Since 2001, private equity firms have invested more than $2 trillion to
acquire or take stakes in some 11,000 companies around the world.
The current credit environment may have slowed private equity investment
this year, but the industry’s footprint and influence remain enormous.
Private equity’s unique blend of risks, rewards, challenges and
opportunities has changed the way that many people think about effectively
operating a business.
What do the most successful private equity firms and their portfolio
companies do right? What can all businesses learn from the private
equity experience? Below are key findings from our discussions with
leaders in this sector, summarized in the form of 10 lessons that can be
learned from private equity.
1. Have an engaged and
knowledgeable board
Of all the advantages of private equity, one
of those most often cited is the strength
and focus of the board of directors.
Portfolio company boards tend to be smaller
and more hands-on — so everybody counts and must contribute. Investor
representatives
on boards meet frequently with
management and can bring to bear the
resources and contacts of their firms. Their
outside directors typically provide valuable
operational, functional or industry expertise,
and can serve as mentors to the CEO.
Portfolio company boards also operate
under fewer regulatory requirements than
public companies and away from the
scrutiny of external shareholders, analysts
and the general public. Without these
pressures and distractions, they have
more time to devote to value-adding activities,
according to private equity leaders.
Portfolio company directors also have significant
equity stakes in their companies;
beyond receiving options or stock as part
of their compensation, they often invest
their own money into the business. This,
private equity executives say, aligns directors
with shareholders and the management
team and increases their focus on
performance. “The biggest difference
between public and private boards is that,
essentially, there is one shareholder —
it’s us and management. We’re partners.
That is the ultimate level of accountability.
We’re giving the CEO great resources in a
focused, high-performance board, but
we’re driving accountability and we’re
measuring it,” said JP Conte, chairman
and managing director of Genstar Capital.
2. Develop a clear and compelling plan for changing the business
With valuations at high levels, private
equity firms no longer can rely on financial
engineering and sharp cost-cutting to
create value. In most cases, portfolio
companies must be strategically transformed
and restructured to reach the
level of profitable growth required to
accomplish the exit strategy, whether it is
selling the company or taking it public. Central to portfolio company success
is
reaching an agreement upfront between
the board and management team about
the potential for the business and defining
a plan for getting there. Private equity
firms use the extensive due diligence
process to understand the business fundamentals
and identify opportunities to
improve performance.
To make sure management buys into the
plan and commits to its milestones,
Aurora Capital Group hosts what it calls
an “outside-in session” with management
after the transaction closes. “We literally
spend an entire day with the management
team and we turn the tables around. We
share with them all of the work we’ve
done underlying our investment decisions.
The point of that meeting is to make sure
that we all agree on a set of facts and
data, and together define what full potential
is for this business. We then create a
blueprint that details who’s responsible
for what and how fast,” said Aurora
Capital Managing Partner John T. Mapes.
3. Align equity holders and the management team around the business
objectives
Portfolio company CEOs and their top
executives typically have a significant
amount of personal wealth tied up in the portfolio company. As a result, their
interests
are closely aligned with the interests
of shareholders, and they have an incentive
to accelerate the rate of change.
Private equity’s potential financial rewards
tend to attract “economically motivated”
managers. “That lines up well with
investors,” Mapes said. “Investors want to
get the biggest return in the fastest way
humanly possible. If they aren’t set up that
way, public companies will attract very
good executives, but they may value things
other than economics.”
With both management and directors
heavily invested in the company, a true
partnership develops between the CEO
and the board, Conte said. “That leads to
great communication about what’s going
on at the company, sooner rather than
later,” he said. John Samuel, who was CEO
of Molnlycke Health Care, one of Apax
Partners’ most successful deals, agreed:
“With private equity, you need to be much
more straightforward and open about the
challenges you face, what you are doing
about them and the likelihood of success.”
4. Be diligent about cash flow management
In most private equity situations, portfolio
companies have high levels of debt, requiring constant attention to cash flow,
spending levels, debt repayment and financial
targets. “Cash is king” at portfolio companies,
so finding new sources of revenue
and controlling costs are top priorities for
their CEOs. In practice, this means that
portfolio company management is disciplined
about concerns such as ensuring
that capital spending proposals have a payback
and improving receivables collection.
