Jul 09, 2018

 

Pete Stavros, Head of Industrials, speaks to our efforts to affect operational change within the portfolio of companies that we invest in as a control investor, and shares examples of these efforts in action with a particular focus on incentivizing employees to create value.

Please visit the KKR Industrials’ YouTube page for case study examples of some of the companies referenced in this presentation.

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Incentivizing Employees and Creating Value

Pete Stavros
Head of Industrials, KKR

 



Preamble

Good morning. As Craig mentioned, my name is Pete Stavros. I am a partner in the New York office and I run our industrials group. As an industrials investor, as you can imagine, I spend most of my time with manufacturing companies. Within a manufacturing company, the majority of the workforce are blue-collar workers who are paid an hourly wage. In fact, that is usually the vast majority of the employee base. Despite the fact that that group of employees is so large and so important, what we find time and time again is that the relationship between the blue-collar workers and the company that they work for is not a positive one. It oftentimes is outright contentious. Of course, that impacts performance. We have been spending the better part of the past decade trying to understand why that relationship is not working, what we can do to improve it and thereby improve the performance of our companies and drive some of the operational change that Johannes and Craig have talked about. Also, positively impact the lives of these employees. That is really what I would like to talk about for the next 25 minutes or so.

History of Hourly Employee Relations

This history of poor employee relations when it comes to blue-collar workers, this goes back generations. This is of course where the labor union movement started. This is actually a picture of my dad. He was a blue-collar worker. He worked for a construction company in Chicago and earned an hourly wage. I just remember at the dinner table countless conversations about conflict between the workers and their employer. As a kid growing up, I was able to see this through the eyes of an employee. Now as an adult, I get to see it through the eyes of the company. It has been kind of fascinating to see both sides of it.

Misaligned Incentives

There are a lot of reasons I am sure why this relationship does not work. But one of the really obvious ones that I have observed is the hourly wage itself creates a huge misalignment of incentives. You have got on the one hand the employer who cares about quality, cost, on-time delivery and the employee who just cares about hours because that is exclusively how they are paid.

If you look at the bottom line just as one example, think about a situation where the employer falls behind on a job. They have got upset customers. They are working overtime to try and catch up. It is very expensive, terrible thing for the company. It is actually a great thing for the employee. They get more hours and they get time and a half or double time for the overtime hours.

Current Engagement Model

If you are the employer and you have got the vast majority of your employee base as blue-collar workers with exactly the wrong incentives, how do you engage? How do you behave? What is very common is to just apply an extreme amount of oversight and monitoring of your employees.

As you can imagine, the employees often do not react well to this. They evade oversight where they can. Where they cannot, they meet the bare minimum of expectations. Over years, this really devolves into a situation where the company gives up on the people, the people give up on their jobs. They stop investing themselves in their work and worker morale is very poor.

KKR Industrials as Engagement Laboratory

Here is what we have been trying to do in industrials. We have been trying to use our portfolio as a bit of a laboratory to experiment with ways of changing this relationship. We are in a great position to do this because of course, we are constantly buying new companies. That moment of change in ownership is a golden opportunity because people are not only open to change, they are expecting change.

CHI Overhead Doors

What I would like to do now for about ten minutes is take you through a case study. This is one of these examples that Johannes and Craig both referred to. This had been owned by private equity three times prior to KKR, a lot of head-scratching when we bought the business. What could you possibly do with this? This had been owned by Smart Money for 20 years. One of the things that had not been addressed was engagement and using the whole workforce to drive the operations of the business.

CHI Employees

The company makes overhead garage doors like the one you see here in the picture. They are based in Arthur, Illinois. When we bought the business, the company had from top to bottom about 800 employees, each one represented here by a purple dot. Now, 600 of the 800 were hourly workers in the manufacturing plant. Another 54 were truck drivers paid by the mile so very similar to being paid by the hour. Then you have got the balance here of salaried office employees.

Now, of the total employee base, 18 had ownership in the business when we bought the company. Those are the green dots in the lower left corner. Those 18 people got a payout of $57 million when we bought the business and $30 million went to two people. This is really a microcosm of the industrial world in this country. The vast majority of employees barely getting by on an hourly wage. Then a small segment with ownership and as everyone in this room knows, capital is so much more productive than labor. That is the group getting ahead. The getting ahead is concentrated in the hands of a couple of people. This is kind of what we see in almost every situation.

