Education Of A Dealmaker: "I Got Cocky"

Clayton's chairman recounts what went wrong five years agoand how the firm is engineering a comeback

By Emily Thornton

Clayton's deft handling of the HD Supply deal reflects some important lessons learned from the firm's darkest times earlier in the decade.

"I convinced myself that we could do whatever we wanted," laments Joseph L. Rice III, the 75-year-old chairman, co-founder, and name partner of private equity firm Clayton, Dubilier & Rice Inc., his head bowed as he stares down at a conference room table inside the firm's nondescript Park Avenue headquarters. "The only way I can explain it is that I got cocky."

Rice is recounting the most painful episode in his otherwise stellar career: how his vaunted firm got caught up in a fast-money mindset, jumped into industries it didn't understand, and embraced debt too enthusiastically—mistakes that resulted in crippling losses for its investors and prompted sweeping changes in the way Clayton operates.

In 1998, Clayton took a controlling stake in U.S. Office Products Co. for $270 million. The publicly traded roll-up of more than 100 companies seemed to have ample room for operational improvements. Allon H. Lefever, a co-founder and board member, shared Clayton's vision of transforming the labyrinthine collection of local distributors into a centralized powerhouse. He also was impressed by the heavy hitters Clayton brought in. General Electric Co. (GE ) veteran Charles P. Pieper became chairman and later CEO, and then-Tyco International (TYC ) CEO L. Dennis Kozlowski, at the time viewed as the czar of acquisition sprees, joined the board. But Lefever's optimism quickly faded.


Pieper ended up juggling several crucial jobs at once. While chairman of U.S. Office, he was also nonexecutive chairman of Alliant Foodservice, a company that Clayton bought in 1995, nonexecutive chairman of Clayton-owned moving company North American Van Lines, and a director of Clayton-owned Dynatech Corp., later renamed Acterna. When U.S. Office's then-CEO left for a dot-com in 1999, Pieper added that to his long list of titles. Pieper, now a vice-chairman in the alternative investments division at Credit Suisse Group (CS ), declined to comment on his workload then.

U.S. Office stopped making acquisitions and began slashing expenses, but the strategy was slow to show results. Investors started hammering its stock. Valued employees bolted. And U.S. Office was perilously close to defaulting on its debt. Clayton invested $51 million more in April, 1999, but it didn't stanch the bleeding. In March, 2001, U.S. Office filed for bankruptcy protection. Clayton lost more than $320 million. Rice views the setback as the firm's most humbling. The business, he says, was much weaker than he thought. "We underestimated the degree of difficulty," he says.

Clayton had also started veering into new industries. It bought Dynatech, then a 39-year-old communications equipment company, for $277 million in 1998 and promptly saddled it with some $1 billion in debt to buy a European telecom equipment tester. New debt covenants stipulated that the renamed Acterna (JDSU ) keep at least $25 million in cash and a revolving loan on its books. But when customers reeled in their capital spending, sales tanked and Acterna defaulted. It filed for bankruptcy protection in 2003 with fewer than half the employees it had in 2002 and $408 million in losses. "It wasn't so much shocking as it was numbing," says Rice. "That was such a good business and its outlook was so bright. [Failure] was hard to reconcile." The 2002 bankruptcy of jetmaker Fairchild Dornier Corp., based near Munich, which Clayton had bought in 2000 and tapped Pieper to run, resulted in a loss of $381 million.


Clayton still manages the two funds that took the heavy losses. Those portfolios have returned 4% and 20%, respectively, since their 1995 and 1998 inceptions, compared with the Standard & Poor's 500-stock index' respective returns of 139% and 52% over the same periods. When Clayton hit the road in 2005 to raise money for its latest fund, several big investors, including the Washington State Investment Board and the Virginia Retirement System, declined to ante up.

The firm addressed its problems with a physician-heal-thyself strategy based on the tactics it used to revive companies. First, Rice and CEO Donald J. Gogel retooled upper management, replacing eight partners and hiring stars like former GE CEO and current BusinessWeek columnist Jack Welch and former Emerson Electric (EMR ) co-CEO George W. Tamke. Employees now endure quarterly reviews led by Welch, which he says resemble the ones he conducted at GE. "The reason I went [to Clayton] was so I could continue doing a lot of the things I was doing before," he says.

Most important, the firm avoids industries it doesn't know well, including real estate, oil and gas, retail, merchandising, entertainment, telecommunications, and others. Clayton says that the companies it buys are No. 1 or 2 in their industries. "This firm had to change," says Managing Partner Kevin J. Conway. "We had no choice."

Business has improved since the changes were implemented. In the past year, the firm has reaped more than $3 billion for its investors, mostly by selling companies. And it says its most recent fund, which among other things bought a piece of the Hertz Global Holdings Inc. (HTZ ) rental car company and quickly sold shares to the public, has gross returns of 85% since its 2005 inception.

But it's too early to declare the comeback complete. Clayton owns minority stakes in several companies that are struggling. One, Westmont (Ill.)-based relocation and moving services provider Sirva Inc. (SIR ), is facing a Securities & Exchange Commission investigation into its accounting after restating several years worth of earnings results. Its stock has plunged 94% since Clayton took it public in November, 2003.

Even the eye-popping returns of Clayton's latest fund require an asterisk. In the fuzzy realm of private equity math, firms typically factor into the return numbers only the companies from which they have already gotten cash. Right now just three of the six controlled by Clayton's 2005 fund are being counted: Hertz, electrical equipment maker Rexel Group, and beauty supplies distributor Sally Beauty Holdings Inc. (SBH ), which make up only 29% of the fund. There's no way to predict the returns by the time investors are able to pull their money out of the 10-year fund. Clayton says it has returned 2 times investors' initial investments since its inception—less than the 2.7 multiple that Kohlberg Kravis Roberts & Co. and Blackstone Group (BX ) say they have delivered.

Rice insists Clayton has learned from its mistakes and is on the road to recovery. "Were we unhappy with [the 2000-2002 episode]?" he asks rhetorically. "Sure. Did we fix it? Yep. Will it recur? I don't think so." Then he pauses. "I hope not."

With Susan Zegel

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