A key player in this effort is the chief financial
officer, who typically has a commanding
role in improving cash flow and driving
value. Vivek Paul, partner in the Venture
Group of Texas Pacific Group and formerly
vice chairman of Bangalore-based Wipro,
sees the CFO role as both consigliere and
irritant to the CEO, whether the company
is private or public. “CFOs are in the best
position to challenge a CEO as to whether
he can do more,” he said.
5. Focus on growth and building value
Having to answer to many investors and
stakeholders and navigate myriad corporate
demands, public company leaders can
lose their focus on the business. The private
equity environment removes some of
those distractions and focuses the organization
on a few clear objectives aimed at
value creation. “I liked the directness of
the approach, the total focus on value creation
without having to water down your
plan because one is worried about how
investors might react,” said Samuel. “The
great thing about private equity is that you
never have to worry about the real agenda. The real agenda is ‘Make money.
Create
value.’ That’s it.”
In addition, the relationship between the
board and management creates a culture
of accountability for performance, private
equity leaders say. “The performance
demand on the CEO is more direct in private
equity,” said Paul. While a public
company director might present a concern
indirectly in the form of CEO coaching,
portfolio company directors are more
likely to be direct. “On the private equity
side, you pick up the phone as soon as
you feel there is value to be had and say,
‘I think we can do this a little bit better.
Let me know if you need any help analyzing
this.’ The conversation is much more
direct,” he said.
6. Act decisively
While a portfolio company has to be far
more focused on fewer goals and a welldefined
end game, the alignment of its
management and board makes it easier
to mobilize the organization to accomplish
those goals and make decisions
quickly. Management teams and boards
are analytical — ideas are presented and
evaluated based on their potential impact
on income or cash flow — and important
decisions can be made without involving
layers of management or external stakeholders. Board members, particularly
those from
the private equity investor, speak frequently
with management, helping to
streamline decision making. “As the lead
directors at our companies, we’re on the
phone with our CEOs every week. The
CEOs are running major businesses and
often need to effect a lot of change on an
accelerated basis. They want to bounce
ideas off someone, and what’s more powerful
than reflecting on an idea with your
top shareholder who owns 70-plus percent
of the company?” Conte said.
7. Plan for the longer term
Quarterly financial reporting is a fact of
life for public companies and likely will
continue to be. With this focus on quarterly
results, however, the public environment
can be hypercritical in the shortterm
and less strategically oriented. The
finite time frame for achieving an exit
strategy, typically three to five years, gives
structure to portfolio company plans and
encourages risk-taking that may pay off
over the medium to longer term. Private
equity tends to have a greater appetite for
risk, making it easier for portfolio companies
to make dramatic moves or embark
on fundamental changes in strategy.
Portfolio companies do have to hit shortterm
performance targets; they have bank
payments to make and covenants to
keep. At the same time, they have more
room to make changes or investments for
the long-term benefit of the company,
even if they result in a bad quarter in the
short term, private equity leaders say. “It’s not all about the next quarter of
the
current year; we take a three-year look at
how we can make the company better,”
Mapes said.
8. Cultivate a sense of urgency
In a portfolio company, the leverage and
alignment of management incentives with
company performance combine to create a
“burning platform for change.” This burning
platform encourages an action-oriented
culture, with a bias toward making
decisions.
“By its nature, the higher debt level creates
a crisis. There’s not as much room for
error when you have a levered balance
sheet, so it makes management very
proactive and creates an atmosphere that
encourages people to make decisions and
act. Public companies are relatively unlevered,
and so the onus is on the CEO to
create that atmosphere,” Conte said. In the
private environment, there is more tolerance
for making a mistake than for missing
a promising opportunity, said Paul.
“My sense is in public companies, there is
a much higher cost of flubbing it and a
much lower penalty for missing an opportunity.
In other words, what’s not done
doesn’t get punished,” he said.
9. Draw on expert advisers
When they are looking for investment
opportunities or need advice during the
due diligence process, private equity firms
tap their networks of operating executives,
advisory board members and board directors
of other portfolio companies as
resources. When a challenge arises or a
portfolio company needs help opening a
new door, the CEO and board members
are able to reach out across the family of
portfolio companies to find the expertise
they need.
