In December 1998, as Silicon Valley was teeming with engineers who had quit their day jobs to chase the dot-com dream of IPO riches, a group of four tech-industry veterans made what at the time seemed like a wrong-way bet: that going private would be the next big thing for technology companies.

With Internet startups from Pets.com to Webvan to BBQ.com littering the landscape, tech seemed more lucrative, and more risky, than ever. But David Roux, Jim Davidson, Glenn Hutchins, and Roger McNamee didn’t see it that way. The four banded together and risked $112 million of their own money, plus about $400 million from tech executive acquaintances, on the premise that tech businesses were mature enough to generate steady, predictable returns.

“Our big insight was that the new economy was just like the old economy,” says Mr. Roux. While private equity investors had steered clear of technology because they worried that earnings and cash flow were too volatile, the average tech company in the 1990s was boosting revenues by 15 to 20 percent a year, he says—six times as fast as the overall U.S. economy. Even larger, more established tech businesses were growing 10 percent a year.

Instead of trading equity for cash, it was time for technology companies to fuel growth by increasing debt loads, the four thought. After a day of mogul-hopping on the ski slopes outside Salt Lake City, the partners shook hands and borrowed the name of a nearby fishing hole to launch Silver Lake Partners, the first buyout firm focused exclusively on tech.

Leveraging Experience

The four figured they collectively had enough experience and understanding of the technology industry to make better calls than just about anyone else in the private equity business.

The firm has helped bring leveraged buyouts—once the province of old-economy industries such as food and tobacco—to the high-tech world. Just as IPOs have been the lifeblood of new technology companies for the last couple of decades, SilverLake’s efforts are now helping LBOs breathe new life into older technology. And along the way, such deals are making boatloads of cash for the investors who bankroll them and the financiers who engineer them.

Mr. Roux, who had served in executive positions at Lotus Development and Oracle after earning a master’s degree in economics from CambridgeUniversity and an M.B.A. from HarvardUniversity, had the operational experience.

Mr. Davidson came from Hambrecht & Quist, where he headed the investment bank’s technology banking business, and Mr. Hutchins had spent years in the private equity business, first at Thomas H. Lee Partners and later at the Blackstone Group. Mr. McNamee, a private equity veteran who co-founded Integral Capital Partners and served as a technology fund manager at T. Rowe Price, has since stepped back from SilverLake to focus on Elevation Partners, a media and entertainment-focused private equity firm he co-founded in 2004.

Seven years after placing their audacious bet, the partners pulled off the largest technology buyout—and the third-largest leveraged buyout—in history, with their $11.6-billion deal to take data-management software maker SunGard Data Systems private.

Undervalued Companies

SunGard had everything SilverLake looks for. It was a market leader with healthy cash flow, a large customer base, a tested management team, a strong brand, and a division or two with spin-off potential. Even better, from the buyout shop’s point of view, the company was undervalued by the public markets—and it had a low debt-to-equity ratio, so it could be loaded up with long-term debt to finance a buyout.

“It’s clear to anyone in the business that there are good businesses out there that the public markets might be undervaluing,” says Ben Bisconti, a managing director at Accel-KKR, a buyout firm that specializes in purchasing closely held, often family-run technology companies.

The leveraged buyout burdened SunGard with $7.7 billion in long-term debt, up from the $509 million showing on the company’s balance sheet at the end of 2004. But the company has plenty of cash flow to cover the debt-service costs, and the deal gave it the flexibility to make further acquisitions without worrying about short-term Wall Street analysts’ expectations.

“Finally, we have shareholders with the same kind of long-term view and long-term horizon as our employees and clients,” says SunGard CEO Cristóbal Conde. “We can do a lot of things we could not do as a public company.”

That’s a refrain often repeated by companies going private, and to a certain extent it rings true for SilverLake’s deals. The firm’s portfolio companies have a track record of being able to pump up spending on research and development, capital investments, and customer support—in stark contrast to the typical LBO playbook, which has often called for slashing expenditures on new product development, as well as cutting jobs and dumping pension plans to slice costs.

“There is more of an emphasis on the process of growing or at least sustaining the company on a technology basis in these buyouts than would have been the case in a traditional old-economy company,” says Josh Lerner, a professor of investment banking at HarvardBusinessSchool. “SilverLake has executed brilliantly with this.”

