Wanted: Real CEOs
Private equity firms are no longer just content with financial reengineering-they want operating savvy.
November 2 2005 by Joan Warner
Jack Welch does it. Lou Gerstner does it. So does Colin Powell’s son, Michael, the former Federal Communications Commission chairman.
These are just a few of the boldface business names that have entered the fast-growing world of private equity. Once an enclave dominated by financial “Masters of the Universe” who bought and sold companies for quick paper profits, private equity firms today play a hands-on role in shaping industries from aerospace to water filtration. Private equity partnerships control a vast and growing pool of capital-some $300 billion at the end of 2004-with which to build their portfolios.
But they’re finding that throwing money at deals is not enough. To stand out in an increasingly cutthroat field, they are hiring former chief executives and other C-level veterans as operating partners, adding practical experience to financial wizardry. “Historically, these firms looked to buy companies on the cheap, hold them for five or six years, and then sell higher,” says Steven M. Bernard, director of M&A market analysis at Robert W. Baird & Co., a global asset management and investment firm. “Now it has become more competitive, and they’re trying to differentiate themselves by getting more involved. They need former CEOs on their boards, people with operational backgrounds. If you don’t have one, you’re not going to win.”
It may be an oversimplification to say that today’s private equity firms pick up where the leveraged buyout firms of the 1980s left off, but today’s dealmaking stars are generating comparable excitement. After slumping in the wake of the stock market crash of 2000, mergers and acquisitions are hot again. According to Thomson Financial, M&A volume hit $833 billion last year-a 46 percent increase from 2003 and the biggest year-on-year gain since 1998. And private equity firms are cutting themselves a thick slice of the pie, accounting for nearly 10 percent of global deal activity. Through mid-2005, the dollar value of buyouts worldwide reached $101.5 billion-about the same as the LBO total for all of 1988.
Deal size is where the parallel ends, though, according to industry experts. The LBO kings of two decades ago were famous for financing takeovers with junk bonds-sometimes borrowing 90 percent of the acquisition price-and then stripping their targets of assets before taking them public again at a profit. Running companies was neither their forte nor their goal.
Today’s private equity financiers raise capital from high net worth and institutional investors, sometimes topping it up with debt, then roll their sleeves up to grow their portfolio companies’ revenues before reselling them or taking them public. In some cases, they do this organically; in others, they combine the acquired business with one or more they already own, or with a new acquisition. “If you go back to the 1980s, you made money the day you bought the company,” says Timothy DeVries, managing partner at Norwest Equity Partners, the private equity arm of Wells Fargo. “You got it at a bargain because markets were less efficient. Now you have to create value.” Norwest has three operating partners on its roster, which DeVries believes gives the firm an edge among the 900-plus private equity firms crowding the field today. “There are a lot of us out there trying to buy companies, and there are a lot of different personalities in our industry. The most important thing for the management team [at our targets] is having a cultural fit with their investors. They want someone who shares their philosophy.”
In addition, private equity firms today are more specialized than their predecessors. Rather than doing any deal that looks potentially profitable, the most successful firms zero in on specific industries and hire expertise in those areas. For example, Providence Equity Partners, where Michael Powell is now a special advisor, has a long track record in media and telecommunications, with a portfolio of companies in those industries worth some $9 billion. The hope is that the former chief of the Federal Communications Commission will help the partners get ahead of industry trends and pinpoint the next hot deals.
The Operational Advantage
Why would a CEO jump from the peak of a corporate pyramid into a financial partnership? Sometimes, the captains of industry just don’t want to retire. Lou Gerstner is chairman of The Carlyle Group, the blue-chip private equity firm with $30 billion in capital, 150-plus companies in its portfolio and connections in political capitals all over the globe. He joined in 2003, almost immediately after he left Big Blue, bringing the accumulated wisdom of years as CEO of American Express Travel Related Services, RJR Nabisco and IBM.
Similarly, Jack Welch joined New York-based private equity firm Clayton, Dubilier & Rice as a special partner in October 2001, just months after waving good-bye to General Electric. It’s not a full-time gig, but Welch sits on the screening committee, assessing new investments and performing operating reviews of portfolio companies at CD&R, which has $3.5 billion in capital.
Indeed, CD&R prides itself on being among the first private equity houses to recognize the advantage of bringing in tried-and-true executives to complement its number-crunchers. “Our seven operating partners have run businesses, and they have a network,” says Donald J. Gogel, the firm’s president and CEO. “They have experience in global sourcing, Treasury and sales force management. That’s a proprietary edge.” The operating advantage seems to have paid off: Among other high-profile turnarounds, CD&R in 1991 bought an assortment of lethargic product lines at IBM and turned them into inkjet printing behemoth Lexmark, which now trades publicly and has a market capitalization of $10 billion. The firm also masterminded Kinko’s transformation from a scattered chain of copy shops into a single, global corporation, which was bought by FedEx last year for $2.4 billion.
Sometimes, the migrating executive has a turnaround, too. Former Ford Motor CEO Jacques Nasser left the carmaker under a cloud in late 2001, having watched his company lose money and market share. The following year, he joined One Equity Partners, the private equity arm of Bank One (now owned by JPMorgan Chase), as a senior partner. Nasser promptly stepped into the chairmanship of Polaroid, which One Equity had acquired after it filed for bankruptcy protection. He and his partners got rid of money-losing operations, trimmed the work force and struck a deal to license the well-known Polaroid brand name to various consumer electronics makers. By last May, Polaroid was profitable and trading publicly again; this spring, the company was sold for $426 million. Besides getting his share of One Equity’s take in the deal, Nasser held 3 percent of Polaroid stock, worth nearly $13 million.
