The free flow of capital into innovative start-up businesses has been the force behind U.S. economic growth, but threats to the nation’s dominance in global investing are brewing, according to Robert E. Grady, managing partner of Carlyle Venture Partners, who gave a keynote address at the recent Wharton Private Equity Conference.

Increased regulation, including Sarbanes-Oxley, declining investment in education and research, tighter controls on visas, and new competition from overseas exchanges could endanger U.S. dominance of capital formation and investment, Grady told the conference, whose theme was “Driving Returns: Value Added Investing.”

“American policy makers should realize that for 35 years the technology sector, the startups and the venture sector have been the job-creating engine of the U.S. economy. It does not necessarily have to be so, and it will not be so unless we make the right policy choices,” Grady said, noting that in 1970, only 28 venture firms managed $1 billion in investments, but by 2004 those numbers had grown to 1,068 firms with $261 billion under management. Meanwhile, private equity buyout firms had $503 billion under management, up from $187 billion in 1997.

Venture investing, he said, has spawned new companies that have generated jobs and economic growth. Even during the soft economic period between 2000 and 2003, job growth at venture-backed firms was up 6.5%, while overall U.S. employment dropped 2.3%. “If you look at the roots of U.S. economic out-performance for the last couple of decades, I would put the availability of risk capital just about at the very top of that list,” said Grady, who is also chairman-elect of the National Venture Capital Association. With 72% of the world’s venture capital managed by U.S. firms, the industry gives the nation a competitive lead over other countries, he added.

Grady suggested that the private equity industry is now entering a new era, with megafunds raising the stakes for fund managers and investors. A survey of 109 institutional investors by Coller Capital, a private equity firm headquartered in London, found that 44% plan to increase their allocations to private equity, compared to 30% six months ago.

The buzz generated by private equity was noticeable even at the World Economic Forum in Davos last month. Martin Halusa, chief executive of Apax Partners, told The Times of London that funds as large as $100 billion, enough to take some of the world’s largest companies private, could be raised in the next 10 years. “The private equity industry is set to grow hugely,” Halusa said. “It has delivered better returns than many other asset classes and institutions are increasing their asset allocations.”

In other Davos coverage, The New York Times reported on a dinner — titled “Escaping the Market’s Tyranny” — attended by top global private equity fund managers, including Daniel Loeb, hedge fund manager of Third Point. According to the Times, Loeb asked why buyout firms can take public companies private and reap huge returns, beyond what public companies and their shareholders are able to attain. Loeb suggested private-equity firms are essentially arbitraging the public markets and “appropriating profits that should belong to public shareholders.”

Yet despite the new focus on private equity, Grady told the Wharton conference participants that for now, it remains a modest player in U.S. equity funds, which total $4.4 trillion, including $8.1 billion held by mutual funds and $1.3 billion by hedge funds. He did note, however, that private equity transactions as a share of all mergers and acquisitions rose from 14.7% in 2003 to 17.7% in 2004. “Private equity is becoming more of a force.”

And he sees no signs of a bubble. “I would say in the venture capital industry we are at a normalized place in the cycle … a healthy, but appropriately healthy, part of the cycle.” He did point to one indicator that concerns him: Financial firms, such as private equity and hedge funds, are paying as much, or more, than strategic buyers for companies. Traditionally, strategic buyers — typically companies working in the same industry — have been willing to pay a premium.

The Pace of Globalization

Grady suggested that future investment will be shaped by three major trends: innovation, globalization and convergence. “Despite wild asset swings, the innovation never stopped,” he noted. For example, Internet users have grown 20-fold between 1995 and 2004, while the number of cell phone users is expected to grow from 1.5 billion in 2004 to 2.2 billion in 2009. Innovations shaping the near future include wireless connections to the computer, the use of cheap open-source technology, software for the service industry, and the integration of technology and healthcare, he said.

The pace of globalization is evident in a Carlyle portfolio company, AuthenTec Inc., which makes fingerprint scanners. The company, based in Melbourne, Fla., has only 60 employees but designs products in Finland, France, California and Korea. AuthenTec’s products are manufactured in Shanghai and sold to large multinational customers, including LG, Fujitsu, Hewlett-Packard and Toshiba.

“Think about this,” said Grady. “A company in central Florida with 60 employees is 100% integrated into the global supply chain.” Not too long ago, it would have been usual for a company that size to have business in the next county. Globalization of capital markets is also shaping investment. Even in China, domestic financial firms are beginning to sprout up. “The growth of the Chinese ecosystem is phenomenal.”

Meanwhile, convergence in technology is creating demand for investment capital. For example, Grady noted that in Korea, cell phones display television and movies, can be used as an ATM or credit card and can receive traffic information. If an owner loses his or her cell phone, the phone can tell the owner its location.

Changing financial structures for transactions have created new paths for private equity, Grady suggested. As the IPO market moves toward fewer and larger deals, gaps are opening up for private equity. And while many private equity firms are raising large funds to finance bigger transactions, some venture funds that once worked with mid-sized private companies are shrinking back to focus on venture capital and early-seed companies.

