The Dream Makers
IF YOU JUST SORT OF STUMBLED into this place -- admittedly a little difficult since it's on the 30th floor of a skyscraper near Wall Street, but let's say you did anyway -- and you happened to overhear a conversation, you might have a very hard time figuring out whether you were in a "little shop of horrors" rather than a leveraged buyout boutique.
LBO Hotshot #1: "You look depressed. What's the matter -- you break your pick (exhaust every conceivable possibility)?"
LBO Hotshot #2: "Just about. The division looked great -- I mean it was covered with hair (problems concealing opportunities). But the new product they were working on just tanked (failed). They tried all kinds of tweaks and twoks (fine tunings and major adjustments), but they had to put a pin (terminate) in it anyway. It absolutely cratered (messed up royally) their projections."
LBO Hotshot #1: "Guess we'll have to shoot this puppy in the head (reject the deal)."
LBO Hotshot #2: "It's too bad. I thought it could be a screamer (a great investment)."
Good Lord, what manner of men are these? Imagine, little puppies. The fiends.
Fortunately, underneath all this metaphorical mayhem, there lies a far more palatable reality, which, in its own way, is still no less shocking.
The fiends in question are actually six young, rather mild-mannered men, clean cut and listing toward preppy, representing Weiss, Peck & Greer (WPG), a private merchant banking firm. They are: E. Theodore Stolberg, 37; Kim G. Davis, 33; Wesley W. Lang Jr., 30; Stephen L. DeMenna, 34; Peter B. Pfister, 28; and intern Bradford Peck, 25. Despite the tough talk, they have no noticeable inclination toward wanton violence. Quite the contrary, it can even be said they are possessed of a rare and distinctly humanitarian sensibility. Superficially at least, they might be mistaken for any other group of LBO hotshots on the prowl in Wall Street, but that would be a regrettable error since there are a number of important differences.
Rather than focusing on huge deals like a $6.2-billion Beatrice Cos. buyout or a $4.25-billion Safeway Stores transaction, WPG concentrates on small to midsize opportunities with purchase prices generally ranging from $10 million to $100 million. And where many buyout specialists never involve themselves beyond the sheer mathematics of the initial financial leverage, and still others rapidly liquidate the underlying assets to pay down debt, this group attempts to build value through ongoing operating improvements in the portfolio companies themselves.
Finally, and perhaps most surprising, they do this by emphasizing what they call "human motivation" much more than numbers. They believe -- and their results appear to bear them out -- that the buyout must serve a higher calling, which is to nourish the passionate, occasionally miraculous, commitment of employees suddenly become owners. By placing people before figures, they look to create what might be called leveraged buyouts with heart -- an offering not often associated with Wall Street.
"It's beautiful to watch," says Stolberg, the group's founder. "There's a vast ocean of frustrated middle managers out there, and we're helping them become entrepreneurs. It may sound arrogant, but I really think we're dream makers."
Well, maybe so. After all, look at 43-year-old Robert J. Morrill, now part owner of Microwave Radio Corp., in Lowell, Mass., a manufacturer of portable television broadcast equipment. Twenty years ago, after he got out of the navy, Morrill started up a small roofing business, today recalled fondly as the entrepreneurial bug that bit him. But life, as it will, had different plans, and Morrill spent most of the next two decades working for a huge corporation. Even so, he never gave up on the idea that one day he might still have his own company. In December 1985, he got his chance.
Then a divisional vice-president with M/A-Com Inc., Morrill convinced his employer that it would make sense to let him buy a single product line within that division as part of a companywide restructuring. The line was burdened with various corporate overheads, bruised by an unwieldy and ineffective service department, and excluded from potentially lucrative government business because M/A-Com was too big to qualify for the small-business set-aside program. None of these problems, however, was attributable to any inherent deficiency in an otherwise robust product. So high of heart Morrill, most often in the company of his collaborator, Edward Dahn, an M/A-Com marketing manager, set out on his quest. For six months he wandered around Boston trying to find financing. He saw 20 different venture capitalists, all but one of whom rejected his petition. For some, his projected growth rate of 15% to 20% a year was too slow; for others, his potential market was too small, or his idea fell into an unacceptably murky area somewhere between a bona fide start-up and a de facto refinancing of an existing business.