Low Worker Morale – Safety Concerns

You see some of that and you wonder what employee morale might be like. Well, in the manufacturing world, one other thing to look at if you want to get a quick snapshot of how employees are being treated is look at safety. This is something we see time and again. The workers are usually not being taken care of at the most basic of levels. They are not even getting sent home safely at night.

This, what we are showing you here is the total recordable incident rate. It is an OSHA-mandated statistic which shows you for every 100 workers in the manufacturing plant, how many are getting injured on the job every year. Simple first aid does not count. These are typically trips to the hospital.

You can see when we bought the business, there were 14 out of every 100 workers with let us say hospital visits every year. As I mentioned, we had 600 in the plant. Six times 14 would be 84 hospital visits per year. Over the course of let us say a five-year hold period, that would be most of the workforce which is kind of a staggering failure on the part of the company.

First Ever Employee Survey − 2016

We did the first employee survey the company had ever seen shortly after we bought the business. Not surprisingly, the results were terrible. We had a 30% response rate and 90% of the results were well below benchmark. In our favorite question, most people who filled out the survey said it would have absolutely no impact. Unfortunately, the survey company got rid of that question, so we cannot track our performance against it.

Performance Reflected Low Employee Engagement

As is always the case, this lack of engagement will manifest itself in poor performance. The company had as an example quality challenges that matched their safety challenges. If you have a safety issue, you will always have a quality issue because it reflects a lack of process or a process that is out of control. That is what we had at CHI.

There was also no margin growth despite pretty robust volumes as the housing market was recovering. There was excess working capital in the business. This is a build-to-order model and they had still a ton of inventory in the business.

New Approach under KKR

We bought the company. We brought in new leadership, established a new set of priorities. We brought a real process orientation to the business. Then importantly, we rolled out this employee engagement model that we have been developing over the better part of the past decade.

Our Employee Engagement Model

This is constantly evolving. We are trying to improve it all the time,but as it stands today, there is three legs to the stool on our engagement model. The first one is investing in the workforce, making people feel cared for, showing you want to invest in their professional development. Making everyone in the business an owner, down to the janitor who sweeps the floors in the manufacturing plant. Then engaging with the community through the company. This kind of community service is all about building pride in the organization. I would like to just talk through each of these in the next few slides.

Engagement: Investing in the Workforce

First, investing in the workforce. Again, this is all about making people feel cared for. We typically would have training in everything from lean manufacturing through to sales force effectiveness.

In this case, the burning platform, as I showed you, was and remains safety of the employees. You can see in a short period of time, we have cut the injury rate in half. But you can also see it is still well above the benchmark. There are two things that we are doing right now that we think will take us below the benchmark and hopefully on a path to world-class safety.

I think these two will give you another sense for how this employee base feels they have been treated over time. The first one is, we are changing the staffing model. What the company had done was because the business is so seasonal, they would lay people off right before the holidays during the slow period and then rehire in the spring to save on labor costs. That was obviously a morale issue, but it was also a safety issue because the people that you let go off right before the holidays, they cannot afford to wait around until the spring. They would go off and do other things, which meant you had a portion of your workforce that was new every spring. Then they hit their first busy season in the summer and those were the ones who all got hurt. We are changing that. We are going to keep the labor force intact through the slow season. It is going to cost us a little bit of money on labor, but it is going to have a huge safety benefit and a huge morale boost.

The second thing is we are air-conditioning the facility. In the height of busy season in July and August, it gets to be 110 degrees in the plant. In the trailer that we are loading the doors into, it can get to be 125 plus in the trailer.

You have got people running around like mad to meet production requirements. All they have got are a couple of fans to try and cool them off and so they get hurt. They make mistakes. We think that is going to have another big morale boost and safety benefit. That is the first thing we do, invest in the people.

Engagement: Making Everyone an Owner

The second thing is as I mentioned make everyone an owner in the business. You go from a situation like this to one where everyone participates in the financial upside in the business. To give you a sense for how we do this, we do this with very large option plans so much larger than a typical private equity firm would do. It is important that we use options because we obviously only want our investors getting diluted to the extent there is real performance.

In terms of order of magnitude, what we are talking about, if you take one of our truck drivers at CHI, we gave them an opportunity to invest up to $5,000 in the deal right alongside KKR in the same terms. They could do zero and we would still give them free options. However, if they did the maximum of $5,000, we gave them free options that under our base case we think will be worth $200,000. This is really life-impacting amounts of money.

