By Doug McInnis
American business runs on money. Without it, the best inventions will never become tomorrow’s promising startups, and even mature businesses will wither and die. But the sources of business financing are rapidly changing. Hundreds of billions of dollars from private equity financing have poured into the business world, bringing about a fundamental restructuring of the American economy in ways that should help U.S. businesses profit in the blistering competition of the global economy.
“Private equity investment is huge,” says Dan O’Connell, a 1968 graduate of the University of Illinois and director of the Golder Center for Private Equity and Entrepreneurial Finance at the College of Business. “It’s everything from investors who finance the guys working in their garage on what may become the next Apple Computer to the group of investors involved in international transactions. And it’s everything in between.”
You only have to look down the road from the College of Business to see how the concept of private equity funding is being put to work to reshape the economy. The University’s Research Park on the south edge of campus is home to 50 companies that employ nearly 1,000 people. Many of these companies are startups working to commercialize technologies that originated in labs at the University of Illinois, which has gained a reputation as one of the nation’s top ten invention factories. The money for many of these startups comes from Illinois Ventures, a private equity firm with offices in Chicago and Champaign. The firm draws its capital from the University, the state of Illinois, and from private and institutional investors. By helping to jump-start the tech companies of the future, Illinois Ventures is helping to grow new companies that will replace old-economy jobs that are being lost.
“We’re active in life sciences, information technology, and the physical sciences,” says John Banta, a 1983 graduate in finance and the CEO and managing director of Illinois Ventures. “But we’re particularly interested in areas where those domains converge. That’s where interesting problems tend to get solved, because people who don’t normally work together do work together. And that’s where the real innovation takes place in areas like energy, advanced materials, new media, and specialized software.”
Moreover, the fund takes an activist role in funding innovation. “Traditionally, universities have relied on an approach where ideas were thrown out into the marketplace and then they would see which ones stuck,” explains Banta. “We look for problems that need a solution, and then we go to universities and federal laboratories and see if they have technologies that might solve them.”
According to Murillo Campello, an associate professor of finance, the United States is about the only country where you could have this kind of emergence of the private equity market. “In America, complete strangers are willing to look at someone else’s idea,” he says. “They can come in with plenty of money and make the thing a reality.”
Campello, whose teaching focuses on international corporate finance, explains: “Other countries do use private equity, but not to the extent found here. That gives the United States an edge.”
Something Old, Something New
New firms looking for startup capital aren’t the only beneficiaries of private equity funding. Old-line firms are also being reshaped through leveraged buyouts (LBOs), which are often partially financed by a pool of private equity capital.
Giant LBO specialists, such as Kohlberg Kravis Roberts & Co. or the Carlyle Group, for example, may swallow a company in its entirety, or they may buy a division or subsidiary of a large company looking to shed a unit that no longer fits its corporate goals. After the buyout takes place, private equity may take an active role in trimming fat or selling off units that don’t fit.
“Private equity makes U.S. firms more efficient and that helps them compete in the global economy,” says Michael Weisbach, who holds the Golder chair in corporate finance at the University and serves as academic director of the College’s Golder Center for the Study of Private Equity and Entrepreneurial Finance.
Because the investment is privately done, private equity investments aren’t subject to the same pressures for quarterly profit growth as investments made by public firms. This is an advantage because it allows firms financed by private equity to seek substantial long-term growth rather than simply trying to better the previous quarter’s results. This strategy allows fragile startups to develop their products and find a place in the marketplace without pressure from bankers or investors for quick results. It is an ideal arrangement to nurture the new economy.
In many ways, private equity is the polar opposite from most bank lenders. “A bank loan officer is not trained to know much about the fundamentals of the businesses they finance,” says Campello. “They think in terms of red light, green light. Banks look at accounting ratios (an indicator of a company’s financial health). They think in quarterly terms, never more than a year. Private equity investors think in terms of three years to five years and beyond depending on the type of investment. With private equity, you’re more involved with the idea behind a venture, rather than accounting ratios.”
But there is a price. Private equity firms often insist on a hefty ownership stake in the firms they finance.
For private investors, the rewards are potentially huge. So too are the risks. “When you invest in a startup, the investment may go nowhere,” says Weisbach. “You’re betting on a home run. You’re looking for the next Google.”
With that in mind, it’s not surprising that the major players in private equity deals include wealthy individuals and institutional investors such as pension funds. Typically, though, these investors only put a portion of their portfolios into private equity. The balance tends to be in safer investments.
Tending to the Herd
Private equity is not without controversy because reshaping old-line companies often means fewer jobs, at least in the short term.
“The hardest thing a private equity investor has to do is shrink a company,” says the Golder Center’s O’Connell. “Really good private equity investors realize they are dealing with human beings. They do not casually shrink a company because they understand the impact. The good investors say, ‘We can either have a lingering death for all 1,000 of a company’s employees, or we can let 200 or 400 of them go so that the other 600 can survive and prosper.”
So as the years have passed, private equity has given life to countless new companies and reshaped many others. O’Connell likens private equity to tending a herd of cattle over the long term. “There are two things you have to do to keep the herd healthy. The first thing you need is new calves. The venture capitalists provide the cash for that. The other thing that’s needed is to tend to the existing herd. The buyout guys do that by finding ways to make old businesses more efficient.”