Ultimately, Morrill found his way to Stolberg and friends and also found the fit he was looking for. "It was a question of chemistry," Morrill says. "I need people around me with a sense of humor, and all those other guys couldn't crack a smile."
On its part, the LBO group was not only sublimely indifferent to the venture capitalists' point of view, but also nearly ecstatic that the deal should come with such interesting "hair." In the end, though, and in keeping with the group's people-centered ideology, it was Morrill's strength of character and commitment that made the difference. Within 60 days, the leveraged buyout was complete. And since then, Morrill and his partners -- Dahn and Fredrick Collins, who originated the product line 28 years ago -- have been meeting their projections regularly, with new orders now approaching $7 million.
"You know that fairy tale character, the frog prince?" Stolberg asks. "Well, sometimes I think that's the best way of describing what we do: we take frogs, give them a kiss, and watch them turn into handsome princes."
At first such whimsical notions are difficult to reconcile with Stolberg's outward demeanor and appearance, but he is a man of many parts. Although he is fashionably svelte and prone to wearing double-breasted suits of stylish cut, and although his features are sharp and angular, all of which suggest a cool, professional reserve, he is, instead, affable and warmhearted. He is also, according to his own analysis, "twitchy," which in this case translates as enthusiastically high-strung. When he gets excited, which is frequently, he sputters and sparks with colorful turns of phrase and decidedly mixed metaphors. And there are times during particularly anxious moments when all he seems able to do to moderate the considerable energies within him is sit at his desk and flip number 2 yellow pencils into the cork panels of the ceiling above, hoping they'll stick.
When Stolberg came to Weiss, Peck & Greer in 1981 to organize the firm's leveraged buyout capability, he brought impressive, if varied, credentials to the job. He had been a small-college, All-American football player and first in his M.B.A. class at Indiana University. He took a job as a corporate finance specialist with prestigious First Boston Corp., and as part of his duties became manager of a corporate development project for the National Commercial Bank of Saudi Arabia.
Once freshly installed at WPG, Stolberg spent his first year and a half building up a network of contacts and carefully evaluating the buyout market. Then, backed by an exploratory allotment of $5 million and eager to make a good impression, he was at last ready to engineer his first buyout. It was not an auspicious beginning. "Out of all the companies I've been involved with," he says, "I'm particularly proud that this one's still in business. It's kind of like having survived the Bataan death march."
In this case, Stolberg had spotted a division of a Cities Service subsidiary that seemed an ideal buyout candidate. The division extracted copper and sulfur in Copper-hill, Tenn., but its operations were suffering from neglect and its products limped into markets that received them indifferently. "It was a chance for our Statue of Liberty play," Stolberg says. "You know, give us your tired, your weary, your hungry, and we'll give 'em a new life." But only months after his $50-million buyout elevated the division into a freestanding company called Tennessee Chemical Corp., the new owner-managers called to report a catastrophic mine cave-in. It had spared human life but forever buried $25 million worth of equipment under a quarter mile of Tennessee dirt. Even though Stolberg and management were eventually able at least to stabilize the company's operations, the incident hardly inspired confidence in his luck, if not judgment. Stolberg in sure he would have been fired except that shortly after the disaster he completed another buyout that turned out to be a genuine screamer. And from there, Stolberg's enterprise grew steadily in funding and staff.
Currently backed by a $50-million fund specifically dedicated to buyouts and able to draw on another $150-million general fund if necessary, the team has completed eight buyouts since 1981 with a total purchase price of $225 million. That amount also includes Weiss, Peck & Greer's original equity participations totaling $15.3 million, an investment that has since appreciated to $105 million. Of this performance, Philip Greer, one of the firm's founders, was moved to remark: "It's simply the best thing we're doing."
Not surprising, they that actually do the work are also very well rewarded. Counting base salary and bonuses and various distributions from the funds, an individual's annual compensation can easily exceed $1 million. But that's not all. They can also invest personally in the transactions, and therein lies the path to truly extraordinary gains. In one case, an investment of $35,000 has since grown to roughly $850,000 in less than four years. Leveraged buyouts with heart, it might be useful here to observe, may be humanitarian, but they can hardly be called charity.
