company or pension fund. By the mid-1980s, however, for a host of reasons, the appetite for mezzanine loans was drying up, leaving LBOs one tranche short. And it was this void that junk bonds filled.

The true test of this new type of financing came in 1988 with KKR's hostile takeover bid for RJR Nabisco, the giant corporate conglomerate that owned such storied brands as Oreo, Del Monte, and Winston-Salem cigarettes. To say that it was a big deal in the financial world would be an understatement. At $31.3 billion, $6 billion of which consisted of junk bonds, it was more than three times the size of the previous record, which KKR's 1986 purchase of Beatrice Foods for $8.7 billion. Even more significantly, the high-flying antics of Nabisco's CEO -- recounted in the book Barbarians At the Gate -- attracted the media, which then exposed the LBO industry's ridiculously high profits and less-than-commendable tactics. While KKR prevailed in its bid for the company, it convinced the industry of the value of anonymity -- which they quickly sought to reclaim.

To continue reading about the rise of leveraged finance and private equity firms, see part two of this series, "The Golden Age of Private Equity."

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Fool contributor John Maxfield does not have a financial position in any of the companies mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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