Now, we have learned that it is more complicated than just sprinkling ownership around the company and then flying back to New York and watching the results flow in. As Johannes mentioned, we are deeply, deeply involved in our companies from an operating perspective.

We also do a lot to try and have this ownership be real for folks and drive performance and make it more than just a feel-good story. Part of that is education. A lot of people have never owned equity before. These options are options in a levered capital structure. It is a complicated concept to explain.

We figured out how to do it over time. We have gotten better at it. Then what we do is share a lot of information about our business plans. It is quasi kind of open-book management. We share the business plan, where we are headed, how much money we make, where we expect margins to go and then we try and tie the high-level plan down to all the different functions of the business, so people know how they are contributing and how what they are doing every day creates value.

We do a lot to make the ownership feel real. We do some things that would sound silly to people in this room. We print physical stock certificates. We have found that the physical manifestation of ownership really makes this feel real and tangible to people. Even though the stock of CHI, it is a private company. It is not publicly traded. We actually opened Fidelity accounts for people so that as our valuation mark improves, they see value being created for themselves and their families.

Then the most impactful thing you can do which we try and do every chance we get is to pay an early dividend even if it is tiny because there is nothing quite like people receiving a check to understand that the ownership is real.

CHI’s First Dividend in 2017

That is what we did at CHI. What we wanted to do was just play a 60-second video to bring you on to the shop floor in Arthur, Illinois and have you feel what the enthusiasm that starts to build pretty quickly. This is only a little over a year into the investment. We paid a very, very small dividend. It was only out of excess cash.

For the hourly workers, the range was $1,300 to $4,000 which may not seem like a lot. But you have got to keep in mind, we are the fourth private equity firm to show up. They have never seen anything like this. Also, we emphasized that if we kept performing, we could deliver many, many, many times this amount of money to people. Lastly, keep in mind, half of America has no savings or negative net worth. A lot of those people operate in manufacturing facilities.

As you watch the video, also just keep in the back of your mind what was when we showed up in terms of employee morale, safety, lack of investment in the facility, the staffing model. Now, everything is starting to turn around. If we can roll that quick video.

[VIDEO]

That is obviously what we are going for is to get people to think differently about the company and their role at the company.

Community Involvement Engenders Pride in the Company

Those are the first two legs of the stool. I mentioned investing in the people, making everyone an owner. The third part is this idea of getting the company involved in the community. This is one of these things a lot of companies do on a check-the-box basis, but what we found is if you do it in a meaningful way through the work of all the employees, it can really have an impact on how proud people feel to go to work every day.

What we do is we find a charity that has a need for the product that our company manufactures. It is tied in almost naturally with the mission of the company. Then we strike a formal partnership where we provide financial support, free product, free training, and then we get the employees involved in the charity.

In this case, Homes For Our Troops builds customized homes for wounded vets like the one you see here in the picture. We provide garage doors all over the country for wounded vets.

Then in the local community, we are sponsoring entire homes. When those homes are getting built, we basically rent buses and bus our employee base out to the home and help build it.

I have been at CHI shareholder meetings where sometimes you get a bigger reaction out of some people through this work we are doing in the community than you even do around the ownership stuff.

Employee Survey Update − 2017

One year later, we did our second employee survey. The results were dramatically better. We went from a 30% response rate to an 80% response rate with the results going from 90% below benchmark to 60% above benchmark. Still a long way to go but a huge improvement in just one year.

Engagement: Practical Example of Changed Behavior

One of the questions that our investors often ask us is can you give us an example of changed behavior. What does an engaged employee look like? Here is an example. This is Larry Beal. He is 60 years old. He has been with CHI for many years. Larry invested the maximum amount, the $5,000 I referred to earlier. He is looking at a very significant potential payout. Larry is very, very focused on helping the company get better.

I am going to give you one example. As I have mentioned, we spend a lot of time directly involved in our businesses. We do things like ride along with truck drivers making deliveries to really understand how value is being created and where additional opportunities might come from.

This is an actual route that Larry and I drove together. This is from Arthur, Illinois. This is his Central Wisconsin and Western Wisconsin routes. You can see he goes almost to Minneapolis all the way up almost to Duluth back to the center part of the state. Then we inexplicably sent him to Northern Michigan to deliver one garage door.

Larry says, ‘Hey, Pete, before I was an owner, all I cared about was miles. It is $0.90 a mile. You could have me driving around in circles for all I care. But I really wanted to show you that this is what I am seeing out of our scheduling department and there is no way we are making money on this stuff because I know what you pay me to deliver a door. I know roughly what we are charging for a door.’