Despite those opportunities, Grady, who worked in the Office of Management and Budget under President George H.W. Bush, pointed to policy issues that he said could put a damper on the U.S. investment industry and eventually on the broader economy as well. For example, government regulation, such as accounting rules requiring companies to treat stock options as an expense, will have a chilling effect on entrepreneurship. In addition, the expense of complying with Sarbanes-Oxley legislation is a major burden on young companies.

Constraints on investment analysis and research will also hurt small firms that need to get their story out to investors. According to Grady, Wall Street firms have dropped 30% of the companies they cover and for which they make markets. “Less research and less trading brings less equity and fewer listings, ultimately leading to fewer companies and less funding for innovation,” he said, adding that disincentives to investment may drive companies to finance in other markets. London’s Alternative Investment Market (AIM) had 519 listings while U.S. exchanges had 11. The Mumbai exchange now has 7,000 listed companies. “It does beg the question, ‘Will the U.S. continue to be the home of finance?'”

Grady pointed to several policy prescriptions. First, increase spending on basic and university research, and reform elementary and high school education, particularly teacher pay. He argued that in half the states, the best K-12 teachers are paid the same as the worst teachers. “Education is the only industry I can think of where if you are any good, its 100% irrelevant to your compensation and ability to keep your job.”

Second, he called for liberalization of caps on working visas and a reduction in spending for so-called entitlement programs — such as Medicare and Social Security — to free up resources for investment. Third, government should pay more attention to building infrastructure to support economic growth, including roads, telecommunication systems, energy and water. The environment for company formation needs to be improved, he said, again pointing to stock-option expensing as a strong disincentive to entrepreneurs. He also called for a flat tax.

In addition, the U.S. needs to make a new commitment to free trade and open markets. China has signed dozens of bilateral agreements and the United States has signed five, he noted. Meanwhile, last year U.S. officials thwarted China’s attempt to buy a U.S. oil company, Unocal Corp. “We should be the advocates for free trade, not the free-trade blockers. In a world of free flowing capital and people, free trade is critical.”

How to Beat the Crowd

Thomas S. Murphy, Jr., co-founder and president of Crestview Partners, who delivered a second morning keynote at the conference, had his own take on the private equity market. With established private equity firms raising larger and larger funds and new competitors swarming into the sector, companies need a disciplined approach in order to remain standing in the crowded field. “The world needs another private equity firm like a gunshot,” said Murphy, a former partner at Goldman Sachs & Co.

Despite that, he added, big private equity firms will get bigger, leaving room in their wake for new companies like Crestview, which was formed in 2005. “The drift to the megafunds in our business is pronounced. We think that creates a lot of opportunity for other people to step into their place.” Crestview focuses on contrarian investments with an eye toward change due to dislocation by new technology, services or products.

In the current hot market, it is essential to avoid deals where the price has been bid up in an auction process beyond what projected returns can justify, Murphy said. In 2005, for example, Crestview took an initial look at 146 investments. Of those, the firm followed up on 30 and submitted a proposal for 10. In the end, the company signed three deals. “It’s a competition, but there is still room to make money” for firms that are disciplined about the deals they choose. “If you don’t have deal flow, you are going to have a temptation to say ‘Yes.’ The ability to say ‘No’ is much more important.”

Cell Phones Will Rule

For private equity investors willing to take on risk to make money and end poverty, Africa is a wide-open investment opportunity, said Alan Patricof, co-founder of Apax Partners, in a luncheon keynote at the conference. Patricof, who helped launch Apple Computer, America Online and Office Depot, scaled back his work at Apax four years ago to devote time to nurturing economic growth in the developing world. “The most important issue I can think of for this century is the alleviation of poverty.”

With a population more than double that of the United States, Africa offers vast growth potential. “The opportunities are enormous and the availability of capital is limited,” he noted, adding that funding for small projects, including microfinance loans, is available in Africa, and larger investments are being made by multinationals. “But if you need $1 million or $500,000 or $250,000, there is nobody.” Economic development, he said, is the best way to combat terrorism. “If people have jobs and are working, they don’t have time to throw bombs, and if the people around them are working as well,” they, too, don’t have time for terrorist acts.

Patricof also reflected on the most recent boom and bust cycles in the United States investment market. The worst is over, he said. “The opportunities are out there. The returns are better and there is not an enormous crush of companies.”

The biggest trend in investment will be continued developments related to cell phones, he predicted. In addition to television and computer screens, the cell phone is a new screen that will generate technology and media opportunities. “If you can develop content that is creative with some risk to it, there will be insatiable demand for [it] to fill these screens.”

As for government regulation, Patricof said small companies may be overly burdened by SEC requirements, and he argued that the venture capital industry has a relatively unblemished reputation when it comes to dealing fairly with investors. But he is concerned about the growth of unregulated hedge funds. “There is a lot of money going into hedge funds and maybe there are people there who shouldn’t be [there]. Maybe it needs extra supervision.”

While some private equity firms have been able to deliver returns of 30% to 40% for investors, Patricof said that type of payoff will be even more difficult to achieve in the future. Still, he added, investors can expect returns in the low to upper teens, which will likely outpace the stock market. “Even if you can earn 10%, that looks attractive.”