LBOs are best known as financial plays. As practiced by Clayton, Dubilier e? Rice, they can also promote corporate renewal. Rehabilitating the Leveraged

by W. Carl Kester and Timothy A. Luehrman

Once the rage of Western capitalism,..leveraged critics complained about "paper entrepreneurs." have lost their glamour and much oFtheir And when the boom faded, a wave of respectability. Suggest an LBOtoday as a healthy ensued. Since 1987, scores of companies that had way to create value, and polite company outside of been acquired in highly leveraged transactions and Wall Street will assume you are just trying to stim- that managed more than $65 billion in assets have ulate lively conversation. Propose it as a means filed for . The spectacular fall of Drexel of improving operating performance by restoring strong, constructive relationships among owners, W. Car] Kester is the M.B.A. Class of 1958 Professor of managers, and other corporate stakeholders, and Business Administration at the Harvard Business School you may be viewed as a refugee of the 1980s, de- in Boston, Massachusetts. Timothy A. Luehrman is an associate professoT at the Harvard Business School. They luded by the decade of greed. are the authors of "The Myth of Japan's Low-Cost Capi- It's easy to see why LBOs have developed such tal" (HBR May-June 1992) and are currently conducting a negative image. Even when they were booming. field research on sources of value in leveraged buyouts.

DRAWING BY CHRISTOPHER BING 119 LEVERAGED BUYOUTS

Burnham Lambert and junk- pioneer Michael under corporate ownership. Furthermore, the com- Milken added to the perception that the LBO wave panies they managed ultimately thrived. had been whipped up and sustained by unscrupu- CD&R's experience over more than a decade pro- lous financiers who enriched themselves at the ex- vides insights into what constitutes best practice in pense of others. Harrumphing members of Con- tbe ownership and governance of corporate enter- gress held hearings. Soon, a chorus of I-told-you-sos prises. Contrary to what many people think, tem- from LBO critics and finger-pointing in the savings- porary ownership by an LBO firm can provide an and- and banking industries turned leverage important bridge to better -term management into a dirty word. Even the LBOs that "worked" and performance. Moreover, this form of ownership were dismissed as good luck or, more often, the is adaptable to a much wider universe of businesses result of deep and painful cuts in employment, in- than commonly assumed-including not only the vestment, and R&D spending. Indeed, it seems as undcrperforming low-tech companies that have if almost every sales or purchasing manager has a long been associated with LBOs but also neglected story to tell about a good customer or supplier who divisions and other pieces of corporations with po- was "ruined" hy an LBO. tential tor growth and an appetite for investment. Although some leveraged buyouts may have de- served the criticism they have received, we helieve Challenging Old Assumptions that the overall public perception about them has been distorted. Right now, it is premature to dis- In 1987, CD&R (which was called Clayton & Du- miss LBOs as artifacts of the 1980s and to discuss bilier until 1992) executed an LBO that transformed their impact entirely in the past tense. Leveraged Borg-Warner's Industrial Products Division-a pro- deals are still coming together, including some ducer of industrial pumps, seals, and fluid-control equipment witb revenues of $245 million-into a stand-alone company called BW/IP International. The divi- Under the right conditions, sion's parent, Borg-Warner Corpora- LBOs are not merely deals. They tion, had shifted its strategic priori- , "^ , 1 1 r ^^^^ away from industrial machinery the division's president, Peter Valli, represent an alternative model ot businessesukeand a team oBW/IP^,f executivemresponses joined, forces with the LBO firm to buy the corporate ownership and control. business for $235 million. More than large ones. More important, LBOs are evolving in 90% of the purchase price was financed with . ways that we think will establish them as a perma- Equity worth $20 million was owned by manage- nent feature of the corporate financial landscape. ment (20%), Clayton a Dubilier (70%), and subor- Under certain circumstances, they offer a useful dinated lenders (10%). format for effective governance of corporations. At first, BW/IP's managers were alarmed by both Under the right conditions, LBOs are not merely the price tag and the debt burden. When they were deals. They represent an alternative model of cor- running a suhsidiary of a large, diversified parent, porate ownership and control just as public owner- they had had little need to concern themselves ship, ownership, and franchise with liability management. But once they were on arrangements do. their own, their instincts told them to begin con- Our research at one particular LBO firm, Clay- serving and repaying the debt as quickly as ton, Dubilier & Rice (CD&R), in New York City, re- possible. Indeed, that was what they had assumed veals an approach to ownership and governance LBOs were all about: tightening cash management; that challenges the dominant puhlic view about putting a clamp on new investment and develop- leveraged buyouts and their effect on corporate per- ment expenditures; selling assets as needed and us- formance. Instead of finding impersonal transac- ing available cash to reduce leverage; and then sell- tions in which the buyers put a lid on investment, ing the business at the first suitable opportunity. growth, and managerial autonomy, we found the To their surprise, however, the advice they got opposite. In fact, chief executives with a capacity from Martin Dubilier, a founding partner of Clay- for strong leadership and sound, independent deci- ton & Dubilier and the firm's lead representative sion making say they had more freedom to exercise on BW/IP's board of directors, clashed with those discretion under LBO ownership than they had had assumptions. Instead of pressuring managers to

