Can private equity beat the market again? Mega-shop TPG makes a $48 billion bet that the answer is yes
It's a late August morning in Jim Coulter's office on the 33rd floor of one of San Francisco's tallest buildings, and the view has cleared. With the fog burned off the Bay, the Golden Gate Bridge is glittering in the sunshine. It's a glorious San Francisco moment, but Coulter doesn't seem to notice. Instead he's at a whiteboard, diagramming the private equity business in green marker.
"It's a three-box model," Coulter says, drawing boxes and filling them in with abbreviations—"SP" for "stockpickers," "DG" for "deal guys," and "PM" for "portfolio managers."
Coulter, 51, along with David Bonderman, 68, is co-founder of the 19-year-old private equity firm TPG Capital, which has engineered many of the largest and most visible deals the industry has seen, including the 1997 purchase of J. Crew for $475 million and the 2006 initial public offering, which valued the company at $1.1 billion; the $43.2 billion acquisition of Texas utility TXU, renamed Energy Future Holdings; and the $27 billion takeover of casino company Harrah's, now known as Caesars Entertainment. TPG, with 278 employees in 14 offices, controls $48 billion of investments, putting it at the top of the private equity world, along with Blackstone (BX), Carlyle, and KKR (KKR). Such success has put Coulter at No. 221 on Forbes' list of the wealthiest Americans, with an estimated net worth of $1.8 billion. (He is tied with Bonderman, also at $1.8 billion.)
Each player in the buyout industry uses its own blend of Coulter's three boxes. TPG, Coulter says, emphasizes portfolio management and deals. Portfolio management isn't about stocks. Rather, it's a focus on improving the performance of acquired companies, often in the tiniest ways. Coulter argues that it's TPG's operations team—60 fixers who go into companies and search for efficiencies—that sets the firm apart, not the stockpickers or deal guys, who put the purchases together. "There is some secret sauce to what we do," he says.
"Private equity," strictly speaking, describes a business that deploys capital outside of the public markets, but the "private" is often emphasized in its secondary meaning as well. It's traditionally among the most secretive of businesses, partly because a deal is like a poker hand, best deployed by surprise, and partly because the fees, and some of the industry methods, such as paying out enormous dividends from overleveraged acquisitions, work better when no one is watching.
That has changed, to some extent, as private equity firms have gone public. Both Blackstone and KKR are now publicly traded, and Carlyle is said to be mulling an offering in 2011. TPG has held out, and Coulter says there are no plans to take the firm public.
It's unusual for TPG to invite a reporter into the firm, but these are unusual times for TPG, and for private equity. Returns, in aggregate, are beginning to look a lot like those of the market, which threatens the rationale for the industry and its eye-popping fees—usually 20 percent of any profit it creates for investors, along with a 2 percent management fee, win or lose.
In general, an investor in private equity commits money to a fund for 10 years. Thus, most judge a fund's performance after it's had five or so years to make investments, grouping them by "vintages," the year a fund started investing. According to PitchBook, a private equity deal database, the average return for funds raised in 2001 was 22 percent, while funds from 2005 were averaging 4 percent. TPG's funds, in that time, returned similar results. And it's still lugging around boom-era baggage, including Energy Future and the memory of losing $1.3 billion in a minority investment in Washington Mutual.
The profile of its deals and the wider notoriety of the industry in the public and political spheres mean TPG can't operate in the shadows anymore, unless it wants its critics to be the only ones talking. "We're more in the public eye," says Coulter, who argues that some of the anger at private equity, from anti-Wall Street politicians, labor leaders, and disappointed investors, comes from a misunderstanding of what the firms—and his in particular—actually do. "It's time for us to enter the narrative," he says.
Still, some habits aren't easily broken. As Coulter fills his whiteboard with explanations, he's also playing the poker game. A few days later he'll fly to New York City for a dinner meeting with J. Crew Chief Executive Officer Mickey Drexler, setting in motion an offer to purchase J. Crew—again. This time, for $3 billion.
Like the rest of the industry, TPG is still coping with a buyout boom that was powered by cheap credit—and destroyed by its sudden disappearance. The boom crested in 2006 and 2007, when 9 of the 10 biggest deals in history were announced. Among them was the acquisition of TXU and the purchase of Harrah's, both TPG projects.
Private equity firms are under scrutiny not just from the public but from their investors, who have poured record amounts into buyout funds. Those institutional players, still tender from the financial crisis, are demanding more information from firms they already invest in as well as those looking for fresh commitments. They're also questioning how much they'll pay for the privilege of investing, according to observers such as Colin Blaydon, director of the Center for Private Equity and Entrepreneurship at Dartmouth College's Tuck School of Business. "Every investment that's being done now, the fee issues are right upfront," he says. "This is a big conversation that's going on everywhere."
