Run Of Exits Gets CD&R Back On Track

If Clayton, Dubilier & Rice, as expected, comes back to market to raise a new fund in early 2008, will it be greeted with cheers, boos, or something in between?

There’s no question that CD&R has been on a roll of late, and limited partners must be encouraged to see its name in the headlines for blockbuster wins like its 2005 deal to acquire rental car company The Hertz Corp. The New York buyout shop, whose latest fund is about 75 percent invested, has also been climbing steadily up-market to where the big money has been made recently. So far this year, the firm has been party to a flurry of activity that includes about $23 billion in new deals and nearly $10 billion in exits.

Prominent among recent deals is the pending $10.3 billion CD&R-led carveout of construction equipment wholesaler and distributor HD Supply from Home Depot alongside Bain Capital and The Carlyle Group, and the firm’s $3.5 billion sale of scientific product distributor VWR International to Madison Dearborn Partners. The latter deal generated a 4.5x return for CD&R and its investors, and a 78 percent IRR after a three-year hold period.

Founded in 1978, CD&R has 36 investment professionals, about two-thirds of which are based in its Park Avenue headquarters and the remainder in its U.K. office. Its seventh fund, raised in 2005, totaled $4 billion. For now, the firm doesn’t appear to have the size fund, or organization, that would let it do Hertz and HD Supply-size deals at will. For comparison, Bain Capital and Carlyle Group have north of 175 and 350 investment professionals, respectively, and both invest out of 11-figure funds.

It’s not clear whether CD&R has aspirations to raise a mega-fund when that seventh fund is depleted. But if so, the firm faces a number of challenges, including boosting the interim performance of its fifth and sixth funds, transitioning to new financial partners, and dealing with the prospect of a downturn in the financing markets that could affect some of its most recent deals.

Focused Strategy

Prospective investors will certainly want to know the fate of a pair of previous CD&R funds—1995’s Clayton Dubilier & Rice Fund V and 1998’s Clayton Dubilier & Rice Fund VI—which together house more than $1 billion in soured investments. These include telecom technology testing company Acterna Corp., aircraft manufacturer Fairchild Dornier and Office supplier U.S. Office Products Co.

According to backer Washington State Investment Board, Funds V and VI generated IRRs of just 2.3 percent and 2.5 percent and mediocre multiples of 1.15x and 1.09x, as of Dec. 31, 2006, though those figures do not account for a run of recent, lucrative exits for CD&R. Washington State is not believed to have re-upped in CD&R’s seventh fund.

In a story published by The Deal in 2003, CD&R Chairman Joseph Rice and CEO Donald Gogel laid out a patchwork of blame for the blowups, including the 9/11 terror attacks (Fairchild Dornier), the collapse of telecom spending (Acterna) and personal mea culpa (U.S. Office Products Co.)

Several deal-makers left the firm in the wake of those deals. Charles Pieper, who had been the front man on both the Fairchild Dornier and U.S. Office Products deals, left the firm in late 2002. Other departures include that of former Partner Brian Finn, who left in 2002 after working on the Acterna deal, and James Rogers, who last December simultaneously announced his resignation both as an operating partner at CD&R and as chairman of moving company Sirva Inc., which CD&R took public in 2003. Sirva, which returned to CD&R many times its original investment, recently has been in the news over accounting troubles.

Out of its experience with Funds V and VI appears to have emerged a CD&R intently focused on buying underperforming divisions and subsidiaries from large, multi-location distribution businesses. Six of CD&R’s last nine deals have been carveouts, including Hertz, which came out of Ford Motor Co. and U.S. Foodservice, which had been a unit of Royal Ahold. “By extracting these businesses from their parent companies and putting a pure focus on profitability and key growth drivers, we can help make these businesses more valuable over time,” said Partner Richard Schnall.

Patience has been another hallmark to CD&R’s recent success. The firm has a longstanding habit of pursuing deals and building relationships with senior management of target companies for years before a transaction is consummated. Indeed, the buyouts of Culligan and Brick Bros. had the shortest lead times—18 months—of the firm’s nine most recent deals. Other deals like Hertz and HD Supply had been pursued proactively for three years by CD&R before the firm’s interest culminated into a transaction.

At any given time, Schnall said, CD&R has hundreds of potential target companies on its radar and is in active dialog with as many as 30 to 50. “Most deals don’t happen, so you have to chase a lot of transactions to find the ones that will,” Schnall said. He noted that the firm looks at about 100 transactions per year and aims to close two to three of them.

