|
SuperReturn 2006
European Private Equity & Venture Capital Summit
February 21, 2006
Henry R. Kravis, Co-Founding Member, Kohlberg
Kravis Roberts & Co.
Good morning. Thank you, Derek, for that kind introduction.
It’s a pleasure to see so many friends, investors,
and business associates at this year’s conference.
The tremendous growth of private equity and venture
capital in Europe, the U.S., and around the world is
largely the result of the hard work of the people in
this room today. When I began in this business in the
late 1960s, a small conference room in an office would
have been more than adequate for an industry gathering.
The SuperReturn organizers asked me to speak about
“value creation in the large buyout space.”
There have, of course, been many significant changes
in the market for complex, global businesses over the
years, and I thought the most efficient way to approach
the topic is to focus my remarks on three areas: changes
in the way KKR does business, the reasons we made them,
and the impact of these changes on value creation.
KKR’s transformation to the firm it is today
began in the late 1990s. This was a time when my partner
George Roberts and I were frankly dissatisfied with
the performance of the firm. We were making too many
mistakes. KKR had been a pioneer in the private equity
industry, but continued industry leadership in an increasingly
competitive and complex business environment, we believed,
required a fundamental rethinking of our methods. Unlike
the early days of management buyouts, the capital we
all have had become a commodity, and anyone could run
an LBO model. To deliver the returns our investors demanded,
we had to bring more than cash to the table when discussing
acquisition opportunities with CEOs. When we went to
see a CEO and opened our briefcase and there were only
dollars or Euros in it, the CEO would say, “You
are no different than the last five firms with whom
I have met.” If we were to differentiate ourselves,
we had to understand his industry and his company as
well as he or she did. We had to understand the economic
drivers, the metrics, the risks inherent in the business,
and the opportunities to create additional value.
After serious discussion and self-assessment, we arrived
at some basic conclusions about taking our business
to a higher level. Perhaps the most important result
of our deliberations was the realization that we needed
to deepen our expertise in specific industries. The
days of financial engineering were over, and we had
to start thinking and acting more like “industrialists.”
Selecting quality opportunities and paying reasonable
prices remained an important part of our work, but the
focus of our firm had to move from buying a company
to making an acquired company more valuable. Our job
had to begin the day we bought the company. “Any
fool can buy a company, just pay enough.” The
hard and important part of our job was what we did with
the company to create shareholder value once we acquired
it.
Our new emphasis on industry specialization and operational
improvements in our portfolio companies went into effect
in 2000 and had far-reaching implications for KKR and
its investors. Among the institutional changes we made
were organizing our investment professionals into industry
teams and charging those professionals with becoming
experts in their fields. To be credible with CEOs and
other industry players, our executives had to develop
a deep understanding of the various industries. Today
we have nine industry groups in the US and seven industry
groups in Europe, all headed by a partner and staffed
with three to five other executives from KKR.
George Roberts and I insisted that our investment professionals
from each industry group spend time with purchasing
managers, marketing people, sales personnel and manufacturing
managers – among others – all the way up
to the various CEOs. We wanted everyone at KKR to speak
with customers and suppliers and to attend trade shows.
I’m not talking about going to Wall Street investor
conferences, but walking the floors of industry trade
shows. We wanted our investment teams to learn why some
company booths drew more people than others, and which
new product had the potential of making an existing
one obsolete and put a competitor at a complete disadvantage.
In other words, we feel it is very important to focus
on the detailed operations of an industry rather than
merely the financial engineering.
KKR’s efforts to improve operations in its portfolio
companies have changed the firm’s hiring practices.
Many of our people – who I think are among the
very best in the industry – have a broad range
of strategic, consulting, operating, and finance backgrounds
and come from operating corporations rather than Wall
Street. Over the past five years, all of our senior
hires – with one exception – have been executives
with extensive industry experience. People like Michael
Calbert, the former CFO of Randall’s Food Markets;
Ken Freeman, former CEO of Quest Diagnostics; Clive
Hollick, the former CEO of United Media in the UK; Deryck
Maughan, former CEO of Salomon Brothers and CEO of Citibank
International; Michael Marks, the former CEO of Flextronics,
a top provider of electronics manufacturing services;
John Saer, the former CFO of KSL Recreation Corporation;
and Reinhard Gorenflos, the former CFO of ARAL, the
leading gas station operator in Central Europe. All
of the people I’ve named work full time for KKR,
and they have made a big difference in how we think
about our business and businesses we acquire.
