The history of private equity, venture capital, and the development of these asset classes has occurred through a series of boom-and-bust cycles since the middle of the 20th century. Within the broader private equity industry, two distinct sub-industries, leveraged buyouts and venture capital experienced growth along parallel, although interrelated tracks.
Since the origins of the modern private equity industry in 1946, there have been four major epochs marked by three boom and bust cycles. The early history of private equity—from 1946 through 1981—was characterized by relatively small volumes of private equity investment, rudimentary firm organizations and limited awareness of and familiarity with the private equity industry. The first boom and bust cycle, from 1982 through 1993, was characterized by the dramatic surge in leveraged buyout activity financed by junk bonds and culminating in the massive buyout of RJR Nabisco before the near collapse of the leveraged buyout industry in the late 1980s and early 1990s. The second boom and bust cycle (from 1992 through 2002) emerged from the ashes of the savings and loan crisis, the insider trading scandals, the real estate market collapse and the recession of the early 1990s. This period saw the emergence of more institutionalized private equity firms, ultimately culminating in the massive dot-com bubble in 1999 and 2000. The third boom and bust cycle (from 2003 through 2007) came in the wake of the collapse of the dot-com bubble—leveraged buyouts reach unparalleled size and the institutionalization of private equity firms is exemplified by the Blackstone Group's 2007 initial public offering.
In its early years through to roughly the year 2000, the private equity and venture capital asset classes were primarily active in the United States. With the second private equity boom in the mid-1990s and liberalization of regulation for institutional investors in Europe, a mature European private equity market emerged.
Pre-WWII
Investors have been acquiring businesses and making minority investments in privately held companies since the dawn of the Industrial Revolution. Merchant bankers in London and Paris financed industrial concerns in the 1850s; most notably Crédit Mobilier, founded in 1854 by Jacob and Isaac Pereire, who together with New York-based Jay Cooke financed the United States Transcontinental Railroad.
Later, J. Pierpont Morgan's J.P. Morgan & Co. would finance railroads and other industrial companies throughout the United States. In certain respects, J. Pierpont Morgan's 1901 acquisition of Carnegie Steel Company from Andrew Carnegie and Henry Phipps for $480 million represents the first true major buyout as they are thought of today.
Due to structural restrictions imposed on American banks under the Glass–Steagall Act and other regulations in the 1930s, there was no private merchant banking industry in the United States, a situation that was quite exceptional in developed nations. As late as the 1980s, Lester Thurow, a noted economist, decried the inability of the financial regulation framework in the United States to support merchant banks. US investment banks were confined primarily to advisory businesses, handling mergers and acquisitions transactions and placements of equity and debt securities. Investment banks would later enter the space, however long after independent firms had become well established.
With few exceptions, private equity in the first half of the 20th century was the domain of wealthy individuals and families. The Vanderbilts, Whitneys, Rockefellers and Warburgs were notable investors in private companies in the first half of the century. In 1938, Laurance S. Rockefeller helped finance the creation of both Eastern Air Lines and Douglas Aircraft and the Rockefeller family had vast holdings in a variety of companies. Eric M. Warburg founded E.M. Warburg & Co. in 1938, which would ultimately become Warburg Pincus, with investments in both leveraged buyouts and venture capital.
Origins after WWII
It was not until after World War II that what is considered today to be true private equity investments began to emerge marked by the founding of the first two venture capital firms in 1946: American Research and Development Corporation (ARD) and J.H. Whitney & Company.Wilson, John. The New Ventures, Inside the High Stakes World of Venture Capital.
ARD was founded by Georges Doriot, the "father of venture capitalism"WGBH Public Broadcasting Service, "Who made America?"-Georges Doriot" (founder of INSEAD and former dean of Harvard Business School), with Ralph Flanders and Karl Compton (former president of MIT), to encourage private sector investments in businesses run by soldiers who were returning from World War II. ARD's significance was primarily that it was the first institutional private equity investment firm that raised capital from sources other than wealthy families although it had several notable investment successes as well.The New Kings of Capitalism, Survey on the Private Equity industry The Economist, November 25, 2004 ARD is credited with the first major venture capital success story when its 1957 investment of $70,000 in Digital Equipment Corporation (DEC) would be valued at over $35.5 million after the company's initial public offering in 1968 (representing a return of over 500 times on its investment and an annualized rate of return of 101%). Former employees of ARDC went on to found several prominent venture capital firms including Greylock Partners (founded in 1965 by Charlie Waite and Bill Elfers) and Morgan, Holland Ventures, the predecessor of Flagship Ventures (founded in 1982 by James Morgan).Kirsner, Scott. "Venture capital's grandfather." The Boston Globe, April 6, 2008. ARD continued investing until 1971 with the retirement of Doriot. In 1972, Doriot merged ARD with Textron after having invested in over 150 companies.
