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Alumni Russell Carson ’67 and Henry Kravis ’69 played pivotal roles in shaping the private equity industry. In this edited transcript from a special event on June 18, Dean Glenn Hubbard, the Russell L. Carson Professor of Finance and Economics, talks with these innovators as they reflect on an industry that may be in as much flux today as it was during its formative years.

Glenn Hubbard:

Welcome to what I think will be an extraordinary conversation on private equity.

Economists, of course, pontificate on what could account for America’s productivity improvement. I think much of the agreement is that our markets for risk capital — private equity in particular and venture capital — have helped make the American economy the leading adopter of innovation. At Columbia Business School we’re very much in that business. We are about three things: the power of ideas, talent and network. All three are in strong exhibition tonight.

Russ Carson and Henry Kravis symbolize the modern private equity industry. Their business strategies are different, but both are extremely successful at what they do, they both went to Columbia Business School and they have both been extraordinarily generous to the world around them.

How did you get into this business? How’d you get started? And what are the two or three big changes you’ve seen along the way?

Russell Carson:

I got into the business totally by accident. I graduated from Columbia Business School in 1967 and went to work for Citibank, and was working in the planning department when the bank decided it should get into the venture capital industry. I helped the bank set up a legal vehicle that could accomplish that and wound up as the first employee of the venture capital subsidiary. I was the CEO of the business for the last four years that I was there.

I don’t think the term leveraged buyout had been coined at that point. The term venture capitalexisted, but wasn’t talked about much. It was a very small, very collegial industry. I think Henry and I would both be very honest with you and say neither of us expected to have businesses of the size and scale that we have today. It just didn’t seem at all feasible at the time that we started in the business.

Henry Kravis:

I came at it a little differently. Every summer in college I worked at Goldman Sachs, starting as a runner, and then in the research department. I was fortunate; it taught me how to understand best practices and really understand how industries worked. After Columbia I eventually went to Bear Stearns, where I worked with my current partner George Roberts, and with Jerry Kohlberg. Jerry really is the inventor of what is now known as private equity.

In 1965 Jerry did a transaction for a little company called Stern Metals. The owner wanted to sell, but he didn’t want to sell it to a large company, he didn’t want to take it public and he wanted to keep an interest. Jerry had this idea of having your cake and eating it too. Mr. Stern of Stern Metals was able to keep 25 percent, sell 75 percent and turn over the business to a group of people at Bear Stearns. We did a number of deals, one at Bear Stearns, and in 1976 we left to start KKR.

Life is funny. One of the great breaks we had was telling Bear Stearns, “We’re going to go start our own firm and we’d like to offer you half of the firm.” They said no. And thank God.

So off we went. We were three guys and a broom, basically. In 1976 there was no such thing as private equity. We were introduced to Henry Hillman, in Pittsburgh, who helped Kleiner Perkins get started. It was a $25 million fund, and he took half the fund.

We went to a few insurance companies that had invested with us at Bear Stearns. They said, “We think what you’re doing is great. We don’t want to back you, but we’ll be your investment committee.” We just didn’t want to do that. We were entrepreneurs, and we wanted to do our own thing, and not report to the Prudential Insurance Co.

George and I went out to dinner, and we started talking about what we need to get started. We said, “Why don’t we go to eight individuals, we’ll ask them to put up $50 thousand a year, and that will entitle them to see every deal that we do, but if they do like something, they would pay us 20 percent of the profits.” It seemed like a good number. We cobbled together the $400 thousand from eight people. The first full year, 1977, we bought three companies. Today, over the last year and a half, we’ve raised $31 billion of new equity capital for private equity, all over the world. What has changed is the enormous availability of capital. Deals have gotten much bigger, they’re more complex, they’re global. I remember in 1979, going to Europe, because Paul Volcker put on credit controls. We had announced that we were going to buy McKesson, and we couldn’t raise any money here because there was no acquisition lending. I flew to London to talk to people, and I just got blank stares from these institutions. How can three guys and a broom buy companies? We couldn’t raise any money.

Today the UK is a huge market, Europe’s a big market, Asia’s a big market, South America, South Africa. It’s a global business. I agree with Russ — we didn’t have a clue that it would ever grow to be this way. Some days I wake up and think it was pretty nice the way it was when there was just us and Russ in the business. But those days are over.

Glenn Hubbard:

It’s easy to celebrate private equity. Returns have been very, very high. There’s a huge amount of interest from investors. But do you think we might be near the top — in actual private equity deal making or in credit markets, which are vital for financing?

Henry Kravis:

We’re right in it now. You’ve been reading a lot of articles saying that we’re not going to be able to finance US Food Service, or we’re not going to finance First Data, and so forth. That makes good reading, I suppose. But the facts are that we have firm commitments from the banks. These are commitments that cannot be broken. The banks stepped up to do financings with no covenants. You could raise $20 billion literally over a weekend. They’d fall over each other to underwrite the equity and the debt. Today this is really backed up. They have to go ahead and fund the debt that they have underwritten. The equity is being placed rather easily, and so they’re looking at some debt right now that they’ll have to live with for a while. We’ve had times like this before, where some event caused turbulence, and that’s what we’re going through right now.

Russell Carson:

I’ll comment briefly on the change I’ve seen in the last several years. Our scale is somewhat different than Henry’s and our strategy is quite different. We only invest in the healthcare and information- and business-services industries.

We have about 30 companies in our portfolio, aggregate revenues of $21 billion, EBITDA of about $4.1 billion and probably employ close to 200 thousand people. This is a very large enterprise.

