Introduction to Private Equity E-Book

Cyril Demaria

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Wiley Finance Series
• Sprache: Englisch

Seitenzahl: 414

Veröffentlichungsjahr: 2010

Beschreibung

Introduction to Private Equity is a critical yet grounded guide to the private equity industry. Far more than just another introductory guide, the book blends academic rigour with practical experience to provide a critical perspective of the industry from a professional who has worked at many levels within the industry, including insurance, funds of funds, funds and portfolio companies.

The book looks at private equity from the point of view of the individual or the business. How is a private business valued? How is the acquisition transaction processed? What are the due diligence issues that should be considered before moving ahead? A valuable insight to a rather opaque market.

Introduction to Private Equity covers the private equity industry as a whole, highlighting its historical development in order to put its recent development into perspective. The book covers its organization, governance and function, then details the various segments within the industry, including LBO, Venture Capital, Mezzanine Financing, Growth Capital and beyond. Finally, it offers a framework to anticipate and understand its future developments.

It provides a balanced perspective on the current corporate governance challenges which are affecting the industry and draws perspective to understand the evolution of the sector, following one of its major crises.

Leseprobe

Table of Contents

Dedication

Title Page

Copyright Page

Foreword

Acknowledgements

About the Author

Introduction

A MOVING TARGET

A CONSUBSTANTIAL LACK OF INFORMATION

BENIGN NEGLECT, MALIGN CONSEQUENCES

KNOWING THE DEVIL TO CIRCUMVENT IT

Part I - What is Private Equity?

Chapter 1 - Private Equity as an Economic Driver: An Historical Perspective

1. POOLING INTERESTS TO IDENTIFY AND EXPLOIT SOURCES OF WEALTH

2. CHAMPIONING ENTREPRENEURSHIP

CONCLUSION: AN ATTEMPT AT DEFINITION

Chapter 2 - Modern Private Equity - A French Invention?

1. USA: THE FOUNDRY OF MODERN PRIVATE EQUITY

2. EUROPE: ADAPTING A SUCCESSFUL MODEL OR CREATING ITS OWN?

CONCLUSION: EMERGING MARKETS, BUILDING CASTLES ON SAND?

Part II - The Private Equity Ecosystem

Chapter 3 - Private Equity: A Business System Perspective

1. WE ARE ALL INVESTORS IN PRIVATE EQUITY

2. ORGANISATION AND GOVERNANCE OF PRIVATE EQUITY FUNDS

3. MEASURING PERFORMANCE, MANAGING RISKS AND OPTIMISING RETURNS

4. PITFALLS AND CHALLENGES

CONCLUSION

Chapter 4 - The Universe of Investment

1. VENTURE CAPITAL: FINANCING COMPANY CREATION

2. GROWTH CAPITAL: FINANCING COMPANIES’ EXPANSION

3. LEVERAGED BUY-OUT: FINANCING COMPANIES’ TRANSMISSIONS

4. OTHER INTERVENTIONS IN PRIVATE EQUITY

CONCLUSION

Chapter 5 - The Process of Investment: A Matter of Trust and Mutual Interest

1. STEP 1: PRELIMINARY ANALYSIS

2. STEP 2: VALUATION

3. STEP 3: NEGOTIATING

4. STEP 4: STRUCTURING

5. STEP 5: COMPLEMENTARY DUE DILIGENCES

6. STEP 6: TRANSACTION

7. STEP 7: MONITORING AND EXIT

CONCLUSION

Part III - Private Equity in Teenage Time: Trend Setting, Fads and Responsibilities

Chapter 6 - Private Equity Evolution: Trends or Buzzes?

1. IS PRIVATE EQUITY GOING MAINSTREAM?

2. IS PRIVATE EQUITY (STILL) CREATING VALUE?

3. PRIVATE EQUITY: BETWEEN BUBBLES AND CRASHES

CONCLUSION

Chapter 7 - Private Equity and Ethics: A Culture Clash

1. GREED

2. DESTRUCTION

3. PHILANTHROPY

4. TRANSPARENCY

5. CONFIDENTIALITY AND SELF-REGULATION

CONCLUSION

General Conclusion - Private Equity Today and Tomorrow

Glossary

Bibliography

Index

For other titles in the Wiley Finance series please see www.wiley.com/finance

This edition first published 2010

© 2010 Cyril Demaria

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Library of Congress Cataloging-in-Publication Data

Demaria, Cyril.

Introduction to private equity / Cyril Demaria.

p. cm.

Includes bibliographical references and index.

eISBN : 978-0-470-71188-0

1. Private equity. I. Title.

HG4751.D46 2010

332.6—dc22

2010005161

A catalogue record for this book is available from the British Library.

Set in 10/12pt Times by Aptara Inc., New Delhi, India

To my family and my friends

Foreword

Private equity can be described as ‘investments in private companies in privately negotiated transactions’. This means that private equity is an asset class that is normally opaque, illiquid and difficult to analyse.

