Excerpts: Phil Canfield in the Deal Maker Spotlight
May 17, 2011
“Today, it is still about returns but, more importantly, return drivers.”
Philip A. Canfield
Phil Canfield shared insights with Global M&A Network about the importance of return drivers in raising follow-on funds, the effect of cash overhang on private equity deals, deploying GTCR’s $3.25 billion tenth fund, and criteria for identifying the “right leader,” which is central to the firm’s Leaders Strategy style of making deals and managing its portfolio company performance.
Q: Has the credit crisis and economic recession of late altered the buyout strategy at GTCR and the private equity industry at large?
Mr. Canfield: I don’t think they have really altered things at the strategic level for GTCR or the industry at large. We are all still fundamentally trying to make investments that can return 2x to 4x our capital over a four- to seven-year period. The dramatic downturn may have made people more cautious than was warranted in late 2008 and 2009. And the current availability of inexpensive financing and PE overhang may be making people more aggressive than they should be now. But, these are the normal cycles within PE. I think the one dynamic that has changed is, what is required to raise follow-on funds? It used to be all about returns. Today, it is still about returns but, more importantly, return drivers.
Q: How are investors evaluating return drivers today?
Mr. Canfield: Investors want to know—did you generate your returns through PE expansion, leverage or improved operating performance? Investors are looking for firms that get their returns by increasing operating performance. And they want to invest in firms with an investment strategy that consistently puts the firm in a position to drive operating performance in a differentiated manner. For us, that is our Leaders Strategy, finding and creating partnerships with world-class leaders and then buying businesses with them. Finally, investors want to see that you have an organization built to support and drive your strategy. So today, to raise money, you need returns (driven by operating performance), a differentiated and defensible strategy, and a well-run organization that drives the firm’s strategy in a consistent, disciplined manner.
Q: Congratulations on raising the tenth buyout fund at $3.25 billion. How will the fund be deployed and over what period?
Mr. Canfield: Thank you. The fund will be deployed principally by leveraging the Leaders Strategy across our growth sectors: Information Services & Technology, Healthcare, Financial Services & Technology and Growth Business Services. We typically deploy our funds on a ratable basis over a four-year period. However, the timeframe could be as short as three years or as long as five depending mostly upon the investing environment. If we feel really good about the opportunities we are seeing, we accelerate the pace. If we feel less comfortable, we slow down.
Q: What are the incentives driving buyout deals for the next 12 months as the economy and financial markets continue to strengthen?
Mr. Canfield: Right now, it is all about the overhang. There is nearly a half-trillion dollars in overhang at this time. In three years, two-thirds of that will have expired if not invested. The money will not get returned (with a few exceptions), so there will be lots of LBOs done in the next 24 months.
Q: How will the “overhang” affect the deal activity? Any insight on deal competitiveness or driving valuations?
Mr. Canfield: Everything else being equal, the overhang will drive valuations up. We think it is always important to have an edge or an angle when making PE investments. Our edge is our Leaders Strategy and we feel that strategy will be particularly important and effective in the highly competitive environment we are likely to see in the coming year or two.
Q: What is an ideal company for a GTCR buyout and how do you spot them?
Mr. Canfield: For us, a division of a large public company with $75 million to $200 million of EBIDTA, where the division is underperforming relative to the core business of the parent and underperforming relative to its competitors. Through our Leaders Strategy, we can buy that business for a fair price from the parent, basically the price any other PE firm would/could pay. We then can generate our returns because our management leaders can increase the fundamental operating performance of the business—by increasing the revenue growth AND cutting cost. As a result, we’ll get improved operating performance and probably an increased multiple when we take the business public (one-half our exits) or sell to a strategic.
Q: GTCR won the North America Private Equity Deal of the Year Award (2010) for its acquisition of Protection 1, Inc. This deal originated from GTCR’s long-standing relationship with Tim Whall. Is having relationships with known industry experts an important part of GTCR’s deal sourcing strategy?
