Times are tough for private equity firms, but for those able to find a strategy that works, institutions will always be willing to pay a premium for the return private-equity can deliver, said Joseph L. Rice III, founder of Clayton, Dubilier & Rice, in a speech this month to members of the Wharton Private Equity Club.
Rice and his partners founded CD&R 25 years ago when private equity investment was a new frontier. Since then, the firm has invested $4 billion in 36 companies with a total transaction value of $18 billion and revenues of $25 billion. Former General Electric chief executive Jack Welch is now a partner.
“It’s a tough market for a firm that doesn’t have a franchise,” said Rice. “The rules of the game have changed. Returns are going to [be different], and they are never going back to where they were before.”
According to a report by Thomson Venture Economics and the National Venture Capital Association, commitments to venture capital funds fell sharply last year. In 2002, 108 funds raised $6.9 billion. The year before 331 funds raised $40.7 billion.
Rice said an oversupply of $125 billion in contractually committed capital in the market is driving up prices for assets to the point where it will be difficult to earn solid returns. Another drag on returns, he added, is higher equity requirements. In the 1980s, he could finance a deal by putting up only 10% of the equity. Now, it takes a 40% to 50% equity investment.
“That alone changes the returns so dramatically that it’s almost hard to believe,” Rice noted. He recently went through the exercise of recalculating the firm’s 1986 Uniroyal deal that returned 125%. Under today’s equity standards it would have returned 17%.
Institutional investors have grown more sober about private-equity markets, but will continue to turn to the industry to provide stronger returns for at least part of their portfolio, he suggested. “The institutional investor, who is [our] lifeblood, has come to recognize that like all financial instruments, there is a pulse to this business and the returns that have been achievable are not absolute.”
Institutional investors are looking to private equity for a return of 500 basis points above other investments, he said, which means that private equity deals must return 15-16% to remain above returns of 9-10% expected over the long run in the stock market. “Still, investors will pay for that 500-point basis spread. It means a tremendous amount to them.”
Rice sees no improvement soon in the public markets, which are crucial to private-equity investors as the primary means of cashing out of an investment. “You have a stinky economy. You’ve got a war. You’ve got some people who have abused their position as corporate executives. The combination of all those things has served to deaden the markets.”
Golf Games and Rolodexes
Rice trained as a lawyer, but early in his career worked on a buyout transaction and became hooked. In 1969 he founded a buyout firm that failed, he said, because it relied too much on financial strategies and not enough on operational knowledge. He later teamed up with Martin Dubilier and Gene Clayton who had spent their careers running troubled businesses for institutions. They started out as consultants with the idea of later becoming a buyout firm.
CD&R, based in New York City, now has 15 partners, seven of them with top-level corporate experience. Rice said that including operational experts in the firm, along with people with financial experience, was revolutionary at the time CD&R was founded. The operating experience allows the firm to better understand how the portfolio businesses operate and to help guide management in a turnaround. “Finally, it gives you the ability to take over management of the company in the event it fails.”
While operational people are good for the turnaround aspect of the business, they are not of much use when prospecting for new deals, said Rice, describing the operations partners at his firm as having “rolodexes you would die for” but being loathe to try to sell their golfing buddies on doing a deal with the firm. Rather it is the financial partners, like himself, who create new business: “The financial guys are the ones always hustling,” said Rice. “Operational guys have never developed that skill.”
The firm’s minimum investment is a hefty $250 million, which Rice said helps keep their portfolio focused on fewer companies. But that also makes it harder to sweep problems under the rug. “I am more humble today than three years ago. Until 1999 I would have stood up here and said that we are the most successful organization in this business. But in the last three years we’ve taken some real shots.”
Rice said one operational partner severely misjudged his ability to turn around a portfolio company. Twice. “Since I’m the oldest member of the firm I was the one who was supposed to provide adult supervision, so I’m now in a position where I’ve got to look back and say, ‘Did I really do what I’m supposed to do?’”
Some private equity firms, according to Rice, have performed better in the current environment by relying on other product lines, such as real-estate funds, hedge funds or mezzanine financing. “The strategies employed by those people have turned out to be a good strategy – a better strategy than ours, quite frankly. They have a product line that does well in down markets and that does well in up markets. We’re a one-trick pony.”
A multi-product strategy takes more people and is harder to implement, he suggested, adding that he wanted to keep CD&R small and focused. “While I admire the strategies of people with multi-product lines, it just wasn’t one that I wanted – except when we’re going through a period like this. Then I would love it.”
The firm’s biggest success, according to Rice, was its 1991 buyout of IBM’s Impact printer business that is now publicly-traded Lexmark International. His personal favorite deal was CD&R’s $250 million buyout of Harris Graphics in 1983, which laid the groundwork for the firm’s first fund. “When you are living from deal to deal with no income coming in except what you generate from deals it’s a very big change to have a fund that pays every quarter. It makes it an entirely different business.”
The firm currently has stakes in Kinko’s, online business incubator Guidance Solutions, and sporting goods manufacturer Remington Arms.
Private Equity Abroad
Opportunities for private-equity firms can be found abroad, primarily in Europe, Rice suggested, adding that Europe is a better location for investing now than the U.S. because European businesses have not undergone the streamlining that occurred in America. That streamlining, he added, was driven by global competition and shareholder activism. “Industry [abroad] cries out for rationalization and restructuring. But the fact is, it has been crying out for about the last 20 years.”
Europe needs to undergo a cultural and political evolution to break down the social contract that provides rich government benefits to workers before industries are able to restructure, he said. “It’s going to be a better market, but one where you need a tremendous amount of patience.”
Successful buyouts overseas depend on investing in a country with an established rule of law and stability, Rice added. Latin America meets the first criteria but perhaps not the second, while Asia is an immature market and it will be a long time before investors make money there. “It is a market dominated by personal relationships. It’s good if you have the right relationships but it’s not good if you don’t.”
Meanwhile, Rice said, private-equity investment itself has grown into a mature business in the years since he founded the firm. “The private-equity business really wasn’t a business; it was a lot of fun making it into one. The pioneering part is behind us.”
The nature of private-equity deals will continue to evolve, growing larger and more complicated, he predicted. “You can still have a very interesting and financially rewarding career. It’s just not going to be what it was before.”