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ABSTRACT
While the business model of private equity has remained largely unchanged since the 1980s, private equity as an industry has undergone a dramatic transformation. In the early 1980s, private equity was both highly profitable and highly controversial. Today, on the other hand, it is an important asset class and its returns are modest. This paper will document both of these changes and identify the several factors that contributed simultaneously to private equity's declining profitability and to its increasing public acceptance. This paper will also identify another change that private equity underwent in the 1980s, which has been largely ignored: the change in how private equity fund managers are compensated. The change in manager compensation had a material impact on the industry. While heralded as unequivocally positive for private equity investors, these compensation terms created new agency costs between investors and private equity managers and contributed to the increasing significance of fixed compensation in private equity.
INTRODUCTION
Private equity funds, such as Kohlberg Kravis Roberts & Co. (KKR) and Forstmann Little, first entered public consciousness in the late 1970s.1 While the business model has remained largely the same, private equity today is very different from what it was during the 1970s and 1980s. Most evidently, private equity has transformed from a niche investment strategy to an asset class and industry. In 1980, there were only about fourteen leveraged buyout funds.2 Today, there are thousands of private equity funds internationally, with the number having doubled from 2004 to 2014.3 As of June 2016, private equity funds managed a total of about $2.49 trillion in assets.4
Not only has the private equity industry grown significantly, but its profitability and reputation also have changed since its earliest days. In the 1980s, private equity was both highly controversial5 and highly profitable.6 Frequently, in the 1980s, it was described as excessively risky, illogical, and bad for the economy.7 The president of Chemical Bank, for example, wrote in 1985 that he worried leveraged buyouts were "simply . . . a perverse result of greed and not a logical, rational thing."8 While the private equity industry remains the subject of criticism-most notably, when Mitt Romney ran for President in 20129-today, it is not only much less controversial, but also frequently celebrated...