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.
The success of the governance model rests in the ability
of private equity firms to exert ownership control over management
and create sustainable above-average performance, McKinsey
reports. In contrast to the public model of diffuse shareholders,
powerful CEOs and nonexecutive directors who rely on management
for information, private equity firms create more effective
independent boards that devote considerable time to the company
and receive support from analysts and independent research.
The private equity model also uses high levels of equity-based
compensation to align managers with owners.
The board of a private equity owned company is generally
much smaller and may be as small as five members, notes Joseph
F. Trustey, managing partner in the Boston office of Summit
Partners, a private equity and venture capital firm that
has raised $9 billion in capital since its founding in 1984.
Smaller boards can be more nimble; decisions that take weeks
or months in public companies are often settled in days.
The board will generally include a few members from the sponsor
firm with industry expertise and some outside members with
deep industry experience.
"The role of the board depends on the policies of
the sponsor," Trustey says. "At Summit, we take
a very active role in strategic issues, but not in the day-to-day
running of the business. More ownership among both board
members and executives provides good incentives and alignment."
While public company board members often have little or
no equity interest in the company, board members at private
equity owned companies often have substantial equity stakes
that enhance their focus on value creation. To build the
far more knowledgeable and engaged boards that they need,
public companies should significantly increase director compensation
to double or more today's average S&P 1,500 rate of $125,000
a year, according to Harvard Business School's Malcolm Salter.
He also suggests that directors should make a threshold commitment
of $500,000 to $1 million at companies with more than $3
billion in revenues.
The ability of private equity boards and executives to
make tough decisions quickly and spend less time on process
is consistently cited as one key to their success. "This
is the hardest point to tackle in a public company,"
Pettit says. "CFOs have to address the culture and the
compensation structure that supports it."
Compensation contributes to the corporate culture and
can encourage risk taking and entrepreneurial behavior. "The
board must have the expertise and the power to exercise greater
scrutiny over the CEO and the CFO, and to reward them with
equity stakes that go far beyond public company rewards,"
Pettit notes.
Public company CFOs can emulate the private equity model
by working to help reshape the board, conducting an intense
strategic assessment of the business, creating significant
equity incentives for managers who meet value creation goals,
and using senior executives to actively evaluate business
unit management.
A study by The Boston Consulting Group (BCG) also concludes
that the superior governance model used by private equity
owned companies is the source of higher returns. Sophisticated
shareholders and management align around a focused drive
to create equity value on the basis of a rigorous outside-in
analysis and an agreed-upon set of metrics.
BCG recommends that public companies mimic private equity
owned company practices by conducting in-depth due diligence
on all aspects of the business and constructing a strategic
dialogue between senior management and leading investors.
The responsibility for building the dialogue with key investors
should rest with senior managers, not just the CEO or investor
relations staff.
BCG also advises public companies to pursue the private
equity model by creating an engaged and effective board with
industry expertise, concentrating on value creation through
growth, replacing the quarterly time horizon with a long-term
perspective and using high levels of incentive compensation
to get managers to act like owners.
A BCG benchmark study found that managers at private equity
owned companies have the equivalent of as much as one to
two years of salary invested in the business, and receive
eight to twelve times the amount invested upon exit. Some
private equity owned companies require senior executives
to invest significant sums of their own capital.
Perhaps more importantly, private equity owned companies
extend profit sharing and equity-based plans to a much larger
group of employees. Under the new expensing rules, public
companies have reduced broad-based equity plans, but CFOs
may need to reevaluate this move.
The debt position of private equity owned companies is
distinct. Private equity deals may run on six to eight times
more debt than equity. "Debt is a good discipline,"
says Trustey. "A private equity owned company is generally
more leveraged, but it needs a balance sheet that will allow
growth. So there is a natural tension for the CFO, and the
company operates under greater pressure."
Pettit notes that public companies are sitting on too
much cash and need to reduce excess liquidity. They can do
this through paying out dividends or making stock repurchases,
but it is more productive to grow the business by investing
in internal projects, he advises. In some cases, however,
the hurdle rates are set too high. "The CFO sets those
rates, and may need to update the work on the weighted average
cost of capital and reevaluate the relationship to the hurdle
rates," Pettit says. Then the CFO may need to educate
the board about resetting the hurdle rates.
Private equity owned companies are commonly faulted for
operating in an excessively short time frame that does not
build long-term value, with most slated to change ownership
after an average of five years. But market pressures force
public companies into an even shorter time frame.
"Strategically speaking, in a private equity company,
the time horizon of a five-year window is certainly better
than the quarterly window common among public companies,"
Pettit says. He advises CFOs at public companies to move
out of the quarterly perspective and place a greater emphasis
on cash flow than earnings per share. The relevant question
for the CFO, he says, is where the company's cash flow should
be in three to five years.
Many of the practices adopted by private equity owned
companies are related to their explicit commitment to selling
within the foreseeable future. "Private equity companies
are always looking at an exit strategy and terminal value
and managing that terminal value," Pettit notes. Public
company CFOs can benefit from adopting the same mindset.
"The point is not that pubic company CFOs should push
for more aggressive divestitures, but that they can benefit
from looking at all of the options for each business unit
and actively managing the company's whole portfolio instead
of treating units as a legacy," Pettit says.
According to OC&C Strategy Consultants, private equity
owned companies are successful because they focus on cash
from the core business, costs and management. The process
begins when private equity firms call on outside experts
to conduct massive due diligence before any deal. The information
gained becomes the basis for a deep, objective and externally
validated understanding of the business and fundamental drivers
in the market.
Based on this knowledge, private equity owned companies
divest noncore elements, acquire value-creating core assets,
streamline the business model and cut working capital. In
the course of stripping out costs, however, they are careful
to protect customer-facing functions. All of these actions
can be duplicated in the public company context.
OC&C notes that private equity owned companies install
incentives based on crystal-clear cash-creation goals, with
zero tolerance for underperformance. It recommends that public
company boards stop endorsing lackluster annual strategic
plans, demand an approach that adopts private equity best
practices, and create the vehicles needed to reward the level
of performance required.
Private equity firms are now sitting on a huge pile of
cash and aggressively seeking ever-larger targets. "There
will always be a good public market for many companies, but
there are good grounds for taking some companies private,"
Trustey says. Summit looks for predictable and strong cash
flow, above-average growth in the sector and a strong management
team.
The advantage for the CFO in going private is that there
are fewer shareholders and compliance issues, Trustey notes.
"Also, the compensation in a private equity owned company
is much less centered on salary and bonus and more stock-based,
which is where the real money comes from. The CEO and CFO
in a private equity owned company are much more likely to
own a larger share of the company."
The McKinsey study notes that if public companies do not
adopt the superior governance model used by private equity
firms, private equity may eventually rival the public market
in size. Whether the goal is greater shareholder returns
or preparing the company to go private, mimicking the best
practices honed by private equity owned companies is a viable
path for public company CFOs.
Receiving the Private Equity
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Crossing Over From Private Equity to Public Company:
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