Jimmy Lee: The First Crowdfunder? (In Memoriam)
James “Jimmy” Lee, a giant of the private equity industry, died suddenly today at the age of 62.
The business of private equity is that of buying companies. A private equity firm will buy a company, streamline its operations, and sell it off for a (hopefully) hefty profit. The secret sauce of private equity is leverage, or the act of borrowing money to multiply the effective value of your equity bid. A private equity firm chips in a small percentage of the purchase price in equity, and then arranges debt financing for a company in order to complete the purchase. In a sense, the firm borrows against the strength of their name, and their reputation as being competent, imaginative, and effective managers. If their investment goes south, so will the equity that they have invested, and so will their reputation.
This process is sometimes (perhaps rightfully) maligned as extractive. The debt is assumed by the company that is being purchased, and not the private equity firm. The streamlining of operations very often includes layoffs, and exposes tensions in the labor-management relationship. Another of the most common tactics used by private equity firms to generate value from their investments is to, after having increased profitability and paid off a portion of the borrowed money, relever the company and use that funding to pay a dividend to themselves. And of course, when companies go south, they are left with a high level of debt relative to their earnings.
It is, however, worth examining who is providing the leverage for these investments. Today, when a startup wants to raise money, they will approach Angel investors, then various institutional investors and exchange a slice of equity for operating capital. The most bootstrapped startups, or those that have a very specific vision or product, will sometimes try their luck on crowdfunding, on such sites as Kickstarter and Indiegogo. In crowdfunding, there is no equity obligation to the backers, simply the fulfillment of perks, and oftentimes, if the company is unsuccessful is scaling production, even those perks are not fulfilled.
Given relatively recent popularity of this model, it may come as a surprise that the private equity industry has tried something very similar in the past. In fact, not only was it a runaway success, but it also helped spur the mainstream acceptance of leverage as a tool for private equity investors. It was called syndicate lending, and Jimmy Lee was one of its pioneers.
Today, pretty much every major and minor financial institution has exposure to private equity in some manner. Institutional investors such as pension funds line up to participate in buyout funds raised by private equity firms, which use that as an equity basis in their investments, and hopefully return dividends (both in the literal and figurative sense). They find their leverage from a variety of lenders. However, prior to the 1980s, the debt side of the private equity world looked a lot different. Small banks did not have the relative sophistication that they have today. In fact, when raising debt for buyouts, the primary participants tended to be insurance companies, who had money that they needed to park somewhere. This was a reliable and high quality source of funds, but insurance companies also tended to be highly risk averse, so the returns were quite low, and the percentage of equity that firms had to supply was quite high as a result.
However, this all changed starting in 1982. Jimmy Lee, while working at Chemical Bank, innovated on the model and realized that small banks were growing in sophistication, had significant amounts of money to invest, and were less risk averse than insurance companies were. Of course, being small banks they did not have the massive contribution power that the insurance companies did, but there were also many more of them. Chemical Bank, being heavily involved in the merchant banking, was in the right place to capitalize on this opportunity. Because they were less risk-averse than insurance companies, syndicated debt financing allowed private equity firms to make bets on riskier companies, while simultaneously reducing their own exposure. Their own equity investments were also less exposed to the risk of margin calls or other options from their lenders simply because there were more actors, so financial weakness on the part of one was less likely to have a cascading effect.
This is, in effect, a very early form of crowdfunding. Granted, individuals could not invest, but (theoretically) they reaped the benefits by depositing their money in small banks. Jimmy Lee, while at Chemical Bank (which later acqui-merged its way into becoming Chase Manhattan Bank), grew this into a sizable business that has persisted throughout the Savings and Loan Crisis, the Dot-Com bubble, and the Housing Crash of 2008. The relatively high appetite for risk that syndicated lenders tend to display was also a catalyst for the “Junk Bond” era of corporate financing. Seeking ever-higher returns, they were willing to back less stable companies, such as those with a less than stellar cash flow or a complicated capital structure.
This appetite for risk has certainly come with mixed reviews. Many of the municipal junk bond outlays, such as those held by pension funds or generalized bond funds, were fed by the demonstration of the syndicated lending market that there was money to be made in high risk investments. If this all sounds incredibly familiar, that’s because it is. Today, even though crowdfunding investments typically receive no portion of equity, they are voraciously consumed by the investing public. In this case, the desire is not higher returns on parked money, but the emotional fulfillment associated with seeing something come to fruition. It is possible that crowdfunding investors do not understand the risk that they assuming when they contribute their money.
