A Genteel Style of Buyouts


Most private equity outfits didn't get to the top by being nice guys or good sports. But the partners at Madison Dearborn are proving that gentlemen can win at this game, too

The 30 partners at Madison Dearborn negotiate leveraged buyouts as smart as anyone's. They're just so much nicer about it. Chicago's Madison Dearborn Partners—among the nation's largest private equity firms—has delivered average returns of 22% to investors over its 15-year run. Sure, its portfolio companies, like any taken private in a leveraged buyout, are laden with boatloads of debt. But at Madison Dearborn, the deals usually are bloodless; the partnership invests only in companies where it can keep incumbent management. It rarely extracts special dividends and has even cut fees to investors when the partners determined performance was lagging.

Named for its headquarters address at the northwest corner of Madison and Dearborn Streets, the firm is a bastion of Midwest sensibility. Offices in its 38th-floor suite are understated, save for a giant, red fiberglass bull purchased at auction for $28,000 by co-founder and Chairman John A. Canning Jr. after the city's "Cows on Parade" street art exhibit in 1999. Ties are mandatory, and there are two spares at the reception desk lest anyone forget. Why? "This is serious business," says co-CEO Paul J. Finnegan.

Contrast that to the swagger of the boys from Blackstone (BX), Kohlberg Kravis Roberts, and other East Coast buyout shops. It's hard to imagine Canning, 63, a pillar of Chicago's civic community, throwing a birthday party for himself like the highly chronicled bash Blackstone CEO Stephen Schwarzman hosted last year when he turned 60—a $3 million blowout at the Park Avenue Armory for more than 250 of New York's glitterati, including Donald Trump and Barbara Walters. For his 60th, Canning went to a Cubs game with his family and had a cookout at home. (To be fair, Canning isn't leading the lunch-bucket life: His wheels include a 2000 Bentley.)

Larger and Larger Deals

A Middle America CEO looking to sell a business could easily be intimidated by a New York hotshot. "They talk fast, they're too slick," says T. Bondurant French, chief executive of Adams Street Partners, a regular Madison Dearborn investor and a specialist in private equity. "Madison Dearborn is just as sharp, and there is less arrogance."

Madison Dearborn cannot match the biggest in private equity, outfits such as Carlyle, Blackstone, and KKR, whose war chests total upwards of $35 billion. But controlling $16 billion in funds, it places No.?13 among more than 500 firms ranked by Thomson Financial (TOC). Bloomberg puts Madison Dearborn among the 10 biggest private equity firms in dealmaking from January, 2005, through last September.

Its returns are anything but middling. Three of its funds place in the top quartile, which return more than 20% a year, and another ranks in the top half, according to London-based Private Equity Intelligence, which surveys 3,600 funds worldwide. Its fifth fund is too recent to be ranked. And its deals have been growing larger. Madison led the $6.9 billion buyout of Vernon Hills computer distributor CDW and the $6.4 billion takeover of investment firm Nuveen last year. It's a 9% partner in a much bigger deal, the $42.4 billion buyout of Bell Canada Enterprises (BCE).

In November, Madison Dearborn started raising money for a $10 billion fund, its sixth and largest, up from the $6.5 billion fund raised in 2006. With a profit of $1.2 billion in the sale of Bermuda-based satellite-service provider Intelsat in February, its biggest single gain yet, Madison Dearborn is on track to have its best year, with a projected distribution of more than $2 billion to investors. That would top 2005, when it returned $1.93 billion.

Deals, of course, will be harder to execute in the midst of the credit crunch. Buyout firms will probably have to hold on to companies longer. And with banks and investors wary of even low-risk deals, they'll likely have to pay higher rates on debt, which would pinch their own returns.

But Canning and his crew remain on the lookout for new possibilities, such as all-equity deals. Signaling faith in itself, the partnership is expanding its offices by 54%, moving up to space that had belonged to Sara Lee (SLE) on the 45th to 47th floors of Three First National Plaza. "If you have good returns, people throw money at you," says Steven N. Kaplan, a professor at University of Chicago Graduate School of Business who specializes in venture capital and private equity.

