Paul Calthrop, Vice President, Australia, Bain International
The best private equity firms have earned returns over a sustained period of time that outweigh anything seen in the corporate sector. U.S. private equity groups like Texas Pacific Group (TPG), Berkshire Capital and Bain Capital, and European groups like Permira and EQT deliver annual returns greater than 50% year after year, fund after fund. What drives this? Are they just financial sharpshooters - hunters in pinstripes? Or is there something that those of us running public companies can learn from their very evident success?
Bain has a point of view on this. Over the years we have observed closely what the private equity players have done, believing that the results were too impressive to ignore. The lessons we learned caused us to spawn a separate firm, Bain Capital that has been one of the most successful of its kind. And we consult more often than any other firm to the leaders in the field.
What then are the lessons learned? The first observation, based on studying more than 2000 private equity transactions over the last ten years, is that the secret to their success does not lie in any fundamental structural advantage they hold over public companies. Rather it lies in the rigour of the managerial discipline they exert on their businesses. Top private equity firms excel at bedrock business issues ranging from leadership talent to corporate governance - and these are learnable lessons and mindsets.
The typical firm manages a large and diverse portfolio of companies - up to 20 at a time - yet few of those companies share synergies. They are prototypical examples of that rarest and most unfashionable of animals - the conglomerate. With a strict mandate to add value to each company, the private equity professionals must strip the business of business to its essentials.
We have learned that the successful private equity firms share five traits that are easy to emulate. Here's how they translate into actions:
The top private equity firms are run by leaders who think like owners. With the backing of independent boards, they make fast decisions and act rapidly. They are intolerant of poor leaders in their portfolio companies, and they don't hesitate to replace them. In many companies, the board finds this exercise daunting, even when it has all the right reasons to replace someone. Private equity leaders create a burning platform and act. They don't spend too much time determining that the business model won't work.
Private equity pros develop a clear investment thesis to outline how they'll drive value from each portfolio company over a three to five year timeline. They then use that thesis to guide every action the firm takes. The best investment theses are often extraordinarily simple; they lay out in a few words the fundamental changes needed to transform a company. To develop an outline in the first place, they first assess the 'full potential' performance of a business over a three to five-year timeframe. That mindset enables the firm to concentrate on the two or three issues that will determine a portfolio company's success. It also avoids the incremental approach - last year plus x% - common to most internal planning exercises.
Private equity firms rely heavily on debt financing. On average, about 60% of their assets are financed with debt compared with the 40% that is typical for public companies. The high debt to equity ratio helps strengthen managers' focus, ensuring they view cash as a scarce resource and allocate capital accordingly.
But private equity firms also make equity work harder; they treat the balance sheet as a tool for growth, rather than as a scorecard. That means they rapidly redeploy or cut off unproductive capital, be it fixed assets or working capital. They create new ways to convert traditionally fixed assets into sources of financing.
This unwillingness to accept unproductive capital extends to companies as a whole. Private equity firms maintain a willingness to sell or shut companies that fall too far behind plan. And if the right opportunity knocks, they will sell. 'Every day you don't sell a portfolio company, you've made an implicit buy decision,' says TPG's chief executive, Jim Coulter.
The balanced scorecard, introduced by Kaplan and Norton, triggered a real enthusiasm for measuring a broad range of financial and operational indicators. As a result, many large companies significantly increased the number of measures they tracked. The top private equity firms have firmly resisted measurement mania. They hone in on only the metrics that will help them keep track of a portfolio company's direction. They measure cash rather than earnings, and returns on capital rather than on sales. They keep an eye on how market conditions will affect the companies in their portfolio instead of analysing trends and historic data. In short, they rely on simple dashboards.
Private equity firms always maintain an independent view. Once they've appointed a management team and board, they take on the role of an active and demanding shareholder. Because they do not act like administrators or employers, they can adopt an unsentimental approach to their ownership, stay lean, and focus unflinchingly on results.
Underlying the actions of top private equity firms, there is an understanding that their raison d'etre is to increase the economic value of their portfolio companies within a three to five year time frame. Most public companies would claim this as their goal as well. However, in reality public companies tend to fall into the short/long term trap. They focus on the half and full year results to keep the stock market happy. And they have long term 'visions' for the company at the other end of the spectrum. Private equity companies know that within five years they must be in a position to sell the company for more than they paid for it. This is the acid test, and it allows the right medium term focus on driving a compelling growth story.
What is the actionable learning for public companies? Consider these questions:
- Have you created a burning platform and made the tough calls on key people?
- Have you got a three
to five year investment thesis that identifies the two or three things
that will deliver the full potential of the company?
- Are you working the balance sheet hard?
- Do you have measurement mania or have you identified the few key factors that make a difference?
- Are you acting as a shareholder, or as an employer/administrator?