The Rise of Private Equity and the Decade of the Leveraged Buyout

Private equity came into its own in the 1980s. George Fenn, Nellie Liang and Stephen Prowse argue that this was due to the widespread adoption of the limited partnership as the means of organizing the private equity partnership. Thanks to this organizational innovation, private equity, once the province of wealthy families and industrial corporations, was now dominated by professional managers acting as general partners (largely on behalf of institutional investors who provide finance as limited partners). This partnership form relied on high powered incentives to overcome extreme informational asymmetries and incentive problems. Between 1980 and 1995, funds invested in the organized private equity market grew from $4.7 billion to more than $175 billion.


Leveraged Buyout

Private equity firms employ a wide range of strategies. Though perhaps best known as a force behind leveraged buyouts (discussed later in this section), they also invest in anything from distressed debt to real estate. Perhaps most important, venture capital is a subset of private equity. Fenn, Liang and Prowse argue that the growth in private equity has enabled more funds to flow, both to classic start-up companies and to established private companies. Between 1980 and 1995, venture capital outstanding grew from $3 billion to $45 billion. Venture capital financed the rise of many of Americas most innovative firms, including Genentech, Microsoft, Oracle, Intel and Sun. It is fair to say that venture capital played a crucial role in making the United States a leader in high-tech industries, particularly biotechnology and computers. Nonventure private equity also increased substantially during the 1980s, when blockbuster leveraged buyouts (LBOs) dominated the business headlines, culminating with the $31 billion takeover of Nabisco by Kohlberg Kravis Roberts (KKR). In this type of acquisition, the financial sponsor or a private equity firm uses a significant amount of debt to purchase the target company, sometimes using the target companys assets as collateral. LBOs, management buyouts and employee buyouts can, at their best, produce corporate makeovers that result in greater efficiency and competitive advantage. Although LBOs boomed during the 1980s, severe competition at the end of the decade reduced the profitability of deals as funds were forced to pay more for firms. This led to a fall in the number of LBOs for several years.

The rise of the LBO sparked another set of innovations regarding corporate governance. In response to the increasing number of hostile bids that occurred during this period, a number of antitakeover techniques were developed. Initially, these involved charter amendments, such as supermajority voting provisions that might require, for example, that 80% of shareholders approve a merger. Another example is staggered terms for board members, which can delay transfer of effective control for a number of years. An important characteristic of charter amendments is that shareholder approval is required. In 1982, an alternative anti takeover defense was developed to protect the El Paso Company from a raid: the issuance of what came to be known as poison pill securities. There are a number of variations on these, including preferred stock plans, flip over plans and back end plans. Preferred stock plans were the exclusive tool of choice for fending off takeovers until 1984. With these, the potential target issues a dividend of convertible preferred stock to its shareholders, granting them certain rights if an acquiring party purchases a large position (30% in one plan) in the firm; the board of directors can choose to waive these rights. The preferred stockholders can require the outside party to redeem the preferred stock at the highest price paid for common or preferred stock in the past year. If a merger occurs, the acquiring firm must exchange the preferred stock for equivalent securities that it must issue. These preferred stock plans made it more difficult for raiders to acquire firms by removing an incentive for shareholders to bid early on, because they can always be sure of obtaining the highest price paid. Crown Zellerbach used the first flip over plan as a poison pill in July 1984. The first step in executing this strategy is the issue of a common stock dividend consisting of a special form of right. This gives the holder the right to purchase common stock at an exercise price well above its current market price. It can be exercised starting 10 days after an outside party obtains or bids for a substantial amount (such as 20%) of the target firms stock for up to 10 years. Ordinarily, nobody would want to exercise these rights because the exercise price is well above any likely market price. However, if a merger occurs, they flip over and allow the holder to buy shares in the merged firm at a substantial discount. This makes hostile mergers extremely costly, but friendly mergers are still possible because a company can repurchase the rights for a nominal fee unless they have been triggered.

The back-end plan was also introduced in 1984. When acquiring a target, firms often made a two-tier bid: They initially paid a high price for a majority of shares and then used their voting power to force a merger at a lower price, so the remaining shareholders did worse than those who initially tendered. This structure provides an incentive for shareholders to tender. Back-end plans are similar to flip-over plans, except the rights issued put a minimum on the amount acquirers must pay in the second part of a two-tier offer.



