Morgan Stanley Roundtable on Private Equity and Its Import for Public Companies

New York City | April 25, 2006 Photographs by Yvonne Gunner, New York

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Alan Jones: Good morning, I’m Alan is now known as private equity, as a way Carl Ferenbach is a Managing Direc- Jones, Head of Corporate Finance here at of overcoming this agency problem in tor at Berkshire Partners, a private equity Morgan Stanley, and I want to welcome public companies. But, for all of his aca- fi rm that he co-founded in 1986. Prior you all to this roundtable discussion of demic accomplishments, most of Mike’s to helping start Berkshire, Carl was a private equity. I think the highest compli- time these days is spent outside the acad- partner at the Thomas H. Lee Company ment you can pay someone is to say that emy. Since 2000, he has been Managing and, before that, a Managing Director you have learned from him or her. I have Director of the Monitor Group’s Organi- of Merrill Lynch in charge of the fi rm’s learned from a number of people at this zational Strategy Practice. And he is also M&A and leveraged buyout practices. table, and I expect to learn a great deal the Co-Founder and Chairman of Social Carl has been chairman or a director of more today. I’m especially pleased to have Science Electronic Publishing, or what many of Berkshire’s companies, includ- the chance to discuss this subject with most of us know as “SSRN.” ing Crown Castle International, U.S. Michael Jensen, who was my professor at Steven Kaplan is the Neubauer Fam- Can, and Wisconsin Central—the last of the Harvard Business School over 20 years ily Professor of Entrepreneurship and which provided the material for one of ago—and who, as I’ve just discovered in Finance, as well as Faculty Director of Mike Jensen’s case studies that continues the past few minutes, has taught most of the Polsky Entrepreneurship Center, at to be used at Harvard. As you can guess the people in this room. So thanks for the University of Chicago’s Graduate from this list of companies, Berkshire’s joining us, Mike, and we hope you will School of Business. To go along with his investment strategy has included the go on teaching us for a long time. many published papers on private equity transportation, communications, and The people at this table represent an and entrepreneurial fi nance, and on cor- industrial manufacturing sectors. impressive assembly of both academic porate governance and M&A, Steve has Brian Hoesterey is a Partner of AEA and practitioner approaches to private been recognized as one of the top-rated Investors, a buyout fi rm started in 1969 equity. So let me begin just by intro- business school teachers in the country. that has a reputation for bringing exten- ducing everyone. And I’m going to start He also serves on the boards of three sive operating experience to its deals. with the academics since I’ve gone to the companies: Accretive Health, Columbia Brian joined AEA in 1999 and focuses trouble of writing down the names of the Acorn Funds, and Morningstar. on investments in the specialty chemi- chaired professorships and committing Meyer Feldberg is, happily for us, a cals and value-added industrial products them to memory. Senior Adviser at Morgan Stanley. Meyer sectors. He currently serves on the board Michael Jensen is the Jesse Isador has been associated with more academic of directors of Compression Polymers, Strauss Professor of Business Admin- institutions than time permits me to Henry, Pregis, and Unifrax. Before join- istration Emeritus at the Harvard name. He was the Dean of Columbia’s ing AEA, Brian worked for BT Capital Business School. While at the Uni- Business School from 1989 to 2004; and Partners, the private equity group of versity of Rochester in the ’70s, Mike before that, he served as President of the Bankers Trust, McKinsey & Company, wrote a paper with Bill Meckling on Illinois Institute of Technology, Dean of and Morgan Stanley. Like a number “Agency Costs and Theory of the Firm” Tulane’s Business School, and Associate of other people here, Brian received an that revolutionized the theory of corpo- Dean of Northwestern’s Kellogg School. M.B.A. from Harvard. rate fi nance by focusing on the confl ict Perhaps most relevant for this discussion, John Moon is a Founding Partner of interests and incentives between Meyer has served on the boards of a num- and Managing Director of Metalmark management and shareholders that ber of public as well as private companies, Capital, a private equity fi rm that is reduces the value of public companies. including Revlon, Federated Department active in a broad range of industries, And after he moved from Rochester to Stores, PRIMEDIA, Sappi Limited, UBS including industrials, healthcare, fi nan- Harvard in the ’80s, Mike became the Funds, and Select Medical Corporation. cial services, and energy and other most prominent and vocal academic Now let’s turn to the people in our natural resources. John is a director of spokesman for leveraged buyouts, or what group who practice private equity: a number of Metalmark portfolio com-

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panies. Prior to helping start Metalmark implications of private equity for pub- of the enormous growth in private equity in 2004, John was a Managing Direc- lic companies? And here let me set the for public companies. It raises questions tor of Morgan Stanley Capital Partners table a little bit. None of us needs to be that managements and boards may soon and, before that, he was a Vice President reminded of the increasing importance of fi nd themselves addressing if they have in the Investment Banking Division of private equity. There’s clearly an enormous not already: Is our company leaving value Goldman Sachs. John has a Ph.D. as amount of money dedicated to it right “on the table” in the form of excess cash well as an A.M. from Harvard, and he now. Morgan Stanley estimates that there and unused debt capacity? Is it possible is an Adjunct Professor of Finance at are now some 2,700 funds that either have that we would operate more effi ciently, Columbia Business School. raised, or are in the process of raising, a and be more valuable, in the hands of a Cary Davis is a Managing Director total of half a trillion dollars. When you private equity fi rm? And if we decide that at Warburg Pincus, where he focuses on add the leverage that can be put on top of we’re more valuable as a public company, investments in software and fi nancial these funds, this is an enormous amount of should we consider taking a page out of the technology companies. With invest- purchasing power. When a number of us private equity playbook and invite some of ments closer to the growth end of the here were at the Harvard Business School our largest investors onto our board? spectrum, Cary operates more like a some 20 years ago, there were probably I’m going to start by asking my for- venture capitalist than a leveraged buy- only four private equity fi rms that had $1 mer professor—and I can’t tell you what out specialist. He is a director of Cassatt, billion funds. Today there are more than a thrill it is for me to be “cold-calling” GlobalSpec, Pi Corporation, TradeCard, 150 fi rms of that size. In fact, the largest Michael Jensen like this—the fi rst of Secure Computing, and Wall Street Sys- new funds being raised these days are in our two main questions: How do private tems. Like John, Cary is also an Adjunct the $10-$14 billion range. And by virtue equity fi rms add value? And, again, just Professor at Columbia. of their increasing size, and their willing- to be provocative, do they add value? Now that I’ve mentioned our cast of ness to work together in “club” deals, they characters, let me set the stage by telling can do much bigger transactions than Part I: How Private Equity Adds Value you a bit more about what we plan to dis- was ever thought possible. With all this Jensen: Thanks, A.J., for all the kind cuss. There are two main questions that I’d equity capital available, and with the help words. like us to consider. The fi rst is: How does of remarkably forgiving leveraged fi nance In answer to your fi rst question, I private equity add value? Or, to make it markets, today’s fi nancial sponsors are able have no doubt that private equity adds a bit provocative, does private equity add to pay much higher prices for assets than value—and it has been adding value since value? And in this fi rst part of the discus- they could fi ve or six years ago. the movement took off in the early ’80s. sion, I’d like us to explore how the answers So, we’re clearly seeing private equity Some of the players have changed, and to those questions have changed over fi rms paying bigger prices, doing larger the fi nancing structures and the kinds of time. I for one think that the role of pri- deals, and, as a result, having a much more companies taken private have changed vate equity in the industrial restructuring signifi cant role in the global economy than somewhat. But the general results, as can of the U.S. in the 1980s is very different they did ten or 20 years ago. Private equity be seen in the operating gains and rates from the role it is playing today, particu- transactions now account for a quarter of of return that have been documented by larly in the U.S. And, as we look at other all global M&A activity—and they also all kinds of academic studies, have been parts of the world, including Europe and account for half of the leverage loan vol- very impressive. Now, as happens with all Asia, I would also like us to consider the ume, a third of the high yield market, and economic activities, there have been fail- possibility that private equity will play the a third of the IPO market. ures as well as successes. There have been transformative role in those places that it So none of us around this table needs periods of overshooting, with too many did here in the ’80s and ’90s. to be reminded of the importance of pri- players chasing too few good deals. At the The second main question I’d like vate equity. And, as I said earlier, I want to end of the ’80s, for example, there were us to think about is this: What are the use this forum to explore the implications a lot of overpriced deals because the buy-

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out fi rms, as I argued in the early ’90s, buyouts and what later became known mous; it was well in excess of $10 billion, were not putting enough of their own as “private equity” were fundamentally a even if KKR’s investors never made a capital into the deals. But, on the whole, new way to think about corporate gov- dime on the deal. the market has spoken in the summary of ernance, a new model of management if But just to lay some groundwork for the growth of private equity activity that you will. the rest of this discussion, let me quickly you just gave. Private equity has clearly I should also mention that around the summarize the arguments I was making succeeded in adding value; if it hadn’t, time I met Carl, Steve Kaplan, who was back then. The growth of leveraged buy- the funds wouldn’t be able to raise so then my Ph.D. student at Harvard, was outs and private equity in the 1980s was much capital today. fi nishing up his path-breaking doctoral part of a phenomenon that I characterized Back in the mid-1980s, when I thesis on management buyouts. And as “the rebirth of active investors.” Active fi rst became interested in what is now Steve’s research, along with the impor- investors were people like J.P. Morgan called private equity, one of the events tant work of my colleague Bill Sahlman in the 1920s who held large positions in that affected me a lot was meeting Carl on venture capital, really focused my both the debt and the equity of an orga- Ferenbach at a session somewhat like attention on this new management and nization, often served on the board, and this one. Carl had just come back from governance model. were actively involved in the strategic a week of riding around on a “Hirail” car But then, as often happens with direction of the fi rm. A series of laws and in northern Wisconsin. He was focused fi nancial innovations, LBOs started regulations dating back to the Depres- on Berkshire Partners’ purchase of 2,000 to come under attack in the press and sion, including the 1934 SEC Act and the miles of railway that was the core asset of conventional business circles. Some of Investment Company Act of 1940, had Wisconsin Central. As a director of the the worst deals that were getting done the effect of driving active investors off of company, Carl had become concerned at the end of the ’80s began to come corporate boards and pretty much out of about its performance and insisted on apart. And the leveraged buyout of RJR the corporate governance arena. And the going out and meeting its customers and Nabisco in 1989 for $25 billion, which consequence of these laws and regula- employees in person. And I thought to became the subject of Barbarians at the tions, as I argued in a number of papers myself, “Well, this is really interesting. I Gate, was unpopular in large part because and forums, was a corporate America don’t know many directors of companies it was now seen as a threat to large pub- that was largely unmonitored and uncon- who spend their time riding around in lic companies, to corporate America and trolled by outside investors. The result was railroad cars talking to employees and the Business Roundtable. The fact that massive ineffi ciencies—ineffi ciencies that customers, especially in northern Wis- a fi rm the size of KKR, with 30 or 40 were both refl ected in and made worse by consin in January.” Having grown up in professionals, was willing to bid $25 bil- the conglomerate movement of the late Minneapolis, I know something about lion—and was able to raise that much ’60s and ’70s. These ineffi ciencies in turn what that means. money—for the purchase of a company provided opportunities for the so-called So that was my introduction to pri- like RJR Nabisco was a revelation to me. “raiders” and restructurings of the ’80s, of vate equity. And I learned a lot from Carl After all, that $25 billion represented an which LBOs and private equity were an about what makes it work. In fact, we almost 100% premium over RJR’s value important part. ended up writing a number of Harvard under its CEO Ross Johnson, which was This may be hard for us to imag- cases about some of Berkshire Partners’ about $13 billion before the fi rm was ine today, but at the start of the 1980s, portfolio fi rms, including one on Wiscon- put in play. What I learned from read- the shareholders of U.S. public compa- sin Central. And after watching Carl and ing Barbarians at the Gate—and I’m not nies were basically the only important his partners at work, and looking at the sure the author ever realized what he had stakeholder group that were not well successes of some of the other fi rms like found—is that the sheer waste of value represented in the corporate boardroom. KKR and Clayton & Dubilier, it started under Johnson, and thus the gain from And the ineffi ciencies that resulted from to become clear to me that leveraged taking the company private, was enor- the absence of monitoring led, as I said,

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After looking at the successes of fi rms like KKR and Clayton & Dubilier, it started to become clear to me that leveraged buyouts, and what later became known as “private equity,” were fundamentally a new way to think about corpo- rate governance, a new model of management, if you will. But what surprises me is that so few public companies are actually taking advantage of this new management model. I think it’s possible for public companies to take almost all of the major competitive advantages of the private equity sector and implement them in one way or another without actually going private.

