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How a comic strip cat became one of Wall Streets influential deals · Economy & Finance

0:00
Speaker 1: He sounds like he was quite a strong believer in
0:02
Speaker 1: capitalism and in the profit motive. Dara said, almost like
0:06
Speaker 1: a Gordon Gekko character who believed that greed was good.
0:09
Speaker 2: I think he doesn't necessarily believe that it's greed that
0:12
Speaker 2: is good, but rather entrepreneurialism or what he thinks of
0:16
Speaker 2: as being that. He genuinely believes that. what needs to
0:19
Speaker 2: happen to America's economy. It needs somebody to come along
0:22
Speaker 2: and really breathe life into it.
0:24
Speaker 3: Somebody in government compared him to Genghis Khan at one point, right?
0:27
Speaker 2: Yes, and I think that gives you both a sense
0:29
Speaker 2: of where he's coming from politically, but also a sense
0:33
Speaker 2: of his character.
0:43
Speaker 3: Today on The Story of Money... We're going to be
0:47
Speaker 3: delving into a story that connects Gordon Gekko with Garfield
0:51
Speaker 3: the cat.
0:52
Speaker 2: I love it.
0:53
Speaker 1: I mean, I was a teenager in the 1980s and
0:56
Speaker 1: they are both icons of the 1980s. Gordon Gekko famously
1:01
Speaker 1: said greed is good, epitomizing the attitude of Wall Street
1:05
Speaker 1: in those days. And Garfield, well, what can I say?
1:08
Speaker 1: He was a cartoon character famous for loving lasagna.
1:12
Speaker 3: And believe it or not, that link is relevant. But
1:16
Speaker 3: there's something else that links them beyond being born in
1:19
Speaker 3: the 80s. And that's the subject of today's episode. And
1:22
Speaker 3: that is the business deal that launched the private equity industry.
1:27
Speaker 1: And I mean, let's be honest, it wasn't the first
1:30
Speaker 1: ever private equity deal out there. But the key point
1:33
Speaker 1: is that this was the deal that put private equity
1:36
Speaker 1: on the map. And back then, in fact, it wasn't
1:39
Speaker 1: actually called private equity. The key word is the leveraged
1:43
Speaker 1: buyout era of the 1980s.
1:46
Speaker 3: And that's where Gordon Gekko comes in, of course, because
1:49
Speaker 3: LBOs were all about borrowing up to the hilt, tons
1:52
Speaker 3: and tons of debt. in order to gobble up a stodgy,
1:56
Speaker 3: inefficient company and then beating it into shape or breaking
2:00
Speaker 3: it up and selling it off for parts, essentially. And
2:03
Speaker 3: obviously it's hugely relevant today because private equity now controls
2:08
Speaker 3: a swath of the corporate world. It's one of the
2:10
Speaker 3: biggest alternative asset classes out there in the world. And
2:14
Speaker 3: that means it's still pertinent to ask just how much
2:17
Speaker 3: value this kind of more cutthroat, buccaneering form of capitalism has.
2:22
Speaker 3: born in the 1980s, actually adds.
2:24
Speaker 1: Welcome to the story of money from the Financial Times.
2:28
Speaker 3: I'm Robin Wigglesworth.
2:29
Speaker 1: And I'm Gillian Tett, child of the 80s.
2:39
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3:14
Speaker 3: Okay, so Gillian, I promise we will get to Garfield
3:17
Speaker 3: soon enough. But first of all, we have somebody much
3:20
Speaker 3: more important to introduce. And that's our guest today, Hetty O'Brien.
3:23
Speaker 3: And Hetty is the author of a new book about
3:26
Speaker 3: private equity's influence on the world today. It's called The
3:29
Speaker 3: Asset Class, killer name. And Hetty is also a fantastic
3:32
Speaker 3: opinion and long read writer at The Guardian. So Hetty,
3:35
Speaker 3: thanks for being here today.
3:37
Speaker 2: Thank you very much for having me.
3:38
Speaker 1: Now, Hetty, you work for Guardian, which is not usually
3:42
Speaker 1: a publication that delves into the finer details of financial structures.
3:47
Speaker 1: So tell us, you know, what made you want to
3:50
Speaker 1: write about private equity?
3:51
Speaker 2: Well, I think that's part of the reason is that
3:53
Speaker 2: I kept finding private equity in places you just wouldn't
3:56
Speaker 2: expect it, whether that was in housing or in care
3:59
Speaker 2: homes or in our water system. And it just seemed
4:02
Speaker 2: as though after 2008 in particular, the industry had gone
4:06
Speaker 2: on this incredible spending spree, buying up everyday services and
4:10
Speaker 2: so on. And it just made me really curious. I
4:13
Speaker 2: was wondering what on earth is private equity and why
4:15
Speaker 2: has it grown seemingly so powerful? But I think the
4:19
Speaker 2: more I looked into it, the more I realized that
4:21
Speaker 2: it goes back way beyond 2008. And there is this
4:24
Speaker 2: fascinating story about this renegade group of financiers in the
4:28
Speaker 2: late 1970s and early 80s who really see themselves as
4:33
Speaker 2: involved in this kind of revolution that is going to
4:36
Speaker 2: breathe life into America's tired economy. And they believe that
4:40
Speaker 2: they've discovered this tool of kind of financial ingenuity that
4:43
Speaker 2: will do so and that will really revive entrepreneurialism. And
4:47
Speaker 2: yet at the same time, now we're seeing all sorts
4:50
Speaker 2: of critiques directed at the industry. And so I think
4:53
Speaker 2: the sense in which it was trying to do something
4:56
Speaker 2: that perhaps it hadn't fully managed to achieve in the
4:58
Speaker 2: present day was just a contradiction that I found very interesting.
5:03
Speaker 3: I can understand that. And today, obviously, we are going
5:05
Speaker 3: to be focused on one of those renegades you mentioned,
5:07
Speaker 3: those early days, long before, frankly, the term private equity
5:11
Speaker 3: had even been invented. And this renegade we're going to
5:14
Speaker 3: be focusing on is who you call the father of
5:17
Speaker 3: private equity. And I think lots of listeners might think
5:20
Speaker 3: that there's somebody like, you know, Kohlberg, Kravis, Henry Kravis,
5:25
Speaker 3: George Roberts, the founders of KKR, who did one of
5:28
Speaker 3: the first deals. Actually, we're going to be talking about
5:32
Speaker 3: former US Treasury Secretary William E.
5:35
Speaker 2: Simon.
5:36
Speaker 3: Can you tell us a bit about him? Because he
5:37
Speaker 3: was kind of summed up this kind of more ideological
5:41
Speaker 3: bent that you mentioned, right?
5:43
Speaker 6: Yeah.
5:43
Speaker 2: And I think compared to some of the other private
5:46
Speaker 2: equity people that we know and have heard about, he's
5:49
Speaker 2: largely been forgotten from the history books, which I thought
5:52
Speaker 2: was really interesting. He is this polarizing, fascinating, quite abrasive figure.
5:58
Speaker 2: And he's born a year before the crash of 1929,
6:02
Speaker 2: or maybe a couple of years before the crash. And
6:04
Speaker 2: so he comes of age during the New Deal. He
6:07
Speaker 2: goes into the US Army, and then he ends up
6:10
Speaker 2: going into finance. He works at Salomon Brothers, where he
6:13
Speaker 2: is a bond trader. He's an incredibly good bond trader.
6:17
Speaker 2: It seems to really suit his kind of binary approach
6:20
Speaker 2: to things. There's no grey in the bond business. It's
6:22
Speaker 2: all yes, no, buy, sell. And he's very decisive as
6:26
Speaker 2: an individual.
6:27
Speaker 1: He sounds quite an unusual type of public servant then,
6:30
Speaker 1: because back in the 1960s and 70s, the people who
6:33
Speaker 1: were serving in high office usually weren't coming from Wall
6:38
Speaker 1: Street as such. And yet, he sounds like he was
6:41
Speaker 1: quite a strong believer in capitalism and And in the
6:43
Speaker 1: profit motive, Dara said, almost like a Gordon Gekko character
6:47
Speaker 1: who believed that greed was good.
6:49
Speaker 2: Well, I think he doesn't necessarily believe that it's greed
6:53
Speaker 2: that is good, but rather entrepreneurialism or what he thinks
6:56
Speaker 2: of as being that. I mean, greed is more of
6:58
Speaker 2: a byproduct, perhaps. But I think he genuinely believes that
7:02
Speaker 2: what needs to happen to America's economy, which he thinks
7:04
Speaker 2: is really stuck in the doldrums, is it needs somebody
7:07
Speaker 2: to come along and really breathe life into it. And
7:11
Speaker 2: I think that when you think about where he was
7:13
Speaker 2: coming from, he really entered government, I think it was 1974.
