Friday, September 09, 2005

In keeping with a long history of internal turmoil.

Where stealthily waged civil strife is a way of life.

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The myth of China Inc - Chinese industry and the state

1,533 words
3 September 2005
The Economist
ECN
376
English
(c) The Economist Newspaper Limited, London 2005. All rights reserved

The scare stories—and the chaotic reality

AS HU JINTAO, China's president, flies to America this month, commercial ties between the two countries are at a new low. Alongside tensions about China's currency, its growing trade surplus with America and intellectual-property theft, is a new concern: the aggressive international expansion of China's corporations.

In Washington, the $18.5 billion bid by CNOOC, a mainland oil producer, for Unocal, a Californian rival, was portrayed not as a commercial deal, but as a state-funded grab for strategic American assets. It triggered such political opposition that CNOOC abandoned its bid. The FBI has just launched an initiative to expose economic espionage by visiting Chinese students and businessmen. And in Congress, Richard D'Amato, a Democrat and the chairman of the US-China Economic and Security Review Commission, worries aloud that Chinese firms listing shares in America are siphoning American money into a “China bubble”. Nor is concern confined to the United States. India's security bureau is reportedly considering restricting the expansion in India of Huawei, a Chinese telecoms-equipment maker, over its suspected military ties.

The real scaremongers assert that the Chinese state is a single—and single-minded—entity with a master plan to reclaim China's rightful place at the centre of the world. China's companies are thus mere tools of an expansionist policy propagated by Beijing's leadership. More subtle are the fears that, because it is impossible to untangle the ownership of most Chinese companies, foreigners cannot be sure to whom they are selling. When the ultimate authority could be the Communist state, that is a worry.

The Chinese government certainly wants to create globally competitive firms and it is pushing some to secure strategic resources, like oil and metals, overseas. The Chinese state also still has a broad influence over business. But the chaotic way this power is exercised contributes to the weakness, not the strength, of Chinese firms. “It is not a plausible argument that China Inc can take a co-ordinated Long March overseas,” argues George Gilboy, a professor at the Massachusetts Institute of Technology and, until recently, head of strategy for Shell in China. “It can't even manage that domestically.”

After two decades of reform and privatisation, only about a third of China's economy is still directly controlled by the government through state-owned enterprises (SOEs). But these are concentrated in key sectors like defence and utilities. While many of the biggest state firms have publicly quoted subsidiaries on international stock markets, the government retains ultimate ownership—one of the objections raised against CNOOC. The top 190 or so SOEs are directly controlled by the State Assets Supervision and Administration Commission (SASAC)—set up in 2003 to restructure these often moribund firms.

And yet even this group of elite companies is not guided by a single, controlling hand. Take telecoms: China's early decision to deregulate the sector and break up the state monopoly into four competing firms—two fixed-line (China Telecom and China Netcom) and two mobile (China Mobile and China Unicom)—was widely admired. It made China the world's largest telecoms market and created fat profits for operators. Yet Beijing's bureaucrats now threaten to undo this good work. Frightened by the growth of new services and a price war, they recently forced the bosses of the four firms to take each other's jobs to discourage competition, to the amazement of some independent directors.

Infighting among bureaucracies with competing agendas crops up again and again across China's industrial landscape. It made life so difficult in the power industry, that some foreign investors quit in disgust, causing power shortages. Overseas investors have been equally befuddled in the media sector, where joint-ventures promised over the past two years are suddenly off the agenda. The media regulator, SARFT, which also oversees cable television operators, is battling MII, the telecoms regulator, to prevent the big telecoms operators from launching competing internet TV services. That SARFT happens to be the last of four stamps of approval needed to obtain a licence could cripple the industry before it is born.

Battles between competing branches of central government are overlaid by struggles between central government and local officials, who want to protect jobs in their own backyard. In a country with a saying “the hills are high and the emperor is far away”, edicts from Beijing are routinely ignored.

The contrast with Japan is stark. The Japanese government had less direct control over its corporations, but its officials co-ordinated their domestic development before earmarking sectors for overseas expansion. The Chinese bureaucracy, while in direct charge of more of the national economy, is riven by factional infighting.

Unhappily, the resulting chaos is also hurting the most promising two-thirds of the economy that is in private hands. Private companies are often beholden to state banks for capital and to local officials for favours and contracts. Since private enterprise was not even acknowledged until 1988, entrepreneurs had to bring state investors aboard as political protection, becoming so-called “red-hat” companies. Yasheng Huang, a professor at MIT, says that the results can be disastrous: “Government shareholders may be passive at first, but once a company succeeds, they interfere. Countless Chinese firms have been driven to bankruptcy or failed to grow big because local governments decided to exercise their legal claims on ownership.”

Take Kelon, a refrigerator maker. Currently on the brink of collapse after an embezzlement scandal, it once was China's best firm. With the help of its tiny township government in Shunde county, its founders, Pan Ning and Wang Guoduan, turned it from the 42nd-largest fridge maker in 1984 into China's biggest in six years. Focused management and marketing flair (Chinese people put fridges in the living room to impress visitors, so Kelon made the smartest models) led to a Hong Kong listing and global awards. However, in the late 1990s, Guangdong's provincial government forced Kelon to take over a loss-making SOE air-conditioner maker at an exorbitant price. Because Mr Pan and Mr Wang had not shifted ownership to Hong Kong, Guangdong officials could force the Shunde shareholders to fire them and appoint a bureaucrat to replace them. He then rapidly ruined the company.

Now, worryingly, something similar may threaten Haier, China's leading white-goods maker, which recently failed with a bid for Maytag, an American rival. Admired globally for its efficiency and innovation, Qingdao-based Haier is the creation of Zhang Ruimin, China's most famous entrepreneur, who transformed a company so demotivated that its workers used to urinate on the factory floor. Yet Mr Zhang has just lost a long fight to reward his managers with shares via a Hong Kong listing. Late last year SASAC ruled that Haier was owned by the Qingdao government and that management buy-outs at big SOEs were forbidden. Compare that with Legend (now Lenovo), which bought IBM's computer business—it escaped state influence and has flourished. A “red-hat” company, it was originally banned from selling personal computers in China, so went to Hong Kong to export, set up a joint venture and obtained a Hong Kong listing. Although it returned to China to manufacture, its production and research facilities are registered as Hong Kong affiliates, not with Legend China, and it is reducing the share owned by its state sponsor. Mr Huang of MIT argues, “there is nothing domestic about Legend except the nationality of its managers. It is as foreign in China as GE.”

Reasons to be fearful

Foreign fears about the expansion of Chinese firms are often compounded by the murkiness of their ownership. Take Huawei, a telecoms firm that is the most global of any Chinese company, and also among the least transparent. Although technically private, its shares are probably owned by local state telecoms customers. It also has a $10 billion credit line from China Development Bank, famed for its loans to support state policy. Its founder, Ren Zhengfei, was a former People's Liberation Army officer. But the fact that no one knows who runs Huawei could weaken it. It has grown fast in a booming market, but its unclear ownership means it cannot easily get a stockmarket listing, nor reward staff with stock options. It may also hinder plans for overseas expansion—like a rumoured bid for Britain's Marconi—since potential foreign partners will be wary of a firm with such an opaque ownership structure.

Fears that Chinese firms are acting as the commercial arm of an expansionist state are thus belied by a more complicated and disorderly reality. The real reason to fear China's overseas expansion is quite different. Because Chinese firms have grown up in an irrational and chaotic business environment, they may export some very bad habits. As Mr Gilboy puts it: “when Japanese companies took over American ones, they mostly made them better. If the Chinese run foreign firms like they operate at home, driving prices down, misallocating capital and over-diversifying, that is genuinely something to fear.”

Why America dominates higher education.

Because of its organization--or lack thereof.

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Secrets of success

2,565 words
10 September 2005
The Economist
SUN
English
(c) The Economist Newspaper Limited, London 2005. All rights reserved

Secrets of success

America's system of higher education is the best in the world. That is because there is no system

IT is all too easy to mock American academia. Every week produces a mind-boggling example of intolerance or wackiness. Consider the twin stories of Lawrence Summers, one of the world's most distinguished economists, and Ward Churchill, an obscure professor of ethnic studies, which unfolded in parallel earlier this year. Mr Summers was almost forced to resign as president of Harvard University because he had dared to engage in intellectual speculation by arguing, in an informal seminar, that discrimination might not be the only reason why women are under-represented in the higher reaches of science and mathematics. Mr Churchill managed to keep his job at the University of Boulder, Colorado, despite a charge sheet including plagiarism, physical intimidation and lying about his ethnicity.

With such colourful headlines, it is easy to lose sight of the real story: that America has the best system of higher education in the world. The Institute of Higher Education at Shanghai's Jiao Tong University ranks the world's universities on a series of objective criteria such as the number of Nobel prizes and articles in prestigious journals. Seventeen of the top 20 universities in that list are American (see table 1, previous page); indeed, so are 35 of the top 50. American universities currently employ 70% of the world's Nobel prize-winners. They produce about 30% of the world's output of articles on science and engineering, according to a survey conducted in 2001, and 44% of the most frequently cited articles.

At the same time, a larger proportion of the population goes on to higher education in America than almost anywhere else, with about a third of college-aged people getting first degrees and about a third of those continuing to get advanced degrees. Non-traditional students also do better than in most other countries. The majority of undergraduates are female; a third come from racial minorities; and more than 40% are aged 25 or over. About 20% come from families with incomes at or below the poverty line. Half attend part-time, and 80% of students work to help support themselves.

Why is America so successful? Wealth clearly has something to do with it. America spends more than twice as much per student as the OECD average (about $22,000 versus $10,000 in 2001), and alumni and philanthropists routinely shower universities with gold. History also plays a part. Americans have always had a passion for higher education. The Puritans established Harvard College in 1636, just two decades after they first arrived in New England.

The main reason for America's success, however, lies in organisation. This is something other countries can copy. But they will not find it easy—particularly if they are developing countries that are bent on state-driven modernisation.

The first principle is that the federal government plays a limited part. America does not have a central plan for its universities. It does not treat its academics as civil servants, as do France and Germany. Instead, universities have a wide range of patrons, from state governments to religious bodies, from fee-paying students to generous philanthropists. The academic landscape has been shaped by rich benefactors such as Ezra Cornell, Cornelius Vanderbilt, Johns Hopkins and John D. Rockefeller. And the tradition of philanthropy survives to this day: in fiscal 2004, private donors gave $24.4 billion to universities.

Limited government does not mean indifferent government. The federal government has repeatedly stepped in to turbocharge higher education. The Morrill Land Grant Act of 1862 created land-grant universities across the country. The states poured money into community colleges. The GI Bill of 1946 brought universities within the reach of everyone. The federal government continues to pour billions of dollars into science and research.

The second principle is competition. Universities compete for everything, from students to professors to basketball stars. Professors compete for federal research grants. Students compete for college bursaries or research fellowships. This means that successful institutions cannot rest on their laurels.

The third principle is that it is all right to be useful. Bertrand Russell once expressed astonishment at the worldly concerns he encountered at the University of Wisconsin: “When any farmer's turnips go wrong, they send a professor to investigate the failure scientifically.” America has always regarded universities as more than ivory towers. Henry Steele Commager, a 20th-century American historian, noted of the average 19th-century American that “education was his religion”—provided that it “be practical and pay dividends”.