Michael Jensen

to the rise of corporate raiders and to the But whatever you want to call them, and equity at the individual business unit formation of these new organizations like these new organizations found a way to or divisional level, not at the corporate KKR, Forstmann Little, and Berkshire accomplish much of what had been done level as in the conglomerates. And if you Partners. When I started writing about by J.P. Morgan and other pre-Depression think about how conglomerates operate, them in the mid-’80s, I referred to them fi nanciers. If you look just at their port- this difference in fi nancial structure can as “LBO associations” or “LBO partner- folios of assets, the LBO partnerships of make a huge difference. Every business ships.” But after LBOs got a bad name, the ’80s were remarkably similar to the effectively stands on its own bottom, the term “private equity” came into U.S. conglomerates, with lots of different which means that fi nancial problems vogue. And in the interest of clarity, let businesses having no apparent synergies. that affect one operation cannot bring me mention that “private equity” com- But the LBO fi rms were set up very down another. And it is impossible for prises not only LBO fi rms like KKR, but differently from their public company the LBO partnership headquarters to use classic venture capital fi rms like Kleiner counterparts. They raised money to fund funds from one business or division to Perkins—and, although there are impor- their activities not from public equity subsidize the activities of others. tant differences between these activities, markets but from institutional invest- Equally important, the operating there are remarkable similarities between ments in private limited partnerships heads of each business have signifi cant the ownership and governance systems of in which the buyout sponsors were the equity stakes in their own businesses—as venture capital and LBO fi rms, which is general partners. Each unit or division of opposed to, say, stock options in a diver- why we lump them together. the LBO association was funded by debt sifi ed collection of businesses over which

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they exercise almost no control. And the its customers, competition, employees, limited partners have to be paid back in equity stakes of these operating heads and so forth—stays up to date. seven to ten years, those principals who were considerably larger than those of While I was working up one of my case want to stay in business have got to main- U.S. public company CEOs. In a study studies with Carl, I was given the chance tain a reputation that will allow them to of executive pay in U.S. public companies to observe a few of his portfolio company get back into the market and raise new in the ’70s and ’80s, Kevin Murphy and I board meetings. The only formal board funds. These reputational effects are a estimated that the average U.S. CEO in members were the CEO of the company very important feature of private equity; the ’80s saw his personal wealth go up by and Carl and his partners. Other manag- they provide discipline and pressure for about $3 for every $1,000 increase in the ers were in the room and played important increases in effi ciency, but in a way that value of the fi rm. By comparison, Steve roles, but they were there ex offi cio, not as does not discourage companies from Kaplan’s thesis found that the CEOs of board members. And I was struck by two investing in long-term value. They are businesses owned by LBO fi rms—the things. One was that, unlike the pub- not driven by quarter-to-quarter market people who were previously running lic company board meetings I’d been in, reactions to operating results. divisions inside conglomerates—earned there was a tremendous amount of con- To sum up, then, the structure and about $64 for every $1,000 in share- fl ict, disagreement, heated discussion. conventions of private equity have pro- holder wealth. So that’s quite a change Also quite different from the practice of vided U.S. capital markets with a way in incentives. public company boards, the confl icts and to recreate old-fashioned active invest- And just as important, under the LBO issues that came up were never resolved by ing in a way that complies with the laws or private equity governance system, the voting. There was lots of disagreement— of insider trading and a bunch of other performance of the operating companies arguments about things like whether the regulatory constraints. In the process, the and their top managements is overseen company should continue to run fast fer- private equity fi rms have invented—or by much smaller boards that consist ries between New Zealand’s north island perhaps “rediscovered” is a better word— mainly of the fi rm’s largest investors— and the south island—but there were no a better way to run a group of different other than the CEO, there are typically votes. My rule of thumb is that if you end businesses, one that is very different from no insiders. And, as you can imagine, the up taking a vote to resolve business ques- how the typical U.S. public company is kinds of discussions that take place in a tions like that—in fact for anything other run. The differences are so striking that room with just the fi rm’s major owners than a legal matter—you’re in real trouble; I like to defi ne private equity fi rms as are dramatically different from what goes you’ve got a breakdown in the system. “organizations that run governance sys- on in most public company board meet- So, I saw a board working in a way tems that run businesses.” ings. The quality of these discussions is that was very different from what I’d The result has been enormous just much higher than what takes place seen in the public sphere. They were increases in corporate effi ciency and with most public company boards. In going at it hammer and claw and there value. Looking back, we can now see fact, my sense is that the due diligence were no punches pulled. But they gen- that LBOs played a major role in restor- process that the buyout fi rms go through erally reached agreement, and everybody ing the profi tability and competitiveness in vetting and pricing a deal causes those seemed to like each other, when the day of American business in the 1980s. principals and their managers to learn was done. The new management model looked so more about the business than probably Another important difference between promising to me that in 1989 I wrote an has ever been known since it was a public public conglomerates and private equity article in the Harvard Business Review company, or a division of a public com- fi rms is that the funds have limited time predicting that LBO fi rms would end pany. And the close contact between the horizons. Each fund has a fi nite life, up taking over a large fraction of the buyout principals and the managers of typically seven to ten years. And the mature sectors of the U.S. economy. I the fi rm helps ensure that this detailed principals in the private equity fi rm have also predicted that the Japanese model specifi c knowledge about the business— their reputations on the line. Because the of corporate governance, then viewed as

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the dominant model of business in the in evidence today. A major source of lost sentative from the University of Chicago world, was failing and on the verge of value in those days had to do with what into the fray. collapse. I pointed out that the Japanese I call the “agency costs of free cash fl ow.” Steve, you have done a great deal keiretsu looked very much like the U.S. Much like today, in the 1980s the U.S. of research on the performance of the conglomerates of the 1960s and early economy was full of companies with buyout funds. Following up on what 1970s, and my prediction was that they stable cash fl ow, large cash balances or Mike has said, I’d like to have a better would come apart at the seams and there unused borrowing power, and few valu- understanding of whether and how pri- would be a long period of decline. able investment opportunities in their vate equity fi rms are actually making All that has pretty much come to pass. core businesses—investments that prom- operating differences, improvements in It was essentially the leveraged restruc- ised to provide returns above the cost of how the businesses are run. Mike just turing movement of the 1980s, and the capital. In other words, companies had suggested that the increased due dili- pressure for value maximization that lots of “free cash fl ow,” which I defi ned gence and monitoring, the attention to came with it, that launched the remark- as cash that could not be profi tably rein- detail exemplifi ed by Carl Ferenbach’s able increase in the productivity of U.S. vested in the business. At the same time, long train trips to the hinterland, are a industry in the ’80s that has continued top managers had strong incentives to key source of value in private equity. Your pretty much to this day. The private keep that cash—and perhaps spend it on work has tried to tease apart some of the equity organizations were a major part low-return projects, including diversify- strands—to identify the different major of that effort to dismantle ineffi cient ing acquisitions—incentives that have factors—that are thought to contribute conglomerates and boost productivity. mostly to do with the personal benefi ts to the overall performance and value And I’m not at all surprised to see private of running bigger organizations. of private equity. For example, there’s equity spreading around the world. The In this sense, the free cash fl ow prob- a school of thought that says that the only puzzle to me is why it has taken so lem is about the natural propensity of returns to leveraged buyouts and private long for this to happen. corporate managers—natural, that is, in equity are primarily the result of a highly the absence of signifi cant equity owner- leveraged bet on equities, with most Jones: Mike, your description of private ship—to prefer size over profi tability. By of the benefi ts coming from the use of equity has a lot to do with solving the retaining rather than paying out excess other people’s money. You’ve done a lot agency problem of aligning the interests capital, management keeps the reinvest- of work to get at the root of how the best of managers and shareholders in public ment decision inside the fi rm instead fi rms produce their returns. And, unless companies that you and Bill Meckling of giving it back to the capital markets. I’m mistaken, one of your most recent identifi ed in the 1970s. Do you still see And as I predicted then—and I haven’t studies shows that while the industry as the growth in private equity as driven seen anything that would cause me to a whole has not outperformed the broad mainly by what you described as a gover- revise that prediction—the retention of equity indices, the top fi rms consistently nance issue, by the need to monitor and excess capital leads to waste and value outperform those averages. Is that a fair control corporate managers who are fail- destruction. Some of that is still going statement of your fi ndings? ing to maximize value? on today. I would argue that Microsoft, for example, could signifi cantly increase Steve Kaplan: Thanks, Alan. I’ve been Jensen: The main impetus for private its own value by paying out a lot more of teaching a course on private equity for equity has been the failure of public its excess capital than the $30 billion it the last ten years, and researching private companies to maximize value. In the ’70s announced a year or so ago. equity and corporate governance since I and early ’80s, the absence of effective was one of Mike’s doctoral students at monitoring of companies by investors The Performance of Buyout Funds Harvard back in the ’80s. In my research, led to all kinds of unproductive prac- Jones: Thanks, Mike. Now that we’ve I have tried to answer the questions you tices, some of which are still very much heard from Harvard, let’s bring a repre- just asked by studying private equity

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In the late 1980s and after, more and more transactions saw buyout fi rms bidding against each other to do the fi nancial and governance engineering. As a result, more of the value started to go to the sellers. Buyout fi rms have responded by developing industry and operating expertise that they can use to add value to their investments. This increased focus on improving opera- tions is a big change. Given the combination of fi nancial and governance engineering with this operational engineering, private equity is likely adding more overall value today than it did in the ’80s and the ’90s.

Steven Kaplan investors both at the fund level and at cash fl ows. The operating improvements the purchase with debt, producing some the portfolio company level. in my sample companies translated into “short-term” profi ts by cutting expenses, Let’s start with the company level, above-market increases in both enter- and then fl ipping the assets through a sale with the work that looks at the perfor- prise values—that is, the values of the or IPO. LBOs do, of course, rely on debt mance of the individual companies that companies’ debt plus equity—and in fi nancing—for tax and other reasons. are purchased by the private equity funds. equity returns. But there is a lot more going on inside In the thesis I did at Harvard under The next question this raises is, where LBOs than fi nancial engineering. And Mike’s direction, I gathered as much data do the operating improvements and the that’s why I think a better description of as I could about these companies—data value-added come from? I think there are the process of adding value in LBOs is that were then and still are hard to come two main parts to the story. One has to “fi nancial and governance engineering.” by. What I found—and this generally has do with what is referred to in the busi- What do I mean by fi nancial and been confi rmed in later work by others ness as “fi nancial engineering.” Mike governance engineering? Primarily three studying both U.S. and European mar- doesn’t like that term because it has a things. First is the change in manage- kets—is that companies that undergo negative connotation. It conjures up a ment incentives. The early buyout fi rms LBOs and MBOs experience signifi cant picture of “fi nancial” investors scaveng- discovered the importance of giving improvements in operating margins and ing for undervalued assets, fi nancing management a big equity upside in the

