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

Rehabilitating the Leveraged Buyout

by W. Carl Kester and Timothy A. Luehrman

Once the rage of Western capitalism,..leveragedbuyouts have lost their glamour and much oFtheirrespectability. Suggest an LBOtoday as a healthyway to create value, and polite company outside ofWall Street will assume you are just trying to stim-ulate lively conversation. Propose it as a meansof improving operating performance by restoringstrong, constructive relationships among owners,managers, and other corporate stakeholders, andyou may be viewed as a refugee of the 1980s, de-luded by the decade of greed.

It's easy to see why LBOs have developed sucha negative image. Even when they were booming.

critics complained about "paper entrepreneurs."And when the boom faded, a wave of bankruptciesensued. Since 1987, scores of companies that hadbeen acquired in highly leveraged transactions andthat managed more than $65 billion in assets havefiled for bankruptcy. The spectacular fall of Drexel

W. Car] Kester is the M.B.A. Class of 1958 Professor ofBusiness Administration at the Harvard Business Schoolin Boston, Massachusetts. Timothy A. Luehrman is anassociate professoT at the Harvard Business School. Theyare the authors of "The Myth of Japan's Low-Cost Capi-tal" (HBR May-June 1992) and are currently conductingfield research on sources of value in leveraged buyouts.

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Burnham Lambert and junk-bond pioneer MichaelMilken added to the perception that the LBO wavehad been whipped up and sustained by unscrupu-lous financiers who enriched themselves at the ex-pense of others. Harrumphing members of Con-gress held hearings. Soon, a chorus of I-told-you-sosfrom LBO critics and finger-pointing in the savings-and-loan and banking industries turned leverageinto a dirty word. Even the LBOs that "worked"were dismissed as good luck or, more often, theresult of deep and painful cuts in employment, in-vestment, and R&D spending. Indeed, it seems asif almost every sales or purchasing manager has astory to tell about a good customer or supplier whowas "ruined" hy an LBO.

Although some leveraged buyouts may have de-served the criticism they have received, we helievethat the overall public perception about them hasbeen distorted. Right now, it is premature to dis-miss LBOs as artifacts of the 1980s and to discusstheir impact entirely in the past tense. Leverageddeals are still coming together, including some

under corporate ownership. Furthermore, the com-panies they managed ultimately thrived.

CD&R's experience over more than a decade pro-vides insights into what constitutes best practice intbe ownership and governance of corporate enter-prises. Contrary to what many people think, tem-porary ownership by an LBO firm can provide animportant bridge to better long-term managementand performance. Moreover, this form of ownershipis adaptable to a much wider universe of businessesthan commonly assumed-including not only theundcrperforming low-tech companies that havelong been associated with LBOs but also neglecteddivisions and other pieces of corporations with po-tential tor growth and an appetite for investment.

Challenging Old AssumptionsIn 1987, CD&R (which was called Clayton & Du-

bilier until 1992) executed an LBO that transformedBorg-Warner's Industrial Products Division-a pro-ducer of industrial pumps, seals, and fluid-control

equipment witb revenues of $245million-into a stand-alone companycalled BW/IP International. The divi-sion's parent, Borg-Warner Corpora-tion, had shifted its strategic priori-

Under the right conditions,LBOs are not merely deals. They

, " , 1 1 r ^^^^ away from industrial machinery

r e p r e s e n t a n a l t e r n a t i v e m o d e l ot businessesukeBW/IP ,mresponse,

corporate ownership and control.large ones. More important, LBOs are evolving inways that we think will establish them as a perma-nent feature of the corporate financial landscape.Under certain circumstances, they offer a usefulformat for effective governance of corporations.Under the right conditions, LBOs are not merelydeals. They represent an alternative model of cor-porate ownership and control just as public owner-ship, venture capital ownership, and franchisearrangements do.

Our research at one particular LBO firm, Clay-ton, Dubilier & Rice (CD&R), in New York City, re-veals an approach to ownership and governancethat challenges the dominant puhlic view aboutleveraged buyouts and their effect on corporate per-formance. Instead of finding impersonal transac-tions in which the buyers put a lid on investment,growth, and managerial autonomy, we found theopposite. In fact, chief executives with a capacityfor strong leadership and sound, independent deci-sion making say they had more freedom to exercisediscretion under LBO ownership than they had had

the division's president, Peter Valli,and a team of executives joinedforces with the LBO firm to buy thebusiness for $235 million. More than

90% of the purchase price was financed with debt.Equity worth $20 million was owned by manage-ment (20%), Clayton a Dubilier (70%), and subor-dinated lenders (10%).

At first, BW/IP's managers were alarmed by boththe price tag and the debt burden. When they wererunning a suhsidiary of a large, diversified parent,they had had little need to concern themselveswith liability management. But once they were ontheir own, their instincts told them to begin con-serving cash and repaying the debt as quickly aspossible. Indeed, that was what they had assumedLBOs were all about: tightening cash management;putting a clamp on new investment and develop-ment expenditures; selling assets as needed and us-ing available cash to reduce leverage; and then sell-ing the business at the first suitable opportunity.