You go through the math, and of course, Larry is right. We are making no money. This was reasonably pervasive in the scheduling department. What was happening was we were overriding our own route scheduling system to accommodate small deliveries. Our heart was in the right place. We wanted to accommodate small customers and small orders, but it was costing us a lot of money. This is what happens when employees start to become engaged is it almost becomes an issue of prioritizing all these ideas.

CHI Operational Transformation: Results So Far

To touch on what both Johannes and Craig mentioned, here is an example. Again, we were the fourth private equity firm to show up. It is a building products company so people said margins were already very good at 21%. KKR must be crazy. Why would they be buying this?

You can see in under three years, we are pushing 30% in the EBITDA margin. We have taken almost all of the working capital out of the business. This started at 12% of revenue which in the industrials world is totally respectable, probably top quartile. By 2018, I think we will be negative on working capital.

Potential Macro Impact of this Engagement Model

In the time we have got left, what we wanted to do was to talk to you or maybe tell you about some of the conversations we have internally about what could this kind of engagement model mean for the industrial economy if this were to become more common. We discuss it on three dimensions: wealth and income inequality, productivity and technology disruption.

Just to touch on the last one which might be the least clear, the idea is that technology is great unless you are the blue-collar worker who is getting disrupted. If we can get our employees using their whole brains like Scott Nuttall likes to say and get them behaving like employee owners, they are less likely to get disrupted and more likely to survive alongside of technology. I will give an example of that.

Capital Safety

Starting with inequality, we all know there is a massive inequality problem in the country. Broad-based ownership could be a part of the solution. We wanted to illustrate what this can mean for people by touching on Capital Safety. This was a business we bought in 2012. They make fall protection equipment so like the safety harness and the cabling system you see this gentleman wearing on top of a wind tower. We owned the business for three and a half years and sold it to 3M.

Employee Ownership Prior to KKR

When we initially bought the business though, this was what the picture looked like so very similar to CHI − 1,250 employees, 35 people had ownership. The vast majority were hourly workers in the plants and the distribution centers making $14 to $18 an hour.

Those 35 people when we bought the business got a payout of $157 million and two people got $60 million of the $157 million. Again, a microcosm of the industrial economy more broadly.

Employee Ownership (Update)

We rolled out our engagement model, our broad-based ownership, our operational improvement program. It was a great investment for our investors. It was a fantastic outcome for the employees when we sold the business.

We went from only 35 people even participating in ownership to 204 making more than $100,000 and 44 making more than $1 million. If you are worried about the top two people in the lower left here, they actually made more money with us than they did in the prior deal. This can work. Everyone can participate in value creation.

Capital Safety Exit

We want to play one other video. This one is about 90 seconds long. This is some footage that was captured inside of our Red Wing, Minnesota plant. This is the moment that the employees find out what their equity is worth. This is the first time they hear that news, if you can play that video.

[VIDEO]

One of the unexpected benefits of this program was the impact it had on our senior leadership teams and how much easier it became to drive operational improvement and break down barriers to change. That gentleman, Kevin Coplan at the end who ran the US business for us, once we rolled out that program, it just kind of became all about how do we maximize the value of the equity and really deliver for our people.

Capital Safety Operational Transformation

Now, although it has nothing to do with inequality, we cannot pass up the opportunity to show you the results again just like CHI, fourth private equity firm to own Capital Safety. Margins were already really good in the mid 20s. These are EBITDA margins. You can see in three and a half years, we took them from the mid 20s to almost 40%. People would have said that was impossible.

Operational Transformations: A Broader Set of Results

Craig tells me there are some people here who are tough critics and we need to show a little bit more data. Just so you do not think we are cherry picking, this is the last five industrial deals we have done. You can see the margin improvement on the low end has been 600 basis points. On the high end, it has been over 1,000 basis points. Three of these businesses had been owned by private equity firms who prided themselves in operational change.

Gardner Denver: Engaged Employee-Owners Driving Productivity

Moving on to productivity, this is probably intuitive that engaged employee owners will be more productive employees. But, wanted to give you one example. I would love to talk about Gardner Denver because this was a public company in 2013. At the time, there were 6,000 employees and there were 86 people with ownership in the company: 86 out of 6,000.

We took the company private, rolled out this engagement model. We have now taken it and transformed the company during the years it was private. It is now public: 6,400 employees. Everyone is an owner in the company. The least amount of ownership anyone has is equivalent to about 70% of their annual compensation so totally changed culture.