Private equity's performance vs. the public markets has been compelling, especially from 1998 to 2005, says Steven Kaplan, a professor at the University of Chicago Booth School of Business, who has done extensive research on private equity returns. "This was a period when firms like TPG had begun to invest in operational capabilities," Kaplan says. "They did better than the public markets over that time, and that's why so much money came in." The problem, he says, is that as the industry grows and competition for each deal increases, "the excess returns get competed away."
Right now firms such as TPG are ready to prove their merit. Private equity firms collectively emerged from the crisis with more than half a trillion dollars in commitments they needed to spend, according to PitchBook. TPG has $17 billion. The open question is whether or not they can spend that money wisely—or at least more wisely than the market overall—when adjusted for their fees.
The deals getting done now are different from those in the boom, and Coulter believes that benefits TPG. "We've seen something of a fundamental change," says Dartmouth's Blaydon. "There are three ways to make money in a leveraged buyout—the capital structure, buying low and selling high, and actually improving the cash flows of the company. The last is the only one that investors think can actually deliver the returns in the future, given everything we've gone through."
Investors "are much more interested today in how you're going to deliver that value you're promising," Coulter says. "They say, 'Give me examples.'"
As for the investors, "We measure success by [earnings before interest, taxes, depreciation, and amortization] growth as opposed to balance-sheet restructuring," says Alan Van Noord, chief investment officer of Pennsylvania's Public School Employees Retirement System. "Managers understand that they have to be more operational in nature and that financial engineering only goes so far."
TPG is hardly the only firm responding to criticism by showcasing its operations skills. Clayton, Dubilier & Rice, a competitor, has former General Electric (GE) Chief Executive Jack Welch, who works with the firm as a special partner. Part of his job is to keep CEOs motivated. The firm also has former Procter & Gamble (PG) CEO A.G. Lafley and Gap (GPS) chief Paul Pressler, a retail expert. KKR has an internal operations group called Capstone that has doubled its head count since 2007, to 60.
Greg Brenneman, now chairman of private equity firm CCMP Capital Advisors, ran TPG companies that included Continental and Burger King. Brenneman, who stays in touch with TPG's Bonderman—at minimum, they have a standing yearly breakfast in Colorado—says the financial engineering days are over, giving an advantage to fixers such as his firm and TPG. "It really is how you're going to make money in the next five years in private equity," Brenneman says. "The operators are back on top again."
In early September, just weeks after the still-secret J. Crew meeting with Drexler, Coulter is in New York and swings by a small conference room with a view of Central Park where Richard "Dick" Boyce has set up for the week. A former Pepsi vice-president for strategic planning, Boyce has run TPG's operations group out of San Francisco for 14 years.
"I'm definitely a process maven," says Boyce, patting a stack of spreadsheets as though it were a favorite pet. Charts, he says, are his mother tongue. At one point, grasping for a way to explain his duties, he concedes, "I tend to think in slides." He'll often grab a piece of paper and sketch out a timeline or interlocking circles to illustrate a point.
Coulter, too, with an engineering degree from Dartmouth, is a self- described nuts-and-bolts guy. Like Boyce, he thinks and speaks in bullet points. You get the feeling that he likes taking things apart just to put them back together. If you had to put the founders in their own boxes, Coulter might be the portfolio manager, while Bonderman, who will hop on his private plane at a moment's notice to have lunch with a CEO, is more of a deal guy. (Bonderman, a constant world traveler, flies his used Falcon 900 in excess of half a million miles in most years.)
These days, 60 people work for Boyce in operations, up from just one when TPG bought J. Crew back in 1997. "Before, it was some guys with some good ideas," says Boyce. "It's a business now." His employees include specialists such as Deb Conklin, a senior adviser in San Francisco for the operations group who spends months embedded in TPG-acquired companies, figuring out everything from the optimal place to store parts on an assembly line to how a casino buffet should be arranged to maximize profit. Coulter—like the rest of TPG—calls Boyce's department the "ops" group and says that from the beginning he'd hoped it would be a crucial part of the business.
Coulter and Bonderman met during the late 1980s, working in the office of Robert Bass in Fort Worth, alongside such managers as future Colony Capital Chairman Thomas J. Barrack Jr., Lone Star Fund's John Grayken, and future TPG partner Kelvin Davis. Lawyer Bonderman linked up with former investment banker Coulter, then in his late twenties.
The two spun out of Bass, joining GE Capital's Bill Price, to pursue a purchase of Continental Airlines in 1993, pooling their own money along with cash from other private investors in a deal that would launch what was then called Texas Pacific Group, in a nod to their having had offices in Fort Worth and San Francisco. The Continental deal was a coup: TPG made more than 10 times its initial $60 million investment in about five years, mostly through operational improvements in customer service. Food and baggage handling were a focus. Coulter, flying coach with Bonderman one day, found the meal so bad that he FedExed it to headquarters.
Bonderman says the Continental deal gave birth to the idea of an operations-centered investment firm. "That put us on the map in the first place," he says. "In the popular psyche, there's a lot of respect for Henry Ford being an industrialist but not for those considered financial engineers. There's an undercurrent of that, and it's important for us to make it clear that we actually add value."
