Emulating Private Equity

Private equity firms continue to sit at the pinnacle of
the business universe with annual average returns that every
public company wants but rarely achieves. The standard explanation
for the disparity is that only private equity owned companies
are free to take on extraordinary debt and ignore the enormous
regulatory burdens that preoccupy public companies.

Private equity managers produced record-breaking results
in 2006, with buyout firms posting returns of more than 25
percent, according to Mercer Investment Consulting. The best
private equity firms are now pulling capital and executive
talent out of the public company realm at an alarming rate.

No one disputes the private equity advantages derived
from the lower cost of capital that comes from higher leverage
-- or the benefits gained when companies live beyond the
reach of Sarbanes-Oxley. But the growing amount of evidence
available on the private equity experience is forcing a new
consensus that the high returns stem from differences that
go to the very essence of how private equity owned companies
are run.

"In some cases, private equity owned companies create
real value through their use of debt, and a lot of focus
is placed on debt financing," says Justin Pettit, a
New York City-based vice president with Booz Allen Hamilton
who specializes in corporate finance and shareholder value.
"But when you look at the yield curve, the relative
advantage of debt over equity is a smaller differential than
it has been in the past. All too often there is not a lot
of value created through higher debt."

To the extent that the success of private equity owned
companies does not hinge on the debt structure they adopt
or their greatly reduced regulatory burden, the best practices
of the private equity model can be replicated by public company
CFOs. A series of new studies captures the best practices
that boost private equity returns well above those produced
by the public company model.

These studies and experts on private equity returns conclude
that the success of private equity firms today does not derive
primarily from the use of debt or paying lower prices for
companies, but from their governance model and their approach
to value creation. Extensive research by McKinsey & Co.
concludes that the impact of the private equity governance
model is so profound that the huge returns generated are
the result of "governance arbitrage" rather than
the financial engineering or price arbitrage models that
marked private equity firms in the past.