120 HARVARD BUSINESS REVIEW Mav-fLine 1995 squeeze more cash out of the company and reduce the hard day-to-day work. But management the debt as quickly as possible, Dubilier advised Clayton &. Duhilier with keeping the company fo- them to search for good new investment opportuni- cused outward on growth rather than inward on ties in their industry. Without growth, he argued, its debt burden. As one BW/IP executive puts it, the business could survive, but it would not prosper "Dubilier helped us see what was good about us, and the returns would not be worth the effort. and he got us to invest in it." Dubilier's convictions were put to the test a year Since its founding in 1976, CD&R has acquired after the buyout when Valli called him to discuss an 21 businesses with annual sales ranging from $20 opportunity to acquire a small manufacturer of cen- million to $2 billion. Executives at other portfolio trifugal pumps. The proposed $18.5 million acqui- companies also report that the firm has given them sition would double BW/IP's installed base of cer- guidance and support. One CEO says, "CD&R's tain types of pumps and strengthen its in partners told me, 'Don't think of it as our company; aftermarket parts and services, the fastest-growing think of it as yours. And run it as though you were segment of its business. But it also would require going to own it forever."' This approach has pro- additional borrowing and getting the banks to duced impressive results: Since the beginning, the waive some covenants on BW/IP's substantial debt. eash-on-cash compounded annual rate of return on At Borg-Warner, such a request would have had CD&R's investments has exceeded 100% per year to undergo a lengthy bureaucratic process begin- (more than 80% after adjusting for management ning with a written proposal analyzing the pump fees and CD&R's share of operating cash flow). maker's past performance and strategic fit, and Looking at its performance record, one might forecasting its future performance. Onee headquar- imagine either that CD&R has devised a break- ters had reviewed the proposal, corporate staffers through approach to husiness management or that would visit the division and hear a presentation. If the firm has simply been lucky. Neither is the case. they liked what they heard, the proposal would be To be sure, equity in the hands of management and turned over to Borg-Warner's Corporate Planning new incentive compensation packages can better Committee, which met monthly. The committee align the interests of owners and managers, but no would review the proposal, hear another presenta- one attributes the performance of CD&R's compa- tion, and probably ask for further study and analy- nies to incentives alone. Indeed, despite similar sis. At best, it would take the committee several pay-for-performance packages in all the portfolio months to come to a decision. Valli and his team companies, approximately 40% of the CEOs at the had run that gauntlet several times, only to be re- time of the buyout have had to be replaced for in- buffed or lose opportunities because of delays. adequate performance. Neither does high leverage In the environment created by Clayton & Du- alone explain the firm's success. Leverage, of course, bilier, things were different. The firm's financial amplifies equity returns, but it cuts two ways: and strategic analyses were every hit as thorough as Highly leveraged equity claims are quickly wiped Borg-Warner's, but the approval process was far out when a company runs into problems. And more streamlined. Thanks to the relationship that most of CD&R's companies did, in fact, encounter had developed between Dubilier and Valli in their prohlems at one time or another. first year of working together, Valli got the firm's approval to make the acquisition in the course of a single telephone conversation. As it turned LBOs are adaptable to a mueh out, nobody had any regrets: Both the LBO and the acquisition were great wider universe of businesses successes. By the time BW/IP went public, in 1991, the value of its com- than eommonly assumed. mon had grown from $20 mil- lion to $352 million, reflecting a compounded re- what explains CD&R's success; We learned the turn on equity in excess of 100% per year. The inost about how this LBO firm succeeds by looking company's revitalized core businesses had im- at situations in which something went wrong un- proved along almost every dimension: higher mar- expectedly and had to be corrected. According to ket shares, higher operating margins, and better one partner, "What's different about us is that we working capital management and asset utilization. can fix our mistakes." The manner in which the BW/IP's team of executives were obviously vital "fixing" takes place is integrally tied to the firm's to the deal's success, because it was they who did approach to ownership and governance, which re-