The focus on carveouts of distribution companies has paid dividends. This year alone, CD&R has held no less than five liquidity events. Along with VWR International, CD&R announced in June that it would sell Brake Bros., a U.K.-based food distribution business, to Bain Capital for £1.4 billion ($2.8 billion), earning a 4x return and a 34 percent IRR in the process. CD&R acquired Brake Bros. in 2002 for £434 million.

Earlier this year, CD&R’s $22.25 per share secondary offering of Hertz stock helped generate a 3x return on the firm’s late 2005, $15 billion deal to acquire the car and equipment rental company alongside The Carlyle Group and Merrill Lynch Global Private Equity. In April, CD&R recapped its three-year portfolio company Culligan International Co., letting it take a $360 million dividend from the water products company. To date, the Culligan investment has returned about 3x CD&R’s money. Elsewhere, the IPO of electric product distributor Rexel, which CD&R, Eurazeo and Merrill Lynch Global Private acquired in 2005, returned more than twice the investors’ money.

A number of these exits promise to lift Fund VI’s performance, as VWR International, Brakes Bros., and Culligan were made with equity from that vehicle. The Rexel investment was split between Funds VI and VII, while Hertz is a pure Fund VII play.

Next Generation

Notably, all of these liquidity events stem from deals led by CD&R’s next generation of financial partners.

The 29-year-old firm has chosen the future captains it wants to steer the firm’s acquisition activities in the days to come—Partners David Novak, 38; Schnall, 37; and David Wasserman, 40. Since 2002, the trio has led CD&R’s nine most recent transactions, including this year’s LBOs of HD Supply (Novak) for $10.3 billion, ServiceMaster (Wasserman) for $5.5 billion, and U.S. Foodservice (Schnall) for $7.1 billion.

Novak, Schnall and Wasserman share a history that pre-dates their tenure at CD&R. The three all attended Harvard Business School at the same time: Wasserman graduated in 1995 while Novak and Schnall followed in 1996. Novak and Wasserman knew each even earlier, having played basketball together as undergrads at Amherst College. They joined CD&R in successive years, with Schnall coming aboard first in 1996, followed by Novak in 1997, and Wasserman in 1998.

“It’s been a natural generational evolution,” Wasserman told Buyouts, when asked about the trio’s ascension.

Meantime, CEO Gogel, 57, remains actively engaged in each of the firm’s transactions, while Managing Partner Kevin Conway, 48, continues to run CD&R’s investment committee. Chairman and Co-founder Rice, 75, also remains active with the firm, keeping tabs on its inner workings and organization. Having senior talent aboard that has seen a credit cycle or two should come in handy in the months ahead.

The recent pushback in the debt markets related to issuer-friendly terms, such as PIK-toggles and covenant-lite structures, ensnared two of CD&R’s recent deals, U.S. Foodservice and ServiceMaster. U.S. Foodservice ended up canceling a $650 million high-yield bond offering after having already cut it back from its originally intended $1.5 billion. Meanwhile, ServiceMaster Co., which owns TruGreen and Terminix home services, delayed and ultimately shelved its $1.15 billion high-yield bond offering. Both deals closed, however, with bridge loans in place where the bond issues would have been.

Wasserman, who led the ServiceMaster deal, said that the pulled bond offerings will have little to no impact on CD&R’s investments in either company, but said that the way bond investors are beginning to push back could change how LBOs are financed from here on out. “The financing markets got out a little bit ahead of themselves, and now we’re seeing a return to the norm,” Wasserman said. “When that happens you always have a little bit of a shakedown in the market.”

Nevertheless, bridge loans have their disadvantages. Because they are intended to be temporary structures used to span only the period of time from when a deal is closed to when a more permanent capital structure can be put in its place, they tend to carry higher interest rates than other forms of financing. That higher interest rate typically increases in regular increments the longer the bridge is in place—an incentive for the borrower to refinance. But if support for the bond deal cannot be drummed up, the issuer is stuck with a comparatively expensive piece of leverage.

CD&R partners we spoke with agreed that the PIK-toggle structure and the covenant-lite loan are probably things of the past, at least for the time being. That too, could have repercussions, as companies levered without these issuer-friendly features have less flexibility in difficult times. Indeed, uncertainly surrounds the firm’s third deal of the year, the agreed-to $10.3 billion carveout of HD Supply from Home Depot, whose financing, as of press time, was not finalized.

“This is a great business, with $13 billion on the top line and $1 billion in EBITDA. It’s number-two in its market in the U.S. and globally, and it has classic improvement opportunities,” said Novak, who led the deal. “That’s a story that we’re prepared to tell, and I think makes for a compelling investment case.”

“That being said,” Novak added, “the market is what it is, and we’ll have to see. It’s clearly a tough environment right now, and the terms of this financing were handed to us during a time in which the market conditions and pricing were very different.”