The Hard Truth About Operational Excellence w/ KKR's Pete Stavros

[MUSIC] The reality is operational improvement and driving operational change is really hard, like really hard. >> That's Peter Stavros, global co-head of private equity at KKR. And if you ask Pete what it will take to generate alpha in a more challenging environment, he'll come right back to some of the industry's fundamentals. They source proprietary deals and they drive real operational improvements. It may sound like what you hear from any number of fund managers until Pete starts unpacking the discipline required to make it actually work. >> Senior folks on our team, they couldn't run a factory, but they'd come close. >> Today on Dry Powder, we'll explore what a prototypical KKR deal really looks like, how their operational depth works in practice, and how the firm is navigating today's slower deal flow, tougher exits, and stretched LPs. I'm Hugh McArthur, chairman of Baines Global Private Equity Practice, and this is Dry Powder. [MUSIC] Pete, welcome to Dry Powder. It's a pleasure to have you on the show today. >> Thanks for having me. >> What are you seeing in market conditions today around deal making exits? What is the health of the private equity world look like from a buyout perspective? >> Well, fundraising, I think, is difficult. You know, LPs feel stretched, feel over allocated to private markets, to alternatives. I think as many of your listeners will know, one of the mistakes our industry made was over deploying in 2021 and 2022, when the 10 year was 1% and private market multiples were very high. That deal activity in 21/22 was pretty centered on software as well. So it was kind of the wrong industry at the wrong time at the wrong valuation level. And our industry spent that money quickly, meaning lots of funds were raised in 2021, and they were spent in 1824 months. And then they went back out to market asking LPs for more money. And LPs, for the most part, consented and reupped. But now they're waiting for money back and saying, hey, I've basically invested two X. What my normal commit would be over the last five years, where's the money back? So fundraising's tough. New deal activity is slow. I mean, it depends on part of the world. You know, Europe is, I'd say, particularly slow. US is pretty slow. Asia is doing fine. And exits are tougher to come by. You know, in 21/22, if we had a great business, we'd have eight bidders, you know, who were dying to own it. And now you get a few. So it's definitely a slow market, I would say, on all fronts. Now, our whole orientation towards the market is consistency. So we find a way to deploy 20% of our fund every year. So we have this real orientation towards linear pacing. And we don't try and time the market on exit, either. When we've accomplished 80% of what we came to do with the business, we had for the exits. You know, and if there's only two buyers, so be it. I think it's a fool's errand to try and time these things. And that's one of the things that's, you know, held us in good stead, is we've just been really consistent, you know, for 20 years in terms of deployment and money back. There's no doubt that LPs appreciate from their partners predictability at both deployment and getting the money back with liquidity. And so I'm sure it has held you in good stead. Much of the industry is not in good stead on a lot of those areas today. And I think that, you know, some of the capital velocity acceleration period that you're describing in 2021 and 2020, it's interesting that about every decade or so, we seem to see that in the buyout world in particular. We saw in the late 90s, we saw it in 2006, 2007. Usually you get a big recession that happens after that. And in this instance, we've actually not. We have kind of record asset prices where they're actually trading, certainly on the public side, also on the private side as well. And I think that frankly, this last decade right before that capital velocity acceleration of zero central bank interest rates kind of masked in a way, a maturation of the industry. And now we're in a kind of a $5 trillion industry with $3.8 trillion of portfolio companies and buyouts alone and over a trillion dollars of dry powder out there. It's a much, much bigger industry. But triple what it was just in buyouts 10 years ago globally. And given the competitive nature of the industry, I can be great for our audience to get your take on. What do you think it's really going to take to generate alpha in a more expensive, more volatile, more mature environment than we had six or seven years ago? No matter the environment, I think the only way to consistently produce alpha is through operational improvement. And every firm says this. It's one of the frustrations that being a private equity investor is all these firms are very good at marketing. They're very good at telling a story. And the reality is operational improvement and driving operational change is really hard. Like really hard. It takes a huge amount of resource. You can't outsource it. You really got to own it as the investment team. And that is something that takes decades of training. It's something that takes an enormous investment at the firm level in terms of operational