Fundamentals of Private Equity and Venture Capital - PEI Media

GETTING THE MOST OUT OF THIS MODULE
Welcome to Module 1 in the Fundamentals of private equity series. This module
introduces the core principles of private equity and venture capital, examines
how they evolved and provides a broad introduction to today’s markets. It is
designed to work both as a stand alone section and as part of the whole series.
For the benefit of the stand alone reader, a comprehensive glossary has been
incorporated, which explains the background and use of private equity terminology.
All terms which may require explanation or expansion are printed in bold,
to indicate that there is a glossary entry for them.
Private equity – the provision of risk and reward sharing (equity) capital to a company
whose shares are not freely traded on a recognised stock exchange (private).
The evolution of venture capital
and private equity
Introduction
In 1957, American Research and Development
(ARD) – the world’s first ever investment
fund to specialise in backing start-up companies –
invested $70,000 for a 77 percent equity stake in a
new company created by four students with no
business experience. The company was called
Digital Equipment Corporation, and 14 years later
the investment’s value had grown to $355 million.
Spectacular successes like this – similar stories
include Apple, Intel, Sun Microsystems, Federal
Express and even (in a smaller way) Trivial Pursuit
– brought attention to the returns available from a
new way of investing. This, for obvious reasons,
acquired the tag “venture capital”.
The concept of providing financial backing to
entrepreneurs, sharing risks and rewards in a
privately negotiated transaction, has been
around since time immemorial (Queen Isobel’s
backing of Christopher Columbus in the late
15th Century is regularly cited as one of the first
examples). More recently, the 1920s and 1930s
saw companies such as Xerox and Eastern
Airlines founded with private backing from
wealthy family trusts. But it was the pioneer
investors in the US during the 1950s, 1960s and
1970s who gave birth to today’s private equity
industry, albeit an industry that after three
decades of accelerated evolution bears little
resemblance to its forebears.
However the spectacular growth of private equity,
from obscure specialism to economic prominence,
has been far from smooth or painless. On
the basis that those who fail to learn from history
are condemned to repeat it – and there are parts
of this story it would be better not to repeat – a
brief summary of the high and low lights will
bring perspective to all that follows.
Evolution of the US market
The early US venture capitalists were not investment
managers in the conventional sense; rather
they were for the most part successful entrepreneurs
and corporate managers with extensive
experience in building businesses. The funds
they invested were to a large extent their own
money. (ARD for example had, with great difficulty,
raised only $1.8 million, out of a total of $5
million in its first fund, from institutional
investors in 1946; the balance came from the
fund’s managers, individual investors and family
trusts.) Their approach to investing was very
proactive, becoming closely involved in the day
to day running of the companies they backed, so
that their expertise added at least as much value
as their money.
During the 1970s this began, slowly at first, to
change as pension fund and insurance company
fund managers noted the returns some of the
venture capitalists were achieving. These institutional
investors experimented cautiously with
the new asset class; typically only $50 million or
less was raised from these sources each year during
the decade (less than 30 percent of the total,
most of which came from individuals and family
trusts). But suddenly and dramatically a tipping
point was reached in 1980, when commitments
to venture capital, during that year alone, shot up
to around $1 billion, reaching nearly $2 billion in
1982 and over $4 billion in 1983. 1
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THE FUNDAMENTALS OF PRIVATE EQUITY 5