The six "corporate development associates" at Weiss, Peck & Greer are, in effect, a company within a company. Not only do they have their own income statement -- largely composed of the 1% to 1 1/4% of the purchase price they charge clients as a fee for services and the management fee on the limited-partnership pool -- but they also have their own culture characterized by its vigorously descriptive vocabulary, a demanding commitment to superior performance, and a fraternal camaraderie. Much of their time is spent on the road prospecting for deals. Of the nearly 300 deals the group sees each year, almost 85% are rejected in the first 20 minutes, usually because they have been shopped around so widely that a "bake off," or competitive bidding war between buyout shops, is almost certain. The remainder are considered at least worth a plane ticket, but of those only a very few become active candidates. "They're up there on the shelf percolating," says Davis, who prior to joining Weiss, Peck & Greer was a vice-president of acquisitions with competitor Dyson-Kissner-Moran Corp. "Every couple of months we come in and tweak them (get updated). There're maybe 10 or 20 of these things up there percolating, but then one comes down onto the front burner and the fun begins."
While it is common in the corporate finance business to find aggregations of specialists arrayed around one individual whose presence and influence rule the overall effort exclusively, this group seems to have developed a kind of tribal collaboration that is far more democratic. In practice, that collaboration even seems to produce a pulsing syncopation of its own as team members convene informally, then wander off to pursue individual initiatives, then reconvene to compare notes and digest meanings. As a given deal's deadline approaches, the pulse quickens under severe, spastic pressures, and the group's focus intensifies to accommodate marathon, around-the-clock deliberations that sometimes go on for days. During the final moments of their most recent buyout, for example -- a fertilizer plant in southeastern Idaho -- the group had to resort to techniques more common to a tag team of wrestlers than a band of sophisticated financiers. Assembled in a New York City law firm, the team met continuously over three days, scrutinizing every last word of the buyout's closing documentation. When one member's eyes glazed over, he would call up a fresh replacement and slink off to get some sleep under a conference table.
Over time, the combined experience of the team's individual members has coalesced to produce a rather formidable paradigm known as the "Screen." Wesley Lang, who came to the group after extensive experience in corporate finance with Manufacturers Hanover Trust Co., describes it as a "set of shared beliefs compounded of philosophy, anecdotes, and practical advice," a definition that at least hints at the diversity and reach of the Screen's unwritten precepts. Most often the Screen enters conversation as a device similar to a radar display that is scanning, always scanning, to detect the presence of a potential screamer -- like Microwave Radio.
Philip Greer, the founding partner, first heard about the company at a dinner party and later mentioned it to team member Steve DeMenna, who paid Morrill a visit. The results of that initial contact got Morrill and his partner, Edward Dahn, an invitation to the firm's New York office for a more extensive irradiation under the Screen's illuminating glow. Morrill might even have experienced a slight electrical tingling as he approached the conference room where the associates had assembled, in effect already adjusting the sensitive controls of their instrument.
Even at the most elemental level, Morrill's deal met two important criteria. First of all, although M/A-Com's asking price of roughly $3 million placed the proposed buyout a bit under the group's favored range, it nonetheless shared the intent of their overall strategy. Buyouts with purchase prices under $100 million, the team has found, generally attract far less attention than monster undertakings and are, as a result, more realistically priced; they require fewer layers of financing and thus can be completed quickly; and they are small enough that the new management can have a noticeable and immediate impact on operations. "Also," Davis adds, "in huge deals you don't have the time or the setting to really understand in every business unit what the human-motivation factors are. You do the numbers and pray every Sunday that the human stuff is right."
Second, Microwave was the right type of deal -- a product line within a division rather than an entire company. As a rule, the team avoids company buyouts in which the original owners cash out and go home because the second-line management's understanding of the business is often underdeveloped. The value of this particular observation was reinforced not long ago when the group acquired, for $20 million, Superior Manufacturing & Instruments Inc., based in Long Island City, N.Y. Here the original owners had aged to the point where they were more interested in personal liquidity than in running a business. After they cashed out, the new management team decided to expand by developing a line of sophisticated high-voltage power supplies. Unfortunately, after signing several large contracts, management discovered they did not have the operational depth to perform, particularly in engineering. "We disappointed a lot of people," says Stolberg. "I badly underestimated how much the old president knew about the business. I should've involved him more and put him on the board, but I didn't and so we broke our pick." The lesson was more than merely academic. According to Stolberg, the team's initial $2-million equity investment is now worth only half as much, the only loser in the entire portfolio.