However, private equity investing offers many advantages compared to investing in public and more liquid asset classes. The underlying companies can be acquired in a private transaction, often in a specific process leading to attractive acquisition. The companies can be developed privately on the long term, hence maximizing their chances to succeed, when most public companies are only targeting short term benefits. Fund managers active in private equity normally have much more information when they make investment decisions compared to those investing in public companies. Incentives for the management can be better aligned with the investors’ interests. Fund managers exercise a higher degree of control on the companies they have invested in, and develop them aggressively without having to worry about how every decision is understood by the public. Through private equity investments, investors can target industries or niches where there are no public companies.

Private equity is a very complex asset class, more of an art than other forms of investments which are analyzed and compared quantitatively. Private equity is an asset class where manager selection plays the highest role of all asset classes. There are normally several private equity managers that are in the same state of development of their own activities. Some have decades of experience and some have worked as a team for a long time. Some have made several investments in the same industry repetitively and some of them have sold their investments at significant levels of profit. This means that analysing private equity investments and fund managers requires skill and experience.

Private equity is no longer as private as it used to be. Because of all the large leveraged buy outs during the end of 1980s and the mega leveraged buy outs during the past few years, private equity transactions have been widely reported and followed. Private equity is a long term asset class and investors will realise the final return long after they have made decision to invest. Warren Buffett stated once that it is extremely important to understand where to invest in because eventually ‘only when the tide goes out do you discover who’s been swimming naked’.

Despite all these mentioned difficulties and hurdles, Cyril Demaria has been able to write an interesting and extremely well formulated book about private equity. Cyril has seen and experienced private equity from many angles and in different roles. Cyril has been an investor directly in start-up companies and more developed and well established businesses. Cyril has also been an advisor and investor in private equity funds. Most importantly, Cyril has been writing about the private equity industry in many papers and magazines for more than a decade. The experience Cyril has gathered from all his professional activities and his passionate interest in private equity has enabled him to write this book in an easy and understandable way but still giving the reader a very good picture of the asset class and also its pitfalls. In this book, Cyril has been able to give the topic of private equity more flavour with a lot of anecdotes and historical references which hopefully shows the reader that private equity as such is not a new invention.

I have had the honour of working together with Cyril and have read his articles and papers for many years. Cyril is a very knowledgeable person in private equity, he is critical and does not swallow all the polished information that is generally written about private equity.

This book opens the world of private equity to the reader in a very understandable way, making this opaque asset class more understandable for the reader and hopefully an interesting asset class to invest in.

Tom Eriksson Aeris Capital

Acknowledgements

I would like to thank Tom Eriksson and Gesa Eichler for their help in the review of the contents of this book; Pete Baker and Aimee Dibbens, of John Wiley & Sons, for their patient and very kind support.

About the Author

Cyril Demaria is a Partner at Tiaré Investment Management AG, a Zürich-based wealth and investment management company. Prior to that, he created a multi-strategy fund of funds focused on the environment. He was also an Associate in private equity funds of funds (Zürich, CH). He participated in the market development in France, and evaluated American, European and Middle Eastern private equity funds. As a Portfolio Manager responsible for private equity fund investments at a major French insurance group (Paris, FR), he managed 27 investments totalling EUR 60 million in private equity funds and funds of funds. As Head of Corporate Development at Externall (Paris, FR), he managed four asset acquisitions and raised debt financing to do so. He started his career in a hybrid venture capital and funds of funds firm (San Francisco, US; Paris, FR). He currently manages a small business angels fund (Pilot Fish I, vintage year 2009).

A French citizen, Cyril Demaria holds a BA in Political Sciences from the Institut d’Etudes Politiques (Lyon, FR), Master in Geopolitics applied to Money and Finance (Paris, FR), Master in European Business Law (Paris, FR) and a Diploma from HEC (Paris, FR). He is a DBA candidate at University Sankt-Gallen (CH, graduation: 2012).

An Associate Professor at ESSCA (Angers, FR & Budapest, HU), EADA (Barcelona, SP), and ZHAW (Zürich/Winterthur, CH) he lectures on Private Equity, LBO, Money and Finance and International Finance. He collaborates regularly as an expert with the SECA, AFIC and EVCA. He is the author of:

- Développement durable et finance, Maxima, 2003;

- Introduction au private equity, Revue Banque Editeur, 2006, 2nd ed. 2008, 3rd ed. 2009 - foreword by Xavier Moreno (former President of the AFIC, Managing Partner of Astorg Partners);

- Profession: business angel - Devenir un investisseur providentiel averti, with Fournier M., Revue Banque Editeur, 2008 - foreword by Claude Bébéar (Chairman of the Board of Axa, Chairman of the think tank Institut-Montaigne);

- Le marché, les acteurs et la performance du private equity suisse, with Pedergnana M., SECA, 2009 - foreword by Patrick Aebischer (President of the Ecole Polytechnique Fédérale de Lausanne).

[email protected], [phone]

Introduction

Why another book about private equity, and especially an introductory one?

The answer lies in my experience of reading the different kinds of literature available and my recurring lack of satisfaction regarding their ability to combine so as to formulate an articulate theory. Each piece of the private equity puzzle is interesting, but they somehow do not represent an harmonious and clear picture. I am obviously not the only one to be dissatisfied: the success of the abridged French version of this book (Demaria, 2006 & 2007), of which the first edition as well as the updated reprint were sold out each within less than a year, tends to confirm it.

Cartoon I.1 The potentially disruptive impact of a French input ...

© 2009 Wiley Miller and Universal Uclick. Reprinted by permission.