From Recession to a Revolution in Corporate Finance

During the 1950s and 1960s, when inflation was low, interest rates were stable and the United States faced little international competition, financial planning was not a top concern for corporate managers. Financing, for many companies, involved little more than balancing the corporate checkbook. This was, however, an unusually fruitful period for high level theoretical thinking that laid the groundwork for further financial innovation. In 1958, professors Franco Modigliani and Merton Miller (both of whom would later win Nobel prizes) published a groundbreaking article titled “The Cost of Capital, Corporation Finance and the Theory of Investment”. The Modigliani–Miller theorem posits that, under perfect market conditions, the value of a firm is independent of its capital structure. This theorem launched a new way of thinking about capital structure and a generation later, researchers are still analyzing how real world frictions impact the theorems idealized assumptions. The early 1960s also saw the introduction of the Capital Asset Pricing Model (CAPM), a formula for pricing securities based on the expected rate of return plus a risk premium and Monte Carlo methods for valuing complex instruments by shifting uncertain variables in simulated outcomes and averaging the results. Moving beyond the realm of theory, the pace of real world financial innovation quickened sharply in the 1970s, born out of a bitter recession in which interest rate spikes and skyrocketing energy prices followed hard on the heels of a stock market collapse. Many firms needed to restructure themselves in order to survive, others were eager to commercialize exciting new technologies despite the tough environment. As the downturn took hold in 1974, banks curtailed lending to all but the largest and highest rated companies, while the most innovative firms those with the highest returns on capital and the fastest rates of growth were shut out. This pent up need for capital provided the impetus for another leap forward in the field of corporate finance.

Building on the research of W. Braddock Hickman and others, who discovered that below investment grade debt earned a higher riskadjusted rate of return than investment grade bonds, financier Michael Milken realized that premium high yield bonds more than compensated investors for the added risk of default. He soon built a vast market for high yield debt that provided innovative companies with the ability to finance growth and the flexibility they needed to manage their capital structures in changing times. High yield debt (known pejoratively as junk bonds) was not an entirely new concept, but the market for it had shriveled up for most of the twentieth century. Before the 1970s, virtually all new publicly issued bonds were investment grade and only the debt of large ultra blue chip companies fell into this category. Until this time, the only publicly traded junk bonds were issues that had once been investment grade but had become fallen angels, undergoing downgrades as the issuing company fell into financial distress. The interest payments on these bonds were not high, but with the bonds selling at pennies on the dollar, their yields were tempting. Companies deemed speculative grade were effectively shut out of the capital market and forced to rely on more expensive and restrictive bank loans and private placements (which involve selling bonds directly to investors such as insurance companies). Milken realized that the debt market for fallen angels and troubled securities could have a wider purpose: It could be utilized to create securities for up and coming companies that simply needed access to capital. After all, tens of thousands of publicly traded firms (in fact, 95% of the publicly traded companies with more than $35 million in revenues) were not being served by the corporate bond market. The junk bond revolution began in 1977, when Bear Stearns underwrote the first new issue junk bond in decades and Drexel Burnham Lambert developed new issue high yield bonds for seven companies once shunned by the corporate bond market. Companies could now issue bonds that were below investment grade from their inception. Because high yield bonds are deemed to be riskier than other types of debt, they typically promise higher yields than investmentgrade bonds. It began to dawn on investors that junk bonds could actually outperform investment grade bonds over time and they flocked to this new market. From 1979 to 1989, the high yield debt market grew almost 20-fold, to almost $200 billion. Junk bonds financed the successful restructuring of numerous manufacturing firms, including Chrysler. The subsequent use of these instruments as a component in hostile takeovers eventually produced a strong backlash, but the primary function of the high yield market was providing capital for corporate growth, expansion and survival.


