Research

Thomas C. Franco, Partner with Clayton, Dubilier & Rice (CD&R), shares his thoughts on the current state of thinking about private equity amongst limited partners (LPs), as well as the mechanics of driving operational value creation in portfolio companies. Founded in 1978, private equity investment firm CD&R has built a reputation for its culture of operations; the company oversees US$13 billion in assets under management.

Given your role as the leader of the fundraising team at CD&R, what insights can you share regarding limited partners’ thoughts on private equity at the moment?

Private equity, in general, has performed pretty well through the financial crisis and the subsequent recession. However, post-Lehman Brothers there has been a significant change in the way investors view the private equity opportunity— the scars are still visible—and as a result attitudes have shifted along several dimensions.

First, investors in private equity are looking for more control in the investments they make—most notably through co-investments with general partners (GPs) and direct investments. Investors now want to have more say in how their capital is being deployed and co-investments give them a degree of control and selectivity. In the most extreme instances, investors are themselves evolving into GPs, and you clearly see this trend among some of the larger Canadian pension plans and Asian sovereign wealth funds.

Second, in a world that is experiencing lower growth— significantly lower growth depending on where in the world one stands—there is more interest from investors in growth-oriented opportunities. This is good news for fund managers that either have a demonstrated growth profile to the investments that they make, or are located in geographies that are growing more rapidly than some of the more developed economies.

Finally, more than ever before, investors are looking for differentiated strategies—the ability to do something special. That differentiation can manifest itself in a number of ways: GPs can position themselves in an interesting geography, cultivate a sector specialization, or have the capabilities to do something meaningful with an asset once it is owned—namely, improving the operational profile of the business that is acquired.

CD&R has built a reputation for hands-on operational improvements within its portfolio companies. When your operating partners and you look across the global investment landscape, do you perceive that the levers of value creation vary across markets, or are they relatively constant?

We think that there is some variability. However, no matter where you are located, there are always efficiency and productivity gains that can be achieved in a business; you never really run out of opportunities to enhance efficiency. It’s like painting a bridge—when you finish, you go back and paint it again. So value creation is an ongoing focus, and while the level of intensity may vary to some degree by market, it’s not necessarily a difference in kind.

Growth-oriented value creation initiatives have become more important, and we—like many other private equity firms—have put more resources behind these initiatives. These take many forms in developed markets: acquisitions, marketing, digital strategies, pricing, etc. In more growth-oriented markets, where the management talent pool may be constrained, the last few years have made it more important to address and enhance cost and productivity. I suspect that the inherent growth in emerging markets over the last few years may have masked the importance of sound management, as well as the cost and productivity opportunity for private equity investors, so these may be the areas where growth-market firms will increasingly seek to differentiate themselves over the next investment cycle.

Looking back at CD&R’s historical performance and stewardship of portfolio companies, what are the three critical operational enhancements that drive value creation?

Number one is people; number two is people; and, number three is people. We are very committed to the proposition that people drive business performance. We spend a lot of time making sure that the right people are sitting in the right seats in our portfolio company organizations, and to do this we spend a lot of time on talent assessment.

One of our Advisory Partners—Bill Conaty—was the former Head of Human Resources at General Electric. We spend a great deal of time deploying Bill across the portfolio to work with our human resource leaders, who we believe should working hand-in-glove with our portfolio company Chief Executive Officers to build sustainable platforms for management excellence. When we conduct operating reviews of our businesses on a quarterly basis, a good portion of the agenda is devoted to discussing the talent architecture of our portfolio companies with the Chief Executive Officers.

{pagebreak}

Sticking with the theme of human capital, in EMPEA’s recent Private Equity Talent Management in Emerging Markets Survey, operational expertise was the skillset GPs deemed to be in shortest supply relative to demand. Given the gap in skillsets, what would you recommend to newer fund managers that are seeking to build up their operating capacity?

Executive expertise—whether in growth markets or in developed markets—is clearly in short supply, so it needs to be rationed. Large companies with many different business units are unable to adequately deploy management resources across their platforms, leaving many significant businesses locked within large corporations that are really rudderless in terms of management and leadership. This dynamic is helping to drive deal flow as these non-core, orphan divisions are a source of opportunities for private equity firms.

