A Fatal Flaw of America ’ s First VC Firm
“ If one of our companies is suddenly in need of $ 25,000 , we can do nothing about it . We have to go to our lawyers … and it may be sixty days or more before we get an answer . By that time a small company , as you know , can become very , very dead .”
— Georges Doriot , co-founder of ARD ( letter to Ralph H . Demmler , chairman of the SEC )
In 1946 , a group of leading academics , financiers and industrialists founded Advanced Research and Development ( ARD ), which was the first private venture capital ( VC ) firm in the United States . Under Georges Doriot ’ s leadership , ARD blazed the path for the emerging profession . But unlike modern VCs , ARD was structured as a closed-end investment company and was thus subjected to SEC regulation .
ARD ’ s structure ultimately proved untenable because SEC regulations failed to accommodate many fundamental aspects of venture investing . Examples included limits on incentive compensation for fund employees and caps on ARD ’ s permissible ownership percentage in portfolio companies . Doriot battled constantly with the SEC to obtain waivers , but ultimately , the investment company structure was unworkable . Textron Corporation acquired ARD in 1972 , and its influence waned .
Despite ARD ’ s demise , Doriot proved the viability of VC investing , and several of his proteges launched firms of their own . But having witnessed ARD ’ s struggles with the SEC , they structured their funds as limited partnerships . This provided the flexibility they needed to fund early-stage ventures , several of which would become the largest corporations in the United States .
abundance of capital . The only problem was that most trustees refused to invest in VCs because they feared that it violated the DoL ’ s interpretation of the Prudent Man Rule under the Employee Retirement and Income Security Act ( ERISA ) of 1974 . The law stated that trustees must discharge their duties “ by diversifying the investors of the plan so as to minimize the risk of large losses .” Most trustees interpreted “ the risk of large losses ” as an implicit ban on VC funds , which invariably invested in many companies that were likely to produce large losses . Fear of ERISA violations forced trustees to stick with traditional funds that invested in high-quality bonds and stocks . Trustees of non-ERISA plans , such as public pensions , adopted similar policies out of an abundance of caution . This starved VCs of desperately needed capital throughout the 1970s .
Under pressure from its membership , the National Venture Capital Association ( NVCA ) lobbied Congress to help end the capital drought . These efforts paid off , and on June 21 , 1979 , Lanoff announced a shift in the DoL ’ s interpretation of the Prudent Man Rule , stating , “ Although securities issued by a small or new company may be a riskier investment than securities issued by a blue-chip company , such an investment may be entirely proper under ERISA ’ s prudence rule .”
No longer impeded by ERISA , trustees opened the spigots for VC funds . For the three-year period ending in 1977 , VCs raised a mere $ 60.4 million . Over the next three-year period , they raised nearly $ 800 million . But VCs were not the sole beneficiaries of the new DoL guidance . The limited partnership model that VCs embraced was soon replicated by former investment bankers to form the first buyout funds . Thus began a 45-year flood of capital into areas of the market that are collectively referred to as alternative asset classes .
Beautiful Decade for a Leveraged Buyout
“ I am not a destroyer of companies . I am a liberator of them . The point is , ladies and gentlemen , that greed , for lack of a better word , is good .”
— Gordon Gekko in Wall Street ( 1987 )
In 1982 , Federal Reserve Chairman Paul Volcker ’ s legendary monetary tightening campaign ended the grueling , 17-year period known as the Great Inflation . The return of price stability also created a once-in-a-lifetime opportunity for another alternative asset class . Investors referred to these funds as leveraged buyout ( LBO ) funds , buyout funds or sometimes simply private equity funds .
The objective of a buyout fund was simple . Fund managers purchased companies using mostly debt and a small amount of equity . Then , they aggressively repaid the debt by selling non-strategic business units , eliminating extraneous costs and improving strategy and operations . After a few years , the fund would sell its entire position — often for a much higher multiple than the one applied at the time of purchase . The first buyout funds emerged in the late 1970s and 1980s and included firms such as Forstmann Little , Kohlberg Kravis Roberts ( KKR ) and Thomas H . Lee Partners .
Conditions in the 1980s were ideal for buyouts . First , the cost of debt steadily declined throughout the decade due to Volcker ’ s victory over inflation . Second , price / earnings ratios of publicly traded firms increased , as lower inflation reduced the required return for equity investors . Finally , many companies were laden with inefficiencies due to the habitual practice of overdiversifying throughout the 1960s and 1970s . In combination , these factors provided buyout funds with an extraordinary
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