7:16
Speaker 2: It was under the Nixon administration. He was Treasury Secretary.
7:22
Speaker 2: And during that period, Nixon's elected after Lyndon B. Johnson,
7:26
Speaker 2: who was engaged in this huge Great Society program of
7:30
Speaker 2: using the power of the federal government to address all
7:33
Speaker 2: of these kind of social ailments. And all of that
7:36
Speaker 2: is based on vast deficit spending. And Simon looks at
7:40
Speaker 2: this and he thinks, firstly, as a conservative Catholic, that
7:45
Speaker 2: the family, not the state, should be really where people
7:47
Speaker 2: are turning to for help. And secondly, that this is
7:51
Speaker 2: a vast program of government overreach that is extending. far
7:55
Speaker 2: too deeply into people's lives and is also involving the
7:58
Speaker 2: running up of huge amounts of public debt. And so
8:01
Speaker 2: there's a kind of irony in the sense that, yes,
8:04
Speaker 2: he goes into government, but he also kind of despises
8:07
Speaker 2: government or at least government at that point in time.
8:10
Speaker 3: Somebody in government compared him to Genghis Khan at one point, right?
8:14
Speaker 4: Yes.
8:14
Speaker 2: And I think that gives you both a sense of
8:16
Speaker 2: where he's coming from politically, but also a sense of
8:20
Speaker 2: his character. I do think he manages to alienate quite
8:23
Speaker 2: a few people on his journey.
8:25
Speaker 3: In your book, you make the case that there are
8:26
Speaker 3: a lot of key moments in his time from government
8:29
Speaker 3: that kind of really crystallise his conservative but extreme pro-market beliefs.
8:35
Speaker 3: What were those moments and why were they so formative
8:38
Speaker 3: for him?
8:39
Speaker 2: Well, I think the first moment is actually some of
8:42
Speaker 2: the trips he makes to the USSR during his time
8:45
Speaker 2: as Treasury Secretary. He makes, I think, two trips and
8:48
Speaker 2: he hangs out with Brezhnev, who he thinks is actually
8:51
Speaker 2: a very nice, jovial guy. And they have sturgeon caviar
8:55
Speaker 2: and vodka and they seem to have a really good time.
8:57
Speaker 3: Sounds very convivial.
8:58
Speaker 2: Yeah, it does sound very convivial. And Simon gets back
9:02
Speaker 2: on his plane back to the US and he writes
9:05
Speaker 2: about this later. And he says, actually, what he'd seen
9:09
Speaker 2: during his time in Soviet Russia was a sense in
9:12
Speaker 2: which the Russian economy was entirely propped up by Western
9:16
Speaker 2: ingenuity and invention. So the Russians were buying caterpillar bulldozers,
9:20
Speaker 2: they were buying synthetic fur coats, they were buying factories
9:24
Speaker 2: that had been completely ready-made and then they were importing
9:28
Speaker 2: those into Russia. And all of this stuff was coming
9:31
Speaker 2: from the West. And so whilst this Russian economic situation
9:35
Speaker 2: entirely depended upon the West, what he feared was happening
9:38
Speaker 2: was that that Soviet approach to government, the sense of
9:43
Speaker 2: overreaching state planners was migrating from Russia westwards. And it
9:47
Speaker 2: was a sort of sickness infecting both Western Europe and
9:52
Speaker 2: eventually he feared it would infect America. So that was
9:56
Speaker 2: one of the first formative moments in his political journey.
10:00
Speaker 2: Another one was slightly later when he was made the
10:04
Speaker 2: energy czar during the oil crisis. And this was a
10:07
Speaker 2: period of huge panic and unrest. And there was a
10:11
Speaker 2: real sense of actually society is almost falling apart here
10:15
Speaker 2: because everything in America depends upon fossil fuels. And when
10:19
Speaker 2: he was put into that position, there was a lot
10:23
Speaker 2: of political pressure to introduce a rationing program that would
10:27
Speaker 2: conserve fuel by rationing it out. And he was really
10:30
Speaker 2: opposed to that. He thought rationing was kind of akin
10:33
Speaker 2: to the type of government planning that he'd seen in
10:36
Speaker 2: Soviet Russia. And so he instead decided to try and
10:40
Speaker 2: cobble together this system of fuel allocation that really didn't work.
10:44
Speaker 2: But to him, what he took away from that was
10:47
Speaker 2: that you cannot try and mimic the invisible hand of
10:51
Speaker 2: the market by using the levers of government.
10:54
Speaker 1: Essentially, what we have then in the middle of the
10:57
Speaker 1: 1970s is this hard-nosed, no-nonsense free market ideologue, William E.
11:04
Speaker 4: Simon.
11:05
Speaker 1: Who strongly believes that you need to have competition and
11:09
Speaker 1: the profit motive to drive efficiency and growth. And he's
11:14
Speaker 1: a former financial trader, so he knows how markets work.
11:17
Speaker 1: He's also been in the government during the 1970s under
11:20
Speaker 1: both Nixon and Ford, and that's made him even more convinced,
11:25
Speaker 1: his experience of being in government and then seeing the
11:27
Speaker 1: Soviet Union, that you have to have free market forces
11:30
Speaker 1: to deliver growth. So, That's our key character. And then
11:35
Speaker 1: in 1977, something critical happens. The Republicans lose power, get
11:40
Speaker 1: kicked out, and a brand new Democratic president comes in,
11:45
Speaker 1: Jimmy Carter. So how does that unleash what happens next?
11:50
Speaker 2: I mean, Simon is massively disillusioned by this. He was
11:54
Speaker 2: obviously hoping that Gerald Ford would win. And I think
11:56
Speaker 2: there's a sense in which Simon is almost 10 years
11:59
Speaker 2: too early in terms of his political instincts, because really
12:02
Speaker 2: later these take off during the Reagan administration. But Simon
12:06
Speaker 2: effectively takes a break from public service and he decides
12:10
Speaker 2: that he's really done with government. He goes back to
12:12
Speaker 2: New Jersey, where he's from. And he writes a book
12:16
Speaker 2: and that book becomes a bestseller. And that book is
12:19
Speaker 2: called A Time for Truth. It is a complete jeremiad
12:23
Speaker 2: of a book. It's actually very funny at points and
12:26
Speaker 2: extremely polemical. And Simon really didn't like writing. So he
12:31
Speaker 2: managed to find a ghostwriter called Edith Efron, who was
12:34
Speaker 2: a good friend of Ayn Rand, to write the book
12:37
Speaker 2: for him. And it made a series of arguments about
12:40
Speaker 2: why government intervention was was a bad idea and why
12:43
Speaker 2: there was this risk that America was drifting towards what
12:47
Speaker 2: resembled more of a Soviet or what he called social
12:50
Speaker 2: democratic model. And I think then he decides, partly because
12:55
Speaker 2: he's no longer in government, that he really wants to
12:57
Speaker 2: try and find a way of enacting his political instincts
13:01
Speaker 2: or principles in another sphere. So he decides to go
13:05
Speaker 2: back into business. and at least look for ways within
13:08
Speaker 2: the kind of business realm that he can adopt some
13:11
Speaker 2: of these ideas and really enforce them and have a
13:14
Speaker 2: big effect. And so he becomes president of the Olin Foundation,
13:18
Speaker 2: which is a think tank that is really working to
13:21
Speaker 2: roll back some of those New Deal regulations and principles.
13:24
Speaker 2: He also gets involved with the Heritage Foundation, which is
13:28
Speaker 2: a similar think tank. And by the time Reagan is
13:32
Speaker 2: vying for the Republican presidential nomination, It really looks as
13:36
Speaker 2: though Simon is going to play a huge role within
13:40
Speaker 2: the Reagan administration if Reagan gets elected. But actually, Reagan
13:44
Speaker 2: basically takes one look at what Simon wants, which is
13:47
Speaker 2: control of levers of economic policymaking that are normally answerable
13:52
Speaker 2: to the president. And he basically says, I think this
13:55
Speaker 2: guy wants too much power. I'm not really willing to
13:58
Speaker 2: have a self-appointed czar in charge of my economic policies
14:01
Speaker 2: because For Simon, that really is a red line. He's
14:04
Speaker 2: quite uncompromising. As I said, he really is quite black
14:07
Speaker 2: and white. And so again, he decides, right, well, if
14:10
Speaker 2: I can't do this in government, I'm going to try
14:12
Speaker 2: and do this in business. And that really is a
14:15
Speaker 2: key moment because that's when he starts to think about
14:19
Speaker 2: things that later become known as leveraged buyouts.
