Pain is a big topic in private equity at the moment. Although many private equity operators are reassuring themselves that there is light at the (far) end of the tunnel in the shape of cheap assets currently for sale, most practitioners still insist that things are going to get worse before they're going to get better.
Credit Suisse First Boston's global head of private equity, Larry Schloss, sitting in the bank's New York headquarters on Madison Avenue, takes a markedly different view. His business, with $28bn in committed capital the largest private equity operation in the world, has already been hit by “fire and rainstorm,” as he describes it. “We've gone through the worst already. I honestly can't think of anything else that could happen.”
In 2000, Schloss and his colleagues at what was then the merchant banking group of Donaldson, Lufkin & Jenrette (DLJ), the independent Wall Street investment bank, were in the middle of raising DLJ Merchant Banking Partners III, a new multi-billion dollar buyout fund, when suddenly the roof caved in. Practically overnight, DLJ was acquired by investment banking leviathan, Credit Suisse First Boston. Few people inside DLJ had seen the merger coming. As far as DLJ's private equity business was concerned, it was safe to assume that most bets were now off.
DLJ's private equity team, comprising buyout, venture,
real estate, mezzanine, secondaries and fund investment specialists, had to be convinced that CSFB was going to provide a suitable new home for their talents. It was clear that the business needed to be integrated with CSFB's existing private equity operations. The CSFB group was much smaller than DLJ's, but there was still significant functional overlap to deal with and reporting lines to be agreed. (As a result, the number of staff in the buyout group for instance has been reduced from 90 at its peak to around 50 today. Today CSFB Private Equity has around 130 professionals in total.)
Culturally the two banks had little in common. And private equity is one of those places where personalities can shape a business profoundly. Even today, when members of the combined private equity group that has emerged since are at pains to explain that it really doesn't matter any more whether a colleague was originally a DLJ or a CSFB “guy”, it's hard not to come away with the impression that it in fact does. And who was to say whether CSFB would really have the stomach for a private equity business the size of DLJ's?
Closer to home, the new DLJ buyout fund had to be resold to limited partners that had already put in 3bn, not to mention the additional effort required to win new commitments now that control had changed.
To make matters worse, the technology bubble bursting helped neither the DLJ fundraising nor CSFB's efforts to make its investment work. Suddenly the bank looked like it had severely overpaid on the $11.5bn acquisition. Soon after it also found itself embroiled in one of the worst corporate governance scandals in the history of Wall Street, the repercussions of which persist to this day. Both played an important role in bringing about the replacement of Allen Wheat, CSFB's chief executive, with John Mack, who took over in 2002 with a brief to move aggressively to restore the bank's profitability.
Given such turmoil, it seems astonishing that Schloss's business has remained intact, albeit with the inevitable staff turnover. Also impressive, and a reflection of the considerable might of the DLJ private equity franchise, is the fact that despite the merger and the collapse of a core part of its target market, DLJ Merchant Banking Partners III eventually closed on $5.3bn of commitments in late 2001, then the largest buyout vehicle ever raised.
People with first hand memory of the merger and its aftermath give Schloss considerable credit for steering the group through this difficult period. One former colleague, who describes Schloss's approach to negotiating the integration as characteristically focused and outspoken, says it was in no small part his vision of how the business should work and how the various pieces would fit together that was subsequently implemented.
A new environment
From the outset, the task of successfully integrating the businesses must have seemed daunting. Schloss admits he and his colleagues had “no idea what the ride was going to be: the bubble bursting, the chief executive getting fired, the investment bank involved in IPO investigations – we were not used to this kind of environment.”
Given the uncertainty over the group's future throughout the entire period, was independence not the simpler, more desirable option? After all, the problem was bigger than CSFB going through an extremely taxing period in an extremely taxing market. At an even more fundamental level, the very concept of captive private equity investment operations sitting within investment banks was – and still is – being questioned. Indeed, faced with deteriorating asset valuations on their balance sheets, allegations over internal conflicts of interest and changing capital requirement that make private equity a difficult place to be for banks, several of CSFB's peers have since turned their back on their private equity businesses. So why did Schloss and his team decide to stay, and why did the bank encourage them to?
