Where The Smart Money Is Flowing The dream team of tech investing spent two years on the sidelines. Now Silver Lake is getting back in--and Wall Street's watching.
By Adam Lashinsky

(FORTUNE Magazine) – Technology's malaise still hangs like a cloud over Sand Hill Road, the epicenter of venture capital investing in Silicon Valley. For three years entrepreneurs have trekked to this set-back strip of glass-and-dark-wood-hued buildings in Menlo Park, Calif., to pitch ideas, only to walk away empty-handed. Many of the investment bankers who set up shop in the late 1990s to feed off the deals have left town. If Sand Hill Road wore a mood ring, it would surely be glowing black.

Except in the offices of Jim Davidson. Davidson is a former semiconductor banker at Hambrecht & Quist and a founder of Silver Lake Partners--a buyout fund that raised $2.3 billion by being considered the dream team in tech investing. The other founders include Roger McNamee, a top venture-capital and hedge-fund manager; Dave Roux, a former senior executive at Oracle and Lotus; and Glenn Hutchins, who abandoned buyout heavyweight Blackstone Group to start the firm. In 1999 the four bucked conventional wisdom that said debt-heavy tech deals couldn't (or at least shouldn't) be done. When the returns came in, they had roughly doubled their investors' money. Now the team is again out to prove it knows better: For the first time since 2001, Silver Lake is pumping money into tech.

"We're geared up for what we think will be pretty good times," says Davidson, reclining on a couch in his corner office, a Segway "human transporter" parked a foot away. He looks out the window at the major investment banks and venture firms within view. "Everyone around us hears that and says, 'What are you smoking?'"

Whatever it is, investors want some. Plenty of false prophets have tried calling tech's turn almost since the Nasdaq started plunging in March 2000. But Silver Lake thinks it sees bottom, and this time people are listening. Despite a handful of early (and costly) missteps, the firm has proved that it's willing to take big risks. Silver Lake made nine investments, totaling $1.3 billion, between its founding in mid-1999 and early 2001. And then it stopped. That's right. Even as stock prices were collapsing, presumably creating attractive buying opportunities, Silver Lake tended to its existing portfolio and otherwise sat on its hands. But early this year it ratcheted up the investment machine again. First it took a $200 million stake in contract manufacturer Flextronics. Then it bought $177 million of public debt in bankrupt telephone carrier WorldCom (more on these bets later).

Today Silver Lake is scouring the tech landscape for new investments, especially in areas ripe for consolidation such as software, services, and telecom. Its requirements are simple: Any deal must need more than $50 million in equity, involve a market leader--Silver Lake doesn't think of itself as a turnaround shop--and be firmly rooted in the technology world, where the partners have an edge. Besides hunting new deals, Silver Lake is also bulking up. Ed Zander, former president of Sun Microsystems and one of the most sought-after executives in Silicon Valley, is coming aboard this summer. And the firm is adding a chief operating officer, Alan Austin, formerly a partner in the venture firm Accel Partners. All this activity--plus the fact that Silver Lake has invested about 75% of its original fund--appears to signal that the firm is planning on raising a second multibillion-dollar fund, most likely toward the end of the year. (Silver Lake won't comment on fundraising plans.)

So why invest now? McNamee offers three reasons. First, tech stocks appear to be priced about right. With the Nasdaq recently at 1500--down some 70% from its March 2000 peak--the bust survivors are far less expensive than they used to be. More important, he says, the intelligence from Silver Lake's portfolio companies--most notably Seagate, the disk-drive maker it took private in 2000 and public again in December--suggests that things have stopped getting worse for market leaders. And if you believe, as Silver Lake's partners do, that the exuberance that drove up tech stocks now is working in reverse, things begin to seem pretty good. "People dramatically overinvested on Y2K," says Davidson. "Now people are saying they'll never invest in technology again. That's just crazy. It's silly to think businesses won't want to differentiate themselves. And technology is the way to do that."

But tech represents something else to many investors: an alternate universe where fundamentals never mattered and companies behaved differently from the rest of the economy. Silver Lake's optimism is based on the idea that that universe has been obliterated. Technology companies have to make profits now, just like other businesses. "This isn't creating a new physics," says McNamee of doing tech LBOs. "This is applying Graham and Dodd to an industry that previously wasn't mature enough. The laws of economics now apply."