Mr. Canfield: It is the core of the Leaders Strategy. Finding and partnering with world-class leaders and then buying businesses with them—that is what we do. As in the case with Protection 1, we will often partner with the same team multiple times throughout the course of a decade.
Q: What is the most difficult part of negotiating a stand-alone buyout transaction?
Mr. Canfield: It is very hard to generalize about the answer to this question. Each deal is different, interesting and challenging. Most deals require a fair bit of resourcefulness on the part of the deal-makers to get to something that works for both sides. Sometimes creativity is required around structure of the consideration in order to bridge the bid/ask spread on value. Sometimes, it is more nuanced terms in the contract. Sometimes, it is about transition services or how the obligations to the shared customers will be met. Every deal has one or two things that are make/break and require creativity. That is what keeps us all coming back for more—it is challenging and creative work!
Q: Any example of a “make/break” situation that required your deal team creativity? Under what circumstances would GTCR walk away from a deal?
Mr. Canfield: We once had a situation where we discovered in due diligence that the seller, which was a large public company, had issued performance guarantees to all of the customers of the division we were buying. The seller wanted to transfer the guarantees, asking us to take them. But they were potentially as large as the entire purchase price of the deal. Also, the customers did not want to lose the guarantees and we, as the new buyer, did not want to lose any customers. After lengthy negotiations, we ultimately structured an arrangement whereby the seller kept the guarantees but we had an incentive through a reverse earn-out to work the guarantees down over time. We clearly do walk away from deals from time-to-time. We work hard to indentify and address make/break issues early on and deal with them upfront. That is the most time efficient for us and the most fair for others involved in the process.
Q: Where do you think valuations for technology companies are headed in 2011 and how does this impact the tech M&A sector?
Mr. Canfield: With all the capital and cheap credit available, it is hard to see how prices won’t go higher for everything. I think the same is true for tech. High prices place a premium on being right about the growth prospects for a company. For us, this is where the combination of our domain expertise and our Leaders Strategy come into play. The domain expertise puts us in a position to be right about growth more often than not and the Leaders Strategy puts us in the position to execute and achieve the growth.
Q: What are the criteria for identifying the “right leader”?
Mr. Canfield: For us, that “leader” has to be a proven creator of equity value. He/she has to be driven and passionate about business. Our “leader” has to have a clear vision for what needs to happen in their industry, a compelling point of view about how the companies in their industry can better serve their customers, and a view on how to build a business that provides the absolute best, most comprehensive and most valued service to the customer. As well, our “leader” has to be a person we enjoy being partners with. Today, we mostly do this because we like to win and we like to have fun growing companies. If we can’t be successful, build a strong, long-term relationship with the management team and have a good time doing it—then no thanks!
Q: As an active volunteer for the Chicago Foundation of Education, what are your thoughts on bringing value to the public education system in America?
Mr. Canfield: As you know, I am passionate about this topic. Like in business, alternatives and competition drive the creation of better service offerings. Frankly, the public education kids get is only as good as the neighborhood their parent(s) can afford to live in. Schools should compete for students—and students should be able to choose the public school they want to attend. There are many ways to accomplish this to many varying degrees—charters, vouchers, etc., all are different ways of creating more choice. Choice and competition are the only things that will improve public education in the long run.
Q: Finally, what book are you currently reading?
Mr. Canfield: I usually read several books at once. Right now I am reading and almost done with Intellectuals and Society by Thomas Sowell. And I am about one-third of the way through Fault Lines by Raghu Rajan. Intellectuals and Society is very interesting because it dives into the root motivations and incentives of the intellectual elite and then catalogs over the centuries how the intellectual elite often get things wildly wrong. It is fascinating. Fault Lines is interesting to me because Rajan makes a link between income inequality and cheap, poorly allocated credit. His argument is that it is easier for governments to redistribute consumption vis-a-vis credit than wealth vis-a-vis taxes. And then he goes on to show all the crazy distortions that happen in markets when this occurs.