But back to Morrill. After the first coarse sweep, the group turned up the dials for a more detailed look at three major areas: management, company operations, and the financial structure of the deal itself. Of the three, the quality of management is by far the most important. "The biggest problem a deal will face," says Stolberg, "is can the divisional manager make the transition to becoming president of an independent company and do that under leverage. You know, it's very difficult betting on people. That's the art of this business." It is also its greatest risk. Over the years, the team has put together a Rogues' Gallery of Undesirable Management Types, any one of which will cause the Screen to crackle ominously.
First, there is the general manager in a large corporation who has several business units reporting to him and takes on delusions of grandeur. "This is a little tricky," Stolberg says, "because a guy like that will always say to you, 'I'm responsible for $400 million in revenues,' or 'I run four businesses.' But after some probing you find out that all he's got is a monitoring role. He's not an operating guy; he's a group 'staffee."
Next consider the general manager who actually does have operating responsibility -- but no guts. "He says everything he thinks you want to hear," says Steve DeMenna, "but pretty soon you'll find out that he doesn't really want to take a risk and invest his money. He really wants a teed-up deal -- 20% of the company for nothing, a big salary and a bonus, a country club membership, and a car."
From Wes Lang comes a description of yet another classic type -- the general manager who thinks he's a chief executive officer but always needs strong direction. "This is the guy who can't make decisions on his own," Lang says. "He needs the consensus of a president and a board of directors. If you do his deal, you'll get a phone call from him every other day saying that he's got a problem at the plant or this machine's not working and what do you think. He doesn't put the bit in his mouth."
And finally, there's the manager whose ethics are a little loose. "This one manager was bidding on his own division," Stolberg recalls, "but at the same time the parent asked him to show it to other bidders. So what did he do? He wore a big red carnation. On the right lapel, it signaled his people that competitors were around and to talk the place down. On the left, it meant his own backers were there and to talk it up. If he'd do that to his own company, you can be sure he'll do it to you. We passed."
The team expects more than mere technical competence from its managers -- that is, something more than a thorough understanding of the business and industry, dexerity with basic business skills, and a record of demonstrable effectiveness. Above all, members say, they are looking for "good human beings with the right stuff," a rich discovery unearthed more by intuition and feel than by hard analysis.
They may be hard to find, but at least there are a few clues to look for. Successful candidates invariably display the same characteristics, including an optimistic worldview heavily colored with a sense of fair play, initiative coupled with calm persistence, and a willingness to commit "emotional equity" as well as the personal financial investment routinely required of every manager-owner. The one question the team must always answer positively before it will proceed any further is, "Will they make good partners?"
"It's not always easy to tell," says Stolberg. "You've got to cut through the cosmetics, and that can be difficult when everybody's wearing their Sunday best. The key is to ask the open-ended question and just listen. It doesn't matter which question you ask -- keep it general, keep zeroing in on the human motivations on why he wants to do the deal, are his motivations right, is his background relevant, and then you get into how bad does he want it."
It was against this backdrop that Morrill began to talk about his successful, 18-year management career with M/A-Com, about how the dream that had started with the roofing company suddenly came alive again. But he didn't know anything about venture capital, let alone buyouts, so he checked books out of the local public library. And then, what a letdown when he asked that first bank for help and they gave him a form to fill out as if he were applying for a MasterCard. Unbelievable. But oh, man, it was nothing compared with the long, frustrating hegira through the offices of the venture capitalists. He used to bring a rented videocassette player and a brief tape about the product to every meeting, but eventually he got so sick of seeing it that he had to leave the room. But no, he never allowed himself to get discouraged, not really. Someone sooner or later would surely recognize the merit of his proposal. It was simply the right thing to do, so right that he was willing to leave behind at M/A-Com nearly $300,000 in accrued bonuses and deferred compensation.
"And that," says Stolberg, "was the sound of the right stuff talking. Plus, that man had the smell of Yankee honesty all over him."