To their surprise, however, the advice they gotfrom Martin Dubilier, a founding partner of Clay-ton & Dubilier and the firm's lead representativeon BW/IP's board of directors, clashed with thoseassumptions. Instead of pressuring managers to

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squeeze more cash out of the company and reducethe debt as quickly as possible, Dubilier advisedthem to search for good new investment opportuni-ties in their industry. Without growth, he argued,the business could survive, but it would not prosperand the returns would not be worth the effort.

Dubilier's convictions were put to the test a yearafter the buyout when Valli called him to discuss anopportunity to acquire a small manufacturer of cen-trifugal pumps. The proposed $18.5 million acqui-sition would double BW/IP's installed base of cer-tain types of pumps and strengthen its position inaftermarket parts and services, the fastest-growingsegment of its business. But it also would requireadditional borrowing and getting the banks towaive some covenants on BW/IP's substantial debt.

At Borg-Warner, such a request would have hadto undergo a lengthy bureaucratic process begin-ning with a written proposal analyzing the pumpmaker's past performance and strategic fit, andforecasting its future performance. Onee headquar-ters had reviewed the proposal, corporate stafferswould visit the division and hear a presentation. Ifthey liked what they heard, the proposal would beturned over to Borg-Warner's Corporate PlanningCommittee, which met monthly. The committeewould review the proposal, hear another presenta-tion, and probably ask for further study and analy-sis. At best, it would take the committee severalmonths to come to a decision. Valli and his teamhad run that gauntlet several times, only to be re-buffed or lose opportunities because of delays.

In the environment created by Clayton & Du-bilier, things were different. The firm's financialand strategic analyses were every hit as thorough asBorg-Warner's, but the approval process was farmore streamlined. Thanks to the relationship thathad developed between Dubilier and Valli in theirfirst year of working together, Valligot the firm's approval to make theacquisition in the course of a singletelephone conversation. As it turnedout, nobody had any regrets: Both theLBO and the acquisition were greatsuccesses. By the time BW/IP wentpublic, in 1991, the value of its com-mon stock had grown from $20 mil-lion to $352 million, reflecting a compounded re-turn on equity in excess of 100% per year. Thecompany's revitalized core businesses had im-proved along almost every dimension: higher mar-ket shares, higher operating margins, and betterworking capital management and asset utilization.

BW/IP's team of executives were obviously vitalto the deal's success, because it was they who did

the hard day-to-day work. But management creditsClayton &. Duhilier with keeping the company fo-cused outward on growth rather than inward onits debt burden. As one BW/IP executive puts it,"Dubilier helped us see what was good about us,and he got us to invest in it."

Since its founding in 1976, CD&R has acquired21 businesses with annual sales ranging from $20million to $2 billion. Executives at other portfoliocompanies also report that the firm has given themguidance and support. One CEO says, "CD&R'spartners told me, 'Don't think of it as our company;think of it as yours. And run it as though you weregoing to own it forever."' This approach has pro-duced impressive results: Since the beginning, theeash-on-cash compounded annual rate of return onCD&R's investments has exceeded 100% per year(more than 80% after adjusting for managementfees and CD&R's share of operating cash flow).

Looking at its performance record, one mightimagine either that CD&R has devised a break-through approach to husiness management or thatthe firm has simply been lucky. Neither is the case.To be sure, equity in the hands of management andnew incentive compensation packages can betteralign the interests of owners and managers, but noone attributes the performance of CD&R's compa-nies to incentives alone. Indeed, despite similarpay-for-performance packages in all the portfoliocompanies, approximately 40% of the CEOs at thetime of the buyout have had to be replaced for in-adequate performance. Neither does high leveragealone explain the firm's success. Leverage, of course,amplifies equity returns, but it cuts two ways:Highly leveraged equity claims are quickly wipedout when a company runs into problems. Andmost of CD&R's companies did, in fact, encounterprohlems at one time or another.

LBOs are adaptable to a muehwider universe of businesses

than eommonly assumed.

what explains CD&R's success; We learned theinost about how this LBO firm succeeds by lookingat situations in which something went wrong un-expectedly and had to be corrected. According toone partner, "What's different about us is that wecan fix our mistakes." The manner in which the"fixing" takes place is integrally tied to the firm'sapproach to ownership and governance, which re-

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volves around a few basic principles: direct lines ofcommunication between owners and top manage-ment; considerable managerial autotiomy undernormal circumstances and a willingness by ownersto step in and direct operations to correct chronicproblems; and trust-based relationships amongowtiers, managers, and key creditors. The princi-ples are interdependent. However, although eachone may sound simple, practicing them all at onceis difficult. What enables CD&.R to accomplish thisis its operating capability.