Financial instruments had traditionally been lumped into categories based on whether they related to debt or equity, but in recent decades those distinctions have blurred. Changes in the corporate bond market and the growth of structured finance in fixed income asset classes enabled greater flexibility in managing corporate capital structures and a wide array of products emerged to help corporations lower the cost of capital and account for various types of risk. Bond warrant units offer a prime example. Corporations could exchange these hybrid securities (combining equity and debt components) for the assets of companies they were seeking to acquire. This type of instrument was first used in the 1960s in deals such as Loews Theatres acquisition of cigarette manufacturer Lorillard; the transaction involved Loews exchanging $400 million in 15-year, 6.875% bonds and 6.5 million warrants. Almost $1.5 billion of these types of transactions were completed in the late 1960s and early 1970s. Recession gave way to recovery in the early 1980s, but stock prices, though rising, were still considerably below replacement costs. Companies were hesitant to embark on new common stock offerings that might dilute the holdings of existing shareholders. Interest rates were declining but remained historically high, making the prospect of long term borrowing equally unappealing. Bond warrant units proved to be a good tool for resolving this dilemma. They made the dilution of ownership more palatable because they were exercisable above the current market price; they substantially reduced borrowing costs while allowing companies longer time horizons for repayment. Dozens of non investment grade companies had opted to issue bond warrant units by 1983; cumulatively, they raised almost $3 billion through this avenue. Golden Nugget sold $250 million in these instruments to expand operations in 1983; three years later, MGM sold $400 million in 10% bond warrant units to refinance the bank debt used in its acquisition of United Artists. MCI stands out as one of the largest such offerings in this time period. Its management had been consumed with the never ending task of raising short term capital to build an ambitious long distance network; however, in 1983, the company issued $1 billion in 10-year bond warrant units with a coupon of 9.5%, substantially less than what US Treasuries were yielding at the time. Now the company had the capital and the freedom to focus on creating a cuttingedge fiber optic telephone network even though the profits it would generate remained further down the road.

As with MCI, other growth oriented companies needed to finance the buildout of new technology infrastructure. They needed the right capital structure to urvive and thrive until that investment could pay off. Zero coupon, payment in kind (PIK) and split coupon securities emerged as additional financial tools for the task. These debt securities are sold below face value because they promise no periodic cash interest payments. Instead, the interest is internally calculated based on time to maturity and credit quality. The buyer of such a bond receives the rate of return by the gradual appreciation of the security, which is redeemed at face value on the maturity date. In the case of a PIK, the issuer is given the option to make interest payments in additional securities or in cash, providing flexibility in regulating cash needs for the enterprise. In April 1981, J.C. Penney made a public issue of zero coupon bonds. This offering, along with a tax benefit that existed at the time, boosted the popularity of these instruments. Although the tax loophole was quickly closed when firms started taking advantage of it on a large scale, the market for zero coupons nevertheless continued as investors found their payment characteristics desirable because of a lack of reinvestment risk. Investment banks initially stripped government securities to satisfy this demand, but eventually the Treasury stepped in and took over this role. Firms such as McCaw Cellular, Turner Broadcasting and Viacom International were burning through current cash flow to expand their cellular telephone networks, cable television programming and cable television systems, respectively so they turned to the high yield market to finance growth. In 1988, McCaw issued $250 million in 20-year discounted convertible debentures paying no cash interest for 5 years, freeing up cash flow for expansion. (The firm later merged with AT&T in 1994.) Turner Broadcasting issued $440 million in zero coupon notes that deferred interest payments until maturity. Viacom issued $370 million in PIK securities, with the flexibility to pay interest in additional securities rather than cash. Time Warner, News Corporation and other firms used similar financing strategies to transform the way we use media, communications and information technology. Commodity linked securities also came into vogue during this time period. In 1980, Sunshine Mining issued the first silver backed, commodity indexed bonds in 100 years. By linking these securities to the price of silver, Sunshine could pay about half the interest rate of a straight debt issue (about 3% less than what US Treasuries were paying at the time). Investors shared in the profits when the price of silver rose and this paid off handsomely at various points. Meantime, Sunshine lowered its cost of long term capital. All of these innovations in corporate high yield debt instruments involved some form of risk reallocation. Zero coupon bonds enable interest to be effectively reinvested and compounded over the life of the debt issue. Interest rate risks can be managed through adjustable rate notes and floating rate notes, while commodity linked bonds address price and exchange rate risks. Securities can be structured to reduce the volatility of cash flow to the extent if interest or principal payments are associated with changes in a companys revenues; the debt service burden is shifted from times when the firm is least able to pay, to times when it is most able to pay. Currency risk can similarly be managed through tools like dual currency bonds, indexed currency option notes, principal exchange rate linked securities and reverse principal exchange rate linked securities. The advent of information processing technology (such as credit scoring) and asset pricing models (such as CAPM, which enables analysis of asset prices based on risk and rates of return of a particular financial asset compared to the overall stock market) gave rise to products that could enhance liquidity. An infinite variety of features attached to bonds and notes reduced agency costs, transaction costs, taxes and regulatory bottlenecks. This remarkable surge of creativity in the high yield debt market ultimately spawned additional ideas for preferred stock, convertible debt and equity innovations.