14:23
Speaker 3: So he decides not to go into administration because he
14:25
Speaker 3: can't get what he wants out of Reagan. But how
14:28
Speaker 3: does he... kind of stumble almost into this kind of
14:31
Speaker 3: leveraged buyout industry, which I mean, let's face it, it
14:34
Speaker 3: wasn't even an industry at the time, right? How did
14:37
Speaker 3: that happen?
14:38
Speaker 2: No, and it's actually really kind of serendipitous for him.
14:41
Speaker 2: He's golfing in New Jersey, and he has membership of
14:44
Speaker 2: a particular club where there's this other guy who also
14:47
Speaker 2: plays golf there called Ray Chambers. And Chambers is kind
14:51
Speaker 2: of the opposite of Simon. I mean, he's got a
14:55
Speaker 2: business background as an accountant. He used to work for
14:58
Speaker 2: Price Waterhouse. And he had become very successful during the
15:04
Speaker 2: 1970s because he had been involved with the nursing home
15:08
Speaker 2: business through a company called MetroCare. And it was during
15:12
Speaker 2: the 70s that there was an IPO for MetroCare that
15:15
Speaker 2: left Chambers with quite a lot of money. And rather
15:18
Speaker 2: than just retire, he'd actually had a second insight, which
15:21
Speaker 2: was that there were all of these undervalued companies hanging
15:25
Speaker 2: around in the late 1970s, many of which could support
15:29
Speaker 2: large amounts of debt on their balance sheet. And a
15:31
Speaker 2: kind of wily entrepreneur or somebody who was smart and
15:35
Speaker 2: realized that there was value to be tapped here could
15:38
Speaker 2: borrow against the value of those companies' assets and use
15:41
Speaker 2: that debt to finance their purchase, which is what looks
15:45
Speaker 2: a lot like a LBO. And so Simon and him
15:48
Speaker 2: got talking. And not only was a sense that, I guess,
15:52
Speaker 2: opposites attract in the sense that Simon could do the
15:55
Speaker 2: big picture stuff, the fundraising, the political networking, Chambers could
16:00
Speaker 2: do the detailed stuff. There was also a sense from
16:04
Speaker 2: Simon that Chambers had really spotted something, but he was
16:07
Speaker 2: doing it on a scale that could be far, far bigger.
16:10
Speaker 2: And Simon could see that actually you could apply this
16:14
Speaker 2: principle to anything. much larger conglomerates. And that was where
16:18
Speaker 2: you could really start to have an effect.
16:21
Speaker 1: So in terms of their skill set, it seems a
16:23
Speaker 1: bit like a match made in heaven. And, you know,
16:27
Speaker 1: what was Simon hoping to get out of doing all this? Well,
16:32
Speaker 1: there's a number of things I think he was hoping
16:34
Speaker 1: to get out of it.
16:35
Speaker 2: One of them was personal. He did want to make money.
16:38
Speaker 3: Former bond trader. I'm assuming that was a large part
16:41
Speaker 3: of the motivation, especially after working in government service for
16:44
Speaker 3: a bit.
16:44
Speaker 1: This was the era of breeders good, wasn't it?
16:47
Speaker 2: He also had seven children to support. Seven was that
16:50
Speaker 2: as well.
16:51
Speaker 3: I've got three and they are a massive financial drain,
16:54
Speaker 3: I can assure you, yes.
16:57
Speaker 2: So when he went into government, he had put his
17:01
Speaker 2: fortune from Salomon Brothers, which was roughly $ 5 million into
17:05
Speaker 2: a blind trust to avoid conflicts of interest. And when
17:08
Speaker 2: he left government, it had shrunk by about half. So
17:10
Speaker 2: there was a sense in which he really needed to
17:13
Speaker 2: make that up and hopefully make more as well. I
17:17
Speaker 2: think there was also, he spotted effectively opportunity. I think
17:21
Speaker 2: the post-war era was one in which this kind of
17:24
Speaker 2: managerial corporation emerged as being the dominant way of doing business.
17:28
Speaker 2: And there was a sense in which these CEOs who
17:31
Speaker 2: were in charge of these vast corporations had embarked on
17:34
Speaker 2: these empire building projects, buying up subsidiaries and unrelated companies
17:39
Speaker 2: that they really didn't know much about and forming these
17:43
Speaker 2: quite large but quite shaky and quite bureaucratic conglomerates. And
17:48
Speaker 2: Simon compared these to watching a sumo wrestler compete in
17:53
Speaker 2: figure skating in the sense that many of these companies
17:57
Speaker 2: were completely the opposite of an efficient, lean, mean machine.
18:02
Speaker 2: And so I think he saw that that was a
18:05
Speaker 2: ripe opportunity, but also at the same time, there was,
18:08
Speaker 2: you know, those ideological principles he'd been trying to do
18:13
Speaker 2: something about for a number of years. And actually, one
18:16
Speaker 2: of the things that he really wanted to do was to,
18:19
Speaker 2: as he saw it, really give some of these kind
18:22
Speaker 2: of inept managers a bit of a kicking and actually
18:26
Speaker 2: show them that it was entrepreneurs who should be in
18:28
Speaker 2: charge of the economy, or at least, you know, private
18:32
Speaker 2: individuals who had a better sense of where value existed
18:35
Speaker 2: and weren't so complacent and weren't kind of dining out
18:38
Speaker 2: on the company credit card and having these various forms
18:41
Speaker 2: of corporate largesse.
18:43
Speaker 3: Yeah, and probably not an entirely unfair critique in the
18:47
Speaker 3: 80s as well. So we're in 1981 now. Simon &
18:51
Speaker 3: Chambers decided to set up a partnership I love that
18:54
Speaker 3: they call it Wesray. So William E. Simon, Wes and
18:58
Speaker 3: Ray from Ray Chambers. So they have this partnership called Wesray.
19:03
Speaker 1: And can I just say, by the way, I think
19:04
Speaker 1: Wesray is a dreadful name.
19:06
Speaker 2: But anyway, Hetty.
19:07
Speaker 3: I've heard worse than finance. I think we both have,
19:09
Speaker 3: haven't we, Gillian?
19:10
Speaker 2: Absolutely, yes. What did this ghastly named Wesley actually do?
19:14
Speaker 2: So yeah, somewhat unimaginatively named Wesray. It was very much
19:19
Speaker 2: involved in small scale things at first. There was an
19:22
Speaker 2: oyster farm in Long Island. There was a subsidiary of
19:25
Speaker 2: a far larger company that sold cans and matchsticks and
19:29
Speaker 2: that sort of thing. And there was a company, I think,
19:32
Speaker 2: that rented musical instruments to children's schools or something. So
19:36
Speaker 2: these were not really particularly memorable or era-defining deals.
19:40
Speaker 3: Right.
19:41
Speaker 1: I mean, just to be upfront about this, this wasn't
19:44
Speaker 1: the first ever leveraged buyout to take place.
19:47
Speaker 3: Yeah. I mean, I thought the one I've always thought
19:49
Speaker 3: was the first one or generally considered it just wasn't
19:52
Speaker 3: this high profile is KKR, which I've already mentioned, Purchase
19:56
Speaker 3: of Houdail Industries. But it just was far less high
20:00
Speaker 3: profile than the one Wesray put together that we're going
20:04
Speaker 3: to be exploring today. Partly because the one we're going
20:07
Speaker 3: to be digging into now was so insanely profitable, right?
20:11
Speaker 3: So it really kind of telegraphed to the entire world
20:14
Speaker 3: the financial potential of this new nascent embryonic LBO industry.
20:21
Speaker 2: It's not the first, but it's certainly the most significant
20:25
Speaker 2: in terms of the sheer amount of money that was made.
20:28
Speaker 2: And therefore, it became a touchstone, a way of almost
20:31
Speaker 2: proving a proof of concept for the LBO as a form,
20:35
Speaker 2: because it showed that you could come away with an
20:37
Speaker 2: astronomic amount of money, of profit. So I think that's
20:41
Speaker 2: what makes it really, really significant. And in terms of
20:44
Speaker 2: the actual, just the sheer coverage that it generated, it
20:47
Speaker 2: was on the front of New York Magazine. The Times
20:50
Speaker 2: covered it. Everyone and every media outlet seemed to be
20:54
Speaker 2: talking about this at the time. So it really cut through.
20:57
Speaker 3: Okay.
20:58
Speaker 1: So you created a lot of narrative suspense here.