resources. Who owns that agenda? I think is critical both in terms of identifying the opportunity and then who's on the hook to deliver it. So there's lots of strategies out there. There's folks who say I'm going to pick one or two sectors and that we're going to be experts in those sectors. Those people who say we're going to be very thematic. We're going to pick the right investment themes. And I think there's this other strategy of we're genuinely going to drive change and operational improvement in a different manner and with a different degree of intensity. In my opinion, I think that's the winner. I think that's the one that can sustain through cycles that will differentiate you over time. I think picking the right sector at the right time, the right theme is really tough to do in a repeated fashion. For example, picking an investment theme, finding those themes that aren't already priced in to the deal. It's tough. Now operational improvement on the other side, hard to identify. It's less common to have all the resources to do it. It takes a tremendous amount of effort. There's only so much resource to go around. I think it's tough if you're not a firm with the resources and with the experience to go to go drive it. So that's my view anyway. Is that's the real differentiator and the real source of that. Alpha creation on a consistent basis. So if I'm hearing you correctly, Pete, you're saying that in themes or hot subsectors or things like that, they tend to be fully priced because everybody's piling in because it is a theme or it is a subsector that happens to be in favor. Therefore, on a repeatable basis, themes change, hot subsectors change is hard to kind of have the legs to generate alpha consistently if that's your model. Whereas if your expertise is really driving operational value creation and getting really good at finding levers across industries where you look and you say, I can make that better. I can fix that. I know how to actually improve the performance of this business working in partnership with management and potentially external advisors or whatever the ecosystem I need to put together is that that's actually the repeatable model that you feel highly confident has the legs to go through any business cycle. That's my view. Yeah. I think that's fascinating because as you point out, a lot of people talk the talk, but it's very difficult to actually walk the walk with provable results at the end of the day. And I guess the provable results would be the consistent deployment and the consistent realization of returns that you're talking about from year to year. And the individual case studies. When we can show our investors, hey, this investment, we don't love doing secondary inter-shary buyouts. A lot of what we do are carveouts and take privates because those are richer targets for ops improvement. But when we do have those case studies and we've got many of them where they look at this business has been owned by not one, not two, but three smart PE funds. And we went out and took the margins up a thousand basis points, where we doubled the growth. How's that possible? And when you dig into it, we're living at these businesses. If it's an industrial business, we've got people literally working in the factory. I mean, our investment teams, we really pride ourselves on how operationally inclined they are. Now, if you were to spend time with just sticking with that example, which is my old wheelhouse of industrials, our senior folks on our team, they couldn't run a factory, but they could come close. I mean, they know enough to be able to walk around and identify opportunity, ask the right questions. I used to take our industrial team over to Japan for two weeks a year. And we would study under this group, Couching a Jitsu, that helped develop the Toyota production system. And then we'd come back and I'd make everyone go do four Kaiser events, a year and go live in factories. So it's really in the DNA of the firm. We think like operators. We really don't think like finance people. And I love the transfer of talent into a portfolio company. That's an incredibly powerful statement about the amount invested you have in generating operational excellence and create really getting the value from that. But obviously, macro forces and other things do impact the companies that you buy. And so I'm wondering how you think about portfolio construction. And is there a way to think about that to help mitigate the risks of some of the turbulence that we see in today's markets? So yes, so we've got a big portfolio construction effort. It was born out of a mistake that we made. So I mentioned the mistake our industry made in 21 and 22. We made that mistake prior to the great recession. So if you look back at our 2006 fund. We invested most of it prior. to the recession. So we invested it way too quickly and that had multiple negative impacts. We were overexposed to a period of time when multiples were high and operating earnings were elevated. We then ended up being underexposed in that fund to the post-recessionary environment because we didn't have capital left. So we kind of got the worst of both worlds. The fund was still fine. You know, it was still a double, but the IRR was disappointing. We