With respect to the shortage of available management talent in some developing markets, I believe that identifying narrow areas for improvement—your basic blocking and tackling—would suggest that recruiting rigorously trained functional experts from major corporations and using them to improve execution around discrete disciplines such as supply chain management, working capital management, etc., could generate outsized returns at specific portfolio businesses. In other words, I’m not sure that hiring a supernova CEO from a large Fortune 500 company—and applying that skillset in a growth market context—will necessarily be as impactful as hiring a highly trained, experienced and talented functional expert, whether that person is knowledgeable in finance or operations.

Your firm’s India entry strategy consisted of taking a minority stake in Kedaara Capital. What are the pros and cons of using this approach to enter new markets, and what are CD&R’s plans to repeat this model in other emerging markets?

Our model is predicated on making investments where we know more about the business than perhaps even the seller. Our operating executives have to know their way around the neighborhood; and if they don’t, we’re unlikely to know as much about the business as the seller or drive the operational transformation. So good investment judgment and post-acquisition value creation are by nature very local; our local expertise is in North America and Europe, and that is where we will invest the capital that we manage.

When we look at the growth markets around the world, the first questions we ask are: what do we know about these markets and what would we be able to do to enhance value? The reality is that we are not equipped to search for investment opportunities in regions where we don’t have deep expertise or connectivity, and therefore a partnership- type model makes sense: working with individuals who are embedded locally and who have the relationships, resources and credibility to source transactions and then create value once a business is acquired.

It just so happens that the Kedaara platform, which came into existence about two years ago, is run by a group of managers who have adopted a strategy that is operationally focused, and we have an operating partner—Vindi Banga—who had deep expertise in India, notably running Hindustan Unilever, one of the largest consumer companies in the country. So it was relatively easy for us to make a decision to experiment with what I would describe as a joint-venture arrangement with the Kedaara team.

A similar alignment of stars would have to occur for us to consider other geographies. While I certainly don’t see that as a near-term prospect, I expect we will assess opportunities to pursue similar arrangements over the long term.

A number of the mature private equity firms with which CD&R grew up have branched out to become financial supermarkets—and often publicly listed at that. Yet CD&R has stuck to its knitting and remained a pure-play private equity firm. What are your thoughts on the evolution of the industry and what do these developments mean for private equity going forward?

Every organization has to adopt a strategy that satisfies four elements: 1) a determination of what the central purpose of the organization is; 2) where it’s going to play; 3) how it will win; and, 4) which capabilities and infrastructure are required to support the platform. We are focused on combining investment judgment with our operating expertise to drive returns from building stronger and more profitable businesses. In fact, over our history, 88% of the value creation is attributable to fundamental business improvement as measured by EBITDA growth. That is our central purpose.

In terms of where to play, we have decided to play in the ponds where others are not fishing. Typically, we pursue an industry segment—and businesses within that segment— for several years before we commit capital; and we believe that this long-term sourcing strategy fosters deeper insights, which not only provide a competitive edge in the sales process, but also ensure that the transformation that we wish to drive post acquisition is accomplished on an accelerated basis. We’re looking for businesses that require real transformations in everything that defines how the business operates: strategy, R&D, supply chain management, manufacturing, marketing, product mix, pricing, and sales and service.

We also know how we will win: by making these businesses perform better. Finally, I would say that if you’re going to have this as your strategy, you need the staffing that can accomplish this, and that’s why we’ve combined experienced investment professionals with senior operating talent.

Other firms have taken a different path. They have scaled their businesses and are operating both in multiple geographies and in multiple alternative asset classes. In their own way, they provide investors a one-stop shop, which implies certain assumptions about the purpose of your organization, where you play, how you will win, what constitutes winning, and what capabilities you need to support that model. Good, bad or indifferent, these highly dispersed models are different from our more focused approach to value creation.

What advice do you have for the next generation of practitioners eager to build a career in the industry?

The environment has certainly changed since I started in the industry. Coming into this business with a clear recognition that it’s about more than just having capital—it’s about bringing real solutions and problem-solving skills to transactions—will separate the firms that will have a sustainable competitive advantage from those that will be subject to the cyclicality of the fundraising market. As long as you have a clear and compelling vision of how you’re going to create value, and you offer something in addition to just capital—which has become somewhat of a commodity, frankly—you will be differentiated in the eyes of the sellers of businesses and also the providers of capital, which are the two pillars on which this business depends.

Finally, what’s the best book you’ve read in the last 12 months?

Hologram for the King by Dave Eggers. It’s a novel with a bit of a post-modern Death of a Salesman theme.