21:00
Speaker 3: Yeah.
21:01
Speaker 1: It's 1982 and Wes Ray is about to do this
21:04
Speaker 1: iconic deal, which made history, as you said.
21:07
Speaker 3: What was it?
21:08
Speaker 2: You wouldn't think it would be iconic given that it
21:09
Speaker 2: was for a greeting cards company, which doesn't really seem
21:12
Speaker 2: to be one of the kind of industries of the
21:14
Speaker 2: future when we think about, you know, capitalist ingenuity. But
21:18
Speaker 2: it was for a company called Gibson Greeting Cards, which
21:21
Speaker 2: was a greeting cards company based out of Cincinnati. It
21:24
Speaker 2: had been manufacturing greeting cards for many, many years. Crucially,
21:28
Speaker 2: it was sitting on some very valuable intellectual property, which
21:32
Speaker 2: was Garfield the Cat. It owned the rights to Garfield
21:35
Speaker 2: the Cat, a very popular company. cartoon feline, as we
21:39
Speaker 2: all know. And it was also one of the textbook
21:43
Speaker 2: types of forms of value hidden within a conglomerate that
21:47
Speaker 2: Simon had been looking for, Simon and Chambers. Gibson was
21:52
Speaker 2: owned by Radio Corporation of America, and they had bought
21:55
Speaker 2: the company without necessarily realizing the true value of the
21:59
Speaker 2: asset that they were sitting on. And now they were
22:01
Speaker 2: looking to unload it. And there was a sense in
22:05
Speaker 2: which it hadn't been fully optimized and there was value
22:09
Speaker 2: to be had here if you knew where to look.
22:11
Speaker 3: So they weren't just massive Garfield fans, essentially. That's not
22:14
Speaker 3: why they went for Gabeson. No.
22:16
Speaker 2: I mean, they may have been, but that's, yeah, I
22:18
Speaker 2: guess that's not the main reason. So tell us.
22:21
Speaker 1: Exactly what happened. I mean, how did this deal all
22:23
Speaker 1: come together, with or without the cat?
22:26
Speaker 2: So RCA sets this purchase price for about $ 80 million.
22:29
Speaker 5: And Wesray.
22:33
Speaker 2: Buys the company by investing just $ 1 million of equity.
22:39
Speaker 2: That is made up of Chambers and Simon each put in,
22:43
Speaker 2: I think, around $ 330, 000. And the rest comes from Wesray's
22:48
Speaker 2: other partner and employees. And so they have basically bought
22:53
Speaker 2: the company using just a million dollars. How did they
22:56
Speaker 2: do this? They borrowed 79 million and also sold off
23:00
Speaker 2: some of the company's real estate assets to finance the transaction.
23:06
Speaker 2: And I don't think this has ever been done before
23:09
Speaker 2: that point in terms of buying a company for that little,
23:13
Speaker 2: injecting so little of your own capital into a deal.
23:17
Speaker 2: And Simon does loads of fundraising. There is, as I mentioned,
23:21
Speaker 2: this piece in New York Magazine after the deal goes through,
23:24
Speaker 2: that says the deal is wrought as if by the
23:27
Speaker 2: hand of Uncle Sam because Simon relies heavily upon his
23:32
Speaker 2: contacts in the US government to open doors, but also
23:35
Speaker 2: from his time as Salomon Brothers. So he's really the
23:37
Speaker 2: kind of hustling fundraiser and Chambers is doing the accounting
23:43
Speaker 2: and the detail. And there is a moment when it
23:47
Speaker 2: looks like the deal is not going to go through
23:49
Speaker 2: when General Electric, which is one of the lenders for
23:51
Speaker 2: that $ 79 million.
23:53
Speaker 2: Wants to pull out and Simon says if he was
23:57
Speaker 2: still working at Salomon Brothers he'd chuck you out of
23:59
Speaker 2: a window or something along I'm paraphrasing but it's something
24:02
Speaker 2: like that and Chambers manages to talk him down from
24:05
Speaker 2: his perch and so the deal completes and that's that's
24:09
Speaker 2: what happens and and actually during the time before they
24:13
Speaker 2: then take the company public very little changes.
24:16
Speaker 1: Why do they even try and structure it in LBO
24:18
Speaker 1: in the first place why didn't they just go and
24:20
Speaker 1: buy it in the normal way.
24:22
Speaker 2: There's A lot of benefits for doing it this way.
24:25
Speaker 2: First of all, if it fails, then Gibson, not them,
24:29
Speaker 2: are responsible for paying off that $ 79 million of debt.
24:32
Speaker 2: So they will only lose $ 330, 000 each. Also, there's the
24:38
Speaker 2: fact that the interest payments on all of that debt
24:41
Speaker 2: reduce their taxable profits, which means that more money gets
24:44
Speaker 2: rerouted to them as kind of capitalist disruptors rather than
24:48
Speaker 2: the government taxman, making it more profitable for them as
24:52
Speaker 2: a deal. And there's also the fees that they can
24:55
Speaker 2: charge the company for the privilege of being owned by them.
24:58
Speaker 2: And Simon is quite open about this. He says, we
25:01
Speaker 2: charge the company fees and then some. Again, I'm paraphrasing.
25:05
Speaker 2: But it basically meant that they got the company for
25:07
Speaker 2: free by covering their initial 330,000 purchase equity that they
25:12
Speaker 2: had invested. They managed to recoup that by charging the
25:15
Speaker 2: company fees while they owned it. So there are a
25:18
Speaker 2: number of reasons why this just looks like an incredible opportunity.
25:22
Speaker 2: And it really is hard to overstate just how revolutionary
25:26
Speaker 2: that was. This had not been done before at this scale.
25:29
Speaker 5: Yeah.
25:29
Speaker 3: I mean, this is kind of, it's not even just LBO.
25:31
Speaker 3: It's like LBO maxing almost to use the modern vernacular
25:35
Speaker 3: where you're borrowing basically almost all the money and the
25:38
Speaker 3: tiny little sliver of equity you're putting in actually is
25:41
Speaker 3: covered by the fees almost instantly that the company itself
25:44
Speaker 3: is paying you. which sounds incredible. But so how did
25:48
Speaker 3: the deal play out? I'm guessing they made out like bandits, right?
25:53
Speaker 2: Yeah, I think you could say that. I mean, I
25:56
Speaker 2: think that the thing that was really interesting to me
25:59
Speaker 2: while I was looking into this was I was trying
26:00
Speaker 2: to understand, well, what had they done during this period
26:04
Speaker 2: of ownership? Because they take it public roughly 18 months
26:08
Speaker 2: after the deal first closes. And the typical private equity
26:13
Speaker 2: narrative is that you instill kind of operational improvements. You
26:17
Speaker 2: basically turn a company around and you create value in
26:20
Speaker 2: a way that it didn't previously exist. One of the
26:25
Speaker 2: things that I found striking about this deal was that
26:27
Speaker 2: actually very little changed in the company. The management structure
26:31
Speaker 2: still looked pretty much the same. There hadn't been any
26:33
Speaker 2: dramatic kind of operational changes that had occurred during their
26:38
Speaker 2: period of ownership. And actually, Simon himself was pretty open
26:42
Speaker 2: about this. He was just lucky. They bought it when
26:45
Speaker 2: there was a downturn. The markets then recovered. They sold
26:48
Speaker 2: it 18 months later. And they effectively had borrowed when
26:54
Speaker 2: interest rates were low. And they had seen a massive opportunity.
26:58
Speaker 2: And the timing had paid off. And so when the
27:01
Speaker 2: IPO happens 18 months afterwards, after the deal closes, its
27:06
Speaker 2: value has soared to something like $ 290 million. million up
27:11
Speaker 2: from the purchase price of 80 million. So for each
27:14
Speaker 2: dollar they invest, they make something like a $ 200 return
27:18
Speaker 2: on that investment. I would have loved to be involved
27:21
Speaker 2: in this. It just sounds like so fabulously profitable. Probably
27:25
Speaker 2: wouldn't be a journalist.
27:27
Speaker 3: A 200 times return on 18 months sounds pretty incredible, right? Yeah,
27:31
Speaker 3: that is. It is fascinating that they didn't really sort
27:34
Speaker 3: of do anything. Because like you say, that is actually
27:37
Speaker 3: a core part of the narrative back in those days.
27:40
Speaker 3: And obviously today that, you know, private equity with the
27:43
Speaker 3: right incentives, the right management team, a more hard-headed approach
27:49
Speaker 3: to capital allocation, they'll turn, you know, coal into diamonds.
