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Visiting Lecturers



Bruce Rauner D'78
Managing Principal, GTCR Golder Rauner, LLC

Visit Date: November 5, 2002
Class Topic: LBO Perspective—Roll ups

Center for Private Equity and Entrepreneurship: Where are the opportunities right now for MBAs in the private equity industry?

Rauner: Despite the current contraction in the business, I see a bright, long-term future for private equity. That said, there's no denying we are experiencing a major shakeout, declining fund sizes, etc. So far, the shakeout has mostly affected venture funds, but we are going to see it hit the LBO funds too.

As for the fundraising environment, everyone complains bitterly about it, but the reality is that I see a lot of capital out there that's got to be invested. LPs who have never had allocations for private equity are now getting them; there's also renewed interest in European funds—Asian too, but mostly European. Sure, huge LPs like Yale are decreasing their commitments, but I think that's probably appropriate, given how much bigger they are than most LPs anyway. They are aiming for a happy medium in this tough environment and I support that.

Fund performance is going to continue to decline. The reality is that it's been declining for a while. If you exclude the recent three years of unsustainably good venture capital returns (which made the business appear almost ridiculously easy) you'll see the overall decline. So average returns will keep creeping down. Top performers will continue to do extremely well, however. And bottom performers—well, it will be very, very ugly. Some of those funds, both venture and LBO, won't return capital at all.

Center for Private Equity and Entrepreneurship: The performance of the top quartile firms is so much better than the rest. Will the generational change that is inevitable at these top firms alter or perhaps derail their success? Or will they remain the same, and on top? How do firms like Golder, Thoma, Cressey, Rauner institutionalize their success for the long term?

Rauner: That's a very good question, and the answer is complicated. Some leading firms will remain on top and others will lose their footing. The degree to which a firm can extend its success over a long period of time depends on whether they have an internal "star system"—where most of the deals rely on two or three exceptionally talented partners who will eventually retire—or whether they have a superior process of training younger colleagues how to succeed and run a quality firm.

Center for Private Equity and Entrepreneurship: Right now, private equity firms have a lot going on because of the difficult economic environment. Monitoring problems in one fund's portfolio may keep general partners from successfully raising new funds. What's your take on that?

Rauner: I think the negative impact of a weak economy on funds is over-emphasized. Our firm's best funds were I, III and VII—and they corresponded to the '81, '91 and '01 recessions. Recessions can create a pretty decent environment in which to do deals. A firm's strategy can wind up being more effective because target companies are more eager to obtain capital and will accept terms that are more favorable to investors. On the other hand, quality companies generate a lot of interest in lousy market—there are lots of bidders! So that can be rough. In such auctions, middle-market and small-cap companies tend to be easier to bid on. There are fewer bidders for those companies and the companies themselves tend to be less sophisticated sellers. Again, though, a downside emerges: There is a lot less margin for error when you're dealing with smaller companies.

Center for Private Equity and Entrepreneurship: Some of the big firms do stand-alone big buyouts rather than consolidations because of the circumstances you've mentioned. These players have been looking more and more towards Europe for attractive opportunities. Is that a good strategy, in your opinion? Would you ever look in that same direction?

Rauner: No, we are not going to look to Europe or focus on opportunities or CEOs outside the U.S. I tend to be fairly skeptical when American firms assume they can apply their culture, style, personal connections and relationships effectively in a foreign company. There are so many elements of risk in our business already: leverage, taxes, the macro economy, etcetera. When you add the major issues you get in other nations—a different regulatory environment, a different tax environment, currency exchange rates, labor laws, different economic cycles, government policies, a different language—there are suddenly another 20 key variables that can hurt you. Some could help you, but, generally, they hurt you. Also, there is a reason the U.S. economy is the dominant economy and there is a reason other economies tend not to do as well—and now you're going to put a whole bunch of assets in those economies? To me, that doesn't make a whole lot of sense.

Center for Private Equity and Entrepreneurship: I remember being in a seminar in Italy about private equity, and someone asked whether there were any great buyout industry consolidation models in the U.S. that could be transported to an Italian context. Having heard you talk about funeral home consolidation, I suggested it. Immediately, I heard 20 different reasons, given the culture and the regulations in Italy, why there isn't a snowball's chance in hell anyone could consolidate the Italian funeral home industry. So I think I understand what you are saying.