It would be difficult to exaggerate the group's emphasis on management. Indeed, were it not for this emphasis its entire approach to the LBO marketplace would be a ridiculous contradiction in terms. Since 1981, Stolberg has seen the market explode (see box, "The Boom in LBOs," page 126) as the success of early pioneers attracted competition from newly formed LBO shops, whose numbers are now counted in the hundreds. In the process, the scramble for the best turnkey deals -- those free of operating or other problems -- became so intense that purchase prices, in many cases, passed beyond economic logic.
"There's simply too much money chasing too few deals," says Stolberg, "particularly the bigger deals. I think deals driven purely by the mechanics of finance have about run their course." Rather than follow the pack, the team adjusted its focus to emphasize building value through operating improvements in smaller deals that were a little too hairy to be bid out of sight. And to do that, they needed the best managers they could get -- managers like Morrill.
Scanning, always scanning, the Screen now moved on to contemplate the specific operating environment of Morrill's product line. And here, too, the buyout conformed to the team's specifications.
Perhaps it would be too much of an exaggeration to say that it does not really matter to the team what business a division or company is in, but it is nonetheless relatively insignificant. Of far greater importance to those who read the Screen are the requirements that the product line in question have some defensible competitive edge, an appreciable share of the available market, and, of course, significant opportunities for future growth that at the moment of acquisition are not, for one reason or another, being adequately exploited. Viewed from this perspective, the product line that would soon be called Microwave Radio was very well qualified. At the time of the buyout, Microwave offered a complete line of portable microwave equipment primarily used for electronic news and sports gathering. Steve DeMenna and Wes Lang, who did much of the original number crunching, estimated with $4.5 million in revenues, the business unit was either first or second in its $10-million industry, with roughly a 40% share and an opportunity to move easily into much larger markets worth some $100 million. M/A-Com, for its own reasons, had decided that the highly specialized nature of the equipment did not fit in with its newly remodeled business objectives.
For a moment, the team worried that Microwave might not fit in with their interests, either. Maybe the market was too small after all? And how could anyone really fathom the operations of a product line that had not had its own independent profit-and-loss statements during its 25-year history? But right here, at a point where many another firm had done the opposite and walked away from the deal, Stolberg and associates put Morrill before the numbers and thereby put a little heart in the buyout. They were convinced he had the right stuff, and they were not to be disappointed. It soon became clear that Morrill had conceived a plan that would allow the company many years of profitable and rapid growth before the presumed market ceiling became a threat, if ever. All he had to do was remove some of the hair.
Almost every WPG deal features some kind of depilatory ritual in which problems become opportunities, just as frogs become handsome princes. It is the very stuff of dream making. In fact, the team insists that management be able to list four or five specific improvements they can make in the business after the buyout is done, or else they're not interested. "If they can't do it," says Stolberg, "they're probably not good managers anyway." But in this case, Morrill and his partners, living up to the team's expectations, had already spotted the right improvements: get out from under the burdensome corporate overhead, move into less expensive quarters, develop international sales, apply for government business, streamline marketing by trimming the product line from 20 items to 10, and institute a new customer service program that could reduce repair turnaround time from 30 days to 2 days. Once some of these adjustments were factored into the first-year pro forma projections, like magic, Microwave, which had lost money in the previous two years, turned an operating profit of $600,000. And with that, M/A-Com's asking price of roughly $3 million began to look very attractive indeed.
"In the old days," Stolberg says, "back when doing deals was a slam dunk, I could buy a good company for 4 times earnings. But now, there are a lot of people around who don't mind paying 8 times, or 10, or even higher. It's gotten ridiculous." The Microwave deal's multiple of 5 times EBIT (earnings before interest and taxes) was like buying a gallon of gasoline for 50?. Moreover, the team's computer model predicted that the company could easily be worth $15 million in only a few years. All that was necessary now was to build the financial bridge to get there.
Most of the calculations that ultimately produce a given deal's financial structure assume a five-year period of operations. The team first projects a profile of what the new company's operating results will look like in the fifth year and then hypothesizes what value is likely to be placed on those results if the company were to use any one of three so-called "paths to liquidity": taking the company public, selling it, or having management buy out WPG's interest. That ending value must give WPG a compound annual rate of return over the five-year period of at least 50%, and it must also make the equity position of each of the top managers worth at least $2 million -- a wholly pleasant experience for managers known in-house as "the equity pop." From these premises, mathematics alone will reveal the deal's basic debt-to-equity ratio, which then must be tinkered with to make room for future growth, particularly through acquisitions.