27:54
Speaker 3: And in this case, it was just basically luck. And
27:57
Speaker 3: also a few of Gibson's competitors went bankrupt in those
28:00
Speaker 3: 18 months, right?
28:01
Speaker 2: That was another factor, I think, that helped to explain
28:04
Speaker 2: why it became so astronomically profitable. I also liked the
28:08
Speaker 2: fact that Simon was quite open about this. I think
28:11
Speaker 2: at one point he said later on, this deal has
28:13
Speaker 2: been poured over by business professors, but actually it's very
28:17
Speaker 2: unlikely to be repeated because it was mainly luck. And
28:21
Speaker 2: I think there's something kind of refreshingly honest about that.
28:24
Speaker 1: And yet the reality is that when Wall Street saw
28:27
Speaker 1: what had happened and a 200 times return had just
28:32
Speaker 1: been created in this deal.
28:34
Speaker 3: In 18 months.
28:35
Speaker 1: In 18 months. Yeah. So, you know, the reality is that,
28:39
Speaker 1: you know, there's never an idea on Wall Street that
28:42
Speaker 1: other people don't want to replicate if it works and
28:44
Speaker 1: makes money. And so unsurprisingly, contrary to what William Simon said,
28:48
Speaker 1: we're about to see a dramatic boom in copycat LBOs.
28:53
Speaker 1: And that didn't just lead to specific deals. It began
28:56
Speaker 1: to change the wider business culture on Wall Street. It
29:01
Speaker 1: paved the way for the explosion in private equity we're
29:03
Speaker 1: living with today. Also, of course, it sparked a lot
29:08
Speaker 1: of controversy. So we'll be coming back to that after
29:12
Speaker 1: the break.
29:19
Speaker 6: Alternatives play a key role in investor portfolios. Traditional stocks
29:23
Speaker 6: and bonds are becoming increasingly correlated. In the most recent downturn,
29:28
Speaker 6: equities and fixed income were both significantly negative. Alternatives can
29:33
Speaker 6: add diversification to your portfolios and lower correlations between the
29:37
Speaker 6: asset classes. Both of those can help your portfolio And
29:30
Speaker 6: we are back.
29:30
Speaker 5: So, It's 1983.
30:01
Speaker 3: News of this Gibson greeting cards deal's success has spread
30:06
Speaker 3: across Wall Street like wildfire. It made William Simon quite rich,
30:11
Speaker 3: actually very, very, very rich, without very much work either
30:15
Speaker 3: on his end. And it seems everyone is now looking
30:18
Speaker 3: for ways to replicate this success.
30:21
Speaker 1: No surprise there.
30:23
Speaker 5: But.
30:24
Speaker 1: This deal isn't the only reason why the LBO industry
30:28
Speaker 1: is about to explode. It just so happens that the
30:32
Speaker 1: excitement about a 200 times return was colliding with some
30:37
Speaker 1: other bigger structural factors that influenced how people regarded it
30:41
Speaker 1: as well. Hetty, explain to us why the bigger political
30:45
Speaker 1: economy context mattered so much.
30:48
Speaker 2: I think it's really important to understand this. I think
30:51
Speaker 2: what happens after the Second World War is that there
30:55
Speaker 2: is this period of American supremacy with a lot of
30:58
Speaker 2: the companies that emerged from that period really dominating the economy.
31:03
Speaker 2: But then towards the 1970s, you get the European and
31:07
Speaker 2: Japanese markets had been somewhat sleepy after the Second World War,
31:11
Speaker 2: actually roaring back to life after factories are rebuilt from
31:14
Speaker 2: bomb damage and so on. And there is a sense
31:17
Speaker 2: in which a lot of these managerial corporations that had
31:21
Speaker 2: dominated the period after the Second World War in the
31:25
Speaker 2: US are now coming under competition from other places. At
31:29
Speaker 2: the same time, there is this point about the financing
31:33
Speaker 2: that I found really interesting when I was doing this research,
31:35
Speaker 2: which is that A lot of the banks prior to
31:38
Speaker 2: the LBO wave taking off were lending to countries like
31:42
Speaker 2: Mexico and Brazil. And when the Latin American debt crisis
31:46
Speaker 2: sparked in the early 1980s, these banks had built up
31:50
Speaker 2: these massive syndicated lending teams that basically had nowhere to
31:55
Speaker 2: lend that money to. And so they basically just changed course,
32:00
Speaker 2: steered the ship in another direction and started lending to LBOs.
32:05
Speaker 2: At the same time, there is a really important bit
32:08
Speaker 2: of government regulation that really changes the game and leads
32:11
Speaker 2: to a massive influx of capital into this industry. And
32:15
Speaker 2: that's with the Securities and Exchange Commission that starts to
32:19
Speaker 2: allow private funds, which have previously faced strict limits on
32:23
Speaker 2: the amount of money that they're able to raise from investors,
32:27
Speaker 2: to raise more money from a greater number of investors.
32:30
Speaker 2: And so that means that you're also seeing much more
32:33
Speaker 2: capital flooding into this industry. So I think those three
32:36
Speaker 2: factors really come together to help explain why this really
32:39
Speaker 2: takes off when it does.
32:41
Speaker 3: Yeah, because I looked up the numbers here. And in 1981,
32:45
Speaker 3: before these rules had been introduced, LBO funds raised $ 250 million,
32:51
Speaker 3: which was real money back then, but not massive. But
32:54
Speaker 3: by 1987, they'd raised $ 14. 6 billion. So clearly, it's a
32:56
Speaker 3: massive change. And there is one more component here, right?
33:04
Speaker 3: And it happens to be about one of the people
33:07
Speaker 3: I find the most fascinating, pretty much in financial history,
33:11
Speaker 3: Michael Milken. So Mike Milken, for the people that don't
33:14
Speaker 3: know him, in the 1980s, he sat inside an investment
33:18
Speaker 3: bank called Drexel Burnham Lambert. And he became known as
33:22
Speaker 3: the junk bond king. And he wasn't just, frankly, the
33:25
Speaker 3: king of the junk bond market. He was its creator,
33:29
Speaker 3: its godfather. He really kind of conjured it up almost,
33:32
Speaker 3: not quite out of thin air, but not far from it.
33:35
Speaker 3: Junk bonds, they are essentially bonds issued by companies that
33:38
Speaker 3: are not rated investment grade by one of the big
33:41
Speaker 3: credit rating agencies. And anything below BBB is essentially considered
33:47
Speaker 3: junk or below investment grade. Essentially, it's the way the
33:51
Speaker 3: credit rating agency says, you know, there be dragons. I'd
33:55
Speaker 3: love to hear how Mike Milken and his junk bond
34:00
Speaker 3: machinery fits into this story, because that was also another
34:03
Speaker 3: big factor that came in and powered this phenomenon, right?
34:07
Speaker 2: Absolutely. And I think Milken is totally fascinating, but also
34:11
Speaker 2: he has this one major insight. He's, I mean, he's firstly,
34:14
Speaker 2: he's totally obsessed with bonds. He knows absolutely everything you
34:18
Speaker 2: can know about bonds.
34:18
Speaker 3: All good people are obsessed with bonds, Hetty. It's just
34:21
Speaker 3: a fact of life.
34:22
Speaker 2: And he basically has this insight, which he picks up
34:26
Speaker 2: during his time at Wharton, where he's studying finance. And
34:30
Speaker 2: he realizes that actually a lot of these lower rated
34:33
Speaker 2: bonds from companies that have either fallen on hard times
34:37
Speaker 2: or don't really have an established reputation or the types
34:40
Speaker 2: of things that Wall Street's old guard might treat with
34:43
Speaker 2: sort of slight derision and wear rubber gloves when dealing
34:46
Speaker 2: with them. you can actually make a lot of money
34:49
Speaker 2: by trading in these junk bonds because at certain points
34:52
Speaker 2: in an economic cycle, the return on those can be
34:54
Speaker 2: better than they would be for higher grade bonds or
34:58
Speaker 2: higher grade companies. And so he is dealing with something
35:02
Speaker 2: that has previously been stigmatized and he sees his role
35:06
Speaker 2: as much more actually than just a bond salesman. He
35:09
Speaker 2: is really thinking of his work as something like reviving
35:13
Speaker 2: this spirit of American entrepreneurialism. So it's a similar kind
35:17
Speaker 2: of ethos to that shared by Simon. And I loved
35:21
Speaker 2: finding out that he printed off this map of the
35:25
Speaker 2: US and put pinpoints on it for his children to
35:27
Speaker 2: see all of the different companies that his junk bonds
35:30
Speaker 2: had financed. So that was everything from film studios on
35:35
Speaker 2: the West Coast, to a nursery chain, to a number
35:38
Speaker 2: of casinos actually in Las Vegas. And I kind of
35:42
Speaker 2: wonder what Las Vegas would have looked like if it
35:45
Speaker 2: hadn't have been for Michael Milken.