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company, and that was very unusual in and governance engineering. As a result, from 1980 to 1995—was about equal to the early ’80s. They also asked—and still more of the value started to go to the the return investors would have earned ask—management to make a meaningful sellers. Buyout fi rms have responded by on the S&P 500 over that period. On and often substantial investment in the developing industry and operating exper- average, then, we did not fi nd the supe- company. This way, management has not tise that they can use to add value to their rior performance that is often given as only a signifi cant upside, but a signifi cant investments. They differentiate them- the justifi cation for investing in private downside as well. Another important fea- selves by having the industry knowledge equity. The result also appears at odds ture of incentive compensation in LBOs to ensure that their portfolio companies with the value creation story at the fi rm is that management’s equity is illiquid have effective strategies and operations, level that I just described. until the value is proved. So, you put and by having a network of operating But there are at least two reasons the your money in and you get a big equity executives to ensure that their portfolio average fund returns do not provide the stake, but you don’t get to take it out— fi rms have the best managers and advice. whole story about the effectiveness of that is, you cannot sell a share of stock For example, Brian Hoesterey’s fi rm, private equity investors. First, the returns or exercise an option—until you’ve either AEA Investors, was among the fi rst to are net of fees. Given the lucrative fee created value or you have failed. hire former CEOs to help manage their structure in private equity, it is safe to On top of the management incen- funds’ investments. Berkshire Partners, conclude that the private equity funds tives, you have the pressure of leverage, Carl Ferenbach’s fi rm, has had a strong do beat the S&P gross of fees. Although the need to produce enough operating operating focus since its start in the mid- the fees are diffi cult to estimate precisely, cash fl ow to make payments of interest ’80s. In contrast to the pioneers in the they effectively exceed 3% per year. and principal. And that means that you ’80s, almost every buyout fund today will Second, the returns to the private don’t have the free-cash-fl ow problem say, “We have a strong operational focus. equity funds do not take account of any that Mike just mentioned where excess We have former CEOs, and we have for- gains to the sellers in the private equity capital is sloshing around waiting to be mer operating executives, who are going investments. Because many of the com- spent. You have to pay out the money, to help our companies add value.” panies are purchased in competitive which focuses the mind. The increased focus on improving auctions, it is common for a substantial The third important piece is the operations is a big change. It is much amount of value added to go to the sellers. active oversight by a board that consists more pervasive than it was 20 or even To illustrate this, consider KKR’s purchase mainly of the fi rm’s largest investors. So, ten years ago. Given the combination of RJR Nabisco that Mike mentioned ear- you have people like Carl, Cary, Brian, of fi nancial and governance engineering lier. KKR ended up paying $30 billion for and John sitting on the board and mak- with this operational engineering, pri- the debt and equity of a company whose ing sure that management is doing what vate equity is likely adding more overall enterprise value was about $17 billion as they’ve committed to do. value today than it did in the ’80s and a public company under Ross Johnson. So, that is fi nancial and governance the ’90s. And because they paid such a high price, engineering—and that’s the essence of Now that I have talked about how KKR and its investors ended up earning a the story of how LBOs and private equity private equity fi rms create value, the next low return. In that deal, KKR effectively created value in the ’80s. Today, there is question is whether that value creation paid out the entire value added to RJR’s another piece that was less prevalent in is translated into returns to investors public shareholders—something on the the ’80s but has become increasingly in the private equity funds. Antoinette order of $13 billion. Although there was important. You might call this piece Schoar of MIT and I studied that in a little left over for KKR’s investors, a large “operational engineering.” paper published last year in the Journal amount of value was created. In the late 1980s and after, more and of Finance. We found that the average Viewed in the light of fees and gains to more transactions saw buyout fi rms bid- return on all the private equity or buy- sellers, our fi nding of average net returns is ding against each other to do the fi nancial out funds in our sample—those raised consistent with the idea that private equity

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funds add value. Now let’s move to the Ferenbach. Carl, how do you think pri- for Mike’s course. The market had spo- second major fi nding of our study, which vate equity adds value? Both Mike and ken. The course was asking some very has to do with the best performers. Steve focused on three benefi ts of private important questions about the goals and When you sort all the private equity equity: direct monitoring of top manage- governance of large organizations—and partnerships into good and bad partner- ment by the fi rm’s largest investors; the the students who were going back into ships, there is a clear tendency for the pressure of heavy debt in forcing out free the business world were apparently very better performers to repeat their perfor- cash fl ow; and the alignment of incen- interested in those questions. mance and to outperform the market on a tives from giving the management team One of the main drivers behind the consistent basis and net of fees. That fi nd- a meaningful economic participation in growth of the LBO market was the insti- ing is important for two reasons. First, you the success of their own business. tutionalization of capital that started do not see that kind of persistence in stud- Based on your 20-plus years of experi- around 1980. At that time, the pool of ies of other kinds of funds. For example, ence in this business, what can you tell us capital available for such transactions in studies of mutual funds, there is very about these and other ways in which pri- resided mainly in insurance companies. little if any persistence, particularly on the vate equity adds value? And please don’t But it then began to spread to univer- positive end of the distribution. Today’s say that you too were a student of Mike sity and private endowments, and to best performers are not any more likely Jensen’s. retirement funds, including the pension to be tomorrow’s best performers than the plans of large corporations and state typical fund today. And the same seems Carl Ferenbach: No, I’m too old for governments. The states of Michigan, to be true of hedge funds: there is not that. Wisconsin, Washington, Oregon, and much evidence of persistence in the data California were all early participants in on hedge funds. But it is clearly there in Jensen: Carl taught my class. funding the fi nancial entrepreneurs who the data on private equity, both for buyout created the leveraged buyout business. funds and for venture capital funds. Ferenbach: That’s right. W hen Michael The people who went into the LBO And the fi nding is even more com- left the University of Rochester and came business back then, including my part- pelling in the sense that the differences to Harvard in 1984, he started teaching ners and me, did so because we thought between the best and worst performers are a course called “CCMO,” which is short that owning and helping to run busi- probably understated by a “survivorship” for “Coordination, Control, and the nesses would be interesting and fun—and problem. That is, if your fund’s perfor- Management of Organizations.” And maybe even profi table. And the kinds of mance is poor, you are less likely to raise while Mike was certainly well known businesses that we were looking at came another fund; and in this way, the worst- in academic fi nance circles at the time, from two main sources: the public con- performing funds are continually culled he was new to Harvard and his views glomerates that Mike mentioned earlier from the system. This means that the funds were pretty controversial. But within and private, founder-owned businesses that do make it into our tests are owned by two years or three years of joining the without a clear succession plan. partnerships that have succeeded in rais- faculty, much of that had changed. I Although conglomeration may have ing another fund. Even within this group remember Mike calling me and ask- been a value-maximizing strategy for of surviving funds, we fi nd a statistically ing, “Can you come out and talk to my companies in the late ’60s and ’70s, by signifi cant separation between the better class? We’re going to do the Wisconsin the early ’80s conglomerates were clearly funds and the worse ones. Central Case.” And when I asked him proving to be an ineffi cient way to orga- how long this would take, Mike told nize companies and deploy capital. A Practitioner’s View me, “Well, I’ve got seven sections this What conglomeration meant in practice Jones: Thanks, Steve. Let’s step out of year.” What that meant was that virtu- was that there were a lot of people inside the academy for a moment and turn to ally the entire second-year MBA class at large organizations running businesses a seasoned practitioner of the art, Carl Harvard Business School had signed up while having zero ownership of those

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We run our board meetings with our portfolio companies in two buckets. We don’t talk about fi nancial information until after we’ve had an afternoon talking about how the business is working. The fi nancial information is just sup- posed to provide a check on the business. And if the information doesn’t mirror the business reality, we all know that it isn’t right; it isn’t measuring what’s going on in the business. But you won’t know that unless you spend time asking all those other questions fi rst.

Carl Ferenbach

businesses. And they had very little to So, the original leveraged buyout busi- by introducing the incentives, by giving say about what happened to the profi ts ness was a combination of divestitures by equity to the former managers in the con- generated by their businesses, which conglomerates and private sales. It was a glomerates—or the successor managers in typically went somewhere else in the business where the equity put up 10% to the family businesses—in most cases for organization. Conglomerates were noto- 15% of the capital and lenders put up the the fi rst time in their careers. For those rious for misallocating resources and, by rest. The prices were much lower than people who had previously managed in the early ’80s, it was clear they were fail- they are today, in part because there wasn’t conglomerates, it was no longer a matter ing to produce acceptable shareholder much of a credit market. Mike Milken of securing funds from corporate head- returns. And one of the functions of the was just starting to build the high yield quarters; resources were scarce and you early LBOs was to help pull the con- market. So the credit market was mainly had to invest them effectively. And if you glomerates apart. But I should add that the banks and the life insurance industry. made an investment, the payback had to we did only friendly deals; we were buy- But the important thing is that a lot of be fairly quick and certain because much ing only when they were selling. people managing businesses were given of the capital structure was senior bank At the same time, there were a lot of signifi cant equity stakes for the fi rst time, debt that had to be paid back in fi ve years. World War II veterans who had founded and I think that was a major contributor That was the basis on which the money businesses after the war and had reached to the success of LBOs in the ’80s. was loaned. the point where they needed to make The transactions we did in those days But now let’s fast forward to the 21st changes in the ownership of those busi- were also highly structured deals; they century and the world Alan described so nesses for estate reasons. Leveraged took a lot of time to do. The conven- well in his introduction. Our fi rst fund acquisitions were a way for the compa- tional wisdom in those days—and I think back in 1984 was a $50 million fund, nies to remain independent and, in many it was accurate—was that the value in which took us nine months to raise. In cases, for a new generation of managers those transactions was created mainly at 2005, the buyout portion of the private to become owners with us. the time of the deal. The value was created equity marketplace, excluding venture

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capital, raised a total of $82 billion in one-time dividend distributions that can think you can sustain and keep building new capital commitments. It’s a highly be a valuable way of recapitalizing the on those improvements. I should add effi cient and sophisticated capital mar- fi rm. And, as Mike said, governing fi rms that sustainability of performance in the ket that is now divided into a bunch of with small boards consisting mainly of 21st century is very diffi cult. Competi- different segments. There are megafunds large owners will also continue to be a tive information travels so quickly, and like the ones raised recently by TPG and major source of value. innovations can be copied so readily in Blackstone. KKR raised a $13 billion But, as Alan and Steve also suggested, so many different parts of the world, fund this past year, or at least is closing there are some relatively new sources that the fact that you are a good busi- in on that. There are niches, such as the of value, or at least a shift in empha- ness is yesterday’s news. It’s your ability mid-market and the small market, as sis toward what I like to call company to continue to be a good business that well as sector funds that focus on specifi c building. Private equity today is increas- is the critical skill. It’s effective manage- industries. And there is a large and grow- ingly much more than just having a lot ment processes over and over again, and ing fund-of-funds business that can pick of wonderful people on your staff who it requires continuous monitoring. and choose among all these different sec- know how to buy and structure busi- Let me also mention that we run tors. This means that private equity, in nesses. It requires an effort that says, our board meetings in two buckets. We the past 25 years—which is a remarkably “OK, we’ve just done a very thorough don’t talk about fi nancial information short time, not much more than a gen- due diligence of the business, we think until after we’ve had an afternoon talk- eration—has become a very large and we know what we’ve got, and we’ve just ing about how the business is working. active and effi cient capital market. closed the transaction. But let’s forget We discuss questions like: How are the The question that arises today is this: that bit of history. Now we’ve got to sit problems with the customer relationships How do the private equity fi rms take down as a group and fi gure out what we we all learned about in the planning pro- these resources that they’re all accumulat- as managers and owners want this busi- cess getting resolved? Who’d we lose? ing and make them worth more than they ness to look like going forward. We have Who’d we gain? How’d we do it? How were before? A couple of my colleagues to plan that methodically. And once we much of it was price? How much of it and I recently heard Alan’s counterpart have agreed on the plan, we have to hold was competitive advantage? What are at a major competitor predict that the ourselves to it. We’re going to measure we doing to continually enhance that? returns in private equity would normal- our performance regularly and, when Will it take capital? These are the pri- ize at around seven percent in the future. necessary, we’ll make changes in the mary issues that we’re dealing with when That didn’t make the business sound very plan. What’s more, we have to recruit we get together. The fi nancial informa- interesting to us. But, if that’s really the the people we need to execute our plan. tion is just supposed to provide a check environment we’re looking at, how can (I’ve never seen a business that had all on the business. And if the information a buyout fi rm distinguish itself from its the right people in it.) And we may have doesn’t mirror the business reality, we all competitors? to be fairly ruthless about the wonder- know that it isn’t right; it isn’t measuring And that’s why I would argue that the ful person who’s been with the company what’s going on in the business. But you contributions to value of today’s buy- and helped it get to where it is, but who won’t know that unless you spend time out fi rm are somewhat different from doesn’t fi t the execution of this plan— asking all those other questions fi rst. the ones that Mike focused on. Giving because that’s what we are here to do. So that’s the process that we go managers a signifi cant equity stake and Everybody has to understand the game through, and that your management using debt to force out free cash fl ow will plan and the rules of the game.” teams have to put themselves through, in continue to be important. This more So, again, you have to understand order to get the continuous improvement effi cient deployment of investor capital why you think you have a fundamentally we think is necessary to add value today. has been helped by having the tax rate good business, why you think you can It’s a continuous process of learning how on dividends at 15%, which encourages improve its performance, and why you we can do things better. For example, at

