The Venture Capital Firm is Born

In 1946 the first two venture capital firms American Research and Development Corporation. (ARDC) and J.H. Whitney & Company were formed. ARDC was founded by Georges Doriot, the “father of venture capitalism,” 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.

ARDC was the first institutional private equity investment firm that raised capital from sources other than wealthy families. ARDC 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%. In 1972, Doriot merged ARDC with Textron after having invested in over 150 companies.

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.

The Private Equity Fund is Born

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 net profits of the partnership. Such vehicles had limited lives, of typically seven years, which drove private equity behavior in managing the companies they purchased. They were not organized to be buy and hold investors.

Warren Buffett, often described as a stock market investor rather than a private equity investor, employed many of the same techniques in the creation on his Berkshire Hathaway conglomerate. In 1965, Buffett assumed control of Berkshire Hathaway, then a textile company. Buffett, however, used the Berkshire Hathaway corporation as an investment vehicle to make acquisitions and minority investments in dozens of insurance and reinsurance industries such as GEICO and other companies including American Express, The Buffalo News, the Coca-Cola Company, Fruit of the Loom, Nebraska Furniture Mart, and See’s Candies.

Buffett’s value investing approach and focus on earnings and cash flows are characteristic of later private equity investors, though he generally does not face the same pressure they do to harvest the fruits of their investment by selling the company in a finite period of time. Buffett would distinguish himself relative to more typical leveraged buyout practitioners through his reluctance to use leverage and hostile techniques in his investments.

Importantly, the structure he developed using Berkshire Hathaway allowed him the latitude to indulge in his frequently quoted favorite holding period should the investment merit it: forever. Private equity funds typically need to harvest their investments and return the proceeds to investors after some investment horizon, spelled out in the fund documents, concludes. Using a corporation as his investment vehicle gave Buffett great flexibility.

In the years following the end of World War II, the Great Depression was still relatively fresh in the minds of America’s corporate leaders, who considered it wise to keep corporate debt ratios low. As a result, for the first three decades following World War II, very few American companies relied on debt as a significant source of funding. Companies and empires called conglomerates grew, and middle management swelled. Corporate profitability began to slide.

The Leveraged Buy Out Arrives

It was in this environment that the modern leveraged buyout, known until then as a bootstrap acquisition, was born. In the late 1970s and early 1980s, newly formed firms such as Kohlberg Kravis Roberts and Thomas H. Lee Company saw an opportunity to profit from inefficient and undervalued corporate assets. Many public companies were trading at a discount to net asset value, and many early leveraged buyouts were motivated by profits available from buying entire companies, breaking them up and selling off the pieces. This “bust-up” approach combined with the power of debt to finance these acquisitions eventually led to the media backlash against the greed of so-called “corporate raiders” caricatured by books such as The Rain on Macy’s Parade and Barbarians at the Gate.

The acquisition of Orkin Exterminating Company in 1964 by Henry Kravis, Jerome Kohlberg, and George Roberts, investment bankers at Bear Stearns, is among the first significant leveraged buyout transactions. In the following years, the three bankers would complete a series of buyouts including Stern Metals (1965), Incom (a division of Rockwood International, (1971), Cobblers Industries (1971) and Boren Clay (1973). Unable to convince Bear Stearns to develop a dedicated fund to pursue these investments in house, the trio left Bear in 1976 to start KKR, their own firm. By 1978, the nascent KKR was successful in raising its first institutional fund with approximately $30 million of investor commitments.

Pension Plans Buy in to Private Equity Investing

The boom in leveraged buyouts in the 1980s was supported by three major legal and regulatory events. The failure of the Carter tax plan of 1977 that would have, among other results, reduced the disparity in tax treatment regarding interest paid to bondholders and dividends paid to stockholders made the continued use of leverage to reduce taxes available. Debt continued to be the most tax efficient way to finance acquisitions.

With the passage of ERISA in 1974, corporate pension funds were prohibited from holding certain risky investments including many investments in private equity related companies. In 1978, certain parts of ERISA restrictions were relaxed under the “prudent man rule,” thus allowing corporate pension funds to invest in private equity, and a major new source of capital to invest in private equity became available.

On August 15, 1981, Ronald Reagan signed into law the Economic Recovery Tax Act of 1981, lowering the top capital gains tax rate from 28 percent to 20 percent, and making potentially high return investments even more attractive for taxable investors such as corporate treasuries, and insurance companies.