There have been honourable attempts to paint a portrait of this emerging asset class, by famous and reputable institutions, such as The Institute of Chartered Accountants of England and Wales (ICAEW). Many academics from different disciplines as well as finance practitioners have also tried to contribute to public enlightenment. One of the criticisms made of these written works is that they remain prisoners of ill-adapted theoretical frameworks. Designed as toolboxes for analysing quantitative data, these frameworks soon reveal their limitations as they were not designed specifically to analyse this asset class. Hence, private equity cannot be turned simply into equations as is done for hedge funds. Qualitative analysis is a determining factor at every level of the private equity pyramid of financing. For that reason, using mathematical tools designed for other areas of financial or economical analyses means taking the risk of encountering the limitations of such an exercise.

The second reason lies in the discrepancies which can be observed between academic research and empirical observations by practitioners. There are constant gaps between the findings of the former and the facts as reported by the latter. This holds true for the analysis of fund performance, for the source of value creation in private equity, for the origin of the relative decline of venture capital in certain countries and many other areas. However, highly acclaimed academics, such as Josh Lerner, Antoinette Schoar and Paul Gompers, are extending our knowledge of this difficult and largely misunderstood part of a broader category of finance called ‘alternative assets’.

A MOVING TARGET

Private equity is constantly being redefined. Establishing a typology of transactions is thus especially tricky, notably when there is semantic confusion. Although being only one of the components of the private equity market, LBO and private equity are used interchangeably in the United States. Beyond the fact that LBOs represent the great majority of investments made in private equity (whether in the US or in Europe), it is its bad reputation which got the word ‘LBO’ blacklisted. Associated historically with asset-stripping, this reputation is now contaminating the expression ‘private equity’. Warren Buffet classified private equity managers as being ‘porn shop operators’, and the semantic confusion between private equity and LBO as ‘Orwellian’.

Because of its intrinsically changing nature, the expression ‘private equity’ covers only part of its field of action. The ‘private’ or unlisted element is no longer decisive; nor is that of ‘equity’.

One mistake is to state that ‘private equity’ is (just) ‘equity’. From this assumption, it might also be assumed that private equity may be analysed validly with the tools used for public equities. This has so far been proven wrong: the timeframe, the risks, the skills required and the returns associated with private equity investments differ substantially from those associated with public equities.

If not ‘equity’, then ‘private’ could appear as defining the sector and open it to the non-listed methods of analysis. Once again, this has been proven wrong: not only is there no proprietary private finance method of analysis which could be transposed as such, but that which defines ‘private’ assets is more their lack of listing than common factors defining them as belonging to ‘alternative assets’.

A CONSUBSTANTIAL LACK OF INFORMATION

Ill-adapted theoretical modelling and the frequent gaps between research and the facts result from a lack of information: information is collected scarcely, heterogeneously and unsystematically . Not only has this been the case to this day, but will remain as such for the foreseeable future.

Producing information costs the economic agents a great deal and is sometimes disproportionately expensive compared to their size and revenues. As private equity deals with small-and medium-sized companies and these account for most of their activity (the criteria being the size and number of companies being financed), it is highly unlikely that there will be a ‘pure and perfect information context’ any time soon for non-listed companies - which happen to make up 99% of the total number of companies in a given economy.

This lack of available information has resulted in some methodological simplifications. For example, observers assimilate casually the findings for a part of the sector, for example large buy-outs operated in listed companies, as a general rule for the entire activity of leveraged buy-outs. This is proven wrong regularly. Small- and medium-sized companies are bought out by different fund managers, with substantially different financing techniques and investment purposes.

Another inaccurate simplification is to assimilate the private equity sector with private equity funds. Even though these intermediaries are probably a good indication of the trends in the sector, they certainly do not sum up private equity activity. Fund managers have organised themselves in rich and powerful national (such as the British Venture Capital Association or the Association Française des Investisseurs Capital) and regional associations (e.g. the European Venture Capital Association and the National Venture Capital Association) which tend to hide the existence of other players.

For example, business angels play a significant role in the venture capital sector - even though largely yet unknown. These business angels, also called angel investors, are the very first individuals willing to support an emerging venture. Corporations, endowments, foundations, high net worth individuals, state-owned structures, banks, insurance groups and other economic players are also making direct investments which are not necessarily observed by the associations mentioned above.

BENIGN NEGLECT, MALIGN CONSEQUENCES

Those simplifications have significant consequences: findings are not put into perspective; action plans taken, notably to correct market imbalances, are ill-adapted; and there is a growing antagonism between the different parts of the private equity system for that reason.

For example, the French (2007) and British (2009) governments have been focusing on start-ups at seed stage, because according to public statistics, venture capital funds have not been investing in them sufficiently. This was perceived as a market imbalance which had to be corrected. Whether true or not, this gap in financing has been targeted by a set of measures heavily financed by the tax payer’s money.