35:47
Speaker 3: Well, CNN as well. CNN was financed entirely by junk bonds.
35:51
Speaker 3: So Ted Turner, it was something, obviously, Ted Turner recently
35:54
Speaker 3: passed away. And maybe as a bit of a bond nerd,
35:56
Speaker 3: I was almost disappointed to see the lack of mentions
35:59
Speaker 3: of Mike Milken's role in in birthing CNN in all
36:02
Speaker 3: the obituaries for Ted Turner.
36:04
Speaker 6: Yes. Yeah.
36:05
Speaker 2: And I think he, Mike Milken, didn't initially really foresee
36:09
Speaker 2: just how pivotal junk bonds would become for takeovers or
36:14
Speaker 2: for what became known as leveraged buyouts. In fact, he
36:17
Speaker 2: hadn't thought that this was going to be necessarily their use.
36:20
Speaker 2: But what they provided was a vast new pool of
36:23
Speaker 2: capital that allowed outsiders to basically approach large companies that
36:28
Speaker 2: they would have never previously been able to dream of
36:31
Speaker 2: taking over. And junk bonds were the weapon to finance
36:35
Speaker 2: those transactions. I think it would have been pretty much
36:38
Speaker 2: impossible to imagine the LBO wave taking off in the
36:41
Speaker 2: way that it did without Mike Milken and his junk bonds.
36:45
Speaker 1: So in many ways, it was a kind of insurgency,
36:47
Speaker 1: a use of asymmetric power, to use a term that's
36:51
Speaker 1: very popular today, and took a lot of people by surprise.
36:55
Speaker 1: And it's worth pointing out, as you said, that William
36:58
Speaker 1: Simons was driven by not just a desire to make money,
37:02
Speaker 1: but also this quite evangelical desire to proclaim the value
37:06
Speaker 1: of free markets right across America. But even back then,
37:11
Speaker 1: there was starting to be controversy. And as the LBO
37:15
Speaker 1: market boomed, back in December the 5th, 1985, the FT
37:21
Speaker 1: published an article that was entitled, How Mr. Simon Opened
37:25
Speaker 1: the Floodgates. and it talks about how the Gibson greeting
37:29
Speaker 1: deal took Wall Street by storm. It mentions a stat,
37:33
Speaker 1: the number of LBOs jumped from 164 in 1982 to
37:39
Speaker 1: 250 in just two years in 1984. So you have
37:43
Speaker 1: this astonishing stat. Of course, on the face of it,
37:47
Speaker 1: looks really good, doesn't it, Robin?
37:49
Speaker 3: Well, yes, but The other interesting thing about this article
37:54
Speaker 3: is that it also brings up a lot of questions
37:56
Speaker 3: from critics. And there were critics at the time, and
37:59
Speaker 3: there weren't some labor union officials from companies being dismembered.
38:03
Speaker 3: They're from the Wall Street elite that are also a
38:06
Speaker 3: little bit concerned about this phenomenon. There's a quote here
38:09
Speaker 3: from a senior partner at the investment bank, Lazard. Hetty
38:14
Speaker 3: and Gillian, we all know who he is, but it's
38:16
Speaker 3: Felix Rowerton. who the FT describes as one of the
38:20
Speaker 3: most respected Wall Street bankers, but really is frankly a
38:23
Speaker 3: legend on Wall Street. He told our reporters at the time,
38:27
Speaker 3: and I'm going to dig out the exact quote here. First,
38:30
Speaker 3: it bets the company on a combination of continued growth
38:34
Speaker 3: and lower debt rates with no margin for error. Second,
38:39
Speaker 3: it substitutes debt for permanent capital which is exactly the
38:44
Speaker 3: opposite of what our national investment objective ought to be.
38:48
Speaker 3: And that's a direct quote from Felix Rowerton. So, I mean, Hetty,
38:52
Speaker 3: I'd love to hear why you think this practice, although
38:57
Speaker 3: it was embraced by people like Milken and Simon, was
39:00
Speaker 3: so controversial in at least parts of Wall Street's old guard.
39:04
Speaker 2: Yeah, and I think this is really fascinating, actually, because
39:07
Speaker 2: it's very easy to find critics of private equity in
39:10
Speaker 2: the places one would expect, labour unions and so on.
39:13
Speaker 2: But actually, even today, you still get criticisms coming from
39:17
Speaker 2: people who you would think of as being the kind
39:19
Speaker 2: of arch defenders and believers in capitalism. And Felix Roetin
39:23
Speaker 2: is one of those, or was one of those. And
39:28
Speaker 2: I think it really comes back to that point that
39:30
Speaker 2: Gillian made. This is a group of renegade, insurrectionary outsiders
39:34
Speaker 2: who are tearing up effectively what remains of the post-war
39:39
Speaker 2: consensus in terms of America's corporations. There was another quote
39:43
Speaker 2: that I came across from Felix Rowerton, and he described
39:46
Speaker 2: that large corporations can be treated like artichokes and simply
39:50
Speaker 2: torn apart. And so I think it's that that comes
39:53
Speaker 2: back to that question of power. Who holds power now
39:56
Speaker 2: on Wall Street? And it's looking as though power is
39:59
Speaker 2: tilting away from the old guard, the people like Felix Rowerton,
40:03
Speaker 2: who came of age during this particular moment and had
40:07
Speaker 2: this idea of national investment objectives, which is something that
40:11
Speaker 2: kind of belongs also to that period of government intervention
40:15
Speaker 2: in the New Deal. And it's tilting towards people who
40:18
Speaker 2: are these financial outsiders or were previously and are now
40:23
Speaker 2: managing to take over corporations and in some cases, tear
40:26
Speaker 2: them apart like artichokes.
40:28
Speaker 1: But the difference is, though, it wasn't just about the
40:32
Speaker 1: old guard, the incumbents hating the a bunch of disruptive
40:36
Speaker 1: newcomers who are threatening their power, there were also much
40:39
Speaker 1: bigger philosophical questions at the same time, like does this
40:44
Speaker 1: type of wheeling and dealing create a very short-term vision
40:47
Speaker 1: of capitalism, which is potentially very bad for the economy overall?
40:51
Speaker 1: And if you are structuring this to assume that interest
40:55
Speaker 1: rates will always be low and growth will continue, is
40:59
Speaker 1: that creating a bunch of risks for the future? And
41:01
Speaker 1: what's fascinating is is that those two questions are incredibly
41:06
Speaker 1: important right now, given that we just had a period
41:09
Speaker 1: of ultra-low rates and reasonable growth, and given there's real
41:13
Speaker 1: concern about short-termism in a wider sense.
41:17
Speaker 2: Yeah, and I think these questions have continued to stalk
41:20
Speaker 2: the LBO and then private equity industry to this day.
41:24
Speaker 2: In terms of the research that I was doing, I
41:27
Speaker 2: couldn't see that the industry had ever really managed to
41:30
Speaker 2: match its 1980s high point in the sense of its
41:34
Speaker 2: ability to create value and returns and these operational improvements
41:38
Speaker 2: that it had injected into some companies. Because when you
41:42
Speaker 2: look at the academic literature... There is a real sense
41:44
Speaker 2: that actually the early LBOs did kind of do what
41:48
Speaker 2: they said they did on the tin. There were more companies,
41:52
Speaker 2: large conglomerates that were sitting on these undervalued assets.
41:55
Speaker 6: Right.
41:55
Speaker 1: That's fascinating because in some ways, the story of financial
41:59
Speaker 1: innovation is about somebody having a good idea, which works
42:03
Speaker 1: well and often has real merit in the first few deals.
42:06
Speaker 1: And then because it works, everyone copies it and clones it.
42:10
Speaker 1: and takes it to extremes and applies it in areas
42:13
Speaker 1: where it shouldn't really be applied, and things go horribly wrong.
42:16
Speaker 1: I mean, that was the story of credit derivatives, the
42:18
Speaker 1: story of LBOs, and the story of so much else.