This emphasis on “paying dividends” remains a prominent feature of academic culture. America has pioneered the art of forging links between academia and industry. American universities earn more than $1 billion a year in royalties and licence fees. More than 170 universities have “business incubators” of some sort, and dozens operate their own venture funds.

Nothing quite like it

There is no shortage of things to marvel at in America's higher-education system, from its robustness in the face of external shocks to its overall excellence. No country but America explores such a wide range of subjects (including some dubious ones such as GBLT—gay, lesbian, bisexual and transgender studies). However, what particularly stands out is the system's flexibility and its sheer diversity.

For a demonstration of its flexibility, consider New York University. NYU used to be a commuter school with little money and even less prestige. In the mid-1970s, it was so close to bankruptcy that it had to sell off its largest campus, in the Bronx. But today it is flush with money from fund-raising, “hot” with would-be undergraduates across the country, and famous for recruiting academic superstars. The Shanghai world ranking puts it at number 32.

The academic superstars certainly helped, but two other things proved even more useful. The first was NYU's ability to turn its location in downtown Manhattan into an asset. Lots of universities have fine economics departments, but having the stock exchange nearby adds something extra. The second was the university's ability to spot market niches.

What made all this possible was the fact that power is concentrated in the hands of the central administration. Most universities in other countries distribute power among the professors; American universities have established a counterbalance to the power of the faculty in the person of a president, which allows some of them to act more like entrepreneurial firms than lethargic academic bodies.

The American system's diversity has allowed it to combine excellence with access by providing a wide range of different types of institutions. Only about 100 of America's 3,200 higher-education institutions are research universities. Many of the rest are community colleges that produce little research and offer only two-year courses. But able students can progress from a humble two-year college to a prestigious research university.

To be fair, one reason why America's best universities are so good is that they have borrowed liberally from abroad—particularly from the British residential universities that grew up in Oxford and Cambridge in the Middle Ages, and from Wilhelm von Humboldt's German research university in the early 19th century.

Serpents in paradise

But America's academic paradise harbours plenty of serpents. The political correctness that has plagued Mr Summers is just one example of a deeper problem: America's growing inclination to abandon the very principles that have made it a world leader.

Ross Douthat has recently created a stir with his exposé of Ivy League education, “Privilege: Harvard and the Education of the Ruling Class”. High-school students compete furiously to get into Ivy League universities such as Harvard, but Mr Douthat, who graduated from there only three years ago, argues that they are seldom stretched when they arrive. A few professors try to provide overviews of big subjects, but many stick with their pet subjects regardless of what undergraduates need to learn. Mr Douthat wanted to pick a comprehensive list of classes in his chosen subjects, history and literature, but ended up with a weird mish-mash taught by “unengaged professors and overburdened teaching assistants”. Looking back on his experience, he feels cheated.

He is not alone. In many ways, undergraduates are the stepchildren of American higher education. Most academics pay more attention to research than to teaching, and most universities continue to neglect their core curriculums in the name of academic choice.

From time to time, universities try to improve the lot of the undergraduate, as Mr Summers is currently doing at Harvard: reforming the core curriculum, taming grade inflation and asking professors to concentrate on teaching rather than self-promotion. But reformers are fighting in hostile territory. The biggest rewards in academic life are reserved for research rather than teaching, not least because research is easier to evaluate; and most students are willing to put up with indifferent teaching so long as they get those vital diplomas.

Complaints about the neglect of undergraduate education are as old as the research university, but the past few years have produced a host of new criticisms of American universities. The first is that universities are no longer as devoted to free inquiry as they ought to be. The persecution of Mr Summers for the sin of intellectual rumination is symptomatic of a wider problem. At a time when America's big political parties are deeply divided over profound questions, from the meaning of “life” to the ethics of pre-emptive war, university professors are overwhelmingly on the side of one political party. Only about 10% of tenured professors say they vote Republican. The liberal majority has repeatedly shown that it is willing to crush dissent on anything from speech codes to the choice of subjects worth studying.

There are signs that scientists, too, are turning against free and open inquiry, though for commercial rather than ideological reasons. Corporate sponsors are attaching strings to their donations in order to prevent competitors from free-riding on their research, such as forcing scientists to delay publication or even blank out crucial passages from published papers. When Novartis, a Swiss pharmaceutical giant, agreed to invest $25m in Berkeley's College of Natural Resources, for example, it stipulated that it should get a first look at much of the research carried out by the plant and microbial biology department.

The second criticism is that America's universities are pricing themselves out of the range of ordinary Americans. Between 1971-72 and 2002-03, annual tuition costs, in constant 2002 dollars, rose from $840 to $1,735 at public two-year colleges and from $7,966 to $18,273 at private four-year colleges. True, the federal government spends over $100 billion a year on student aid, and elite universities make every effort to subsidise poorer students. One study of admissions to selective colleges shows that, in 2001-02, students with a median family income paid only 34% of the “sticker” price.

Still, the sheer relentlessness of academic inflation is worrisome. Elite colleges have little incentive to compete on price; indeed, they tend to compete by adding expensive accoutrements, such as star professors or state-of-the-art gyms, thus pushing up the cost of education still further. And the public universities that played such a valiant role in providing opportunities to underprivileged students are being forced to raise their prices, thanks to the continual squeeze on public funding. The average cost of tuition at public universities rose by 10.5% last year, four times the rate of inflation.

The dramatic rise in the price of American higher education puts a heavy burden on middle-class families who are too rich to qualify for special treatment. It also sends negative signals to poorer parents who may be unaware of all the subsidies available. Deborah Wadsworth, an opinion pollster, points out that universities may be courting a popular backlash. Americans increasingly regard universities as the gatekeepers to good jobs, but they also see them as prohibitively expensive. The result is a steady erosion of public admiration for these formerly much-esteemed institutions.

This points to a third criticism: that universities are becoming bastions of privilege rather than instruments of social mobility. From the 1930s onwards, America's great universities did much to realise the American creed of equality of opportunity. James Bryant Conant, Harvard's president from 1933 to 1953, opened up scholarships to academic merit, and the vast post-war expansion of higher education extended Conant's meritocratic principle to millions of students. “Flagship” public universities such as Michigan, Texas and Berkeley, California, provided world-class education for next to nothing.

Meritocracy in retreat

But the march of academic meritocracy has now slowed to a crawl, and, on some fronts, has even turned into a retreat. William Bowen of Princeton University and two colleagues, in a study of admissions to elite universities, found that in the 11 universities for which they had the best data, students from the top income quartile increased their share of places from 39% in 1976 to 50% in 1995. Students from the bottom income quartile also increased their share very slightly: the squeeze came in the middle.

Mr Summers points out that Harvard now offers free tuition to students whose families earn less than $40,000 a year, and greatly reduced fees to students from families earning $40,000-60,000. Other elite universities have followed suit. Yet at the same time those universities give priority to athletes, people applying early (who often come from privileged backgrounds) and the children of alumni (“legacies”). Duke University encourages the offspring of wealthy parents to apply early and considers their applications sympathetically.

The real threat to meritocracy, however, comes not from within the universities but from society at large. One consequence of the squeeze on funding for public universities, created by Americans' reluctance to pay taxes, has been an academic brain drain to the more socially exclusive private universities. In 1987, seven of the 26 top-rated universities in the US News & World Report rankings were public institutions; by 2002, the number had fallen to just four.

The biggest risk to American higher education is the erosion of the competitive principle. The man often cited as the architect of American academia's current success is Vannevar Bush, who was director of the office of scientific research and development during the second world war. After the war he insisted that research grants be allocated to universities on the basis of open competition and peer review. But in the 1980s universities began undermining this principle by lobbying their local congressmen for direct appropriations. In 2003, the amount of money from the federal research budget awarded on a non-competitive basis topped $2 billion, up from $1 billion in 2000.

American academia's merits still outweigh its faults. Many American undergraduates are savvy enough to get a first-class education. Many academics resist the temptation to censor ideological minorities. The vast bulk of research grants are allocated on the basis of merit. Yet American universities are acquiring a growing catalogue of bad habits that could one day leave them vulnerable to competitors from other parts of the world—though probably not from Europe, which has overwhelming academic problems of its own.

Would you want to have this man's schedule?

Leader of the free world has nothing on him.

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The Bionic Manager
Tough, tireless, coolly rational, Jeff Immelt is remaking GE. His team is with him, but his strategy isn't working where it counts most--in the stock.

Geoffrey Colvin
With Adam Lashinsky in San Francisco

4,146 words
19 September 2005
Fortune
U.S. Edition
88
English
© 2005 Time Incorporated. Provided by ProQuest Information and Learning. All Rights Reserved.

If you could build a CEO to specs, how would you do it? As a platform, you'd engineer someone with machine-like stamina--someone who could work 100 hours a week for 24 years with no apparent ill effects. You'd add intelligence enough to excel at the nation's best schools, vision enough to peer into the future and recognize the world's most promising business opportunities. You'd make him a discerning judge of talent, and you'd make him tough--able to push aside his own handpicked managers if they didn't deliver. He would budget his time with iron discipline: up at 5:30 daily for a cardio workout while reading the papers and watching CNBC, allocating 30% of his workweek to people evaluation, 30% to operations, 30% to growth initiatives, and 10% to governance, investor communications, and board communications.

And since you could do whatever you want, you might as well engineer all of those extraordinary elements into a disarming package: tall (6-foot-4), good-looking, genial, relaxed, approachable.

Jeff Immelt is that wish-list CEO. The only thing missing is wish- list results. General Electric's CEO--the alpha male of the executive class, just ninth in a line of succession that began with Thomas Edison--is trying to solve one of the biggest problems any CEO now faces by pulling off one of the largest transformations any CEO has tried in years. (For a boss in an even tougher bind, see "Can One Man Save GM?") To get GE's terribly performing stock back on track, Immelt has to make this mammoth outfit grow faster. To do that he has to answer the largest questions shaping the world economy--which countries, which industries will grow fastest and biggest? And he has to get 320,000 employees--teammates, he always calls them--to follow his lead. Whether he succeeds or fails will influence the management of corporations worldwide and determine the future of the most widely owned company on the planet. Millions of people are betting hundreds of billions of dollars on his success.

Yet the guy is a mystery. Ask intimates what's most important about him, and you get a variant of the same answer: "He is exactly the person who you think he is when you meet him," says John Rice, whom Immelt recently made a GE vice chairman. Warren Buffett, a major fan, says, "He doesn't feel he has to dazzle anybody this month or this week." Fittingly, Immelt says of himself, calmly, "I'm direct and I'm truthful."

The lack of pretension or even tension is what everybody notices, but it leads you seriously astray in understanding the man, the way he works, and whether he's up to his considerable challenge. You might think, for example, that Immelt is easy to work for--not especially demanding. That's a mistake. He is brutally demanding, even by GE standards. He has repeatedly done something most CEOs find unbearably painful: taken executives out of high-level jobs he had put them into, and quickly. He promoted Yoshiaki Fujimori to head GE Plastics but less than two years later moved him out. He made longtime GE executive Gary Rogers a vice chairman--but in 2003 Rogers stepped down to be a "senior advisor" to the company until his retirement a year later. Says Jack Welch, who until now has not commented publicly on his successor: "He's a lot tougher than you might think, but it's beneath his affable manner. That's a combination that works."

