Point of View

Commitments to private equity continued at a torrid pace through the first half of 2006. While some institutional investors are seasoned veterans at the game, others are making their first foray into the asset class. To help investors find value in a crowded marketplace, Northern Trust recently hosted a series of symposiums on the state of the private equity markets. These discussions included industry experts Donald J. Gogel of Clayton, Dubilier & Rice, John A. Canning, Jr. of Madison Dearborn Partners, and Robert P. Morgan, Northern Trust’s director of private equity investing. Here is a collection of their thoughts and perspectives.

Point of View: By some estimates, private equity deals could reach $300 billion this year. What has been driving the growth of private equity markets?

John Canning: The robust credit markets have allowed terms and rates unprecedented in our history. To put this into context, think back to 1981 when prime rates reached 21%. It was cheaper to put a buyout on your credit card in 1981 than it was to borrow the funds from a bank. In recent years, we’ve experienced unprecedented low interest rates, and deal volume goes with low interest rates.

Another factor is Sarbanes-Oxley. For smaller firms, it’s very costly and burdensome to comply with those accounting and disclosure regulations. As a result, some of these firms are going private.

Bob Morgan: There are several factors, but liquidity and investors’ search for return come to mind. Increased liquidity in the debt markets makes it easier to do deals. That’s why more money is flowing in and why we’ve seen such a rise in the number of deals. It’s also causing an increase in purchase prices. Valuations are up in this market. At an eight-and-a-half times average purchase multiple in 2005, we’ve seen a nice spike from 2004. It’s certainly a more valuation-rich environment.

But the reason that most investors are looking at this asset class is the potential for returns. Take a look at the long-term return numbers, and private equity has consistently outperformed the public indexes.

Point of View: What about returns? As they say, past performance does not indicate future results. Do private equity funds offer advantages that can sustain that outperformance?

Don Gogel: Private equity provides several structural advantages over public companies that will help sustain the kind of superior returns you’ve seen recently — perhaps for the next 30 years, in my opinion. First, general partners work with committed capital that we don’t necessarily have to invest. We’re not a mutual fund. I’m not an active manager until I decide the conditions are right. I can sit on my hands, as I have in the past. Second, we benefit from expectations that there will be changes when we make an investment. There is a new sheriff in town, in other words. Third, public companies are slower to make needed changes. But because we don’t have the pressure to manage to the next quarter’s earnings announcement, we can move swiftly to address strategic, operating and talent issues. We’re not bound to any legacy strategies or even to current management teams.

Point of View: In an increasingly efficient market, how are you able to create value for your investors?

Bob Morgan: There will always be good companies embedded in bad structures. Private equity managers provide the skills to release that value. Madison Dearborn’s and Clayton, Dubilier’s portfolios are filled with good examples of this.

John Canning: We try to take advantage of improvements that we can make when a company is trapped in an ownership structure that doesn’t allow management to create value.

For example, we were looking at a company that for all its life was a very confusing story. As a result, it was undervalued by the markets. The company had five different businesses — none of which had anything to do with each other.

For years, our people would visit the company and ask, “What are you doing with all these businesses?” It didn’t make any sense. And we couldn’t understand what was going on. Finally, a transaction occurred that led them to call us and say, “Let’s sit down and talk.”

Private equity provides a mechanism that allows large struggling corporations to remain competitive in response to changes in technology, input costs and global competitiveness.
— Don Gogel, Clayton, Dubilier & Rice

They wanted to execute on a particular transaction but needed to divest these assets in order to make it happen.

They wanted to go through an auction, and we knew there was no way in the world anybody was going to show up for that. And as they started down that path, they quickly came to the same conclusion.

We went to them with a multi-pronged approach. We offered what was a high price relative to their peers at the time, and we used a significant amount of leverage in our deal. It was a dangerous capital structure for what is basically a commodity and cyclical business.

So what did we do? Were we taking a real risk here? Well, from our long courtship, we already knew the assets very well — better than any other potential buyer. We knew where there was value. Within four months we knew we could sell one of the divisions for a significant price, pay down the debt and make our effective purchase price be less than four times cash flow. That took the business totally out of harm’s way from a capital structure standpoint.

The next thing we did for the new company was go back to the seller and lock up a long-term sales agreement to supply certain materials it used. That generated significant revenue and cash flow, which took the risk and downside out of our most commoditylike product.

And the third thing we did was structure the deal so we were able to allocate the costs of the separate businesses from a tax basis so that when we sell them, we immunize any significant tax liability.

What looked like a simple transaction when it was announced in the papers actually took us about two years to do — from start to structure to finish. The value of our investment has appreciated significantly.

Don Gogel: The hallmark of every Clayton, Dubilier deal is that one of our partners is capable of being the chief executive officer of the business. In fact, one of our partners actually assumed the CEO role in half of our investments.

We typically assume the role of a very active chairman who is deeply involved in budgeting, human resources management, capital expenditure and strategy, and pricing — from the macro level to the micro level.

As a result, the premise of achieving returns lies in transforming the business. Operating improvements sit front- and-center of every one of our investments. Roughly 90% of all the returns we have generated have come from increases in earnings on an organic basis.

We can encounter a fair amount of dysfunctionality in the businesses we acquire. For example, in one of our investments, the charismatic founder of the company described himself as being wild, undisciplined and difficult. He was the Johnny Appleseed of a highly fragmented industry. He traveled the country and approached people in restaurants, bars, rock concerts. . .and sold them on his idea for a business. Eventually, he created more than 100 separate Sub-chapter S corporations with each doing its own thing. There was no common general ledger, no common signage, no common point-of-sales system, no franchise agreement. It was a loosely affiliated entrepreneurial organization.