When Silver Lake started, high tech was in its wild West days--choosing when and whether to apply economic laws. The idea of doing an LBO or even applying leverage to a tech deal seemed crazy. Typically buyout firms snap up big stakes in companies by taking on minimal amounts of equity and huge dollops of debt. To service the debt, the takeover target must have either easily disposable assets or predictable cash flows. Tech businesses seem to have neither: The most important assets of a technology company, as the cliche goes, walk out the door at the end of each day, and the industry's volatility traditionally has made a shambles of predictability.

Roger McNamee didn't see things in the conventional way. He was one of the financiers of the tech boom--in 1991 he started Integral Capital Partners, a firm that did venture and public investing and that scored big with early bets on Intuit, Rambus, and the Cisco-acquired Cerent. But by 1998, McNamee was already fretting publicly that the tech bubble couldn't be sustained, and he reasoned that if valuations collapsed, there'd be better buying opportunities. McNamee quickly started looking for like minds and teamed up with Davidson, as well as with Roux, who was then head of business development under Larry Ellison at Oracle. Roux brought in Hutchins, his undergraduate classmate at Harvard and a Democratic Party fundraiser who'd done a brief stint in the Clinton White House working on the infamous health-care reform plan. The foursome convened just before Christmas 1998 on a ski trip to Deer Valley, Utah, and agreed to move forward (literally) while on a run above Silver Lake Village. By May 1999 they'd raised $2.3 billion from a Who's Who of the technology world, including Ellison, Michael Dell, and Bill Gates--as well as corporate pension funds and university endowments.

The partners quickly assumed roles they continue to play: McNamee the visionary and idea man; Roux the operations guru, portfolio company coach, and firefighter; Davidson the Silicon Valley financial expert; and Hutchins the architect of LBOs and other complex instruments tech investors typically don't touch.

For all those pedigrees, their early deals were duds. Three of Silver Lake's first four investments weren't traditional buyouts but rather injections of "growth capital" into private companies or spinoffs of big companies looking for dot-com capital. The biggest flop was a $200 million stake in Submit Order, a unit of a distribution company called Digital Storage. Submit Order set out to be the Internet fulfillment center for established retailers. Its largest customer? Kmart. Submit Order is no longer around.

A better bet was Silver Lake's investment in Gartner, the Stamford, Conn., tech-research firm. Silver Lake was a voracious consumer of Gartner's research, but the company's business had stalled. Viewing Gartner as a way to get in on tech without wagering on chips or software, Silver Lake in April 2000 purchased $300 million of convertible debt. It also insisted on a so-called reset provision, enabling it to convert its stake into more common shares if Gartner's stock tanked. It did. But by the end of 2002, Silver Lake's repriced investment was worth $435 million. "When I saw them do that, I thought, 'These guys know what the f----k they're doing,'" says Jay Jordan, CEO of buyout firm Jordan Co. and chairman of the investment committee at the University of Notre Dame's endowment, an investor in Silver Lake.

Still, Silver Lake hadn't proven itself as an LBO shop. "A good LBO portfolio has one good winner, one loser, and a bunch of singles, doubles, and triples," says Hutchins. The firm needed to swing for the bleachers, which is where Seagate came in. Seagate's CEO, Steve Luczo, had long been frustrated that Wall Street awarded little value to his company's disk-drive business, even though it delivered fairly steady cash flow. A former investment banker, Luczo had been talking informally to McNamee since 1998 about solutions. At the time a stake Seagate owned in software maker Veritas was worth more than its main business; Luczo and his investors wanted to buy the company, distribute the Veritas shares to Seagate shareholders while they were high (Veritas shares were trading above $100, compared with around $24 today), and take the rest of Seagate private. The trick was finding investors who wanted into a notoriously cyclical business like disk drives.

"Our business is an odd one," says Luczo. "If you're behind in technology, the answer isn't that you cut expenses or capital. It's that you add expenses in the form of R&D and add capital. This isn't intuitive to the guys buying bottling plants and whatnot."