KKR’s global resources also include our senior
advisers, who have held top positions in major U.S.
and European corporations. Our senior advisers serve
on the boards of portfolio companies, sometimes acting
as chairman, evaluate individual investment opportunities,
and help us focus on operations once we have made the
investment. They include Ed Artzt, the former chairman
and CEO of Procter and Gamble; George Fisher, former
chairman and CEO of Eastman Kodak and Motorola; Paul
Hazen, former chairman and CEO of Wells Fargo; Joe Forehand,
current chairman and former CEO of Accenture; and Roger
Carr, former CEO at Williams plc in London.
Today, if you talk to a KKR professional for any length
of time, you will likely hear the firm’s mantra:
“to be successful, the real work in a private
equity transaction begins on the first day of owning
a company. Buying a company is easy. Just pay enough
and you will own a company.” The hard part is
making changes in the way a company operates so as to
increase shareholder value. In the late 1990s, we made
mistakes by not immediately getting the management of
a newly acquired company to agree to certain first steps
for change. We thought management had gone down the
road and turned right, but in fact they had turned left.
We had to find them and bring them back to where we
thought they were going. This is time consuming and
set us back by six months or more.
To make sure we corrected this mistake, we began implementing
a “100-day plan” that is agreed upon by
management and ourselves. This way we ring-fence the
management and have an agreed upon plan to immediately
improve the operations of the company. This plan is
a detailed agreement on the steps necessary to achieve
strategic and operational goals – for example,
what are you going to do to improve margins and productivity?
How can we shorten the supply chain? It is a very detailed,
line-by-line, person-by-person review and strategy.
In many ways, it looks like a 100-day plan that, say,
GE would implement once they buy a company. A 100-day
plan assigns specific responsibilities to managers,
KKR professionals, and our own in-house consultants
and is an effective means of holding management accountable
for results. This one improvement in the way we operate
is probably the most important change we have made.
In addition to the daily or weekly KKR interaction
with management, KKR actively monitors its investments
at the board level, and we rigorously review the performance
of companies before our portfolio committee. When necessary,
we put people in the company who work with management
to improve certain operations. A key KKR resource for
strengthening operations is our in-house consulting
business, called Capstone. We didn’t have a comparable
resource for most of the 1990s, and, consequently, we
had been missing opportunities to improve businesses.
With a team of 18 consultants based in New York, Menlo
Park, and London, Capstone focuses on operational issues
that have an immediate impact on the bottom line in
such areas as manufacturing, product sourcing, and sales
and marketing. We don’t require our companies
to use Capstone, but we find that most managements eagerly
embrace its operational expertise and bottom-line focus.
In fact, our biggest problem is getting the Capstone
personnel back from the company where they are working,
because managements want to keep them engaged since
they are truly value added.
One of Capstone’s most valuable contributions
is helping our portfolio companies develop actionable
metrics to monitor performance. I have been very surprised
how few companies have truly good metrics in place.
Financial statements, as valuable as they are, give
you a rearview look at performance. Appropriate metrics
in manufacturing, sales, distribution, purchasing, and
other areas help you look at a business going forward.
They identify opportunities to improve operations and
measure progress toward goals.
Our input, including metrics, 100-day plans, and active
monitoring create a productive sense of urgency in our
portfolio companies from the first day of our ownership.
These changes have been very instrumental in the strong
improvements in our portfolio of companies.
When we looked at our business in the late 1990s, we
also recognized that the world was shrinking and that
we needed to have a global footprint. Many of the companies
we buy are multinationals that require diligence and
operational efforts across different markets. In addition
to our offices in New York and Menlo Park, we have opened
offices in London and Paris and we have recently established
a presence in Asia, with new offices in Hong Kong and
Tokyo.
Our global perspective not only helps us make better
investment decisions around the world, but also strengthens
our ability to improve our portfolio companies –
wherever they may be. For example, we can help our U.S.
and European companies globally source key parts, shorten
supply chains, and enter new markets due to our Asian
presence. For our European multinationals, KKR’s
presence in the U.S. can assist in such areas as finding
management talent and addressing operating, accounting,
legal, and regulatory issues.
