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Going Private


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Ask J. Crew Group Inc. chairman and chief executive Millard S. "Mickey" Drexler what it's like to run a public company, and he curls his fingers into the shape of a pistol. "You have a gun to your head," he says. Drexler knows of what he speaks. He spent four years running AnnTaylor Stores Corp. (ANN) and seven years as CEO of Gap Inc. (GPS), where he gained his reputation as a turnaround artist before being ousted in 2002.

Drexler, 61, could be enjoying an uncommonly comfortable retirement right now. Instead he's working harder than ever, trying to revitalize the fashionable clothier. He loves the challenge of transforming companies, and retailing is in his blood. But the best part about the new gig is that he doesn't have to answer to public shareholders every step of the way. Drexler works for Texas Pacific Group, a $22 billion Fort Worth private-equity firm. It hired Drexler in 2003 and supported him through a long overhaul that included chucking a year's worth of J. Crew skirts, pants, and sweaters. Now, he says, he has "an ownership that truly cares about long-term shareholder value," in stark contrast to public investors who obsess over quarterly earnings.

Luminaries like Drexler are bolting in droves for private equity, the freewheeling world where investors buy slumping companies and try to turn them around to sell or take public, risking billions of dollars in the process. Former General Electric (GE) CEO Jack F. Welch now evaluates investments at Clayton, Dubilier & Rice Inc., a $6 billion New York firm. (Welch and his wife, Suzy, write a column for BusinessWeek.) Onetime IBM (IBM) chief Louis V. Gerstner Jr., who has alternated between private and public companies for two decades, is back in the private sphere as chairman of the Carlyle Group, a Washington (D.C.) firm with $35 billion in committed capital. Former Ford Motor Co. (F) CEO Jacques Nasser is a partner at the $5 billion One Equity Partners, an affiliate of JPMorgan Chase & Co. (JPM)Former Continental Airlines Inc.

President Greg Brenneman fixed up Burger King for private-equity firms and is about to take it public. Viacom Inc.'s (VIA) former chief financial officer, Richard J. Bressler, works for Thomas H. Lee Partners LP, a Boston fund with $12 billion of committed capital. Gerald Storch, former vice-chairman of Target Corp. (TGT), has been tapped to run Toys 'R' Us for private-equity owners Bain Capital ($27 billion) of Boston and Kohlberg Kravis Roberts & Co. ($11.5 billion) of New York (along with Vornado Realty Trust). And on and on.

It isn't only CEOs who are making the move to private-equity firms. Fast-rising midcareer folks are lining up, too. "The interest has really gone through the roof," says Anthony Lando, partner and director of Benchmark Search Group, a financial-executive recruiter in Stamford, Conn. Newly minted MBAs are joining them. Back in the 1980s most B-school students wanted to be investment bankers. In the 1990s it was tech-related venture capital and dot-coms. Now, private equity is hot.

LONG-TERM LUXURY

The attractions are twofold: money and freedom. The pay can be outrageously good even at the entry levels; for CEOs, it can be spectacular. The flexibility is alluring, too. In private equity there's less annoyance from the Sarbanes-Oxley Act, the controversial regulations passed in 2002 to police publicly held companies. And many private CEOs will avoid the Securities & Exchange Commission's new proposal that would require the highest-paid executives at public companies to disclose their compensation in excruciating detail. (These rules and proposals still apply to companies that issue registered public debt.)

Regulatory issues aside, the fundamental nature of private-equity work is different. CEOs have a freer hand to do the tough but necessary things to repair companies for the long term, with less focus on quarterly results and placating public shareholders and more on meeting the strategic yardsticks of a multiyear turnaround effort. Drexler, for one, says he never could have scrapped so much inventory at a public company focused on short-term results.

Going private dodges another nuisance: activist hedge funds. "You're seeing more instances of hedge funds taking major stakes in companies to cause a sale or major restructuring of a business," says Daniel S. O'Connell, CEO and founder of 18-year-old Vestar Capital Partners, with $7 billion of committed capital. "That will lead to more [companies] going private."

Private-equity CEOs, in other words, don't feel like the gun is pointed at their heads at all times. That allows them to "take risks that public shareholders won't," says Donald J. Gogel, CEO of Clayton Dubilier. For example, since Bear Stearns Merchant Banking (BSC) bought what has become New York & Co. from The Limited in November, 2002, it has refurbished or opened 260 stores, more than half the chain's outlets. A public company would have found it more difficult to make so large an investment in a languishing, minor business. "Managers now understand that involvement in the private-equity world is potentially more interesting, more lucrative, and less of a hassle," says Texas Pacific Group founding partner James "Jim" Coulter.

