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Henry R. Kravis, Co-Chairman and Co-CEO of KKR

What is private equity? Given you're reading this book, I'm certain this is a question you'd like to have answered.

To define the asset class properly is not as simple as looking it up in a dictionary or conducting a quick search on the internet. To do so would give you some version of private equity is capital that is invested privately. Not on a public exchange. The capital typically comes from institutional or high-net worth investors who can contribute substantially and are able to withstand an average holding period of seven years.

But private equity is so much more than its literal definition.

The way I would describe private equity, or PE, today is an asset class delivering market-beating investment returns that has grown college endowments and enhanced the retirement security of millions of pension beneficiaries, including teachers, firefighters, police and other public workers. Just as important, private equity does this by helping companies grow and improve, starting from day one of an investment.

Different firms approach this in different ways, but consistent among them is the first enduring principle of private equity: alignment of interest. This refers to alignment between a company's management and the firm investing in it, but it also means alignment between the firm investing and its own investors.

At KKR, once we make an investment, we work with a company's management team to improve the balance sheet, margins, operations, and, importantly, their topline. These actions may seem obvious steps in how to create successful companies today, but when George Roberts, Jerry Kohlberg and I co-founded KKR a little over 40 years ago, they were not.

In the '70s and ‘80s, companies were less concerned with these efficiencies, perhaps because management was focused on other things. To help solve for this, when we were getting started, we instituted management ownership programs, a concept that was not typical in those days. Running a company as an owner unlocks value and this alignment of interest impacts company profitability substantially. I remember a board meeting at one of our investments in the ‘80s, a business in the oil and gas industry, where management recommended a $100 million oil exploration budget. Our first reaction was that they must be quite optimistic about their prospects to risk that much of the shareholders' capital. We pointed out to them that as shareholders who owned 10 % of the company, they were putting $10 million of their own capital at risk. Moments later, management decided to reconsider the budget. One month later, the exploration budget had been cut in half, and they were acutely more focused on the results of each and every drilling site.

The opportunity to improve companies, the ability to have an alignment of interest with management and us being the shareholders with long-term, patient capital – to me, these are the hallmarks of private equity.

And while we have been focused on delivering exceptional long-term investment returns from the outset, private equity has evolved quite a bit since we started out four decades ago.

After leaving Bear Stearns to start our own firm, we had $120,000 between the three of us – $10,000 each from George and me, which was about all we had at the time, and $100,000 from Jerry who was 20 years our senior. With $120,000 in the bank, we went to raise our first fund, a $25 million private equity fund. Keep in mind there were no such funds in those days and there was no one doing what is now considered private equity. Given this environment, we had a difficult time raising the $25 million on terms that we felt made sense. So we had a thought: Why don't we go to eight individuals and ask them to put up $50,000 each for a five-year commitment and in return, we'd give them the ability to come into any of our deals. And if they did invest, we'd take 20 percent of the profits – what is known today as carried interest.

How did this happen? George's father and my father were in the oil-and-gas business where, in those days, there was something called “a third for a quarter.” If you had a lease and wanted to drill, you put up 25 percent of the cost and found someone to put up the remaining 75 percent of the cost. Consequently, that person gets a two-thirds interest for what they put down and you get a one-third interest. When applying this concept to our own business, we thought 20 percent was close enough to third for a quarter, and that's still the standard today.

When we first started doing deals, private equity transactions, better known as leveraged buyouts at the time, were in their infancy. The PE industry as we know it was not yet born. In fact, we never imagined we'd ever use the term “industry” when talking about what we do.

Private equity deals looked very different than they do today. The asset class was new, and so too was its level of sophistication. As PE explored elaborate capital structures, new sources of funding, larger pools of equity capital and did so through variable economic conditions, we did not properly explain these complexities – or our mission – to the public. As a result, PE deals became associated with hostile takeovers at the time. Referring to PE as “corporate raiders” or “barbarians,” the public's reaction to the very same question I asked you – what is private equity? – was simply: an investment vehicle to acquire, strip and sell an asset for profit. We never thought of it this way; we were always focused on the opportunity at hand to create value at the companies in which we invested. Nonetheless, we and others did not pay enough attention to communicating this with our various stakeholders.

Looking back 40 years later, this is one of the many lessons, perhaps the hardest, that we've learned along the way. These lessons – and the headlines referencing barbarians that came with them – are not exclusive to KKR. The experiences of the early days of PE served as a catalyst for transformation of the entire PE industry.