I don't like the word captive because I don't feel captive
He admits that prior to the merger being consummated, independence was in fact “more than a possibility. We talked about it; investors were encouraging it. We thought, would it be fun to try? Yeah, maybe. And you don't need an investment bank to do private equity. 98 per cent of our competitors are independent, so why not?”
The answer was that in the final analysis, Schloss and his colleagues kept faith in the integrated investmentbanking model as a viable platform for a private equity business. Theirs is a belief in the bank acting as a source of deal flow, capital, banking products, industry expertise and a large geographic footprint. “We asked ourselves, ‘what are we good at?’ We're good at working inside an investment bank. It wasn't broken, we had upper quartile performance, and we were different. There was no need for another independent boutique.”
Also, while immensely powerful in high yield debt issuance, DLJ had never developed a meaningful loans operation. CSFB had. “Initially not everyone was in favour of integration, but the benefits slowly dawned on the sceptics when they started seeing the deal flow and good investment ideas, and realising that this was a bank unlike DLJ and we could get loans too.”
Yet another argument in favour of making the merger work was the responsibilities the team felt towards the huge network of investors, consisting of hundreds of limited partners in previous DLJ funds that the group had built. “If you walk, you have LPs looking at their prior investments being left behind. I don't think they'd be happy with you if you left them high and dry.”
Don't call me captive
Schloss says the group's funds are structured like any other private equity fund, with CSFB just one, albeit the largest, among a multitude of investors. “I don't like the word captive because I don't feel captive. We've grown this as a money management business that the bank invests with. There are no non-private equity people on our investment committees, and we're primarily focused on our participation in the carried interest based on the investment returns. We receive bonuses, but we don't participate in any investment banking fee revenues for services provided by CSFB.”
CSFB accounts for between five and 15 per cent of each fund's total capital, levels that Schloss predicts will reduce over time, as the bank adjusts to Basle II rules on bank capital adequacy. Since both the firm and the private equity group are keen on increasing third party funds under management, this makes for a “nice commonality of interest.”
Schloss also insists that potential conflicts of interest with other parts of the bank are not a problem. Tom Dean, another key individual in the group who runs the $9.3bn buyout business, also makes this point. He says: “The way we interact with other parts of the bank has not been optimised yet, but it's improving every day. We work hard to get deal flow from our investment banking colleagues, and they are becoming more familiar with private equity as a corporate finance tool. But the firm cannot force a deal onto us that we don't want to do. We have to be sensitive how we say no, but we have a fiduciary duty to our investors which cannot be challenged.”
Schloss says that the need to do deals for the right reasons – to generate investment return, not to help win investment banking fees – is one that the bank understands well: “You need to have thick-skinned people, and you have to be able to turn down anyone within the organisation. A lot of organisations can't handle that, but CSFB can handle it just fine.” Schloss sits on the bank's Executive Committee, which is chaired by John Mack, whom he describes as an “advocate” of the private equity business.
So are there no drawbacks to being part of an institution as vast as CSFB? When it comes to his personal involvement in the business, Schloss says that along with what he calls investment strategy, the management part of his role as global head of the private equity group has become more time-consuming. “What I lost in the transition, actually a while ago, is I don't get to do deals anymore. CSFB is a big place, and I don't want my people to get lost in it, so I'm the one to worry about that. I participate in virtually every investment committee [excluding Sprout Group, DLJ's venture capital unit]. If you have this many funds, there is a lot going on.”
If you have this many funds, there is a lot going on
Schloss, who was a DLJ investment banker financing oil deals and leveraged buyouts before helping to set up a proprietary LBO business in addition to Sprout, clearly misses the kick he used to get out of the buying and selling of companies. “The fun part was always, you go out, you meet the management team, you visit the plant, you figure out the projections, you talk to the seller, you negotiate, you buy the business, and four years later you make four times your money. And you were there for the whole four years, and you were on the board – that is fun. You've got to keep doing that, but there aren't enough hours in the day to do the deals anymore.”