The contrast between Immelt and Welch is striking but misleading. It's true they couldn't appear more different: The Big Easy vs. Mr. Tightly Wound. But Welch could just as enthusiastically hug a manager as chew him out, while Immelt appears to have ice water in his veins. He may well be tougher than the man once famed as one of America's toughest bosses. As Welch himself says, "At times I might get too emotional. He doesn't."

Immelt's ease could tempt you to infer that success has been a breeze--that maybe he doesn't apply himself terribly hard. That too would be wrong. FORTUNE 500 CEOs are an extraordinarily hard- working group, yet even in that elite universe Immelt qualifies as a hero of capitalist labor. Says his brother, Steve: "He works pretty hard at making it look easy. When we were kids he'd sneak away--to study." That was when they were growing up in Cincinnati, where their father was a 38-year GE employee, a middle manager in the aircraft-engine business. Even in high school, Jeff was busy-- football, basketball, baseball, great grades. Today, says Steve, "it looks easy because he's working his butt off in a way you don't see."

Immelt, 49, says he's been working 100 hours a week for 24 years. That does not take him back to his 1978 graduation from Dartmouth, where he was football team captain (as offensive tackle) and a fraternity president who liked to party. Nor does it go as far back as his two-year stint marketing Duncan Hines brownie mix at Procter & Gamble, where he sat next to Steve Ballmer, now CEO of Microsoft. The future chiefs of the world's two most valuable companies played paper-wad basketball, "were incorrigible," says Immelt with a laugh, and "were never going to be employees of the month." The 24 years go back to his time at Harvard Business School, which Immelt says he approached like a job. The most valuable thing he learned there? "There are 24 hours in a day, and you can use all of them."

Most hard-charging types have put in a 100-hour week or two. But month after month, year after year--is that even possible? Let's do the math. If you worked from 7 A.M. to 9 P.M. seven days a week, you'd still be two hours short of 100 hours. If Immelt has been working that hard for 24 years, then he has already done 60 years' worth of 40-hour weeks. Around GE they say he has grown noticeably thinner and grayer since becoming CEO. Maybe the wonder is that it didn't happen sooner.

These days, after his early exercise routine, he heads to the office a few exits up the Merritt Parkway in Connecticut. He regularly reviews his calendar to check that he's allocating his time properly--evaluations, operations, growth, governance, communication. "I've always been extremely disciplined," he says. The day generally ends with a dinner for customers or employees. That's when he's at home. He spends about 60% of his time on the road, where the hours are at least as bad. Here he is on a recent swing through San Francisco: The first meeting is with institutional investors at 7 A.M. Then he addresses some 200 retail investors at 8:30, standing comfortably for 25 minutes with his left hand in his pocket and his right hand holding his PowerPoint remote; after his talk, he answers questions for an hour. Then it's more institutional investors, followed by GE salespeople in Burlingame, a presentation to customers, and finally a big reception for customers and top salespeople. He seems as energetic at the end of the day as at the beginning. He had run virtually the same routine in Los Angeles the day before. (Yes, his wife, Andrea, knew what she was getting into-- they met when both worked at GE Plastics. Their only child, Sarah, heads off to Boston College this fall, but unlike most empty- nesters, Immelt won't wonder what to do with the extra time.) "You have to have real stamina," he says.

The truth is that an unflinchingly tough, remarkably hard- working boss is what GE badly needs. The company faces a problem-- lousy stock performance--that sounds commonplace but in this case decidedly isn't. What's different at GE, making Immelt's situation unique and significant, is that the trouble and its solution are on a scale that most CEOs never contemplate. The size of the problem: Since Immelt was handed the keys on Sept. 7, 2001, GE stock is down 15% while the major market indexes are up 7% to 11%. That percentage gap is bad news but too abstract to convey the problem's magnitude. Think of it in dollars: If the stock had merely achieved mediocrity, matching the S&P 500 since Immelt's arrival, GE would be worth over $100 billion more than it is. For perspective, there are not 25 companies in America with a total market cap of $100 billion.

Now start thinking about a solution, and again Immelt must plot on a massive scale. To raise GE's stock price by $1, he must produce about $650 million of new, after-tax profits that would continue every year. Again, for perspective: At 300 of the FORTUNE 500 companies last year, total profits didn't reach $650 million. But GE must add that much just to raise the share price by a buck--and the shares are about $6 below where they were when Immelt took over. The fix: Immelt must find opportunities with global scale, since they're the only ones big enough to make a difference for GE. And he must think long term: As with Welch, the board expects him to be a 20- year CEO, and he knows that, barring disaster, he has 16 more years in the job.

Those perspectives lead him to large thoughts on the world's future. Developing economies will grow faster than developed ones, and Immelt believes their need for basic products and services-- water, energy, transportation, health care, financing--will grow faster than their economies. For example, GE figures nearly half the world's people will soon be water-stressed--unable to get the clean water they need. That's a huge long-term opportunity, as are those other industries, so Immelt is making major investments in all of them.

Immelt doesn't worry about what could go wrong in the world as much as he worries about how to position GE for whatever happens. Thus, $65 oil is a problem for his plastics business because it's the main raw material, but it's an opportunity for jet engines, locomotives, and power systems because if GE can make those products more energy efficient, customers will love them. He's confident about most of the trends he's betting on, but he cites two overarching uncertainties--two things "that are going to be determined while I'm in this job that are bigger than GE. One is where health care goes in this country and on a global basis. That's going to be played out in the next ten or 15 years." How will the developed world pay for the health care of its rapidly aging population, and how will the developing world meet its people's fast- rising health-care expectations? The other major uncertainty is "the future of the U.S. as a manufacturing nation--that's going to be played out not in the next 50 or 100 years, but in the next ten or 15 years."

In line with his big-picture expectations, Immelt is recasting GE broadly and deeply. The most fundamental step is changing his portfolio of businesses. Many of his acquisitions have been individually small--a wind-energy business from the defunct Enron, Ionics in water purification--but Immelt is buying the opportunity for future growth. A few buys were quite large, notably Universal, the movie studio and theme-park business, which he combined with NBC. His biggest acquisition was Amersham, a British health-care outfit that he bought for $9.5 billion and combined with the GE unit that makes CT scanners and MRI machines. Those were his portfolio additions. His major divestitures were in GE's insurance business, which wasn't producing the returns on capital he wanted. So he sold parts of it (including one piece to Buffett's Berkshire Hathaway) and spun off other parts last year.

Today Immelt pretty much has the business portfolio he wants. That's the good news. The bad news is that he spent $60 billion on it--new capital invested in the business on which a return must be earned. Thus we reach another critical part of Immelt's strategy, the great growth push. Says Immelt: "We don't buy growth, we grow what we buy," and growing what he's bought is now his overwhelming imperative.

One way he's going after that goal: publicly reviving GE's scientific research labs, bestowing upon them vastly increased dollars and prestige. Immelt figures technology innovation is a key to growth for two reasons. First, virtually every product and service in today's markets is in danger of being commoditized. If GE scientists are on the leading edge of research into, say, nanotubes, as they are, then GE has a fair chance of creating products the competition can't match, at least for a while. Second, innovative products create the best opportunities for services, which are where GE's manufacturing busi- nesses earn their real money. For example, GE makes no money selling jet engines, but it makes a ton of money servicing and upgrading those engines over their 40-year lives. "The most valuable services in the world start with R&D and manufacturing," Immelt says. "Jet engines, gas turbines, MR scanners- -you don't get any of that service revenue without the technology investment." That's why he's casting GE as a tech company, an identity it hasn't had in decades.

Fast growth is what drives Immelt's interest in developing economies. The opportunities are huge for many GE businesses. For example, the U.S. has one commercial aircraft for every 45,000 people, but China has only one per 1.6 million people, and India one per six million; as these economies develop, their demand for jet engines will be vast. They will need electric-generating capacity on an enormous scale. They will be improving the quality of their water and their health care, and doing it for billions of people. Their consumers and businesses will need financial services.

That's heady stuff, but Immelt is thinking much bigger. He realizes that while other companies can compete in any of those businesses, only GE can compete in all of them, and they all involve purchases that are government-made or government-approved. So GE's customers will increasingly be nations with which the company will be, literally, partners in economic growth. You need electricity? We can provide all the equipment. Don't forget you'll also need locomotives to haul more coal from the ports; we can sell you those. Your new electricity will be powering new factories with a tremendous demand for clean water, which we can make sure you get. You'll need bigger airlines to handle all that commerce--we can sell you the jet engines and, for that matter, lease you the airplanes. And of course you can finance everything through us.

The vision is grand but apparently realistic. Revenues from the developing world were up 37% last year, to $21 billion. Immelt says the company has won 70% of China's gas turbine orders over the past two years, and it has won a commitment for 80 locomotives plus control equipment. In Qatar, says Immelt, GE is getting a big chunk of a major pipeline project, plus a $2 billion order from Qatar Airways, plus major water-desalination projects, plus extensive service and training contracts; the target is $10 billion of revenue by 2010. Nicholas Heymann of Prudential Securities, the top-ranked GE analyst, figures 40% of GE's total revenue growth over the next five years will come from developing countries.

Immelt's growth strategy has another feature that says a lot about him. He decided to make GE's marketing as great as its vaunted finance and human resources operations. "At first no one knew what he was talking about," says vice chairman Dave Calhoun. It's not that GE hated customers; it just wasn't customer-centric. "Marketing had become a lost function during the 1990s," says Immelt, so restoring it was a fat opportunity to make GE more competitive. To him it's the basis of an important change in the GE culture, making it more externally focused, measuring GE's success by customers' success. If it works, the change will be significant. As he puts it, "The purpose of this generation of GE leaders is to make the company as good externally and commercially as it has always been operationally and financially."

Immelt is committed to his strategy. Can he execute it? That's rarely a problem at GE, where the disciplines of execution are at the heart of the culture. The biggest challenge through the rough patch of the past few years has been keeping and motivating the very best GE managers. Immelt was pumping up 625 of them this past January at an annual rite that brings them to Boca Raton each year. As usual, he opened with pointed jokes (one of his Top Ten Reasons 2005 Will Be a Great Year for GE: "We've replaced Father of the Pride with a test pattern," a jab at one of NBC's many flops). Then, to the team on whom he relies to carry his strategy, he put up a slide with a surprising tone: "If you didn't leave the last three years, you would be crazy to leave now!" The slide got a big laugh, as intended, because like all good laugh lines, it contained truth. Imploring people to stay? At GE? Yes, when those hard-charging managers are holding loads of underwater stock options.

But step back and look at the very big GE picture --Immelt's character, methods, strategy, and recent results--and you have to conclude the man is equal to his plan. He is changing what he wants to change. And the plan does make sense. In fact, you don't find many doubters; the closest you come are those who say it isn't paying off yet. Even that may be changing. Earnings per share in the past three quarters grew 13%, 19%, and 22%, a huge improvement over the recent past and well ahead of his goal. If he can keep growth anywhere near that, GE's multiple will improve and the stock will do what it's supposed to.

In any case, expect Immelt to just keep doing what he's doing. "He's a marathon runner," says Ram Charan, a consultant who has worked for Immelt and many other CEOs. He notes the Street was none too kind to Welch when he was reordering GE in his first few years as chief. Warren Buffett says, "Over the long run, which he has, the stock will behave itself." Buffett actually expects far more than that from Immelt: "He is likely to be the most respected spokesman for American business during the time of his tenure."