Another example is to be found in federal venture capital funds of funds in the US and the UK (2009). Innovation America and the National Association of Seed and Venture Funds (NASVF) suggested the set-up of a USD two billion fund of funds dedicated to supporting business angels and to funding public programmes. This would be an extension of the Small Business Administration (SBA) programme, which has experienced difficulties in staying afloat. Unfortunately, the track record of public funds of funds is bad (Arnold, 2009b), notably because of the proximity effect and the local political agenda which affects public investment structures (Bernstein, Schoar & Lerner, 2009), whether they are sovereign wealth funds or funds of funds. In the UK, state-backed venture capital funds have underperformed by comparison with their commercial couterparts. The returns of the latter (2002-2004) were 7.7% whereas all VC funds (commercial and public) of the same vintage were 1.7%.

Thus, statistics of private equity performance and activity should be read with caution. They are the result of periodical polls of private equity fund managers answering on a voluntary basis. These figures are not audited; they cover a different sample of funds over time depending on the answer rate, and are applicable in any case to only a portion of the private equity industry.

KNOWING THE DEVIL TO CIRCUMVENT IT

This book will (unfortunately) not be able to avoid the above-mentioned traps completely. I am a prisoner of the same constraints my peers have had to deal with (see Cartoon I.2). The value of the book, if there is one, could be that it was written with these limits in mind. This gives the content a critical perspective which could thus highlight its originality. I will keep in mind the need not to be totally blind to the bias conveyed by the data I am using.

Cartoon I.2 Writing a book about private equity and taking the time to enjoy it

© 2009 Wiley Miller and Universal Uclick. Reprinted by permission.

The second reason why this book differs from the rest lies in its approach to private equity financing as a cycle, and not a static body of financial practices. Two factors motivate this approach:

• Private equity has been attracting an ever increasing amount of capital over the course of the last two decades. This capital inflow has contributed to changing the dynamics of the sector, its structure, its practices and its influence on the overall economy over the course of only four to five business cycles (that is to say on average three years of economic growth and two years of recession). The source of this inflow, notably pension funds, has also exposed the private equity sector to exogenous influences as its visibility has increased.

• Private equity players are constantly innovating and at a fast pace. This innovation potentially explains the persisting gaps between the academic literature and the daily activities of practitioners, as the scientific body struggles to catch up with the pace of innovation. Unfortunately, the lack of available data does not help the work of the scientific community.

Because private equity is evolving constantly and rapidly, it can only be captured partially by a single book. For that reason, dear reader, this book will focus on identified trends; practical and theoretical dialogue; and draw some hypotheses to guide you towards an understanding of upcoming events.

This book will be structured to identify the critical elements that have shaped the private equity industry (Chapter 1) and which remain necessary for those countries willing to establish this industry (Chapter 2). Once these founding parameters have been analysed, we will see how the private equity sector is organised as an ecosystem (Chapter 3) centred on the entrepreneur and the lifecycle of companies (Chapter 4). In that respect, the investment process and the entire private equity activity is based on interpersonal relationships and on arm’s length interactions (Chapter 5). These conclusions will allow us to distinguish the trends and fads affecting an activity in ‘teenage time’ (Chapter 6), before examining the responsibilities (Chapter 7) that the sector will have to handle. The Conclusion will provide some prospective analysis.

Part I

What is Private Equity?

Whenever a company needs financing, two solutions come to mind: the stock exchange and bank loans. The stock exchange is a limited solution. It provides only access to funding for medium- and large-sized companies that meet specific criteria (sales figures, total of balance sheet, minimum number of years of existence, etc).

The conditions for taking out a loan are also strictly defined. Companies must prove their ability to pay back the bank in fixed instalments, which means that they must show a certain term of existence, stability of cash flows, healthy activity and also a limited existing indebtedness.

If neither the stock exchange nor banks finance business creation and development, then who, or what, does? Where does the money come from to finance the transmission or take-over of family businesses, for example? Or to restructure an ailing business? It is ‘private equity’ for that matter.

The expression ‘private equity’ was coined by reference to equity which is not listed and whose exchange is not regulated (Chapter 1). However, this definition only partly reflects the scope of action of private equity players, which has diversified and spread considerably (Chapter 2).

1

Private Equity as an Economic Driver: An Historical Perspective

Christopher Columbus convinced, after seven years of lobbying, the Spanish Kings (Ferdinand II of Aragon and Isabella I of Castile) to sponsor his trip towards the West. His ‘elevator pitch’ must have been the following: ‘I want to open a new and shorter nautical route to the Indies in the West, defy the elements, make you become even more powerful and rich, and laugh at the Portuguese and their blocs on the Eastern routes’ (see Cartoon 1.1).

Cartoon 1.1 A modern view of Columbus’s pitch to the Spanish Kings

Bottomliners © Eric & Bill Teitelbaum. All rights reserved.

He probably did not know by then that he was structuring a private equity deal (here, a venture capital operation). He was indeed, as his project combined these elements: financed by an external investor, a high risk, a high return potential and protection of this competitive advantage.

These elements form the common ground for all private equity deals (venture capital, development capital, leveraged buy-out, etc.). Another element lies in the ‘private’ characteristics of private equity deals negotiated privately between the parties: historically, they were made with non-listed companies.

Even though it is difficult to imagine whether, and how, Columbus did his risk/return calculation when assessing the viability of his project, we can assume that the risks borne by the operation were identified and that there was a plan to mitigate them - or at least sufficiently well identified to light enough candles in church.

The risks were high, but not unlimited (thus distinguishing his venture from pure gambling).

