Warts and all

To ensure the continued flow of capital commitments, private equity firms must assume the role of teacher when approaching institutions – and not sugarcoat the facts, writes Christopher Witkowsky.

A vital part of a general partner’s job is the education of institutional investors, even institutions with which the GP has enjoyed a long relationship.

Turnover at institutions like public pensions is fairly heavy – or at least heavy compared to the long tenure of the senior executives at some of the world’s biggest private equity firms. New board members at pensions or foundations often have no experience with alternative investments, and no understanding of the long hold periods, say, or the J-curve.

Part of the importance of on-site visits for GPs is being able to answer questions from these newbies, and possibly dispel some of the misinformation new board members may bring to the table about private equity.
This type of situation was on display in April when George Roberts, co-founder of private equity giant Kohlberg Kravis Roberts, visited the Washington State Investment Board to give the pension an annual update about the firm. KKR and Washington State have had a tight relationship for 29 years.


The discussion ranged from the performance of the firm’s investments to KKR’s moves into new strategies such as debt.

But during a question and answer session, Roberts was confronted by a new board member who said she was not familiar with private equity. She asked Roberts if the firm’s ability to generate profits “resulted in collateral damage to employees, and how much that might contribute to the overall unemployment and how you view your responsibility in that regard”.

Roberts’ answer was refreshingly straight and candid. The truth is, he said, sometimes the rumours contain some truth. He talked about the firm’s investment in NXP, a semi-conductor company the firm acquired as part of an investment consortium in 2006 for €9 billion. Silver Lake, Apax Partners, AlpInvest and Bain Capital invested alongside KKR.

The firms bought NXP from Koninklijke Philips Electronics. Roberts explained the company was in a “bleak” situation.

“They had been run by a European company that really had never done much, and they saw their factory utilisation drop to 30 percent. There was no choice but to reduce head count in the company, which we did,” Roberts said, according to the transcript of the WSIB meeting.

KKR reduced the heat count in two ways – it sold off two division, bringing in $1.8 billion in cash, and it brought in new management that laid off workers in the remaining divisions.

“As the economy improved and their business improved, they’ve added back some of the folks they needed to run their factories and their business, but the company will never have the same size work force as it had prior to the buyout,” Roberts explained.

Significantly, he said, “if we had not done the deal and Philips had continued to own the business, they would have had to do many of the same things we did”.

Roberts also talked about a more positive situation with the firm’s portfolio company Dollar General, where the company is adding employees, and for the first time in a long time, employees will be getting bonuses.
“There’s been collateral damage in the 54 investments we own as the sales have dropped and we’ve had to decrease the workforce,” Roberts said. “Hopefully as the economy improves, you’ll add people back.”

Mike Michelson, who heads KKR’s private equity operations in North America, said in 2009 KKR companies employed 600,000 people in the US. He said firms can’t “generate the kind of returns over the kind of hold periods we have by shrinking businesses”. The firm’s average hold periods are seven years, and “we expect, over that period of time, to grow our businesses. So what’s kind of inherent in our business model and our investment philosophy is growth, growth of the top line, growth of profitability and growth of employment.”

At one point in the presentation, Roberts’ harkened back to the early 1980s, an easier time for KKR because the firm was the only one around. These days, LPs are much more tuned in to what managers are doing with their money.

Roberts’ candour is a refreshing example of a GP approaching an LP with honesty and not whitewashing the situation, but explaining both the good and bad aspects and what it means for investors. GPs should take note.