Three guys and a broom
The three of us -- Jerry Kohlberg, George Roberts and I -- left Bear Stearns without a job or a business, but we had what we believed to be a good idea. George and I each scraped together $10,000, and Jerry, who was 19 years older and on much better financial footing, put down $100,000 to start the firm we named after ourselves.
The first conversation we had was about what kind of business we wanted to have. Or didn't want to have. We were so appalled by the "eat what you kill" culture at Bear Stearns, we wanted something very different. We wanted a place where everyone would participate and be owners; a place where people worked together and didn't compete against one another; a place that had a culture of inclusion.
We needed to be able to finance deals but raising capital was not easy. We went out to raise a $25 million fund to finance our acquisitions. The first person we spoke to about this plan was Henry Hillman, a Pittsburgh billionaire whose father had made his fortune in the steel business. I had read an article about Hillman's supply of capital to the venture capital firm Kleiner Perkins Caufield & Byers, and I suggested that we call him. George and I went down to see him.
Hillman had never heard of our business or what is now known as private equity. We explained to him the difference between PE and venture capital. While venture capital, for the most part, was about backing new ideas and newly created companies, private equity was about taking existing companies that already have a product and revenues and improving them -- and making bad businesses good, or turning a good business into a great business. We said we would do this by working with management, instilling governance and creating long-term value. We would do this with an industrialist's perspective, not just an investor's perspective.
Five days after the meeting, Hillman promised to put up $12.5 million, or half of the envisioned fund. This was huge progress and we were excited.
Then we went to Prudential, the insurance company. They basically said, "We like you and you have made us a lot of money so we will take the other half of the fund." But there was a catch: They wanted to see every deal and essentially be the Investment Committee. In other words, we would be working for them, in effect. So, we said no.
Later that night, we weren't feeling particularly great about our prospects. George and I met for dinner in New York at Joe & Rose, an Italian steakhouse that no longer exists. Jerry couldn't join. Here we were -- 32 years old, we each had three children, and we had no money and no job. We had to figure out how to get through the wall or over the wall and get to the other side to get KKR started.
We were determined to work out how much we would need to cover our overhead. It was then, after a lot of talking, that we decided we needed $500,000 each year to cover our costs, including payroll and rent for at least five years. We figured we could go to eight individuals, including my father, Raymond, and Hillman, and ask them to invest, ask them for $50,000 each for five years to help cover our overhead. For that, we would show them every deal and they could invest on a deal-by-deal basis. We would cover the remainder of the overhead with fees from the deals.
After that, we had to figure out how we would get our earnings, part of the profit. This is where the idea of "carried interest" was born. This is a share of profits earned by general partners of private equity, venture capital and hedge funds -- a compensation system that has become the industry standard. We borrowed this construct from the oil and gas industry my father had been involved in.
We wrote down these ideas on a napkin at the restaurant and started operations on May 1, 1976.
Finally, with Jerry, we discussed how we should divide the earnings among ourselves. We aimed to ensure equality. Under our arrangement, Jerry would initially get 40% of the earnings while George and I would each get 30%. If someone were to join management in the future, Jerry's share would be reduced to get the shares of the three founders closer to the same ratio.
Now we had a firm and a plan. We just needed some actual business. Compared to today, we had a hard time finding a company to acquire. There was no internet. It was all very manual. We would basically just knock on doors. To private companies, we would say to the management, we will help you create value, and everyone can benefit.
To publicly traded companies, we would say the same but also propose we could help them go private, which would enable them to manage their businesses with a long-term perspective.
In 1977, the company's first year, we acquired three companies, all of which yielded high returns. We focused on making the companies better.
We eventually raised our first institutional fund in 1978 ("the 1976 fund"). We raised $35 million for the fund.