The prospect of reaching the Indies gave quite a good sense of what could have been the return on investment for the financial sponsors: the Spanish Kings and the private investors from Italy. Not only did the potential return exceed by far that which a conventional investment could provide, but the new route had a potentially disruptive impact on international commerce, giving the new born unified Spanish Crown a much needed mercantile boost.

This example illustrates the fact that private equity has always existed, in one form or another, throughout history. Examples of historical buy-outs are more difficult to identify, hence the focus of this chapter on venture capital. Buy-outs transfer majority ownership in exchange for cash and are generally friendly. Typically, buy-outs are conducted with insider knowledge. They have only recently started to become important, as they require sophisticated financial markets and instruments.

Historically, large buy-out operations were ‘barters’, with a strong real estate/commercial focus. This involved mainly swapping countries or towns for other ones. The state today known as New York was swapped by the Dutch West Indies Company (WIC) for Surinam, a plantation colony in northern South America, in 1667 (Treaty of Breda). This turned out to be a bad deal.

In 1626, Peter Minuit, then Director General of the WIC, acquired the island of Manhattan from the Indians and began constructing Fort New Amsterdam. In 1664, owing to commercial rivalry between the Dutch and the English, an English fleet sent by James, Duke of York, attacked the New Netherlands colonies. Being greatly outnumbered, Director General Peter Stuyvesant surrendered New Amsterdam, which was then renamed in honour of James. The loss of New Amsterdam led to the Second Anglo-Dutch War of 1665-1667. This conflict ended with the Treaty of Breda, under which the Dutch gave up their claim in exchange for Surinam.

The emergence of private equity as a dynamic financial tool required the interplay of (i) a supportive social, legal and tax environment, (ii) adequate human resources and (iii) sufficient capital. Together, these three conditions have developed slowly until they reached the current level of professionalism and formalism which characterises private equity. The clear identification and separation of the three conditions forming the ‘private equity ecosystem’ has been a continuous process, which is still under way.

The purpose of this chapter is to identify the key elements distinguishing private equity from other categories of investment. Private equity financing in the early days of venturing was an intricate mix of public policy, entrepreneurship and financing. The quest of European monarchs for greater wealth and power is emblematic for this mix, pooling public and private resources in order to identify and exploit sometimes remote resources (see section 1).

Public policies, entrepreneurship and financing became less complex and slowly gained autonomy. The public interest and policies were separated clearly from the King’s personal interest and will. Once the basic legal and tax framework had been established and adapted to the alterations in social and economic factors, the entrepreneur emerged as the central figure of the private equity ecosystem (see section 2).

Private equity investors developed a capability to identify them, providing capital and key resources to help with their venture and get their share of success. By gaining this know-how and expertise, those investors contributed to further professionalisation, developing strategies to mitigate risks and optimise returns (see Chapter 2).

1. POOLING INTERESTS TO IDENTIFY AND EXPLOIT SOURCES OF WEALTH

The fundamental objective of any rational investor is to increase his wealth1 dramatically. Private equity offers investors the opportunity to finance the development of private companies and benefit from their eventual success. Historically, the raison d’être of those companies has been to identify and control resources, thereby developing the wealth of venture promoters by appropriation.

The main financial sponsor might have been a political leader, who would legally and financially ease the preparation and the execution of the venture for the benefit of the Crown and himself. The control of resources and the conquest of land motivated the launch of exploration ventures (a). Companies were created to support political efforts, thereby guaranteeing the demand for their product in exchange for their participation in a public effort to build infrastructures, create a new market and more generally encourage commerce and the generation of wealth. They could leverage public action (b). Apparently, conflicts of interest did not ring any bells at that time (see Cartoon 1.2).

Cartoon 1.2 A modern perspective on the old ages’ resolution of conflicts of interest in private equity...

© 2009 Wiley Miller and Universal Uclick. Reprinted by permission.

Often, private investors were complementing this public initiative, convinced by the pitch made by a person combining technical competence and know-how, with a vision and genuine marketing talent. This person would be identified nowadays as an entrepreneur - or the precursor of televangelists, when the marketing presentation becomes a seven-year sermon, in the case of Columbus.

(a) Identify, control and exploit resources

The quest to master time and space has given birth to pioneering public and private initiatives, bearing a substantial risk but also a potentially high reward. This reward was usually associated with the geographical discovery of new resources (land control) and/or effectiveness (new routes to the Indies, for example), allowing a better rotation of assets and improving the returns.

Columbus’s project supported a substantially higher risk than the equivalent and usual routes to the East. This project was deemed to be possible thanks to progress in navigation and mapping, and some other technical and engineering discoveries. In that respect, Columbus’s expedition was emblematic of the technological trend, as well as being political, religious and scientific; which he mastered so as to present his project.

The risks taken by Columbus were of two different kinds:

(i) Initial validation of theoretical assumptions, with substantial risks linked to the transition from a theoretical framework to an operational process.2 Columbus’s prediction of the diameter of the Earth (3 700 km instead of 40 000) proved wrong, but his venture was successful in the sense that he reached an unknown new continent. This kind of outcome (refocusing the ‘research and development (R&D) effort’ towards a different outcome) occurs from time to time in companies financed by venture capital even today. Hopefully, not all venture-backed companies have a CEO who under-evaluates the effort to be produced by 10 times;

(ii) Execution of the four successive trips, with the presence of favourable winds and currents, the correct calculation of the time spent at sea with embarked supplies, navigation hazards (storms), morale of the crew and other operational aspects. Operational risks are generally financed by later stage venture capital and expansion investors.

