Buyers and Builders
00:00:00 · Mikk
[00:00:00] S0: All aspects of life, including in our careers, we are best off if we seek advice from the best brain trusts we can find. The private investment professionals who have contributed a great deal, both in capital and in strategic expertise, clearly have much to share with people who want to understand how businesses succeed or fail. Choosing to absorb what these successes or failures teach is akin to adopting mentors for our own careers. And this is from the book, The Masters of Private Equity and Venture Capital. Obviously, for this episode and for you guys, folks interested in lower middle market, we are focusing on specifically on the masters of the private equity side. The selection of a mentor is one of the most important decisions a person can make. It literally can be the first step in directing our own destiny. Our parents influence us profoundly, but not by our choice. Our mentors, on the other hand, we choose their ideas, their habits, their ethics, their successes, their failures. We embrace the best of these winning qualities because we want to emulate the people who embody them. The voices that populate this book are the very best mentors of an important part of our capitalist system, private investment. And individually as a group, these Pioneers of the Trade have built tremendous track records and helped to turn the private equity businesses into major forces in our economy. Admittedly, some private investment professionals have paid too much for companies they acquired, and others fairly can be accused of using too much leverage and managing for short term profit. But the vast majority of private equity investors have breathed new life into countless companies that otherwise might have floundered in an increasingly competitive global economy. Starved for capital or close down altogether. This book, The Masters of Private Equity and Venture Capital, it's written by Robert Finkel, founder and managing partner of Prism Capital. And I like how Robert starts the book because his introduction to private equity actually begins around the dinner table when he was a kid. And Robert was saying, during dinner when I was young, the conversation frequently turned to business. His father would entertain and teach the family by impersonating a Harvard Business School professor named Georges Doriot.
00:02:44 · Mikk
And at the time, Robert didn't fully understand the significance of the person his father kept talking about because professor Doriot was widely considered the founding father of private equity investing. Long before private equity become the enormous industry it is today. And what I find interesting is that Doriot's contribution wasn't simply figuring out how to raise money or invest it. He created a way of thinking and operating in business, pooling investors money and deepening its impact by putting discipline, accountability, and a sense of purpose to work on its behalf. The capital itself wasn't the entire advantage. It was what you did with a company once the capital was there. The discipline you brought, the accountability, the people and the purpose behind it. And Robert Finkel taught beautifully. By harnessing the capital and commitments needed to support innovation, Doriot was introducing a new chapter of the history of capitalism. I also read some additional work and how Doriot was writing and how he describes a company. The study of a company is not the study of a dead body. It is not similar to an autopsy. It is a study of things and relationships. They are very much alive and constantly changing. It is the study of something very much alive which falls and breaks up unless constantly pushed ahead or improved. It is the study of men and men's work of their hopes and aspirations. The study of the tools and methods they selected and built. It is the study of conceptions and creations, imagination, hopes and delusions. And what Professor Doriot described is the misleadingly simple phrase as the study of a company. It's really the essence of what private investment is all about. Companies are hardly cadavers, rather they're complex, living networks of people, capital, products and markets. Likewise, private investment is not simple transaction of buyer meets seller. It is the beginning of a relationship, one that requires nurturing, discipline, sharing, and accountability. If the relationship works, the rewards are rich. If it doesn't, the company suffers and eventually so does the private investment firm because it shares responsibility for the failure, especially in the eyes of the investors who support the fund and expect success. Now here are described the hallmarks of success required in private equity.
00:05:30 · Mikk
The best investors are walking sources of wisdom based on broader experiences than most of the managers with whom they work. They frequently do not have the industry knowledge or possess the operating talent needed to run their portfolio companies, but they do have what few corporate CEOs can hope to have, knowledge about patterns of success based on data points acquired from up close experience in dozens of companies and several industries. The successful private equity investors are people who value the sort of holistic approach to business that Doriot preached. They figure out how to ask the right questions in the right order. They value intellectual honesty and let the facts speak for themselves. They do not let emotions cloud their decisions. Their ability to be self critical, relative, and adaptive is the lifeblood of their livelihoods. They see companies not as mere numbers on a balance sheet, but as a living entities that need support and encouragement to survive. Sometimes the decisions are difficult, other times they're inspired. Not all companies can make it, and sometimes it falls to a private investment professional to decide whether the company can survive. And he sums up this paragraph with a question, are the challenges temporary or final? So now as the title of the book, The Masters of Private Equity, the first master we're going to talk about is Joseph Rice the third. He's the founder and chairman of Clayton, Dubilier and Rice CD and R. And I think he's the perfect person to start with because Rice spent essentially his entire business career in a buyout business. At the time this book was written, he had already spent more than forty years in private equity. His track record included companies like Hertz, Lexmark, Kinko, Sally Beauty, Uniroyal, Goodrich, US Foodservice, and Scotts. But what... What's interesting about Rice isn't just deals, it's the philosophy he and CDR built around them. Today almost every major private equity firm talks about operational value creation. But Rice and CDR were among the pioneers of combining financial skills with real operating capability inside the PE firm. Their idea was very simple. Don't just be good at buying companies, be good at making companies better.