Rise of the Capital Markets and the Birth of Venture Capital

The first reliable census of stockholders took place in 1952, when a NYSE sponsored study reported 6.5 million individual shareholders. It was in this period that Charles Merrill became to stocks what Giannini was to deposits and business loans. By popularizing ownership of securities, he spawned continuous waves of financial innovation between World War II and the end of the twentieth century. Merrill began his efforts before World War I but met no real success until after World War II. In those somnolent years, he revolutionized the brokerage community, convincing the broad middle class that investing in stocks was a sensible and even prudent move. This was no easy task. The average Joe had not participated in the raging bull market of the 1920s but had plenty of all too vivid memories of the crash and the Great Depression. Most Americans simply had no interest in stocks and lacking a broad base of investors, many fledgling companies couldnt hope to attract financing. The banks and bond markets both shunned start ups. Bond buyers of this period were not inclined to gamble on young firms with great ideas but no proven track record. Most established investment banks were conservative through and through when it came to deciding where to put their clients money. Institutional investors had no interest in pioneering broader ownership or more innovative financing. When Merrill commenced his campaign for peoples capitalism after World War II, only 11% of the US population owned equities. Within two decades, that number had risen to one in six Americans, including more than 30.9 million shareholders.


Merrill got his start during a time when small new investment banks and regional firms began underwriting local issues of manufacturers in emerging industries. With the demise of the Consolidated Exchange in the 1920s, the New York Stock Exchange had taken center stage. However, the Curb Exchange (later rechristened the American Stock Exchange in 1953) gained greater respectability, especially as a secondary market for issues of innovative companies. More than 30 organized exchanges arose outside of New York City in major cities, significant over the counter markets took hold as well. New sources of reliable business information became available. Class-A common stock a post World War I innovation achieved new popularity in the mid 1950s, offering investors noncumulative participating dividends without voting rights. Securities design for such Class-A common stock incorporated and required new information about company performance and cash flows into new contracts and monitoring of firm performance. Until common stock offerings became more viable in the 1950s, the only course of action for young companies and potential startups came from the earliest forms of private equity and venture capital.

Two seminal figures in the development of these markets were George Doriot, a former general affiliated with Harvard Business School and MIT president Karl Comptom, who effectively launched the venture capital industry in 1946 with the founding of American Research and Development, a publicly traded closed end fund marketed mostly to individuals. Doriot had a nose for sniffing out the most promising entrepreneurs and he found two in Kenneth Olson and Harlan Anderson, who wanted to start a firm to manufacture small computers. They had no money, no credit and apparently, no hopes when they incorporated Digital Equipment. But Doriot was willing to help out. In 1956, he offered to invest $70,000 in the company in return for a 60% stock interest, Olson and Anderson eagerly accepted. By 1958, the first venture capital limited partnership was formed: Draper, Gaither and Anderson. Start ups soon had another option, too, in risk capital pools federally guaranteed under the Small Business Investment Companies program. Soon growth equity and leveraged buyouts were scaling up, trying to overcome the fundamental problems of business finance: illiquidity, uncertainty and information gaps and the macroeconomic cyclicality of business formation. They were able to do so by incorporating reporting that was required by active investors, these included close monitoring of operations, active board involvement and intervention to protect both minority shareholder and creditor interests. As Sputnik galvanized interest in government commitments to new technology, firm financings began anew. Initial public offerings became another important tool for new and old businesses alike to access the capital markets. In 1956, Ford went public by selling 10 million shares to raise $658 million. IPO activity picked up briskly after that and became a full fledged fad by 1960.