The Carlyle Group's Gerstner says he's thrilled he went private. "The private-equity industry allows an organization, or a part of [one], that is operating at a subpar level to be spun off, refinanced, reenergized, refocused," he says. "It's a very significant part of what is going on in the world today."

For Ann W. Jackson, a 23-year veteran at Time Inc. (TWX), the appeal of private companies is their nimbleness. She joined Ripplewood Holdings LLC, a $10 billion New York firm, last April, and in November became the CEO of educational publisher WRC Media Inc. Jackson and her three division presidents review their progress each week to see if they're slipping off their targets, and move quickly when necessary. "It's a 30-second decision," says Jackson, who has limited her executive team to six to keep down bureaucracy. At public companies, Jackson says, rigid hierarchies prevent such decisive moves.

Vivek Paul, vice-chairman of Indian software maker Wipro Ltd. (WIP) until September, 2005, likes the variety of private equity. He's now part of a team at Texas Pacific investing in different sorts of technology and life sciences companies. "I felt I was a frog in a well at Wipro," says Paul. "Now I have a panoramic view of business across various industries and companies and countries." Former Paine Webber Group Inc. CEO Donald B. Marron enjoys running his own $2 billion private-equity firm Lightyear Capital Inc., which invests in businesses providing financial services ranging from crop insurance to college funding.

Not that private equals perfect. The business is fraught with risk, and fund partners, with hundreds of millions of dollars at stake, can be stern taskmasters. There are also legitimate reasons for public shareholders to be wary of the privatization trend. And for all the faults of the public life, there are still plenty of CEOs who are perfectly happy to remain in the fishbowl.

To a large extent the private-equity phenomenon is cyclical. Another bull market for stocks could slow or even reverse the movement. Wave millions of in-the-money stock options in front of a CEO and suddenly Sarbanes-Oxley and the other headaches of public companies will seem less painful. Sooner or later, the private-equity market will cool off.

But for now it is sizzling. The industry controls $800 billion in capital, estimates researcher Thomson Venture Economics, more than the $756 billion that Americans spent building new homes and renovating existing ones last year. Fifteen years ago there were only a handful of firms managing at least $1 billion; now there are at least 260. Just three firms -- Carlyle, KKR, and New York-based Blackstone Group -- preside over businesses that employ 907,000 people. In 2005, estimates Buyouts magazine, $174 billion in new money flowed into U.S.-based private-equity firms. Who's investing? Well-heeled institutions such as pension funds looking for higher returns than the single digits delivered by the stock market the past few years.

Flush with cash, firms are buying bigger-name companies and enticing higher-profile public executives to come onboard. Private-equity funds have scooped up Dunkin' Brands Inc., Neiman Marcus, Metro-Goldwyn-Mayer, and Toys 'R' Us, to name a few purchases since the start of 2005.

Hear that noise? It's the giant sucking sound of capital and talent exiting the public realm.

THE MONEY BECKONS

No one knows the full extent of the privatization wave. Firms, and the companies they run, are intensely secretive.

But word of the massive amounts of money being made is spreading. Here's how the millions pile up. Partners typically take 1.5% or so off the top as a management fee each year. So four to six partners of a $1 billion fund might split $5 million every year among themselves, after paying out, say, $10 million for staff and other costs, estimates Brian Korb, a partner of Glocap Search, a New York executive recruiting firm.

Partners also get a share of profits, usually 20%, when a company is sold or taken public. Say the value of the companies owned by a private-equity firm doubles, to $2 billion, when they sell them. The partners would split $200 million of the $1 billion increase. (The fund's investors would get the other $800 million.) And any money that partners co-invested with shareholders would also double. To top it off, their investment booty would be taxed at 15% as long-term capital gains (assuming the investment was held at least a year), vs. the 35% that public company CEOs must shell out for their ordinary income.

Not all CEOs are partners, but they don't need to be to earn huge sums. When private-equity firms recruit executives to run companies for them, they typically offer them small cash salaries but also a chance to invest their own money for a stake in the company, sometimes as much as 20%. This is highly risky for the CEO, of course. But it's proving, for now, to be a better incentive than the stock options grants available at public companies, which haven't paid off in the sideways stock market of the past few years.