Aurora Capital Group further leverages
these resources through its annual CEO
roundtable that brings together portfolio
company CEOs to share ideas and discuss
issues. “That has become a real winner for
us and for our investors because value
seems to be generated from those meetings,”
Mapes said.
10. Back the initial team, but be willing to make changes when
necessary
Many private equity firms invest in companies
based on the strength of the management
team. Others parachute trusted leaders
into new investments or those that are
struggling. Regardless of their approach,
private equity firms recognize the critical
importance of strong, effective leadership to
the success of their investments. Firms typically
regard their ability to assess management
as a core competency.
One approach is to evaluate management
within a few weeks of completing an investment. This helps the firm understand
the quality of the executive team,
identify any gaps in the organization’s
capabilities and learn more about executives’
motivations and willingness to
commit to the long-term plan. Early
assessment also helps reveal issues that
the private equity firm may need to manage,
such as a CEO’s tendency to be overly
optimistic. Another approach is to
assess the performance of management
six months into an investment to confirm
that the right team is in place.
As the primary shareholder, a private
equity firm can move quickly to replace
an executive when necessary without having
to worry about the reactions of analysts
or the public. They are able to tap
their CEO networks or bring in an executive-
in-waiting if they need to make a
change or supplement the existing team.
Still, removing an executive in a private
equity environment is not done lightly.
Private equity firms weigh these decisions
against the desire to protect their reputation
with chief executives. “You want to
make sure that you can attract great
CEOs, and CEOs don’t want to feel that they’re walking into a situation with a
trigger-
happy bunch,” said Paul. “You try to
be as supportive as you can be and, in
some sense, you’re an accomplice to the
problem because you’re much closer to
the business than public company directors
might be and, therefore, you do tend
to be fairly understanding. On the other
hand, if the problem is clear, there’s no
inertia about making a change.”
Conclusion
Portfolio companies enjoy a number of
advantages when it comes to building
efficient, high-growth businesses, including
their ownership and compensation
models, fewer competing distractions and
the power of leverage. Meanwhile, public
companies will not be free any time soon
from quarterly financial reporting requirements,
governance rules meant to drive
accountability and transparency, or the
demands of a larger pool of stakeholders.
Nevertheless, private equity’s bottom-line
focus can be adapted to the public environment.
The following are the foundations
of this approach.
A robust and engaged board of directors.
A strong board that works
effectively with the CEO to set strategy
and holds the CEO accountable for
results is essential to the success of any
company, public or private. Attracting the
very best directors — those with the leadership
skills and relevant industry perspectives
— begins with an effective
nominating process. Wise boards will
want to foresee where the company is
headed in the future and take advantage of natural attrition to recruit
directors with
the expertise required to help the company
respond to the new challenges and opportunities
it will face.
A culture of urgency
In the absence of
the high debt levels under which most
portfolio companies operate, a public company
CEO has to create a culture that is
decisive and action-oriented. To do this,
the CEO needs to work with the board and
management to create a partnership based
on performance, together defining the
potential for the business, putting a blueprint
in place and paying attention to the
progress against the plan.
A compensation model that rewards performance
While they may not be able
to match the huge equity-based rewards
that can be gained from a successful private
equity venture, public companies can
structure compensation in a way that
rewards longer-term performance. That
means less reliance on cash and more on
performance-based equity compensation.
A talent assessment process that identifies and develops outstanding
leaders
Making a talent mistake in
today’s business environment can have
dramatic consequences for organizations,
in the form of lack of strategy, missed market
opportunities and poor execution. A
primary responsibility of the board and
CEO is to ensure that the company has
succession-planning and assessment
processes in place. Times of change, such
as a major strategy shift or change in organizational
structure, are natural opportunities
to reflect on the strength of the management management
team, determine whether the
right people are in each role and identify
leadership gaps.
Private equity leaders naturally are proud
of their success in turning around troubled
companies and improving the performance
of others, thus creating value for their
investors, their management team and
their companies. These 10 lessons from
their experience suggest ways that all companies
might perform at higher levels.
About the authors
Catherine Bright leads the firm’s Private Equity
Practice in Europe. Jonathan Visbal leads the firm’s
global Technology, Communications & Media Practice
and led the firm’s Silicon Valley office in San Mateo,
California, from 2000 to 2006. Nick Young leads the
Private Equity Practice in North America.
Notes
This article is included in Point of View 2008.
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