Why did pension plan investors, historically conservative, invest in these vehicles and/or the related high yield debt offerings? As described above, they have hurdle rates of return to meet to keep their corpus growing sufficiently to fund their obligations to their pensioners. The volatility of the publicly traded market returns made predictions there difficult. Many felt they needed to catch up by investing in asset classes that might offer both greater return and greater certainty of return. Growth in private equity surged as institutional investors 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 massive portfolios into what came to be called alternative investments. And others followed these leaders.

These investments were considered attractive because they offered an alternative to investing in real estate and investments that moved with the broad market, stocks and bonds. These investments, mainly in venture capital and leveraged buyout funds, were believed to offer a return pattern independent of market movements. Another term used to describe them is investments with absolute return, which does not vary as the public securities markets move up and down.

The Hostile Takeover Epidemic

The leveraged buyout became notorious as the public became aware of the ability of private equity to affect mainstream companies and “corporate raiders” and “hostile takeovers” entered the public consciousness. Additionally, the threat of the corporate raid could lead to the practice of “greenmail,” where a corporate raider or other party would acquire a significant stake in the stock of a company and receive an incentive payment (effectively a bribe) from the company to convince the acquirer to avoid pursuing a hostile takeover of the company.

The decade saw a large boom in private equity activity culminating in the 1989 leveraged buyout of RJR Nabisco, which would remain the largest leveraged buyout transaction for nearly 17 years. In 1980, the private equity industry would raise approximately $2.4 billion of investor commitments and by the end of the decade in 1989 that figure stood at $21.9 billion.

Milken Flexes His Funding Muscles

Drexel’s ability to underwrite new high yield bond issues became an important tool for the leveraged-buy-out (LBO) firms of the 1980s. Milken’s ability quickly to raise hundreds of millions of dollars in debt for favored clients made the threat of buy-outs credible. Its dominance of the high-yield corporate bond market turned once obscure Drexel into a powerhouse. By 1986, Drexel, which in its long history had never threatened to join the financial elite, was Wall Street’s most profitable firm, in part due to its refusal to allow syndication of its bond issues, which would have allowed other firms to share in the spoils.

Such was Milken’s control of the high yield market and his clients’ confidence in him that Drexel could issue what came to be called a highly confident letter indicating that the client of the moment could produce the funds needed to close a deal, without needing to raise the money in advance. Remarkably, these were accepted by many counterparties, and provided a new source of funds for many small but growing firms, which had not been able to attract support from traditional commercial or investment banks. The entrepreneurial owners of these companies saw the growth potential in their respective industries. These entrepreneurs were the bread and butter business of Milken’s High Yield Department.

Corporate Titans Are Shaken by an Upstart

Management of many large publicly traded corporations reacted negatively to the threat of a potential hostile takeover and boards pursued defensive measures including poison pills, golden parachutes and increasing debt on the company’s balance sheet. Drexel was seen as an upstart firm, greatly to be feared as well as denounced by established corporate leaders. Many of the court decisions allowing the defenses to stand relied on decision making by independent directors, as the best available embodiment of the less conflicted true stewards of the corporation. These court decisions appear to have depended in large part on not only the presence of independent directors but also on the process those directors who were disinterested in the transaction went through to consider the transaction.

Drexel raised capital for small firms which had enough cash flow to meet interest payments to grow bigger, thus the focus on earnings before interest, taxes, depreciation, and amortization, or EBITDA, a concept developed at Drexel. Some industries were not well-suited for debt finance: the mobile-phone business did not generate much upfront cash and cable TV firms had big start-up costs before subscription revenue flowed. One solution was to “over-fund” firms, to raise more capital than they needed so that they could make their initial interest payments with the additional proceeds. Another approach was to use zero-coupon bonds, on which interest payments were deferred until the principal came due.

Drexel’s fees on high yield bond issues were much higher than was typical for investment-grade bonds. The typical Drexel client, however, was not eligible for investment grade financing, and as entrepreneurs growing businesses they were generally much more interested in the availability of the funds than concerned about its cost. Drexel was able to charge an enviable fee for access to Milken’s abilities and scarce investor base.

As part of Drexel fees, the Milken team often demanded equity warrants for the high yield and corporate finance teams involved, as well as for their buyers to sweeten the deal. Of questionable legality, these deals came to be known as the warrant strip or the infamous investment partnerships, and further enhanced the loyalty of those included in the club who received them. In my view, this structure influenced the structure of the partnerships later infamously created by Enron and Ken Lay, a Drexel client and a beneficiary of the warrant strip.