The self-described "tech weenies" at Silver Lake got it right away. Working with the company's existing management and recruiting smaller investments from Texas Pacific Group, August Capital, J.P. Morgan, and Goldman Sachs, the firm invested $382 million in August 2000 and took three seats on its board. That enabled Roux, Davidson, and Hutchins to foster a constant flow of financial and industry information between Seagate's management and Silver Lake's analysts. Just over two years later, with the disk-drive industry buoyant as a result of a brutal consolidation, Seagate went public again. Today the firm's original stake is worth about $1.8 billion, including about $400 million of IPO proceeds that have been distributed to Silver Lake investors. Silver Lake also owns a third of a Seagate spinoff called Crystal Decisions, which is widely expected to do an IPO before the year is out.

Suddenly Wall Street is paying attention to the foursome again. Even competitors are watching with admiration. Says Thomas Lee, head of the eponymous Boston buyout firm where Hutchins once worked: "They've got quite a sweet spot, and Seagate has proved that."

A few months after taking control of Seagate, Silver Lake pressed PAUSE. Its hands were full, and the market still seemed overpriced. Now it's ready to invest again, and a curious thing has happened: Tech executives are as eager to work with Silver Lake as the partners are to make new investments. For example, Silver Lake bought $200 million in convertible debt in Flextronics in February. Shares of all contract manufacturers are down, a result of industry overcapacity and slowdowns by buyers. Flextronics' big customers include Cisco and Hewlett-Packard, and Silver Lake figures that if it's right about a turnaround, market leader Flextronics is a bargain at the bottom of a cycle. For its part, Flextronics gets access to Silver Lake's partners, investors, and investments--even if it doesn't particularly need the money. "They're knowledgeable people, and you can only get so much time over cocktails," says Flextronics CEO Michael Marks, who has known McNamee for years. (Actually Marks gets a little extra face time with some Silver Lake partners: Along with Seagate's Luczo, he's an investor with Hutchins and Roux in the group that recently bought control of the Boston Celtics.)

The firm's riskiest recent bet, however, is on WorldCom, now called MCI. By buying debt during the bankruptcy process, Silver Lake has made the same contrarian wager on telecom that it did three years ago on disk drives: The market hates the sector, but Silver Lake thinks it will win by investing in a leader. "Four years ago we told people we wouldn't touch telecom," says Roux. The valuations were too high, the business models too unproved. Then, about a year ago, the firm started methodically studying a group of about 50 shattered telecom-services companies, trying to figure out which would survive. After winnowing down the list to WorldCom, they began studying how to invest. The company would be valuable once its debt was restructured under bankruptcy, they reasoned, because of its sophisticated network and long-term customers, especially the U.S. government. But WorldCom's management was a mess. That changed when former Compaq CEO and HP president Michael Capellas was named CEO late last year. Roux, who knew Capellas at Oracle, called him and said Silver Lake was interested in investing.

Silver Lake's injection has been a welcome boost for Capellas. Like him, the partners are tech guys. They also know finance, and although Roux initiated the investment, Capellas and Hutchins were talking daily during negotiations. "They've been hugely helpful to me," says Capellas. "They've helped me understand the players in the process. After all, I haven't been through this before."

MCI is just the start. With the addition of Zander, whose departure from Sun in July 2002 set Silicon Valley guessing where the perennially rumored CEO candidate would land, Silver Lake has even more connections in the tech world. "The tectonic plates of consolidation are really coming together, for the first time in my 30 years in the business," says Zander. "These guys do the big stuff. You get to see the big picture here."

That they think the big picture includes a tech rebound is obvious from the excitement at Silver Lake's glass-windowed midtown Manhattan outpost. It's dinnertime on a Tuesday in mid-April, and the partners--in New York for a regular internal meeting--are gearing up for a long night. Zander is passing through, getting to know some of the younger staff members. Hutchins, in suit and cuff links, is unwinding after a day attending a WorldCom creditor's meeting. And McNamee is fretting about finding the right bluegrass band for Silver Lake's June annual meeting in North Carolina. He's also doing what he's been doing in one way or another for nearly 20 years--evangelizing about tech: "Technology has become so embedded in the economy that people would no sooner give up their cellphones and PCs than they would give up their toilets."

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