Consider Drexler. He earns a modest annual salary of $200,000, but he was allowed to co-invest $10 million with Texas Pacific, and now owns a stunning 22% stake in J. Crew. That could turn into as much as a $300 million payday for Drexler if the company goes public; the more he succeeds in turning the company around, the more money he will make. (Drexler declined to comment on the prospect of an IPO, but market watchers expect one this year.)

It's difficult for public companies to compete with that. "When we recruit a CEO to a public company, we can't offer them [even] 5% of the company," says Dennis Carey, vice-chairman of executive recruiting firm Spencer Stuart.

Buyout firms can afford to be generous. Most big ones boast annual returns in excess of 20%, vs. the average 5% return delivered last year by companies in the S&P 500. "If an executive makes his numbers, and we get a 25% to 30% return, he should be paid a lot," says Daniel F. Akerson, who ran wireless outfit Nextel Communications Inc. as well as telecom and broadband services firm XO Communications Inc. (XOCM)before joining Carlyle to co-head the firm's U.S. buyout group in 2003.

Private equity is changing the traditional career cycle for many public company executives. CEOs are no longer content to grind out their last few years running public companies or sitting on their boards. Instead, they're joining private-equity firms as partners to review companies' strategies and to hunt for deals. Or they're heading the companies in firms' portfolios. Or both, as in the case of Jacques Nasser, who at one point was simultaneously chairman of Polaroid Corp. and partner at owner One Equity. "Private equity is becoming a new life-stage for CEOs," says Jeffrey A. Sonnenfeld, professor of management at Yale University. "It's something we have never seen before."

Some executives who fulfill their private-equity mission by taking a company public again are looking to return to the private life. "If you ran a buyout and the exit was to go public, you might stay for a while," says Lawrence Schloss, who ran Credit Suisse First Boston's (CSR) private-equity business before starting a firm called Diamond Castle Holdings LLC, based in New York, last year. "But hopefully you'd get out, and do the cycle again." Two of Schloss's six partners are former CEOs.

Midcareer executives see private-equity firms as the new fast track to running their own shops someday. Jackson says the choice to work for a private-equity firm for the second half of her career was obvious. "I love being the CEO," she says.

Business school students, meanwhile, are angling to get on the partner track. At the University of Chicago, says Julie Morton, associate dean of MBA career services, résumé writing courses for private-equity candidates are oversubscribed. Stanford University is seeing more interest. More 2005 Stanford MBA grads went into private equity than any other area except consulting and consumer products and services.

These students, not yet wary of the public life, are chasing the huge dollars in private equity. The median annual compensation for a 2005 Harvard Business School grad who went to work for a private-equity firm was $174,500, compared with $135,000 for the rest of the class. Last year's Stanford grads did better, with median total compensation of $232,000, compared with $140,000 for the class. Some private-equity funds pay as much as $300,000 to fresh MBAs.

Michael A. Barzyk is a second-year MBA student at Chicago. He worked for a private-equity firm for three years before grad school and saw his two years on campus as a way to polish his skills. The Chicago native took an operations course to get a better handle on management, and spent this past summer working at Sandbox Industries, an incubator. While peers were recently attending "bank week" in New York and doing on-campus interviews with consulting firms, Barzyk was working his contacts, calling on friends, trying to get wind of an opening in a suitable buyout shop. These firms don't recruit on campus, so it's up to candidates to hunt up their opportunities.

NO LOOKING BACK

An awful lot of high-profile converts say they'll never go back to a public company. Gerstner, 63, says he doesn't miss running one "for a second".

That's especially telling because Gerstner worked for a buyout firm before, and things didn't exactly end well. In 1989, KKR tapped Gerstner, then president of American Express Co. (AXP), to run RJR Nabisco. He says he came to realize that KKR had paid too much for the company and couldn't reach its expected returns. When he got the feeling in 1993 that KKR was trying to pull out of RJR, he says, he left to run IBM. (KKR declined to comment.)

With baggage like that, working for a private-equity firm seemed highly unlikely when Gerstner retired from IBM in 2002. His plan was to help fix public schools, advance cancer research, and sit on a few public company boards. Then the phone started ringing. "I got calls from seven private-equity firms," he recalls.