HARVARD RUSINES.S REVIEW M:iy-|Line 1995 121 LEVERAGED BUYOUTS volves around a few basic principles: direct lines of as an active owner to buy Harris Graphics Corpora- communication between owners and top manage- tion, which was triple the size of the firm's three ment; considerable managerial autotiomy under previous acquisitions put together. normal circumstances and a willingness by owners By 1984, Clayton & Dubilier's track record and to step in and direct operations to correct chronic the investment climate were good enough to at- problems; and trust-based relationships among tract to a $46 million limited-partnership owtiers, managers, and key creditors. The princi- fund organized to invest in the equity of the firm's ples are interdependent. However, although each buyouts. In the meantime, the firm was also ex- one may sound simple, practicing them all at once panding its pool of talent. Three new partners ar- is difficult. What enables CD&.R to accomplish this rived with mostly financial skills, and a fourth was is its operating capability. an operating manager who had served suecessfully as chief executive officer of Stanley Interiors. The new funds and a balanced team of finance and oper- How CD&R's Approach Evolved ations professionals positioned Clayton & Dubilier The principles by which CD&R conducts busi- for the wave of buyouts that would run through the ness stem in part from the partners' personal beliefs end of the decade. and experiences. But they also have been shaped Uniroyal, the tire and chemical company, was over the years in response to problems and opportu- the firm's first buyout of a and also nities. The firm undertook its first buyout, of Kux its first billion-dollar deal. That acquisition, com- Manufacturing Company |a maker of commercial pleted in 1985, enhanced Clayton ik Dubilier's decals), in large part because "we wanted to be in stature and reputation on Wall Street: It was big, the deal business, so we had to do a deal," says part- relatively complicated, and, some thought, unusu- ner Joe Rice. Before acquiring Kux in 1979, Clayton ally risky. The Uniroyal transaction and the subse- & Dubilier had specialized in turnarounds, not buy- quent buyout of the Uniroyal Goodrich Tire Com- outs, and all three of its founding partners - Gene pany, in 1988, were both successful financially. But Clayton, Martin Dubilier, and Bill Welsh - were the deals convinced the partners that the firm's skilled in operations. When Rice joined Clayton & skills and operating style were less suited to acquir- Dubilier in 1978, he brought his expertise in fi- ing entire public companies than to acquiring divi- nance and law to guide the firm into leveraged man- sions of public companies. As Rice explains, "With agement buyouts. a public deal, you can't negotiate much besides Kux seemed like a good deal: a small, simple price. I make a living negotiating good acquisitioti business, a clean company, and a good price. But the agreements. We have a good team with strong capa- partners' relationship with the company's man- bilities-we don't make many mistakes-and there's agers turned out to be rocky. Although the deal was a lot I want to talk about besides price. Also, when profitable, the partners concluded that they had to you buy a public company, you buy management- find a better way of monitoring and assisting company executives. In the next deal, the buyout of The balance between operating Stanley Interiors Corporation (a maker of furniture and fabrics) later that year, Dubilier took a more ac- and financial partners is crucial tive role, one he initially thought of as that of chairman of the board to the way CD&R operates. but which has since beeome known within the firm as lead representative. At the same all of it-all sitting in the same spots with the same time, Clayton & Dubilier began formalizing as- mind-set, the same organizational problems, and so pects of its relationships with portfolio companies on. In a private deal, there are many possibilities to to clarify roles, responsibilities, and expectations. change things quickly." The firm has maintained By the time the firm had completed the buyout of that preference ever since. WGM Safety Corporation (a maker of personal safe- Uniroyal and Uniroyal Goodrich were milestones ty equipment) in 1981, the partners had recognized in another respect: They triggered substantial the need to intervene in some situations. They fired growth within Clayton & Dubilier itself. Between an underperforming CEO and replaced him not 1987 and 1992, the firm added nine new partners, with an outsider but with one of the partners. Soon nearly tripling its ranks at the partner level. In thereafter, the firm drew on its growing experience keepitig with the firm's tradition, five of the part-

