CD&R Stays the Course
Clayton Dubilier & Rice's managing partner, Kevin Conway, says CD&R will weather the changes coming to private equity
By Kelly Holman July 17, 2009
Clayton Dubilier & Rice has established a reputation as one of the buyout industry's most venerable investment houses, particularly as a firm well-versed in acquiring orphaned divisions of global corporations. Whereas some of its peers have morphed into large alternative asset managers, CD&R has been successful by staying true to its roots as an operational-improvements-focused private-equity firm.
As testament to its staying power and the attractiveness of its business model, sources say the New York- and London-based firm is raising its eighth investment partnership and has secured more than $4 billion from institutional investors to date. The amount exceeds its $4 billion 2005 vintage fund, which is fully invested.
With 39 investment professionals, CD&R has managed to invest $12 billion in $70 billion of transactions involving 43 U.S. and European companies in the last 31 years. Its portfolio has included a broad spectrum of high-profile corporate brands over the years, especially those that resonate with consumers like Hertz Corp., the rental car giant it acquired from Ford Motor Co. in 2005, Uniroyal Goodrich Tire Co. and Lexmark. In addition, it has purchased industry-leading companies such as food service distributor U.S. Foodservice, which it bought with Kohlberg Kravis Roberts in 2007, and VWR International Inc., a company it sold to Chicago's Madison Dearborn Partners for an impressive four and a half times return on investment.
Kevin Conway, managing partner of CD&R, has ridden the firm's mega-deal wave for the last 15 years. As chair of the firm's screening committee, he has analyzed the firm's investments and worked closely with CEO Donald Gogel to chart CD&R's own operational course.
Before he joined CD&R in 1994, Conway spent 10 years at Goldman, Sachs & Co., where he was a partner and senior member of its mergers and acquisition department, and worked on large strategic transactions. In other words, the 51-year-old Conway brings well-seasoned deal-making tenure to CD&R.
CD&R, it should be noted, announced this week that former GAP Inc. CEO Paul Pressler joined the firm as an adviser.
IDD recently sat down to talk with Conway -- who declined to comment on the firm's latest fundraising effort -- about the changing state of private equity, the economic downturn and CD&R's approach to investing.
IDD: Can you talk about Clayton Dubilier & Rice's investment strategy?
Conway: Our firm's strategy and approach to private equity really hasn't changed in 30 years. We're trying to drive returns through improving the operations of companies that we buy. We have specialized in buying businesses that haven't gotten the resources they need to succeed, be that management's attention, or capital and human resources needed to succeed. We most often find that in corporate carve outs and divestitures, but occasionally find that in a standalone public company.
We try to buy businesses that are industry leaders, relatively stable, less subject to business cycles and are underperforming. It's hard to find an industry leader that's also underperforming, but a number of the businesses that we have bought over the years are franchise businesses and still have ample opportunity for improving their margins, growth rate and market shares.
The reason we like industry leaders is because generally they are less vulnerable in downturns, and the leverage from the operational initiatives that we implement is enormous in both strong and weak economies. With a market leader we also often have the option to consolidate what's often a fragmented industry through consolidating acquisitions. That's the fundamental thesis.
IDD: How has the private-equity landscape changed since CD&R began investing more than 30 years ago?
Conway: Private equity has evolved in a number of ways. Beyond the obvious changes of size and complexity of deals, you have multiple-fund private-equity complexes, investors who are cyclical players, minority stake growth investors, and people wrapping themselves in the mantle of operating improvements. There are many different ways people apply private equity and many approaches under the private-equity label.
What's happened more recently is that it's become easier with the [economic] downturn to differentiate strategies. When you have a bull market and everyone has great returns, it's hard to identify the source of that return. Today, source of return is a critical assessment. If you took on too much leverage during the boom years and now are unable to fundamentally change the businesses in the portfolio, you're going to have real issues either with refinancing, or paying interest and making the investments work. Inevitably there will be a shakeout in private equity and there will be a clear separation between firms that benefitted from the rising tide and others with more sustainable investment models.
IDD: Has CD&R taken any steps to modify its investment strategy in light of the current economic environment?
Conway: As tough as it is, we think our strategy fits this environment. We feel more confident that we can work our way through the downturn because we've done it before. We probably were more bearish than most before the present downturn set in, though nobody could have predicted the severity. The point is that we began preparing the portfolio a couple of years in advance. In our quarterly operating review with our portfolio companies, which Jack Welch leads, we began to accelerate cost and productivity initiatives to get ready for the storm. Today, we are outperforming on cost and productivity measures across the portfolio even with the extreme pressure on the top-line that comes with an economic slowdown.
The financial flexibility that our companies enjoy today is one by-product of a very conservative investment underwriting process. For example, we generally underwrite about half of the cost and productivity that we identify in our due diligence. We also made sure that all of the portfolio companies had capital structures that ensured adequate liquidity for the lean times. We have a tremendous amount of liquidity in each one of the portfolio companies. Often a bad LBO is not a bad company or even a bad investment but one that never had enough liquidity to ride through a tough time in the markets or economy.
IDD: Would you say that you leverage your businesses less than some of your peers?
Conway: I would say that we address leverage on a case-by-case basis. If we leverage a company on the higher end, we do it because we have a high degree of confidence that we can pay down debt in the first year of the investment. When we acquired U.S. Foodservice, for example, we paid off nearly three turns of debt in the first year that we owned the company. In VWR -- a company we've since exited -- we had a similar kind of de-leveraging in the first 18 months of the investment.