But the Polaroid comeback is chump change compared with the private equity deals that industry watchers see ahead. Thanks to swelling flows of funds from investors, firms have money to burn. “We have seen a steady increase of capital going into private equity in the last five years,” says Chris Coetzee, co-director of M&A at Baird. “The business has matured, and a lot more pension funds, high net worth individuals and endowments are looking for alternative asset classes to invest in.” Private equity is especially alluring to such investors when the stock market is sluggish-returns can range between 20 and 30 percent.
The long period of low interest rates has also helped firms fill their coffers, allowing them not only to do bigger deals but also to make more money doing them. “Private equity firms can increase their returns on equity by borrowing more and putting in less equity,” says CD&R’s Gogel. “We’re not back to the 1980s, when LBO firms put up 10 percent of equity and borrowed the rest. But we can carry a large amount of debt sensibly, sometimes putting in just 20 to 25 percent equity.” In addition, the lending environment is favorable. “Banks are still more than willing to lend to fund these transactions at very favorable ratios,” says Coetzee.
All these factors mean that more and more dollars are chasing a limited number of big, lucrative deals. Recently, several top-tier private equity players have even begun pooling their resources to create megafunds that could afford to buy the world’s biggest corporations without batting an eye. That trend is likely to boost demand for seasoned executives even further. A firm might control $60 billion in revenues, when all the companies in its portfolio are added up, and the partners study their cost structures very carefully. Increasingly, they are looking to bring full-time former operating executives on board to streamline costs, for example, through collective bargaining for insurance.
“For the private equity world, it’s not just about top-line growth,” says Scott Dunklee, managing partner of executive search firm Lancer Group in La Jolla, Calif. “The firms are also focused on bottom-line expenses. As these megafunds control more and more portfolio companies, there will be a need for operating guys to go in and take out costs. They could see hundreds of millions in savings.”
Leveraging Skill Sets
Dunklee believes CEO supply will keep up with demand. For one thing, as he puts it, running a publicly traded company in the post-Sarbox era “isn’t much fun anymore.” For another, working as an operating partner for a private equity firm offers a chance to spread your talent around several different investments-and avoid the agita of betting all your chips on a single company. “If you have the right opportunity with the right firm, it’s a great way to leverage your skill set,” says Dunklee.
The private equity professionals who do the hiring agree. “Many good managers would love the opportunity to build a business in private,” says Norwest Equity Partners’ DeVries. “You don’t worry about quarter-to-quarter earnings, and your compensation isn’t disclosed in the proxy. It’s a better management job.” Gogel at CD&R is even more blunt: “Our operating partners know they can work 30 hours a week, still get the stimulus they love and be able to make a pretty good penny in equity participation.” Typically, private equity firms earn a fee of 1 to 2 percent of the funds they manage and get 20 percent of profits when they sell an asset. Individual partners’ compensation varies but often includes stock in portfolio companies that get taken public.
What do the owners and managers at those portfolio companies get out of working with private equity firms? For many, bringing in private investment capital for growth is an attractive alternative to launching an initial public offering or selling majority ownership to a corporate buyer that may have a different business plan. Often, managers retain minority control and have a stake in their company’s next incarnation. Indeed, their comfort level may actually be higher with a financial buyer than a strategic buyer.
And for family-owned or middle-market companies, private equity partnerships offer critical experience, along with capital. “These firms have gained expertise across a portfolio of companies,” says Baird’s Coetzee. “Smaller companies may not know how to source from Asia, for instance. If you’re a second-generation business with no apparent successor, you need capital to take it to the next level, and you need to be part of a broader organization to compete in a global environment.”
The private equity playground is not for everyone. Dunklee cautions that many firms still do business the opportunistic way, buying a theme park one day and an auto parts maker the next. They may bring in executives on an ad hoc basis, more for their Rolodex power than their management skills. “At the end of the day, if you’re an operating executive, you’re used to managing businesses, and private equity firms are still deal animals,” he says. “If you want to get in bed with them, you’d better speak their language.”
Still, CEOs at career crossroads can expect to see more and more opportunities beckoning them into the buyout game as private equity firms add human capital to their treasure chests. For many executives, those chances will prove rewarding in more ways than one.
Sitting in the Driver’s Seat
Private equity firms’ high profile rose even higher in September when The Carlyle Group, Merrill Lynch Global Private Equity and Clayton, Dubilier & Rice announced they would acquire The Hertz Corporation from Ford Motor in a leveraged buyout worth $15 billion. If the deal closes by year-end, as expected, it will be the biggest LBO on record since Kohlberg Kravis Roberts & Co. bought RJR Nabisco for $31 billion in 1989.
With $6.7 billion in revenues last year, second only to Enterprise Rent-A-Car, Hertz has been profitable for Ford. But the automaker needs cash to shore up its ailing operations in North America. Hertz’s new owners, meanwhile, hope to improve the rental company’s efficiency and eventually take it public. One CD&R partner has said the firm had been eyeballing Hertz for more than three years, and the LBO agreement capped a bidding war with a rival private equity consortium that included The Blackstone Group, Bain Capital, Thomas H. Lee Partners and Texas Pacific Group.
Overseeing Hertz’s future will be CD&R operating partner George W. Tamke, who will become chairman. Formerly co-CEO of Emerson Electric, Tamke joined CD&R in 2000. Since then, he has served as chairman of Kinko’s, which CD&R sold to FedEx last year. And he is the current chairman of water treatment company Culligan International, which CD&R bought about a year ago.
Hertz spokespeople say the company’s CEO, Craig Koch, will be keeping his job.