122 HARVARD BUSINESS REVIEW May-)une 1995 ners had experience as CEOs of manufacturing lead representative, usually an , companies, and four were financial experts. The sits on the board of an acquired company and has balance between so-called operating and financial chief oversight responsibility for CD&R. The lead parttiers in both numbers and influence is crucial to representative also determines what the firm ean the way CD&R operates. It is further reinforced hy reasonably expect of the eompany's CEO and man- the firm's compensatioti polieies: AU partners par- agement team. ticipate fitiancially in every deal, and all partners - CD&R's organization and its relationships with portfolio companies arc structured to make the best possible use of the lead representative. In contrast to Once CD&R purchases the complex hierarchies and elabo- rate approval processes typical of a business, operating partners large corporations, CD&R empha- sizes the relationships between the remain active for as long as the senior managers of portfolio compa- nies and the lead representatives. firm owns the company. CD&R's in-house eorporate policy manual carefully describes the firm's financial and operating-at a given level (there are and the lead representative's monitoring and sup- only two) reeeive the same compensation. port activities on the one hand, and the CEO's au- Finaneial partners are the firm's primary link thority and obligations on the other. CD&R pro- with the larger eommunity of deal makers, lend- vides this information to CEOs even before the ers, and investors. They loeate prospective acquisi- buyout is completed. tion candidates and process transactions from start The board of a portfolio eompany is usually to finish: analyzing projections, negotiating prices made up of CD&R's lead representative, two other and other terms, performing due diligenee, arrang- CD&R partners, the eompany's CEO, and three ing financing, and attending to tax and accounting outside directors who are selected by the CEO and matters. They also take the lead in postdeal finan- approved by CD&R. More so than the other direc- cial tnatters, including relationships with lenders, tors, the lead representative serves as the CEO's , refinancings, the sale of portfolio sounding board on both day-to-day operations and companies' assets, and the eventual liquidation of long-term decisions. In addition to contributing an CD&R's interests. understanding of what's involved in running a eom- Operating partners, too, play a significant role pany, this individual is expeeted to listen, ask ques- from a transaction's inception. A prospective candi- tions, react to ideas, and suggest alternative ways date receives serious consideration only after an to address problems and opportunities. operating partner endorses the viability of the en- Although primarily an adviser, tbe lead represen- terprise. To the question, Would you be willing, if tative is often actively involved. The Allison En- neeessary, to step in and run this business yourself? gine Company, a producer of aircraft and industrial at least one operating partner must answer affirma- engines, was a division of General Motors before tively before CD&R invests much time or money CD&R bought it for $340 million in 1993. Allison in a deal. Not surprisingly, operating partners also executives had never had to manage cash and play a large role in the due diligence proeess and working capital, because those and other treasury in formulating operating objectives and perfor- funetions had been handled by GM. At the time of mance goals. the buyout, Allison was turning over its inventory Once CD&R purchases a business, operating of $400 million less than twiee a year. CD&R's lead partners remain active-as board members, consul- representative stepped in to help Allison's man- tants, advisers, owners, and sometimes CEOs-for agers improve their working capital management. as long as CD&R owns the company. This involve- Touring a 3-million-square-foot company facility, ment stands in sharp eontrast to more financially he examined samples of work in process, deei- oriented LBO firms, which generally seek operating phered date codes, and determined that a lot of expertise from outsiders on a fee-for-service basis inventory had been sitting idle in the shop for and often only when a erisis develops. months. With the lead representative's help, Alli- The active role that Martin Dubilier first played son executives established a process for reducing in the Stanley Interiors buyout became a standard working capital. It eventually involved more than part of every transaction by the mid-1980s. The 100 employees, who were offered cash incentives.

HARVARD BUSINESS REVIEW May fune 123 LEVERAGED BUYOUTS

Within ten months, working capital had been re- people are accustomed to hearing critiques from duced by $75 million. their colleagues. Lead representatives generally have discretion Selective Intervention. CD&iR's operating capa- for selecting auditors and agents and for bility and close contact with portfolio companies approving employees' benefits and pension plans. enhance its ability to know when to intervene and CD&R also assumes primary responsibility for how to be constructive if it does. A case in point is maintaining relationships witb banks and subordi- the Kendall Company (now Kendall International), nated lenders, and it helps obtain additional capital a maker of disposable medical products that Clay- as needed for strategic investments. The firm will ton & Dubilier acquired in 1988 for S960 million often assist in selling or noncore parts and that became the firm's first big acquisition to of a portfolio company's business. But tbe lead rep- develop major problems. Everyone involved in the resentative does not otherwise make decisions or transaction now agrees that, among other mistakes, give instructions. Rather, it is up to the CEO to the firm paid too much for the business. More than gather input from staff and other advisers, weigh al- one partner attributes part of the problem to hubris. ternatives, and make decisions. A Kendall executive agrees: "They thought they were magic." The way the deal was structured, everything had to go right in order to justify the pur- Core Management Principles chase price. It was the only CD&.R deal financed in While CD&R brings a high level of operating ca- part with zero coupon bonds - an indication that pability to eacb new deal, that capability is en- even with optimistic cash-flow projections, the hanced by the way in which the firm interacts with company would have to stretch to service its debt. portfolio companies and managers. The firm's in- Things began going wrong almost from the start. volvement is characterized by the principles it has As Kendall's performance slid, employees became come to embrace. obsessed with the debt, key salespeople and man- Direct Lines of Communication. To improve its agers departed, and lenders pressed for repayment. monitoring of portfolio companies, CD&R retains Clayton & Dubilier developed plans to restructure the right to talk to anybody in tbe company, subject operations and sell assets but pulled back in the to two constraints: It must inform the CEO, and face of an unreceptive market. The CEO's job it cannot tell anyone in the company what to do. turned over twice - the second time just before a Normally, of course, CEOs are expected to keep crucial bondholders' meeting. The firm's operating CD&.R's lead representative abreast of the impor- partners convinced their colleagues that Kendall, tant strategic and operating issues as they develop. though weakened, had a valuable core and could be Communication at this level is direct, fast, and turned around. Dubilier himself stepped in as the usually informal. One CEO estimates that in the interim chief executive before recruiting an out- course of six years under CD&R's ownership, he re- sider to lead the recovery. ceived fewer than 20 pages of memos from the firm. The firm's financial partners also played a critical Within CD&R, communication among partners role: working with banks to arrange a financial re- is also direct and informal-a reflection of tbe firm's structuring that would provide time for the oper- flat structure and egalitarian culture. In addition to ating changes to come to fruition. In mid-1992, sharing the workload of meetings, negotiations, Kendall filed for Chapter 11 with a prepackaged analyses, and due diligence, the part- ners have an obligation to contrib- ute by communicating. They share ideas, expertise, opinions, and criti- cisms-including criticisms of them- selves, the firm, and one another. exchange of views to tap the CD&R relies heavily on an open ex- change of views as a way to tap tbe expertise of a very small group. expertise of a very small group (13 professionals, 8 of whom are partners). Whenever bankruptcy. Among the provisions of the complex we asked a partner about problems at specific com- reorganization was the injection of new equity cap- panies, tbe response usually began with, "Well, I'll ital from one of CD&R's funds - an investment tell you the mistake I made" or "So-and-so [anotber that was unanimously approved by that fund's partner] was wrong about..." Everyone in the firm investors. To bolster Kendall's position further, has made mistakes, and, in CD&LR'S open culture. CD&R waived its management fees and gave up its

