If you walk through the hallways of Aldrich you will likely overhear a conversation among fellow HBS students about how to best break into private equity. The Harbus recently had the opportunity to ask just that when we caught up with David Roux, an HBS alumnus and founding partner of one of the Silicon Valley’s most successful private equity firms – Silver Lake Partners. Mr. Roux shared with us his insights on the private equity business, entrepreneurship, developing business ideas at HBS, and the car to drive today in Silicon Valley.
We understand that you measure economic health by keeping close track of the PPS (Porsche-per-Space) ratio. How is PPS doing these days on Sand Hill Road?
It is zero. If you have one, you leave it at home. A couple of leased ones have been returned. The ones that were bought on credit have been repossessed. The people who still have them – they have them hidden away in their garage for fear of sending the wrong signal.
What is the car of choice instead?
Everybody is back to driving Toyota Camrys and Honda Civics. Humble and loveable.
How has your business at Silver Lake changed from the wild days of 1999-2000 to the more sobering atmosphere of 2001-2002?
We were very fortunate to be raising money during the go-go days and spending it during the tech depression. One always wants to raise money while prices are high, and spend money while prices are low.
When we raised money, the notion of building a fund devoted to investing in large, slower-growing businesses with mature business models, positive cash flow, established customer bases, was thought by many people to be old-fashioned, almost retro.
Three years later, it has gone from being an odd sideline to an incredibly mainstream notion. There is a back-to-the-future quality to what we do.
What is it going to take for the private equity industry to prosper again?
There needs to be liquidity. Much like the roach motel; you can check in but you can’t check out. To achieve liquidity, two things need to happen. First, confidence must be restored in the market. Second, we need to have a restoration of growth in corporate profits, which is necessary for an active trade market.
There are two primary exits for us. One is an IPO and the second is a trade sell. There have been essentially no IPOs and the M&A market has been very depressed. So you need to have one or both of those come back before you can have liquidity.
Who will be the winners and losers in the private equity world?
The firms that will prosper are those who have been disciplined and methodical about making investments during the tough times. Not overpaying, structuring defensively, and concentrating on making their portfolio companies survive the nuclear winter.
It’s sort of like mulching your garden before the winter comes. If you want things to grow in the spring, you have to take care of them when times are tough. Survive, then thrive.
The losers (those who are diversified, over-leveraged, who haven’t taken good care of what is in their portfolio) will have a more difficult time.
Particularly those who took their eye off the ball and lost their focus on their limited partners. A lot of people forget that our customers in the private equity world are our limited partners. This is a worrisome time for them and our number one job is making sure those folks are happy which means producing good returns for them. Communicating what is going on in our portfolios is crucial. There is an extra premium in these types of environments for straight-talk, clear communications and high-quality relationships.
It is easy to be a good partner when things are good. Everybody is a great manager when things are flying high. Real differences come into play when times are tough. That’s when you really find out who your good partners are, who your good managers are, and where the real quality relationships are.
As funds face pressure from limited partners who feel overly exposed to private equity, some have gone as far as reducing fund size. Is this an option that Silver Lake has ever considered?
No. If anything, our fund is too small.
Do you believe we will continue to see this trend in private equity in general?
I don’t think it’s complicated. People want their money back when they are not confident that the money can be invested successfully. That is to say, soon and at a profit.
People have asked for their money back for two separate reasons. First reason is the firm has raised too much money and can’t put it to work. They may be good guys, they may have a good strategy, but the fund size is just too big for the current environment, and they just can’t put it to work.
The second reason is that the fund might be the appropriate size, but the investment record to date leads the limited partners to believe that the money will be squandered, will not produce an appropriate return and they don’t want to put more in. That is the “good money after bad” problem.
The worst scenario is a very large fund with very poor fund management. Then you have too much money and a track record of disastrous results. This is known as the “money bonfire,” hundreds of millions of dollars just going up in smoke.
What has been your most surprising investment at Silver Lake to date?
The investment that has been most gratifying is what has happened at Crystal Decisions because it has been so off the charts in terms of performance. Crystal Decisions is an enterprise software company based in Vancouver, British Columbia. When we invested in it two and a half years ago, they had had a difficult couple of years. They had done a tough acquisition that had not really panned out the way they wanted, they were losing money, their revenues were not growing, and they were late getting a few products out the door.
But, they had a very good team, great underlying technology, and happy customers. Crystal was something that I was personally very enthusiastic about but, frankly, when you looked at it, or if you had gotten a case study on them, you would have scratched your head and said, “Yikes.” This was a spicy meatball. This was one of those situations where you really had to rely on an emotional response to the management team, a gut belief in the quality of the market, and a hunch about the positioning and timing of their new product line, to come to the conclusion that this was going to be a good investment.
What has transpired since we became investors is that they have had nine straight quarters of sequential growth, they are gaining market share against everybody they compete against, and they are growing three times faster than the number one player in the market.
Crystal Decisions has literally gone from being a $150 million losing business to a $260 million market leading business that Gartner calls the number one performing enterprise software company in the world. It has been a spectacular performance. And it feels great to be associated with a team like that and to be part of all the things that they have done to succeed.