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the beginning of this decade, the main Ferenbach: It can mean either. It means companies that are controlled by pri- focus of companies that made things was that your culture is as inclusive as your vate equity fi rms and those that apply to on taking out costs. And people forgot problem solving. It involves a lot of “non-controlled” public companies. And how to market in those sectors. But I input, which therefore takes time. People in my experience—and no doubt partly think we’re now rediscovering how to must come to a common understanding. as a result of the above differences—there market. We have a lot of new tools to use When they do, they can usually execute are also signifi cant cultural and behav- in marketing, and there’s an abundance of very effectively because there are not fi ve ioral differences between controlled and information. A big part of our job will be layers of management between where the non-controlled boards. to bring all of the new tools, technology, decision gets made and where it has to be When I say “controlled companies,” and human capability to bear on matur- carried out. That will generally lead us to I am talking about fi rms that are con- ing businesses to make them better. The prefer 50 people over fi ve. trolled by private equity fi rms or one fi rms that succeed in those efforts will of their funds, or by a single individual differentiate themselves. Boards Public and Private representing one of those fi rms who Jones: Thanks, Carl. Meyer, I want to functions as a controlling shareholder. In Jones: Carl, you emphasized the impor- bring you into the conversation and take my experience, the boards of controlled tance of getting the right people. How advantage of the fact that you serve on companies have a split personality. Such important is it to go far down into the the boards of both public and private boards have independent board mem- organization in aligning incentives? In companies. This gives you a great perch bers, and they have management and other words, there’s a CEO and then from which to view the agency problems investor-affi liated, or what are known as there’s a whole group of people down in public corporations that result from “interested,” board members. Though below. How important is it to push misaligned incentives and how private there are some matters on which the incentives down into the organization? equity fi rms attempt to deal with them. entire board acts, in most important Given your experience in sitting on those corporate decisions the board acts only Ferenbach: That decision has to be two different kinds of boards, do you see after the board members representing driven by the culture of the organization. a meaningful difference between pub- the controlling shareholder have met and I don’t think you can create a collaborative lic and private companies in how they discussed the issues and reviewed the culture inside a hierarchical organization behave and respond to incentives? desirable outcomes. Private equity fi rms just by giving a lot of people equity. In tend to exercise considerable operating fact, I’ve seen attempts to do that fail. On Meyer Feldberg: I would guess that, in control over their portfolio companies the other hand, you can clearly destroy, the past 20 years, I’ve served on as many and so their board representatives typi- or fail to create, a collaborative culture by as 15 different boards. Half a dozen of cally meet with management and each not spreading ownership widely enough. them have had controlling shareholders, other on a regular basis. The full board The general trend—which is consis- including KKR, Welsh Carson Anderson may meet six to eight times a year, and tent with our preferences and values—is & Stowe, and MacAndrews and Forbes. the Audit, Nominating, and Gover- toward collaborative organizations and In some cases, I have served on boards nance and Compensation committees structures. We don’t like hierarchical of companies that were public when I often meet even more frequently. structures. But that doesn’t mean that we joined, but were then taken private— Thus, although there is active, full- won’t get behind strong and somewhat and later taken public again. Most of my board governance on some issues, that hierarchical leaders who are also great observations this morning will refl ect my system exists alongside the reality of business builders. experience serving on these boards. management and the controlling share- Let me start by saying that there holder working together to further the Jones: Does collaborative mean fi ve are major differences between the legal interests of the company and the fund. people or 50? and regulatory requirements for public Both Mike and Steve commented earlier

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The due diligence process conducted by most private equity fi rms when buying companies is of a different order of intensity than what goes in most public company acquisitions. And judging from my own experience, I would say that intensive due diligence continues to be conducted by the controlling board members well after the deal is closed. Given their incentives, controlling board members just spend far more time and energy monitor- ing operations and performance than their “non-controlling” counterparts.

Meyer Feldberg that the due diligence process conducted issues, they are sometimes used to review companies are heavily infl uenced by the by most private equity fi rms when buy- governance, audit, and compensation controlling directors. They are usually ing companies is of a different order of issues that eventually fi nd their way onto the driving force in appointing the CEO intensity than what goes on in most pub- formal board or committee meeting agen- and in setting his or her compensation lic company acquisitions. And judging das. In recent years, controlling directors package. And although the outcome of from my own experience, I would say have become increasingly sensitive to gov- this process is ultimately reviewed and that intensive due diligence continues to ernance issues and have attempted not to approved by the compensation commit- be conducted by the controlling board circumvent—or be seen to circumvent— tee and recommended to the full board, members well after the deal is closed. the formal board process or its governance. the reality in controlled companies is that Given their incentives, controlling board As evidence of this concern, controlling the controlling shareholders make the key members just spend far more time and directors seldom meddle in the work of compensation and hiring decisions. energy monitoring operations and per- the audit committee. In my experience, At the same time, however, many con- formance than their “non-controlling” they have often been delighted to have trolled companies now have independent counterparts. In fact, it is entirely pos- independent directors assume responsi- nominating and governance committees. sible that the directors representing the bility for the audit. Controlling shareholders are generally private equity fi rm will meet with the But the compensation committees of anxious to have governance conducted in CEO and other members of manage- controlled companies are a different mat- a transparent fashion, and independent ment every couple of weeks for years. ter. As a number of people have already directors tend to exercise considerable Although these meetings will typically suggested, the compensation package and control over nominating and governance. involve mainly operating and strategic incentive structure for CEOs of controlled Nonetheless, the nominating and gover-

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It doesn’t take much time for anybody who’s worked with a public company to realize that there is often a large information gap between what the CEO knows and what investors know. One of the strengths of private equity is its emphasis on long-term decision-making, and it is the much smaller information gap in pri- vate equity-backed companies that helps make this emphasis possible. The boards of private equity-backed companies, as the economically motivated representatives of the investor base, make it their business to know as much about the prospects and opportunities of the busi- ness as the management teams that run them.

John Moon

nance committee on some boards where essentially take that fi rm out of the busi- “fi nancial and governance” engineering. I’ve served is in fact called just the gov- ness. So it’s an unforgiving marketplace. We’ve also talked about the increasing ernance committee—which tells you that And this takes us back to the point where use of operating partners, either on staff the controlling shareholder has not been Mike started, which was the importance of or being brought in from the outside prepared to cede the authority to nominate the discipline of having to give the money to run companies. When you look at a or appoint new independent directors. back at the end of a fi nite fund life—and business at Metalmark, what makes it an But, again, there’s a lot of discipline in then trying to raise it again. attractive investment for you? the private equity process. And to reinforce that point, let me conclude by coming back The Case of Metalmark Capital John Moon: I’m going to begin by to the statement made a few minutes ago Jones: That’s right. Having to raise the drawing on a couple of concepts that that, in the private equity business, you are capital again is a critically important have already been introduced. The due only as good as your last fund. A private driver for the funds. Let’s now hear from diligence process that Meyer just men- equity fi rm that has had fi ve successful John Moon of Metalmark Capital. John, tioned—and, more generally, getting the funds in a row followed by a failure with how do you try to distinguish yourselves most information possible about the com- the sixth will have diffi culty raising a sev- as investors? We’ve talked about fi nancial panies you invest in and understanding enth. And two failed funds in a row may engineering, and about Steve’s concept of the industries in which they operate—is

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critically important to success. We at ager’s compensation is fairly indirect. By Jones: John, let me stop you there. What Metalmark do this by bringing to bear contrast, the economics of private equity is your response to the question that I our own experience as well as the experi- fi rms are directly linked to the invest- asked Carl a few minutes ago? How far ence of a network of executives who have ment returns to their limited partners. down in the organization does the equity worked with us, some for over a decade. I The customary 1½% management fee need to go to be effective? agree with Mike’s statement earlier that, and 20% carried interest are an abso- when a company is taken private by an lutely critical part of what we do; the Moon: The more time I spend with man- experienced private equity fi rm, the due direct pay-for-performance element agement teams, the more I think that the diligence process probably unearths more built into this arrangement represents right answer from an economist’s perspec- information about the company than has a sharp contrast to the incentives fac- tive—and this is really nothing more than ever been known, or assembled in one ing mutual fund and other conventional common sense—is that the equity should place. And as Meyer just suggested, the money managers. be pushed as deep into the organization as fact that the controlling board members Through carried interest, the gen- there are people who “move the needle.” meet with management every few weeks eral partners of private equity fi rms are And that will differ depending on what means that the initial due diligence is just highly motivated to deal with the diffi - industry we’re talking about. Having said the beginning of an ongoing and collab- cult corporate governance issues that go this, I would also say there have been some orative process, one that continues as long unaddressed in many large public com- examples of great CEOs who embody as the private equity fi rm holds a stake. panies. In their path-breaking paper on virtues that can’t quite be quantifi ed in The second critically important aspect agency costs and corporate governance, economic terms; they have been much of private equity is establishing the proper Mike Jensen and Bill Meckling identi- more generous in spreading the wealth management incentives, which Mike, fi ed what economists now refer to as the than economic theory might prescribe. Steve, and Carl have all commented on. “agency problem.” Practically speaking, Some of the best CEOs will sometimes do As Mike has been telling us for over 20 the problem can be described as fol- things that may not look rational from an years, converting professional managers lows: How do you get a bunch of small investor’s perspective, but create a tremen- and board members into committed own- investors, each with highly diversifi ed dous amount of employee loyalty, which ers can lead to amazing transformations portfolios, to take the time to ensure that can translate into real value creation. in management morale and motivation. managers do the “hard things” required So, how far down does the equity We’re big believers in providing an oppor- to maximize value in the companies need to be pushed into an organization? tunity for managers to share meaningfully they invest in? Small investors don’t have It should be given to those who can move in the wealth they create. much incentive, or much of an opportu- the needle in proportion to how much But, on top of the better informa- nity for that matter, to really work with they can move the needle. tion and the stronger incentives, what the management teams they back. Even may truly be unique about the private the few who do serve on boards don’t Jones: And getting the organizational equity industry is the extent to which really have much incentive to truly chal- incentives right is part of the value that it practices what it preaches. First, lenge management. As a board member, the private equity owner brings to the consider the norm in the conventional the easiest thing to do is to go along with deal, right? asset management industry. Although what the chairman recommends. the investment track record of a con- Private equity fi rms are quite differ- Moon: That’s part of the value added. ventional, long-only money manager is ent: First of all, private equity investors Again, as Meyer was suggesting, a critical very important in attracting additional make sure that the economic incentives part of the private equity story is bringing funds—and presumably infl uences the of the CEO and the executive teams are to bear a set of distinctive skills that trans- manager’s long-run compensation—the aligned with their own, and therefore late over time into a track record of success link between fund returns and the man- with those of their investors. and, ultimately, a positive reputation for