HARVARD BUSINESS REVIEW May-Iune 1995 125 LEVERAGED BUYOUTS share of Kendall's operating cash flow from the orig- longtime turnaround specialist who has been a inal buyout. CD&R operating partner since 1990. "You try to Kendall emerged from Chapter 11 within about figure out what to do. You talk to the managers, set a month. For fiscal 1992, sales grew by 5% and oper- very specific hurdles, and see what happens. It's an ating cash flow increased by nearly 40%. Kendall experiment. Then, hased on what happens, you try covered its annual interest expense 1.7 times, re- another experiment. It takes time. You're always paid approximately 15% of the postrestructuring trying to strengthen a weak person rather than re- deht, and had its stock listed on the NASDAQ. In place him." 1993^ the company did even better: It was ahle to As important as it is to know when to get in- cover its interest expenses 6 times. Throughout the volved, knowing when not to intervene is just as reorganization, the company's bank retained important. Excessive intervention hurts manage- their full value. ment's morale and undermines managers' sense of initiative and willingness to take risks. The BW/IP deal was one situa- tion in which intervention was nev- As important as it is to know er necessary. As Peter Valli, BW/IP's chief executive, describes the rela- when to get involved, knowing tionship, "The partners wouldn't hesitate to push you to do some- not to is just as important. thing, but you could push hack. Each side respected the other's judgment." We asked CD&.R's partners how different manag- CD&R's operating partners are accustomed to such ing a crisis would have been had they not had the relationships. All of them have held senior operat- firm's operating capability to call upon. One part- ing management positions in large corporations. In ner said, "Financial buyers with no operating capa- addition, many have had successful careers as man- bility would eventually see the numbers going had. agement consultants. So they'd talk to the CEO and prohahly hear ex- One executive who has run a company under cuses. Then the had results continue, so maybe both CD&R and another, financially oriented LBO they'd replace the guy. But then what? How do you firm notes some of the differences hetween the two know the new guy is any good? Whom do you get? approaches: "The finance-only LBO firms are actu- Maybe an industry guy, maybe a workout guy - it ally more likely to get in your hair hecause they can go on and on. It's an awful position to he in. worry ahout operations but know they don't under- That's why some buyers walk." stand them. Financial LBO firms ask you for much Despite Kendall's disappointing early perfor- more information - data, reports, everything - and mance and the financial restructuring it necessitat- they don't understand any of it. The CD&R operat- ed, the experience highlights important aspects of ing guys ask for what they need, and you know they CD&R's view of ownership and governance. In the understand it. It's easier for a CEO and the CD&R rescue operation, both operating and financial part- liaison to trust each other because they're hoth op- ners played major roles, and the strength of the erating guys. They can talk." firm's commitment to a company was tested and Trustworthiness. We asked the CEOs of portfolio confirmed. CD&R might well have heen hetter off companies to tell us how managing a CD&R com- financially had it put Kendall into bankruptcy two pany differs from managing a divisitm of a large cor- years earlier, one partner observes. "But we never poration. Second only to the pressures of managing seriously considered it. We felt that it was our proh- with lots of debt, the CEOs cited their ability to lem and we were going to fix it." CD&R's partners trust CD&R's partners, They said that with CD&R take considerable satisfaction in Kendall's current they could discuss problems and opportunities, strength and in the fact that the lenders didn't lose openly, act more independently, and generally fo- any money and the company's operations didn't cus on husiness, rather than feeling compelled to have to he gutted to repay the deht. "game" the corporate control system or to protect Deciding when to intervene can he difficult, even themselves from it. for someone with extensive operating experience, CD&R's partners understand the importance of hecause often the cause of a company's problems trust and work hard to foster and maintain it. Trust can be determined only over time, through patient was indispensable in the creation of Lexmark Inter- interaction with the chief executive and other man- national, a business formed from IBM's printer, agers. "You agonize a lot," notes Bard Howe, a typewriter, and keyboard business in 1991. Accord-