made other mistakes in that fund. We were not disciplined enough on position sizing. So we had some of our worst investments where larger positions. We had too much sector concentration. We were in some of the wrong sectors. So all the mistakes that we made there, that was really the start of our macro team. So we hired a guy called Henry McVey from Morgan Stanley. He built out, I think we have 50 people now and they work with our portfolio managers on exactly that portfolio construction. So investment pacing, position sizing, sector diversification. We truly invest across seven sectors. That's not that common these days. Most of our peers are really focused on a couple of sectors. We truly invest across seven. And then there is hidden correlations, companies that are in different verticals, that actually behave similarly when certain macro variables move. So we look at all that stuff. What we're trying to do is remove as much of the beta as we can from the portfolio. And then again, outperform through this alpha generation that we talked about. That's what we're trying to do. And when you say, Pete, hidden correlations across the portfolio, how does that work in practice? How do you find one? Do you have an example or just what does the process look like? Yeah. So there might be a building products company that's technically in the industrial vertical but acts like a consumer business. So what you do is you would look at as interest rates move, how do all these different positions in the portfolio move, oil price sensitivity, et cetera. And you'll find these hidden correlations that you might not have immediately thought of. So to us, an industrial company isn't necessarily a company that the industrial's team does. It's based on how it moves relative to macro variables. And the way we find it is we get ideally decades of data on each of these companies. And we're looking at not only how those companies perform, but their peer set. So they're comparable companies which we define in our valuations. We're running all sorts of analyses to look for those correlations. I'd like to dig more deeply into this notion of operational depth and have you chat a little bit about how exactly it works. I've heard you describe a prototypical KKR deal as a good business that's undermanaged, which is something that again, this one of those things where it's kind of easy to say, but it's hard to really do. It's hard to find a good business that's undermanaged so you can buy it at a good price. Yeah. What are you really seeing that others are missing when you see a good business that's undermanaged? Well, we're seeing, when we say good business, we've got specific things we're looking at in market structure and competitive mode and what competitors and customers are saying about the company. So we're defining good business, returns on capital. There's a bunch of things we're looking at for quality. And then the trickier one is the opportunity operationally because it's bespoke in every situation. It's not like every time we're going through and looking at quality, customer satisfaction, on time, delivery, scrap, productivity, whatever. The menu might be the same, but what we're picking out is different. And sometimes it's, I'll give you an example. One of my partners did, who's now my co-head of private equity, Nate Taylor, he led an investment in a company called Bountiful, which is a vitamin business, a brand-advied business. And his whole thesis was, we're going to sink the earnings intentionally to drive growth. So we're going to take EBIT down, meaningfully, but we're going to massively improve and enhance their spending on advertising and marketing and promotion. That's kind of a weird, that's a little bit unusual thesis, but that's what I mean. It's always different. That ended up, by the way, working out phenomenally. The trade off there was, yeah, we took earnings down, but it was kind of like shrinking to grow, totally repositioned all the brands and ended up selling it for a strategic multiple to Nestle. But it's different, it's different every time. And I do think it takes a really 10-year team, our PE partners in the US, for example, have been working together for nearly 20 years. Nate and I are on our 21st year at the firm. So we can finish each other sentences. We've all been through this training for the last 20 years together. I think it's hard to develop this. And then on top of that, we've got our whole capstone team. I mentioned our macro team. We've got a huge capital markets team that works with us. We've got a whole slew of industry advisors who often are chairing companies for us. So these are ex-operators who work side by side with us to drive this improvement. Lots of operational and other resources to bring to bear. And we spend just a huge amount of time on each company. And how does having a deeply operational investment team change the way you actually source and underwrite deals? How does that impact the finding of the deal and then what value creation levers you're actually going to dig into? Yeah, in terms of the finding of the deal, I mean, once you get into even 50 million of EBITDA, things are intermediate. I mean, I know our industry loves to talk about proprietary