Perspectives
Staying True to the Promise of Private Equity
Capital Creation 2005, a Speech by Robert Quarta
Wednesday, September 28, 2005

Thank you and good afternoon. I had the opportunity to be here last year and it is a privilege to be with you again.

Since our gathering last year, there has been a great deal of change in our industry. Today, European LBO activity represents 50% or more of European and U.S. buyout volume. And the geographic breakdown of deal volume has become increasingly pan European. Fund raising globally continues to reach ever higher peaks, with several new “mega” funds raised. And obviously, with funds of this size, we are seeing larger deals both in Europe and the U.S., as well as the formation of consortia to complete them.

There is a good deal of talk about the blurring of investment strategies as hedge funds increasingly are making direct investments and private equity firms realize their investments in relatively shorter time frames. The definition of long-term appears to be on its way to becoming a matter of taste.

As we assess these broad industry trends, I think it is worthwhile to step back and consider whether we – as an industry – are staying true to the promise of private equity. Over the years, private equity has been instrumental in facilitating corporate restructuring. The global, broad-based trend toward corporate restructuring creates a rich source of investment opportunities for private equity firms like CD&R and others as corporations set new priorities and restructure for competitive advantage.

None of us want to kill this approach that has worked so well. In other words, the private equity model that has developed during the past 20 years is effective and, I believe, is based on five core principals. The principals have consistently created a competitive advantage and outstanding returns for private equity firms and their limited partners.

What I would like to do in the next few minutes is to offer some perspective on these principals which current developments in the world of private equity may be undercutting.

First, small, highly cohesive firms led by bright, entrepreneurial, analytic people with shared values make better investment decisions than firms with too much scale. There is an almost frantic reach to establish scale that is today measured by private equity funds at the $11 billion level, but aspirationally even larger. To deploy such huge amounts of capital, firms by definition can no longer be small cohesive units, and they cannot invest in the same way they have in the past ... They have to add layers of people, open new offices in new geographies, establish specializations by industry segment, consider expanding into other asset classes, and generally get big and, to some degree, bureaucratic or decentralized. It is hard for me to see how many firms will be able to successfully navigate the change to a multi-line, multi-discipline asset manager...

Second, investment strategies must be focused, consistent ... and differentiated. With the growth in scale, it is increasingly difficult to maintain focus and consistency. The flexibility of private equity to find new areas of opportunity is indeed valuable. But can a single firm really create long-term value by investing – with the same people, in the same fund – everything from a satellite company, British retailer, a European telecom carrier, U.S.-based power generation assets, and a software company. I would not suggest for a minute that only sector funds make sense. But surely there must be some level of focus.2 and expertise that underlies investment decisions in a fund. Moreover, what happens to focus and consistency when General Partners open multiple, parallel lines of business? This has emerged as a real issue as many private equity general partners try to leverage their brands to broaden their product offerings across various alternative asset segments. The theory appears to be to try to create a one-stop shop for every flavor of alternative assets from hedge funds, senior debt and mezzanine financing and real-estate products, as well as traditional private equity. It remains to be seen whether private-equity capabilities can be extended successfully in this manner. Jack Welch, a special partner at CD&R, was recently asked by a reporter about the major dangers that the industry ought to be thinking about today? Jack’s response: “Diversification into new areas always brings with it greater risk and that’s the greatest challenge facing private equity today.”

Third, control matters and it matters a lot. One of the most important advantages enjoyed by private equity firms is their ability to control a portfolio company. In the world of private equity, control implies the absolute ability to hire and fire a CEO, to approve major capital commitments, mergers, acquisitions, new products and channels, geographic expansion. The governance model of most private equity firms has been a model of clarity: the General Partner has the power to make decisions. Managements are not confused. There are few administrative burdens. No bureaucracy emerges. Decisions are made quickly.

Yet, it is fair to ask, what happens when three buyout firms form a cartel to buy one company? And if there is a problem, do seven buyout firms in one deal compound the issue?

At CD&R our activist model means we need to have control. This has been the case in all of our investments. At the moment, for example, I serve as Chairman of Rexel and Italtel, two investments where we have co-investors, and majority Board representation. In keeping with that approach, our operating partner George Tamke, will serve as Chairman in our latest investment – Hertz—where we are investing with Carlyle and Merrill Lynch Global Private Equity. I believe if you examined other investments with co investors, this approach is fairly unique and reflects the confidence of the group in our operating capability and the single vision we have for the investment.

In other words, we are happy to partner on transactions, but only where the governance safeguards are in place to ensure that we can effectively apply our operating value-building model.