For all of the reasons above, Columbus’s project was innovative in many respects. It was guided by ambition and a vision. It was designed to test concretely the validity of a certain number of theories, which would be of great reward if Columbus touched Indian ground after journeying to the West.

The high return potential was related to Columbus’s calculations, according to which the new nautical route could save a substantial amount of time (and risk) to reach the Indies despite the Portuguese land bloc. The return potential would be earned not from the initial trip itself, but from opening a new route for future trips to gather expensive goods (mainly silk and spices) and bring them back to Europe.

Another key element was that this new nautical route would have paved the way to developing a certain number of other new ventures using the route to gain other valuable goods. Columbus’s success would not have been a one-time pay-off but the source of recurring and long-term income.

The time horizon of the trip was calculated in months, which represents a long-term investment , and the pay-off would have been calculated in years. This represents another element that qualifies Columbus’s trip to the West as a private equity project.

Protection by the Spanish Kings of this advantage, by giving a legal right to the private sponsors of the project to the use of this new route (the historical equivalent of the current ‘barriers to entry’ in a given market) was a crucial element of the evaluation of the return on investments. Columbus was promoted to the status of ‘Admiral of the Seas’ by the Spanish Kings, and then to Governor once he succeeded in his venture. This meant that he just had to sit and wait for the profits to come, after making this initial breakthrough (see Cartoon 1.3).

Cartoon 1.3 A modern perspective of the royal advantages given to Columbus... Or the advantages of barriers to entry!

Bottomliners © Eric & Bill Teitelbaum. All rights reserved.

This pooling of the energies and resources of an entrepreneur (Columbus); of Italian private investors (representing 50 % of the pool of money) and of the Spanish Kings as a sponsor syndicate for the project, is another criterion for its qualification as a private equity project. Its commercial purpose, even if not exclusive in this example, is another.

As an additional incentive, Columbus would have received a share of all the profits made via this nautical route. More specifically, Columbus asked, aside from the titles and an official charge, for a 10 % share of the profits realised through the exploitation of the route to the West. He had option rights to acquire one eighth of the shares of any commercial venture willing to use the nautical route that he had opened. This kind of financial incentive (percentage on profits realised and the equivalent of stock options; in private equity this incentive is called carried interest) is often used to reward the management of a company, should it reach a certain number of targets.

Columbus’s venture, however, stands out as different from a typical private equity investment. He benefited from political and legal support which would not be sustainable in an open and fair trade market today - or at least not so openly provided.

The Italian investors were ‘hands off’ in the project. However, Columbus convinced them and enrolled the providers of the three ships in his venture. This implies that even if there was no equivalent of a ‘lead investor’ and ‘investment managers’ (see Chapter 2) to look after Columbus’s project, the monitoring was done according to historical standards, that is to say: on site, day-to-day and probably with vigorous debates about the option of continuing and taking the risk of wreckage; or returning and saving both fleet and crew.

In that respect, the dispute about the reward to be granted by the Kings of Spain to Columbus after his journeys, as well as the difficulty of providing a quick and easy return for the Italian investors (as there was little gold to capture on the Caribbean Islands), is another point comparable with typical private equity operations, an outcome different than that originally planned. Some disputes held in recent years between creators and managers of Internet start-ups and their financial backers prove that this still happens today - and, just like back then, before the courts.

(b) Leverage public policies and a favourable business environment

Even if Columbus’s project was driven by religious and commercial purposes, the political ambitions of the Spanish Kings were the key factor triggering public commitment. Governmental, and more generally public, support is instrumental in contributing to the emergence of private equity ventures by funding fundamental research, financing key infrastructures and creating a favourable environment for the development of ventures. However, private equity projects which qualify as such and which have served public policies are limited in number.

The separation of public and private financing as a key element of the emergence of an autonomous private equity sector

This stems from the fact that with separation of the King as a public body and the King as a private person, projects were no longer financed by public subsidies and the specific convergence of interest which had allowed Columbus to set up his project slowly became a rarity.

The increased control of the use of public money, a greater focus on fair trade and the will to let market forces act as far as possible in favour of private and public interests have played a significant role in the limitation of the state’s direct intervention in private equity projects. This, however, does not mean that this role has totally disappeared: it has evolved towards the establishment of an appropriate legal and tax framework, as well as more complex intervention, mixing public contracts and the active management of public money.

The transformation of public intervention: setting up a legal and tax framework

With progress in commerce, transportation and techniques, entrepreneurs could reach a higher number of clients, as well as producing in quantity and more capital intensive goods. To follow this trend, and finance the investments needed, the entrepreneur often had to seek outside financing, and thus set up a formal company, with agreements, contracts and partnerships with third parties.

