Many investors are scratching their heads this week over competing bids by two start-up telecommunications firms eager to pay upward of $32 billion to buy both baby-bell U S West Inc. and Frontier Corp. They are wondering where these new companies came from?

The upstarts -- Global Crossing Ltd. and Qwest Communications International -- went public less than two years ago. Yet they are already in a position to leverage their fiber-optic networks -- and rich stock valuations -- to swallow bigger fish and become global telecom giants.

One reason so many new ventures like these are forming and maturing so quickly is the rapid expansion of the market for venture capital and other forms of private equity investing. While the NASDAQ and other public stock markets get all the attention, the market for privately negotiated investing is growing much faster.

Unlike publicly traded stocks and bonds, a direct investment in a non-public company is exempt from registration with the Securities and Exchange Commission. On average, it is both riskier and more profitable. One reason: Information is scarce because only public companies face mandatory and standardized disclosures. Another reason: The investment is illiquid. Unlike a public stock or bond, investors typically tie up their money for as long as 10 years.

Greasing the gears of the new economy

The rapid expansion of private equity investing may be an unsung hero of this decade's record-long economic expansion. Companies typically raise capital privately because they cannot raise it through the public debt or equity markets. Private placements are a critical source of capital for start-up ventures, for mid-sized companies seeking to expand, for public firms raising buy-out financing, and for firms in financial distress trying to restructure.

Private placement equity is by far the fastest-growing source of corporate finance, raising more money for companies than initial public offerings or public high-yield bonds this decade. From 1980 to 1995, total private equity under management (which does not include sources such as "angel capital" by wealthy individuals) boomed from less than $5 billion to more than $175 billion, according to a Federal Reserve Board study. Growth is actually accelerating. Last year alone, total new commitments exceeded $85 billion.

As important as the overall growth in private equity has been its increasing emphasis on investments in private small and mid-sized firms. These middle-market firms (between $5 million and $100 million in sales) find it difficult to obtain expansion capital, especially if they are in relatively slow-growing or "low-tech" industries.

During the takeover and leveraged buy-out (LBO) frenzy of the late 1980s -- which did more to rearrange existing assets than it did to create new value -- LBOs absorbed about two-thirds of the private equity that did not go into venture capital, according to a Federal Reserve Board study.

This has completely reversed. From 1991 to 1995, nearly 90% of the $56 billion in non-venture direct investment went into established middle-market firms.

Plugging capital gaps

This trend could help narrow the capital gap between large public companies and smaller private firms. Young and small-growth companies were finding it tough to raise capital because the traditional sources of private placement lending -- commercial banks and insurance companies -- have been shrinking rapidly as a share of U.S. private-capital markets.

Pension funds have replaced banks and insurance companies as the nation's largest source of long-term investment capital. In 1980, for example, U.S. commercial banks held $1.5 trillion in financial assets -- more than twice the $700 billion in total private and public pension-fund assets. By 1997, pension-fund assets exceeded total banking assets by $500 billion.

Similarly, in 1980 insurance-company assets were almost as large as pension assets but now are only half as large. Pension funds currently invest a staggering $6.7 trillion.

Before 1980, however, pension funds were essentially prohibited from making venture-capital investments and other types of direct equity investments. A contributing factor to sluggish economic growth after the mid-1970s may well have been the shrinking availability of long-term risk capital -- a situation that reversed itself by the late 1980s.

Once the government lowered this barrier, big pension plans poured tens of billions of dollars into buy-outs, venture capital and especially into expansion capital for established private firms. A majority of the $85 billion in new money committed to private equity last year came from pension funds, most of it from the largest 100 corporate and public funds.

By their nature, pension funds are ideally suited to capture the premium returns that flow, on average, to less liquid private-placement debt and equity. Mutual funds and most individual investors put a premium on liquidity -- the ability to turn assets quickly into cash. But pension funds aspire to eternal life; they have large reserves and their payouts are predictable far in the future. As a result, the typical pension fund should be no more constrained to the public markets than the typical life-insurance company.

Leverage to negotiate extra benefits

Pension funds are discovering that direct investing also provides a way to target investments that generate extra benefits for plan beneficiaries, plan sponsors and local communities. One example is a $50-million biotechnology venture fund created in April by the Wisconsin Investment Board, the pension plan for state employees.

The fund is an effort to target investments in Wisconsin high-tech start-ups that historically have been overlooked by Silicon Valley and East Coast firms. Pennsylvania and several other public pension plans likewise target a portion of their private equity allocations to in-state small business development.

Another example is the stunning success of the Union Labor Life Insurance Company (ULLICO), which runs a pooled private equity fund for union pension plans. ULLICO's fund is up an average 100% per year since 1992. A big reason is that two years ago, it negotiated an $8 million private placement in Global Crossing. The telecom start-up went public last August, leaving ULLICO with stock valued at more than $1.6 billion -- some 200 times its cost. Because ULLLICO invests on behalf of union pension funds, it also seeks to influence corporate governance policies. Because companies that need private equity expect to negotiate terms, conditions related to a firm's labor relations and environmental practices are fair game.

At Global Crossing, management agreed to use a domestic, unionized company to lay its trans-Atlantic cable, to purchase most components from unionized manufacturers and to employ union seafarers on construction rigs. The bonus: 1,500 new union jobs on top of stellar financial returns.

Pension funds and private equity managers are quietly demonstrating that direct investing can yield both premium financial returns and even "social" goals. As even smaller institutional investors transfer a portion of their equity investments from the public markets to private placements, U.S. innovation and economic growth should benefit as the remaining "capital gaps" between public and private companies disappear.

Michael Calabrese directs the Public Asset Program at the New America Foundation, a non-partisan policy institute in Washington, D.C. His e-mail address is calabrese@newamerica.net.