The Government Fights Back—For Real

We will never know exactly what triggered the long running SEC investigation into Milken and Drexel, but there were some likely apocryphal stories that major corporate executives, frightened of takeover, approached senior government officials to get them to act to stop him. What seems likely to me, a Drexel employee and shareholder at the time and later leader of the shareholders who forced the restructuring of its board, is that regulators believed that too much power was concentrated in one man’s hands.

To the best of my knowledge, there was no such thing as illegal insider trading in the bond market, as the notion that bonds could determine the ownership of a company had not been contemplated by lawmakers. Instead, it was possible to argue that Milken actually created inside information by his ability to finance takeovers of big companies by fast moving entrepreneurs.

Nevertheless, rather than do the difficult work of addressing what might have been a gap in the securities laws, regulators likely thought Milken and Drexel would be easy targets. They could likely more easily curb Milken’s influence by pursuing him for securities law violations than by clarifying the law. To my mind, Milken had not only amassed too much power, but had done so outside the fabric of the accepted system. Quite simply, his power, brains, reach, and outsider status made him a very frightening force.

Drexel Burnham Lambert was first publicly rocked by scandal on May 12, 1986, when Dennis Levine, a Drexel investment banker, was charged with insider trading. Levine pleaded guilty to four felonies, and implicated one of his recent partners, arbitrageur Ivan Boesky. Largely based on Boesky’s promises to provide information about his dealings with Milken, the SEC formally initiated an investigation of Drexel on November 17, 1986. Two days later, Rudy Giuliani, then United States Attorney for the Southern District of New York, launched his own criminal investigation.

For two years, Drexel steadfastly denied any wrongdoing, claiming that the criminal and SEC cases were based almost entirely on the statements of an admitted felon looking to reduce his sentence. Their assertions were, however, not enough to keep the SEC from suing Drexel in September 1988 for insider trading, stock manipulation, defrauding its clients and stock parking. All of the allegedly improper transactions involved Milken and his department.

Giuliani Plays Hardball with RICO Threat

Giuliani began threatening to indict Drexel under the powerful Racketeer Influenced and Corrupt Organizations Act (RICO), under the legal theory that corporations are responsible for an employee’s crimes, which had yet to be uncovered or even alleged. The threat of a RICO indictment, which would have required the firm to put up a performance bond of as much as $1 billion in lieu of having its assets frozen, unnerved many at Drexel, including top management, as simply being indicted would have put the firm out of business, regardless of whether Giuliani proved his case.

Drexel’s CEO, Fred Joseph, observed at a meeting I attended that it had taken him some time to understand the difference between negotiating with a commercial counter party as compared to a government counter party. In the commercial case, the effort is to establish degree of damages done and agree on settlement, make reparations, and move on. The government counter party, on the other hand, did not want to agree on damages. What they wanted was to kill their counter party.

Soon his words would prove to be true. With little time to go before Giuliani planned to indict under RICO, Joseph reached an agreement with the U.S. Attorney in which it pleaded no contest to six felonies, including three counts of stock parking and three counts of stock manipulation. The firm also agreed to pay a fine of $650 million, at the time the largest fine ever levied under securities laws. It appeared then that both the SEC and Giuliani were having a hard time finding a smoking gun.

Milken Pleads, and NOT to Engaging in Insider Trading

Milken was indicted in 1989 and in a plea bargain pleaded guilty to securities and reporting violations but notably not to racketeering or insider trading. Milken was sentenced to ten years in prison, fined $600 million in a global settlement in which all recipients of the warrant strips mentioned above participated, and permanently barred from the securities industry by the SEC. His sentence was later reduced to two years.

Milken left the firm after his indictment in March 1989. In April 1989, Drexel settled with the SEC, agreeing to stricter safeguards on its oversight procedures, including appointment of three independent directors to its large board. No longer able to issue the controversial but effective highly confident letters, Drexel struggled to keep its franchise in high yield bonds alive without Milken. One result was that it did what it had never done before and offered bridge financing to a large client. Bridge financing is intended as a short-term vehicle to fund the transaction while the permanent financing is being put in place. This huge bridge loan placed added strain on Drexel’s ability to finance its operations.

