CD&R deals spread some ill will on Wall Street

By Michael Flaherty

NEW YORK (Reuters) - When Clayton, Dubilier & Rice bought home services provider ServiceMaster in July, the private equity firm showed it was willing to scoop up an entire public company, straying from its usual strategy of acquiring orphaned corporate divisions.

The scrappy leveraged buyout shop also showed that, as in its $7.1 billion purchase of food industry distributor U.S. Foodservice earlier that month, it was going to hang tough on financing terms, despite fears that the credit crunch would force lenders to take losses on the loans.

CD&R's rigid stance on terms probably earned it kudos from institutional investors but left a sour taste in the mouths of some investment bankers, according to several people involved in the deals who asked not to be identified.

CD&R's approach was similar to that of Kohlberg, Kravis Roberts & Co, which also held fast on the financing of several large deals inked before the credit crunch. CD&R brought KKR into the U.S. Foodservice deal.

For both firms, the question is whether they will suffer some form of retaliation in the future for playing hardball with Wall Street's biggest lenders.

For CD&R, the risks of standing up to banks are especially high because the New York firm, investing a $4 billion fund, is considerably smaller than KKR, distributing far less fees to Wall Street -- fees that help offset loan losses.

To be sure, some private equity pros and industry experts applaud CD&R for not bending too far in favor of its banks.

Still, the issue underscores how the credit crunch has strained relations between private equity buyers and Wall Street, after the two sides worked hand-in-glove on more than $1 trillion of buyouts signed in the last two years.

CD&R managing partner Kevin Conway told Reuters that the firm held "extensive discussions" with banks regarding ways to best handle the credit squeeze.

"In balancing our fiduciary obligations to our limited partners, and holding to the original thesis of the investment, we'll do everything we can -- within reason -- to help out the banks in this difficult period," Conway said. "We value our very long-term relationships on Wall Street."

While CD&R made some adjustments to financing terms on both U.S. Foodservice and ServiceMaster, bankers involved with the deals say the changes fell short of significant, structural changes. Banks wanted certain covenants, or restrictions, that would protect investors and make the debt more attractive, but they didn't get them.

Granted, the deals were struck at the front end of the credit crunch, and few predicated how rapidly it would freeze the lending market.

Nevertheless, banks will likely suffer losses on the loans -- a tough pill to swallow, especially when firms such as Apax Partners and Cerberus Capital Management made substantial changes in renegotiating terms to take pressure off lenders.

NEW ERA

CD&R got burned by a few deals in the late 1990s, prompting the firm to hire operational veterans including former General Electric Chief Executive Jack Welch and former Emerson Electric co-CEO George Tamke.

This year CD&R sold health-care products distributor VWR International for more than double what it paid two years ago. Rental company Hertz (HTZ.N), which CD&R and buyout firms bought two years ago, has seen its shares rise more than 40 percent since it went public last November.

So far, CD&R's three deals this year have caused some bankers to grumble.

The argument from the banks is that they face billions of dollars of write-downs if they can't offload the loans. Renegotiating ensures good, long-term relations between buyout firms and their lenders, bankers say.

But should the buyout firms feel compelled to give the banks a break? Some academics think private equity firms are right to stand pat.

"Banks were taking risks in making those promises. Now, when the risk unfolds in an unfavorable fashion, they can't back out. I think their feet should be held to the fire," said S.P. Kothari, deputy dean at the M.I.T. Sloan School of Management. "The banks should be held accountable for the promises they made, otherwise it leads to perverse incentives."