You may have noticed that I haven’t said anything
this morning about financing large buyouts. Part of
the reason is that, as I mentioned earlier, capital
is commodity and, unlike previous decades, leverage
alone will not drive returns. Nonetheless, I believe
that the right capital structure for a transaction is
as important as ever. We are very careful to avoid burdening
our companies with excessive levels of debt. When we
set the capital structure, the right level of debt enables
a company to invest for growth and to weather economic
downturns. If we don’t believe that we can truly
improve the operations of a company after we were to
purchase it, and the only way to have a reasonable IRR
is to leverage it beyond what we consider prudent (because
financing sources will provide the debt), we won’t
make the acquisition. Conversely, we have avoided over-leveraging
or re-leveraging a company once we have acquired it
just to pull our equity out to show a high IRR. We feel
that unless there has been a major improvement in either
the earnings of the company or the levels of debt, we
should leave the capital structure where we originally
set it. We believe in a balanced return of IRR and dollars/Euros
up and dollars/Euros back. In other words, we are looking
for a large multiple of cash, not just IRRs.
I’d like to devote the rest of my time this morning
to discuss briefly two examples of KKR’s operational
approach to improving businesses and creating value.
The first example is ATU, a German company that sells
car parts and operates service centers. The second is
Sealy, the largest U.S. bedding manufacturer. ATU and
Sealy were both purchased in 2004, and both businesses
are very much works in progress. Nevertheless, we think
we have already made substantial headway in improving
them.
* * *
I’ll start with ATU, which operates 536 stores.
The automotive aftermarket in Germany, which was €27.2
billion in 2005, is an appealing industry. Auto replacement
parts and maintenance items tend to be non-discretionary,
and demand for them is fairly stable, regardless of
the economic environment.
Based on our earlier ownership of AutoZone, a chain
of auto parts stores in the United States, we felt confident
about our ability to create value in a retail auto parts
company in Germany. AutoZone’s former chief operating
officer Tim Vargo worked with us during the due diligence
for ATU and after the deal closed, visiting many of
the company’s stores and providing expert advice
in such areas as purchasing, inventory management, and
marketing. Tim, by the way, is another example of the
network of resources and advisers that we make available
to our portfolio companies. We teamed Tim up with one
of our Capstone consultants, who complemented Tim’s
20-year industry expertise with Capstone’s analytical
tools and change management skills.
One of the ways we helped strengthen ATU was by working
with the company to improve inventory management. When
we purchased the company, ATU had too many suppliers
– more than 800. By reducing the number of suppliers,
but purchasing more units from each of them, the company
was able to get volume discounts and improve margins.
We improved the supply chain optimization by setting
up professional category management and automated forecasts
to replenish inventories.
A related inventory-management opportunity was streamlining
the product portfolio of 15,000 parts available at each
store and another 45,000 deliverable within 24 hours.
We are helping ATU run the diagnostics to determine
the Stock Keeping Units that should be part of the core
product portfolio and reduce the number of unprofitable
products in stores and in central warehouses. We expect
to reduce inventory by 10 to 20 percent depending on
product category.
We have standardized ATU’s store base to drive
like-for-like sales through centralized sales space
allocation and optimization. We have also begun to increase
workshop utilization from 55 percent to 65 percent by
improving work practices (i.e., flexible working hours
to optimize peak and off-peak staffing). We introduced
a dedicated workshop consultant in every branch to improve
up-selling and cross-selling. ATU has also successfully
built a number of peripheral businesses. These are growing
rapidly. They include AEM Autoglass that sells replacement
windshields, ATU’s fleet business, and ATU’s
smart repair business. We have also driven a store roll-out
program for additional sales.
As sales have grown, the EBITDA margin has grown from
11.2 percent to 13.8 percent currently, and it is expected
to grow further in the next 12 to 24 months. All of
this is the result of productivity improvements, better
inventory mix, and cost containment.
* * *
Now I’d like to mention some of the operational
improvements we have been making at Sealy, the world’s
largest manufacturer of mattresses and other bedding
products. Even though Sealy had been through several
private equity buyouts prior to our purchase of the
company, we found that we were able to work with the
existing management to make major operational improvements
with the help of Capstone (our in-house consulting group),
all of which have led to major improvements in revenues,
earnings, and margins.