And Drexel Fails

When on February 13, 1990, Drexel could not refinance $300 million of its own short-term debt, as it came due, the firm was advised by the Secretary of the Treasury, the SEC, the NYSE, the Federal Reserve System, and other investment banking firms that no rescue package would be forthcoming. The holding company Drexel Burnham Lambert Group, Inc. and various subsidiaries filed for Chapter 11 bankruptcy protection. It was then the largest and likely the most notorious bankruptcy to date.

As a fairly obscure employee who nonetheless owned stock, I initiated a grassroots organization of the other shareholders, all but one of whom were employees and few of whom had been any part of the small group that attracted regulatory and criminal investigations. I was fortunate to find in attorney Claude Montgomery a very able advocate willing to serve as counsel to the Equity Committee, which we succeeded in getting the bankruptcy court to appoint as a fiduciary for all Drexel shareholders.

And Restructures Its Own Board of Directors

In exchange for our committee’s support for certain company plans, we secured agreement from Drexel, now called the debtor in possession, to restructure the board to favor independent directors as a way to placate the enraged creditors and others who felt betrayed and humiliated and were extremely suspicious of incumbent management. Following protracted negotiations, two independent directors (Fred Zuckerman, former Treasurer of Chrysler, and Fletcher L. Byrom, retired CEO of Koppers, Inc.) whom I had recruited, and I took our seats, immediately thereafter, the SEC deem Drexel an inadvertent investment company required to be governed under the Investment Company Act of 1940.

Given that the shareholders were now dispersed to other jobs all over the Street, every sale transaction the debtor undertook involved a conflict resulting from the need to deal with what were defined as “affiliates” under the ’40 Act rules. The independent directors, therefore, had to make most portfolio decisions, and many operating ones. Recoveries to all parties exceeded expectations. The irony of Drexel’s influence in enfranchising disinterested directors by financing hostile takeovers and then needing disinterested directors to ride to the rescue during its chapter 11 proceeding is noteworthy.

Lasting Impact of Milken and Drexel Burnham

Drexel’s financiers were pragmatic dealmakers. But in their search for profit they brought about what The Economist called in an October 2010 article a democratization of access to credit. In its view, firms that previously had to rely on conservative banks or expensive equity were given the ability to raise funds by offering fixed-interest instruments in which the investors that Mr. Milken had cultivated had invested. This was a boon to the American economy: limiting capital to investment-grade firms limits economic progress. If a firm can pay the rate for its risk, it should get the money it needs.

Unloved as it was, Drexel changed the face of corporate finance and of Wall Street. Drexel has left four enduring legacies: a junk-bond market that has grown at least sevenfold since the firm’s demise; the firms and industries, from gambling to cable television, that owed their rapid expansion to Drexel’s high yield bonds; the lasting influence of the “Drexel diaspora,” the Drexel alumni, continuing leaders in the finance industry; and the acceleration of the rise of independent directors on America’s public company boards.

With outstandings in excess of $1 trillion in 2010, approximately 40% of all outstanding corporate bonds in America were rated as “speculative”, or below investment grade (BB+ or lower), according to Dealogic, a financial-data firm. Even better-class bonds are not as unassailable as they once were; many of the high-grade bonds issued since 1992 have since been rated BBB-, the lowest investment grade. Junk bonds, once despised, are now mainstream. And less noticeably but quite unmistakably, Milken’s financing power changed the face of corporate governance.

Private Equity Goes Public

As private equity reemerged in the 1990s it began to earn respectability. Although in the 1980s, many of the acquisitions made were unsolicited and unwelcome, private equity firms in the 1990s focused on making buyouts more attractive propositions for management and shareholders.

Although there had previously been certain instances of publicly traded private equity vehicles, the convergence of private equity and the public equity markets attracted significantly greater attention when several of the largest private equity firms pursued various options through the public markets. Taking private equity firms and private equity funds public appeared an unusual move since private equity funds often buy public companies listed on exchange and then take them private.

In 2007, Blackstone Group, for example, offered shares in its management company, allowing shareholders to share in its management fees and carried interest earned. In 2006, Kohlberg Kravis Roberts completed an initial public offering for a new permanent investment vehicle (KKR Private Equity Investors or KPE) listing it on the Euronext exchange in Amsterdam (ENXTAM: KPE). They raised $5 billion, alleged to be more than 3 times what they had hoped for, perhaps an indication of the popularity of private equity as an asset class in that the form of the vehicle offered investors otherwise unable to invest in a traditional private equity limited partnership due to size or other restrictions to gain exposure to a portfolio of private equity investments.