How CD&R's Approach EvolvedThe principles by which CD&R conducts busi-

ness stem in part from the partners' personal beliefsand experiences. But they also have been shapedover the years in response to problems and opportu-nities. The firm undertook its first buyout, of KuxManufacturing Company |a maker of commercialdecals), in large part because "we wanted to be inthe deal business, so we had to do a deal," says part-ner Joe Rice. Before acquiring Kux in 1979, Clayton& Dubilier had specialized in turnarounds, not buy-outs, and all three of its founding partners - GeneClayton, Martin Dubilier, and Bill Welsh - wereskilled in operations. When Rice joined Clayton &Dubilier in 1978, he brought his expertise in fi-nance and law to guide the firm into leveraged man-agement buyouts.

Kux seemed like a good deal: a small, simplebusiness, a clean company, and a good price. But thepartners' relationship with the company's man-agers turned out to be rocky. Although the deal wasprofitable, the partners concluded that they had tofind a better way of monitoring andassisting company executives.

In the next deal, the buyout ofStanley Interiors Corporation (amaker of furniture and fabrics) laterthat year, Dubilier took a more ac-tive role, one he initially thought ofas that of chairman of the boardbut which has since beeome knownwithin the firm as lead representative. At the sametime, Clayton & Dubilier began formalizing as-pects of its relationships with portfolio companiesto clarify roles, responsibilities, and expectations.By the time the firm had completed the buyout ofWGM Safety Corporation (a maker of personal safe-ty equipment) in 1981, the partners had recognizedthe need to intervene in some situations. They firedan underperforming CEO and replaced him notwith an outsider but with one of the partners. Soonthereafter, the firm drew on its growing experience

as an active owner to buy Harris Graphics Corpora-tion, which was triple the size of the firm's threeprevious acquisitions put together.

By 1984, Clayton & Dubilier's track record andthe investment climate were good enough to at-tract investors to a $46 million limited-partnershipfund organized to invest in the equity of the firm'sbuyouts. In the meantime, the firm was also ex-panding its pool of talent. Three new partners ar-rived with mostly financial skills, and a fourth wasan operating manager who had served suecessfullyas chief executive officer of Stanley Interiors. Thenew funds and a balanced team of finance and oper-ations professionals positioned Clayton & Dubilierfor the wave of buyouts that would run through theend of the decade.

Uniroyal, the tire and chemical company, wasthe firm's first buyout of a public company and alsoits first billion-dollar deal. That acquisition, com-pleted in 1985, enhanced Clayton ik Dubilier'sstature and reputation on Wall Street: It was big,relatively complicated, and, some thought, unusu-ally risky. The Uniroyal transaction and the subse-quent buyout of the Uniroyal Goodrich Tire Com-pany, in 1988, were both successful financially. Butthe deals convinced the partners that the firm'sskills and operating style were less suited to acquir-ing entire public companies than to acquiring divi-sions of public companies. As Rice explains, "Witha public deal, you can't negotiate much besidesprice. I make a living negotiating good acquisitiotiagreements. We have a good team with strong capa-bilities-we don't make many mistakes-and there'sa lot I want to talk about besides price. Also, whenyou buy a public company, you buy management-

The balance between operatingand financial partners is crucial

to the way CD&R operates.

all of it-all sitting in the same spots with the samemind-set, the same organizational problems, and soon. In a private deal, there are many possibilities tochange things quickly." The firm has maintainedthat preference ever since.

Uniroyal and Uniroyal Goodrich were milestonesin another respect: They triggered substantialgrowth within Clayton & Dubilier itself. Between1987 and 1992, the firm added nine new partners,nearly tripling its ranks at the partner level. Inkeepitig with the firm's tradition, five of the part-

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ners had experience as CEOs of manufacturingcompanies, and four were financial experts. Thebalance between so-called operating and financialparttiers in both numbers and influence is crucial tothe way CD&R operates. It is further reinforced hythe firm's compensatioti polieies: AU partners par-ticipate fitiancially in every deal, and all partners -

Once CD&R purchasesa business, operating partnersremain active for as long as thefirm owns the company.

financial and operating-at a given level (there areonly two) reeeive the same compensation.

Finaneial partners are the firm's primary linkwith the larger eommunity of deal makers, lend-ers, and investors. They loeate prospective acquisi-tion candidates and process transactions from startto finish: analyzing projections, negotiating pricesand other terms, performing due diligenee, arrang-ing financing, and attending to tax and accountingmatters. They also take the lead in postdeal finan-cial tnatters, including relationships with lenders,restructurings, refinancings, the sale of portfoliocompanies' assets, and the eventual liquidation ofCD&R's interests.

Operating partners, too, play a significant rolefrom a transaction's inception. A prospective candi-date receives serious consideration only after anoperating partner endorses the viability of the en-terprise. To the question, Would you be willing, ifneeessary, to step in and run this business yourself?at least one operating partner must answer affirma-tively before CD&R invests much time or moneyin a deal. Not surprisingly, operating partners alsoplay a large role in the due diligence proeess andin formulating operating objectives and perfor-mance goals.

Once CD&R purchases a business, operatingpartners remain active-as board members, consul-tants, advisers, owners, and sometimes CEOs-foras long as CD&R owns the company. This involve-ment stands in sharp eontrast to more financiallyoriented LBO firms, which generally seek operatingexpertise from outsiders on a fee-for-service basisand often only when a erisis develops.