One of our major operational achievements at Sealy
has been helping the company develop business metrics
that are consistent and actionable. For example, the
absence of consistent data and standards across Sealy
manufacturing plants made it difficult to distinguish
between efficient and inefficient facilities. Without
comparable, objective measures, every plant thought
that it was the best one. The KKR and Capstone teams
helped Sealy management develop manufacturing metrics
that monitored costs and waste in each step of the production
process and at each plant. Today Sealy’s CEO posts
the comparative results and productivity rankings at
each facility, which has led to healthy competition
among the plants.
Better manufacturing metrics identified actionable
problem areas and helped drive reductions both in labor
hours per bedding unit and in the amount of unused scrap
material. For example, by focusing on these areas, labor
hours per unit decreased 19 percent and scrap per unit
fell 44 percent. At the same time, safety incidents
in Sealy plants decreased 22 percent.
Our main components of value creation have come from
new product development, productivity improvements,
continued cost reductions and strong cash flow generation.
We expect that over time, the company’s top line
growth will be driven evenly by growth in unit volume
and average unit selling price. For example, we have
pushed management to roll out new product at increased
average prices.
These actions and many others have led to very strong
results. Like the ATU transaction, our Sealy investment
is progressing well. Over the past 20 months, Sealy’s
revenues have increased 21 percent, EBITDA has risen
42 percent, and margins have improved by 241 basis points.
At the same time, the company has paid down substantial
debt from improved cash flow.
* * *
I’d like to conclude my remarks with an observation
about private equity that is often overlooked in discussions
of our industry. KKR’s approach to investing,
and the various approaches of many private equity firms,
leads not only to value creation but also to economic
and social benefits – for example, increases in
employment, innovation, and research and development
in the various portfolio companies. We at KKR are very
strong believers in looking out for all stakeholders,
which include employees, customers, suppliers, shareholders,
and the community. Along these lines, it is imperative
that companies reinvest in the business for growth.
Otherwise the business will eventually stagnate, and
there will be value destruction rather than value creation.
It takes all stakeholders to truly create a world-class
company, and that is why we believe that we must pay
attention to each stakeholder and invest in them accordingly.
We believe in employee training to prepare each employee
for better and more demanding jobs. And we strongly
believe in giving back to the community to make it healthier
and vibrant.
In 2005 an independent survey sponsored by the European
Private Equity and Venture Capital Association found
that European companies financed by buyouts created
420,000 new jobs between 2000 and 2004. Employment in
both venture capital and buyout financed companies grew
by an average of 5.4 percent annually during this period,
which is 8x the annual growth rate of total employment
in the EU. And buyout financed companies employ close
to 5 million people, so the sample is quite significant.
For a longer period, 1997-2004, employment in this
same category of companies grew by an average rate of
2.4 percent annually which is nearly 4x the annual growth
rate of total employment in the EU 25 member states.
The study, conducted by researchers at the Munich Technical
University, found that two-thirds of the buyout financed
companies surveyed either kept a stable headcount or
increased the number of employees during the last five
years.
It is true that some private equity investments require
painful restructuring, particularly in industries with
too much capacity, particularly in the first year after
a buyout. But what critics of private equity fail to
acknowledge is that without restructuring many companies
would be in greater financial jeopardy, threatening
even more workers’ jobs. Often times it is important
to build a strong foundation for future growth, which
may mean some initial pruning of the workforce or relocation/consolidation
of facilities. The outcry from unions in Germany, in
particular, reminds me of what we faced in the US in
the 1980s. At that time we commissioned a similar independent
survey of our own companies and found that, in fact,
we created many net new jobs, particularly in the 2nd
through 5th year of our ownership. With this survey,
and with our 30+ years of private equity experience
owning over 130 companies, I believe that many of the
concerns about employment and the stakeholders are unfounded.
In fact, all of us in this room who are sponsors do
create numerous jobs and much stronger companies positioned
to grow. We should be very proud of this. Being an active
and concerned shareholder of our companies inures to
the benefit of all stakeholders in the long term.
I think all of us here today have a role to play in
communicating the economic and social value of what
our industry provides. Although we are private organizations,
better public understanding of how we create value for
all stakeholders is in our enlightened self-interest.
I am confident that a deeper, more nuanced understanding
of private equity investing in Europe and around the
world will help lead to new opportunities for all of
us, and much stronger and vibrant companies with long-term
increased employment, which will create real value for
the home countries.
Thank you.
|