Partial relief to deal withdrawal symptoms came last year when the bank decided to sell a number of thirdparty private equity fund investments. Schloss managed the sale, with CSFB's fund placement business acting as agent to bring in the bids. Schloss watched one bidder offer to pay 40 cents on the dollar for a fund that another thought was worth 80. “And sure enough people knew different things about different funds, so if you knew a fund was having a realisation soon you'd bid more for it. So our job as a seller was to find out what's going on inside these funds to make sure we had the right price expectations.” Fascinated by the inefficiency of the secondaries market, Schloss sees attractive opportunities in this area of private equity.
For Schloss himself, getting to do deals is likely to remain a rare pastime for as long as he continues to run the group. To what extent the team can continue to grow its asset base will have little to do with how the market's opinion about captive or semi-captive private equity groups may change going forward. Instead investors will vote with their wallets and demand of Schloss and his colleagues to demonstrate the kind of performance they have been able to show in the past. Today's fund size is in no small part a function of yesterday's success.
For instance, DLJ Merchant Banking Partners I, the group's first dedicated buyout fund closed on $1bn in 1992, generated a net IRR of 80 per cent and a cash multiple of 2.8x. Fund II, which in 1997 raised $3bn, turned in a less stellar performance, but, according to Tom Dean, is still expected to finish as a top quartile performer with an IRR in the low teens. Meanwhile Fund III, some $3bn of which has been invested so far, has had “a very strong start”, as Dean says. Around €800m of that has been put to work in Europe, where a team led by Colin Taylor recently invested in the secondary buyout from Nordic Capital of Nycomed as well as a refinancing for Safilo, an Italian eyewear maker. The fund has also sold its investment in the UK bingo chain Gala, to UK-based private equity firms Cinven and Candover.
In 2002, the buyout group invested a total of $1.25bn of capital, while CSFB Private Equity as a whole committed $2bn altogether. It's the busiest the group has been since inception. To Schloss, this is proof that the group's difficulties lie behind it. “It's all working, all cylinders are running. It feels pretty good right now, which I couldn't have told you 18 months ago.”
Whether this will remain so may to some extent be beyond his control. Credit Suisse's new chief executive, Walter Kielholz, recently dismissed suggestions that the group may yet sell CSFB, stressing that investment banking was a business CS wanted to be in. Although sceptics may well point to other bank CEOs who protest a commitment to private equity up to the point of sale, the private equity group at CSFB will have welcomed Kielholz's comments. Another change of control after the recent roller coaster ride would mean another round of discussions with
staff and limited partners. But even if CSFB was to come up for sale at some point, expect Schloss to be in the midst of the discussions mapping out his group's future. As one private equity practitioner who has worked with him in the past puts it: “Larry plays to win.” And either way, the game's not over.
This many funds…
CSFB Private Equity manages a raft of private equity funds. Here is an overview.
Equity: established in 1985, DLJ Merchant Banking Partners raised three buyout funds totalling in excess of $9bn which closed in 1992, 1996 and 2001 respectively. A growth capital fund with $175m in commitments was launched in 2000. The buyout business is run by Tom Dean, head of leveraged corporate private equity.
Mezzanine: DLJ Investment Partners II, the group's second mezzanine fund, closed in November 1999 on $1.6bn, worldwide the largest such fund raised to date. The mezzanine business is led by John Moriarty, COO of DLJ Investment Partners.
Venture Capital: Sprout Group, the oldest branch of the group, has been making venture capital investments as an affiliate of DLJ since 1969. Sprout, whose managing partner is Keith Geeslin, is currently investing Sprout Capital IX, a $1.6bn venture capital fund.
Real Estate: set up in 1995 following the appointment of a team of Goldman Sachs professionals, DLJ Real Estate Capital Partners manages two international real estate opportunity funds with some $2bn in commitments. Barry Sholem is chairman of the group.
Secondaries: known as DLJ Strategic Partners and led by Stephen Can, CSFB Private Equity's secondaries division is currently raising its second fund to acquire private equity partnership interests.
Funds of funds and co-investments: serving institutions and private investors, the Customised Fund Investment Group looks after more than $8bn in commitments to over 450 private equity funds and co-investments. Michael Arpey is leading the charge.