Buyers and Builders
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.
00:16:21 · Mikk
And Joseph Rice said the lesson from this deal was that experience made me conclude that I needed somebody every single time on my side of the table who understood business and could evaluate markets, operations, technology, and importantly, the ability of the business to respond to different cycles in the economy. That failure actually influenced how they built the firm later. He says that when he stuck out in 1978 with Martin Dubilier and Gene Clayton, he deliberately partnered with people who weren't financiers. They came from crisis management. They had actually been brought into troubled companies by banks and insurance companies to help run them day to day. They had also worked with Jerry Goldberg and later KKR evaluating deals. He had the deal making and financial expertise now, and they brought the operating expertise to... On the table as well. Now the next step is all about building the pattern of success, and the great example in the book shows that CDR actually mean... What they mean when they talk about combining financial people with operators. And they bought Uniroyal in the 1980s after Kyle Icahn had made a hostile bid for the company. And a big part of Uniroyal was the tire business, which they eventually combined with Goodrich tire operation. And on the paper, the partnership probably looked sensible. It was fiftyfifty, and they even divided the management positions equally. Goodrich gets the CEO, CDR gets the COO, and Goodrich gets the CFO, and CDR gets the controller. But he describes the result very simply. It was a recipe for disaster. And I think there's a lesson just in that. You can make something look perfectly balanced on paper and still create a structure where nobody's really in control. And eventually, CDR went to Goodrich and and said to them, one of us has to go. Either you buy us or we'll buy you. And CDR bought them out. This is where their operating model becomes pretty interesting. They didn't go searching for somebody after the problem appeared. They already had Chuck Ames, one of their operating partners who could step directly into the CEO role. He took over, revitalized the business, and eventually, they sold it to Michelin on very great terms. And that's the part I I would remember. CDR says its operating partners have actually stepped in as interim CEO in about the third of their investment.
00:19:08 · Mikk
So these aren't retired CEOs sitting around giving advice once a quarter. The idea is if something goes wrong, the person sitting next to us needs to be capable of actually running the company. And it goes back to the principle they built the firm around, put financial capability and operating capability inside the same investment firm. Not advisers on the outside, operators on your side of the table who can actually take over when needed. There is another deal described. It's the company called Lexmark. And CDR was looking at buying IBM's typewriter and printer business and turning them into a completely independent company. Martin Dubilier had actually run a business products company and held the original patent on the daisy wheel printer. This was an area where they had real operating knowledge. Their view was basically this, we can do this. This will be a great business and strategy. Very simple. Use the cash flow from the major businesses to build the laser printer business. They knew they couldn't just take this business out of IBM and continue operating like IBM. IBM had this incredibly strong corporate culture, white shirts, dark suits, regimented training, but it wasn't particularly entrepreneurial. They started changing their incentives. They lowered the emphasis on fixed compensation and increased performance based compensation. But the most important thing they did was ownership. Most importantly, we gave every employee of the new company a direct or indirect ownership interest in it. And the crazy part, when the new company went public, the value of the employees investment interest was greater than at $1,000,000,000. IBM's product development cycle was around thirty months. HP, Heblett Packard was doing it in eighteen months. They decided Lexmark needed to get to fifteen months, and they basically did it. They introduced pay for performance into the development lab and cut the product development cycle in half. The deal closed in March 1991. By the end of that same year, they had already paid down 300,000,000 of debt, which is way ahead of schedule. They streamlined manufacturing, speed up product development, and got the sales force moving. Then in 1995, they took Lexmark public. By the time they were financed, the CDR had returned more than four times the original investment to its LPs.
00:21:53 · Mikk
What they did, they took a piece of IBM, gave it its own culture, changed the incentives, came to employees ownership, and made the company move a lot faster. Previous thirty month, they were able to now do the development cycle in fifteen months. That's the true like operating side of Private Equity. You're not just buying the business, you're changing the environment in which the people inside the business operate. The next two stories are are super interesting, and these are the stories, I think, show both sides of private equity very well. First is Kinko's, and Kinko is the American copy and print shop, the chain of of those shops, which was founded in 1970. And CDR ported in 1960... 1996, but it wasn't really one company. It was 127 businesses spread across The US with different opening hours, different services, even different ways of dealing with customers. George Thumpka, one of CDR's operating partners, eventually run the company on an interim basis. And he used his used this incredibly simple idea called called quality lying, where you take one metric, for example, revenue per employee, rank every store, divide them into four groups, and then study the best performance. What are they doing differently? Then you're gonna just take those practices and push them through the rest of the company. He also throw the units in each quartile to perform at the level of the quartile above them. It was common sense and it worked extremely well. So they eventually sold Kinko to FedEx, but then he gives the very opposite example of a story which didn't go well, and it's the company US Office Products. And this was a roll up of more than 100 distribution businesses. They hadn't done enough due diligence. When the business began to slide, we could not stop the decline, and the business was eventually restructured and our investment was lost. His reflection on that, the whole period is probably the most important part. Looking back on this period, I believe we suffered because we thought we were better than we really were. We thought we could do anything, pride caught before the fall. He also adds, but I also believe that it is a measure of our institutional resilience and the strength of the firm's underlying investment model. Even with significant underperformance of the investments made in 1998 and year 2000, our overall performance continued to be strong.