Fourth, the advantages of being private should not be abandoned lightly. As a private equity investor and a former CEO of public companies, I can say it is impossible to overestimate the advantages of running a large corporate enterprise in 2005 as a private enterprise. One of the most enduring advantages of private equity firms has been their ability to change businesses without the scrutiny and short-term distortion of public shareholders. We pride ourselves on transforming businesses by doing the right thing this quarter and this year, regardless of short term impact on the bottom line ... We like our management teams focused on customers, products and competitors, not stock market price swings and vacillating analyst opinions... We can work more effectively in private. Yet, as we are seeing in quick IPOs, many firms have been taking advantage of fleeting IPO windows to bring new buyouts into the glare (and distraction) of the public markets within the first year of an investment.

Perhaps more troubling was the flurry of activities last year aimed at making private equity a more “public” asset class. During the first half of 2004, at least half a dozen private-equity firms announced their intention to file for IPOS to create publicly traded, closed-end fund vehicles known as Business Development Companies or BDCS. And more recently, The Wall Street Journal carried a prominent article under the headline “Want a Piece of Henry Kravis? Wait for the IPO.” The article made the important point that: “A rationale for private equity being ‘private’ is that they have the luxury of taking a long-term perspective because they don’t have to meet quarterly expectations of public companies.” Presumably, the theory behind taking private equity firms public is to create a more-efficient permanent capital base without all of the effort of building long-term relationships with LPs. But is this worth giving up the critical advantage of private equity – the fact that it is truly private?

Private and public are complementary, they are parallel, they can be mutually supportive – but, I would argue, they should not intersect.

To be fair, I should extend my cautionary note to Limited Partners as well on the matter of being private... There is a tight correlation between illiquidity, being private, and high returns. As some LPs clamor for more and faster liquidity – showing no tolerance for the well-known “J curve” of private equity investing – they risk pushing their GPs to act more like managers of marketable securities. I can assure you that the LPs of Clayton, Dubilier & Rice funds would not have wanted us to trade out of investments like Lexmark, Alliant Foodservice, Kinko’s or Jafra after the inevitable shortfalls in performance along the road to liquidity —liquidity in those cases that delivered three, six, three, and five times capital, respectively, after extended periods of very private ownership.

Finally, the asset class has to-date done a poor job at evaluating risk-adjusted returns. Beyond the problems of lack of transparency and the “J-curve” effect of back-ended loaded value creation, LPs and GPs alike need to reach consensus on how to evaluate the path to success in an investment… There is a lot of talk today about adding value in the underlying company in the GP portfolio even though most returns and realizations of late have been driven by overheated leveraged financing markets and very fickle IPO markets... The challenge is not only how to value an investment midstream, but also how to evaluate the cause for the ultimate outcome and the imbedded risk assumed along the way.

So, where does this lead us?

I have cautious optimism for the asset class, but selective concern for many GPs. I believe that the best private equity managers will adapt and refine their strategy, adding skills to exploit specific opportunities within their area of competence. Gradual, incremental changes in investment approach often provide a chance to expand the scope of activity without abandoning the base on which a firm’s success rests. But as I have suggested, I believe that there are some people and firms in the asset class that may be overreaching. And that could cause problems for all of us.

So I would leave you with these observations.

  • Private equity works. Experienced investors practice this art – in highly collaborative, dedicated firms.
  • It is a focused, consistent and disciplined craft, emphasis on craft.
  • Control matters a lot.
  • And, not every firm will deliver the right level of risk-adjusted returns over the next decade to compel the support of LPs. That is, all IRRs are not necessarily equal. How you generate returns is as important as the returns themselves.

None of us can be sure about some of the new industry developments we are witnessing. At times like this, it is often useful as a gut check to look back on where we came from and how we grew up. Speaking from the point of view of my firm, there is no question that CD&R is a different firm today than it was 27 years ago in terms of how we apply our operationally-focused ownership model. But our fundamental approach to the business remains constant and our commitment to trust – based relationships is deeply rooted in our culture.

In the private equity business, more than anything else, the most important ingredients in an organization are the people and the character they possess . . . their integrity ... the values they share . . . and the trust they have in one another.

The right people tend to create the right organization. As Joe Rice recalled about CD&R’s formation more than a quarter century ago: “There was no written agreement. All of us believed a handshake was more important than a formal contract. We had wonderful confidence in each other.” As an industry, let’s be very careful that we do not lose that wonderful confidence.

Thank you.