More than applauding the firm’s ability to make money, Mr. Lerner suggests buyouts can be good for the industry. “When you look at both the operating success as well as the financial returns, it’s hard not to argue that they’ve been fairly attractive to date,” he says of SilverLake’s deals.

And with companies heavy on cash, the time is ripe for firms to take on more debt, says Mirko Mikelic, a senior portfolio manager at Fifth Third Asset Management in Grand Rapids, Michigan. “In the last 50 years, this is the most cash companies have had on their balance sheets,” says Mr. Mikelic, who oversees $14 billion in bond investments. “Firms have been reluctant to lever up, but now is probably time.”

In It for the Long Haul

To show SilverLake’s commitment to long-term growth, Mr. Davidson cites the example of Seagate Technology. “The first two quarters they were private, they missed their numbers,” he says. The typical response of a leveraged buyout sponsor “is to slash costs and get the profitability back,” he says.

And crush capital spending, interjects Mr. Roux.

Instead, the firm gave Seagate’s managers the green light to ramp up R&D spending and speed up the consolidation of its plants into three main manufacturing centers. The result? Seagate could eventually make any of its seven disk drives on any factory line, slicing costs and allowing it to adjust its product mix on a dime whenever markets changed.

“We could do a 160-gigabyte drive for the same cost, maybe even cheaper, than somebody else could do a 120-gigabyte drive,” says Mr. Davidson. “That’s actually kind of an amazing value proposition for customers.”

Adds Mr. Roux: “It required an act of financial courage to make an investment that would not pay off in the next quarter or the next year.”

R&D spending at Seagate jumped from under $600 million in 1998 to almost $800 million in the year after the buyout, allowing it to pump cash into developing technologies that can store 500 times more information on a single disk, and 12 times more on a micro-drive.

Those investment decisions weren’t made without a struggle, concedes Seagate CEO William Watkins. “I look at the world and say, ‘we can’t save our way into prosperity,’ and Dave Roux goes, ‘yeah, but you can spend your way into disaster,’” he says.

Although SilverLake closely scrutinized Seagate’s spending plans—and Mr. Watkins’ proposal to build what he called “the factory of the future”—the new owners nearly always backed management’s strategies in the end, according to Mr. Watkins.

“They’re really good at that one big decision: ‘We either have confidence in management or we don’t,’” he says. “If they don’t, they replace them.”

Seagate was a winner, returning $1.9 billion so far on SilverLake’s equity investment of $324 million—not counting another $800 million worth of stock the firm still holds.

Not every SilverLake bet pays so handsomely, though.

The firm’s biggest flop was a $180-million investment in SubmitOrder.com, which handled inventory management and order fulfillment for e-commerce companies. Not long after SilverLake decided to back it, the market for technology stocks crashed. And then K-Mart, its biggest customer, went bankrupt and SubmitOrder eventually folded.

Not that SilverLake skimps on research. Every Monday morning, partners in the firm’s Menlo Park, California, office file into a room walled with straw-colored rice paper, and seat themselves around a polished eucalyptus-wood table to review portfolio performance and talk about deal prospects.

Via videoconference, partners in London and New York City virtually join the California group in what Mr. Roux calls “our little Zen temple of capitalism.” Managing directors with ideas circulate a “green sheet,” a brief analysis of a possible deal. Files on prospects getting an initial nod are moved on to a team that takes a deeper look at financial, management, technology, and other details to get a clear picture of their key strategic issues.

Out of 100 or so deals that make it this far, 25 or 30 move on to due-diligence full-court press, a process that consumes thousands of man-hours and can involve more than 100 people, including outside lawyers, accountants, and tax advisers.

The Payback

At the end of that process, “it’s typical for us to be spending a million dollars a week evaluating and analyzing the opportunity,” says Mr. Roux.

In a busy year, the firm might do three, maybe four, deals out of the more than two dozen that come up for serious consideration.

SilverLake has earned a gross internal rate of return of 32 percent on its $2.3-billion first fund, allowing its founders to indulge their passion for basketball by buying stakes in their favorite teams. Mr. Roux and Mr. Hutchins each own a share in the Boston Celtics, Mr. Davidson a stake in the Golden State Warriors.