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the buyout fi rm. It’s something that has ciate with LBOs. So, on the basis of just showing period-by-period results while not received much attention in academic these two pieces of information, I’m also investing for the long term. research until quite recently. But, as the going to assume that Cary will be tell- When I was at Harvard Business work of Steve Kaplan and others sug- ing us about the “new economy” side School in the early ’90s, the two most gests, experienced investment teams in of private equity while Brian will be a valuable classes I took were Mike’s course private equity with a superior historical spokesman for the “old” economy—and on “coordination and control”—the track record have delivered consistently I haven’t found an occasion to use these CCMO course that Carl mentioned higher average returns. That consistency is terms for quite a while. earlier—and Bill Sahlman’s course on harder to fi nd in other asset classes, such as Cary, how does private equity dif- entrepreneurial fi nance. What those mutual funds for instance. fer when your investment is more like courses had in common was an intensive The general partners of a private venture capital than, say, the kinds of focus on agency costs—the loss in value equity fi rm are typically in the board- companies purchased by Brian’s or Carl’s in large organizations that results from room, alongside their highly motivated fi rms? And how does the role of the pri- the misalignment of incentives between industry partners, actively contributing vate equity investor in such companies managers and owners. I believe that the to the decision-making process. The fact differ both from what the public markets private equity industry has gone a long that 20% of the investment value created do and from a traditional LBO gover- way towards solving that agency confl ict, comes back to the general partners gives nance model? as well as the particular form of that con- people like us very strong incentives to fl ict that Mike has called “the free cash measure and monitor performance and Cary Davis: Alan, you’re right to say fl ow problem,” the tendency of man- make value-maximizing decisions. And, that our lens at Warburg Pincus is a little agements in mature businesses to retain to come back to Meyer’s and Mike’s different from that of the other private and then waste excess cash on low-return point, if portfolio companies fail to add equity fi rms represented here. Even projects. The substitution of debt for value, returns will be low and limited though we call some of our transactions equity in LBOs solves that problem by partners will be disappointed. Eventu- “buyouts,” we see ourselves as providing forcing companies to pay out the cash in ally, these fi rms will have trouble raising “growth equity” and all our buyouts are the form of interest and principal. capital for their next fund. The directors focused on growth. My own focus, as you The private equity model is also pre- of most public companies don’t have mentioned, is high-tech growth indus- mised on the idea that everyone needs such concerns. tries. And so some of what has been said a boss, including the CEOs of public so far about some of the more mature companies. And it’s also important that The Growth Side of Private Equity industries may be less applicable in my people’s goals, including the goals of Jones: Thanks, John. Now, let’s bring case. But there is also a lot of common CEOs, are consistent with their bosses’ our other two practitioners, Cary Davis ground. In fact, I would say that perhaps goals. In buyouts by private equity fi rms, and Brian Hoesterey, into the discussion. the biggest difference between our deals whether they’re start-ups or late-stage And let me warn you that I’m about to and Carl’s and John’s is in fi nancial struc- deals, the partners of fi rms like ours effec- stereotype you both. Cary, your efforts ture: our deals tend to be funded with tively become the bosses of the CEO. We at Warburg Pincus are focused primarily much less debt than standard buyouts in have enough at stake, and are suffi ciently on technology and software companies, mature industries. As a consequence, we involved in and knowledgeable about the and the investments of your fi rm are con- probably face—and transmit to our man- business, to ask the hard questions and centrated in earlier-stage deals than the agement teams—a bit less pressure for to have awkward and diffi cult discus- typical mature LBO fi rms that we have near-term results than most LBO fi rms. sions when we aren’t happy with the way been talking about. By contrast, Brian’s But, again, the differences are more a things are going. investment activity is in the mature, matter of degree than kind. All the fi rms But let me mention another kind of industrial-oriented sectors that we asso- represented here face the challenge of agency cost—one that, although I didn’t

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The private equity model is premised on the idea that everyone needs a boss, including the CEOs of public companies. In buyouts by private equity fi rms, the partners of fi rms like ours effectively become the bosses of the CEO. We have enough at stake, and are suf- fi ciently involved in and knowledgeable about the business, to ask the hard questions and to have awkward and diffi cult discussions when things aren’t going well.

Cary Davis hear much about it at Harvard, I tend to enue. And we often begin to make some now doing. Both Carl and Meyer have hear all the time in my conversations with investments in the business that have talked about a shift in focus over time the CEOs of public companies that want been avoided for a long time for fear of from cost-cutting to growing the top to go private. When a CEO in the tech- the effects on earnings. And, by the way, line. And it’s clear that such growth is nology industry comes to me and says, these investments are designed to pay off critically important to the investments “We want you to take us private; the mar- during our time horizon—that is, during that you make in technology and related ket doesn’t appreciate what we’re doing,” the fi ve- to seven-year period after which investments. But does growing the top I’m usually skeptical. My fi rst reaction is, we’re looking for liquidity. line require a completely different incen- “Why should I believe your performance So, some of the increase in value added tive and governance system from the one is going to improve when you’re no longer from a private equity fi rm comes from used to increase value in more mature, a public company? What can you not do this lengthening of management’s time slow-growth industries? as a public company today that you could horizon, and the ability to create profi t- do if you were private?” able growth and value that results from it. Davis: Well, every industry has its chal- The typical answer I get—which I But, as I suggested, I’m still a bit skeptical lenges. But even in businesses focused don’t fi nd very persuasive—is that the about this. I’m not completely convinced on cost cutting where top-line growth is need to meet quarterly earnings targets that public companies couldn’t do this on challenging, we have found opportunity prevents public companies from running their own—and without going private. in the fact that fundamental investment their businesses for the long term. And Why can’t they invest in their future and has been starved to meet quarterly tar- if they were to go private, they would make all the right business decisions— gets. And, in some cases, we have even invest more in the fi rm’s future. Now, it’s and then improve their communication succeeded in accelerating cost cuts by true that when we take companies pri- with investors? making investments in IT and changes in vate, we often take steps right away that the supply chain—and just by continu- reduce revenue and earnings. For exam- Jones: Cary, you describe Warburg as ously questioning the way we do business ple, we might persuade them to get rid growth investors. But I wonder how dif- on a daily basis. of ten percent of the least profi table rev- ferent that is from what other fi rms are

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If you think about the kinds of companies we buy—mostly divisions of public companies and mid-sized private fi rms—it’s clear that a major part of our value added is to provide a set of skills and experiences that they don’t already have. We are helping them to do something that they couldn’t or won’t do on their own. Sometimes it’s by changing the management team. But most of the time it’s by making the existing management team better.

Brian Hoesterey

Back to the Old Economy: investors are still very important to us. competition, we have continued to add The Case of AEA Today we probably have 60 individual former senior management to our inves- Jones: Thanks, Cary. Now let’s turn investors who are either former or current tor base and use them to help create value to Brian Hoesterey and AEA Investors. CEOs, or members of leading industrial through improvements to the operations Brian, AEA was really one of the pio- families throughout the world. And to of our portfolio companies. neers in taking advantage of experienced that group of investors we’ve also added a If you think about the kinds of com- operating partners who sat on your advi- select number of institutional investors. panies we buy—mostly divisions of sory board for a long time and who have In the current environment, there is public companies and mid-sized private been instrumental in a lot of the things more competition to recruit those former fi rms—it’s clear that a major part of our that you’ve done. As you think about CEOs. A lot of other private equity fi rms value added is to provide a set of skills the value added by improving opera- have decided that they like our model. and experiences that they don’t already tions—looking at operations differently And as a result, we’re now competing for have. We are helping them to do some- and changing the way the people run the top managerial talent with perhaps not thing that they couldn’t or won’t do on business—how important has the role of the full list of 2,700 fi rms that Alan men- their own. Sometimes it’s by changing the operating partner or partners been to tioned, but certainly a formidable group the management team. But most of the the success of the fi rm? of high-quality private equity fi rms. We time it’s by making the existing manage- all want the best people to help add value ment team better. Brian Hoesterey: AEA was started in to our companies. Attracting and moti- As Mike pointed out earlier, our col- the late ’60s, when our investors were vating these people has become even more lection of companies and their assets primarily wealthy industrial families diffi cult because today’s CEOs come out makes us look a lot like a conglomerate. from around the world and recently of the companies they’ve run with sig- But we’re able to get most of the ben- retired CEOs of Fortune 100 companies. nifi cant savings from their earnings as a efi ts of the conglomerate structure—the Although our investor base has changed CEO; they’re much better endowed than ability to leverage the fi rm’s general man- somewhat over the years, these kinds of in the past. But, even with the increased agement skills, network of relationships,

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and knowledge base across a variety of capital back after a certain period of time, successful businesses, who have moved businesses—without the loss of focus whether it’s two years or seven years. This around and seen a lot. And they serve as and accountability that seem to drag creates a sense of urgency and moderate day-to-day coaches for the CEO. They down most conglomerates. time pressure. Many family-owned or pri- can help guide the CEO by saying, “I’ve First of all, between our investors and vately held companies don’t feel any such seen this in six different situations. Maybe our offi ces, we have a global footprint. pressure at all. The attitude in such cases you should think about the following.” We can take a mid-sized U.S.-only busi- is, “We’ve owned this business for 50 Or maybe the CEO needs a little more ness and share that lens with them. We years, so we can think very long term.” confi dence to generate change quickly, can help them understand their need to Though long-term thinking is good, and he or she will have a thought-part- think about what’s going on in China, or you also need some short-term catalysts ner there to say, “It’s okay to take risks; about growth opportunities in Eastern and pressure. We will say to the manage- you can generate that change; you can Europe. It’s very diffi cult for the CEO of a ment team, “Okay, that’s great. But what move a little faster than historically the mid-sized U.S.-based or European-based are we going to do in the next year to organization is comfortable moving.” Or company to get that global perspective. get where we want to be in three to fi ve they might say to the CEO, “You need They’re very busy running the business. years?” And in this sense, there are some more talent here. Let’s face it; this team We can help them by drawing on our real benefi ts to a discipline that says, “In isn’t going to get it done. So why don’t own networks of professionals, inves- fi ve to seven years, we’re going to have a you put them on notice and ask for an tors, and outside resources. After all, we day of reckoning.” improvement plan? Or if we can’t come have a much larger base of investments So our approach, then, is to say to up with a plan for improvements, then to spread such costs over. They can take management, “Let’s think long-term by how about a succession plan?” a piece of that insight instead of having all means. Let’s not worry about the next I think it’s in these kinds of situations to build their own infrastructure. quarter or so. But at the same time, let’s that we can really add a lot of value. Being And, fi nally, as Cary was just saying, have well-defi ned goals over that time CEO of a company can be a pretty lonely we can provide them with the breathing period. As long as we’ve mapped out a position. There are very few places to turn room to invest for the long term. We take course of action that gets us to our goal, for someone who provides an objective the shackles off. We say, “Don’t worry just and as long as we’re meeting the mile- sounding board and whose interests are about the next quarter or the next year. If stones that we’ve jointly agreed to, we’re aligned with yours. And I think private you have investments that will have a big willing to forgo some of the earnings equity, done in the right way, can pro- payoff in three to fi ve years, go ahead and gains early on to invest in the future.” vide that sounding board and can make make them.” And that’s something that As already mentioned, a key element CEOs more effective than they would be I think private equity is able to do that in our success has been our ability to on their own. the public market investors either can’t recruit help from outside our fi rm when Of course, one of the advantages of or won’t do. we think it’s appropriate. We believe being the controlling investor is that, if In fact, as Cary was just suggesting, that our investor base is very good at the CEOs don’t get better, you can change I think private equity may provide the board-level governance and at helping us them. That’s a major benefi t of private optimal balance of some time pressure answer some very key questions in due equity over public ownership, where the with freedom from quarterly earnings diligence. But since many of these inves- change process takes much longer. And and a really short-term perspective. Most tors are not going to be there overseeing the CEOs who work for us understand of our investors are IRR driven, some the company day in and day out after this very well. That’s an important part more so than others. But, at the same the deal closes, we often supplement this of the deal. time, I think ours are actually less so than by bringing into AEA full-time profes- some of the traditional institutions. All of sional operating partners—people who, Jones: Nothing concentrates the mind our investors, however, expect to get their as I said earlier, have been CEOs of very like the prospect of a hanging.