Old-Line Heritage

Madison Dearborn has its roots at First Chicago, now part of JPMorgan Chase (JPM). Canning, a native of Bayport, N.Y., high school baseball star, and Duke University-educated attorney, began running the bank's venture capital operation in 1980. Co-CEOs Finnegan and Samuel M. Mencoff each logged more than a decade there before the venture arm was spun out in 1992. One of its first deals was the buyout of Procter & Gamble's (PG) absorbents operation, which earned $310 million, a more than eightfold return when Buckeye Cellulose went public in 1995.

The heritage of the regulated banking industry could explain Madison Dearborn's conservative bent—it is accustomed to orderly processes and controls. In contrast, most rivals hail from the freewheeling investment banking world. Blackstone's Schwarzman, for example, was head of mergers and acquisitions at Lehman Brothers (LEH), while Apollo Management founder Leon Black was a protégé of junk-bond kingpin Michael Milken at Drexel Burnham Lambert.

Madison Dearborn prides itself on collegiality and community. Fees from investors and portfolio companies pay for base salaries and for keeping on the lights, but it is profit from the sale of portfolio companies that brings home the bacon. Madison Dearborn, like other private equity firms, takes 20% of those earnings, called the carry. No one owns more than 9.9% of the partnership, and profits are shared among 30 principals, which encourages younger partners to stay put. Eight of the firm's 14 founders are still at it, while five have retired, and one has died.

"A Human Capital Business"

Although the partnership elevated Finnegan and Mencoff in November, little change is expected. The pair, who helped found Madison Dearborn in 1992, already had been running day-to-day operations as co-presidents. They credit Canning for establishing a sober culture devoid of stars. "We don't depend on one or two rainmakers," Mencoff says. Both acknowledge that co-CEO arrangements can be risky, but as friends and contemporaries, neither wanted to make the other his subordinate, Canning says. For his part, Canning is spending more time in business development and relationship building as the public face of the firm.

What really distinguishes Madison Dearborn as a kinder, gentler buyout firm is its support of incumbent management. Canning's group doesn't look for turnarounds, such as Chicago steel-distributor Ryerson, where buyout firm Platinum Equity ousted CEO Neil S. Novich and two of his lieutenants just days after the October takeover, and targeted 600 employees for layoff. The firm also doesn't go for the sort of dramatic, 100-day plans favored by Blackstone and KKR that often involve operational overhauls. It's not that Madison Dearborn lacks the stomach for bloodletting, says Finnegan. "We just don't have the expertise."

The group prefers to massage companies that haven't reached their potential, perhaps because they were neglected by a corporate parent or need to be shielded from the demands of stockholders. Chicago's Nuveen, for example, has grown steadily over the past five years, doubling its assets under management, to $162 billion,its and diversifying from its base in municipal bonds. But the money manager lacked synergy with its longtime parent, St. Paul Travelers, says Nuveen CEO John P. Amboian. As a private company with what he calls a flexible debt structure, Nuveen will be able to invest more in its organization and in new products, such as mutual funds. "Madison Dearborn recognized this is a human capital business and that people have to be supported," Amboian says.

For Packaging Corp. of America (PKG), a 1999 buyout of Tenneco's (TEN) containerboard business, Madison Dearborn's biggest impact was in encouraging bold investment. "They think big," says CEO Paul T. Stecko. "I used to think a 15% after-tax return on a project was good. They would ask what would it take to get to 50%?"

Madison Dearborn acquired a 55% stake in Packaging for about $4.55 a share, with Packaging's former sister company, Pactiv (PTV), buying the rest. Although the Lake Forest company carried $1.9 billion in debt, its new owners quickly sold land holdings, enabling them to take Packaging public again just 10 months later. Madison Dearborn began selling at the end of 2005 and disposed of its last shares in August, at prices of $20 to $25 a share, for a total profit of $950 million. "They did terrific," Stecko says. Two Madison Dearborn principals remain on the Packaging board.

Eschewing Quick Paybacks

The outfit loads debt onto its companies with the best of them. An analysis by Bloomberg of firms doing the biggest combined buyouts between January, 2005, and last September says Madison Dearborn employs the highest leverage: Its debt was 11.82 times cash flow, outpacing the average of 9.54. Madison Dearborn says the analysis was flawed because it used incorrect data and a misleading methodology that skewed results toward the firm's larger deals. Still, its own analysis calculates its leverage at 6.9 times, placing it fourth, behind Thomas H. Lee, Blackstone, and Bain Capital.