126 HARVARD BUSINESS REVIEW May-|une 199S ing to one CD&R partner who was heavily involved folio companies to take advantage of strategic op- in negotiations with IBM, "Both sides agreed early portunities or to allow managers to take corrective on that they were going to have to trust each other. steps. Ordinarily, lenders will agree to waive More than one IBMcr said to me, in effect, We know covenants or to suspend certain payments tem- you guys won't embarrass us." The trust that was porarily when doing so is in their best interest. established in the Lexmark negotiations carried When the lenders are confident that their flexibility over into positive relationships between the firm will not be abused by the equity owners, there is and Lexmark's managers (most of whom were for- usually less haggling. CD&R's willingness to inject mer IBM employees) and between Lexmark and its more equity capital into Kendall and to give up its employees and suppliers. own share of the company's operating cash flow Trust between CD&R and the CEOs sometimes rather tban cut its losses exemplifies the kind of develops early through good personal chemistry. trustworthy behavior that the firm tries to exhibit. More often, it has to be cultivated. As Alberto Parties that trust each other can interact on the Cribiore, a financial partner who has helped put basis of informal, implicit agreements. Such agree- many deals together, observes, "We're typically not ments arc valuable to both sides because they are in love with these guys [the prospective senior inexpensive and because they permit rapid and managers] prior to the deal, and vice versa." In- highly refined adjustments to a changing environ- stead, trust is built over time in a variety of ways, ment. When people expect frank discussions of all including the alignment of interests through equity material facts, many of the cumbersome control ownership and incentive compensation. Setting re- systems typical of large hierarchical organizations alistic expectations, sorting out responsibilities can be dispensed with. and authority, and then respecting those decisions are also important. The trust that develops between a lead representative and a CEO often fans out into Why LBOs Make Sense both organizations, and it gets tested over time. Despite the unfavorable public perception of Eventually, a reputation for trustworthiness be- LBOs, they are alive and well. Judging from the ex- comes sclf-rcinforcing; People who anticipate perience of CD&R, that is not an accident: As trustworthy behavior from their counterparts are a model for ownership and governance, the LBO more likely to interact informally and see their ex- firm has considerable advantages. Our look at peetations confirmed. CD&R also indicates that the American LBO is still Trust also helps managers innovate and take evolving and that, within the universe of LBO risks. The pressure of substantial debt ean paralyze firms, CD&R represents a distinctive variant-one managers and discourage them from taking addi- that might be labeled an operating (as opposed to tional risks even when it is to the company's advan- a predominantly financial) LBO firm. The strength tage to do so. To have the confidence to take "good" of CD&R's operating capabilities seems unusual. However, we can envision smaller, more narrowly focused firms pursu- 1111 ing a similar approach by concentrat- The trust that develops between r two related industries their partners have exten- CD&R S lead representative hands-on operating experience. The combination of operating ca- the S LLO pability, direct lines of communi- cation, a capacity for selective in- gets tested over time. tervention, and an emphasis on trustworthiness greatly expands the risks, managers must be able to trust that the indi- range of businesses that can be successfully ac- viduals evaluating their performance can make dis- quired and managed as LBOs. criminating, informed judgments. CD&R's operat- The Lexmark deal illustrates how the range of po- ing capability helps instill such confidence. tential buyout candidates is expanding to compa- CD&R also stresses trustworthiness in its rela- nies that look nothing like the stereotypical LBO tionships with LBO lenders. To protect their finan- candidate. To begin with, Lexmark's computer- cial position, lenders require formal contracts with printer business is relatively high-technology, high- explicit terms and covenants. But sometimes the growth, and high-risk, and it demands substantial restrictions need to be relaxed to permit the port- ongoing investment. Before Clayton & Dubilier