42:21
Speaker 1: Good ideas then go bad. So just to recap for
42:24
Speaker 1: our listeners, LBOs go through this massive, frothy heyday of
42:29
Speaker 1: the 1980s, driven by the evangelizing zeal of William Simon,
42:33
Speaker 1: who believes in free markets, and the fact you had
42:36
Speaker 1: this fairly specific set of historical circumstances coming together. that
42:40
Speaker 1: paved the way. It produces big returns for investors. Some
42:44
Speaker 1: of those bloated conglomerates do become more efficient, but then
42:49
Speaker 1: it starts to go wrong because at the end of
42:53
Speaker 1: the 1980s, as I'm sure many of our audience might remember,
42:57
Speaker 1: Michael Milken, the father of the junk bond world, is
43:02
Speaker 1: indicted for racketeering, securities fraud, and insider trading, and his
43:06
Speaker 1: firm is Drexel Burnham Lambert collapses. So how does the
43:11
Speaker 1: LBO industry respond? What happens next, Hedy?
43:15
Speaker 2: Well, I think there is this real sense in which
43:17
Speaker 2: the narrative around LBOs needs to change. And one of
43:20
Speaker 2: the things that Drexel does is it prints these t-shirts saying,
43:22
Speaker 2: junk bonds keep America fit. And despite its best attempts
43:26
Speaker 2: at kind of rebranding junk bonds there really is a
43:30
Speaker 2: failure to do so and so instead of LBOs there's
43:33
Speaker 2: a new language that emerges around this time a lot
43:37
Speaker 2: of these firms start to instead use the term private
43:40
Speaker 2: equity this sounds more respectable it sounds more sophisticated it's
43:45
Speaker 2: private which always sounds fancy and impressive and you have
43:49
Speaker 2: to look at that partly as a response to the
43:51
Speaker 2: fact that the capital that is flooding into this industry
43:54
Speaker 2: is now coming from pension funds and sources that expect
43:59
Speaker 2: a certain level of responsibility and stewardship and long-termism. And
44:04
Speaker 2: when you look at the narrative that surrounds the industry today,
44:07
Speaker 2: first of all, you have the fact that private equity firms,
44:10
Speaker 2: many of them have morphed into these vast asset managers.
44:13
Speaker 2: And second of all, you have the fact that those
44:15
Speaker 2: asset managers now talk about things like really taking care
44:19
Speaker 2: of retirees across the country and doing things that sort
44:23
Speaker 2: of really ensure that your average firefighter or unionised nurse
44:29
Speaker 2: can afford to retire. And it's a just completely different
44:32
Speaker 2: narrative to that that surrounded the LBOs of the 1980s. Yeah.
44:37
Speaker 3: And obviously, junk bonds also became high yield bonds, or
44:41
Speaker 3: as Mike Milken liked to call them, high performance bonds, apparently.
44:44
Speaker 1: And what actually happens to William Simon? I mean, this
44:47
Speaker 1: really fascinating character who had seven kids, worked in the
44:51
Speaker 1: government and was an evangelist for free market capitalism in
44:56
Speaker 1: a very black and white way. Does he end up
44:58
Speaker 1: getting what he would regard as just rewards?
45:02
Speaker 2: Well, he does appear on the Forbes rich list. He
45:04
Speaker 2: manages to build himself a very beautiful boat called Freedom.
45:09
Speaker 2: Both a boat and a philosophy, as he puts it.
45:11
Speaker 2: He has a number of homes. He has a very,
45:14
Speaker 2: very nice life by all accounts. However, he ends up
45:19
Speaker 2: deciding to invest in the kind of Pacific Basin. And
45:22
Speaker 2: he basically makes a series of quite seemingly ill-timed or
45:27
Speaker 2: badly conceived deals that means that he is eventually removed
45:31
Speaker 2: from the Forbes rich list. And it seems as though
45:35
Speaker 2: towards his later life, his reputation as this wily dealmaker
45:40
Speaker 2: who spotted all of this value and did these incredible
45:44
Speaker 2: things with LBOs actually His reputation is somewhat tarnished, I think,
45:48
Speaker 2: by his later investments. And there is a really interesting
45:52
Speaker 2: article I came across from the 1990s in the Wall
45:54
Speaker 2: Street Journal that talked about his decision to do a
45:58
Speaker 2: lot more charitable fundraising, but also talked about the fact
46:02
Speaker 2: that he had lost quite a lot of money and
46:06
Speaker 2: that he had effectively perhaps fallen out with Chambers and
46:11
Speaker 2: that perhaps Chambers had been the one really behind a
46:15
Speaker 2: lot of the more successful deals. And Simon had provided
46:19
Speaker 2: the face of Wes Ray, but not so much the
46:21
Speaker 2: deal-making acumen.
46:23
Speaker 1: In many ways, again, that's quite a common pattern in
46:25
Speaker 1: financial history that someone has a brilliant success and rather
46:29
Speaker 1: than just stopping and celebrating it, feels motivated to try
46:33
Speaker 1: it again and again, and it goes wrong. And you
46:35
Speaker 1: often do end up with seemingly successful teams later falling
46:39
Speaker 1: out with each other. But what actually happened to LBOs?
46:44
Speaker 1: Because you would have thought that after this explosive boom,
46:48
Speaker 1: that when it turned sour, the whole idea would have died.
46:52
Speaker 1: But whether you call it private equity, whether you call
46:55
Speaker 1: it LBOs, they didn't just go away and die quietly,
46:58
Speaker 1: did they?
46:59
Speaker 2: No, it's astronomic in its size and scale and reach today,
47:04
Speaker 2: the modern private equity industry. And it also has found
47:06
Speaker 2: its way into various locations where you would least expect
47:10
Speaker 2: to find it in kind of low return, low risk sectors,
47:13
Speaker 2: such as care homes and water and this sort of
47:16
Speaker 2: thing that you feel as though its model of creative
47:19
Speaker 2: destruction isn't particularly well suited to those sectors. But I also,
47:24
Speaker 2: one of the things I was really interested in was
47:26
Speaker 2: this sense in which it's never quite matched up to
47:28
Speaker 2: its 1980s heyday in terms of operational improvements or returns.
47:33
Speaker 2: And there was a really interesting study I came across,
47:35
Speaker 2: which studied 317 LBOs between 95 and 2000. And it
47:37
Speaker 2: found little evidence of operating improvements. And instead, the main
47:45
Speaker 2: change that had happened to these firms before and after
47:48
Speaker 2: the LBO was a change of their capital structure. So
47:52
Speaker 2: a sustained increase in financial leverage. So put simply, LBOs
47:58
Speaker 2: led to an awful lot of debt, but not necessarily
48:01
Speaker 2: the operational improvements or value creation of that they claim
48:05
Speaker 2: to be doing. So when you think about value creation,
48:08
Speaker 2: you think about something that didn't previously exist, and you
48:10
Speaker 2: think about ingenuity and entrepreneurship and all of the things
48:13
Speaker 2: that we would be in favour of.
48:16
Speaker 3: All the good stuff, basically.
48:17
Speaker 2: All the good stuff. And then when you look at
48:19
Speaker 2: the fact that a lot of LBOs have simply led
48:21
Speaker 2: to a sustained increase in financial leverage, you can't help
48:24
Speaker 2: but wonder, this looks more like a way of gaming
48:27
Speaker 2: tax systems than it does a way of creating value.
48:31
Speaker 1: Of course, the irony in all this is that you're
48:33
Speaker 1: also ending up with these vast private equity companies that
48:38
Speaker 1: in some ways are actually looking a bit like the
48:40
Speaker 1: kind of bloated bureaucratic establishment firms that the LBO pioneers
48:45
Speaker 1: back in the 1980s liked to attack. I mean, that's
48:47
Speaker 1: a tremendous irony, isn't it?
48:49
Speaker 2: And I think that's one of the great ironies that
48:51
Speaker 2: looms over this story. There was a quote from the
48:55
Speaker 2: former CEO, was it, of Revlon, which was a company,
48:58
Speaker 2: a cosmetics firm that was targeted in an early LBO.
49:02
Speaker 2: And he said, I'm paraphrasing, when one of these kind
49:05
Speaker 2: of financial outsiders takes over, they realize that they quite
49:08
Speaker 2: like getting their suits tailored in London and they quite
49:11
Speaker 2: like their French chefs and they quite like to have butlers.
49:14
Speaker 2: And there was a sense in which the outsiders become
49:18
Speaker 2: the elite. And that's just a kind of story that
49:20
Speaker 2: repeats itself throughout history. But also, I think there are
49:23
Speaker 2: a lot of criticisms now coming from people who would
49:26
Speaker 2: think of themselves as being in favor of capitalism, that
49:29
Speaker 2: this really doesn't look like entrepreneurialism or value creation. And
49:33
Speaker 2: some of these huge asset managers have become instead much
49:37
Speaker 2: more focused on chasing fees and expanding the assets under
49:40
Speaker 2: management and also finding new sources of new influxes of
49:44
Speaker 2: capital from which they can charge those fees to. So
49:47
Speaker 2: I think that's sort of an undermining of the principle
49:50
Speaker 2: of the early LBO.