The active role that Martin Dubilier first playedin the Stanley Interiors buyout became a standardpart of every transaction by the mid-1980s. The

lead representative, usually an operating partner,sits on the board of an acquired company and haschief oversight responsibility for CD&R. The leadrepresentative also determines what the firm eanreasonably expect of the eompany's CEO and man-agement team.

CD&R's organization and its relationships withportfolio companies arc structuredto make the best possible use of thelead representative. In contrast tothe complex hierarchies and elabo-rate approval processes typical oflarge corporations, CD&R empha-sizes the relationships between thesenior managers of portfolio compa-nies and the lead representatives.CD&R's in-house eorporate policymanual carefully describes the firm's

and the lead representative's monitoring and sup-port activities on the one hand, and the CEO's au-thority and obligations on the other. CD&R pro-vides this information to CEOs even before thebuyout is completed.

The board of a portfolio eompany is usuallymade up of CD&R's lead representative, two otherCD&R partners, the eompany's CEO, and threeoutside directors who are selected by the CEO andapproved by CD&R. More so than the other direc-tors, the lead representative serves as the CEO'ssounding board on both day-to-day operations andlong-term decisions. In addition to contributing anunderstanding of what's involved in running a eom-pany, this individual is expeeted to listen, ask ques-tions, react to ideas, and suggest alternative waysto address problems and opportunities.

Although primarily an adviser, tbe lead represen-tative is often actively involved. The Allison En-gine Company, a producer of aircraft and industrialengines, was a division of General Motors beforeCD&R bought it for $340 million in 1993. Allisonexecutives had never had to manage cash andworking capital, because those and other treasuryfunetions had been handled by GM. At the time ofthe buyout, Allison was turning over its inventoryof $400 million less than twiee a year. CD&R's leadrepresentative stepped in to help Allison's man-agers improve their working capital management.Touring a 3-million-square-foot company facility,he examined samples of work in process, deei-phered date codes, and determined that a lot ofinventory had been sitting idle in the shop formonths. With the lead representative's help, Alli-son executives established a process for reducingworking capital. It eventually involved more than100 employees, who were offered cash incentives.

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Within ten months, working capital had been re-duced by $75 million.

Lead representatives generally have discretionfor selecting auditors and insurance agents and forapproving employees' benefits and pension plans.CD&R also assumes primary responsibility formaintaining relationships witb banks and subordi-nated lenders, and it helps obtain additional capitalas needed for strategic investments. The firm willoften assist in selling or restructuring noncore partsof a portfolio company's business. But tbe lead rep-resentative does not otherwise make decisions orgive instructions. Rather, it is up to the CEO togather input from staff and other advisers, weigh al-ternatives, and make decisions.

Core Management PrinciplesWhile CD&R brings a high level of operating ca-

pability to eacb new deal, that capability is en-hanced by the way in which the firm interacts withportfolio companies and managers. The firm's in-volvement is characterized by the principles it hascome to embrace.

Direct Lines of Communication. To improve itsmonitoring of portfolio companies, CD&R retainsthe right to talk to anybody in tbe company, subjectto two constraints: It must inform the CEO, andit cannot tell anyone in the company what to do.Normally, of course, CEOs are expected to keepCD&.R's lead representative abreast of the impor-tant strategic and operating issues as they develop.Communication at this level is direct, fast, andusually informal. One CEO estimates that in thecourse of six years under CD&R's ownership, he re-ceived fewer than 20 pages of memos from the firm.

Within CD&R, communication among partnersis also direct and informal-a reflection of tbe firm'sflat structure and egalitarian culture. In addition tosharing the workload of meetings, negotiations,analyses, and due diligence, the part-ners have an obligation to contrib-ute by communicating. They shareideas, expertise, opinions, and criti-cisms-including criticisms of them-selves, the firm, and one another.CD&R relies heavily on an open ex-change of views as a way to tap tbeexpertise of a very small group (13professionals, 8 of whom are partners). Wheneverwe asked a partner about problems at specific com-panies, tbe response usually began with, "Well, I'lltell you the mistake I made" or "So-and-so [anotberpartner] was wrong about..." Everyone in the firmhas made mistakes, and, in CD&LR'S open culture.

people are accustomed to hearing critiques fromtheir colleagues.

Selective Intervention. CD&iR's operating capa-bility and close contact with portfolio companiesenhance its ability to know when to intervene andhow to be constructive if it does. A case in point isthe Kendall Company (now Kendall International),a maker of disposable medical products that Clay-ton & Dubilier acquired in 1988 for S960 millionand that became the firm's first big acquisition todevelop major problems. Everyone involved in thetransaction now agrees that, among other mistakes,the firm paid too much for the business. More thanone partner attributes part of the problem to hubris.A Kendall executive agrees: "They thought theywere magic." The way the deal was structured,everything had to go right in order to justify the pur-chase price. It was the only CD&.R deal financed inpart with zero coupon bonds - an indication thateven with optimistic cash-flow projections, thecompany would have to stretch to service its debt.