We’ve increasingly recognized the need to be not just a financial buyer but also an operator. We now have a whole group of senior operating executives who work with us to try to add operating value to the businesses we own. A lot of people got into the business recently, where the average holding period might have been two years. That’s very different than saying you’ve got to own the business for 10 years, and you’ve actually got to add operating value to it. That’s where I think a lot of the challenges are going to come.

Henry Kravis:

The thing that is really important as you think about the private equity industry is that it has changed dramatically. In the late nineties we made a lot of mistakes at KKR. I’m not saying it’s good that we made the mistakes, but we did learn from our mistakes, because we changed the way we do business. The first thing we did was to make sure we acted and thought like industrialists. The days of just financial engineering are over. You have to really operate the business. Our whole approach at KKR since 1999 is that our job begins the day we buy a company.

I like to say any fool can buy a company. There’s plenty of financing around. But what do you do with a business to create value? We’ve had an in-house consulting firm since the early eighties, but today we have a very large one. These operating consultants put metrics into every business that we’re involved with, they improve productivity, they shorten the supply chain, they improve sales. We expect everyone at KKR to understand their industry from the bottom up, and talk to purchasing managers, marketing people, salespeople, customers, suppliers, and understand the metrics, understand the best practices, the economic drivers, what drives an industry.

Russell Carson:

The financial engineering increasingly has become a small part. Everybody can do financial engineering. I wouldn’t be comfortable having my name on the door if I weren’t providing something beyond just financial engineering and opportunism. We invest across a very broad spectrum of what we call deal sizes, or deal structures. Our biggest buyout was a $7 billion buyout. On the other end of the spectrum, we did a raw start-up that we put $25 million into a couple of years ago, which we’ve turned into a $350 million profit.

Henry Kravis:

You didn’t offer that one to me!

Russell Carson:

It was too small for you! Didn’t have enough zeroes in it to attract Henry.

Industry expertise really makes a great deal of difference for us. We’re the dominant player in those two industries because we know them so well. A third of our companies today are run by CEOs who ran other companies for us in the past. We pay a lot of attention to leadership and management, and it makes all the difference in the world. We control our companies; the hiring and firing decision is ours. And our first choice is always not to run the businesses ourselves, it’s to get the very best people in place to run the businesses, and then support the hell out of them.

Henry Kravis:

Eighty-five percent of the returns in the KKR portfolio over the last 10 years came about as a result of improvements in the business. Only 15 percent came about as the result of a multiple expansion.

Where we’ve made mistakes historically is taking too long to change a CEO. We used to think, “He’ll get better, or she’ll get better. Let’s give them a little while longer. If we let them go now, we’re going to suffer in this or that area.” It’s nonsense. Today, we will move much more rapidly to change out the CEO. As soon as we close a transaction, we put in a very detailed hundred-day plan. It goes through every division, it goes through every product line, it goes through every senior manager, and it’s a plan that we agree on with the management. At the end of the hundred days, we audit that plan and look at what we were able to do, what we weren’t able to do, and why, and where we go from here.

Take a company like Willis Group, which is the third-largest insurance brokerage business worldwide, behind Marsh & McLennan and Aon. The numbers weren’t bad. They had a CEO who had been in there for a few years, who was certainly an improvement over the person before. But Willis wasn’t hitting on all cylinders. So we brought in a new CEO, Joe Plumeri. We gave him one instruction: Blow up the culture. To meet with the old CEO you had to make an appointment, and it took a long time to get to see him, even if you were in the company. Nobody talked to anyone, no one patted others on the back. Joe makes a trip around the world with the then CEO, to be introduced to everybody. He comes back to London, and for the first three weeks he had lunch every day in the cafeteria. Everyone thought he was nuts. No previous CEO had ever come to the cafeteria to have lunch. But he wanted to hear what people had to say. What was wrong with the place. What could be improved. All of a sudden, the flowers started blooming. He made a call to one of their best salesmen, in Tennessee, who had just made a huge sale. Joe called this man and said, “Hi, I’m Joe Plumeri, the new CEO. I’m calling to congratulate you. What a great job you’ve done.” This person says, “The hell you are,” and he hung up on him. No one had ever called to congratulate him. Joe had to call him back and say, “No, I really am the CEO.” They became fast friends. Joe didn’t have to change a lot of the people. It was just a change of culture and a change of leadership. People started feeling good about themselves and had this can-do attitude.

All of the managers in our companies have invested in the equity in their company. They will have some options on top, but they put up real money in relation to the amount of their net worth. Believe me, it focuses their attention.

Owning a company and focusing management’s attention weekly is a lot different than going to six or eight board meetings a year as a board member of a public company. We don’t care about quarterly earnings. Rather, we like to ask a CEO, “Where do you want to be five years from now, and how are you going to get there?” We surprise people when we ask five years. We want them to make investments that are going to make the company a better business over the long term, regardless of the short-term impact.

Glenn Hubbard:

Henry, you’ve put on an enormous number of air miles going all over the world. Where do you think globally the best opportunities are likely to be over the next decade for private equity? U.S.? Asia? Europe?

Henry Kravis:

All of them. I don’t mean that facetiously. We invest all over the world. And we try to create our own ideas. Buying a company just because it’s for sale is a really lousy reason to buy a company. Let’s be on the offense and figure out what are the best companies where we can really add value.

Glenn Hubbard:

Thank you. This was a fabulous conversation. This is a strong connection with the school, with ideas, the talent in this room and the network. So please join me in giving a Columbia Business School thank you to Russ Carson and Henry Kravis.

Russell L. Carson ’67 is general partner of Welsh, Carson, Anderson & Stowe.

Henry R. Kravis ’69 is founding partner of Kohlberg Kravis Roberts & Co.