The firm collects management fees of between 1 and 1.5 percent on the committed capital in its portfolios, though it pays those fees back after the portfolio becomes profitable. Once that happens, SilverLake pays its investors a profit, and then takes 20 percent of the profits for itself.

Once SilverLake fully sells off its stakes in all the portfolio companies of its first fund, it should come close to tripling investors’ money. Assuming it realizes such returns, the firm would rake in a profit of about $920 million on the fund. Distributed evenly, that kind of cash would make every one of SilverLake’s 63 employees—even the secretaries—a millionaire more than 14 times over.

Do the pension funds and university endowments that invest in private equity funds balk at such arrangements? They wouldn’t if they used venture capital firms as a comparison. U.S. buyout funds raised $86.2 billion last year, and posted one-year returns of 32.5 percent in the third quarter, far outpacing the 19.7 percent returns for VC funds during that period.

SilverLake is likely to capture some of that flood of investor cash this year. Sources familiar with the firm say that with its SLP II fund already half invested, the firm is likely to raise a new fund later this year even larger than SLP II.

Global Ambitions

Making no secret of its global ambitions, SilverLake sent managing director Egon Durban to London to open an office last fall. The partners had gotten their feet wet in Europe two years earlier, selling business intelligence software maker Crystal Decisions to Paris-based Business Objects for $840 million.

Mr. Durban, who joined the partnership in 1999 from Morgan Stanley’s investment banking group, sees European tech companies as less mature than their U.S. counterparts and therefore less likely candidates for pure buyouts. He also thinks that Europe’s pro-labor environment can get in the way of deals. “In the U.S. there’s always a mantra that they’re doing the right thing if they’re creating shareholder value,” says Mr. Durban.

Thus, he sees a different kind of opportunity for the partners, what he calls value arbitrage. For example, he says, a mid-cap Norwegian tech company might be listed only in Norway. “French investors don’t touch you. German investors don’t touch you,” he says. And therein lies the opportunity: making it more broadly accessible to raise its value.

SilverLake had a rocky start in Europe. It lost out on two big deals last year—one involving Spanish mobile telephone operator Amena (which France Telecom took for $12 billion). They dropped out of the bidding for TDC, a Danish telephone operator; that deal has not been settled.

SilverLake also has designs on Asia, being a major investor in Seagate (which has a massive Asian presence). Last summer, the company signed former IBM CFO John Joyce as an investment partner. Mr. Joyce previously ran IBM’s Global Services business and spent seven years in Tokyo. He also engineered the sale of IBM’s PC business to China’s Lenovo.

He says SilverLake will soon be recruiting “advisors” in Japan and China to help identify opportunities in Asia. SilverLake measures its profile by how many of the major tech deals it participates in, says Mr. Joyce. “We want to build up that same kind of brand in Asia.”

He thinks the partners’ long-term approach should play well in Asia. Mr. Joyce says he first approached Lenovo chairman Liu Chuanzi about selling IBM’s PC business in 1999—and five years passed before that deal was done. “That’s the type of pace you have to be willing to adhere to when you’re trying to do something [in Asia].”

Being patient isn’t to be confused with being slow. Because SilverLake’s investments crisscross so many segments, the firm is brilliantly positioned to spot trends and act accordingly. Little known to most people is the fact that it is Singapore’s largest private employer—thanks to its interests in Seagate, Avago, a carve-out of Agilent’s semiconductor unit, and contract manufacturer Flextronics. “We’re very much exposed to Asia,” says Mr. Hutchins.

“One of the great advantages that we have is in the portfolio of companies we’re investing in,” he adds. “[They’re] at the forefront of technology.” A look at the Flextronics order book, for example, gives a very good idea of cell phone pickup and how many base stations are being installed.

“The only way you can get to scale with technology companies is to be global, and so your business has to, by design, be global,” says Mr. Hutchins. “We get, oftentimes if we do our jobs right, venture-like opportunities embedded in the company as a result of some new product or application or geography. We call it ‘two ways to win.’”

Talk about having their cake and eating it, too. “The genius of the private equity and technology industry is that we get the downside protection that comes from private equity, and the upside opportunity that comes from venture,” says Mr. Hutchins.