Things began going wrong almost from the start.As Kendall's performance slid, employees becameobsessed with the debt, key salespeople and man-agers departed, and lenders pressed for repayment.Clayton & Dubilier developed plans to restructureoperations and sell assets but pulled back in theface of an unreceptive market. The CEO's jobturned over twice - the second time just before acrucial bondholders' meeting. The firm's operatingpartners convinced their colleagues that Kendall,though weakened, had a valuable core and could beturned around. Dubilier himself stepped in as theinterim chief executive before recruiting an out-sider to lead the recovery.

The firm's financial partners also played a criticalrole: working with banks to arrange a financial re-structuring that would provide time for the oper-ating changes to come to fruition. In mid-1992,Kendall filed for Chapter 11 with a prepackaged

exchange of views to tap theexpertise of a very small group.

bankruptcy. Among the provisions of the complexreorganization was the injection of new equity cap-ital from one of CD&R's funds - an investmentthat was unanimously approved by that fund'sinvestors. To bolster Kendall's position further,CD&R waived its management fees and gave up its

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share of Kendall's operating cash flow from the orig-inal buyout.

Kendall emerged from Chapter 11 within abouta month. For fiscal 1992, sales grew by 5% and oper-ating cash flow increased by nearly 40%. Kendallcovered its annual interest expense 1.7 times, re-paid approximately 15% of the postrestructuringdeht, and had its stock listed on the NASDAQ. In1993^ the company did even better: It was ahle tocover its interest expenses 6 times. Throughout thereorganization, the company's bank loans retainedtheir full value.

As important as it is to knowwhen to get involved, knowing

not to is just as important.

We asked CD&.R's partners how different manag-ing a crisis would have been had they not had thefirm's operating capability to call upon. One part-ner said, "Financial buyers with no operating capa-bility would eventually see the numbers going had.So they'd talk to the CEO and prohahly hear ex-cuses. Then the had results continue, so maybethey'd replace the guy. But then what? How do youknow the new guy is any good? Whom do you get?Maybe an industry guy, maybe a workout guy - itcan go on and on. It's an awful position to he in.That's why some buyers walk."

Despite Kendall's disappointing early perfor-mance and the financial restructuring it necessitat-ed, the experience highlights important aspects ofCD&R's view of ownership and governance. In therescue operation, both operating and financial part-ners played major roles, and the strength of thefirm's commitment to a company was tested andconfirmed. CD&R might well have heen hetter offfinancially had it put Kendall into bankruptcy twoyears earlier, one partner observes. "But we neverseriously considered it. We felt that it was our proh-lem and we were going to fix it." CD&R's partnerstake considerable satisfaction in Kendall's currentstrength and in the fact that the lenders didn't loseany money and the company's operations didn'thave to he gutted to repay the deht.

Deciding when to intervene can he difficult, evenfor someone with extensive operating experience,hecause often the cause of a company's problemscan be determined only over time, through patientinteraction with the chief executive and other man-agers. "You agonize a lot," notes Bard Howe, a

longtime turnaround specialist who has been aCD&R operating partner since 1990. "You try tofigure out what to do. You talk to the managers, setvery specific hurdles, and see what happens. It's anexperiment. Then, hased on what happens, you tryanother experiment. It takes time. You're alwaystrying to strengthen a weak person rather than re-place him."

As important as it is to know when to get in-volved, knowing when not to intervene is just asimportant. Excessive intervention hurts manage-ment's morale and undermines managers' sense of

initiative and willingness to takerisks. The BW/IP deal was one situa-tion in which intervention was nev-er necessary. As Peter Valli, BW/IP'schief executive, describes the rela-tionship, "The partners wouldn'thesitate to push you to do some-thing, but you could push hack. Eachside respected the other's judgment."

CD&R's operating partners are accustomed to suchrelationships. All of them have held senior operat-ing management positions in large corporations. Inaddition, many have had successful careers as man-agement consultants.

One executive who has run a company underboth CD&R and another, financially oriented LBOfirm notes some of the differences hetween the twoapproaches: "The finance-only LBO firms are actu-ally more likely to get in your hair hecause theyworry ahout operations but know they don't under-stand them. Financial LBO firms ask you for muchmore information - data, reports, everything - andthey don't understand any of it. The CD&R operat-ing guys ask for what they need, and you know theyunderstand it. It's easier for a CEO and the CD&Rliaison to trust each other because they're hoth op-erating guys. They can talk."

Trustworthiness. We asked the CEOs of portfoliocompanies to tell us how managing a CD&R com-pany differs from managing a divisitm of a large cor-poration. Second only to the pressures of managingwith lots of debt, the CEOs cited their ability totrust CD&R's partners, They said that with CD&Rthey could discuss problems and opportunities,openly, act more independently, and generally fo-cus on husiness, rather than feeling compelled to"game" the corporate control system or to protectthemselves from it.

