Buyers and Builders
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.
00:24:42 · Mikk
Now their take was that don't blame the bad investments, only look at at at themselves, look at yourself. Because after these failures, CDR realizes they had gone too far up the risk curve. And around this time, Jack Welch joined the firm after spending decades at GE. The idea was that they didn't bring Welch in to run individual portfolio companies. They wanted him to look across the entire portfolio and helping the firm think about strategy. And they then create two things, an operating review and then investment screening committee. The operating review is they put portfolio company management teams in a room with seven operating partners who had all previously been CEOs of a major international businesses. So if you really imagine a CEO and having seven former CEOs sitting across from you going through your business. And the second part is the screening committee, basically quality control before they do a deal. And I think the lesson for them is is pretty simple here. After making those huge mistakes with those investments, they applied the same philosophy to themselves that they applied to their portfolio companies. Joseph saying, in many respects, we as a firm did what we ask our companies to do, respond to changing circumstances decisively and effectively by making positive strategic changes. That's a good operating principle for any business. When when something stops working, don't just explain the failure, Change the system that allowed it to happen, and they did that in a big way. And here on the page 46, this page page is basically Joe Rice reducing decades of private equity experience down to down to five lessons. The first one is probably the most important. Labor hard at the front end of an investment. And in other words, do the hard work before you own the company. Understand the structure, understand the operations, not just the financials, and don't loan the business with so much debt that one bad year kills you. He specifically says to build the balance sheet with plenty of liquidity cushion for tough times. Then he... Another piece of advice or a lesson, go beyond the numbers. I think this connects to everything else in the chapters we covered before.
00:27:18 · Mikk
A spreadsheet can tell you what happened in the business, but it can't necessarily tell you whether the management team is good enough, what operational problems are hiding underneath or what opportunities haven't been exploited yet. Third lesson, be prepared to turn on a dime. Lexmark is his example. They had mature technologies producing cash, and instead of just harvesting that cash, they used it to fund the emerging laser printer business. The old business essentially financed the thing that eventually transformed the company. There's another one which I really like. Look in the mirror. Don't only demand change from your portfolio companies. Be willing to change your own firm. Change the people. Change the processes. Admit when something isn't working. That goes back to CDR's own failures earlier in the chapter where they didn't just blame the investments. They changed how they operated. And the last one is much more personal. It's be passionate about your vocation. And here, I want to read you the page 35 where what he learned earlier on his career, and I read it this to you. I learned years ago the importance of natural talent as prerequisite for success. After graduating from Williams College, I enlisted in the Marine Corps, then went to Harvard Law School and ended up practicing law at Sullivan & Cromwell. At this great law firm, I had the good fortune to work for a born lawyer, John Rabin. He had a very prospective legal mind. John could see all the issues, turn them on their side and view them in a way no one had thought of before. Clients respected him tremendously. He was a great lawyer and everyone knew it. I recognized that my chances for becoming a lawyer on a par with John fell somewhere between slim and none. That motivated me to look for a field in which I too would have that natural ability. One of Sullivan & Cromwell's clients was an institutional research firm called Laird and Company. Its corporate finance practice was the deal business, bootstrap deals, we called them. Laird would find companies they wanted to acquire, then go out and raise the financing necessary to do the deal, which is called bootstrapping and bootstrapping themselves into position to make the purchase. As I grew to understand that business, it appealed to me. When a position opened at Laird, I left the law practice and went to work doing deals.