A world that got to know Welch very well is taking a while to figure out Immelt, who seems strikingly different from his predecessor but turns out to be a lot like him. Immelt's apparent serenity masks rigor, toughness, and a white-hot desire to win. He's quietly confident in what he's doing, but he won't rest--he can't-- until he has proven that his deep redirection of one of the world's great companies is actually working. And of course he won't rest even then.

His easy manner is misleading: Immelt is brutally demanding, even by GE standards.

How hard does he work? Immelt has already done

60 years' worth of 40-hour weeks.

If GE stock had merely matched the S&P, the company would be worth $100 billion more.

Welch on his successor's unflappable toughness: "At times I might get too emotional. He doesn't."

Buffett says, "Over the long run, which he has, the stock will behave itself."

If It's Tuesday, This Must Be Oslo

Immelt says he works 100 hours a week, and this sample of his schedule bears him out. It also illustrates some of his priorities: making GE more global, building its growth businesses, spending time with customers and investors.

THREE DAYS OF JEFF IMMELT'S EMEA TRIP

Sunday - June 26, 2005

08:14 A.M. Ar. Milan

10:00 A.M. EMEA regional session C

1:00 P.M. Controllership update

2:00 P.M. Advanced Materials business review

3:30 P.M. Break

4:00 P.M. Equipment Services business review

4:45 P.M. Consumer & Industrial business review

6:30 P.M. Energy 2015 reception

7:30 P.M. Energy 2015 dinner (customer event) -- Host: John Rice

Monday - June 27, 2005

08:15am Energy 2015 event

Opening Remarks -- JRI

10:00 A.M. Lv. Milan Malpensa -- 10:47 A.M. Ar. Geneva

11:30 P.M. Private Meeting with investment company

12:45 P.M. Investor Relations Group presentation followed by buffet lunch

2:30 P.M. Private meeting with investment company

4:00 P.M. Lv. Geneva -- 5:08 P.M. Ar. Frankfurt

5:45 P.M. Investor-relations meeting / reception

8:00 P.M. Lv. Frankfurt -- 8:52 P.M. Ar. Munich

8:52 P.M. Transfer from airport to hotel

Tuesday - June 28, 2005

Speech to newly promoted GE executives

08:45 A.M. Lv. Munich -- 10:37 A.M. Ar. Farsund Lista

Welcome by local management and guests

12:00 P.M. Tour of existing & new plant

12:15 P.M. Opening of GE Healthcare research center/factory

ceremony begins

2:00 P.M. Lv. Lista -- 3:01 P.M. Ar. Gardermoen, Oslo

2:56P.M. Transfer from airport to Konserthus (concert hall), Oslo

4:00 P.M. JRI to welcome all employees in the large concert hall

5:00 P.M. 2 media interviews JRI

6:00 P.M. GE Day ceremony begins at concert hall

7:15 P.M. Meeting with customer

9:00 P.M. Lv. Gardermoen, Oslo -- 11:10 P.M. Ar. Munich

The key to a successful family business.

Make sure the business appeals to eternal youth.

---

Sweet Smell of Succession
Dynasties don't last forever.
But Estee Lauder's grandkids aren't about to let this beauty empire crumble.

Daniel Roth
Reporter Associates: Doris Burke; Jia Lynn Yang

5,982 words
19 September 2005
Fortune
U.S. Edition
English
© 2005 Time Incorporated.

Every few months the two women gather in the CEO's office to talk about their problems. Both of them--the glamorous, creative type with a fondness for A-list events and the shy, no-nonsense manager who spends her days marketing to soccer moms--get a chance to give the chief executive a piece of their mind. Sometimes they even bring in a moderator to keep the discussion flowing. There's probably a plot for a bad reality show in this scenario; certainly it's an unorthodox use of the CEO's time. But when you're family, you do what you have to do. And in the case of the Estee Lauder Cos., the giant of the prestige-cosmetics world, family is everything. So CEO William Lauder and his cousins Aerin Lauder Zinterhofer, who oversees the Estee Lauder brand's image, and Jane Lauder, a vice president at a new division called BeautyBank, gather and clear the decks: What's bothering them? What is working and what is not? The caution makes sense.

Around the world the conventional wisdom is that they will fail. Not them, exactly, but their generation: the grandchildren of a legendary founder. The Italians say, "Dalle stalle, alle stelle, alle stalle"-- "From the barn stalls, to the stars, back to the barn stalls." In Yiddish it's "Schmattes to schmattes in three generations," or up from rags and back down. In Chinese, it is chilly and blunt: "Wealth does not pass three generations." But Estee Lauder's grandchildren are doing everything they can to make sure the proverbs won't apply to them.

The world of cosmetics and fashion is watching closely to see if they can pull it off. In April 2004, Estee Lauder, the longtime undisputed queen of the cosmetics world, died at age 96. Three months later William became CEO, taking over a job that his father, Leonard, once held. The family business--the Lauders control 82% of the company's voting shares--continues to dominate the high-end beauty industry, with hot brands such as Bobbi Brown in makeup and Aveda in hair care. Lauder captures almost a fifth of the $33 billion U.S. beauty market overall and roughly half of the $13 billion prestige business. But it faces daunting challenges and new challengers. Estee Lauder's empire was built during the age of the great department stores, when the destination for the latest fashions and styles was Neiman Marcus, not Target. That era ended long ago. Yet about 40% of the company's sales still come from mostly older customers at these one-time giants in the U.S. Meanwhile, Lauder is being pressured on the high end of the market by nimble, boutique beauty brands, and on the low end by giant manufacturers such as Procter & Gamble that are determined to erase the boundaries between prestige and mass market.

To make sure the company keeps its edge in the changing cosmetics landscape, the three Lauder cousins are taking on much more than family counseling. (The fourth cousin, William's brother, Gary, 43, is a venture capitalist in Silicon Valley.) They could easily live off the $2.2 billion the family has taken out in stock offerings since the company's 1995 IPO, or on the millions that each makes in dividends every year. Instead, they're hunkered over spreadsheets, ad layouts, and store plans. And they've all carved out roles in the company that appear to fit their personalities perfectly.

Estee's grandkids were long ago assigned their own one- dimensional identities by the media. When you grow up as royalty in New York high society, that's bound to happen. Still, they don't do much to dispel the images. As the eldest, William, 45, is the responsible one, setting the direction and overseeing details. Aerin, 35, is known as the pretty, outgoing one, but she's far more than that. She recently took over directing everything from advertising to counter displays for the flagship--and stagnating-- Estee Lauder brand and personally recruited superstar designer Tom Ford (who is, of course, a friend of hers) to bring it some sparkle, sex, and buzz. The press-wary Jane, 32, is seen as serious and hard- working. She's also a canny problem solver. Mostly behind the scenes, she is leading the company's charge into mid-tier markets that are crucial for growth.

Despite their different personal styles, the third-generation Lauders share an intense dedication to the family legacy. William, Aerin, and Jane all exude earnestness as if it's the next big fragrance. A few years ago they got together and decided to make sure they were all on the same page about where they wanted to take the business. So they drew up a manifesto: "We are not a family business, we are a family in business." While hardly the Gettysburg Address of corporate mission statements, the document made it clear that the good of the company would come first--and that those looking for a family brawl should probably look elsewhere. "My grandparents did such an incredible job building this company, and gave us so many advantages, that you want to be able to keep it going," says Jane. "It's hard to separate your life and your work because they're all kind of the same thing. Maybe there should be more separation, but there isn't."

Estee Lauder's world headquarters is on the 40th floor of the General Motors building, a soaring tower of white marble and glass at the southeast corner of New York City's Central Park. Step off the elevator, and suddenly you're in Lauderland. Spanning the floor are Chinese vases, blue wingback chairs, and crystal lamps and chandeliers. One wall holds a glass curio case filled with delicate plates, teacups, and porcelain figurines; another, a five-foot painting of the face of Estee herself.

Most striking of all is the sea of carpet: wall-to-wall, deep- pile, blue carpet. And it's not just any blue, but Estee Lauder Blue, Pantone color 655. For a time in the mid-1940s, when Estee Lauder was just starting out, she carried a purse full of sample jars when visiting friends or fancy restaurants. After holding up a variety of different-colored containers for inspection in an array of powder rooms, she settled on a specific blue-green that, as she wrote in her autobiography, "whispered elegance, aristocracy, and also complemented bathroom wallpapers."

Each day, William has to walk through this lobby, a relic of his grandmother's era, to get to the hallways of the modern office beyond. "That expression about the first generation and the second generation and the third generation--I'm extraordinarily mindful of that," William said in mid-August, the day before he was to announce Estee Lauder's fiscal year-end numbers, a report card of sorts on how he did in his first full year as CEO.

William does not fit the bill of the stereotypical beauty- business executive. He's a fireplug of a guy, more mid-career banker than metrosexual, and he speaks candidly, albeit in a manner that makes it seem as if he's accessing a vast database of speeches each time he answers a question. "Something I've always felt was the inner thing that drives me is that I have to work twice as hard for half the credit, primarily because of who I am and why I am here. I would never be able to be successful if I perceived that to be successful in my job, I had to step into my father's shoes. I am who I am." He stops and lets a small smile cross his face. "To paraphrase Popeye, 'I yam who I yam.'"

The next day he showed that he was someone who wouldn't be bound by history. Estee Lauder stock jumped 9% as the company reported solid gains in annual sales (up 9%, to $6.3 billion) and profits (up 8%, to $406 million). What got Wall Street excited? William's announcement that he doesn't intend to simply maintain the family franchise. He's looking at axing low-performing brands and searching for cost savings in what is a surprisingly low-margin business. (While it costs the company only $25 on average to buy the ingredients, create the bottles, and put together a $100 product, Estee Lauder shells out another $63 to advertise it in women's magazines and promote it in stores. In the end, Lauder reports operating margins of just 11.4%.) For a company that has long been about spending whatever it takes to make its brands great, this is a radical change. "We can't just say because we did it in the 1960s and '70s this way, we will continue to do it in the 21st century," he told analysts.

To get a firsthand look at the breadth of the Lauder beauty portfolio, walk into the tourist-packed ground floor of Saks Fifth Avenue in New York. Back near the elevators is the counter for the Estee Lauder brand. On a recent morning, it was empty. The crowds were thronging around some of the hipper, younger stands: MAC, Darphin, Michael Kors fragrance. That's hardly a disaster: The Lauders own them all. In the mid-1990s, under Leonard, the company started on an acquisition and licensing binge that, by 2005, left it with 26 brands in four categories--cosmetics, skin care, fragrance, and hair care--ranging from the $1,200 moisturizing Creme de la Mer to the $12 Stila lipstick. For men with a sense of their own superiority, there's even Donald Trump, the Fragrance.

Estee Lauder Cos. has beauty rivals that are much bigger: With $17 billion in sales, L'Oreal owns everything from Maybelline to Kiehl's. And P&G, which sells mass-market favorites like Oil of Olay and CoverGirl, spends as much on research in a month as Estee Lauder does in two years. So far, though, no one has the kind of lock that Lauder does on the types of consumers who seem to be spending freely these days: the rich ones.