To enforce these conventions, a legal and tax framework has to be in place and respected. One of the most ancient examples of a legal framework is known as the Code of Hammurabi, King of Babylonia (1792-1750 B.C., see Gompers & Lerner, 2006). This set of 285 laws was displayed in public places to be seen by all, so that it could be known and thus enforced. This Code liberated the commercial potential of the Babylonian civilisation, notably paving the way for the creation of partnerships. Until then, most companies were initiated and were run by families. Financial support at that time often came from personal or family wealth, and/or from guilds that helped their members set up their venture after being admitted as a member.

With partnerships, Mesopotamian families could pool the necessary capital to fund a given venture, spreading the risk. However, these ventures were not financed by equity investment. Capital infusion mostly took the form of loans, which were sometimes secured by the pledge of a man’s entire estate, with his wife and children considered as being a part of it. If he defaulted on payments, his family would be sold into slavery to pay his debts (Brown, 1995).

In that respect, the Code of Hammurabi initiated the distinction between the entrepreneur and the financier, with the distinction between equity and debt, the creation of collateral for the debt and the privileges attached to loans (such as priority of reimbursement in the case of liquidation of the company).

The transformation of public intervention: infrastructure financing

However, this legal and tax support may not have been sufficient for the emergence of private equity. Besides law, other public actions are usually geared to helping entrepreneurs, directly or indirectly, and create favourable conditions that nurture the creation of companies. Direct help, because of its cost to the public budget and the distortion in competition that it introduces, tends to be confined to a more indirect mode of intervention. This indirect mode of intervention had already been identified and used by Hammurabi, who, aside from being a military leader, invested in infrastructures in order to foster the prosperity of his empire.

During his reign, he personally supervised navigation and irrigation plans, stored grain against famine and lent money at no interest to stimulate commerce. Broad wealth distribution and better education improved standards of living and stimulated extra momentum in all branches of knowledge, including astronomy, medicine, mathematics, physics and philosophy (Durant, 1954). In that respect, the liberation of private energy and the symbiotic relationship between public and private investments greatly rewarded the King for his action.

Public initiatives and private equity financing are still acting in an intricate way in many respects, but the relations between these two spheres have evolved towards autonomy of the private equity sector and a ‘hands off’ approach in public intervention. As a result, public intervention is creating the backdrop for private equity, paving the way for a more subtle interaction, combining contracting, incentives and soft regulations.

2. CHAMPIONING ENTREPRENEURSHIP

However, this favourable legal and tax environment is useless if the social acceptance of risk and innovation is low. The figure of the entrepreneur, as the individual willing to take the initial risk of creating and developing a venture, is therefore central in the private equity landscape.

Without him, private equity does not have any reason to exist (see (a)). However, private equity needs very specific entrepreneurs and companies to finance. The role of the entrepreneur is to support the creation of value (for example by converting product/service innovation into business successes), and therefore generate a financial return (see (b)). Entrepreneurship acts as a transformer of disparate elements in a venture, making it blossom and become an attractive fruit. As a metaphor, private equity could be described as an ecosystem in itself (see (c)).

(a) No private equity without entrepreneurs

The figure of the entrepreneur is at the centre of the private equity universe. He is the one who can transform inputs into something bigger than the sum of the elements taken separately, which are time, capital, work, ideas and other elements. What distinguishes the entrepreneur from other workers is his ability to innovate (at large), to take risks and to create and manage a company. However, not all entrepreneurs are able to manage a company successfully.

What makes private equity attractive is the reasonable and proven prospect of getting a substantially higher reward than on the financial markets (i.e., listed stocks or bonds, often the result of privately negotiated transactions and not efficient and transparent markets). This reward is the counterpart of a risk that would not be borne by the rest of the financial system (banks, individuals and other sources of capital). Thus, private equity-backed entrepreneurs are in fact a small portion of the pool of entrepreneurs that are active in any given country.

The chief image of the entrepreneur is the ‘company creator’. This individual is guided by a vision (see Cartoon 1.4), often supported by an innovation. The emblematic entrepreneur financed by venture capital investors is building a company willing to capitalise on a ‘disruptive innovation’, which could radically change a market or create a new branch of a given industry. James Watt (1736-1819) is probably the incarnation of this category.

Cartoon 1.4 An entrepreneurial vision

© 2009 Wiley Miller and Universal Uclick. Reprinted by permission.

This Scottish mathematician and engineer improved the steam engine, set to replace water and muscle power as the primary source of power in use in industry (Burstall, 1965). Although created in 1689 to pump water from mines, steam power existed for almost a century and several cycles of improvement before the steam engine made a breakthrough. In 1774, James Watt introduced his disruptive ‘Watt steam engine’ which could be used not just in mining but in many industrial settings. Using the steam engine meant that a factory could be located anywhere, not just close to water. Offering a dramatic increase in fuel efficiency (75 % less consumption), the new design was retrofitted to almost all existing steam engines in the country.

Another figure which has emerged over time is the ‘serial entrepreneur’, an emblematic figure in the US which has still to appear in Europe. This is probably related to the different cultural contexts and the social fluidity on the two continents. Thomas Edison (1847-1931) invented and developed many important devices such as the light bulb, the phonograph and the stock ticker. He patented the first machine to produce motion pictures and planned the first electricity distribution system to carry electricity to houses (Bunch & Hellemans, 2004). ‘The Wizard of Menlo Park’ was one of the first inventors to apply the principles of mass production to the process of invention. One of the most prolific inventors, Edison held more than 1 000 patents at a certain stage.

