Think at London Business School
Sunday 12 June 2022
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By Gary Dushnitsky, Nick Mickshik
Don Gogel is Chairman of Clayton, Dubilier & Rice, LLC. He has over 30 years’ experience in private equity investing. Here he shares some profound industry insights with Florin Vasvari, Professor of Accounting; Chair, Accounting Faculty; and Academic Director of the Institute of Entrepreneurship and Private Capital (IEPC) at London Business School.
Florin Vasvari (FV): You’ve been an investor for more than 30 years. What makes the current cycle different from others you have seen?
Don Gogel (DG): Almost everything in private equity [PE] changes over a number of years. I have lived through six discernible cycles, including the great recession, the dotcom boom and bust, and the most recent one, the Covid-induced cycle. All cycles took place in the context of the many changes experienced by PE firms.
This time, the first difference to note is that PE firms are much bigger. When I joined Clayton, Dubilier & Rice [CD&R] in 1989, we were investing out of a $300 million fund and we had five partners. Today, we have 30 full-time partners and we are investing out of a $16 billion fund, so that’s a 50 X size increase. Size has an impact on how we can respond to these crises.
Second, as we have seen through 2021, the speed at which private equity firms, and many public companies, regained their balance in the context of a precipitous drop in activity was really breathtaking – few of us could have known that the rebound would be so quick.
Third, every cycle is unique and this one, being driven by a global health crisis, has some unique characteristics. When you translate that into the tackling of business, there are more commonalities; whether caused by Covid, a macroeconomic crisis or some other fiscal or monetary crisis. That’s because the commonality has to do with the basic metrics of how a business is performing – your revenues, your profitability, your cost base, your customer retention, whether you’re gaining market share, your ability to respond to the crisis – are all quite similar when you’re looking not at the cause of the crisis, but at the nature of the responsiveness.
Fortunately, because PE is a relatively nimble, unencumbered asset class with investors that by definition have a much longer timeframe than public company executives, PE firms have the ability to look beyond the immediate crisis. They have the capability to respond by saying, ‘How do we come out of the crisis at the other end, whether that’s in three months or six months or two years’ time, as a stronger company, with the ability to retain employment, gain share, increase profitability and ultimately move towards a valuable exit on behalf of our investors?’ Keeping that in mind, in terms of parallels with previous crises, there is more in common than there is distinctiveness in what we have just been through.
FV: The PE industry last year and even this year has done pretty well, but the variation among firms has been quite high. Does this environment, where part of the economy is in a crisis and other sectors are booming, concern you?
DG: That’s a perennial question. As an investor and a buyer of companies, I always think prices are too high. As a seller, I tend to think they’re too low, but since we both buy and sell, we try to seek an equilibrium in the capital that we are deploying in new investments, and use our ability to take advantage of what, in certain segments, sometimes seems to be higher valuations to sell businesses and return capital to our investors.
That said, caution is an appropriate approach in this current environment. In some cases, we are looking at historical highs on almost every measure. Even in the technology sector, which has a unique set of dynamics, people are measuring growth rate in double digits, and in some cases 50% or 100% year-over-year. Here, traditional standards of EPS [earnings per share], or even traditional multiples of revenue, apply even less.
For the vast majority of companies that I would consider the targets of PE and for ‘standard’ companies around the world that are typically listed firms, this has been a somewhat unusual period, both in terms of the rapidity of the recovery and the primary demand caused by the relative health of the balance sheets of consumers, as well as companies. We should remember that we went through a liquidity crisis and terrible balance sheets in 2009.
Here, we find ourselves with the opposite: cash is enormously available, liquidity is everywhere, and pent-up demand is pushing prices higher, creating an inflationary environment that we haven’t seen in 20 years or more. Those are all, if not danger signals, a yellow flag that says, ‘Don’t assume that the next year, or two, or five are going to look like the last five, regardless of the pandemic and regardless of the relative health of the public markets.’
So, I would say the biggest change today versus a year ago is inflation. There is every indication that the low-interest-rate period will end sooner rather than later. The rapidity of the increase in rates is still unknown, but the direction is clear and the timing is getting tighter, and that clearly will impact valuations, although of course I hope the impact is minor.
FV: Larry Fink, the chairman and CEO of BlackRock, recently said that calling on public companies to move forward on climate change, without putting pressure on the rest of society to follow the same rules, could potentially create a great arbitrage. Do you think he’s right? Should privately-owned companies be allowed to avoid some of this scrutiny and generate better returns?
DG: The shift in public opinion, including lawmakers in most jurisdictions, has made every business think much more seriously about environmental concerns and climate change, and this has extended now to social and governance issues. But I’m not sure that Larry is correct in saying that the arbitrage is going to be there. I say that because there is pressure on PE firms to be serious about reducing their carbon footprint and being environmentally responsible.
If you expect to raise capital from most state pension funds in the United States or any one of a number of European countries or any of the private sources of capital, you have to be serious about maintaining your ESG credentials. That may require the readiness to forgo short-term profits, and I believe private equity is better able to do that than public companies. I’d argue that, on a performance basis, PE firms can afford to invest in sensible green initiatives better than public companies, because no one’s going to measure us on our short-term financial performance drag.
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“If you believe in the structural advantages that PE has over public companies, there’s no reason why the industry won’t do very well”
FV: The industry has been growing dramatically over the last few years. Are there still opportunities for our students?
DG: Again, because the industry changes all the time, there are no permanent answers here, but look at the evolution of the industry. When I joined Clayton Dubilier in 1989, we had $50 million of capital. There may have been a couple of hundred private equity firms, but many of them would not even have registered to hire from a business school. Today we have 8,000. When I joined the firm in 1989, a number of colleagues said, ‘Oh, too bad. You missed the window. You’re way too late.’ I’m not about to tell you that CD&R’s fifty-fold growth from when I joined to today will be replicated again, but if you believe in the structural advantages that PE has over public companies, there’s no reason why the industry won’t do very well. I have a sense that this industry is going to be good to many people for many years, so there are plenty of reasons for today’s students to pursue PE careers.
FV: A lot of PE firms are looking at ways of creating better value through digitalisation. How do you see digital value-creation evolving in PE?
DG: That’s a very good question. You have to ask, what else does technology bring? Every one of our businesses is laser-focused on what digitisation and technology does in terms of our relationships with our customers and our supply chain, because that is changing dramatically. I see digitalisation increasingly as an investment, and every business we invest in is a technology business and ripe for further digitisation. That makes life a little more complex, but it also makes it more exciting because, if you succeed, you have better service, lower costs and more engagement with your customer.
FV: Some companies, such as Moonfare, are enabling retail investors to invest in PE. How do you think access by retail investors will affect the industry?
DG: I think access for a retail investor is complicated. It’s not that they’re not sophisticated, but it’s hard to live through the J curve that is typical of most PE firms and to watch valuations go down before they go up. It’s not a natural, high-octane retail product, so I think the question for regulators is how to ensure that investors are well-informed about the dynamics of private equity. How many people would want to buy into public company equity if they were told you can’t sell it for 10 years? It’s a great advantage of PE and we’re not about to give it up. If I had to project five years ahead, I think retail investors will still be a very small part of the PE asset base.