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Private equity, Chicago style

by Matt Miller | Published November 29, 2011 at 1:29 PM

The upper floors of the sleek, 57-story 300 North LaSalle building offer breathtaking panoramas of the vast Chicago cityscape and the seemingly endless expanse of Lake Michigan. Those with bird's-eye views include many of the city's private equity shops, names such as GTCR LLC, Thoma Bravo LLC and Waud Capital Partners.

"You could meet with a lot of us without even having to change elevator banks," chuckles Thomas Bagley, the founder and senior managing director of Pfingsten Partners LLC, whose offices occupy the 54th story.

To understand the origins of the private equity firms at 300 North LaSalle and throughout Chicago, brave the wind and take a short jaunt south. Stroll across the Chicago River along LaSalle to another prominent building, 10 South Dearborn St., then jog a bit further to 231 South LaSalle St. The names of those two properties -- Chase Tower and the Bank of America Building -- serve to mask, rather than explain, a remarkably common past shared by much of Chicago's robust buyout establishment.

The singular tale of Chicago private equity can be told through this small patch of downtown real estate, a few trailblazers, most of whom still inhabit it, and two institutions that no longer exist except as memories, First National Bank of Chicago and Continental Illinois Banking Corp. PE in Chicago springs directly from these two banks, as lenders to other buyout and venture funds, as direct investors and as a training ground for most senior PE partners in Chicago today.

Allstate Insurance Co. provided the third major PE root structure. In the late '60s, the insurer claimed to be America's largest venture capital investor, but began to de-emphasize private equity about a decade ago and only recently revived its buyout operations.

For Chicago, this private equity genealogy plays an outsized role in a half-century-old financial history with critical economic ramifications to this day. "You appreciate what started here and what it's grown to become and the importance to the city," says Rob Ospalik, at 38 a relatively young partner at Baird Private Equity, a Chicago-based unit of Milwaukee financial firm Robert W. Baird & Co.

Chicago private equity is usually overshadowed by its bigger and flashier New York cousins; it shouldn't be. The business continues to be a vital, if understated, segment of a thriving regional economy. It reflects both the area's business landscape and its unique financial family tree. "People often talk about Midwest values. I think you find that inherent in Chicago-based private equity funds. It's a different value set," says Ward McNally, co-founder and managing partner of McNally Capital LLC, which manages and invests family offices' capital in both direct investments and private equity funds. "There's more willingness [in Chicago private equity] to hold on to something and let it ride, as opposed to taking on an investment in search of a quick win," says McNally. "That's just in the value stream of the people coming out of organizations" such as First Chicago and Continental Illinois.

Of course, the business is still evolving and maturing. A generational shift is taking place. Some of the industry's most-storied veterans are easing up and making transition plans. Younger principals, with no direct links to the original three institutional wellsprings, are gaining ground. New firms are forming, some of which come from entirely different traditions, including hedge funds.

"It's hard to isolate whether the ethos has changed," says Avy Stein, when asked to reflect on whether there's been a transformation in the industry. A co-founder and managing partner of 17-year-old Willis Stein & Partners, he got his start at Continental Illinois. "It's more a question of how the model is going to evolve," he believes. "The business is more professionalized, more institutionalized. The era of the generalist, if not over, is much tougher. It's much more competitive. The younger guys are a little less collegial."

Chicago private equity firms operate nationally, if not globally, in terms of funding, acquisitions and limited partners. Yet these firms reflect a distinctive environment. Most importantly, says University of Chicago Booth School of Business professor Steven Kaplan, Chicago private equity, like the city itself, remains heavily weighted to the middle market, with few of the megaleveraged buyouts that characterize New York. Chicago is "more of a growth equity kind of place," he says.

"Midwest private equity funds really focus on operational improvements as opposed to financial improvements," adds Maura O'Hara, who heads the Illinois Venture Capital Association, most of whose members are private equity firms. "There's a belief that there's more opportunity for that in the middle market."