In 1878, Edison convinced several investors such as John Pierpont Morgan, Lord Rothschild and William Vanderbilt to invest USD 300 000 in the creation of the Edison Electric Light (EEL) Co., and to fund his experiments with electric lighting in return for a share in the patents derived from his research. J.P. Morgan continued to support the growing company by acquiring shares and backing the company’s merger with EEL’s main competitor, the Thomson-Houston Electrical Company. This merger resulted in the creation of General Electric (Frederick Lewis, 1949).

Not every entrepreneur is able to come up with an idea ready to be produced. Inventors and developers are sometimes hatched in a laboratory and can develop their ideas before spinning off, but most are developing new products and technologies in their garages or other more casual places. To help them support their efforts, some funds have developed ‘incubators’ or ‘entrepreneurs-in-residence programmes’. These programmes offered by venture capital funds provide facilities, support and money to entrepreneurs with interesting ideas. Once the idea has matured, the investors can take an early lead on the development of the company and get a greater share in the company in exchange for past efforts.

One of the most famous ‘entrepreneurs in residence’ was probably Leonardo da Vinci (1452-1519). As well as being an inventor, he was also a sculptor, architect, engineer, philosopher, musician, poet and painter. These activities generated substantial investment opportunities, either for mercantile or for patronage purposes. Da Vinci met ‘investors’ who aspired to both, such as Ludovico Sforza, Duke of Milan, in 1482. Da Vinci wrote a letter to the Duke in which he stated that he could build portable bridges; that he knew the techniques of bombardment and the engineering of cannon; that he could build ships as well as armoured vehicles, catapults and other war machines. He served as principal engineer in the Duke’s numerous military enterprises and was also active as an architect (Encarta Encyclopedia). He spent 17 years in Milan, leaving after the Duke’s fall in 1499.

Under the Duke’s administration, Leonardo designed weapons, buildings and machinery. From 1485 to 1490, Leonardo produced studies on multiple subjects, including nature, flying machines, geometry, mechanics, municipal construction, canals and architecture (designing everything from churches to fortresses). His studies from this period contain designs for advanced weapons, including a tank and other war vehicles, various combat devices and submarines.

These examples are provided by way of illustration, to show the continuity with the figures of entrepreneurship currently backed by venture capital throughout history. Da Vinci was probably more interested by research than entrepreneurship, but the ‘entrepreneur in residence’ model that is active in the Silicon Valley today finds its roots in the Italian financial and political support of exceptional men who were able to make breakthrough discoveries.

Interestingly, the model of entrepreneur in residence was developed in Europe throughout the Middle Ages and the Renaissance, but did not manage to survive after the European Revolutions. The incubator model failed. It was only in the US that entrepreneurs in residence programmes managed to gain a hold. This is linked to the fact that most of these entrepreneurs in residence are serial entrepreneurs, which are still a rarity in Europe.

The difficulty for the entrepreneur is to communicate his innovation, spread the word of his vision and thus convince his partners (employees, managers, financial backers, bankers, clients, providers...) that he is able to lead the company to the next stage and transform his young venture into a business success.

(b) Convert ventures into business successes

Normally, there is innovation in companies financed by private equity, either in the product or in the service it delivers (innovation by destination); or else in the processes it has engineered (innovation by processing); in the way it contributes to structure its market (strategy innovation); or in the way it is managed (financial and management innovation). In order to be able to deliver a consistent and high level of returns, a private equity firm has to focus on value creation and develop specific expertise which is applied to a certain type of innovation (Guerrera & Politi, 2006). However, value creation is not only related to innovation and value creation can be generated in leveraged buy-outs by boosting companies through top line growth, operational improvements or some other area of company improvement. Innovation financing provides us with a template illustrating the logic behind private equity.

In the process of mastering space and time, entrepreneurs have discovered breakthrough technologies and invented new ways of communication. The infant equivalent of private equity was instrumental in financing the development and the deployment of these new technologies. An example of this public action helping to convert innovation into business success lies within the support provided to Galileo Galilei (1564-1642) by the Medici family, and especially Cosimo de Medici.

Galileo’s achievements included demonstrating that the velocities of falling bodies are not proportional to their weight; showing that the path of a projectile is a parabola; building the first astronomical telescope; coming up with the ideas behind Newton’s laws of motion; and confirming the Copernican theory of the solar system. Galileo translated his scientific knowledge into various technologies. In 1598, Galileo developed a ‘Geometric and Military Compass’ suitable for use by gunners and surveyors. For gunners, it offered, in addition to a new and safer way of elevating cannons accurately, a way of computing quickly the charge of gunpowder for cannonballs of different sizes and materials. In about 1606, Galileo designed a thermometer, using the expansion and contraction of air in a bulb to move water in an attached tube.

In 1609, Galileo capitalised on the invention of the telescope, a patent for which was denied to a Flemish designer, Paolo Sarpi, a friend of Galileo, and lobbied the Venetian government against purchasing the instrument from foreigners, since Galileo could at the very least match such an invention. By then, Galileo had improved upon the principle of the telescope. The Venetian government subsequently doubled his earnings, even though Galileo felt that the original conditions were not honoured (Kusukawa and MacLean, 2006).