deals. They are few and far between. I mean, we in the 20 plus years I've been here, there's just a handful of scale situations that we've truly gotten a proprietary look. Sometimes you might get an early look, but they're going to go do a market check. So I think it's less about, hey, we found something others didn't know was out there. And it's more, we're always asking ourselves, why is our financial model different? Why are we looking at a different set of numbers than everyone else? Because if or not, then it's just a cost to capital play. So that's what we're pushing ourselves on every time is why should we own this? Why is this a KKR deal? What are we really going to do with it that others aren't seeing and others couldn't do? And Pete, when you get to close, how does having this operational depth that you've described change how you actually run the business? When you talk about running the business and partnership with management, like what does that look like? So you've gotten to close, you've gotten some conviction around some value lovers, how does it then go? What's the process look like? Yeah, so I think it impacts the way our team's engaged with the business. And I'm using team broadly. So it would be our investment team, capstone, industry advisors. We're really involved. You know, we're not, we try not to smother the company and we try always to leave ultimate decision making the hands of the CEO because if you start making decisions for people, then accountability gets all messed up. But our board meetings are really operationally oriented. So it's not like we're just sitting there grinding through financials. Our typical board meeting, I'll just use this industrial example, you know, again, would first start with the people. So we would focus on safety, engagement, quit rates. So it'd be the first part would be cultural. And then we'd move into operations. We'd all know what the key value creation levers are. It might be procurement, sales force effectiveness, scrap, productivity, whatever. All of those objectives, we would have defined both in the aggregate level. They'd be broken down by facility, by shift. We'd have pretty extensive get charts. We'd be reviewing with management. I mean, we're way into it. And then that all spits out the financials, which are kind of like the least interesting of the discussion. I'll give you an example from when I was more day to day in the trenches. So we bought a company called Gardner Denver. It was a public company that we took private. It was, I would say in disarray, the CEO quit before the sale process, divisional leaders were streaming out of the company during the process, an activist investor really forced the sale. And we spent the next almost 10 years working with management to totally transform it. And that started again with the cultural part. So engagement scores went up something like from the 20th percentile to the 90th. I don't remember exactly the numbers. The quid rate dropped from start to finish by 90%. So we were hiring thousands of fewer people. So you get, you know, yet a totally different business culturally. And then operationally, a lot of what we do in supporting management is we have the benefit of owning 225 companies and having looked at thousands. You know, so we will see patterns. So I had looked at a aerial work platform business that found a way to take out a tremendous amount of costs through value added value engineering. If you're familiar with that, it's a way of basically removing costs out of a product without sacrificing quality. Those aerial work platforms had lots of kind of complicated and expensive electronics that could be optimized. And then it was a high volume standard product. So called our CEO who is exceptional at GD is exceptional. He's still there. It's now called Ingersoll Rand. And today I saw this work over here. We make a lot of standard compressors. And, you know, we should try this. So we brought in some outside help. We rented a warehouse. You know, and we were deeply involved in this whole thing. We dissected our compressor, our highest running compressor in this vacant warehouse we leased from soup to nuts, you know, from the base of the compressor all the way through to the compressor blades. We bought our competitors. comparable offerings did the same thing so you could walk horizontally across that factory and compare every piece of the compressor. Then we had cross-functional teams at the company, everyone from the energy efficiency group to procurement to manufacturing, to sales, all kind of trying to figure out how could we optimize our compressor relative to what we're seeing from competitive offerings. That one project has took a years but that saved us I think $60 million just in our compressor business and we would be doing those kinds of extensive intensive projects throughout our ownership period. I like the way you talk about years to get things done because there are a lot of GPs out there that they'll do a value creation plan and they'll be a big sprint out of the box when you get to post-close to get things done in partnership with management but oftentimes we see that some of the energy for doing that wanes after about the first 18 months of the holding