Financial Poise

The History of Private Equity and Venture Capital

My first installment in this column explains the differences between venture capital and private equity.  One thing I didn’t write about there, but which a number of people have emailed asking about, is the history of the space.  I’ll do my best there to do that – very briefly.

The First Venture Capital Firm

Today’s VC industry traces back to the creation of the VC/PE firm American Research and Development Corporation (1946) by Georges Doriot. ARD raised $3.5 million, of which $1.8 million came from nine institutional investors, including MIT, University of Pennsylvania, and the Rice Institute.

The Small Business Investment Act

The industry picked up real steam in 1958, according to Mark Heesen, president of the National Venture Capital Association, “[a] significant boost was given to the industry with the passage of the Small Business Investment Act.” This gave tax breaks to private investment companies and led to the creation of professionally managed VC firms by licensing private, small business investment companies (SBICs) to help entrepreneurs finance and manage their startups.  From 1960 to 1962, according to Hessen, 585 SBIC licenses were approved, representing $205 million committed in private money. “The experience with SBICs demonstrated a key point – government policy has an extremely important effect on the venture capital ecosystem.”  Read more about the SBIA here.

Evolution of the Prudent Man Rule

Around the same time, another important legal development occurred: the Prudent Man?

Rule underwent a relaxation (including, importantly, because of changes to the Employee Retirement Income Security Act in 1979).

Succinctly stated, the Prudent Man Rule is the standard by which fiduciaries are judged and it used to be formulated in way that pretty much would have forbade fiduciaries to invest in asset classes like venture capital (or at least would have discouraged them from doing so, since doing so could be viewed as an invitation to be sued) but has evolved over time to pretty much allow (arguably demand) such investments depending on the investment portfolio at issue. There are many definitions of the rule; here is one from NASDAQ.

Did You Know?

Some examples of companies funded through early venture capital include America Online, American Microsystems, Compaq, Hotmail, Intel, McAfee, Skype and Xerox.  These companies and others like them, of course, helped to usher in the age of the internet.

What About Private Equity?

Some people consider private equity to be a subclass of venture capital.  I don’t agree; I subscribe to the view of financial journalist David M. Freedman:

In simplest terms, private equity firms invest money into private companies. Venture capital can be viewed as a segment of private equity, at least from an academic point of view.

But for the purpose of making investment decisions, their individual characteristics are sufficiently distinctive that we should treat them as separate asset classes.

Freedman’s article, The Difference between Private Equity and Venture Capital, is worth a read.

The Birth of Private Equity

Private equity – as a separate asset class from venture capital – began life with a different name:  the leveraged buyout, and the golden age of the leveraged buyout (LBO) came in the late 1980s when players like KKR and Michael Milken engineered large leveraged buyouts. As superior returns encouraged more investment in the asset class and as the number of funds proliferated as a natural consequence of fund managers leaving one firm to found a new one, the industry continued to grow into what it is today. A good example of this can be seen by looking at the legendary PE firm, Golder Thoma & Co.

Established in 1980 by Stanley Golder and Carl Thoma, Golder Thoma & Co. originated the “consolidation” or “buy and build” investment strategy, which sought to combine the best of venture investing with the best of leveraged buyouts. This was (and still is) commonly done by investing in a “platform” business (an acquisition in a new area of business intended to be a ‘platform’ onto which to add other businesses, in order to build something new) in a fragmented industry and then working with management to transform it into a larger and more profitable business through internal growth and a series of strategic, industry consolidating acquisitions.

Golder and Thoma worked together at First Chicago Corp. before founding Golder Thoma & Co. Looking at one branch of the genealogy, Golder Thoma & Co. eventually split into Thoma Bravo and GTCR. Looking at a different branch, John Canning took Stanley Golder’s place at First Chicago Corp. and Canning ultimately left to form Madison Dearborn. These three firms are now among the largest and most prominent PE firms. For more on the history of private equity, I recommend this.

Ray’s Pizza

The title of this installment suggests that the history of venture capital and private equity has something in common with the history of Ray’s Pizza.  I may be wrong, but I assume that a lot of the many Ray’s Pizzas in New York City and elsewhere were started by people who used to work at another pizza shop named Ray’s Pizza.  I assume they got their pizza making experience working for someone else and then moved on to open their own shops.  I know of many examples of this in the bagel business.  Anyway, while I don’t know if it’s true about Ray’s, I do know that that model is common in VC and PE – as it is in so many fields:  people learn from people as they work for them, some leave, and some start new firms.  It’s like the song, “Circle of Life,” from the Lion King…

LBO Funds Get a Face Lift

In the 1980s and 1990s, there were no (or few) firms that called themselves “private equity firms” with funds they called “private equity funds.”  Rather, they were called “buyout” or “LBO” firms and funds.   And they got a bad reputation, as explained by Financial Poise / Accredited Investor Markets contributor Charles Smith here, culminating perhaps in the Gordon Gekko character portrayed by Michael Douglas in the 1987 film “Wall Street.”  The industry thus rebranded itself as “private equity” and the rest, is, as they say, history.

Private Equity & Corporate America Today

“From 1996 to 2015,” as noted in a recent Harvard Business Review article, “the number of publicly traded companies in the United States alone dropped nearly 50 percent. Some of this ownership shift includes failure of firms or acquisition of firms into larger conglomerates (either domestic or foreign), but much of the de-listing shift comes from publicly traded firms becoming private [and a] major catalyst for this shift,” according to HBR, “has been private equity firms…”  I estimate that there are about 10,000 U.S. companies owned by PE firms today.

 

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About Jonathan Friedland

Jonathan Friedland views his role as a business lawyer simply: to help clients make money at every opportunity and to protect their interests at every turn. His national practice emphasizes corporate structuring, corporate governance, counseling on day-to-day business affairs, M&A, and corporate restructuring. Most of his clients are privately owned businesses and their owners, particularly…

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