The Gardner Denver Challenge

The CEO Vicente and I spent some time after the IPO thinking about how we could prove to Wall Street that as a result of this engagement model, we could in a differentiated way execute on an operational improvement agenda. We wanted to find something that we could really take a metric and move it in the right direction rapidly by working through all 6,400 engaged employee owners.

We picked net working capital for a bunch of reasons. One is that everyone touches working capital in some way between receivables, payables and inventory.

Two is these are reasonably easily understood concepts because everyone has got inventory at home in their pantry. They all have bills to pay so they all have payables. You can really explain this stuff to people even if they have not got formal training.

Lastly, there is a lot of room for improvement. Gardner Denver forever has had over 30% of revenue in working capital. When we started, it had almost 32%. If we drove the improvement we thought we could, it would free up hundreds of millions of dollars of cash to reinvest in the business.

Our Approach to Improving NWC at Gardner Denver

We really went after this starting about a year ago. We took a train-the-trainer approach which means you basically establish master trainers in your company. They go around the world training new trainers and then they train the rest of your employee base. With just a few steps, you can actually reach all 6,400 employees.

We did a lot of measurement and reporting so that people knew on inventory for example how we were doing by facility, by product line every week.

Then lots of ongoing communication, not just ongoing training but also celebrating success. We found this as a big way to drive engagement and to build on quick wins.

We had a film crew basically follow our management team around and capture these moments. We created little ceremonies out of them. We take the video, translate it into a bunch of languages and zap it around the world. We have found that creates positive followership.

Celebrating Examples of Improved Engagement

I will not play any of the videos in the interest of time, but we have got dozens of these. This example is of a woman named Holly in our Redditch, UK facility. After her training, she went out and resolved a bunch of five-year-old accounts receivable that aggregates to £1 million. Again, people would have said that just would not be possible. Of course, the message to all the employee base is just imagine if everyone would behave this way.

NWC Reduction at Gardner Denver: Early Results

We just started this but we have already taken 230 basis points out of working capital. Gardner Denver is public. We will be announcing second quarter results soon if you are interested. You can see how we are doing on this metric.

CHI Overhead Doors

Then finally, technology disruption. If we go back to Larry the truck driver at CHI, if all Larry is doing is picking up garage doors and dropping them off at customer sites, some day that will get disrupted by autonomous vehicles. But think of all the things a human being can do that a computer or a robot cannot do.

How an Engaged Truck Driver Creates Value at CHI

One is identifying improvement opportunities. Our truck drivers are now constantly coming up with ways to load and unload doors or improve our route efficiency − something a computer cannot as easily do if it takes creativity.

Second is another thing a computer cannot do is actually get out of the truck at every stop and physically unload the doors. We are the only company that does this because we have got this unique relationship with our drivers. It is a huge differentiator and a huge productivity benefit to our customers.

They can provide competitive intelligence to us. When they are dropping off doors, they are in the customers’ warehouses. They can see our share of wallet, whether there has been competitive entry, etc.

They can also serve and do serve as a feedback loop on quality. When they are unloading the doors, they take note of dented panels, missing hardware, etc., report it back to the plant and so we can fix the problem before it spreads.

Lastly, another thing a computer cannot do is serve as another source of customer relationship. These guys are almost like second-line salespeople in the job that they do.

The point in all this is that even if we had autonomous vehicles, as engaged employee owners, they are delivering so much value. We would still have them sitting in the truck doing all of these things even if the truck was driving itself.

Work In Progress

As I mentioned at the outset, this is very much a work in progress. We have started in US industrials. We are working globally and across business lines to see where this could have other applicability. We are honored that Harvard and Rutgers have taken note of what we are doing and are starting to study what we are doing and are helping us isolate the performance improvement impact related directly to employee engagement.

With that, I hope we have done a decent job of proving to you that we are doing a whole lot more than just levering up companies and hoping multiples go up. Hopefully, I have given you some sense for just how deeply involved we get with our businesses once we buy them. As Henry likes to say, that is when the hard work really starts is after you make the acquisition. With that, I am going to hand it over to my partner, Ralph Rosenberg.

 



Disclaimer

Investor Day podcasts and corresponding transcripts have been prepared for KKR & Co. Inc. (NYSE:KKR) for the benefit of its public stockholders and is not intended to be a solicitation or sale of any of the securities, funds or services that they may discuss. Please find a copy of the presentation here.