In other words, the firms say, they want to leave the companies they buy better off when they sell them than when they acquired them.

That reflects a cultural tendency. "This has always been a middle market-savvy, buyout city," says Eric Larson, who now heads Linden LLC, a healthcare-specific private equity shop, but who for many years worked in First Chicago's buyout operations and headed First Chicago Equity Capital, the last iteration of the bank's PE efforts. "The West Coast culture, New York, with its extension of the Wall Street dealflow, they have different ways of understanding risk," he says.

Chicago private equity is undergoing some shift in focus. That, say Larson and others, plays to Chicago's strengths as well: Today the preferred approach stresses not just operational expertise, but sector-specific knowledge.

Brian Miller, another Linden managing partner, recalls how he left Chicago for a two-year stint at Harvard Business School. When he returned in 2002 to help found Linden, he discovered the generalist approach to buyout shops in decline. "Specialists, [using] a focused team working with operating knowledge, this was the new model."

"We see it from our client base. They really want to know where their money is going. Institutions have asked for the same transparency. That has forced GPs to be very focused and specialized," says McNally, whose family owned a majority stake in mapmaker Rand McNally & Co. for more than a century.

McNally himself came out of Continental Illinois and spent several years with Chicago private equity group Edgewater Funds. "In the old days, it would have been one fund making healthcare and industrial investments, and an investor would have made a $10 million commitment. Now it's a $5 million commitment to each specialized fund."

While Allstate was one of the country's first venture capital investors and First Chicago was an early investor in VC mainstays such as TA Associates Inc., Summit Partners LP and Primus Capital, that didn't translate into local venture firms scaling up. Especially for a city its size, Chicago to this day lacks a prominent venture capital presence.

A number of those in private equity strain to explain this, citing everything from the growing capital dominance of Silicon Valley to the sheer number of startups in the Valley and other technology powerhouses. T. Bondurant French, who heads Adams Street Partners, cites the heritage of Chicago private equity itself. These were "generalist firms that invested across industries and stages, since in the Midwest -- relative to Silicon Valley -- there were more later-stage growth equity and buyout opportunities than early-stage technology opportunities."

O'Hara suggests fund size inhibits growth, which creates a self-dampening cycle. "In Illinois we don't have strong support from the LPs for venture funds. Funds here remain small," she says. So "they can't invest in follow-on."

However, the success of Chicago's latest darling, Groupon Inc., has Chicago's financial denizens wondering whether there will be change afoot here as well. "There has been a Groupon effect on this town for sure," says McNally. "We see more venture firms coming into town to not only look for transactions but to raise money and to just see what's going on."

Groupon has spawned at least one new Chicago venture capital firm. Last year, early Groupon investors Eric Lefkofsky and Brad Keywell co-founded Lightbank, with $100 million of mostly their own money. Lightbank has funded Chicago-based startups Sprout Social Inc., OpenChime Inc. and Pawngo Inc., but also startups in Manhattan and Michigan.

To understand Chicago's private equity industry, it's necessary to go back at least a half-century. Most trace the industry's antecedents to the creation of the Small Business Investment Co. program in 1958, which allowed a bank to underwrite what were thought to be "risky investments." Two of the original participants were First Chicago and Continental Illinois. That activity became known as venture capital.

Over the years, the two major Chicago banks gained investing expertise. In 1970, an amendment to the Bank Holding Company Act allowed the use of bank shareholder funds up to 5% of consolidated assets for outside investments. First Chicago was an early backer, for example, of FedEx Corp. Continental Illinois invested early on in Apple Computer Inc.

Stanley Golder headed up First Chicago Capital Corp. and successor firm First Chicago Investment Corp. His counterpart at Continental Illinois was John Hines, the longtime president of Continental Illinois Venture Corp. and Continental Illinois Equity Corp. Along with Allstate's Ned Heizer, they pioneered Chicago's private equity development, although Golder is most often considered the city's PE patriarch.