Gerstner added Carlyle to his list of commitments in 2003 because he thought the private-equity business was changing dramatically. Carlyle's three founders convinced him they were "serious about making [Carlyle] a meaningful entity," Gerstner says.

These days, Gerstner is Carlyle's operational voice on investment decisions. "It's very easy [for someone evaluating a deal] to say, 'The margins are going to go from 14% to 18%, and we're all going to make money,"' he says. "Well, who is going to get the margins up? How is that going to happen?... I get a little antsy when I don't learn a lot about the management group that's going to run [the company] from the first 10 pages of a report." Gerstner also heads a committee that's responsible for ensuring that Carlyle will last beyond its founders.

George W. Tamke isn't going back to a public company, either. "You couldn't write a big enough check," says Tamke, 58, who was a co-CEO of Emerson Electric Co. (EMR) until 2000 and became a partner at Clayton Dubilier that same year. Tamke was chairman of copy chain Kinko's from 2001 to 2004. Now he's chairman of water supply company Culligan International Co. and the rental car company Hertz Corp. And he's relishing every moment.

REASON TO WORRY

The privatization trend has made scholars and recruiters take notice. Brain drains are never easy on the parties losing the talent. Some business thinkers, like management professor Michael Useem at the University of Pennsylvania's Wharton School, see the exodus as a sign that the ascent of widely held companies over the past century might be cresting. With capital in fewer hands, there are fewer checks and balances coming from other stakeholders on how that capital is deployed.

Another drawback: Private companies' financial results are shrouded in secrecy, with few outside observers able to question the numbers. That's why regulators restrict private equity to wealthy investors. "It's definitely caveat emptor," says Nell Minow, co-founder of the Corporate Library, a corporate governance research firm. "They'd better kick the tires carefully."

What's more, the mechanics of a typical private-equity turnaround don't always favor public shareholders. When buyout firms acquire companies, they often load them up with debt quickly to recoup their investment. For example, within 14 months of buying Warner Music Group from Time Warner Inc. for $2.6 billion in March, 2004, a group of four private-equity firms led by Thomas H. Lee had borrowed an additional $700 million in debt and extracted $1.4 billion in dividends and capital repayments, more than recouping their $1 billion investment. Lee co-president Scott M. Sperling says Warner's cash flow improved enough after the buyout to support the debt, pay the dividends, and fund the company's growth.

When private-equity firms bring their companies public again the capital structures of some are shaky. Their governance could be compromised as well. "Most of the time when these things go public...private-equity firms want to get the hell out of there," says Jay W. Lorsch, a professor of corporate governance at Harvard Business School. "They want to monetize their investment and get their guys off the board, because they don't want to be caught in a conflict of interest."

But private-equity firms are also doing things that are decidedly positive for the financial system. As they pay larger sums for companies, they've come to realize that they need better managers to turn those companies around and make their investments pay off. At this stage, the easy deals have already been done. And so, more than ever, the financial whizzes are wooing top operations executives. Texas Pacific now has 16 operating partners, up from two a decade ago. A third of KKR's 27 senior executives have an operational background, up from none 10 years ago. "We've added more people at a senior level with an operational orientation to balance [the investment professionals]," says Marc Lipschultz, a KKR partner.

As a result, the companies being brought public again are operationally stronger, leaner, and better, even if they do carry debt. This is a positive development after the go-go 1990s. "We had a period in which companies went public entirely too quickly," says Minow. "Some of them never should have."

Healthier public companies are good for shareholders, obviously. "I'm fairly optimistic about how private-equity-backed deals will do from an investor's point of view," says IPO market expert Jay R. Ritter, Cordell Professor of Finance at the University of Florida. He notes that private-equity-backed IPOs are generally mature, sound companies with annual sales of more than $50 million. "Historically, IPOs for companies with at least $50 million in sales meet or beat the benchmarks," he says.

For better and for worse, the private-equity boom still has plenty of life. Even if the cycle turns and public companies get hot again, private equity's true believers won't go back. CEOs say the freedom to run their companies as they see fit is exhilarating. Private equity is simply more glamorous than public CEO-dom, says recruiter Stephen R. Bochner at Sextant Search Partners LLC in New York. "It's the difference between driving a speedboat and driving an ocean liner," he says. "When you want to turn a speedboat, you turn the wheel. For an ocean liner, you have to plan two days ahead."

By Emily Thornton, with Nanette Byrnes and David Henry in New York, and Manjeet Kripalani in Bombay


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