The next question is about advice to LPs. You mentioned Yale pulling back some of their allocations. As limited partners look at this asset class and the role it plays within a larger portfolio (like the Dartmouth endowment or a large pension fund), should they be changing their strategy at all? And how should they be thinking about diversification? Do they need to be diversified within private equity investments as well as between private equity and other kinds of securities? And, if so, does a firm like yours provide them with such diversification?

Rauner: Those are very good questions and I am not sure I am qualified to give particularly good answers because I am not a portfolio strategist. I am a CEO-picker and an acquisition hound and that's what I'm good at. So I will just make a couple general comments that are simply personal observations.

At my firm, we are diversified by industry segment, size of deal and amount of leverage. That's by design. Because I have a lot of personal money in the firm's funds and my partners have a lot of personal money in them, we don't ever want to have a fund that doesn't make money. If we specialized more, investing in only one or two sectors, I bet we could drive higher returns by leveraging our knowledge base and our infrastructure more highly, etcetera. The flip side is that, if the sector or sectors [we've chosen] happen to have macro variables that go south, we could be trashed and wind up with an under-performing fund. As a GP, I have a different agenda than our LPs who are diversified by firm, by fund, by fund size, by stage of company, etcetera. And while it may be in the interest of their portfolio to have us specialize more, it's not right for me in my personal portfolio. Also, we don't have homogeneity in the LP base. For several of our LPs, we are one of their major plays if not their only play in this world. So they're more like me, from a risk-diversification point of view. But we also have some LPs who are huge. Our funds are a drop in their bucket, even if they have $100M invested with us. And they have exposure everywhere, all the time.

I am definitely biased toward some amount of diversification in just about everything—whether it be in our fund or if I were overseeing a pension. However, I also think that the best performers tend to be a little less diversified than the median performers, almost by definition. If you're going to be highly diverse, and you're just moving with general stuff, you're bound to be kind of average. If you're going to be a top performer like Yale was for 15 years plus, most people looking at that portfolio are going to say, "That's not very diverse." A lot people have argued that about Yale's portfolio in the past. So now Yale is are shifting that mix and maybe that's prudent. I don't know. Some diversification, just as a general philosophy, is prudent but I also think it's a mistake for most pensions to get too diversified. They become average, if not worse than average. They lose what is high-quality and special about this particular asset class.

Center for Private Equity and Entrepreneurship: A fair amount is starting to be written in industry publications about valuation reporting issues. Is it your sense that the industry could use some level of standardization in reporting? Would that be an overall net benefit given the amount of capital in the industry? Or will these reporting issues disappear if and when fund performance improves?

Rauner: Having a more standardized process or procedure for reporting valuations would be a positive. But I won't argue that it would be a huge positive, or that's it's a big issue. I just don't think it is. Folks who are highly sensitive to what a private company in their portfolio is valued at in any quarter, or at any half-year or year—if it really matters that much to them, they are investing in the wrong asset class. That is not what is important. What matters is how much cash they send into a fund and how much cash that fund sends them back. Other numbers don't have a whole lot of meaning. I ask LPs who want standardized valuations the question, "Why do you need them?" What's the data being used for? If it's being used to pay bonuses for pension managers—that's a really bad idea. Are they being used to judge the performance of the pension fund? That's pretty dangerous. The only thing that matters in the end is the cash-on-cash. And if LPs are using the data to judge the performance of the fund, what will be their response when the values seem to be down or low? LPs would have to answer those kind of questions before I'd say anything other than they [interim valuations] can be misleading, they are very subjective and they are not anywhere near as important as just the final cash number.

Center for Private Equity and Entrepreneurship: No one thus far has examined whether a fund's interim valuations are good predictors of the outcome of the fund.