Emboldened by Continental, Coulter and Bonderman began to think about how to build a firm. "It was very important that we build for the long haul," says Coulter. He and Bonderman were convinced that the messiness of deals such as Continental was part of the opportunity and decided they wanted to institutionalize operations. Coulter, then 32, spun his Rolodex and got in touch with Boyce, whom he'd first met as a Stanford Business School summer associate at Bain & Co., where Boyce worked.
Through deals such as Continental's, TPG posted some of the best numbers in the industry during the 1990s and into the last decade. Its 1994 fund had an average annual return of 36.3 percent, according to data provided by the Oregon Investment Council, which manages that state's employees' pensions.
TPG's 2000 fund had an average annual return of 24.6 percent and returned 2.5 times investors' money, according to the California Public Employees' Retirement System. The average fund of that vintage in the CalPERS portfolio had a return of 7.9 percent and 1.4 times invested capital. More recent comparisons for TPG haven't been as strong. The firm's fourth fund, vintage 2003, is valued at 13.2 percent, about half the CalPERS average of 23.4 percent that year. TPG's ability to get back to those historic highs will come down to its ability to fix what it already owns and to improve the fortunes of its next purchases.
To better the odds of an operational victory, Boyce and his team work in tandem with the deal partners on due diligence, rather than just parachuting in once the paperwork is signed. "On the front end, we help the deal team lean forward and see things that are heavily discounted by another buyer," he says.
Boyce keeps a chart of the skills of each partner in ops. It lists that partner's strengths, reminding Boyce who's a procurement guru, who knows how to tweak a supply chain, and who's an expert on "lean" manufacturing, the art of producing the most with the least effort. Both Coulter and Boyce stress that operations can only be successful if the ops guys are equal to the deal guys in stature—and pay. So at TPG, ops partners are full partners in all profits rather than deal-by-deal hires.
Every company TPG acquires is color-coded red, green, or yellow. Most start out red and stay that way for a minimum of a year. If all goes well and J. Crew's shareholders approve the takeover, Boyce will have the retailer in one of those categories by summer.
Coulter already serves on J. Crew's board, and while it's far from a company in need of a turnaround—net income more than doubled in 2010—J. Crew may benefit from TPG's approach, especially in expanding into markets such as China. Coulter and Boyce can't speak about J. Crew in detail yet, as the deal has not closed, but a person familiar with its plans suggests that TPG is taking J. Crew private—just five years after taking it public—to spend heavily on international expansion and to build new brands such as Madewell. A publicly traded company can be averse to sudden large expansions, which can destroy reported earnings. Privately owned companies face less quarterly pressure.
"We used to come in and do cost work. And if you did that, you had a pretty good exit," says Boyce, an "exit" being the industry term for selling out of a position. "One evolution is that we know we have to be more holistic. If you believe in a challenging economy, you realize you can't cost-reduce your way to glory."
Boyce embodies a type of partner Coulter likes to find and hire—someone who has worked as a consultant and inside a company, actually doing the work the consultants prescribe. That makes an ops guy coming in from a new owner more of a kindred spirit and less of a Wall Street shark. Coulter has a bias toward what he calls "academy companies" such as GE and Pepsi (PEP), where Boyce and others learned how corporations work.
As for Boyce, he staffs his ops team with people such as Deb Conklin, an industrial engineer who ran a division at Stanley Works (SWK). At Houston's Valerus Compression Services, which makes equipment for the natural gas industry, Conklin tromps around the company's facility near Bay City, Tex., in steel-toed work boots and a hard hat, one of the many get-ups she has worn as part of the field operations unit. She walks through the plant shaking hands like a politician, noting how one operational tweak was inspired by the way weights are stacked in a gym.
During four years at TPG, Conklin, 40, has also been a casino hostess and housekeeper at Caesars while serving as the gaming company's vice-president for continuous improvement. She currently spends most weeks in San Diego at LPL Financial, a brokerage firm TPG also owns. "People like me are bored doing the same thing every day," she says.
While Apollo and TPG were renovating Caesars's capital structure—cutting the debt by about $5 billion through a series of exchanges and balance-sheet restructurings—Conklin was embedded in the company. She spent more than a year at Caesars, visiting almost every property, looking for ways to apply her specialty, lean manufacturing methods, to a service business. To that end, Conklin tracked the movements of a short-order cook, creating a "spaghetti chart" illustrating every movement during an eight-hour shift; in that time the cook traveled more than three miles. TPG analyzed the data and then interviewed the cook, tools in hand. To make his route shorter, they moved the hinge of a refrigerator so he wouldn't have to walk around to open it and moved the spice rack so he wouldn't have to take a step to get to it.
In the end, TPG had the housekeepers change their routine in seemingly minor but ultimately productive ways, devising a method for making a bed so each corner need be lifted only once for all four sheets