Estee targeted the high-end market from day one. Or rather Josephine Esther Mentzer did. Esther, as she was called (she dreamed up the name Estee around the time she dreamed up her business), was born in 1907 to Eastern European Jewish immigrants in Corona, Queens. Her father owned a hardware store in a part of town known for its trash: Neighboring boroughs roped manure-filled barges to Corona's dock, and the Brooklyn Ash Co. dumped so much burned refuse there that it changed the landscape. In The Great Gatsby, F. Scott Fitzgerald called Corona the "Valley of the Ashes." In that environment, who wouldn't dream of looking and smelling beautiful?

In high school Estee fell under the tutelage of an uncle who made facial creams in Manhattan. He agreed to let his niece peddle them, and she did so with a passion--in beauty salons, poolside at classy hotels on Long Island, and even while strolling down the street. The young Estee was not shy about stopping strangers, doing an instant makeover, and giving away samples--standard industry practice now but almost unheard-of then. After she married Joe Lauder in 1930, she started mixing her own creams, which put her in the vanguard of the burgeoning beauty industry.

Over the next few decades, Estee built the business by never letting anything stand in her way, including family. When she felt Joe was dragging her down, she divorced him and moved to Palm Beach. Three years later she remarried him and moved back to New York. (First son Leonard was born before the divorce; second son Ronald, who has been a Lauder exec and ambassador to Austria, after.) In 1948, two years after incorporating Estee Lauder Cosmetics, she badgered her way into a counter at Saks. To grow, she took her three- minute makeovers into stores across the country and made a point of touching every face she could, even if it meant running after prospective customers.

For all Estee's marketing moxie, it was her decision to branch into fragrances that vaulted Lauder into the realm of larger rivals like Helena Rubenstein and Elizabeth Arden. The scent business was less than 1% of the $1 billion beauty market in 1950. Then she came up with Youth Dew, a product that was a bath oil and a fragrance, allowing women to put a little in their bath and smell of it the rest of the day. In a classic Estee move (around the company, employees still use the tag line "That's so Estee") she didn't seal the bottles but used a stopper; a woman who pulled off the top to take a sniff wound up with the scent surrounding her no matter where she went.

When Leonard joined full-time in 1958, he identified a major problem with the company's booming business: It had a serious case of Youth Dew dependency. Around 80% of the firm's $800,000 in annual revenues were coming from the Youth Dew line. Leonard, who called his mother Mrs. Lauder at work, looked for a way to fix that. And the principle he decided to apply was born out of his own experience as a father of two boys: the power of sibling rivalry. Rather than look for a way to enter the mass market, Leonard decided to create a new high-end brand that would compete with Estee Lauder and, he hoped, capture its own slice of the prestige market. So in 1968, Leonard launched Clinique.

On a sunny afternoon in August I asked Leonard, 72, how he made sure the corporate siblings challenged but didn't kill each other. We were sitting in the office he still keeps down the hall from William's (Leonard's is much bigger). And he was looking dapper-- Leonard is always dapper--in a stiff, blue, button-down shirt with a white collar that appeared to have been pressed minutes before. "Through a lot of hard work. That's all I can say," he answers. Then he arches his eyebrows and glances at my hand. "I see that you're married. Do you have children?" One, I reply. "Wait till you have two, okay? Then you won't ask me that question."

Over time Leonard's paternalistic streak came to define the culture as much as his mother's drive to touch every customer. While the brands were expected to compete hard, they were also expected to exist harmoniously. Workers who do well still get "blue notes" from Leonard: hand-written comments, frequently signed with smiley faces, on paper from his Lauder-blue notepad. When Lauderites leave, senior management often waves them goodbye with a smile. One employee told me that when she quit, the parting words from her bosses were: "See you soon." And, indeed, she came back.

If work was supposed to feel like family, family time often felt like work. Leonard and Evelyn, who still oversees fragrance development at Lauder, regularly grilled William and Gary about business at the dinner table. In the early 1980s, Leonard even took the boys to Tokyo for their spring break from college--to spend time meeting with retailers. When William said he was ready to follow in his father's footsteps, Leonard set two conditions: First, he had to work for someone else. Second, he had to learn a foreign language. William did both, studying French and putting in three years at Macy's before joining the company permanently in 1986.

By the early 1990s, the beauty retail universe was changing. Women were seeking out smaller, more personal brands instead of simply going with Estee Lauder or Clinique. So Leonard started a buying binge, amassing smaller players and letting them operate mostly as they had. He also expanded the company's culture of sibling rivalry. When, for example, he bought MAC, he also bought one of its rivals, Bobbi Brown, figuring the two would push each other. That approach helped Estee Lauder grow sales from $2.6 billion in 1994 to $4 billion by 1999, when Leonard stepped down after 17 years as CEO and handed over power to longtime right-hand man Fred Langhammer.

"When you live in the shadow of a big tree, you have to run twice as fast to get into the sunlight." That's how Leonard, speaking to the New York Times in 1987, summed up the pressure of building his own reputation. But if Leonard was shadowed by one big tree, William- -who everyone assumed would one day take the top job--was under two.

Anyone who doubted that William could find his own place in the sun only had to check out one of the odder brands at Estee Lauder: Origins. At a company that has always prized itself on being fashion- forward, the brand's bath and body products are all about Mother Nature. While the Estee Lauder brand employs pop culture stars such as Gwyneth Paltrow as spokesmodels, and the edgier MAC uses rapper Missy Elliott, Origins links itself to health guru Dr. Andrew Weil, who looks like a bald Santa Claus. Most important, Origins is the only Lauder brand that gets a big chunk of its sales from freestanding stores.

Origins is William's baby. His dad was dead set against its retail strategy. But in 1990, William, then the head of the upstart division, decided he was sick of watching brands like Ralph Lauren manage to sell both in department stores and at their own standalone outlets. He thought Estee Lauder's brands could do the same and started pressing his father--who was resistant to antagonizing his department store peers--to make the change. "There's a consumer out there," he argued, "who would rather shop in our four-walls environment than in the department store world." William didn't just stop with Origins. He pressed his father for standalone Estee Lauder brand stores, launched online sales, and as CEO has continued to move beyond department stores. The company now has 518 freestanding stores.

William has also pushed to soften the company's sibling-rivalry environment. Rather than keep the personnel in each division discrete, he demands that managers move between brands and learn from one another. Speaking to a group of product-development execs in late July, he let them know that he expected the thawing to continue: "We've tried over the last few years to create a spirit of collaboration amongst you so that you're not looking at, say, Clinique as a mortal enemy, but as a partner with whom we can both attack the mortal enemy--who are the French guys."

I have seen the future, and it is sun-drenched. I know that because next spring Estee Lauder will be giving away some five million kiwi, raspberry, and light-denim-blue little purses to those who buy certain Estee Lauder brand products. The idea for the colors came from Aerin and her team, who spend a lot of time meeting with trend specialists and at fashion shows; the idea for the bags came from Estee, who pioneered Gift With Purchase, now an omnipresent staple of cosmetics marketing.

In certain ways Aerin is the truest descendant of her grandmother. Estee willed herself up from the Valley of Ashes and onto the society pages with the New York elite--and Aerin is right at home there. Blessed with the looks and poise of a model, she's been called one of the most beautiful people in the city by New York magazine, name-checked in the bestselling The Devil Wears Prada, and profiled (at just 24) in Vogue. When she's walking down the street or getting a manicure at Bergdorf Goodman, she's often approached by strangers asking her opinion on makeup. And she thrives on it.

Today she's at a photo shoot at Manhattan's Chelsea Piers, wearing tight Levi's and open-toed, Christian Louboutin shoes and riffing almost jazzlike on the look she's trying to create. She has given a stylist detailed instructions for how to outfit spokesmodel Carolyn Murphy for a July 4, 2006, promotion: "We said we wanted it to be casual. Spring. Fashion. Comfortable. Approachable. Directional. If you notice, it's more casual. Real. Smiling. A headband. Great straw hat. A white oxford, white shirt. Everyone has a white shirt in their closet. It's really making sure we relate to the customer at all levels."

Aerin could easily be working on one of the hipper brands in the Lauder portfolio, the kind that don't need to lure customers with giveaways. Instead she's decided to put her energy into making Estee Lauder, the brand that started it all, relevant to a new generation. The brand isn't exactly dying. It's still the third-biggest in prestige cosmetics after Clinique and L'Oreal's Lancome, but the market has grown, and the extra dollars are going either to new players or to Lauder's younger brands. "There's no sex appeal in Estee Lauder; the brand has become all about the research," says Brent Smith, a former Estee Lauder executive who now runs a brand- consulting firm in Los Angeles. "You have to do that for skin care-- the end goal is to look younger--but people still want to believe that by using the products they're going to look sexier, to have better sex, and have more sex."

For the Lauders, reviving their grandmother's flagship brand is a personal quest as well as a professional one. But it's going to take more than just correctly colored swag. Aerin's social calendar-- long packed with swank fundraisers and charity events--is an asset. Her biggest coup so far: bringing in superstar Tom Ford. As creative director at Gucci, he turned the tarnished brand into a must-have, driving sales from $264 million in 1994 to $3.2 billion in 2004. When he left last year he began plotting his own fashion brand. Aerin and Ford knew each other from parties and events over the years. So when a friend of a friend told her that Ford had started talking to another cosmetics company about a beauty line, she swooped in. "I said before he gets anything, he should really talk to people at Estee Lauder, because we are the best of the best, and we'll give him good advice," she says. "And as a friend, I kind of owe that to him."

Those talks turned into a partnership. Lauder agreed to license Ford's name and give him complete creative control over a standalone beauty line called Tom Ford. The Lauders also asked him to look for ways to bring new life to the Estee Lauder brand. So with Aerin and her boss, John Dempsey, the executive who made MAC into a hit for Lauder, Ford started combing through the archives. They looked through old ads, checking to see what images Estee herself had used. To their surprise, the original image used to sell Youth Dew--a peek at a nude woman about to enter her bath--was quite risque. Ford declared that he wanted to relaunch the scent.

In mid-November, Youth Dew Amber Nude will debut under a line of products called Tom Ford Estee Lauder Collection. The rest of the 11- piece collection features similar updates to Estee's original products. And in a return to the days before the brand became terminally wholesome, the mockup ad I saw featured a nearly nude Carolyn Murphy in an alluring recline, staring right into the camera. "Estee herself said this was an incredibly sexy fragrance," says Ford. "The heritage of nudity is part of Youth Dew. It's not just that I like naked women."

Aerin loves the ad. "That, to me, is modern Estee Lauder," she says. "It's unexpected but still glamorous and elegant. I think Estee Lauder"--and here she's talking about her grandmother--"would have been very excited about that shot."

Tom Ford is certainly generating buzz for Estee Lauder, but few think that alone will be enough to get the brand growing again. Some retailers see Aerin herself as the key to boosting the brand's profile. "What Estee once did in her era, Aerin has the potential to do with a younger generation," says Terry Lundgren, CEO of the company's biggest customer, Federated Department Stores. "What you're seeing in our business is that celebrity names allow a product to get a close look from consumers. Aerin has wonderful relationships with the fashion celebrities. She knows them, she's connected to them, and she speaks their language."

Aerin is getting more comfortable with that idea. "That's something I'm going to do more of," she says. "But I also think it's very modern to be behind-the-scenes, to be very involved with the day-in and day-out running of this department. I think I can do both. I think I'm the link between the past and the present." And she's pretty happy just being that. When I ask her if she'd ever want to hold William's job, she turns to a press person and says, "Is it okay for me to say no?"