For the right company and right situation we'll take higher leverage levels, but only when we have the conviction that we can de-risk the balance sheet very early on through cash flow or divesting non-strategic assets.
We put our portfolio companies through a fairly dramatic transformation operationally, so we don't need as much leverage to drive our ultimate investment returns. We want a capital structure that's going to allow the operating partners and the management teams to do what they need to do to transform the business without worrying about the capital structure. That's the bottom line.
IDD: As you mentioned, there are many new areas in private equity where people are looking to put their money to work. Are you looking at investing in some of those areas?
Conway: CD&R has looked at diversifying for probably every year of the 30-plus years we've been in existence. We always hold it up against what people do we have, what resources do we have and does it fit what we do well? Growth investing and playing the [business] cycle are often very good ways to make money; they don't happen to fit our skill set. Making minority investments in public companies without some kind of operating control doesn't really fit what we do. We need to have a level of influence and control with the management team to drive returns.
We think at some point in various economies in Asia will lend themselves to our form of private-equity investing; we've been looking at it for a decade. But we're not going to run out and hire a former banker and open an office and say, 'OK, now we're in business in Asia.'
Our core strategy is to buy large corporate orphans: businesses that are industry leaders, relatively stable and have dramatic ability for us to drive improvements in the operations. We haven't seen enough volume of those types of businesses coming out of Asian parents to justify having people on the ground there.
That said, we recognize that we need to be global in terms of how we think about businesses and most importantly be able to execute on a global basis. If you're going to have a global customer base, they generally want you to be able to serve them globally.
IDD: There's been a lot of talk in the private-equity industry that government regulations could impact private equity in a negative way. Will new regulations impair private-equity deal making?
Conway: Impair is a pretty strong word, but I do think there could be a meaningful impact from increased regulation. The question will be, will it make it a nuisance and more difficult or fundamentally harm what we do? My sense is that it will be more disclosure-oriented and discriminating in terms of the different types of asset classes within private equity. For example, I would hope that hedge funds and buyout funds are not lumped together. The profiles of these two asset classes are too dissimilar.
My guess is -- given how badly the industry has managed its PR and how loud the cry for a villain is -- the pendulum will probably swing a little further than we would like. If it turns out that limits are put on borrowing, clearly some deals won't get done because sellers won't adjust their expectations. If tax laws are changed concerning the treatment of carried interest or deductibility of interest or the structure of management incentive plans, all of that will have to be factored in to deal structuring.
But it won't mean that private-equity firms will not be able to do a deal.
IDD: It's interesting that your firm has established a position to manage its relationships with Wall Street banks.
Conway: We actually established that role decades ago. Michael Babiarz is the third partner to play that role at our firm. We've always felt that it's useful to have one partner focused on financing across the entire portfolio. It goes back to the bootstrap days when you didn't have a fund and financing was not a sure thing. Having a partner with long-term relationships around the globe with virtually every financial institution is even more relevant given today's capital markets and gives us the confidence that we can get a financing done for the right transaction.
A lot of other firms are putting a partner in charge of financing and we just kind of smile. We think of it as an old idea. Michael's been here 19 years.
IDD: Some firms have used that as a first step to build out a capital markets operation.
Conway: We're not planning to build out a capital markets capability and become an underwriter, if that's what you mean. When the capital markets were effectively closed and as they have gradually reopened, there has been a syndicating role to play on the subordinated or mezzanine side. Michael plays a big role in that, but that doesn't mean we're trying to become underwriters and replicate what the commercial and investment banks have.
IDD: Some private-equity firms have chosen to go public. Does it make sense for private equity to be public?
Conway: It doesn't to us. We're a firm with a relatively simple strategy of driving value. Other firms have gone on to become holding companies participating in multiple businesses organized around alternative investing. Those holding companies lend themselves to going public more easily than a more focused strategy such as ours. Several firms have been very creative about how they think about going public, but it doesn't seem to us that finding capital in the public market is a necessary precedent for our particular business model.
Finding operating talent, financial talent and finding the right transaction are far more common topics of discussion around here.
IDD: Your last investment was in October 2008. What are you hearing from your limited partners about your pace of investment?
Conway: They're very happy to be invested with CD&R given our strategy and how it fits today's market. They trust us to put capital to work at the pace that makes the most sense. Most have been around long enough to know that there will be years when we won't make any investments and years when we will complete two or three deals.
We're blessed with a fairly experienced LP base that understands that this is a long-term asset class and that sitting on your hands is sometimes the right thing to do and at other times being active makes the most sense.
IDD: In some businesses that you've invested in, you haven't exited until the longer end of a holding period. Why is that?
Conway: We generally have longer holding periods because you can't transform a business overnight. It can be frustrating when you see people doing quick flips or higher IRR but lower multiple return on investment transactions in a good market. We generally are trying to improve earnings by 50% to 100%. It's very tough to do that in the first six to 12 months of an investment. On average, we're not seeing the results of all of our labors until the second and third year, and we're not really confident we have the business where it needs to be until three to five years after we buy it.
Generally, I think that holding periods will be longer for all private-equity investments. Ironically, for us I think the world is going to turn around and we will be able to exit sooner. Our companies are going to continue to perform and have a differentiated level of performance in the downturn that a lot of businesses won't have.
So, we are going to create exit options earlier before the capital markets, economy and the corporate buyers are back fully on their feet because of the strength of the types of businesses that we buy and the performance enhancements that we are able to achieve.
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