A Bad Case Of Venture Capital Envy

LBO funds are starting to pile into high-risk Internet deals

The world of leveraged buyouts has never been glamorous. It's about finding down-on-their-luck companies, piling them up with debt, siphoning off cash flow, refocusing management, and flipping them to make a bundle. Mundane, maybe, but a formula that has worked like a charm: Annual returns, after fees, for top-drawer funds averaged 22.7% over the past 20 years, vs. 19.7% for the Standard & Poor's 500-stock index.

These days, though, the funds are seeking, well, sex appeal. LBO houses from Hicks, Muse, Tate & Furst Inc. to Forstmann Little & Co. are starting to pile into high-risk Internet deals. That's a dramatic departure from their typical highly leveraged deals. But it's no mystery why they're changing tack: In 1999, LBO returns were just 15% compared with 90% for early-stage venture capitalists. And the trend will accelerate. "More and more funds are making Internet investing a part of their portfolio, adding to the confusion of their investors," says Jesse Reyes, managing director of Venture Economics, a Newark (N.J.) firm specializing in private-equity research.

Indeed, some LBO investors are more than just confused--they're downright nervous: "My primary concern is whether LBO funds have the [necessary] expertise, or are they learning on our nickel?" says David Locke, senior investment officer of the Los Angeles County Employees Retirement Assn., which invests $1 billion in LBO funds.

The LBO guys, of course, insist they can switch readily from Old Economy industries to the Internet. But their wildly differing strategies suggest that they're still feeling their way.

The most zealous of the new breed is Thomas H. Lee Co. in Boston, a $5 billion LBO shop that has just raised over $600 million to start a separate Internet fund. The firm hired eight Net specialists from General Electric Capital Services Inc. to oversee the fund. "While we are not constrained by our LBO charter, smaller, early-stage investments are more appropriate for a different fund," says founder Thomas H. Lee.

At private-equity fund Kohlberg Kravis Roberts & Co., however, Henry R. Kravis and some of his top execs have made several early-stage investments out of their own pockets rather than use their funds' cash for riskier deals. But the LBO fund has also made Net and telecom investments, albeit in bigger, more mature companies such as CAIS Internet, a provider of broadband Net access.

STILL LEERY. Some LBO players have few qualms about mingling higher-risk Net deals with traditional buyouts. Dallas's Hicks, Muse's private-equity fund invests about 75% of the $7.5 billion it manages in LBOs. But over the past three years, it has made $100 million in early-stage Net investments--though all of them have been in partnership with traditional venture-capital firms.

However, many LBO funds remain leery of the latest fad and how customers would react should they follow it. Vestar Capital Partners, a $2.5 billion buyout fund, for instance, has foresworn Internet investing. "That's stretching our charter beyond what investors intended," says CEO Dan O'Connell.

Skeptics such as Lawrence Schloss, head of Donaldson, Lufkin & Jenrette Inc.'s merchant banking activities, who oversees $6 billion of LBO funds, doubt that the LBO world and Net investing will ever really meld. "The sun doesn't shine on the same dog every day," he says. When the stock market corrects, he forecasts, the LBO guys who strayed will quickly return to business as usual.

Maybe so. But, for now, LBO players are scrambling to find their place in the Internet sun while it lasts.

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