"We're going to use this visit for a couple of days now, telling customers, 'Jane Lauder was here!'" says Carol Carroll, the beauty manager at Kohl's Department Stores in Wayne, N.J. Jane, shifting uncomfortably as Carroll effuses over her, has come here to survey the result of Estee Lauder's second major attempt to go downmarket.

While Aerin attacks the high end of the cosmetic market and makes herself ever more visible, Jane is attempting to connect with the mass consumer while maintaining something like anonymity. She is wholly uninterested in publicity. When she got married three years ago, she turned down all attempts by the press to cover the wedding. "People kept calling and saying, 'Well, at least give us a picture of you in your wedding dress,'" she says. "I felt like, 'That's private.'" That is so not Estee.

Neither, until now, were mass-channel sales. The first time Lauder tried to leave its upper-class clique was when it bought a teen cosmetics line called, coincidentally, Jane, in 1997. The company's skills were no help, however, in a market dominated by much larger players. In 2004, Lauder sold Jane at a loss. William didn't give up: Instead of trying to take on P&G, Unilever, and L'Oreal on their own turf, he built a new playing field. While still COO back in 2003, he started talking to Kohl's, a fast-growing chain of 670 stores catering to middle-market, thirtysomething moms who are pressed for time. The chain had no cosmetics department. William didn't want to just put his products in Kohl's, he wanted to create- -and rule--its beauty business.

The result is what Lauder internally calls BeautyBank, a collection of four new brands that, for now, are sold only in Kohl's. There's no easy way to identify the brands as Estee Lauder products. But each seems to be a doppelganger of the company's existing brands (though Lauder bristles at the assertion). There's the wholesome, Estee Lauder--like brand American Beauty, with Ashley Judd as spokesmodel; Flirt, which, like MAC or Bobbi Brown, is targeted toward women who want to play with colors and want attitude in their cosmetics; Good Skin, a Rodan & Fields type of skin-care line with the de rigueur dermatologist endorsement; and Grassroots, a line of lotions, shampoos (for both pets and people), and bodywashes that mimics the "natural" appeal of Origins. Unlike in drugstores, however, there are plenty of open products to test, and a trained beautician--such as Carol Carroll--is always around to apply the Estee touch.

Jane heads two of the brands: Flirt and American Beauty. While William talks in full speeches and Aerin in a breezy riff, Jane is more reserved, punctuating her thoughts with "you knows" and nervous laughter. Just about everyone comments on her work ethic: in early, no lunch, and addicted to her BlackBerry. Like the rest of the folks at BeautyBank, she works out of a cubicle in an office a block from the headquarters.

If she can nail BeautyBank, it'll be another indication that--as some company watchers have posited--she could be next in line after William. "She's got the smarts and tenacity, and I think she can develop the business savvy and experience," says someone close to the company. "But it's a 15- to 20-year time frame." Until then, Jane will only say that--unlike her sister--she's not ruling out the possibility that she'll want the job. Still, she's not thinking about it yet. "There are so many things we can do to grow this company. You know, Aerin is doing a fantastic job with bringing a younger generation to Estee Lauder, revitalizing it, bringing a new spirit to it. Hopefully, I can build new relationships and grow this side of the business. That's what we're all focused on now. The future? We'll see what happens."

The odds are against the business's staying in Lauder hands. Today large, public, generation- spanning businesses like Estee Lauder are rare birds: Of the FORTUNE 1,000, only 79 are true family companies, controlled by family members descended from the company's founder, according to recent research by John L. Ward, a professor at Northwestern University's Kellogg School of Business. And only 20% of family businesses last beyond 60 years. But then, the odds were never in Estee's favor to begin with. Who would have thought a young woman from Corona could have climbed so far and created so much?

Estee, it appears, had a premonition that her family would be able to buck the odds. In her autobiography, she rattles off the fates of her onetime rivals. By then, Charles Revson's Revlon, Elizabeth Arden, and Helena Rubenstein had all been taken out of family hands. "The personal love and involvement are gone," she wrote. "They're companies now, not a family's heart and soul. It won't happen to Estee Lauder."

A few weeks ago, Aerin was leaving for work when her preschool- age son started crying and asking her why she had to go. She explained that she loved what she did, and she told him about his history. "I said, 'Estee worked so hard for what she created, and it's really important to continue that and make her proud and happy and to be happy with what you do and to continue that tradition.' And I said, 'I hope when you get older, whatever you do, you'll do it well and with passion.'" That may seem heavy for a mere tyke. But at Estee Lauder, the family is serious business.

Why technology transfer has failed to work in medicine.

Legal reasons, of course.

---

The Law of Unintended Consequences

Twenty-five years ago a law known as Bayh-Dole spawned the biotech industry. It made lots of university scientists fabulously rich. It was also supposed to usher in a new era of innovation. So why are medical miracles in such short supply?

Clifton Leaf
Research Associate: Doris Burke

6,630 words
19 September 2005
Fortune
U.S. Edition
250
English
© 2005 Time Incorporated.

Even in the mute efficiency of international wire transfers, $540 million makes a noise when it lands in your bank account. To Kent Alexander, that sound was a thud--and in this case "not one single thud, but a lot of different thuds." All afternoon on July 21, 2005, Alexander, who is Emory University's general counsel, president Jim Wagner, and other senior members of the school's administration were receiving e-mailed reports from the finance department: "121 million just hit!" And then, 50 minutes later, "183 million just hit!" Half an hour after that, an even richer stash arrived. Thud.

"It was an out-of-body experience," says Alexander, 46. "By any definition, it's a huge deal. As one of our trustees was saying, 'It doesn't get any bigger than this on Wall Street.' "

The deal in question had closed only days earlier, when a pair of biotech companies, Gilead Sciences of Foster City, Calif., and Royalty Pharma of New York City, outbid several other parties for Emory's roughly 20% stake in the powerful anti-retroviral drug Emtriva, which is used to treat HIV. The drug was developed more than 15 years ago by three of the university's scientists, working on federal research grants, but received FDA approval only in July 2003. Now, however, Emtriva (a modest seller in its own right) was being married to another antiviral in a single pill. The combination drug, called Truvada, was expected to have a worldwide market of nearly $1 billion in 2006. Emtriva was becoming a blockbuster. Citigroup set up the auction and hammered out the terms with bankers from Lazard. A white-shoe law firm, Covington & Burling, calculated the drug's projected royalty streams through the year 2021, when the patent life was scheduled to end.

The hard work was over, and now it was time for a champagne toast and a brief "end-zone dance," as president Wagner described it. In a short while they could start thinking about how to reinvest their windfall--around $320 million after fees and the 40% cut that belonged to the three Emory inventors. The cash would enhance Emory's leadership in AIDS- vaccine research--and help Wagner's plan to turn the university into a top-tier "destination" school. "This is just such a win-win-win story," Wagner says jubilantly. "We have an invention here that addresses a real international scourge, and we are now taking these resources and reinvesting them in American research and education. It's a pretty happy story."

Well, not entirely.

The Emtriva case may sound like yet another innovation in an unending stream of medical miracles, from "smart drugs" to gene therapy. But believe it or not, it's an example of a profound system failure. For a century or more, the white-hot core of American innovation has been basic science. And the foundation of basic science has been the fluid exchange of ideas at the nation's research universities. It has always been a surprisingly simple equation: Let scientists do their thing and share their work--and industry picks up the spoils. Academics win awards, companies make products, Americans benefit from an ever-rising standard of living.

That equation still holds, with the conspicuous exception of medical research. In this one area, something alarming has been happening over the past 25 years: Universities have evolved from public trusts into something closer to venture capital firms. What used to be a scientific community of free and open debate now often seems like a litigious scrum of data-hoarding and suspicion. And what's more, Americans are paying for it through the nose.

Let's go back to Emtriva for a moment. Raymond Schinazi, a virus specialist at Emory, got the idea for the drug after hearing a lecture by a Canadian researcher, Bernard Belleau, at a 1989 AIDS conference in Montreal. Belleau had discovered a compound that helped shut down the virus's genetic machinery, and Schinazi soon realized that with some chemical wizardry, the substance could be transformed into something far more potent. Thanks to a bit of "serendipity," Schinazi says, he and two Emory colleagues were able to do just that: create a compound that may be orders of magnitude more active than Belleau's. In the end, the difference between the two substances came down to one atom of fluorine. It's a perfect example of how one inspiration can build on another.

This combination of open exchange and fervent competition between great researchers helps bring about scientific advances. And when the system works, the sum of each contribution is greater than the whole. But what happened next in the Emtriva saga was a race to the patent office. Emory got there first--by a week.

That filing in 1990 triggered a morass of lawsuits over Emtriva and a related compound. Belleau's biotech employer sued; so did pharmaceutical giant Glaxo Wellcome (now GlaxoSmithKline), which had licensed what it thought was Belleau's discovery. Emory found itself embroiled in litigation that a veteran patent attorney called the most complex he'd ever seen. (One federal case had 36 individual "lead attorneys.") Emory's squadron of lawyers not only had to fight through those cases but also skirmish through four long challenges at the U.S. Patent & Trademark Office (USPTO) and repeat those battles in Europe, Australia, Japan, South Korea, and Canada. All told, the disputants wrangled on for nearly a decade and a half and consumed millions of dollars in attorney's fees.

And that's just for one dispute. From 1992 to September 2003, pharmaceutical companies tied up the federal courts with 494 patent suits. That's more than the number filed in the computer hardware, aerospace, defense, and chemical industries combined. Those legal expenses are part of a giant, hidden "drug tax"--a tax that has to be paid by someone. And that someone, as you'll see below, is you. You don't get the tab all at once, of course. It shows up in higher drug costs, higher tuition bills, higher taxes--and tragically, fewer medical miracles.

So how did we get to this sorry place? It was one piece of federal legislation that you've probably never heard of--a 1980 tweak to the U.S. patent and trademark law known as the Bayh-Dole Act. That single law, named for its sponsors, Senators Birch Bayh and Bob Dole, in essence transferred the title of all discoveries made with the help of federal research grants to the universities and small businesses where they were made.

Prior to the law's enactment, inventors could always petition the government for the patent rights to their own work, though the rules were different at each federal agency; some 20 different statutes governed patent policy. The law simplified the "technology transfer" process and, more important, changed the legal presumption about who ought to own and develop new ideas--private enterprise as opposed to Uncle Sam. The new provisions encouraged academic institutions to seek out the clever ideas hiding in the backs of their research cupboards and to pursue licenses with business. And it told them to share some of the take with the actual inventors.

On the face of it, Bayh-Dole makes sense. Indeed, supporters say the law helped create the $43-billion-a-year biotech industry and has brought valuable drugs to market that otherwise would never have seen the light of day. What's more, say many scholars, the law has created megaclusters of entrepreneurial companies--each an engine for high-paying, high-skilled jobs--all across the land.

That all sounds wonderful. Except that Bayh-Dole's impact wasn't so much in the industry it helped create, but rather in its unintended consequence--a legal frenzy that's diverting scientists from doing science.

Birch Bayh is likable--eminently so. He has a kind face, easy laugh, and enough self-deprecating charm to get a proud liberal Democrat elected (and reelected twice) in Indiana--a state as Republican red as Birch Bayh is, well, likable. That was a wonderful gift to have in the U.S. Senate, and it no doubt partly accounted for the fact that his patent bill overcame tremendous suspicion (as being "anti small business"), opposition by President Carter, and the Reagan Revolution, which cost Bayh his Senate seat in 1980.