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Part II: Lessons for Public Companies that there are two basic ways to get public Stewart also mentions a number of Jones: Now that we’ve heard from companies to maximize value. They can ways to restructure public companies to everyone, let’s turn to our second major either go private, or they can take a num- make them operate more like the pri- question: What can public companies ber of steps that make them look and act vate equity model. For example, through learn from the successes of private equity? more like companies under the private transactions such as spin-offs and partial And since that’s kind of a large question equity model. IPOs, diversifi ed companies can create a to get our arms around, let’s start with Some public companies have gone network of businesses, each with its own a more manageable version of that ques- private, but many of them tend to come stock price and capital structure, under a tion: In view of the gains to management back to public ownership in one form or single corporate umbrella—an approach teams as well as investors from going another. And other public companies— that was pioneered with considerable suc- private, what’s keeping more public com- and I think it’s an increasing fraction cess by a company called Thermo Electron panies from doing it? of the total, though Steve may contra- in the ’90s. And public companies with a It’s clear that the role of private equity dict me on this—have gone private and big free cash fl ow problem should consider has exploded in the fi nancial marketplace. stayed private over time. But what sur- a major leveraged recapitalization, or what Everyone seems to know about it. Three prises me is that so few public companies is sometimes called a “public LBO.” weeks ago, the term “EBITDA” was not are actually taking advantage of the new As one example of a public LBO, in only mentioned, but actually defi ned by a management model that’s embedded the late ’80s a packaging company called character on “The Sopranos”—an event or implicit in the private equity move- Sealed Air, whose CEO Dermot Dunphy that may turn out to be the high water ment. As we heard from people around had considerable experience as an outside mark of the private equity movement. An the table, that model has a number of board member of LBO fi rms, paid out appreciation of cash fl ow has found its different aspects and features. But I roughly 90% of the company’s pre-trans- way into the popular culture. think it’s possible for public compa- action market value as a special dividend. We all seem to agree that private nies to take almost all of the major Since the market value dropped by only a equity provides a potentially valuable competitive advantages of the private small amount after the payout, it was clear discipline on corporate management. equity sector and implement them in that the company had created enormous And on top of the benefi ts of its manage- one way or another without actually value virtually overnight. And several years ment and governance model, there are going private. later, as if to see whether the market got other reasons why companies shouldn’t For example, in a wonderful Harvard this one right, my former colleague Karen be public. One is the costs of comply- Business Review article called “Reforming Wruck produced a case study showing how ing with Sarbanes-Oxley. Another is the the Corporation From Within,” Bennett this huge payout and change in capital shift in the Wall Street research paradigm Stewart shows that, through the use of structure led to dramatic improvements in such that many small and medium-size what he calls “leveraged equity purchase operating and investment policies, which companies are no longer being covered as plans,” or LEPPs, public companies can in turn resulted in large increases in value public companies and therefore, I would simulate the benefi ts of both leverage over the next few years. argue, don’t really have access to the pub- and equity ownership without imposing But, again, the key is that you have to lic equity market. fi nancial risk on the corporation itself. get top management and operating heads Mike, let’s start with you again. Why Using these LEPPs, which are basically thinking of themselves not as running haven’t we seen more public companies stock options with exercise prices that go businesses, but as running governance go private? up each year at the cost of capital, com- systems that run businesses. To the extent panies can get virtually all of the incentive you succeed, that would be a huge change. Jensen: I can’t answer that question, or benefi ts for individual managers or groups But very few companies have followed the at least not in a way that will satisfy any of managers that you get by levering the course of Sealed Air or Thermo Electron. of us. We talked earlier about the fact company and taking it private. So, where I’m often left in trying to answer

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The enormous growth in private equity raises questions that the managements and boards of public companies may soon fi nd themselves addressing if they have not already: Is our com- pany leaving value “on the table” in the form of excess cash and unused debt capacity? Is it possible that we would operate more effi ciently, and be more valuable, in the hands of a private equity fi rm? And if we decide that we’re more valuable as a public company, should we consid- er taking a page out of the private equity play- book and invite some of our largest investors onto our board?

Alan Jones your question is this: Over and over again failed to adopt more aspects of the private refl ects to some extent the companies’ use I seem to underestimate the time it takes equity model is inertia, the resistance of of some of the elements of private equity. for customs and practices—and perhaps large organizations to change. Management’s equity ownership, for even values or value systems—to change example, is much higher today than it was in ways that would take advantage of what What’s Gone Right with U.S. in, say, 1980. And that means that public are clearly superior techniques. That kind Corporate Governance company CEOs are much more sensitive of change isn’t happening in the head Steve Kaplan: I have a somewhat more to shareholder value than they used to be. offi ces and boardrooms of most major positive view of changes in the U.S. cor- As Brian just told us, the CEOs of today’s companies. The companies have done porate governance system over the past public companies make a lot more money some of it. Many companies have tried the few decades. Mike and I are in basic now than they did 25 years ago—and most heavy use of options and equities to moti- agreement about most aspects of corpo- of the difference has come from increases vate managers—although in many cases, rate fi nance and governance, especially in the use company stock or options rather they’ve misused these instruments. (And, about the value of the market for corpo- than in salary increases. Whereas a typi- just for the record, I have never been a rate control in disciplining management. cal public company CEO in 1980 might big fan of conventional stock options; But where Mike tends to see the glass as have seen his wealth increase by just $1 for my preference has long been for Stewart’s half-empty, I see it as half-full. every $1,000 increase in company value, a LEPPs with their rising exercise prices.) By most measures of governance and typical CEO today would see an increase But the only explanation I can come up performance, U.S. public companies have of $10—a ten-fold increase in sensitivity. with for why more public companies have improved over the last 25 years—and this The emergence of hedge funds and other

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active investors has further added to that boards meet regularly in executive ses- the degree of independence that is pos- sensitivity. CEOs care a whole lot more sion without top management. This sible. Five, six, or seven years ago boards about their stock prices than they did 25 increases board independence and argu- rarely met without their CEOs and other years ago. ably encourages public company boards insiders. But I think that directors fi nd Now, this is not to deny that there have to behave a little more like the principals that when they’re suddenly put into the been abuses of options—particularly in of private equity fi rms. executive session, good things can hap- the late ’90s, when we had the huge stock There have also been some benefi cial pen that weren’t possible before. That’s price run-ups. But it’s important to rec- changes outside the fi rm in the market for the conclusion that Warren Buffett came ognize that the main, or fi rst-order, effect corporate control. Hedge funds today are to in his 2004 Annual Report. of the large option grants since 1980 has targeting public companies and trying to been to align management’s incentives implement some of the same things that CEO Pay and Incentives with their shareholders’. And companies private equity investors would do. Now, John Moon: There are limits, though, to have attempted to limit those abuses by I don’t think that pressure from hedge what these boards can accomplish, even making options less liquid or shifting to funds is as constructive and effi cient as with executive sessions. And, Mike, let restricted stock. For example, many com- giving complete ownership and control me offer up a hypothesis as to why pub- panies today have ownership requirements to private equity investors. But it pushes lic companies are so slow to change. The that require their top executives to hold a in the same direction. way I see it is that private equity provides certain amount of stock or options. Could The bottom line is that the forces that both powerful management incentives public companies do better on this score? operate in private equity are also operat- and effective board oversight. Public The answer is clearly yes. While executive ing to some extent in public companies. companies have come a long way in get- stock options and restricted stock are less They haven’t gotten all the way there, ting the incentives right, but there’s a lot liquid than they used to be, many compa- but things are much better than they more to be done in terms of governance nies would be better off requiring them to were 25 years ago. It’s worth adding that and oversight. be even less liquid. these improvements in governance have A public company CEO who is Another indicator of the effectiveness coincided with a resurgence in the pro- motivated entirely by equity incentives of a corporate governance system is the ductivity growth of the U.S. economy. without much board oversight is a dan- extent of CEO turnover. I just fi nished a While it’s impossible to say how much gerous CEO. It doesn’t take much time paper with Bernadette Minton that shows of an impact these improvements have for anybody who’s worked with a public that, in the past ten years, both CEO had on productivity, it puzzles me that company to realize that there is often turnover and its sensitivity to stock prices so many people can be so critical of U.S. a large information gap between what have increased sharply. The typical For- corporate governance when our produc- the CEO knows and what the public tune 500 CEO now can expect to keep tivity has been so high. knows. And if a public company CEO his or her job for six years rather than the has strong incentives but not much ten years that would have been expected Jones: Steve, do you think we need sepa- oversight, you can never quite get those in 1980. The message here is that the ration of the CEO and the chairman? incentives quite right—in the sense that CEO job is a lot riskier than it used to be, there will always still be some time hori- suggesting that boards are doing a better Kaplan: My sense is that by appoint- zon and governance issues that need to job of monitoring and, when necessary, ing a lead director who presides over be addressed. changing top management. an executive session, you almost get the How do you make sure the incen- While some of the recent governance equivalent of a chairman, whether you tives are working the right way? You reforms are problematic—in particular, call him or her by that name or not. It’s need somebody who’s also motivated to Section 404 of SOX—one reform has the requirement for the executive session maximize value to work with the CEO been benefi cial: the requirement that that really makes a dramatic difference in to ensure that he or she does the right

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things for the long term. One of the Kaplan: While I agree that restricted negative publicity—and rightly so. But strengths of private equity is its empha- stock will make sense for certain situa- CEOs who perform extremely well, and sis on long-term decision-making, and tions, options also will continue to make are paid accordingly, are almost equally it is the much smaller information gap sense for many public companies. As a likely to come under fi erce attack; they in private equity-backed companies that result, I don’t think the fundamental become the bad guys. helps make this emphasis possible. The problem is the design of the options or There’s a huge amount of confusion boards of private equity-backed com- restricted stock. The greater problem in the media about money and compen- panies, as the economically motivated comes from their liquidity. You can sation, and little ability to distinguish representatives of the investor base, give management lots of options and concerns about the relationship of pay to make it their business to know as much restricted stock, but you’ve got to make performance from the general unrest over about the prospects and opportunities of sure they can’t sell much. levels of pay. Take the case of Jim Kilts the business as the management teams at Gillette. Kilts was a hero to Gillette’s that run them. And I just can’t imagine Moon: Options can also create a swing- shareholders for improving the company, that ever being as true of a public com- for-the-fence mentality. With restricted selling it to P&G, and markedly increas- pany board. stock you create a sense of downside. ing the stock price both in absolute terms and relative to his industry. But he took Davis: I agree with your point that a CEO Feldberg: One of the problems with a beating in the press for the amount of with powerful incentives and no oversight executive compensation programs is that money he walked away with. can be dangerous. But I think a big part of when they are designed and put in place, the danger comes from the design of the they are based upon prevailing market Davis: The media always get that wrong. equity instrument—that is, conventional conditions, including competition and And they treat annual option exercise stock options. Many CEOs have gotten the macro environment. Three or four as if it were all part of the current year’s rich not necessarily because their compa- years later, the environment changes and compensation. nies have done so well, but because the there are unintended consequences from incentive package that was put in front of the plan that was designed four years ear- Kaplan: That’s right. This demonization them was not aligned with the values and lier. This does not necessarily mean that of pay is one big reason why so many interests of their shareholders. Building on the plan was poorly designed or that bad U.S. CEOs are going to work in private Mike’s suggestion earlier, I think we could judgment was applied; it’s just that the equity, where their pay packages tend to correct this problem just by changing the plan takes on a life of its own and can be be both signifi cantly higher and out of way CEOs are motivated—that is, with extremely diffi cult to adjust for changes the public eye. payoffs that are tied to the stock price over in circumstances. And if you think there is confusion a fi ve-to-seven year horizon as opposed to about pay in this country, the problem the current stock price. Kaplan: For all my optimism about the is much worse in continental Europe. Now, I don’t know exactly how to progress that public companies have made Take the case of Sweden, for example, translate that into an incentive plan for in recent years, there is one problem that which has a growing market for pri- public companies. But I would guess that I am concerned about—and it’s another vate equity. My understanding is that it looks a lot like restricted stock that reason for companies to go or stay pri- the social stigma that attaches to large must be held for a long period of time. vate. It’s what I call the “demonization” payoffs for success has driven a number I think the widespread substitution of of CEOs and CEO pay. The unfortunate of talented Swedish executives to avoid restricted stock for stock options—which fact is that public company CEOs can listed fi rms and work for private equity- I understand is the current trend—will be pilloried for doing too well. If CEOs funded companies. And this is going on lead to a major change in behavior inside whose companies perform poorly get to some extent in the U.K. and, indeed, large corporations. paid a lot, there’s bound to be a lot of all over Europe.