Perspectives
Staying True to the Promise of Private Equity
Capital Creation 2005, a Speech by Robert Quarta
Wednesday, September 28, 2005

Thank you and good afternoon. I had the opportunity to be here last year and it is a privilege to be with you again.

Since our gathering last year, there has been a great deal of change in our industry. Today, European LBO activity represents 50% or more of European and U.S. buyout volume. And the geographic breakdown of deal volume has become increasingly pan European. Fund raising globally continues to reach ever higher peaks, with several new “mega” funds raised. And obviously, with funds of this size, we are seeing larger deals both in Europe and the U.S., as well as the formation of consortia to complete them.

There is a good deal of talk about the blurring of investment strategies as hedge funds increasingly are making direct investments and private equity firms realize their investments in relatively shorter time frames. The definition of long-term appears to be on its way to becoming a matter of taste.

As we assess these broad industry trends, I think it is worthwhile to step back and consider whether we – as an industry – are staying true to the promise of private equity. Over the years, private equity has been instrumental in facilitating corporate restructuring. The global, broad-based trend toward corporate restructuring creates a rich source of investment opportunities for private equity firms like CD&R and others as corporations set new priorities and restructure for competitive advantage.

None of us want to kill this approach that has worked so well. In other words, the private equity model that has developed during the past 20 years is effective and, I believe, is based on five core principals. The principals have consistently created a competitive advantage and outstanding returns for private equity firms and their limited partners.

What I would like to do in the next few minutes is to offer some perspective on these principals which current developments in the world of private equity may be undercutting.

First, small, highly cohesive firms led by bright, entrepreneurial, analytic people with shared values make better investment decisions than firms with too much scale. There is an almost frantic reach to establish scale that is today measured by private equity funds at the $11 billion level, but aspirationally even larger. To deploy such huge amounts of capital, firms by definition can no longer be small cohesive units, and they cannot invest in the same way they have in the past ... They have to add layers of people, open new offices in new geographies, establish specializations by industry segment, consider expanding into other asset classes, and generally get big and, to some degree, bureaucratic or decentralized. It is hard for me to see how many firms will be able to successfully navigate the change to a multi-line, multi-discipline asset manager...

Second, investment strategies must be focused, consistent ... and differentiated. With the growth in scale, it is increasingly difficult to maintain focus and consistency. The flexibility of private equity to find new areas of opportunity is indeed valuable. But can a single firm really create long-term value by investing – with the same people, in the same fund – everything from a satellite company, British retailer, a European telecom carrier, U.S.-based power generation assets, and a software company. I would not suggest for a minute that only sector funds make sense. But surely there must be some level of focus.2 and expertise that underlies investment decisions in a fund. Moreover, what happens to focus and consistency when General Partners open multiple, parallel lines of business? This has emerged as a real issue as many private equity general partners try to leverage their brands to broaden their product offerings across various alternative asset segments. The theory appears to be to try to create a one-stop shop for every flavor of alternative assets from hedge funds, senior debt and mezzanine financing and real-estate products, as well as traditional private equity. It remains to be seen whether private-equity capabilities can be extended successfully in this manner. Jack Welch, a special partner at CD&R, was recently asked by a reporter about the major dangers that the industry ought to be thinking about today? Jack’s response: “Diversification into new areas always brings with it greater risk and that’s the greatest challenge facing private equity today.”

Third, control matters and it matters a lot. One of the most important advantages enjoyed by private equity firms is their ability to control a portfolio company. In the world of private equity, control implies the absolute ability to hire and fire a CEO, to approve major capital commitments, mergers, acquisitions, new products and channels, geographic expansion. The governance model of most private equity firms has been a model of clarity: the General Partner has the power to make decisions. Managements are not confused. There are few administrative burdens. No bureaucracy emerges. Decisions are made quickly.

Yet, it is fair to ask, what happens when three buyout firms form a cartel to buy one company? And if there is a problem, do seven buyout firms in one deal compound the issue?

At CD&R our activist model means we need to have control. This has been the case in all of our investments. At the moment, for example, I serve as Chairman of Rexel and Italtel, two investments where we have co-investors, and majority Board representation. In keeping with that approach, our operating partner George Tamke, will serve as Chairman in our latest investment – Hertz—where we are investing with Carlyle and Merrill Lynch Global Private Equity. I believe if you examined other investments with co investors, this approach is fairly unique and reflects the confidence of the group in our operating capability and the single vision we have for the investment.

In other words, we are happy to partner on transactions, but only where the governance safeguards are in place to ensure that we can effectively apply our operating value-building model.