Rauner: From my experience, after 22 years in the business, I would have to say they are not. When someone compares the performance of the first years of a fund with the performance of the 11th year of a fund, very often the reaction is "Hello? What's the connection?" In the late 1970s and early 80s when I got into the industry, it was a given that the first three years of a fund would generally yield negative returns. Stan Golder, my firm's founding partner, used to say, "Lemons mature more quickly than pearls." The lousy deals are usually going to blow up in the first few years and good ones take time to mature and then they'll crank and hit it. That used to be how venture was done, and that's still the way we run our business—that's the reason we are a blend between venture and buyout.

In the go-go 1990s, when the stock market was red-hot and there was pretty good leverage, we had some quick winners that made our firm look positively heroic. And because the rising tide was raising all the boats, even lousy deals were still looking OK. And then at some point reality kicked in, and it's a different dynamic now because most funds mature more slowly. So interim values have become very stressful and I think they generally provide misleading evidence about how the fund will ultimately do.

For example, during its first 24 months, our sixth fund looked like it was going to be the best fund we'd ever had—and we've had 10X and 6X funds, so that's saying something. And now it's pretty clear that same fund will be almost certainly our worst performer ever. I think it will still be a top-quartile fund, but I'm angry about it. It will probably be net 10—that's atrocious. We've always had net 25 or net 30. So I'm mad and we've dropped the management fee as a result of it, which shocked the LPs because it'll still be top-quartile and there are a lot guys out there who have negative PAL and they're not giving up management fees. But here's the point: Whoever was making decisions based on those early interim numbers on Fund VI was seriously wrong. In the same vein, the middle years of Fund I and Fund III didn't look particularly good. They were OK, but not great. But they turned out to be phenomenal funds.

Center for Private Equity and Entrepreneurship: Do you have any advice for newly minted Tuck MBAs who want to be successful in the private equity industry? How should they launch their career if they ultimately want to be a private equity fund manager?

Rauner: The answer to that question is the same one for finding success in business or success in life generally, and that is persistence. Persistence, persistence, persistence. If you have that, you can be in this industry. It's going to be huge, it's going to get bigger, and you can do well in it. And the second point, which I preach to all our people, is that success in business is all about a network. Every waking moment you should be thinking about "What's the network?" How does this person, this conversation, this relationship, this friendship, this piece of paper, this letter—how does it fit in the network? Your personal network is your permanent attribute; it defines who you are in business. Your reputation—our firm's reputation is our most important asset. It's easy to destroy, and very difficult to build. When living life, and conducting yourself in business, you need to keep those points in mind because they drive everything else.

That said, it's a difficult time to get into business because there is a contraction and a shakeout going on. There's much, much less hiring than there was in the late '90s, obviously. During the '80s and late '70s, Stan Golder and a handful of other firms were the only private equity firms who would hire MBAs. We would go to campuses and it would be us and maybe one other firm. We've built our whole firm by recruiting MBAs and training them. Now that the industry has obviously become more mature and professional, there's a huge amount of MBA recruiting. And I see that trend generally continuing to grow. I see a lot of opportunity in the industry going forward.

I would advise MBAs to focus on firms that have either a quality system or a star system, get in there and learn from them; learning the best practices is obviously the goal, and it's not easily achieved. Focusing on firms that are raising a fund or that you hear are raising a fund, and cold-calling them can result in success. They probably will be hiring and sometimes they don't even know it. Or they know they are hiring but they don't think they'll start for six or 12 months. But get in there and hustle! Hustle is the key to success in our business, and firms respond to hustle and creativity and networking since that is what drives business. Doing that impresses GPs and then there's at least a chance a person will get hired.

I know that Jackie Morbier of TA used to tell her story—and I love to tell it since it's something I didn't do—I just had blind luck, I just got a letter from Stan Golder, so didn't even interview or get recruited or anything. But Jackie wanted to work at TA, and they were trying to say no and brushing her off, and she said, "Well let me just use a phone and don't pay me. I'll just be here, and you watch." And it worked. TA's model is a little more conducive to that than some buyout models, because you basically eat what you kill—that is, you just dial for deals, cold-calling companies. So it's a little easier. But our firm is not too different. If you can cold-call CEOs and convince them to meet with us, that creates a lot of value and we'll hire you. I'm not recommending people run around and work for free, but if you want to be in the business, it's going to take some creativity and flexibility to get hired right now.

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