"All tracks lead back to one guy: Stan Golder," says Linden's Larson. "He was the lion in Chicago."

Carl Thoma joined First Chicago Investment Corp. in 1974. He says the bank made some great investments in the '70s. "The track record at First Chicago was excellent," he recalls. "We did exceedingly well on buyouts."

The next big milestone came in 1976, with the emergence of Kohlberg Kravis Roberts & Co. LP. Jack Levin, 75, is a longtime senior partner at big Chicago law firm Kirkland & Ellis LLP who was working with private equity long before the term was coined. He counseled both Golder and Hines. His office is still in 300 North LaSalle, a dozen or so stories down from some of the firms he and his colleagues continue to advise. (Kirkland & Ellis has developed what is probably America's largest private equity practice. According to Levin, the firm has 270 lawyers around the globe engaged in private equity-related work.)

Levin sounds a bit like a schoolteacher as he explains a key piece of private equity history, the first fund formation. "The very first ones to go out were three guys named Kohlberg, Kravis and Roberts. They were at Bear Stearns," Levin begins, as he describes how the firm one day discovered the plans, threw out the partners, "locked their offices and posted armed guards. They were left adrift."

The three got in touch with both Hines and Golder, both of whom agreed to have their banks invest in the fund. As Larson tells it, Golder not only gave the trio money, but office space as well, in First Chicago's New York digs.

As Thoma explains, the Chicago financier William Blair, who founded the predecessor firm to William Blair & Co. LLC in 1935 (he died in 1982), approached Golder in the late 1970s about a Chicago-based fund. Golder and Thoma spun out their own firm in 1980. Originally Golder Thoma & Co., the firm expanded with the addition of partners Bryan Cressey and Bruce Rauner, morphed and divided over the years. In February of this year, GTCR closed a $3.25 billion fund. Of the original partners, only Rauner remained at the firm for the celebration. Golder died in 2000. Thoma now heads Thoma Bravo. Cressey leads Cressey & Co.

After Golder and Thoma exited, John Canning Jr. took over at First Chicago Investment, and, say those in the industry, oversaw several more years of successful investing.

However, after the savings and loan debacle of 1990, banking regulators revised the definition of what were then called "highly leveraged transactions," which necessitated increased capital requirements. The bank balked. Canning and his team spun out of First Chicago Venture Capital in 1992 to form Madison Dearborn Partners LLC, with the bank as a lead investor.

Madison Dearborn is today Chicago's largest buyout shop. Fund VI, its latest, closed in May 2010 with $4.1 billion, although that's less than half the $10 billion the firm originally projected in 2007.

Madison Dearborn is also the one Chicago private equity firm to move into the realm of megabuyouts. Its timing, however, proved terrible. In 2007, at the height of the market, Madison Dearborn acquired Chicago-based money management firm Nuveen Investments Inc. for $5.75 billion and computer products marketer CDW Corp., based in nearby Vernon Hills, Ill., for $7.3 billion.

Canning, now chairman, and other executives didn't respond to requests for an interview.

First Chicago didn't exit private equity completely. In 1991, the bank set up First Chicago Equity Capital -- the names are confusing -- which used bank capital to make smaller, middle-market buyouts. Larson headed that operation. First Chicago Equity Capital outlived the various mergers that First Chicago underwent and became a foundation for One Equity Partners, which is now J.P. Morgan Chase & Co.'s PE arm. The shift from First Chicago to Bank One and J.P. Morgan Chase triggered a slew of new firms and new funds. Water Street Healthcare Partners, for example, came from One Equity Partners' healthcare practice.

Madison Dearborn itself helped spawn other private equity firms. Linden, for example, started in 2001 with office space and some funding from Madison Dearborn. Its first independent fund closed in 2005, with $200 million. Its second fund closed last year, with $375 million.