It’s one thing to get good results when the wind is at your back. It’s a totally different thing when the wind is roaring in your face. It could not be a more difficult or challenging environment out there in the marketplace. To see these kinds of results, not for a quarter or two but for ten straight quarters, is a spectacular testament to the quality of teamwork, the underlying soundness of vision, and the operational excellence they have provided.
Many students at HBS and soon-to-be graduates are very interested in the field of private equity. Which makes me very nervous. Business school students are historically very dangerous leading indicators of things about to go off a cliff. People don’t go to Harvard Business School because they are wild and crazy. Rather, they tend t
o be very thoughtful, analytical, deliberate, and measured. They like to see a trend on a very clear and successful trajectory. The problem for entrepreneurship is that you really have to get ahead of things. By the time it’s going full tilt, it might be too late to get on the train.
When I was at HBS, the thing that absolutely everyone wanted to do was go into investment banking. This was the age of Mike Milken and Drexel Lambert. Wall Street was rocking. In 1983, 1984, and 1985 everybody piled in, and of course in 1986 and 1987, the wheels came rolling off.
In contrast, in my class there were a handful of people who were entrepreneurs. I don’t know what the numbers were for 1999, 2000, and 2001, but my guess is that everybody wanted to become a dot-com person. Thus, it always makes me nervous when HBS people want to do private equity because that almost certainly means that there is too much private equity.
What is the ideal profile of someone looking for a successful career in private equity?
This is the kind of business where you must have a point-of-view. It’s not the sort of business where you get up in the morning, come to work, read the Wall Street Journal, check the website, and think, “What does that tell me?” It’s not a deductive process.
Rather, almost all the things we do start from a point of view that says, “I believe X” and I am going to go out and check and see if my theory works. For example, we had a view when telecom could not have been hotter and storage was not. At that time there couldn’t have been a less well-liked or more malign sector of the technology industry than storage and disk drives.
However, we said to ourselves, there is a logical inconsistency in loving telecoms and hating disk drives. Because you can’t believe that bizillions of electrons are going to be flying around on networks without also believing that those electrons have to start some place and end some place. They have to start on a drive and they have to end on a drive.
Our point of view was, that drives were undervalued. There is also a separate question, which is whether one has an opportunity to invest in this space – that is a question of attainability. But first you have to have a point-of-view. Do you like it or do you not?
For example, in Crystal’s case we had a point of view that we liked the business intelligence space. Business intelligence is an area we liked because it leverages investments you have already made. In an environment like this one, people don’t want to do lots of neat new stuff.
Instead they want to do stuff that gets more out of what they have already invested in such as having better reporting and analytics. This is what Crystal is all about; it helps them get more out of what they already have.
Once you have a point of view, you must then prove yourself right or wrong, which means you must have a willingness to gather data, opinions and perspectives and then be intellectually honest at all times about what you have found.
You have to have a theory, you have to do the due diligence to prove your theory right or wrong, and you have to be intellectually honest about it. If the data doesn’t look good, you have to be willing to cut bait and do something else. The scariest part is when the data looks great, it feels good, but everyone you talk to says, “Why on earth would you do that?” That’s when it takes betting courage to put your money down when everybody else thinks it’s a bad idea. You have to have the courage of your convictions. You never make money going with the herd; all the big money gets made where everybody else thinks it’s nutty.
Is there a specific background you look for?
There is not one type. A good private equity person can come in a lot of flavors.
Private equity, unlike venture capital, is inherently a team sport. When making a venture investment, one person can do the due diligence because often times they are only investing in a few people, there is no technology, no history, and there is no product. They are basically betting on a few people.
In the private equity world, however, it is very different. We are going to go out and evaluate a whole industry. We are going to look at all of the players, the industry structure, the historical financials, pricing trends, unit economics, profitability by product line, profitability by segment, and profitability by distribution channel. We are going to do every piece of analysis you learn how to do six ways from Sunday, and then we are going to double-check everything again.
But no one person can do all the financials, do all the competitive analysis, call all the customers, meet with the management team, and evaluate the technology. The good news for you and your colleagues at school is that there are lots of different ways to be successful here.
Silver Lake and many of the other firms we work with look to build a group of people with complementary skills. For example, I was an operating guy for many many years. I have done start-ups, I have done turn-arounds, I have done big growth companies. In each situation I learned something different and gained some new experiences.
My partner Glenn Hutchins has spent essentially his entire career in private equity doing growth investing. Another one of my partners, Jim Davidson, was an attorney and then an investment banker for many years, so he is “Mr. Transaction/Execution” guy. Another one of my partners, Roger McNamee, has been a money manger and investor for 25 years. And so there is not a single path to success. There is not a single personality type or perspective or set of experiences. If, however, I had to list four or five things that we look for and we like to see at all levels it would be the following:
1) You need to have a point of view.
2) You need to have incredible intellectual honesty about what you do.
3) You need to command strong communication skills.
4) You need to be great at something.