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Why Public Companies Don’t has clearly underperformed and then with ourselves, we would recognize that Go Private failed to reform in some way, it can be these systems effectively pay people to lie Ferenbach: I want to come back to extremely diffi cult to say, “You know about what they think they can do. this question of why we don’t see more what? I think we should go private so Private equity cuts out this mess just by companies going private. There are two that we’re off the board and this company separating the budget completely from the practical reasons. The fi rst has to do with can have a governance structure that will performance evaluation process. In place the price and the process. And by that I make it a better company.” Can you of the budget negotiation process in public mean the price and process from the per- imagine a group of human beings sitting companies, private equity makes one non- spective of someone who wants to buy a around a table having that conversation? negotiable demand—generate enough listed company, and from the perspective Not likely. cash to make your payments of interest of a seller that has to engage in a process and principal. And, as Carl explained of selling it to all potential comers. As a Jensen: But why not, Carl? Why can’t to us, it is the board’s job to see that the would-be buyer, you’re entering into a they see the benefi t of changing the gov- proper milestones are set up and met. If all process where the one thing you know ernance structure? this gets done, the big payoff comes in the on day one is that you are going to spend form of the value of the equity at the end a seven-fi gure number just to have the Ferenbach: People who serve on public of the fi ve- or seven-year cycle. ability to tell somebody what you think boards tend to be successful people, but But Carl’s right. From the viewpoint the company is worth. And if the seller they also tend to know very little about of the average public company board disagrees, then somebody else has to pay private equity and how it works. And pri- member, going to private equity is like a higher price—end of story. Well, unless vate equity people generally don’t sit on inventing a whole new system. What I’m you think you have a very high prob- public company boards. My point is that saying is that people in private equity ability of getting the deal, that’s just too a public company director is not likely to know how to create structures that could expensive a proposition for most of us to say, “I’ve got a friend who’s an investor in do wonders for many of those compa- engage in. So, from the buyer’s perspec- AEA.” It just doesn’t work that way. nies, both in the short run and over the tive, taking public companies private is long run. But the people responsible for not very attractive. Jensen: Well, I’m surprised it doesn’t running or overseeing those companies As for the directors of the public com- happen more often, given the potential refuse to see it. pany, their fi rst reaction to an offer from gains from making these changes. To go So, there’s this huge prize out there— a private equity fi rm is generally going to back to what Steve said earlier, I agree the potential gains in effi ciency and value be, “Our stock price should be higher.” that we have made some progress. But to from better internal control systems. And They’re typically not eager to hear from me the glass is not half full; I don’t think what I think Steve and I disagree about is private equity people who think the com- it’s even ten percent full. And what frus- perhaps two things: the size of the poten- pany’s already fully valued. Now, in some trates me is seeing what I believe are these tial gains and how quickly they could be cases, an offer of a 5% premium over enormous gains that are possible. realized by changing corporate owner- market may be enough to entice them to Take the budgeting systems that are ship and control systems. do a deal, but in most cases it won’t. And used inside many companies not only for to the extent buyers and sellers are likely planning purposes, but—in far too many Jones: I think we need some kind of out- to have different views about the intrinsic cases—as the basis for performance eval- side catalyst to make this happen. One value of the fi rm, it may be hard to even uation and bonus awards. We all know possibility is activist shareholders. Hedge think about doing a deal. that these systems are incredibly fl awed, funds may be playing this role today, The second reason many companies that they encourage people to “sandbag,” and we’re also seeing the reemergence of don’t go private is behavioral. If you are to understate the true profi t potential of corporate activists like Carl Icahn and on the board of a public company that their operation. And if we were honest Nelson Pelz.

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Ferenbach: There’s another catalyst critical part of the governance system that Boone Pickens and Carl Icahn and Sir at work here in the form of good old- has enabled the company to perform. James Goldsmith who were vilifi ed by fashioned competition. There are a lot the press and public opinion—and, of of private equity-owned companies that Hoesterey: I think this catalyst issue is course, by the Business Roundtable. And have gone public. And when they go very important because when we look at there was much the same reaction to the public, they typically don’t turn around public companies, we too are aware of the leveraged buyouts of the 1980s. But now and say, “The old public company gover- pitfalls that Carl mentioned—which is that the resistance to both hostile take- nance system was really better, so I think why we tend not to focus much attention overs and LBOs has largely disappeared, I’m going to forget everything we’ve on such companies. The cost of trying to management buyouts of divisions of pub- learned from being a private company.” get something done is too high, and the lic companies have become a widespread They generally continue to operate with certainty is too low. And on top of this practice—and even LBOs of entire pub- somewhat higher leverage ratios, and deterrent, public companies have this lic companies, though not very common, higher than average concentrations of very diffi cult agency problem with the are socially acceptable. ownership, than their public competi- CEOs and their ability to control or just But the critical step is getting the tors. And I think the overall performance ignore their boards. Most CEOs are not CEOs to understand that this can help of these “round-trip” public companies is eager to give up the freedom they have as their companies. Of course, not all CEOs also pretty good relative to their competi- the top executive of a public company. will be invited to be part of these man- tors’—although this is an area where we So, although there may well be sig- agement transitions, but those who are probably need more studies. nifi cant benefi ts for public company will share in the gains. And if the past is But this raises another interesting shareholders in allowing private equity any guide to the future, the vast major- question, one that comes within the pur- investors to exercise some control over ity of these new companies will end up view of regulators and even legislators. As management—to force people to think adding value. The companies will grow a private equity owner, when one of your about things differently—most CEOs and become more successful and infl u- companies goes public, regulations and are unlikely to see it that way. I think ential. And that’s why I object to Steve’s listing requirements force you to drop off the very best ones do; they are able to statement that the glass is half full. Yes, all of the key board committees once your visualize the benefi ts and would welcome there have been improvements. But my fi rm falls below the 50% ownership level. the oversight and strategic advice coming point is that these improvements come And when that happens, you tend to from knowledgeable investors. But most nowhere near what is possible. have one focus, and that’s unloading the CEOs are going to be reluctant to have And, by the way, I’ve been a big fan rest of your stock as quickly as possible. a boss with real power and control. And for years of splitting the jobs of the CEO Such regulations, by effectively forcing until there’s a major change in the gover- and the chairman. And that is now begin- large investors off of boards, lead to an nance structure of public companies, or ning to happen. But that’s nowhere near ineffi cient form of governance. They are the threat of some outside force material- enough. Having an outsider or an aca- driving private equity capital out of pub- izes, I don’t think that most CEOs will demic like me as the chairman isn’t the lic companies instead of encouraging it to volunteer to make that trade. same thing as having Brian or Carl be the stay. And so I think we need to fi nd a way chairman. That’s a totally different world, to make legal and regulatory changes, as How Big Will the Deals Get? and we have a long way to go to get there. well as changes in listing requirements, Jensen: I remember when it was con- And I think we will. I feel a little out of that would encourage large investors to sidered inappropriate and ill-bred for the character in saying this, but if you look at continue to serve on boards of public CEO of a Fortune 500 company to launch history, I believe there is some hope. companies. The current rules discourage a hostile takeover. So the hostile takeover the continued investment and partici- movement was started by a handful of Kaplan: Mike, did I really hear you say pation of the investors who have been a unaffi liated corporate raiders, people like that?

Journal of Applied Corporate Finance • Volume 18 Number 3 A Morgan Stanley Publication • Summer 2006 33 ROUNDTABLE

Jones: Maybe we should issue a com- Jones: But that’s exactly why I raise or $500 million of stock. And that is memorative coin! the issue of size, Mike. You are asking new and different. Also important is the But, Mike, let me ask another provoc- why public companies can’t make these 1992 change in SEC rules that permits ative question: Does size matter? In other changes themselves. They have seen the different shareholders to coordinate their words, have we reached the point where playbook from the private equity fi rms. efforts to approach management and put we can think about doing an LBO of a My point, though, is a little different— pressure on companies. This rule change Fortune 200 company? The high water namely, that many public companies, has clearly had a positive effect, allowing mark in this business was reached in 1989 having reached a certain size, appear to hedge funds to work with other funds with the purchase of RJR Nabisco by feel immune from both private equity and shareholders. And I think it will KKR for $25 billion. And we’ve recently and activist shareholders. continue to encourage more activism of begun to see deals approaching that size this kind. again, such as Tele-Denmark at $15 bil- Ferenbach: I think that’s true. And I So, these two developments alone— lion and SunGard at $11 billion. These also think it’s not just inertia. There’s an the productivity of the U.S. economy were both “club deals” made possible by old saying that people are the victims of and the new forms of shareholder activ- bigger funds and greater access to the their backgrounds, and I think that is the ism—suggest to me that important leverage lending market. And my own case with many corporate board mem- changes have been happening. view is that we will see the RJR record bers. You become increasingly insular if And, Mike, I certainly don’t disagree eclipsed within the next 12 months. you keep adding people with the same with your argument that there are still But, at what point do companies sort of experience. The people who could major gains to be made. But I strongly become so big that their boards feel com- make the change are actually happy with disagree with your statement that your pletely insulated from the pressure for the status quo. thinking has not had an impact on the value maximization that either private behavior of corporate America. A lot equity or hedge funds bring to bear? Kaplan: Well, before we go much farther of the benefi cial changes in the past 25 down this track, I want to emphasize years have come from some of the prin- Jensen: Well, size does matter; it is still a what has gone right in recent years. First, ciples and practices you’ve espoused over deterrent to a takeover, certainly a takeover as I mentioned earlier, is the productiv- the years. And undervaluing the changes that requires signifi cant leverage. But it’s ity of U.S. companies. Over the last we have accomplished has the effect of only a deterrent to somebody on the out- ten years, the productivity of the U.S. reinforcing what I see as the excessive side taking a company private. My point economy in relation to that of other and unwarranted criticism of the U.S. is that there are huge gains from leaving developed countries has been nothing corporate governance system that has these companies public, and then turning short of spectacular. So the economy come with the recent corporate scandals. upside down the way managements and clearly hasn’t performed badly. And My point is that, when you take the long their boards think about the governance while governance may not be the most view, events like Enron and WorldCom structure and the management system. important cause of such productivity, we are aberrations. And stressing the gap The model for doing that is the way Berk- clearly have not had a governance melt- between what we’ve done and what is shire Partners, AEA, Clayton & Dubilier, down. possible causes people to overlook our or KKR runs their shop. And then we can The second important point is the accomplishments. fi gure out how to implement the impor- rising pressure on corporate manage- My main answer to critics of U.S. tant features of this model in Fortune ments today—and it’s being brought to corporate governance is that we have 200 companies around the world. I don’t bear on companies of all sizes. I recently come a long way over the last 25 years. believe, conceptually, that it’s all that dif- heard someone say that 25% of Fortune But, as you say, Mike, we still have a long fi cult, even with the behavioral problems 500 companies now have a large hedge way to go. Carl mentioned. fund investor, as defi ned by a 5% stake

34 Journal of Applied Corporate Finance • Volume 18 Number 3 A Morgan Stanley Publication • Summer 2006 ROUNDTABLE

Hedge Funds, Private Equity, and how does all this now play out? shareholders and themselves. But activ- the “Convergence” of Financial The other interesting debate today is ist shareholders can be very public about Institutions whether or not big companies really under- what they want. And nobody misses Jones: Speaking of accomplishments, stand the lessons of private equity. And, Carl Icahn’s point. some people have suggested that the pri- if they get it, to what extent will they act vate equity movement has succeeded in on it? I feel pretty strongly that we fi nally Jones: That’s right. Even though he picking most of the low-hanging fruit. have a catalyst in the form of activists like owned only about 3% of Time Warner, Conglomerates have harvested divisions hedge funds and old-fashioned corporate he commanded an extraordinary amount that don’t fi t their strategies and, Mike’s raiders. But are large public companies of attention. He didn’t get everything he comments notwithstanding, we’ve seen a now willing to do what was unimaginable wanted, but he forced a change. One rea- good number of public-to-private transac- just four or fi ve years ago? Are we on an son I’m so focused on the catalyst issue is tions. So, on the basis of just this evidence, arc that is going to continue for some that we’ve witnessed the ability of rela- I would argue that U.S. corporations have time? Or is there something that’s likely tively small shareholders to shake things in some measure responded to the private to change or redirect this? up. And, as Steve noted earlier, the ability equity model of management and corpo- since 1992 for shareholders to coordinate rate governance, restructuring themselves Ferenbach: One of the impediments their activism has made a difference. without going private. to change in the U.S. that we neglected But my question is this: Can we now to mention earlier is the great diffi culty, Ferenbach: Well, think about Black- expect these events to be played out in under U.S. law, for a director of a U.S. stone taking a 3.3% position in Europe and Asia? The U.S. private equity company to feel comfortable having a Deutsche Telekom. Though they don’t fi rms clearly think so, since they started conversation with a major shareholder. have anything like a controlling posi- moving their people to Europe in 1997. We’ve seen a number of our portfolio tion, they clearly think they’re going to And they’re moving people to Asia now. companies go public and then have large have a meaningful impact on that orga- What can we expect to happen in Europe investors buy 10-15% ownership stakes nization. and Asia, and does this movement of and become very involved shareholders. people signify that the low-hanging They’re not private equity shareholders, Kaplan: I think this brings us back to fruit’s been picked in the U.S.? but they’re smart and they’re vocal, and Alan’s earlier question about the limits to the management knows they’re there. the size of private equity deals. My feel- Feldberg: I do think that the U.S. has And they have a view, particularly on ing is that we are not going to see deals done an excellent job in cost cutting and compensation and the use of capital. much bigger than $25 billion. None of in driving up productivity levels. The big So that kind of dialogue is going on the buyout fi rms have enough money to issue facing many industries now is how between management and the inves- commit much more than a billion dollars to drive top-line growth. The Europe- tors in some public companies. The to a single investment. If you put four ans are also having a diffi cult time with board only hears about that dialogue or fi ve fi rms together in a club deal, you top-line growth, but they still have cost- from management. So it’s a highly fi l- might be able to get an equity base of fi ve cutting opportunities and productivity tered conversation. Socially, we’ve had or six billion dollars. And leveraging that gains ahead of them. the view that we don’t want to under- up four or fi ve times gives you a purchase mine the CEO—particularly if the price of $20 to $25 billion. Jones: I agree, but it will be interesting CEO is also the chairperson—by allow- But, again, in the case of very large to see how much of this can be achieved. ing sidebar conversations to take place. companies, what we are seeing is hedge The kinds of restructuring that we now People on the board are worried about funds—or in the case of Deutsche routinely do in the U.S. are harder to inadvertently communicating inside Telekom, private equity fi rms like Black- imagine in France, for example. But information and thereby tainting the stone—taking signifi cant minority