The ability to rise above the pack is much harder these days as the pack has grown larger. It wasn't always that way. French's firm, for example, is primarily a fund-of-funds. French, 59, recalls the early days of investing in venture funds when he was with First Chicago. "In 1979, when we started investing, we'd find the best venture fund in Atlanta, the best one in Minneapolis. They were local, just as Chicago was local. A venture fund in Atlanta was just not going to do a deal in Seattle."

That changed dramatically in the '90s. Now, he says, "it's hard to draw a circle around any geography. Capital flow is going in all directions. NEA [with offices in Silicon Valley and Maryland] is probably the most active venture here. They have no Chicago offices."

More fundamentally, Chicago today lacks large locally based banks, a real departure from the days when LaSalle Avenue was studded with powerful Chicago institutions. As a city, it has suffered through a series of consolidation waves. Chicago had traditionally been a unit banking city, meaning its major banks had few branches and few retail deposits, forcing them to serve a predominantly corporate, wholesale market -- not a bad business considering the region's commercial vigor.

In May 1984, Continental Illinois suffered a run after losses from a tiny, if go-go, oil-and-gas bank in Oklahoma, Penn Square Bank NA. Many feared Continental Illinois would fail, and the Federal Deposit Insurance Corp. stepped in, arguably the first bailout of a too-big-to-fail bank. Continental Illinois eventually emerged, paid off the FDIC and operated successfully as the wholesale Continental Bank. In 1994, rapidly expanding San Francisco-based retail powerhouse Bank of America Corp. acquired Continental (BofA was acquired by Charlotte, N.C.-based NationsBank Corp. in 1998).

First Chicago didn't last much longer, though with a little less drama it did survive the colorful reign of former Occidental Petroleum COO A. Robert Abboud, who was sacked in 1980, and a merger with NBD Bancorp Inc. (the old National Bank of Detroit) in 1995. First Chicago NBD Corp. merged with Bank One Corp. in 1998 (temporarily retaining the headquarters in Chicago), and was then swallowed up by J.P. Morgan Chase in 2004.

The consolidation continued. In 2007, BofA acquired LaSalle Bank Corp., which had been owned by ABN Amro Bank NV since 1979. Then in July of this year, Harris Bank, which Bank of Montreal had acquired in 1984, merged with Wisconsin's Marshall & Ilsley Corp., retaining its Chicago headquarters.

How all this affected the growth of Chicago private equity is a matter of considerable debate. With a near-constant revolving door of bosses, power struggles and managerial and strategic shifts, the ownership changes certainly made running the banks' own private equity operations more difficult. "I once had four business cards in two years," says Bill Drehkoff, another Linden partner who came out of First Chicago private equity.

The turmoil produced defections and a kind of private equity diaspora. That may have diffused the talent across Chicagoland, but it severely curtailed the transmission of institutional knowledge through the banks, say veterans of First Chicago and Continental.

"The training was disrupted," says Larson. "That was devastating."

Equally important was the prominent role First Chicago, Continental Illinois, LaSalle and Harris banks once played as financiers of private equity transactions, critical to the middle market, which was their preferred turf. The term "Chicago mafia" came to describe the city's midmarket financiers.

How much the loss of headquarter banks has affected the broader Chicago economy is also a hot topic. Views differ. "The banking landscape is radically different than it was 20 years ago," says Pfingsten Partners' Bagley. He, for one, takes his business to banks in Wisconsin, Ohio, Pennsylvania and Missouri.

Others argue that the city continues to be a funding source. "There's enough liquidity here to make everyone honest," says Christopher Williams, senior managing director and co-founder of Madison Capital Funding LLC, a Chicago-based subsidiary of insurer New York Life Insurance Co. with $4.4 billion under management. Madison Capital primarily provides senior debt financing, but also does some co-investing and fund investing, all in the middle market. Williams hailed from Continental Illinois.