I think it is safe for me to speak on the industry's behalf when I say we have learned there is so much more to investing than buying low and selling high. As my colleague Bill Cornog will expand upon in Chapter 13, we've learned to think of ourselves as industrialists. When we buy a company, we ask ourselves: what can we do to make it better? How can we create value? What constituents should we be mindful of and will factor into a good outcome for everyone?

At KKR, key to answering these questions is the development of what we call 100-Day Plans. These plans are put into place as soon as we make an investment. That means we hit the ground running from the day a transaction closes. Our goal is to focus, with a sense of urgency, on the creation of value. As part of this process, we establish upfront operating metrics. These can often reveal underlying problems with a business before those problems can be seen in the financial data. In this way, we can make difficult operational and personnel decisions as early as possible in the process. Recognizing, acknowledging and addressing problems up front are part and parcel of the successful ownership model.

This value creation process involves not only understanding a company's balance sheet and financial statements, but also its employees, their impact on the world around them and being good participants in community life. This all contributes to value creation – or destruction.

As an industry, we've learned that we can make a difference by integrating our performance-focused investment philosophy with environmental, social and governance (ESG) initiatives. It is our responsibility – not only to serve our investors through great investor returns – but also to support them by investing in the communities of the corporations in which we invest. Over the years, I think the PE industry has picked up on this quite a bit.

And while that doesn't mean every company we invest in is advancing an ecological solution, I believe PE-backed companies can help solve challenges – economic or otherwise – in their communities. Whether it's improving municipal water treatment facilities, funding sustainable economic initiatives in underprivileged communities or reducing waste and promoting eco-efficiency in plants and factories, incorporating ESG practices has become a focal point throughout the lifecycle of an investment.

As I mentioned earlier, one of the key principles to making this work is the alignment of the interests of all parties – managers, investors and employees alike.

Investing alongside one's investors, or our limited partners (LPs), is the best demonstration of partnership. While the principle of alignment has not changed from four decades ago, it has definitely been emphasized more greatly in recent years. We, and others, have continued to make larger firm and employee commitments to our funds, further incentivizing our employees to do well for our investors.

With the addition of new technologies and important groups like the Institutional Limited Partners Association, there is also a focus on making sure LPs have greater visibility into the underlying details of the companies in which they are invested. This enhanced transparency is not limited to the PE industry alone, and our world is better off for it. Information is at our fingertips. This is a good thing and promotes efficiency, integrity, and accountability. In my opinion, these are the mainstays to being a trusted partner in private equity, not just to LPs but to all of our stakeholders.

Today, success in PE involves many more facets and many more faces related to a deal. Our constituents include our limited partners and their beneficiaries but also the employees of our portfolio companies, stockholders, regulators and government officials as well as the media. As the collection of stakeholders has evolved quite significantly, so has the industry's approach to engaging with them.

To succeed in PE, communication and transparency are key. As we work to build strong relationships with our stakeholders, we remember: people do business with people they like and trust.

As far as the mainstays to being a good investor? I'd say curiosity and a sense of history. To me, people who are curious are going to be far better stewards of others' money. Why? If there's no curiosity, you're basically doing something that's already been done by someone else. Moreover, being knowledgeable of the past means you can learn from past mistakes and, hopefully, not repeat them. Without these two attributes, one will miss out on opportunities, or experience slip-ups, by not seeing the whole picture.

Now I know this has been a long answer to what is private equity? In my mind, at the forefront of this lengthy explanation has been one of my favorite quotes from General Eric Shinseki: “If you don't like change, you will like irrelevance even less.” The industry has gone through many changes, but by doing so, private equity continues to attract some of the most sophisticated investors in the world.

While we will have to wait and see how the asset class continues to evolve, I anticipate that private equity of the future will need to prioritize diversity to remain germane.

Too many of the same people means too much of the same thinking – an element of today's industry that I feel greatly needs to be addressed. As we discussed earlier, more of the same is a stepping stone to irrelevance. We need to value having more diverse groups of people – diversity of gender, race and ethnicity, and especially diversity of experiences and thinking. There is no doubt that diverse groups drive better outcomes – it has been proven time and again – it creates a better work environment, more creative ideas and is a critical focus area of our investors. I think this is a lesson we are in the middle of and hope the industry will heed this important message in order to succeed in the future.

So what is private equity?

You will hear many answers to this question from industry leaders in the chapters ahead, but what I hope I've made clear is that private equity is so much more than its literal definition. For me, private equity always has been and always will be about building value over the long-term.