Journal of Applied Corporate Finance • Volume 18 Number 3 A Morgan Stanley Publication • Summer 2006 35 ROUNDTABLE

positions. They are doing what Icahn are asking themselves the same question we have the patience and the staying tried to do at Time Warner. He went from the other direction. They’re say- power to run this business as an owner there and said, “There’s a problem we ing, “We look at broad industry groups, for the next three-to-fi ve years?” And need to fi x.” And if other investors agree, and we have tremendous talent that we that’s where I think most hedge funds they will support him. If they don’t agree, bring in to do research. Maybe we can will come up short. they won’t—which seems to have been fi nd another use for it.” And though the the case at Time Warner. model of many hedge funds is to make a Jensen: That’s right. If hedge funds really lot of relatively short-term trades, there want to get into private equity, they have Jones: Some hedge funds are either are many other hedge funds that are ask- to learn how to run governance systems considering, or already making, private ing their investors to lock up for two or that run businesses. They would then equity-like investments. Do the hedge three years so that they can make lon- stand a chance of being able to compete funds have what it takes to compete in ger-term bets on corporate performance. in this business. But that’s a huge learning private equity, or do the private equity And then they go out and make large, curve to work down, and I would be very fi rms have a competitive edge in terms fairly long-term bets on individual com- surprised if that could be made to happen of human capital and reputation that panies. Today many of those hedge funds within a decade—if it ever happens. It’s should keep the hedge funds from mak- are asking themselves, “Well, if we can too big of a cultural gap. It reminds me ing major inroads? reach that level of understanding of indi- of Salomon Brothers’ attempt to break vidual companies, why can’t we take that into the LBO business with their buyout Ferenbach: That’s a very good ques- into the buyout market?” of Revco in the late ’80s. That deal— tion—one that we talk about a lot Now, all this begs the question, “Well, which is the subject of another case study internally and with some of our inves- if they came, would they succeed?” And by Karen Wruck—was an unmitigated tors—and I don’t have a defi nitive the answer… disaster. It was a disaster from the begin- answer. Some of our private equity ning; and to compound the problem, the brethren have gone the other way and Jensen: The answer is no. people who put the deal together had no diversifi ed into the hedge fund business. idea that ongoing oversight and corpo- I just mentioned Blackstone’s investment Ferenbach: Well, yes and no. There rate governance were going to be required in Deutsche Telekom, which is similar are circumstances in private equity—we after the deal closed. They were basically to a hedge fund investment. Another would describe them as being “around traders who saw what they thought was example is Bain Capital, which manages the edges”—where the hedge funds’ skills an undervalued asset. And they and their a very successful hedge fund. And we’ve would serve them well. What hedge funds creditors were taken to the cleaners. asked ourselves on more than one occa- are good at is exploiting ineffi ciencies. sion whether we should be running some So, to the extent that you can identify an Kaplan: I agree with Mike completely on kind of special situations vehicle. Each ineffi ciency in the private market—and this one. It’s true that the hedge funds year we go through a winnowing process they are there to be found—hedge funds are now hiring some of the younger peo- that begins with, say, 1,000 transaction can be counted on to fi nd and profi t ple who have spent three to six years in opportunities and we end up doing an from them. The big problem, however, is private equity. So they are getting some average of about four deals. If you have that hedge funds generally require liquid- of the intellectual capital. On the other spent a lot of time and money on, say, ity, and the private equity market is, of hand, it’s instructive to think about what 100 of those 1,000 possible deals, you course, illiquid. That’s one of its defi ning happened toward the end of the ’90s, end up with a lot of unused intellectual characteristics, and I think it could be a when there was an attempt at conver- capital. And our thought is that perhaps major barrier to entry. The hedge funds gence between venture capital and private we should put that to work. that are really intent on getting into pri- equity. During this period, some private The people who run hedge funds vate equity have to ask themselves: “Do equity fi rms moved downstream into

36 Journal of Applied Corporate Finance • Volume 18 Number 3 A Morgan Stanley Publication • Summer 2006 ROUNDTABLE

venture capital-like technology invest- play a more meaningful role in the gov- global in scope. And the winners, of ments. By and large, those investments ernance of public companies. course, will be those institutions that can didn’t work. Enough money was lost that Another recent development worth attract and retain the best people. most limited partners today don’t want noting is something I would call the There will also be a lot of differentia- to hear about private equity going down- “institutionalization” of the most suc- tion, specialization in terms of industry, stream or VCs going upstream. cessful buyout fi rms and hedge funds. As country focus, those sorts of things. But they have expanded their fund sizes and I think we’re already well on our way to Jensen: And private equity is a lot closer the scale of their operations, they have that. The private equity industry is still a to classic venture capital than it is to been forced to develop management very young industry. I started in the busi- hedge-fund investing. What is the prob- skills. And in the process, they have been ness a bit over 25 years ago, and I’ve seen ability that the University of Chicago developing an ownership class and men- most of these fi rms change dramatically could be made to look like the Harvard tality. The partners of the private equity just in that period. I think we should Business School or vice versa? The cul- fi rms participate in increases both in the expect to see a lot more change. tures are both so strong that it would value of their portfolio companies and in require many generations for that kind the value of the private equity fi rm itself. Kaplan: My prediction is that, 25 years of change. I don’t see it happening. And as the fi rms expand and acquire from now, there will still be hedge funds, franchise value over and above the value and there will still be private equity funds Kaplan: Neither do I. The two types of of their individual investments, the part- and classic venture capital funds. Venture investing require very different skills and ners will show greater interest in how the funds are very different from the others, have very different liquidity characteris- fi rm itself is managed. At some point, and I don’t ever expect them to converge tics. The only way to make them work some of these fi rms will even think about with the others. And I also think that pri- together is to keep them separate—that going public—but if and when they do vate equity and hedge funds will remain is, create separate organizations with sep- this, their organizational design skills will different businesses. They may be under arate compensation systems but under really be tested. the same umbrella, but, as I said earlier, the same corporate umbrella. Carlyle and I also think that we will see some you will have different kinds of people Oak Hill, among others, have done this. convergence of the skills exhibited by with different compensation and owner- fi nancial institutions of all kinds. The ship structures doing the investing. And, Ferenbach: One of the biggest impedi- fi nancial institutions we grew up with in addition to some of the factors I’ve ments to the convergence of hedge funds in the 20th century that still remain— already mentioned, I feel pretty confi dent and private equity is the difference I mainly a few big commercial banks—will in predicting the continued existence of mentioned earlier in the regulatory bur- gradually become history. At the same such specialized fi rms for one reason: dens imposed on U.S. publicly listed time, the much more free-form fi nancial Smaller, specialized fi rms attract very companies. In the private markets, we institutions that have already come to smart and talented people—and they have accounting rules to comply with, dominate certain markets—including, will continue to do so. but we don’t have any of the New York for example, some of the most success- Stock Exchange, NASDAQ, or SEC reg- ful private equity and hedge funds—may Jones: I’m sure you’re right about that. ulations with respect to governance, nor well end up becoming much larger and Well, this is a good place to end. I think do we have the Sarbanes-Oxley require- more diversifi ed fi nancial institutions in this has been a terrifi c exchange, and I’ll ments for internal controls. As I said their own right. And among today’s larg- end where I started by thanking everyone earlier, these regulations present a big est institutions, some investment banks for coming and participating. As I said at problem for us when we take a company are increasingly taking on the traits of the outset, I have learned from a number public; and if we could fi nd a way to hedge funds. Hedge funds and private of you over the years. And I’ve learned a loosen them, private equity fi rms could equity fi rms will also be increasingly lot from all of you today. Thank you.

Journal of Applied Corporate Finance • Volume 18 Number 3 A Morgan Stanley Publication • Summer 2006 37 ADVISORY BOARD EDITORIAL

Yakov Amihud Donald Lessard Editor-in-Chief New York University Massachusetts Institute of Donald H. Chew, Jr. Technology Mary Barth Associate Editor Stanford University David Modest Jason Draho Azimuth Trust Company George Benston Design and Production Emory University Stewart Myers Mary McBride Massachusetts Institute of Michael Bradley Technology Duke University G. William Schwert Richard Brealey University of Rochester London Business School Alan Shapiro Journal of Applied Corporate Finance (ISSN 1078-1196 [print], ISSN Journal of Applied Corporate Finance is available online through Synergy, Michael Brennan University of Southern California 1745-6622 [online]) is published quarterly, on behalf of Morgan Stanley by Blackwell’s online journal service, which allows you to: University of California, Blackwell Publishing, with offi ces at 350 Main Street, Malden, MA 02148, • Browse tables of contents and abstracts from over 290 professional, USA, and PO Box 1354, 9600 Garsington Road, Oxford OX4 2XG, UK. Call science, social science, and medical journals Los Angeles Clifford Smith, Jr. US: (800) 835-6770, UK: +44 1865 778315; fax US: (781) 388-8232, UK: • Create your own Personal Homepage from which you can access your University of Rochester +44 1865 471775. personal subscriptions, set up e-mail table of contents alerts, and run Christopher Culp saved searches University of Chicago Charles Smithson Information for Subscribers For new orders, renewals, sample copy re- • Perform detailed searches across our database of titles and save the Rutter Associates quests, claims, changes of address, and all other subscription correspon- search criteria for future use dence, please contact the Customer Service Department at your nearest • Link to and from bibliographic databases such as ISI. Howard Davies Blackwell offi ce (see above) or e-mail [email protected]. Sign up for free today at http://www.blackwell-synergy.com. London School of Economics and Joel M. Stern Political Science Stern Stewart & Co. Subscription Rates for Volume 18 (four issues) Institutional Premium Disclaimer The Publisher, Morgan Stanley, its affi liates, and the Editor can- Rate* The Americas† $356, Rest of World £218; Commercial Company Pre- not be held responsible for errors or any consequences arising from the use Stuart L. Gillan G. Bennett Stewart mium Rate, The Americas $475, Rest of World £289; Individual Rate, The of information contained in this journal. The views and opinions expressed in Americas $95, Rest of World £53, 80‡; Students** The Americas $50, Rest this journal do not necessarily represent those of the Publisher, Morgan Stan- Texas Tech University EVA Dimensions € of World £28, €42. ley, its affi liates, and Editor, neither does the publication of advertisements constitute any endorsement by the Publisher, Morgan Stanley, its affi liates, Trevor Harris René Stulz *Includes print plus premium online access to the current and all available and Editor of the products advertised. No person should purchase or sell any Morgan Stanley Ohio State University backfi les. Print and online-only rates are also available (see below). security or asset in reliance on any information in this journal.

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