Fourth, the advantages of being private should not be abandoned lightly. As a private equity investor and a former CEO of public companies, I can say it is impossible to overestimate the advantages of running a large corporate enterprise in 2005 as a private enterprise. One of the most enduring advantages of private equity firms has been their ability to change businesses without the scrutiny and short-term distortion of public shareholders. We pride ourselves on transforming businesses by doing the right thing this quarter and this year, regardless of short term impact on the bottom line ... We like our management teams focused on customers, products and competitors, not stock market price swings and vacillating analyst opinions... We can work more effectively in private. Yet, as we are seeing in quick IPOs, many firms have been taking advantage of fleeting IPO windows to bring new buyouts into the glare (and distraction) of the public markets within the first year of an investment.

Perhaps more troubling was the flurry of activities last year aimed at making private equity a more “public” asset class. During the first half of 2004, at least half a dozen private-equity firms announced their intention to file for IPOS to create publicly traded, closed-end fund vehicles known as Business Development Companies or BDCS. And more recently, The Wall Street Journal carried a prominent article under the headline “Want a Piece of Henry Kravis? Wait for the IPO.” The article made the important point that: “A rationale for private equity being ‘private’ is that they have the luxury of taking a long-term perspective because they don’t have to meet quarterly expectations of public companies.” Presumably, the theory behind taking private equity firms public is to create a more-efficient permanent capital base without all of the effort of building long-term relationships with LPs. But is this worth giving up the critical advantage of private equity – the fact that it is truly private?

Private and public are complementary, they are parallel, they can be mutually supportive – but, I would argue, they should not intersect.

To be fair, I should extend my cautionary note to Limited Partners as well on the matter of being private... There is a tight correlation between illiquidity, being private, and high returns. As some LPs clamor for more and faster liquidity – showing no tolerance for the well-known “J curve” of private equity investing – they risk pushing their GPs to act more like managers of marketable securities. I can assure you that the LPs of Clayton, Dubilier & Rice funds would not have wanted us to trade out of investments like Lexmark, Alliant Foodservice, Kinko’s or Jafra after the inevitable shortfalls in performance along the road to liquidity —liquidity in those cases that delivered three, six, three, and five times capital, respectively, after extended periods of very private ownership.

Finally, the asset class has to-date done a poor job at evaluating risk-adjusted returns. Beyond the problems of lack of transparency and the “J-curve” effect of back-ended loaded value creation, LPs and GPs alike need to reach consensus on how to evaluate the path to success in an investment… There is a lot of talk today about adding value in the underlying company in the GP portfolio even though most returns and realizations of late have been driven by overheated leveraged financing markets and very fickle IPO markets... The challenge is not only how to value an investment midstream, but also how to evaluate the cause for the ultimate outcome and the imbedded risk assumed along the way.

So, where does this lead us?

I have cautious optimism for the asset class, but selective concern for many GPs. I believe that the best private equity managers will adapt and refine their strategy, adding skills to exploit specific opportunities within their area of competence. Gradual, incremental changes in investment approach often provide a chance to expand the scope of activity without abandoning the base on which a firm’s success rests. But as I have suggested, I believe that there are some people and firms in the asset class that may be overreaching. And that could cause problems for all of us.

So I would leave you with these observations.

  • Private equity works. Experienced investors practice this art – in highly collaborative, dedicated firms.
  • It is a focused, consistent and disciplined craft, emphasis on craft.
  • Control matters a lot.
  • And, not every firm will deliver the right level of risk-adjusted returns over the next decade to compel the support of LPs. That is, all IRRs are not necessarily equal. How you generate returns is as important as the returns themselves.

None of us can be sure about some of the new industry developments we are witnessing. At times like this, it is often useful as a gut check to look back on where we came from and how we grew up. Speaking from the point of view of my firm, there is no question that CD&R is a different firm today than it was 27 years ago in terms of how we apply our operationally-focused ownership model. But our fundamental approach to the business remains constant and our commitment to trust – based relationships is deeply rooted in our culture.

In the private equity business, more than anything else, the most important ingredients in an organization are the people and the character they possess . . . their integrity ... the values they share . . . and the trust they have in one another.

The right people tend to create the right organization. As Joe Rice recalled about CD&R’s formation more than a quarter century ago: “There was no written agreement. All of us believed a handshake was more important than a formal contract. We had wonderful confidence in each other.” As an industry, let’s be very careful that we do not lose that wonderful confidence.

Thank you.