Chapter 2 Part 1: How the USA Built the Private Equity Machine
Chapter 2 of Demaria’s book opens with a fun question: is modern private equity a French invention? The word “entrepreneur” is French. The guy who basically created modern venture capital, Georges Doriot, was French. But he did it in America. At Harvard, not in Paris. That tells you something about where the conditions were right.
This chapter is split into two big sections. The first one covers how the USA built the system that made private equity work. That is what we are looking at today.
Scandals First, Then Rules
Before the 20th century, big projects like railroads and canals were funded by a messy mix of political and private money. Politicians picked winners, investors got cozy with government officials, and the whole thing was ripe for corruption. The Panama Canal project in France was one of the biggest bribery scandals of that era.
Western democracies eventually decided this was not going to work anymore. The solution? Separate public policy from public money. Stop letting the same people make the rules and hand out the cash.
In the USA, this started with the War Finance Corporation in 1918. Originally set up to fund war industries, it got repurposed for agriculture and railroads. The key idea: create structures with controls so public money does not just flow to whoever has the best political connections.
Small Business Gets Its Own Agency
During World War II, Congress created the Small War Plants Corporation to help small companies participate in the war effort. This was a big deal. For the first time, the government recognized that small businesses matter for national interest and deserve dedicated support.
After the war, this thinking kept going. The Small Business Administration (SBA) was born in 1953. The SBA did not just hand out loans. It ran educational programs and helped entrepreneurs learn how to actually grow businesses.
Then in 1958, Small Business Investment Companies (SBICs) were created. This is basically the unofficial birthday of the modern venture capital industry in the USA. The Federal Reserve had said it plainly: small businesses could not get the credit they needed to keep up with technology. SBICs were the answer.
But here is the thing Demaria points out: Silicon Valley was not built overnight. The government’s role had a “stop and start” pattern over two decades. It was not some clean master plan. It was messy, inconsistent funding that somehow worked out.
DARPA: When Defense Spending Creates the Future
The Cold War changed everything about where money went. Defense got the biggest slice of public spending, which meant defense led the way in research and development.
DARPA (originally just ARPA) was created in 1958 as a direct response to the Soviets launching Sputnik. The agency ended up inventing some of the most important technologies of the modern era: hypertext, computer networks, the graphical user interface. You know, the stuff that eventually became the internet and everything you use on your computer today.
This shift from infrastructure budgets to defense spending had a huge effect on entrepreneurship. It created both the ideas and the market for them. Defense contracts gave small companies actual customers, which is just as important as giving them money.
ERISA: The Rule That Almost Killed PE
Not everything the government did helped private equity. In the 1970s, the stock market tanked. IPOs dried up. Investors were stuck holding investments they could not sell. Returns were terrible.
Congress responded by passing ERISA in 1974, which told pension fund managers to stop taking big risks. Since private equity was considered high risk, pension funds basically stopped investing in it. In 1975, venture capital funds raised a grand total of $10 million. That is nothing.
It took until 1978 for ERISA to get clarified so that pension funds could invest in PE again. Around the same time, capital gains tax dropped from 49.5% to 28%. Lower taxes meant better net returns for investors, which made it easier for VC firms to raise money. These two changes together reopened the floodgates.
Universities and the Defense Connection
Doriot set up ARD at Harvard in 1946. Location mattered. He chose America over France. He chose Harvard and never tried to replicate it at INSEAD, the European business school he co-founded.
ARD’s biggest win was investing in Digital Equipment Corporation (DEC), created by two MIT engineers. MIT and Harvard sit in the same Boston area, so the network effect was real. When DEC went public in 1970, it showed the world what venture capital could do: fund a tiny startup and take it all the way to the stock exchange.
Doriot’s former ARD people went on to start their own firms, spreading the model. Eventually, this energy moved to the West Coast. Silicon Valley grew even stronger than Boston because it had more diverse local industries and less dependence on military contracts.
Universities feed the whole system. They produce the talent, research, and deal flow. Alumni networks help VC firms find opportunities and grow their companies. And because universities have defense research contracts, the VC world stays connected to government-funded innovation.
The Israel Model: A Different Approach
Demaria spends time on Israel as a comparison. With 8.7 million people, Israel has over 1200 investment structures and 8000 active tech companies. The connection between military service and startups is direct: students graduate, do 2-3 years in the military working on real technology, keep the intellectual property, then go start companies.
Instead of copying the American model, Israel built its own version and plugged it into the US system when needed. Israeli startups get early funding locally, then re-incorporate in the US to access bigger VC money and eventually list on NASDAQ. Companies like Waze, Check Point, and Mobileye came out of this pipeline.
The Challenges Nobody Talks About
Despite all the success, Demaria lists real problems with the US model.
The patent system is a mess. It over-protects minor improvements and lets patent trolls sue innovators. When you are a VC trying to fund incremental improvements to existing technology, dormant patents that suddenly get activated against your portfolio company can kill your returns.
Building startups keeps getting more expensive. The “lean startup” idea sounds nice, but it mostly works for non-critical consumer apps. Medical tech, infrastructure software, mission-critical systems? You cannot ship a “minimal viable product” and hope for the best. On top of that, talent hubs like Silicon Valley and Boston are victims of their own success. Rents and salaries keep climbing, but you cannot just move startups to cheaper areas because VC is a local business. Fund managers need to be close to their companies.
And after the 2000 dot-com crash, venture capital returns were mediocre for years. Too much money chasing too few good deals, valuations getting inflated, exit options drying up. Demaria even hints that the situation in 2019 (when the book was written) might be heading toward a similar cycle.
The Takeaway
The USA did not become the center of private equity by accident. It took decades of public policy, defense spending, university networks, and some lucky timing. But the model has real limits: patents, costs, geographic concentration, and boom-bust cycles.
The key lesson from Demaria: there is no universal formula. The American model works because it grew out of American conditions. Israel found success by building its own version instead of copying someone else’s homework.
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