But Madison Dearborn avoids the enriching dividends that some buyout firms take in recapitalizations. In 2006, Clayton, Dubilier & Rice, Carlyle, and Merrill Lynch (MER) collected $1 billion in a one-time dividend—nearly half of the $2.3 billion they put up to acquire car rental giant Hertz (HTZ) just six months earlier. At Burger King (BKC), investors TPG Capital, Bain Capital, and Goldman Sachs (GS) in 2006 recouped their $325 million investment with a $367 million dividend even before an initial public offering several months later.

Critics say recapitalizations to pay dividends reduce equity and leave many companies more vulnerable to cyclical downturns by sticking them with new debt. A recent analysis by Moody's Investor Services of the dividend practices of 14 private equity firms found that nearly 35% of downgrades were attributable to extracting dividends. Madison Dearborn was among the least aggressive, Moody's (MCO) found, and the payouts that it did take were part of club deals. "We resist the temptation of immediate payback in return for greater gain down the road," Finnegan says.

Madison Dearborn has won high marks among investors for reducing fees or dropping them altogether. (It charges 1.5% of the amount invested in a particular fund.) When its third fund, launched with $2.2 billion at the height of the tech boom in 1999, lagged in the years after the bust, the partnership suspended its fee in 2002 and hasn't reinstated it. Similarly, when its fourth fund, with $4 billion, was slow to get off the ground in 2000, the partnership reduced its fee by 37.5 basis points. Says Gary Silverman, who runs Kaye Scholer's private equity practice in Chicago: "They look like stand-up guys."

Courting the Sellers

When credit markets seized up last summer, Madison Dearborn played nice guy again. Investment banks led by JPMorgan Chase and Lehman Brothers developed lender's remorse after they couldn't market $4.9 billion in debt for computer wholesaler CDW without big losses. Some other private equity firms might have said, tough. KKR, for example, was portrayed as taking a hard line with its investment banks in its buyout of Denver's First Data last fall. But Madison Dearborn agreed to modest changes, including raising some interest rate caps, says Madison Dearborn Managing Director Benjamin D. Chereskin.

Madison Dearborn probably scores the most points for its lack of pretension, which helped it win the 1998 bidding for Reiman Publications of Greendale, Wis. Founder Roy Reiman had told prospective buyers early that his wife would be involved in the sales decision. Ted Forstmann, a corporate raider immortalized in Barbarians at the Gates for his unsuccessful 1988 bid for RJR Nabisco, flew in on his private jet, presented his offer, and gave Reiman about 30 minutes to make up his mind, without bothering to spend any time with his family, says a source familiar with the bidding. The Madison Dearborn crew, which was happy to spend time with both husband and wife, won the day. A spokesman for Forstmann said his associates didn't recall the encounter.

CDW Chief Executive John A. Edwardson, who presided over the auction of the company last spring, was struck by how many of the East Coast bidders resembled Gordon Gekko, the ruthless raider portrayed by Michael Douglas in the 1987 movie Wall Street. He says their mantra was the same: "We know more about running companies than any management team could ever know." Meantime, Madison Dearborn made the effort to learn what the company was about. Its team logged the most hours in an online document-room where proprietary data was available to all the bidders.

The CDW auction was sparked by an unsolicited takeover proposal to director Michael Krasny, who founded the company in 1982. Annual growth had slowed, and "we walked in believing that the company's best years were behind it," says Chereskin, the lead partner on the deal. Instead, as the team dug into the numbers, it became convinced that the $8.1 billion reseller had much greater growth potential if, for instance, it pumped up its 2,600-member sales force. Even with its debt load, Chereskin says, the company will be in a better position to make overdue investments and still return 20% to investors, a group that includes Providence Equity Partners and senior managers at the company.

Madison Dearborn's new challenge is the credit crunch. With debt financing virtually nonexistent, the action is likely to shift. Rather than buy companies outright, Madison Dearborn could take stakes in businesses that need capital to make acquisitions or expand. Of course, a recession could humble private equity firms, or make them ornery. But Madison Dearborn is likely to stay in character. "We don't flaunt it," Mencoff says. "We return phone calls on time."


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