The First Leveraged Buyout
The 1960s and 1970s witnessed the birth of a series of private equity and venture capital firms that would lay the foundations for the private equity industry that we have today. At the time, private equity deals primarily consisted of venture capital investments in early and mid-stage private companies but the first leveraged buyout transactions began with Lewis Cullman and Herb Weiner in what they called “bootstrap” operations. Orkin Exterminating had recently undergone a generational change as founder Otto Orkin ceded the company to his children in 1960, which they then took public in 1961, selling roughly 15% of the company in the public market at $24 per share (PrivCo incorporates both generational and leadership change tags on its private company profiles, allowing subscribers to search for companies that have recently undergone a relevant change).
By late 1961, the market had peaked and Orkin was trading at $30 per share, only to drop to $18 per share by mid-1962. Despite having an annual revenue of $37 million, $6.7 million in EBIT, and $10 million in cash, the market had then valued the company at $43.2 million, down from the $72 million it had been less than a year prior. By modern-day standards, Orkin Exterminating Company was an ideal buyout candidate. As per Orkin’s report of earnings at $1.25 per share in October 1963, Cullman’s offering of $26 per share represented a P/E multiple of 20.8x. In June 1964, Lewis Cullman and Herb Weiner had brokered Rollins Broadcasting’s $62.4 million buyout of Orkin Exterminating Company, Inc. with a $40 million loan from the Prudential Insurance Company, $10 million equity from Rollins Broadcasting (via loan from Chase Bank), $10 million in sellers notes, $2.4 million cash on hand, and only $1,000 personal cash investment.
In July 1964, BusinessWeek called the Orkin Exterminating Company deal one that “truly captures the imagination”. Shortly after, three Bear, Stearns, & Co. bankers would begin to replicate and, through trials and tribulations, began to perfect the leveraged buyout. Jerome Kohlberg, Jr., then head of corporate finance at Bear Stearns, and his protégés Henry Kravis and George Roberts, would leave Bear Stearns in 1976 to found private equity firm Kohlberg, Kravis & Roberts (KKR). Meanwhile, venture capital firms began to mushroom. In 1973, the National Venture Capital Association (NVCA) was formed. The industry witnessed its first significant fundraising year with a collective raise approximately $750 million in 1978. This crop of early venture capital firms would fund game-changing technology companies like Apple, Compaq, and Electronic Arts.
A small handful of true private equity firms like Warburg Pincus (1966) and Clayton, Dublier & Rice (1978) also emerged in the 1960s and 1970s, later to become buyout powerhouses in the 1980s. These first private equity firms began taking on the same limited partnership organizational structure we see today. In a limited partnership, the private equity firm acts as a general partner, managing investments from a fund composed of money that is contributed by limited partners, which may include pension funds, endowment funds, and high net-worth individuals. In what became known as “2 and 20”, limited partners are expected to pay an annual management fee to the general partner, usually around 2%, in addition to a performance fee, which is usually around 20% of the fund’s profits.