The final Microwave structure was a model of economy and efficiency, employing as it did a line of reasoning common to many buyouts. The WPG team put up $150,000 in equity representing a 75% ownership, while Morrill, Dahn, and Collins contributed the required cash for a 25% stake. The team then added a $1-million revolving loan from a bank and took back a note for $1.35 million fully subordinated to the bank debt. The type of debt used was, in itself, extremely important, because the bank will view the subordinated debt as permanent capital that both decreases the bank's overall risk and encourages it to expand the "revolver" again after the balance has been paid down should an acquisition present itself.
In other ways, too, the final structure served Microwave's best interests. For example, the team's projections indicated that cash flow would cover interest charges by a factor of 2 and that the company would be able to reduce its total debt to within 50% of the capital structure within 18 months. Moreover, $2.35 million in debt against $200,000 in equity represented leverage of roughly 12 to 1. Because the team also agreed to allow M/A-Com future royalties representing 5% of sales of the acquired product line in excess of $4.5 million, the value of that concession, in effect, pushed the total purchase price to roughly $3.2 million. But here, too, the terms worked to Microwave's advantage, since the company's products would be sold by M/A-Com's sales force, among others.
After six months of frustration and 20 rejections, but only 60 days after their first meeting with the team, Morrill and Dahn became entrepreneurs. For Morrill, the process of building value had just begun. "I found that the sense of responsibility to the people who work here was nearly overwhelming," he says. "Things are much more real. They're just not numbers on a piece of paper anymore." More than anything else, Morrill discovered that the activities he had once taken for granted in a large company now required an extraordinary amount of personal attention. Today when he loses a piece of business or when a receivable starts to get a bit moldy, he's quick to pick up the phone and talk to the customer personally. "You can't keep yourself aloof from your business," he says. "You take nothing for granted. You take it personally. You're scrapping all the time."
When they work right, the magic of leveraged buyouts with heart can work wonders. They can, as in Robert Morrill's case, breathe new life into a dream 20 years waiting or, as happened one day near Soda Springs, Idaho, restore 400 jobs and repair the tattered prospects of an entire town (see box, "High Noon in Soda Springs," page 122). No doubt there are still more wonders to perform, but they're getting harder to find. Indeed, in recent years as the scramble for deals intensified all around them, the team's attention has been drawn ever more inward toward their concept of partnership. Even as they cull for new screamers, the team has redoubled its efforts to build value in the companies already owned, using such methods as refinancings, acquisitions, and sale and lease backs.
And here, too, their results have been impressive. Not long ago, the team engineered an acquisition for TransLogic Corp., which immediately doubled its size -- and the company continued to grow rapidly from there. Late this year, TransLogic is slated to become the first company in the team's portfolio to translate its paper return on investment into hard cash. Stolberg estimates that the company's initial public offering will be valued in excess of $50 million. Of that amount, Weiss, Peck & Greer will realize roughly $25 million on an original equity investment of $1.25 million. At the same time, the manager-owners will themselves become multimillionaires.
But for all the success of a TransLogic, there are many other times when -- despite the team's considerable insight and experience -- the magic just doesn't seem to be there. Once, for example, Stolberg met several times with the president of a subsidiary of a much larger company who was contemplating a leveraged buyout. The deal looked promising, but for some reason Stolberg just couldn't decide whether this manager had the right stuff, and the group subsequently rejected the deal. But this man went elsewhere, got his buyout done anyway, and went on to manage his way to great success. After a polite pause just long enough to let his accomplishments sink in at WPG, the man, still a friend of Stolberg's, jokingly sent him a memorial plaque on which were two tiny metal balls and the following engraved inscription: "The Badge of Uncourage to E. Theodore 'BB Balls' Stolberg. Let it be known that in the face of great adversity, difficult decisions, and monumental unknowns, 'BB Balls' Stolberg crumbled, thereby allowing opportunity and great personal wealth to escape."
Stolberg is still amused to read it. "Well, give us a break," he says. "I mean, we're still learning."