Brendan Carroll is a partner at Victory Park Capital, a relatively new private equity firm formed in 2007. He doesn't see the lack of a money center bank -- that is a bank with a large wholesale business, a term rarely used today -- headquartered in Chicago a problem. Carroll begins to list current middle-market lenders in Chicago: LaSalle, homegrown PrivateBancorp Inc. -- now manned by LaSalle refugees -- Madison Capital, American Capital Ltd. and GE Capital Corp.'s two major Chicago acquisitions, Heller Financial Inc. and Ares Capital Corp.

"That's how this city grew up," continues Richard Levy, Carroll's partner, who sits in a facing chair. "They weren't competing for the New York deals. They continue to do what they know."

French's firm reflects both the changes in Chicago private equity and the links to a shared institutional past. Adams Street Partners began life as part of First Chicago's trust department in 1972. In 1978, Congress reduced the capital gains tax, and regulators clarified what is commonly called "the prudent man rule." The result was that pension funds began pouring capital into private equity.

"We were seeing dealflow in Chicago become much more challenged," French says, "so we started to co-invest with some of the [PE] principals we knew well." French called the resulting fund-of-funds "the first in the world."

In 1989, management, led by then-chief investment officer Gary Brinson, bought out the bank's institutional assets, with the bank as a major investor. Six years later, Swiss Banking Corp. acquired Brinson Partners. Two years after the two big Swiss banks Union Bank of Switzerland and SBC merged in 1998, another management buyout led by French took control of what was still called the venture group. The new firm launched on the corner of Adams Street and LaSalle. Adams Street Partners now inhabits offices in what is commonly known in Chicago as the UBS Tower.

With $22 billion now under management, Adams Street is 90% a fund-of-funds, with investments in many of the large venture and private equity funds. The remaining 10% is directly invested. Of that, 60 venture investments are now on the books, and 15 buyout firms.

French marvels at his firm's continuity, despite changes in ownership. "I've been here for 31 years," French says. "We have the same clients."

Despite the demise of its two biggest banks and numerous ownership changes, Chicago private equity has benefited from a remarkable degree of continuity, which may be a testament to the city itself. "Chicago is a much more closely knit community" than New York, says Bagley, who believes the city's entire private equity universe may consist of no more than 400 individuals. "We either worked together or did business together," he says.

Madison Capital's Williams describes how often he still runs into the old gang, at Gibson's Bar & Steakhouse, at a Bulls game, at the Union League Club, even at the local Equinox gym working out at lunch.

But both recognize the generational shift. "The next generation in Chicago will come from existing private equity firms, not financial institutions spawning private equity like they did 20 years ago," says Bagley.

"You used to see bankers who covered private equity migrate to [private equity]. You don't see as many people taking that path," says Williams. "Now you see private equity pull the smart kids out of Midwest schools, train them for two years, teach them modeling, boot them out to grad school. Some are going to come back."

Change, in fact, is at the gate. The partners at Victory Park, for example, trace their roots to hedge funds, specifically Magnetar Capital LLC, based in Evanston, Ill., the home of Northwestern University, just north of the city. "We don't come from a traditional private equity fund," says Levy, who formed the firm in September 2007.

For one, Victory Park invests in distressed companies, eschewing the traditional Chicago model, which favors healthy businesses. "We're very comfortable around the Bankruptcy Code," says Levy.

This month, Victory Park led the $62 million purchase out of Chapter 11 of the Giordano's Enterprises Inc. pizza chain. In May, the firm bought regional airline Gulfstream International Group Inc. out of bankruptcy for approximately $28 million.

"What we do is different," says Carroll. "We are called a private equity fund, but one-third of the time we're only a lender; one-third of the time we start as a lender, like what we see and invest; one-third of the time we truly act as a private equity sponsor."

The firm just raised a $480 million traditional private equity fund.

Veterans say they're finding it harder to figure out who's who. "From where I sit," says Thoma, from the conference room of his 43rd-story office in 300 North LaSalle, "there's a whole new group. Maybe up until 10 to 15 years ago, everyone knew each other. We've been around a long time. We worked together one way or another. In that sense we were kind of joined at the hip."

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