At the time, the gospel of the U.S. government, or at least of the longtime Democratic majority in Congress, was that if the government paid for it, the taxpayers owned it. That was the thinking that drove some of the nation's proudest achievements--the splitting of the atom, the development of antibiotics, the moon shot, and the nuclear Navy.

Bayh sought to turn that policy on its head, essentially giving away all this taxpayer property for free--and, some worried, creating potentially thousands of new private monopolies in the process. It was a heretical view (for a liberal, no less), but Bayh was convinced that government ownership was squashing innovation and the nation's productivity. The stagflation of the 1970s was already clouding the new decade of the '80s; America's economic engine seemed to be choking; and the domestic automobile, steel, and electronics industries were fast losing their global dominance. There seemed to be a productivity malaise descending on the homeland- -and some kind of catalyst for change was needed.

It was a report by the Comptroller General of the U.S. that offered, if not the remedy, one culprit for the national gloom: unlicensed patents. A 1979 audit of government-held patents showed that fewer than 5% of some 28,000 discoveries--all of them made with the help of taxpayer money--had been developed, because no company was willing to risk the capital to commercialize them without owning title. "Discoveries were lying there, gathering dust," says Bayh today, from his office at the Washington law firm Venable LLP. "So the taxpayers weren't being protected. We'd spent $30 billion in research for ideas that weren't helping anybody."

When the bill was finally passed, against all odds, on the last possible day of a lame-duck session of Congress, it didn't make a whiff of news beyond the Beltway. Even Bayh had no clue what effect the new amendments would have. "I don't think anybody could have reasonably anticipated the enormity of the chain reaction that followed," says Bayh today.

A dozen schools--notably MIT, Stanford, the University of California, Johns Hopkins, and the University of Wisconsin--already had campus offices to work out licensing arrangements with government agencies and industry. But within a few years Technology Licensing Offices (or TLOs) were sprouting up everywhere. In 1979, American universities received 264 patents. By 1991, when a new organization, the Association of University Technology Managers, began compiling data, North American institutions (including colleges, research institutes, and hospitals) had filed 1,584 new U.S. patent applications and negotiated 1,229 licenses with industry- -netting $218 million in royalties. By 2003 such institutions had filed five times as many new patent applications; they'd done 4,516 licensing deals and raked in over $1.3 billion in income. And on top of all that, 374 brand-new companies had sprouted from the wells of university research. That meant jobs pouring back into the community.

A modern alchemy was at work: Ivory towers were being turned into gold, and society was benefiting from hundreds of novel treatments introduced for a host of diseases. After years of intense study and living grant to mouth, investigators at the University of California at San Francisco, for example, had come up with a treatment for infants with respiratory distress syndrome, an ailment that affects some 25,000 babies a year. A startup by University of Florida researchers got $15 million from some VCs in Menlo Park last year to develop a gene therapy for a type of emphysema called Alpha-1. Physicists at the University of Wisconsin in Madison figured out a way to turn static MRI views of blood vessels into videocamera-like images.

The anecdotal reports, fun "discovery stories" in alumni magazines, and numbers from the yearly AUTM surveys suggested that the academic productivity marvel had spread far and wide. But that's hardly the case. Roughly a third of the new discoveries and more than half of all university licensing income in 2003 derived from just ten schools--MIT, Stanford, the usual suspects. They are, for the most part, the institutions that were pursuing "technology transfer" long before Bayh-Dole.

Even so, every school labors under the fantasy that it's going to find the next Emtriva--or Gatorade, a huge success that came out of the University of Florida. The jackpot is too rich not to go for it.

In 2001, economists Richard Jensen from Notre Dame and Marie Thursby of the Georgia Institute of Technology published a survey of university licensing activity over a five-year period in the 1990s. They asked administrators and faculty researchers at 62 universities, "What's the most important outcome of technology transfer?" The top answer by far given by university officials was "revenue." Yes, it was nice to see important discoveries commercialized and the knowledge disseminated as widely as possible. But hey, we're in this for the money.

That certainly seemed to be the message in a recent court case involving Columbia University. Last year Columbia threatened to revoke the licenses of several leading biotech and pharmaceutical companies for the use of a critically important process in drug discovery and development called co-transformation. (The companies sued, and the cases ended up in a federal court in Massachusetts.) In the late 1970s three Columbia researchers, Richard Axel, Michael Wigler, and Saul Silverstein, all working with funding from the NIH, figured out a way to vastly improve the efficiency of a technique used in genetic engineering. They filed for patents in February 1980- -prior to Bayh-Dole. But the NIH assigned the title to Columbia once the university promised to "use all reasonable effort to bring the [Axel patents] to the commercial market through licensing on a non- exclusive, royalty-free, or reasonable royalty basis." The federal agency even admonished Columbia not to engage in "repressive" licensing practices.

The Axel patents were amazingly huge moneymakers for Columbia (and yes, the three inventors got rich too), bringing in a total haul of about $600 million during their 20-year patent life. The university had licensed co-transformation to 11 drugmakers and collected royalties on 19 different drugs for various diseases. Amgen had used the Axel technology while making its bestselling anemia drug, Epogen; Bayer and Wyeth each made hemophilia drugs; Genentech used it in making its blockbuster breast-cancer drug, Herceptin.

But when the patent life ran out, Columbia announced that-- surprise--it had secured a new patent, issued in 2002, that won't expire until 2019. (The patent application was filed in secret in 1995.) And the invention, as it turns out, comes out of the original taxpayer-funded work done by Axel, Wigler, and Silverstein long ago (and somehow not included in the three patents Columbia had already received). University lawyers had pulled off the trick by filing a secret "continuation" application (which keeps an original patent disclosure alive for possible new claims to be added) and then abandoning it--repeating this procedure again and again until the clock was about to run out. So the patent granted in 2002, noted federal district court Judge Mark Wolf, "relates back to its great- great-great-great-great-great-grandparent application" in 1980. The aim of this new "submarine" patent, says Boston attorney Donald Ware, who represented several of the plaintiffs, was to enable Columbia to surface with a claim "covering new advances the biotechnology industry had made during the intervening years." By delaying their filing as long as possible, they could get many more years of patent protection. And revenue, of course.

U.S. patent laws were amended in 1995 precisely to prevent this method of gaming the system. (Patents now expire 20 years after the original filing, or "priority date," rather than 17 years after the issue date, as they used to.) But Columbia managed to file two final applications on June 7, 1995--the day before the new law was to go into effect. When Judge Wolf indicated he was inclined to rule in favor of the plaintiffs, Columbia promised it would no longer attempt to charge the companies a licensing fee. (The case was then dismissed.)

No one at Columbia University would speak on the record about the Axel patents. The university's outside counsel, David Gindler, of the Los Angeles firm Irell & Manella, insists the school did nothing improper. "I don't think Columbia had a strategy to do anything other than get the full patent protection to which it's entitled," he says. "Universities should be able to get the same thing that companies get." Gindler elaborates: "It's perfectly proper for Columbia to do what any of the other biotech companies would do--to request companies take licenses to the patent and pay a reasonable royalty."

And later Gindler elaborates further: "Columbia acted no differently than the rest of the business community in the United States."

Columbia is hardly the only academic center to fancy itself a hard-charging corporation. Court dockets are now clogged with university patent claims. In 2002, North American academic institutions spent over $200 million in litigation (though some of that was returned in judgments)--more than five times the amount spent in 1991. Stanford Law School professor emeritus John Barton notes, in a 2000 study published in Science, that the indicator that correlates most perfectly with the rise in university patents is the number of intellectual-property lawyers. (Universities also spent $142 million on lobbying over the past six years.) Attorney Gindler defends the legal wrangling as part of a global good: "The money that comes into universities like Columbia for licensing is plowed back into the mission of the university to conduct more research," he says. "It's not used to pay shareholders or to fill corporate coffers. It's used for a really noble purpose."

So what do universities do with all their cash? That depends. Apart from the general guidelines provided by Bayh-Dole, which indicate the proceeds must be used for "scientific research or education," there are no instructions. "These are unrestricted dollars that they can use, and so they're worth a lot more than other dollars," says University of Michigan law professor Rebecca Eisenberg, who has written extensively about the legislation. The one thing no school seems to use the money for is tuition--which apparently has little to do with "scientific research or education." Meanwhile, the cost of university tuition has soared at a rate more than twice as high as inflation from 1980 to 2005.

The enormous investment by tuition-paying students, parents, and taxpayers of all ages might be worth it if the university research was paying off huge dividends. But here's the hard, surprising truth: In one crucial area of science--productivity, which Bayh- Dole was intended to supercharge--it isn't.

Measuring productivity, in general, is a difficult thing. In science it is nigh impossible. How can you tell whether an idle experiment in a basement lab somewhere is going to pay off one day with a cure for Parkinson's disease or ALS? You can't. And yet scientists try to measure their own scientific "output" all the time, and the unit of measurement is the number of papers that run in top-tier journals. Publish a lot in, say, Nature or Cell, and chances are you'll get your grant or tenure. It's a crude measure, but one that's quietly accepted in academic circles.

Each year, the National Science Foundation calculates which countries are contributing to the global knowledge pool by tallying up the number of their researchers' published papers in key journals all over the world. The U.S. traditionally holds an edge, not least because the vast majority of influential academic journals are published in English (and often edited and "peer-reviewed" by American scientists).

Trouble is, even with that advantage, the U.S. contribution to global knowledge has been stagnating. While the number of journal articles produced by American researchers has risen slightly since 1988, the rest of the world has raced ahead (see chart).

Or you could forget such squishy "knowledge indicators" and go to the hard stuff: drugs. FDA scientists have an entire vocabulary for describing new compounds that come into its office. When something is considered truly novel and innovative, the FDA calls it a new molecular entity, or NME. Many of the other drugs regulators see are reformulations, old compounds with new indications for use, or "me too" drugs that are similar to several on the shelf. But even the label NME doesn't mean a drug necessarily fills a critical gap in health care.

When regulators see promising clinical data for a drug that really is needed by patients right now--as with the HIV drug Emtriva in 2003--it gives the drug a "priority review." The idea is to get it out to doctors as quickly as possible. So those who want to measure the performance of the world's drug manufacturers should look not only at the total number of FDA-approved compounds and biologics in a current year, but also at how many priority NMEs are making it through. By both measures, the productivity picture is much worse than it was in 1996 (although 2004 seems to have had a bumper crop). From 2000 through the end of 2003, the average number of priority NMEs each year was eight; in the previous four years, it was twice that.

For a number of common diseases, it seems that progress has stalled. Since the advent of genetically engineered human insulin in 1977, there has been relatively little new help for diabetics. Age- adjusted death rates for those with the disease have gotten worse, not better, during the past 25 years. Patients with Parkinson's, Alzheimer's, and multiple sclerosis have waited anxiously for anything promising to appear in the pipeline. And in cancer, one remarkable study led by the FDA's cancer czar, Richard Pazdur, seems to say it all: A full three-quarters of the 71 cancer drugs approved by the agency from 1990 through 2002 did not show any survival benefit over the old, standard care.