Our firm is a well-rounded firm of extremely talented individuals where the extreme talent may be one or two things. Which is inherently different from a firm full of well-rounded talent. Together our team is well-rounded as opposed to everyone being kinda okay at everything. It takes a whole bunch of different folks to create a winning team.
If a soon-to-be graduate of HBS is looking to start in private equity but is finding limited opportunities due to the current market conditions, what experience do you think he or she should acquire in the short term to land an associate position when the market does open up?
I would tell them to get the best operating experience at the best-run company they can join. Knowing how a well-rounded company operates is the very best thing they can possibly do.
When you think about what you need to be a valuable player in private equity, there are really not that many training opportunities inside the industry. That’s just the nature of the industry. However, if you have previously been on the operations side, the enormous value of knowing how a company is supposed to work makes you much better at evaluating prospective investments, helping to avoid problems, helping to fix problems and evaluating management teams in the private equity world.
What skills did you gain when you were at HBS that helped you later in your career in industry and today in private equity?
The real answer is that I didn’t actually spend a lot of time at HBS when I was at HBS. I spent most of my first year running my first start-up. We had an office in Harvard Square and I spent most of my time there my first year. My second year I spent most of my time starting my second company.
Has HBS been valuable to you later in your career?
A lot of the people that I met at HBS continue to be business partners and colleagues over the years. Where I sit right now, I am probably 500 yards away from five or six classmates
, each of whom has a different responsible job in venture capital, Goldman Sachs, Morgan Stanley, law firms, etc.
As remarkable as it sounds, that guy you had pizza with and drank too much beer with over the weekend, believe it or not, in ten years he will have a responsible job. The most remarkable thing about your school career is that the person you didn’t think was employable winds up as the CEO one day. You will just be astounded.
When I graduated from HBS we had a terrific woman in my section, Ellen Hochman, who had an advertising background and was as funny as could be. After we got out of school I had no idea what happened to her.
My fifth HBS reunion I got invited to speak on the entrepreneur panel. Who would show up? Ellen Hochman. What is she doing on the entrepreneurial panel?
So, I gave my talk and felt very clever, and so on. Eventually Ellen starts to speak about graduating from HBS, not finding a job in advertising, going down to New York, getting a job in a video store and I had no idea where she was going with this. And then she started talking about finding this tape, really liking it and thinking to herself that others would probably want to buy it as well. The short version is that Ellen Hochman created “Buns of Steel” and the whole product around fitness tapes and invented the infomercial and all the rest of it. It’s one of those things you never would have guessed based on sitting around studying in your study group.
Do you find that in your successful portfolio companies some of the stronger members of the management teams have less than traditional backgrounds?
I would say, in all candor, that HBS graduates scare me.
Can you expand on that?
They scare me as entrepreneurs. Name your most successful entrepreneurs of the last twenty years. That would be Bill Gates, Larry Ellison, Michael Dell, Steve Jobs. Not only do none of them have MBAs, none of them are college graduates. These are people for whom risk management, brand name companies, career management are not only not done, they are totally alien concepts that have never crossed their minds.
Being an entrepreneur is an inherently irrational task. It freaks out a lot of highly rational people. As soon as you have anybody with a reflex to run the expected value outcome or “let’s do a Monte Carlo” simulation on the likely results, you have pretty much lost it.
What you really need are nut-cakes who are just going to jump of the cliff because that is what a lot of entrepreneurial behavior is about.
But do these nut-cakes have a good sense of intuition? Do they at least possess a good hunch about what they are doing?
Don’t get me wrong. The four guys I have just mentioned are highly intelligent, very smart, have high IQs, and possess great communications skills. When I say nut-cakes I don’t mean that they are not enormously talented. I am just saying that they are not particularly good employees. These are not people you would want to have work for you.
People need to be honest with themselves about why they are entrepreneurs. Are they entrepreneurs because they truly have a passion for creating something new that has never been created before? There are a lot of people who became entrepreneurs, at least in name, during the last dot.com boom because they thought there was a very high return, not because that was truly what they wanted to do with their lives. In fact, it really freaked many people out.
I would press people the same way about private equity. I would encourage people who are thinking about getting into private equity to think about whether they have a passion for investing. Do they like to be a coach rather than a player? Because that is a lot of what private equity is about. You are on the sideline. People who are really running the race are the portfolio companies. Can you sleep well at night making very large deal investments?
What is your most vivid memory of HBS?
I took a course in my second year called “Entrepreneurial Management.” I wrote a paper about this company I wanted to start. The teacher, despite the fact that he was not an entrepreneur and had never been an entrepreneur, had all sorts of reasons why he thought my idea was really difficult and was not going to work.
It was especially fun to return five years later, during which time I had started the company, raised the money, hired the people, and sold the company, to discover that same professor who had told me it would never work, had been denied tenure.
In the end, the market worked.
Author’s Note: Unconfirmed sources report that Mr. Roux drives his Mercedes to work these days, while his Porsche remains safely tucked away in his garage until increased liquidity and growth in corporate profits return.