At first, most offerings were made by old line investment banks that wouldnt touch a company with less than a five year record of successful operations. These banks had reputations to safeguard and werent about to trade them for quick one time profits. Then, as the mania gathered steam, marginal underwriters sprouted to peddle low grade merchandise. They were more salesmen than bankers, small timers who operated on shoestrings and werent in business for the long haul. Their operations were legitimate enough but were laced with dubious practices (a common enough occurrence when worthwhile movements hit the mania stage). The later absorption of IPOs into white shoe investment banking would not happen until the high tech boom that began in the 1980s. The IPO craze fell out of favor as a bull market ground to a halt in 1968–1969. Once more it became difficult for start ups to obtain financing. But this time the situation was mitigated by the continuing growth of venture capital. By the 1970s, VC had become firmly established as a crucial source of funding for up and coming firms in new industries.

Giannini and the Democratization of Capital

Through the efforts of Morgan and others, a great number of financial innovations increased access to capital for larger enterprises. Corporate and industrial power was concentrated in these behemoths and centralized in Wall Street banks. But soon the doors were destined to swing wider. The initial attempt to pry open capital access to the broader public began in commercial banking and it was the brainchild of a man who seemed to be the polar opposite of the august J.P. Morgan. A continent away from Wall Street, Amademo Peter Giannini was born in California in 1870, the son of an Italian immigrant farmer. Giannini attended school until the age of 14, when he joined his stepfather in the fruit and vegetable trade. There he gained the hands on experience in small business that would shape his worldview. In 1903, Giannini took over his deceased father in laws properties, including a minority interest in the Columbus Savings Association. Suddenly, the young vegetable merchant was a banker. In 1909, he formed the Bank of Italy the institution that would later become Bank of America. In those days, American banking was dominated by East Coast titans who catered to institutions, corporations and the upper crust. These banks made loans to only the most creditworthy customers and modest, immigrant run enterprises need not apply.


From the first, Giannini focused on small depositors and borrowers, intending to open banking to the masses. His turning point came with the 1906 San Francisco earthquake and fire. When the larger banks had to close down in the aftermath of the disaster, he pitched his tent on a pier and made loans to distressed businessmen on the spot. The legend of A.P.Giannini was born. Within a few years time, he was opening branches in other parts of California, beginning with San Jose, all concentrating on the same small depositors and borrowers that had made the San Francisco bank so successful. Giannini made no secret of his ambition to go national and even international in 1928, he even changed the banks name to Transamerica. The success of this upstart riled Wall Street and Washington, but despite their efforts to cook up regulations to thwart him, Gianninis bank had become the largest in America by 1945. Gianninis popularization of small business loans and home mortgages began to shape emerging public policies regarding capital access. His move to democratize commercial banking contributed to the explosive growth of Californias agricultural economy and its real estate and entertainment industries.

Another revolution of access was also taking place around this time as the first form of mutual funds opened a new channel of capital for business finance. John Elliott Tappan was among the handful of financial innovators seeking higher yields for thrifty small savers. He devised a new method of mobilizing funds, selling face amount certificates that could be purchased by ordinary folks paying monthly installments over several years. Paying a higher compound interest rate than was available from banks or other traditional financial intermediaries, Tappan founded Investors Syndicate. His instruments were backed by first mortgages and became a modern, liquid alternative to real estate or land for urban Americans who no longer earned their income from agriculture. His financial innovations informed the development of the life insurance industry, opened the market to small investors and paved the way for the modern day mutual fund industry.