00:08:09 · Mikk
And you'll see this again and again in Rice's chapter, he talks about bringing experienced operators into the investment process, people who had actually run large businesses, managed through recessions, hired and fired people, deal with competitors and made difficult operating decisions. That experience became part of how CDR invested. And there's one line in in his profile that I think tells you a lot about about this man who we are going to learn from. And his lesson is nothing in the world can take a place of persistence. Again, when this book was written, Clayton, Dubilier Rice had around 10,000,000,000 US dollars under management. And today, the firm is many times larger. Recent regulatory data puts it at roughly 87,000,000,000 in assets under management. So just to put the scale into the perspective there, twelfth flagship fund alone raised 26,000,000,000. We're talking about the firm that took this operating philosophy. Joe Rice is describing here and scaled it into one of the largest private equity firms in the world. What makes Joe Rice and CDR interesting is that they understood something early that almost every private equity firm talks about today. You can't create all the value from their spreadsheet. They brought in people who had actually run major companies and put them alongside the dealmakers. Rice puts it simply, an operating capability has been the essence of our firm from the very beginning. And you can see it in the deals. They used that operating perspective in the 200 fill... 50,000,000 Harris graphs carve out in Uniroyal and later when they carved Lexmark out of IBM. But personally, my favorite example comes from two thousand and eight two thousand eight September. Lehman Brothers has failed. AIG is being bailed out, and financial markets are really like falling apart. Everyone is preparing for what could be a brutal recession. CDR is holding its annual strategy meeting, and the natural reaction is exactly what you'd expect. Protect the portfolio, cut risk, lower forecast, preserve cash. Rice admits that even he had gone into what he calls a defensive crouch, and then Jack Welch gets up. Rice had recruited Welch after he retired from GE to become a special partner at CDR. This is someone who had spent decades actually operating through different business cycles. And Welch sees the exact same crisis completely differently.
00:10:57 · Mikk
And his message basically is this, your companies are market leaders. They're well capitalized. Yes, protect yourself, but look around. Your weaker competitors are hurting far more than you are. So instead of retreating, you should attack. They started thinking about taking market share, giving flexible terms to strategic customers, recruiting talent from weaker competitors and simply making acquisitions. And Welch reduced their entire strategy to one line, hammer them, don't play defense, Play offense. This is the operating perspective in practice. Financial person might see a crisis and think like, how do we protect the downside? And then you have this extremely experienced operator who can look at the exact same situation and simply ask, where is the opportunity that only exists because everyone else is in trouble? That's why Rice says operating partners have lived through business cycles before. They've seen what happened when markets collapse. They've seen competitors panic. They've made payroll, lost customers, hired people, cut costs, gained market share. There is a kind of pattern recognition that comes only from actually having lived through it. Operating perspective is for us the single most important aspect of our investment model. The section is how much value they put on having actual operators involved in the investment process. And the firm looks at something like 100 offering books for every deal they actually do. And often it's the operating partners who see something their financially oriented partners don't. Again, which makes sense. There are things you probably only learn after you've actually had to run a large company. They had people like George Tamke, who spent years at Emerson Electric and eventually got the job... Top job. Fred Kindle, the former CEO of ABB. Ed Liddy, who transformed Allstate's relationship with its insurance agents and was later brought in by Henry Paulson to help save AIG when it was close to failure. These people can look at management team and pretty quickly tell whether they have the talent and experience to actually do what the investment requires. Operational ability is almost like hair color or being naturally good with languages. If you've got it, people who've got it themselves can usually see it. And if you don't, they can see that too.
00:13:42 · Mikk
This reminds me something Urs Wietlisbach talks about at Partners Group. I was doing a research episode on them and they have a very similar philosophy, but what I really like is how they combine it with incentives. And Urs was saying they're big believers in sweat equity. Their senior managers own shares in the companies, and they don't just give them huge salaries and hope they'll act like owners. And he was giving a few examples where they've had those CEOs make 100,000,000 or more from their equity. And these CEOs made Partners Group six, four, six or seven times its money. And the specific example was BCI Pharma Services, where they brought in a heavyweight pharmaceutical executive as chairman. And importantly, he put a lot of his own money into a... This specific deal as well, and Partners Group end up up making around four times its money. You have the private equity people, the management team, and then a serious industry operator sitting around the same table. And all of those people have skin in the game. You don't need the finance guys. Pretend they know how to run everything. Find people who have actually done it. Get them involved. Give them ownership. And if they create an enormous amount of value, let them make an enormous amount of money with you. Now from the from the book, there's a great story about how he learned the importance of having operators around the table. In 1969, he starts an investment firm with three other people. The problem was that all four of them were finance guys. They were good at reading financial statements and putting deals together, but they didn't really understand the operating side of the business. They agreed to buy a magnetic tape company with a guy who is supposed to become a CEO. And this guy tells them the company has this great differentiated technology. And they they believe him, not because they've done the work and agreed with him, but because none of them knew about the technology to challenge him. Eventually, realized that the product isn't technologically advanced at all. It's basically a commodity, and the deal is bust. They knew finance. They knew deals, but there was nobody sitting on their side of the table who actually understand the business well enough.