CD&R's partners understand the importance oftrust and work hard to foster and maintain it. Trustwas indispensable in the creation of Lexmark Inter-national, a business formed from IBM's printer,typewriter, and keyboard business in 1991. Accord-

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ing to one CD&R partner who was heavily involvedin negotiations with IBM, "Both sides agreed earlyon that they were going to have to trust each other.More than one IBMcr said to me, in effect, We knowyou guys won't embarrass us." The trust that wasestablished in the Lexmark negotiations carriedover into positive relationships between the firmand Lexmark's managers (most of whom were for-mer IBM employees) and between Lexmark and itsemployees and suppliers.

Trust between CD&R and the CEOs sometimesdevelops early through good personal chemistry.More often, it has to be cultivated. As AlbertoCribiore, a financial partner who has helped putmany deals together, observes, "We're typically notin love with these guys [the prospective seniormanagers] prior to the deal, and vice versa." In-stead, trust is built over time in a variety of ways,including the alignment of interests through equityownership and incentive compensation. Setting re-alistic expectations, sorting out responsibilitiesand authority, and then respecting those decisionsare also important. The trust that develops betweena lead representative and a CEO often fans out intoboth organizations, and it gets tested over time.Eventually, a reputation for trustworthiness be-comes sclf-rcinforcing; People who anticipatetrustworthy behavior from their counterparts aremore likely to interact informally and see their ex-peetations confirmed.

Trust also helps managers innovate and takerisks. The pressure of substantial debt ean paralyzemanagers and discourage them from taking addi-tional risks even when it is to the company's advan-tage to do so. To have the confidence to take "good"

1 1 1 1

The trust that develops betweenCD&R S lead representative

S LLOthegets tested over time.

risks, managers must be able to trust that the indi-viduals evaluating their performance can make dis-criminating, informed judgments. CD&R's operat-ing capability helps instill such confidence.

CD&R also stresses trustworthiness in its rela-tionships with LBO lenders. To protect their finan-cial position, lenders require formal contracts withexplicit terms and covenants. But sometimes therestrictions need to be relaxed to permit the port-

folio companies to take advantage of strategic op-portunities or to allow managers to take correctivesteps. Ordinarily, lenders will agree to waivecovenants or to suspend certain payments tem-porarily when doing so is in their best interest.When the lenders are confident that their flexibilitywill not be abused by the equity owners, there isusually less haggling. CD&R's willingness to injectmore equity capital into Kendall and to give up itsown share of the company's operating cash flowrather tban cut its losses exemplifies the kind oftrustworthy behavior that the firm tries to exhibit.

Parties that trust each other can interact on thebasis of informal, implicit agreements. Such agree-ments arc valuable to both sides because they areinexpensive and because they permit rapid andhighly refined adjustments to a changing environ-ment. When people expect frank discussions of allmaterial facts, many of the cumbersome controlsystems typical of large hierarchical organizationscan be dispensed with.

Why LBOs Make SenseDespite the unfavorable public perception of

LBOs, they are alive and well. Judging from the ex-perience of CD&R, that is not an accident: Asa model for ownership and governance, the LBOfirm has considerable advantages. Our look atCD&R also indicates that the American LBO is stillevolving and that, within the universe of LBOfirms, CD&R represents a distinctive variant-onethat might be labeled an operating (as opposed toa predominantly financial) LBO firm. The strengthof CD&R's operating capabilities seems unusual.

However, we can envision smaller,more narrowly focused firms pursu-ing a similar approach by concentrat-

r two related industriestheir partners have exten-

hands-on operating experience.The combination of operating ca-pability, direct lines of communi-cation, a capacity for selective in-tervention, and an emphasis ontrustworthiness greatly expands the

range of businesses that can be successfully ac-quired and managed as LBOs.

The Lexmark deal illustrates how the range of po-tential buyout candidates is expanding to compa-nies that look nothing like the stereotypical LBOcandidate. To begin with, Lexmark's computer-printer business is relatively high-technology, high-growth, and high-risk, and it demands substantialongoing investment. Before Clayton & Dubilier

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purchased it for about $1.6 billioti, it had not beenstructured as a freestanding division, so the firmhad to pull it together from various parts of IBM.Organizing the company required cooperation andexpertise frotn many quarters: operating and finan-cial partners at Clayton &. Dubilier, executives atIBM, suppliers and customers, andmany outside advisers. The deal re-quired some 70 different contracts,mostly hetween Clayton & Dubilierand IBM; it used more equity thantypical buyouts do (with IBM itselfbecoming an equity investor); its se-nior debt came from a small numberof banks that held on to the debtwithout syndicating it; the subordi-nated debt came from a single insti-tutional investor; and two other institutions pur-chased all the preferred stock (thus eliminating anyneed to sell puhlic securities). The Lexmark trans-action is a ringing endorsement of the firm's ap-proach to LBOs hy sophisticated investors.

CD&R completed five more acquisitions total-ing $2 billion from 1993 through February 1995-the firm's most active period since 1987 and 1988,when it closed five deals totaling more than $2 bil-lion. Those five companies are growing rapidly andrequire considerable ongoing investment or havesubstantial operating risks stemming from the needto bring ahout a turnaround. Whereas other LBOfirms normally avoid such companies, CD&R, con-fident in its operating capabilities, seeks them out.