We stepped in and ultimately built a new company on top of the old and dramatically changed its growth profile. We transformed the company from a local service provider with a customer base mostly of consumers and small businesses to a global business-service enterprise with a growing and high-margin corporate customer base. The business was eventually acquired by a large company, resulting in a $1 billion gain for our fund.

There will always be good companies embedded in bad structures. Private equity managers provide the skills to release that value.
— Bob Morgan, Northern Trust

We will buy businesses, such as in this case, where the existing management has objectives, ambitions, passion and enthusiasm but needs operational expertise and new ownership to help the company get to the next level. We also will invest in noncore-operating units, or what we refer to as corporate orphans, where this passion and value potential are largely muted by the parent organization.

Point of View: How has the industry changed in size and scope over the years?

John Canning: Five and six years ago, the big funds were $4 billion and $3 billion. Now you’ll have 10 firms that’ll have between $8 billion and $15 billion funds by the end of this year. A $10 billion fund can establish $50 billion worth of deals over the life of its fund.

There has also been a move to what the industry calls club deals. The theory is that by forming these club deals you can increase the size of the acquisitions. You limit competition because as you grow, there’s much less competition from synergistic buyers that can afford to compete.

The downside is that if you buy a public company and pay more than the public offering, how are you going to get out of it? And what about governance issues? Each of the managers in the club deal is highly competitive. Can seven general partners all be chief and succeed? We’ll see.

Bob Morgan: The top 10 funds that raise money in any given year generally account for half the total capital raised. Last year, the top 10 firms actually accounted for 55% of all the capital raised in the market. So we’re seeing megafunds at the top end of the scale and a highly fragmented market at the lower end. The buyout market seems to be bifurcating between the mega-funds and the smaller, emerging funds.

Point of View: What are the global opportunities for this asset class?

Don Gogel: Private equity has emerged as an extremely constructive force not only here but also in the broader global economy. You see the fits and starts of private equity entering different economies. It wasn’t that long ago that public officials in some countries described private equity firms as locusts descending on their economy. Now those same finance ministers are applauding private equity investments in their countries. The landscape has changed dramatically and will continue to change as private equity plays a bigger role. Some fundamental forces at work have linked the rise of private equity firms to the broader corporate restructuring that’s evident around the world.

Private equity by nature is flexible. It’s transitional. It’s entrepreneurial. It’s risk-taking. It can fill spots in the global restructuring environment that public company capital cannot. It’s very difficult for public companies to adapt quickly enough to the global changes in virtually every market in the world.

Private equity provides a mechanism that allows large struggling corporations to remain competitive in response to changes in technology, input costs and global competitiveness. Countries like China and India compete aggressively for more and more business. Private equity investors are helpful because they allow businesses in the United States, and increasingly in Europe, to compete by focusing their resources on the things they do best.

Point of View: What are some factors that could slow the market?

Don Gogel: Credit spreads and the availability of capital drive this business both up and down.

The likelihood of higher interest rates and the inability to refinance will clearly make it more challenging for the most highly leveraged companies.

There’s no doubt that distressed investing is going to have its day in the sun eventually. Whether it’s in 2007 or 2008, the cycle will change and there will be defaults. Against a backdrop of increased volatility, we believe the most sensible strategy is to continue to focus on generating returns, not from financial engineering or market-timing moves, but from operating performance improvements and strategic repositioning initiatives in the businesses we own.

Point of View: How has the growth of hedge funds affected private equity deals?

John Canning: There’s a lot of talk about hedge funds encroaching on private equity territory. Hedge funds have a lot of advantages we don’t. They don’t disclose to their investors what they invest in. They can trade in debt. They can go hostile.

What they don’t have is a compensation system that is focused on the long term. When they mark to market, they take their compensation every year. Why would they get into the private equity business and wait five and six and seven years to get paid? We’re not seeing them come into our market.

Don Gogel: This doesn’t make for very good headlines, but we do not see competition from hedge funds. The hedge funds active in buyouts are not in the market for control. And that’s the business we’re in. We’re in the market for control. There are some marginal hybrid hedge funds, but they’re few in number.

Most hedge funds have entered private equity largely with debt securities or other exotic securities to help fund activities. That fueled the liquidity. But we really don’t see them as competitors, at least at the high end of the market.

Point of View: Bob, what are some other factors investors should keep in mind when considering private equity allocations?

Bob Morgan: The risk factor with private equity investments is always a consideration, but investors sometimes have difficulty defining risk in private equity — and rightly so. Volatility doesn’t provide a good measure because these investments aren’t valued every day or even every month, and sometimes not even every quarter. There’s also the issue of tying up your capital for a long time.

We try to take advantage of improvements that we can make when a company is trapped in an ownership structure that doesn’t allow management to create value.
— John Canning, Madison Dearborn Partners —

With venture funds, the median returns are incrementally higher than they are on the buyout side. But there’s great uncertainty about what that return is and how it’s going to play out around that median. A look at the differential between the upper- and lower-quartile-performing funds over the last 10 years in private equity is significant — especially in venture capital, where more uncertainty exists.

When people ask us about the market, we acknowledge there’s a lot of money in this market. We also note the need to be careful. It’s crucial when structuring a private equity portfolio not to time these markets. Invest consistently. Don’t chase returns. I think many investors learned those lessons in the venture capital boom in the late 1990s.

It’s also important to diversify. We invest with well-known firms on the large U.S. buyout side. But we also invest with small and middle-sized buyout funds, early-stage venture funds, late-stage venture funds and European funds. We think it’s very important to diversify as broadly as possible. We also believe there will always be a difference between the top-tier firms and the average firms, and the key to generating strong returns is to access these top-quartile-performing funds.

Taking the Long View on Private Equity

Over the long term, private equity investments outperformed benchmarks such as the Nasdaq and the S&P 500.

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