period and people kind of get distracted and go back to doing other jobs and other deals but sounds like once you get your ecosystem of folks, your team dug in there, they're working years and years and years to get whatever value on the table, the 80% number you referenced earlier that you can get as quickly as you can and that intensity doesn't go away because of your operational culture, it's stick to it, stick to it, stick to it. Those are the people we're looking for. Sometimes young folks will ask me, what's KKR looking for in private equity? What advice do you have for me? I want to be a private equity investor and I always say get operational experience. If you love operations that really to my mind is what makes a great investor. It's again just my opinion it's less about calling a theme, calling a market and it's much more about having insight into what you can do with a business, culturally, operationally, of course financially and people hear love that stuff. So the energy definitely doesn't wane because that's the whole reason we think we exist is to try and make these businesses better. Makes a lot of sense. Pete, let me return to some of the other industry issues that I want to talk to you about. Some of these you've mentioned already and some of them you haven't but we talked a little bit about the pressure on exits, the aging assets, the capital velocity accelerating a few years ago. With this big backlog that we have right now, unsoldened aging assets, how are you thinking about exits today at KKR? I know that the model should be what you said which is kind of let's go for 20% year five predictable but the conditions and how you've been investing. Do you see them as attractive enough to kind of do that right now or is it we in a period where it's a little bit more challenging? Yeah, it's hard to believe but this will probably be our largest exit year ever in private equity at KKR and it's again it's not us timing the market like now's the time to sell. We put a fair bit of capital out over the past five to six years. Our fund size has grown so we've got you know more sizeable assets let's say to sell and we're 80% done with the work and so we head for the exits. So we've got kind of linear pacing on the way in spend 20% of a fund every year for five years. It's not so much about time because if we accomplish 80% of what we came to do in three years we'll exit. It might take us eight years but once we're done with our plan we go public or sell. That's what we've already done a bunch of this year and we'll do more of. Now you recently raised one of the largest funds in the market. In fact I think it's the largest North America focused by our fund ever if I'm not mistaken and we talked at the outset of our show here about how difficult the fundraising conditions are for buyouts right now. How did that happen? Take us inside the fundraising effort and how did we get to such a big number and such great success in a market that most players are really struggling and taking a long time to come anywhere near their number. Yeah we were really obviously thrilled with the outcome and grateful for the trust that our investors placed in us with that 23 billion dollar US fund and you're right it is the largest US fund ever raised and there's a lot of market headwinds to your point you know private equity just overall there's concern over LPs short of liquidity there's a lot of concern over software and AI and how much our industries exposed to those not just software but particularly in those ventages that we mentioned China for the most part was a big allocator to the US and is not right now given geopolitical concerns is the whole list of reasons why this should not have gone well and the reason it went well is the returns have been excellent for 20 years our LPs benchmark us very clearly versus our pure set and we're pleased with what they saw they also view our strategy as lower risk meaning we're across seven verticals not one or two and underneath the performance is operational improvement and then we've got a very consistent team our average tenure you know is I think 16 years and many of us have been here longer than that and then I do think LPs particularly some of the public pension funds care about how you're getting returns so when they see what's happening with the workforce at these companies and many of them come to see it for themselves you know we always invite them as we do with reporters hey come and see it we're not saying it's perfect we're not saying it works every time but there's such a genuine effort to engage with front line folks in a different way but I think those are the reasons we were able to make that fund racing outcome happen well they they have to be happy with what they see if you get to a number like 23 billion that's a really commendable on the next episode of dry powder we'll dive into AI private wealth and one of the more fascinating extensions of KKR's value creation playbook broad-based employee ownership we've now done this with 85 companies about 200,000 front line workers we think they are in a position to make $14 billion of wealth for themselves so the numbers are massive I'm Hugh Mecker out there thank you for listening (upbeat music)