CD&R acquired its neu'est businesses from Xe-rox, General Motors, DuPont, Westinghouse, andPhilip Morris. The husinesses (all of which werevalued at $300 million or more at the time of pur-chase) no longer fit their former parent's strategicinterests, and each had suffered from some formof neglect: overspending, lack of controls, or under-investment. The recent acquisitions were not small-to medium-sized low-tech businesses whose stag-nation or decline was the reason they were goodLBO candidates. Rather, they were parts of main-stream corporate America that had heen subopti-mally governed: businesses with valuable marketpositions and opportunities that required liquidityand access to capital in order to thrive. Today thereis no shortage of such acquisition candidates.

Corporate Governonce and the Questfor Best Practice

The recognition that parts of mainstream cor-porate America are suboptimally governed is hyno means new. Corporate governance has heen

a prominent topic of study and debate since theearly 1990s, vs hen academics and practitionersalike began hypothesizing that good governancecontributes to competitiveness. What followed wasan international effort to formulate, or at least de-scribe, a model of best practice for corporate gover-

Debt and equity are not merelydifferent types of financial

claims. They are alternativeapproaches to governance.

nance. A 1992 report by Great Britain's "CadhuryCommittee" attempted to set forth principles ofbest practice in British corporate governance. In theUnited States, leveraged buyouts, venture capitalfirms, and relational investing (as practiced, for ex-ample, by Warren Buffett) have all been studied aspossible models for best practice. In a similar vein,observers have also touted the organizational ad-vantages of the industrial groups of Japan, Ger-many, and Scandinavia.

Is there a best-practice model for governing busi-ness enterprises that can be applied across theboard? If LBO firms such as CD&R can acquirelarge divisions of mainstream corporations and in-crease value through better governance, then whycan't the corporations do it themselves hy adoptingsimilar operating approaches, avoiding the transac-tion fees, and letting their shareholders keep theprofits the LBO investors would make? Unfortu-nately, it's not that simple. Senior managers are sel-dom able to impose the necessary operating disci-plines on themselves. Nevertheless, they can learnsome valuable lessons from CD&R's experience.

The first lesson may be obvious, but it bears re-peating: How a company is governed matters.There is ample evidence other than CD&R's port-folio to support this assertion, although the firm'sresults bear it out. Among the firm's 15 acquisitionsbefore 1990 (it is too soon to tell about five of the sixmore recent deals), only one company failed to dou-ble its earnings before income and taxes. Thosegains did not come from laying off employees: Headcount rose at some companies and fell at others; onaverage, it rose modestly (less than 4%). Nor didthey "just happen" as the result of new incentivecompensation schemes or managers owning equi-ty; in fact, operating problems usually arose thatrequired active intervention. To put the lesson an-

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other way, governance affects how important deci-sions get made and therefore how efficiently a com-pany's resources, including capital, are utilized. Poorgovernance can be very costly.

Because LBOs tend to be viewed primarily as fi-nancial transactions, their effects on governanceare often overlooked. Finance and governance arecommonly seen as distinct and separate spheres ofactivity. In fact, the two are closely related. AsCrihiore observes, "With equity, [corporate gover-nance] is a matter of constant negotiation. Withdebt, it's a matter of reality - did you hit yourcovenants or not?" His comment underscores thefact that debt and equity are not merely differenttypes of financial claims. They are, in addition, al-ternative approaches to monitoring corporate per-formance and directing management - in otherwords, to governance.

By its very nature, debt constitutes a fairly rigid,rules-based approach to governance. Borrowerscontract with lenders to make regular cash pay-ments of interest and principal, and they agree torestrict the payment of dividends and the sale of as-sets, and to maintain minimum levels of workingcapital. Failure to abide by the rules can lead to fur-ther constraints or, ultimately, seizure and liquida-tion of the company's assets. Although covenantscan be waived and terms renegotiated, such stepsare costly and are not undertaken lightly.

Equity, by its nature, is more flexible and forgiv-ing. Individual shareholders may come and go,stock prices may rise or fall, but equity as a class is"patient." Equity investors can and should inter-vene selectively and administratively to correctperformance shortfalls, rather than relying on fi-nancial triggers to bring other safeguards into playautomatically. In effect, pure debt and pure equityoccupy opposite ends of a continuum of potential

Though ownership by an LBOfirm may be transitory, theimprovements can endure.

governance regimes. The imperatives of debt makefor a rigid but fundamentally simple and low-costregime, while equity's flexihility makes it moreadaptive but inherently more complex and costly.

The ideal form of governance for a business at aparticular stage depends on the nature of the assetsbeing managed, the transaction stream those assetssupport, and the number of attractive growth op-

portunities within the company's reach. In general,a business that has easily redeployable assets(multiuse facilities, conventional rolling stock,low-technology manufacturing equipment, and soforth) and that faces relatively few good growth op-portunities will be better governed by the simple,low-cost, rules-based regime provided by debt. Suchbusinesses do not require much cash, and their as-sets are readily transferable to other managementteams in the event of default. In the early days, LBOfirms sought to acquire companies with just thisprofile: ordinary businesses with stable cash flowsand readily salable assets.