An Age of Creative Destruction

As the curtain fell on the nineteenth century and a new era dawned, advances in financing paved the way for the shift from steam power to electrification, from coal to oil and from rail to auto. These shifts drove innovation and expansion and built new fortunes. From 1880 to 1913, the gold standard spread, joint stock banks competed with merchant banks and the world witnessed an explosion of new corporations and stock offerings. Futures markets in organized commodity and currency exchanges grew, and corporations tried on new organizational forms, including holding companies, trusts and other corporate or trading entities. Almost overnight, it seemed, finance made it possible for marvelous new inventions to hit the market: electric generators, dynamite, photographic film, light bulbs, electric motors, internal combustion engines, steam turbines, aluminum, prestressed concrete and rubber tubing. By the 1920s, the US Patent and Trademark Office was granting record numbers of patents. This epoch of technological progress was marked by the emergence of major corporations built on these advances and by a new realization that investing in intangibles could lead to very real returns. The growth in the number of investors, along with the increased willingness to take risks for capital gains, drove financial innovation.

creative destruction

Innovation materializes at the nexus between finance and technology. From this intersection, Joseph Schumpeter constructed his complex but compelling theory of business cycles. The gales of creative destruction, he observed, rendered old investors, ideas, technologies, skills, plants and equipment obsolete in the continuous drive to improve productivity, efficiency and standards of living. This period of history proved that human knowledge and creativity could be monetized through innovation and catalyzed by finance, leading Schumpeter to map out his ideas of dynamic entrepreneurial capitalism and cast aside the static equilibrium models that the economists of his day favored. Business failures also hastened the development and adoption of new securities. Between the Civil War and the Great Depression, the United States lurched through 20 recessions and 15 major bank panics and financial crises. The reorganization of railroads and the improvisation of financing that often accompanied restructuring related to bankruptcies opened new avenues for innovations in business finance. As costs outstripped their original estimates in the building of railroads and industrial plants, preferred stocks enabled near bankrupt firms to raise additional funds. Long maturity bonds arose in the late nineteenth century and were used repeatedly for reorganizations through the Great Depression. Another innovation at the beginning of the twentieth century came in the form of warrants. These were usually issued with bonds or stocks and essentially consisted of an option that allowed the holder to buy stock at a predetermined amount for a limited amount of time. They were first deployed when the American Power and Light Company issued 6% notes in 1911. They were sporadically used until 1925, when they enjoyed wide popularity for several years. Warrants would reemerge as valuable tools in the 1960s, as we shall see later in this chapter.

Many decades later, during the credit crunch and business crises of the 1970s and 1980s, the financial innovations of this earlier period would resurface as useful building blocks. Expanding on these earlier advances, financiers found new ways to allow for balance sheet and operational restructuring. Firms came to enjoy flexibility in adapting their capital structures to market conditions selling debt or equity, for example or exchanging one for the other when market conditions were most receptive, without tax consequences, to strengthen their balance sheets. Having the opportunity to deleverage (that is, to reduce debt) was a fundamental reason why relatively few companies defaulted in the 1970s and 1980s. Many companies whose debt was considered extremely risky in the 1970s such as Westinghouse, Tandy, Chrysler and Teledyne found ways to manage their capital structures and return to profitability. In the early 1980s, firms such as International Harvester, Allis Chalmers, Mattel and Occidental Petroleum were able to deleverage by issuing equity in exchange for debt. They were able to attract investors, maximize shareholder value and often forestall bankruptcy, thus preserving jobs even as the economy stalled.

JP Morgan and the Twin Transformations of Industry and Finance

The close of the nineteenth century saw the rise of financial capitalism. Investment banking became a powerful force in the American economy after the Civil War and JP Morgan was the living, breathing symbol of this era. Born into a family of London bankers, Morgan made his first important splash in 1879, successfully selling 250000 shares of New York Central stock for the Vanderbilt interests. This move demonstrated that Morgan had placement power, meaning that he could distribute large amounts of securities without disturbing the market. This ability, earned by providing results for customers, was and remains the key to an investment bankers prowess.

During the next 15 years, Morgans attention was focused on railroad reorganizations: working with the Northern Pacific, arranging a truce between the Pennsylvania and the New York Central and restructuring the Baltimore Ohio and the Chesapeake Ohio. By the early 1890s, he had a hand in reviving the defunct Richmond West Point Terminal Co, which he folded into the Southern Railway Co and then into the Erie and the Philadelphia Reading Railroad. In the course of these projects, banks began to develop close relationships with clients. Indeed, the practice was known as relationship banking. Bankers served on their clients boards of directors and were kept on retainer for their advice on a wide variety of matters beyond financing.