What about the explosion in the biotech industry over the past 25 years--aren't those firms churning out innovative products? Here again, the numbers suggest otherwise. Consider the Nasdaq biotech index, which is a fair proxy for the industry. The combined market cap of its 157 companies is around $319 billion. This huge stake held by public shareholders is the direct result of Bayh-Dole, which gave these brave new firms something of value--intellectual property- -to take to the market. The legislation also made it possible for venture capitalists to bring companies public quickly and thus see a return on their initial investment.

What the law didn't do was give the companies something worthwhile to sell. Only 36 of the 157 companies on the index are profitable. And judging by the cold, hard measure of revenues, it's clear that few have produced drugs that doctors view worthy enough to prescribe. Forty percent of Nasdaq's bio-wonders had sales under $20 million in the past 12 months; 22% had less than $5 million. For every Genentech success story, there are dozens of teetering failures, with laser-fast burn rates and very little to show the buy- and-hold believers who purchased shares on the open market. Indeed, the industry as a whole has lost more than $45 billion since birth.

How could a law with so much intuitive promise to liberate research and boost productivity have the opposite effect? You can put part of the blame on the nation's patent policies--which began their own strange evolution at the same time as--you guessed it-- Bayh-Dole. The Supreme Court's decision in 1980 to allow for the patenting of living organisms opened the spigots to individual claims of ownership over everything from genes and protein receptors to biochemical pathways and processes. Soon, research scientists were swooping into patent offices around the world with "invention" disclosures that weren't so much products or processes as they were simply knowledge--or research tools to further knowledge.

The problem is, once it became clear that individuals could own little parcels of biology or chemistry, the common domain of scientific exchange--that dynamic place where theories are introduced, then challenged, and ultimately improved--begins to shrink. What's more, as the number of claims grows, so do the overlapping claims and legal challenges. This isn't merely a hypothetical situation, a "worst-case scenario" painted by academic hand-wringers. It has already happened, as two professors at the University of Michigan Law School, Michael Heller and Rebecca Eisenberg, observed in a seminal 1998 article in Science magazine.

Now technology-transfer offices instruct faculty to go over the most embryonic of discoveries "in-house," to see if there is anything potentially marketable in the work before they talk to colleagues. Researchers are told, always, to file provisional patent applications before publishing a paper or speaking at a conference. (Such public disclosures, according to European patent laws, immediately nix any chance to patent the finding overseas, where much of the licensing market is.) Before sharing resources like cell lines, reagents, tissue specimens, gene expression data, or knockout mice (those bred without certain genes to simulate a disease process), researchers at different universities are now asked to sign a "material transfer agreement," or MTA, and that means first having to run the contract by one's department head or a university lawyer. Then there is the most vexing of all patent-law confections: the "reach-through licensing agreement," or RTLA. These contracts grant the owner of a patented biomedical tool the right to a royalty on any compound that's ultimately discovered through its use. Imagine a carpenter having to pay Black & Decker a percentage of every kitchen he rebuilds.

Heller and Eisenberg dubbed this new dismal state of affairs the "Tragedy of the Anticommons." And that's what it is--a tragedy that's still in the making.

In October 1990 a researcher named Mary-Claire King at the University of California at Berkeley told the world that there was a breast-cancer susceptibility gene--and that it was on chromosome 17. Several other groups, sifting through 30 million base pairs of nucleotides to find the precise location of the gene, helped narrow the search with each new discovery. Then, in the spring of 1994, a team led by Mark Skolnick at the University of Utah beat everyone to the punch--identifying a gene with 5,592 base pairs and codes for a protein that was nearly 1,900 amino acids long. Skolnick's team rushed to file a patent application and was issued title to the discovery three years later.

By all accounts the science was a collective effort. The NIH had funded scores of investigative teams around the country and given nearly 1,200 separate research grants to learn everything there was to learn about the genetics of breast cancer.

The patent, however, is licensed to one company--Skolnick's. Myriad Genetics, a company the researcher founded in 1991, now insists on doing all U.S. testing for the presence of unknown mutation in the two related genes, BRCA1 and BRCA2. Those who have a mutation in either gene have as high as an 86% chance of getting cancer, say experts. The cost for the complete two-gene analysis: $2,975.

Critics say that Myriad's ultrarestrictive licensing of the technology--one funded not only by federal dollars but also aided by the prior discoveries of hundreds of other scientists--is keeping the price of the test artificially high. Skolnick, 59, claims that the price is justified by his company's careful analysis of thousands of base pairs of DNA, each of which is prone to a mutation or deletion, and by its educational outreach programs.

Whatever the answer, it's clear who pays for it. You do. You pay in the form of vastly higher drug prices and health-care insurance. Americans spent $179 billion on prescription drugs in 2003. That's up from ... wait for it ... $12 billion in 1980. That's a 13% hike, year after year, for two decades. Of course, what you don't pay as a patient you pay as a taxpayer. The U.S. government picks up the tab for one in three Americans by way of Medicare, Medicaid, the military, and other programs. According to the provisions of Bayh- Dole, the government gets a royalty-free use, forever, of its funded inventions. It has never tried to collect. You might say the taxpayers pay for the hat--and have it handed to them.

What might progress have looked like without the law? No one can answer that for sure. But one possible scenario is what happened to that other high-technology, university-incubated industry: the computer business.

Intellectual property was and is important in information technology. But very few electronic hardware, software, or Internet- related inventions are licensed through university intermediaries. Even companies that swear blood oaths against each other don't tie themselves into knots licensing bits and pieces of their technologies in airtight, exclusive deals. Rather, they broadly license their entire patent portfolios. In a piece of hardware that may straddle technology covered in a hundred patent claims, the strategic value of a single patent is low, says David Mowery, a professor at the Haas School of Business at UC-Berkeley. "One reason you see these big cross-licensing deals is because the effort required to determine the value of every patent in Sun's pile as opposed to IBM's as opposed to HP's is so great relative to the likely value of any single patent. So they come in with their proud stack and they just say, 'We'll let you have access to ours if you let us have yours.' "

This necessary sharing of resources has created giant new businesses and business models. And the effusive crosstalk between rivals is one driver in the lowering of prices for technology components (see chart). Semiconductor prices have fallen by an astounding 28% a year since 1974, in near synchronicity with Moore's law, coined way back in 1965. Meanwhile, the American consumer has benefited from one paradigm shift in technology after another.

Universities believe, however, that biomedical discoveries-- which account for more than half their invention disclosures and most of their licensing revenue--are simply a riskier proposition than computers. Not only are the failure rates sky high, there's also the FDA to worry about. No company would invest the huge capital to turn what was essentially a theory into a compound if it knew that rivals could come along later, after the hard work was done, and sell the same pill. Besides, exclusive deals let the schools offload their patent costs--often as much as $25,000 for the first filing--right away.

Those fears aside, the truth is that even if some skittish VCs stay home, the science will get done. In other words, Bayh-Dole has served mostly as a nervous mother for a science that never needed one. New biomedical discoveries are now coddled and kept out of the rain--and it's hurting progress.

The NIH recently said it thinks research tools should be freely licensed, for example, but there are no teeth in its policy. According to the provisions of Bayh-Dole, federal agencies do have the power to "march in" when necessary technology is not being disseminated into the public domain. In 25 years, however, the NIH has never used that power.

A better solution is simply to amend the law. The right to make a profit from a taxpayer-funded discovery should come with an explicit demand: The patent holder has to license the invention as broadly as possible--which would make exclusive deals the rare exception, not the rule. The fact is, the right people will always find a way to turn a good idea into something tangible. If you have any doubt, spend an afternoon in Cambridge, Mass.

"There are doughnuts in the conference room this morning," says John Preston. "A Saudi crown prince is coming for a visit." Preston, a senior lecturer at MIT's Entrepreneurship Center, former head of the university's technology licensing office, and a true pioneer in tech transfer, isn't the least bit excited about the prominent guest. It is hard to tell--but he may be excited about the doughnuts.

Here in his ground-floor office in the Muckley Building, next door to Kendall Square, Preston, 55, is drinking from a mug that's marked NERD PRIZE. It's a pet name for the Entrepreneurship Center's now somewhat famous "$50K Competition"--in which students and even faculty researchers vie for seed money based on the quality of their business plans. The contest, now in its 16th year, has showcased some notable winners--and losers. (The top prize in 1998 went to Internet search engine Direct Hit, which was later sold to Ask Jeeves for $447 million; the loser, Akamai, now has a market cap of $1.9 billion.)

The "$50K" is just one of scads of MIT projects to bring out the inner entrepreneur in campus denizens. At MIT, the discourse between university and industry isn't merely pervasive, it's a central feature of the culture. Every student has to do research; every faculty member gets a day off a week to consult for industry.

A 1997 BankBoston (now Bank of America) study tried to trace the effects of MIT's commitment to "useful knowledge," as the school's founder put it in 1861--tallying up all the companies founded by at least one MIT alum or faculty member, in addition to those spun off from an MIT lab. The study identified 4,000 companies, employing 1.1 million people, which together have $232 billion in annual worldwide sales. Among the bounty: blue-chip names like Hewlett-Packard (co- founder Bill Hewlett, class of 1936), Raytheon (Vannevar Bush, class of 1916), Intel (Robert Noyce, '53), Gillette, Tyco International, Digital Equipment Corp., and Campbell Soup. All these big companies formed way before Bayh-Dole.

Many of the companies (and jobs) remain in the Boston area, attracting more talent, venture funding, and commercial investment-- which, in turn, creates new companies. The loop feeds on itself, and a "cluster," that El Dorado of economic development, is born.

MIT understood that dynamic before anybody else. Forty years before Bayh-Dole, in fact, it set up a university office to license home-grown discoveries. By the mid-1980s--in part, thanks to a national attitude shift after the law's enactment--MIT wasn't merely granting rights to its technology, says Preston, but also aggressively taking equity positions in startups and doing its best to nurture young companies with money, management help, and the advice of seasoned MIT entrepreneurs. Even Preston--a big fan of Bayh-Dole--admits that the science would have probably come anyway.

Later, tooling around in Preston's Saab 9-5, the evidence of past economic booms and boomlets is unearthed like an archeological dig. History seems to fold upon itself in the redbrick building at 700 Main Street (what used to be called 28 Osborn). This is the place to which Alexander Graham Bell made his first long-distance phone call in 1876. Later, in another flush time, the building was used to make railroad cars, then Federal-style furniture for the Brahmins across the River Charles. The faded white lettering from the factory still calls out from the facade. The building was then rented by Edwin Land in the 1930s to house a research facility for what would one day be a newfangled camera called Polaroid. And then, at the turn of the millennium, it became the home of Transkaryotic Therapies, a homegrown biotech that was acquired in July by British company Shire Pharmaceuticals.

American ingenuity, it seems, never needs much of a jump start. Just a good sign painter.

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162%

? Change in NIH appropriations, most of which becomes grant money for academic institutions, 2003 vs. 1993.

157%

? Change in U.S. patents issued to academic institutions, 2003 vs. 1993.

Your Tax Dollars at Work Bayh-Dole by the numbers

98%

? Rise in NIH budget from 1998 to 2003--much of which goes to fund university research.

49%

? Typical share of each federally funded research grant ("RO1") that universities claim to cover "indirect costs"--that is, overhead.

21%

? Increase in lab space, measured in square footage, at American universities, from 1998 to 2003.

32%

? Average rise in tuition at public four-year universities from 1998 to 2003.