HARVARD BUSINESS REVIEW May-June 1995 LEVERAGED BUYOUTS

purchased it for about $1.6 billioti, it had not been a prominent topic of study and debate since the structured as a freestanding division, so the firm early 1990s, vs^hen academics and practitioners had to pull it together from various parts of IBM. alike began hypothesizing that good governance Organizing the company required cooperation and contributes to competitiveness. What followed was expertise frotn many quarters: operating and finan- an international effort to formulate, or at least de- cial partners at Clayton &. Dubilier, executives at scribe, a model of best practice for corporate gover- IBM, suppliers and customers, and many outside advisers. The deal re- quired some 70 different contracts, mostly hetween Clayton & Dubilier Debt and equity are not merely and IBM; it used more equity than typical buyouts do (with IBM itself different types of financial becoming an equity ); its se- nior debt came from a small number claims. They are alternative of banks that held on to the debt without syndicating it; the subordi- approaches to governance. nated debt came from a single insti- tutional investor; and two other institutions pur- nance. A 1992 report by Great Britain's "Cadhury chased all the (thus eliminating any Committee" attempted to set forth principles of need to sell puhlic securities). The Lexmark trans- best practice in British corporate governance. In the action is a ringing endorsement of the firm's ap- United States, leveraged buyouts, venture capital proach to LBOs hy sophisticated investors. firms, and relational investing (as practiced, for ex- CD&R completed five more acquisitions total- ample, by ) have all been studied as ing $2 billion from 1993 through February 1995- possible models for best practice. In a similar vein, the firm's most active period since 1987 and 1988, observers have also touted the organizational ad- when it closed five deals totaling more than $2 bil- vantages of the industrial groups of Japan, Ger- lion. Those five companies are growing rapidly and many, and Scandinavia. require considerable ongoing investment or have Is there a best-practice model for governing busi- substantial operating risks stemming from the need ness enterprises that can be applied across the to bring ahout a turnaround. Whereas other LBO board? If LBO firms such as CD&R can acquire firms normally avoid such companies, CD&R, con- large divisions of mainstream corporations and in- fident in its operating capabilities, seeks them out. crease value through better governance, then why CD&R acquired its neu'est businesses from Xe- can't the corporations do it themselves hy adopting rox, General Motors, DuPont, Westinghouse, and similar operating approaches, avoiding the transac- Philip Morris. The husinesses (all of which were tion fees, and letting their shareholders keep the valued at $300 million or more at the time of pur- profits the LBO investors would make? Unfortu- chase) no longer fit their former parent's strategic nately, it's not that simple. Senior managers are sel- interests, and each had suffered from some form dom able to impose the necessary operating disci- of neglect: overspending, lack of controls, or under- plines on themselves. Nevertheless, they can learn investment. The recent acquisitions were not small- some valuable lessons from CD&R's experience. to medium-sized low-tech businesses whose stag- The first lesson may be obvious, but it bears re- nation or decline was the reason they were good peating: How a company is governed matters. LBO candidates. Rather, they were parts of main- There is ample evidence other than CD&R's port- stream corporate America that had heen subopti- folio to support this assertion, although the firm's mally governed: businesses with valuable market results bear it out. Among the firm's 15 acquisitions positions and opportunities that required liquidity before 1990 (it is too soon to tell about five of the six and access to capital in order to thrive. Today there more recent deals), only one company failed to dou- is no shortage of such acquisition candidates. ble its earnings before income and taxes. Those gains did not come from laying off employees: Head Corporate Governonce and the Quest count rose at some companies and fell at others; on for Best Practice average, it rose modestly (less than 4%). Nor did they "just happen" as the result of new incentive The recognition that parts of mainstream cor- compensation schemes or managers owning equi- porate America are suboptimally governed is hy ty; in fact, operating problems usually arose that no means new. Corporate governance has heen required active intervention. To put the lesson an-

128 HARVARD BUSINESS REVIEW May-June 199.5 other way, governance affects how important deci- portunities within the company's reach. In general, sions get made and therefore how efficiently a com- a business that has easily redeployable assets pany's resources, including capital, are utilized. Poor (multiuse facilities, conventional rolling stock, governance can be very costly. low-technology manufacturing equipment, and so Because LBOs tend to be viewed primarily as fi- forth) and that faces relatively few good growth op- nancial transactions, their effects on governance portunities will be better governed by the simple, are often overlooked. Finance and governance are low-cost, rules-based regime provided by debt. Such commonly seen as distinct and separate spheres of businesses do not require much cash, and their as- activity. In fact, the two are closely related. As sets are readily transferable to other management Crihiore observes, "With equity, [corporate gover- teams in the event of . In the early days, LBO nance] is a matter of constant negotiation. With firms sought to acquire companies with just this debt, it's a matter of reality - did you hit your profile: ordinary businesses with stable cash flows covenants or not?" His comment underscores the and readily salable assets. fact that debt and equity are not merely different By contrast, businesses with highly attractive types of financial claims. They are, in addition, al- growth opportunities or a need for functionally spe- ternative approaches to monitoring corporate per- cific assets (dedicated to a particular customer or formance and directing management - in other supplier, locationally fixed, or dependent on specif- words, to governance. ic human capital, for example) will be better gov- By its very nature, debt constitutes a fairly rigid, erned by a regime dominated by equity. Such busi- rules-based approach to governance. Borrowers nesses typically require substantial managerial contract with lenders to make regular cash pay- discretion and administrative flexibility. Not sur- ments of interest and principal, and they agree to prisingly, husinesses with mixed characteristics are restrict the payment of dividends and the sale of as- best suited to hybrids of the pure rules-based and sets, and to maintain minimum levels of working discretion-based extremes. Some of the hybridized capital. Failure to abide by the rules can lead to fur- adaptations we observe in the real world (Japanese ther constraints or, ultimately, seizure and liquida- industrial groups, for example) are quite sophisti- tion of the company's assets. Although covenants cated and highly evolved. can be waived and terms renegotiated, such steps Businesses change over time and so, too, should are costly and are not undertaken lightly. the type of governance they employ. Some changes Equity, by its nature, is more flexible and forgiv- are discontinuous and driven by phenomena exter- ing. Individual shareholders may come and go, nal to the business; others occur gradually and may stock prices may rise or fall, but equity as a class is result from internal factors or from a company- or "patient." Equity investors can and should inter- industry-specific life cycle. Regardless of what is vene selectively and administratively to correct driving the change, it is unreasonable to expect one performance shortfalls, rather than relying on fi- form of governance to remain optimal in all cir- nancial triggers to bring other safeguards into play cumstances. Managers should abandon the idea of a automatically. In effect, pure debt and pure equity single dominant model of best practice to which all occupy opposite ends of a continuum of potential well-managed companies should conform. Instead, well-managed companies will pass through several forms of ownership and control - some of them perhaps Though ownership by an LBO more than once. This is a natural and desirable consequence of continual firm may be transitory, the corporate renewal. improvements can endure. A leveraged buyout is one form of governance through which a rela- tively wide cross-section of busi- governance regimes. The imperatives of debt make nesses may pass. CD&R's system of combining for a rigid but fundamentally simple and low-cost operating and financial expertise with direct regime, while equity's flexihility makes it more communication, selective intervention, and an em- adaptive but inherently more complex and costly. phasis on trust helps overcome some of the rigidi- The ideal form of governance for a business at a ties of high leverage. For some businesses, a tradi- particular stage depends on the nature of the assets tional pure-finance LBO might be a mistake, but an being managed, the transaction stream those assets "operating" LBO might make sense as an efficient support, and the number of attractive growth op- way to accomplish a transition from one phase of