By contrast, businesses with highly attractivegrowth opportunities or a need for functionally spe-cific assets (dedicated to a particular customer orsupplier, locationally fixed, or dependent on specif-ic human capital, for example) will be better gov-erned by a regime dominated by equity. Such busi-nesses typically require substantial managerialdiscretion and administrative flexibility. Not sur-prisingly, husinesses with mixed characteristics arebest suited to hybrids of the pure rules-based anddiscretion-based extremes. Some of the hybridizedadaptations we observe in the real world (Japaneseindustrial groups, for example) are quite sophisti-cated and highly evolved.

Businesses change over time and so, too, shouldthe type of governance they employ. Some changesare discontinuous and driven by phenomena exter-nal to the business; others occur gradually and mayresult from internal factors or from a company- orindustry-specific life cycle. Regardless of what isdriving the change, it is unreasonable to expect oneform of governance to remain optimal in all cir-cumstances. Managers should abandon the idea of asingle dominant model of best practice to which allwell-managed companies should conform. Instead,

well-managed companies will passthrough several forms of ownershipand control - some of them perhapsmore than once. This is a natural anddesirable consequence of continualcorporate renewal.

A leveraged buyout is one form ofgovernance through which a rela-tively wide cross-section of busi-

nesses may pass. CD&R's system of combiningoperating and financial expertise with directcommunication, selective intervention, and an em-phasis on trust helps overcome some of the rigidi-ties of high leverage. For some businesses, a tradi-tional pure-finance LBO might be a mistake, but an"operating" LBO might make sense as an efficientway to accomplish a transition from one phase of

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the business's life cycle and one form of governanceto the next. Though ownership hy an operating LBOfirm may he transitory, the evidence from CD&Rsuggests that a company's improvements in opera-tions can he enduring.

The continuing evolution of the operating LBOcould hring suhstantial henefits to U.S. husinessand to the overall economy. Currently, CD&R hyitself has the capacity to undertake ahout two high-impact transactions per year. In contrast to the1980s, when the firm's prospeets eame from invest-ment bankers who presented the deals to severalfirms, today's opportunities are more along thelines of Lexmark, in which the selling company of-fers the deal to the huyer directly.

CD&R has held its companies an average of fourand a half years. As the pool of potentially attrac-tive LBO candidates expands and the transactionsthemselves hecome more complex, we can expectto see LBO firms holding on to portfolio companieslonger. Nevertheless, CD&R has no plans to he-come a relational investor in the mold of WarrenBuffett's Berkshire Hathaway. To motivate and re-tain the hest deal makers and to keep their skillssharp, the firm must initiate new deals. To remainsmall and foeused and to reward partners, in-vestors, and managers, it needs to divest its hold-ings in companies that are ready for a transition tosome other form of governance. Doing so makesroom for new investments.

One can imagine circumstances in which theahility of CD&R and other LBO firms to put dealstogether could be seriously impaired. So far, how-ever, the firms that stress operations have shownstaying power. CD&R, for its part, has survived thedeath of Duhilier and the retirements of two found-ing partners and several others. Moreover, it hasheen ahle to continue assemhling the necessary fi-nancing despite the disfavor shown to LBOs hymany lenders and financial regulators.

If, as we expect, more firms hegin to adopt ele-ments of CD&R's approach and the operating LBObecomes more prevalent, the impact on U.S. husi-ness will be suhstantial. It will facilitate efficientchanges in the governance of assets worth hillionsof dollars, culled from some of the world's largestcorporations. Most of those companies will seetheir operations improve and investments increasehefore they return to public ownership directlythrough stock offerings or indirectly through salesto other puhlic companies. The firms that facilitatethis process should be ahle to survive the ups anddowns of Wall Street well into the future.

Respectability and RewardsNot so many decades ago, capitalism itself was

held in low esteem hy many as a means of organiz-ing economie activity. Intellectual skepticismahout its merits, hostility toward its mechanisms,and unease with some of its apparent side effects alleontributed to its poor image. Today the image ofcapitalism is mueh improved, but not because to-day's critics are more insightful than yesterday's.Rather, capitalism has proved its usefulness hy suc-ceeding in extended, real-world competition againstalternative systems.

Today's skepticism ahout leveraged huyouts islikely to undergo a similar transformation. LBOsrepresent a young and still evolving organizationalform under the umhrella of capitalism. Like othercomplex forms of ownership and eontrol, includingthe modern public corporation, LBOs may alwayshe imperfect. Even so, they are well suited to cer-tain important tasks. Over time, as they compete inthe real world, LBOs will establish a record of oper-ating successes that should cause the skepticismto give way to qualified respect. In the meantime,suhstantial rewards await the pioneers who perfectthe form and demonstrate its eapabilities. ^

Reprint 95305

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