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Private Equity
The Federal Deposit Insurance
Corporation (FDIC) preserves and promotes public confidence in the
U.S. financial system by insuring deposits in banks and thrift
institutions for at least $100,000; by identifying, monitoring and
addressing risks to the deposit insurance funds; and by limiting the
effect on the economy and the financial system when a bank or thrift
institution fails.
An independent agency of the federal
government, the FDIC was created in 1933 in response to the
thousands of bank failures that occurred in the 1920s and early
1930s. Since the start of FDIC insurance on January 1, 1934, no
depositor has lost a single cent of insured funds as a result of a
failure.
According to the Federal Deposit
Insurance Corporation (FDIC), the private
equity market in the United States has evolved over the years, with
financial institution involvement only becoming significant in the
1960s and 1970s.
Where these funds are invested also has
changed over time.
Currently, most private equity
funding is used to fund start-up or early-stage companies or to
bring large public companies private.
Private equity
investments can be made through limited partnerships or they can be
direct investments. Subsidiaries of banking organizations are
probably the largest direct investors in this market.
Evolution of
the Private Equity Market
Given its history, merchant banking is often thought of as a
European, and especially British, financial specialty, and British
institutions continue to maintain a major presence in this area.
Since the 1800s and even earlier, however, U.S. firms (such as
J.P. Morgan) also have been active in merchant banking.
However, although
both investment banks and commercial banks, as well as other types
of businesses, have been authorized to engage in private equity
investment in the United States, financial institutions have not
been major providers of private equity.
Until the 1950s, U.S. investors in private
equity were primarily wealthy individuals and families.
In the 1960s and 1970s, corporations and financial institutions
joined them in this type of investment. (In the 1960s, commercial
banks were the major providers of one kind of private equity
investing, venture-capital financing.)
Through the late 1970s, wealthy families, industrial corporations,
and financial institutions, for the most part investing directly in
the issuing firms, constituted the bulk of private equity investors.
In the late 1970s,
changes in the Employee Retirement Income Security Act (ERISA)
regulations, in tax laws, and in securities laws brought new
investors into private equity. In particular, the Department of
Labor's revised interpretation of the "prudent man rule" spurred
pension fund investment in private equity capital.
Currently, the major investors in private
equity in the United States are pension funds, endowments and
foundations, corporations, and wealthy investors; financial
institutions-both commercial banks and investment banks-represent
approximately 20 percent of total private equity capital, divided
approximately equally between the two.
The
U.S. Department of the Treasury (Treasury) estimates that at
year-end 1999, commercial banks accounted for approximately $35
billion to $40 billion, and investment banks for approximately
another $40 billion, of the $400 billion total investment in the
private equity market.
At $400 billion as of year-end 1999, the
private equity market is approximately one-quarter the size of the
commercial and industrial bank-loan market and the commercial-paper
market.
In recent years, funds
raised through private equity have approximately equaled and
sometimes exceeded funds raised through initial public offerings and
public high-yield corporate bond issuance.
The market also has grown dramatically in recent years, increasing
from approximately $4.7 billion in 1980 to its 1999 figure. Despite
this tremendous growth, the private equity market is extremely small
compared with the public equity market, which was approximately $17
trillion at year-end 1999.
Typical Uses of Private Equity
Private equity financing is an alternative to raising public
equity, issuing public debt, or arranging a private placement of
debt or bank loan.
The reasons companies seek private equity
financing are varied.
For example, other forms of
financing may be unavailable or too expensive because the company's
track record is either nonexistent or poor (that is, the company is
in financial distress).
Or a private company may want to
expand or change its ownership but not go public.
Or a firm
may not want to take on the fixed cost of debt financing.
Public firms may seek private equity financing when their capital
needs are very limited and do not warrant the expense, time, and
regulatory paperwork required for a public issue.
They also
may seek private equity to keep a planned acquisition confidential
or to avoid other public disclosures.
They
may use the private equity market because the public market for new
issues in general is bad or because the public equity market is
temporarily unimpressed with their industry's prospects.
Finally, very often in recent years,
managements of large public firms have felt their firms will benefit
from a change in capital structure and ownership and will choose to
go private by means of a leveraged buyout (LBO).
Although
companies seek private equity for all these reasons, most private
equity funding has been used for one of two purposes: to fund
start-up or early-stage companies (venture capital) or to bring
large public companies private in LBOs.
Of
the $400 billion in outstanding private equity investment at
year-end 1999, venture-capital investments accounted for
approximately $125 billion and nonventure-capital investments for
approximately $275 billion.
LBOs were by far the most common
use of nonventure-capital private equity.
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