HARVARD BUSINESS REVIEW May-|unt LEVERAGED BUYOUTS the business's life cycle and one form of governance If, as we expect, more firms hegin to adopt ele- to the next. Though ownership hy an operating LBO ments of CD&R's approach and the operating LBO firm may he transitory, the evidence from CD&R becomes more prevalent, the impact on U.S. husi- suggests that a company's improvements in opera- ness will be suhstantial. It will facilitate efficient tions can he enduring. changes in the governance of assets worth hillions The continuing evolution of the operating LBO of dollars, culled from some of the world's largest could hring suhstantial henefits to U.S. husiness corporations. Most of those companies will see and to the overall economy. Currently, CD&R hy their operations improve and investments increase itself has the capacity to undertake ahout two high- hefore they return to public ownership directly impact transactions per year. In contrast to the through stock offerings or indirectly through sales 1980s, when the firm's prospeets eame from invest- to other puhlic companies. The firms that facilitate ment bankers who presented the deals to several this process should be ahle to survive the ups and firms, today's opportunities are more along the downs of Wall Street well into the future. lines of Lexmark, in which the selling company of- fers the deal to the huyer directly. Respectability and Rewards CD&R has held its companies an average of four and a half years. As the pool of potentially attrac- Not so many decades ago, capitalism itself was tive LBO candidates expands and the transactions held in low esteem hy many as a means of organiz- themselves hecome more complex, we can expect ing economie activity. Intellectual skepticism to see LBO firms holding on to portfolio companies ahout its merits, hostility toward its mechanisms, longer. Nevertheless, CD&R has no plans to he- and unease with some of its apparent side effects all come a relational investor in the mold of Warren eontributed to its poor image. Today the image of Buffett's . To motivate and re- capitalism is mueh improved, but not because to- tain the hest deal makers and to keep their skills day's critics are more insightful than yesterday's. sharp, the firm must initiate new deals. To remain Rather, capitalism has proved its usefulness hy suc- small and foeused and to reward partners, in- ceeding in extended, real-world competition against vestors, and managers, it needs to divest its hold- alternative systems. ings in companies that are ready for a transition to Today's skepticism ahout leveraged huyouts is some other form of governance. Doing so makes likely to undergo a similar transformation. LBOs room for new investments. represent a young and still evolving organizational One can imagine circumstances in which the form under the umhrella of capitalism. Like other ahility of CD&R and other LBO firms to put deals complex forms of ownership and eontrol, including together could be seriously impaired. So far, how- the modern public corporation, LBOs may always ever, the firms that stress operations have shown he imperfect. Even so, they are well suited to cer- staying power. CD&R, for its part, has survived the tain important tasks. Over time, as they compete in death of Duhilier and the of two found- the real world, LBOs will establish a record of oper- ing partners and several others. Moreover, it has ating successes that should cause the skepticism heen ahle to continue assemhling the necessary fi- to give way to qualified respect. In the meantime, nancing despite the disfavor shown to LBOs hy suhstantial rewards await the pioneers who perfect many lenders and financial regulators. the form and demonstrate its eapabilities. ^ Reprint 95305

130 HARVARD BUSINESS REVIEW May-June 199.S