J.H. Whitney & Company was founded by John Hay Whitney and his partner Benno Schmidt. Whitney had been investing since the 1930s, founding Pioneer Pictures in 1933 and acquiring a 15% interest in Technicolor Corporation with his cousin Cornelius Vanderbilt Whitney. By far, Whitney's most famous investment was in Florida Foods Corporation. The company, having developed an innovative method for delivering nutrition to American soldiers, later came to be known as Minute Maid orange juice and was sold to The Coca-Cola Company in 1960. J.H. Whitney & Company continues to make investments in leveraged buyout transactions and raised $750 million for its sixth institutional private equity fund in 2005.
Before World War II, venture capital investments (originally known as "development capital") were primarily the domain of wealthy individuals and families. One of the first steps toward a professionally managed venture capital industry was the passage of the Small Business Investment Act of 1958. The 1958 Act officially allowed the U.S. Small Business Administration (SBA) to license private "Small Business Investment Companies" (SBICs) to help the financing and management of the small entrepreneurial businesses in the United States. Passage of the Act addressed concerns raised in a Federal Reserve Board report to Congress that concluded that a major gap existed in the capital markets for long-term funding for growth-oriented small businesses. It was thought that fostering entrepreneurial companies would spur technological advances to compete against the Soviet Union. Facilitating the flow of capital through the economy up to the pioneering small concerns in order to stimulate the U.S. economy was and still is the main goal of the SBIC program today. The 1958 Act provided venture capital firms structured either as SBICs or Minority Enterprise Small Business Investment Companies (MESBICs) access to federal funds which could be leveraged at a ratio of up to 4:1 against privately raised investment funds. The success of the Small Business Administration's efforts are viewed primarily in terms of the pool of professional private equity investors that the program developed as the rigid regulatory limitations imposed by the program minimized the role of SBICs. In 2005, the SBA significantly reduced its SBIC program, though SBICs continue to make private equity investments.
The real growth in Private Equity surged in 1984 to 1991 period when Institutional Investors, e.g. Pension Plans, Foundations and Endowment Funds such as the Shell Pension Plan, the Oregon State Pension Plan, the Ford Foundation and the Harvard Endowment Fund started investing a small part of their trillion dollars portfolios into Private Investments - particularly venture capital and Leverage Buyout Funds.
Growth of Silicon Valley (1959–1981)
During the 1960s and 1970s, venture capital firms focused their investment activity primarily on starting and expanding companies. More often than not, these companies were exploiting breakthroughs in electronic, medical or data-processing technology. As a result, venture capital came to be almost synonymous with technology finance.
It is commonly noted that the first venture-backed startup was Fairchild Semiconductor (which produced the first commercially practicable integrated circuit), funded in late 1957 by a loan from Sherman Fairchild's Fairchild Camera with the help of Arthur Rock, an early venture capitalist with the firm of Hayden Stone in New York (which received 20% of the equity of the newly formed company). Another early VC firm was Venrock Associates.The Future of Securities Regulation speech by Brian G. Cartwright, General Counsel U.S. Securities and Exchange Commission. University of Pennsylvania Law School Institute for Law and Economics Philadelphia, Pennsylvania. October 24, 2007. Venrock was founded in 1969 by Laurance S. Rockefeller, the fourth of John D. Rockefeller's six children as a way to allow other Rockefeller children to develop exposure to venture capital investments.
It was also in the 1960s that the common form of private equity fund, still in use today, emerged. Private equity firms organized limited partnerships to hold investments in which the investment professionals served as general partner and the investors, who were passive limited partners, put up the capital. The compensation structure, still in use today, also emerged with limited partners paying an annual management fee of 1–2% and a carried interest typically representing up to 20% of the profits of the partnership.
An early West Coast venture capital company was Draper and Johnson Investment Company, formed in 1962Draper Investment Company History Retrieved, July 2010 by William Henry Draper III and Franklin P. Johnson Jr. In 1964 Bill Draper and Paul Wythes founded Sutter Hill Ventures, and Pitch Johnson formed Asset Management Company.
The growth of the venture capital industry was fueled by the emergence of the independent investment firms on Sand Hill Road, beginning with Kleiner, Perkins, Caufield & Byers and Sequoia Capital in 1972. Located in Menlo Park, California, Kleiner Perkins, Sequoia and later venture capital firms would have access to the burgeoning technology industries in the area. Kleiner Perkins was the first venture capital firm to open an office on Sand Hill Road in 1972.