By the early 1890s, the railroad system was mature and its presence helped to create manufacturing companies that could operate nationwide. Railroads, telecommunications and financial enterprises were once the only private firms using the capital markets to sell major bond issues, but now a handful of industrial companies began to approach the market. When they did, debt financing rather than stock issues prevailed, since the investing public remained skeptical about common stocks. At first, these industrial companies did not seek out the services of investment banks. Companies hoping to raise funds through borrowing turned to loan contractors, who arranged loans based on collateral. Some commercial banks would finance local enterprises and occasionally a broker would canvass his investors to discover whether there was any interest in making loans. Several individuals, such as Charles Ranlett Flint and John W. Bet a Million Gates, were promoters who would go from one deal to another, bringing parties together and then presenting the results to an investment banker to arrange the financing. In any case, manufacturing operations in this period were modest affairs, usually owned and managed by their founders. Common stock offerings for industrial companies were rare.

By the early twentieth century, investment bankers had replaced promoters and loan contractors as the principal source of financing for industrial companies. In addition, they extended their influence throughout the economy, forming alliances with commercial banks and insurance companies. Into the Morgan orbit came First National Bank, Chase National, Bankers Trust and Guaranty Trust. The investment bankers clients were governments and big business and the resulting alliance dominated corporate America until the 1980s. In the course of his long and productive life, Morgan led the restructuring of many railroads and industrial corporations and even swooped in to help save government finances during the currency crisis of 1896, the railroad crisis in 1898 and the credit crunch of 1907. Yet he did little to provide small businesses and individuals with greater access to capital. As Alvin Toffler and Bradford DeLong have described, Morgans organizational strategies and financial methods were geared toward large scale industrial consolidation and concentration in striking contrast to the financial innovations and corporate strategies that were to generated broader entrepreneurial capitalism during later periods.

The Nineteenth Century Ushers In Rapid Innovation

Hamiltons First Bank of the United States was followed by the Second Bank of the United States, which lasted from 1816 to 1836 and there was considerable distrust of the concentration of power these institutions represented. In a report on the Second Bank, John Quincy Adams wrote, Power for good is power for evil, even in the hands of Omnipotence.


The controversy came to a head in the debate on rechartering the Second Bank in 1832. Although Congress passed the bill, President Andrew Jackson successfully vetoed it. A strong bias toward decentralizing the banking system emerged, along with an aversion to powerful financial institutions of any kind. As a result, the US banking system remained highly fragmented throughout the nineteenth century. Unlike every other industrializing country, the United States failed to develop nationwide banks with extensive branching networks. But this vacuum strengthened the role of financial markets and created a wide open playing field for financial innovation. In the last half of the nineteenth century, the New York market grew in prominence, due in part to bonds issued during the Civil War and the active trade in them during the following decades. This era witnessed a host of innovations, including the development of the market for commercial paper, which allowed corporations with a strong financial position to borrow short term in the markets more cheaply than they could borrow at a bank.

As the nation emerged from Reconstruction, the Herculean task of building railways to span the sprawling North American continent offered another proving ground. The vast scale of the undertaking, the enormous capital it entailed, and the constant reorganizations of the railroad companies themselves came to define the great period of American development and innovation that we turn to in the following section. As Peter Tufano has documented, many of the standard contract forms we still use today preferred stock, convertible bonds, warrants and bond covenants were instruments developed and refined during this period of rapid technological invention and commercialization. Preferred stock was used to raise capital for railroads between 1843 and 1850, it constituted 42% of the capitalization of trusts, mergers and recapitalizations from 1890 to 1893 and 13% of the total value of securities issued between 1919 and 1927. Income bonds, a type of debt security in which only the face value of the bond is promised to the investor (with coupon payments occurring only with sufficient income earned), were advantageous for distressed railroads facing reorganization during the late nineteenth century. Convertible bonds and notes, devised in the late 1850s, accounted for 13% of bonds issued from 1914 to 1929. This era saw major strides in the means and methods available for supplying capital.