49:52
Speaker 3: Yeah, I mean, I know lots of quite libertarian hedge
49:56
Speaker 3: fund managers who think essentially the modern private equity industry
50:00
Speaker 3: is pretty much an accounting gimmick. And these are not
50:03
Speaker 3: people who think that companies should not be you shouldn't
50:07
Speaker 3: be able to buy them and turn them around. They
50:08
Speaker 3: just think that as it actually functions today, modern private
50:13
Speaker 3: equity has become a bloated conglomerate in itself, essentially.
50:19
Speaker 2: Yeah, and this is something that came up again and
50:21
Speaker 2: again with interviews, in interviews of people who you would
50:24
Speaker 2: think that they would, you know, sort of be in
50:26
Speaker 2: favour of something like private equity, and yet actually were
50:29
Speaker 2: completely opposed to it because of those very reasons. Because actually,
50:32
Speaker 2: it resembles, yeah, the conglomerates of old. But also, it's
50:36
Speaker 2: really struggling to do its job, or at least the
50:38
Speaker 2: job it set out to do, which is generate those returns.
50:42
Speaker 2: And there was something, I mean, Robin's written about this
50:45
Speaker 2: in terms of the, I think it was in the
50:46
Speaker 2: six years before 2024, the industry took in $ 1. 5 trillion
50:52
Speaker 2: more from investors than it actually created in returns, which
50:55
Speaker 2: is just the kind of statistic that you find, I
50:59
Speaker 2: think was fascinating, actually.
51:01
Speaker 1: And to what degree was this a kind of made
51:02
Speaker 1: in America phenomena? I mean, as you say, it was
51:06
Speaker 1: driven by William Simon's belief that the country was under
51:10
Speaker 1: threat from socialism, communism, they had to fight back. And
51:14
Speaker 1: of course, America's always had a much more buccaneering, risk-taking,
51:19
Speaker 1: profit-seeking mentality, arguably, than much of Europe. Was this a
51:23
Speaker 1: made-in-America phenomena?
51:25
Speaker 2: Absolutely. I think when you look at where Simon and
51:27
Speaker 2: others were coming from, there was a real sense in
51:29
Speaker 2: which they were reacting to the Well, the government programs
51:34
Speaker 2: of the New Deal and the sense in which the
51:35
Speaker 2: government have vastly expanded and that there were these new
51:38
Speaker 2: forms of regulation that emerged during that period that they
51:41
Speaker 2: wanted to roll back.
51:42
Speaker 1: So I'm very curious. I mean, William Simon is not
51:46
Speaker 1: around today. He, in fact, died in 2000. But I
51:51
Speaker 1: wonder if he had been alive today, what would he
51:53
Speaker 1: have made of how the industry has developed?
51:55
Speaker 2: Yeah, it's a really good question. I think he probably
51:58
Speaker 2: wouldn't necessarily think that it had anything to do with
52:01
Speaker 2: the kind of entrepreneurial spirit that he hoped to inject
52:05
Speaker 2: into the American economy. As we've discussed, it doesn't really
52:08
Speaker 2: seem to be doing that. But at the same time,
52:11
Speaker 2: he didn't do that much to improve Gibson Greetings. So
52:15
Speaker 2: perhaps he would have thought this was actually a fabulous
52:17
Speaker 2: way of making money. And if you get rich, then
52:19
Speaker 2: so be it. But I suspect he probably would think that, yeah,
52:23
Speaker 2: it really doesn't resemble the type of ideological ideas commitment
52:26
Speaker 2: to entrepreneurialism that he had.
52:29
Speaker 1: Of course, the counter argument would be that when Adam
52:31
Speaker 1: Smith first developed his vision of what might be called
52:35
Speaker 1: capitalism in the sense of free market competition, driving growth
52:39
Speaker 1: and innovation, his only vision of companies in those days
52:43
Speaker 1: were family owned firms, where the owners were the managers
52:47
Speaker 1: as well. And you had an elision of interest between
52:50
Speaker 1: owners and managers, which of course, you don't have on
52:54
Speaker 1: Wall Street today in the form of public companies. And
52:57
Speaker 1: one of the reasons why things have gone wrong sometimes
52:59
Speaker 1: in the past is the owners of the companies can't
53:01
Speaker 1: see what's happening inside the company and don't feel they
53:03
Speaker 1: have real skin in the game in terms of ownership.
53:06
Speaker 1: So some people would argue that private equity is better
53:08
Speaker 1: that way because at least the owners and the managers
53:12
Speaker 1: tend to be more or less the same people.
53:15
Speaker 2: And that's the classic argument in favor of private equity
53:18
Speaker 2: is that it can better align the misalignment of interest
53:23
Speaker 2: between those owners and managers. And when you look at
53:25
Speaker 2: its use of debt, it was supposed to historically provide
53:28
Speaker 2: a kind of rod for executives' backs so that those
53:32
Speaker 2: managers would no longer be able to spend lavishly on
53:36
Speaker 2: their clay pigeon shooting retreats and expensive and pointless computer
53:41
Speaker 2: equipment and would instead have to be focused on creating
53:44
Speaker 2: that kind of what we now know as shareholder value.
53:48
Speaker 2: But I think that there is also a kind of
53:50
Speaker 2: largesse now within companies private equity industry, as we've kind
53:53
Speaker 2: of discussed. And I'm not sure that that argument really
53:56
Speaker 2: holds up, particularly in terms of the use of debt
54:00
Speaker 2: as a way of delivering that alignment. And I think
54:02
Speaker 2: there's never really been sufficient empirical evidence that that discipline
54:07
Speaker 2: of debt really works in the way that the private
54:10
Speaker 2: equity industry has historically argued that it would.
54:13
Speaker 1: Well, I must say one conclusion I take away from
54:15
Speaker 1: all this is that Hegel, the great German philosopher, was
54:19
Speaker 1: correct when he said that history moves through pendulum swings
54:23
Speaker 1: of reaction and counter-reactions, or as he said, thesis and antithesis.
54:28
Speaker 1: And the very fact you had this era of corporate
54:31
Speaker 1: management after World War II basically paved the way for
54:34
Speaker 1: a reaction was this outburst of world entrepreneurial creative destruction
54:39
Speaker 1: after that. Of course, we're now living today with a
54:42
Speaker 1: counter-reaction in the other direction. But Robin, I know you've
54:45
Speaker 1: got thoughts on this.
54:46
Speaker 3: Well, I think especially that point that Hetty raised around debt,
54:49
Speaker 3: I think is fascinating just because the rhetoric, the theory
54:55
Speaker 3: behind it was that debt was a disciplining tool. It
54:58
Speaker 3: kept companies lean and mean. I worry that really it's
55:02
Speaker 3: more of a systemic increase in corporate debt that makes
55:05
Speaker 3: the entire corporate world, that's everybody really, more fragile in
55:09
Speaker 3: case of shocks. You know, the number of AAA rated companies,
55:12
Speaker 3: we talk about rating agencies and They can get stuff wrong,
55:15
Speaker 3: but they actually get more stuff right than people think.
55:18
Speaker 3: And the number of AAA companies has dropped, I think,
55:21
Speaker 3: in the hundreds in the 80s. I think there are
55:24
Speaker 3: only six or seven left in the world today. And that,
55:27
Speaker 3: I do worry about that. Whenever we have shocks, it
55:30
Speaker 3: just means that more companies go bust quicker. And the
55:34
Speaker 3: macroeconomic impact of that is that much more violent than
55:37
Speaker 3: ideally we would like it to be. That actually, solidity...
55:42
Speaker 3: And creditworthiness. Our values have sadly disappeared a little bit.
55:47
Speaker 1: Leverage is a bit like alcohol. A little bit makes
55:49
Speaker 1: the world better. Too much is destructive.
55:52
Speaker 3: Well, that sounds like a great note to end the show,
55:54
Speaker 3: given that it's, you know, it's sunny outside. I hope
55:57
Speaker 3: we can all go out for a quick drink, maybe soon.
56:00
Speaker 3: Thanks for coming in, Hetty. It's been an absolute pleasure.
56:03
Speaker 2: Thank you for having me. It's been great.
56:05
Speaker 3: That's it for the story of money from the Financial Times.
56:08
Speaker 3: I'm Robin Wigglesworth.
56:09
Speaker 1: And I'm Gillian Tett.