[Morning Class Group 6] Drivers of the high returns of PE firms

Topic: What drives the high returns of private equity funds

You may imagine the private equity firms simply take a business private, load it with debt, strip its assets, then sell it a few months later for multiples of the purchase price-a strategy that seems decidedly hostile to the long term. But the experience of properties put through strategy workout by private equity firms suggests that the exercise can actually enhance long-term performance and the ownership over the long haul is neither sufficient to set a company up for the future.


1. Identification of key success levers

2. Financial restructuring

3. Incentive structure

4. Buy-and-Sell vs. Buy-and-Keep

1. Identification of key success levers

(1) Define a investment thesis

a. Have a three - to -five year plan

Private equity firms manage businesses to the intermediate term-three to five years-about the time they typically hold an investment before selling. This time frame removes the often counterproductive focus on quarterly numbers yet still create urgency to transform the business quickly.

b. Stress two or three key success levers

The top private equity firms focus all their energies on accelerating the growth of the value of their businesses through the relentless pursuit of just one or two key strategic initiatives. They narrow their sights to widen their profits.

c. Focus on growth, not just cost reduction

The successful private equity firms tend to focus not on cost reduction but on growth. Imposing a stronger strategic focus usually entails aggressive pruning of existing business, but creating a path to strong growth is what produces the big returns on investment.

(2) Don't measure too much

a. Prune to essential metrics

The top private equity firms have steadfastly resisted measurement mania. Believing that broad arrays of measures complicate rather than clarify management discussions and impede rather than spur action, these organizations zero in on just a few financial indicators: those that most clearly reveal a company's progress in increasing its value.

b. Focus on cash and value, not earnings

Private equity firms watch cash more closely than earnings, knowing that cash remains a true barometer of financial performance, while earnings can be manipulated. And they prefer to calculate return on invested capital, which indicates actual returns on the money put into a business, rather than fuzzier measures like return on accounting capital employed or return on sales.

c. Use the right performance measurement for each business

Managers in private equity firms are careful to avoid imposing one set of measures across their entire portfolios, prefering to tailor measures to each business they hold. "We use their metrics, not out metrics," says James Coulter, founding partner of Texas Pacific Group, in explaining how his firm develops measures for its businesses. "You have to use performance measures that make sense for the business unit itself rather than some preconceived notion from the corporate center."

d. Link incentives to unit performance

Private equity firms put teeth in their measures by directly tying the equity portion of their managers' compensation to the result of the manager's unit, effectively making these executives owners. Often, the management teams own up to 10% of the total equity in their businesses, through either direct investment or borrowings from the private equity firms.

2. Financial restructuring

(1) Use debt to gain leverage and focus, but match risk with return

Private equity firms rely heavily on debt financing. On average, about 60% of their assets are financed with debt, far more than 40% that 's typical for publicly traded companies. The high debt-to-equity ratio helps strengthen managers's focus, ensuring they view cash as a scarse resource and allocate capital accordingly. PE firms also make equity work harder. They look at their balance sheets not as static indicators of performance but as dynamic tools for growths. For example, the most sophisticated firms have created new ways to convert traditionally fixed assets into sources of financing.

Consider the story of Punch Tavern Group. TPG acquired the chain of 1,470 UK pubs from BT Capital Partners and other investors in 1999 for £869 milliion. A few month later, TPG and Punch made a bold move to acquire Allied Domecq's 3,500 pubs, squaring off against a much larger suitor, Whitbread, in what became the most hotly contested bid in the European PE markets. TPG and Punch outmaneuvered Whitbread and won the deal, in part by working Punch's balance sheet to lower the cost of financing the acquisition.

TPG's financing consisted of a £1.6 billion bridge loan, which it later refinanced by securitizing its newly acquired pub assets. Thanks to the stable and predictable nature of pub revenues, Punch was able to isolate the rents it earned on real estate(an important source of cash flow to the company) and package them as real-estate investment securities that could be sold to investors. As a result, it achieved a more efficient capital stucture, saving approximately £30 million in annual interest costs. In combination with a focused investment thesis-tailoring pub products and prices to local markets-the innovative use of the balance sheet enabled TPG to restore growth to a business that for years had posted flat to declining sales. Punch's pub revenues have been increasing at more than 7% annually, despite the maturity of the overall industry.

(2) Redeploy or eliminate unproductive capital-both fixed assets and working capital

The private equity firms work the balance sheet by aggressively managing the physical capital in a business. They realign the capital base of the company, closing down peripheral businesses so as to release funds for investment in the core.
Consider how the U.S. firm GPCR Golder Rauner turned around SecurityLink(a company that installs and monitors security systems), which it bought in 2001 from telecommunication giant SBC Comunications and merged with Cambridge Protection Industries(another security business it had invested in). SBC had viewed SecurityLink as a loss-making, noncore business, but CTCR'S managers saw trapped value in the unit. They realized that the key to making profits lay in selling directly to customers and focusing only on regional markets where they could achieve market share leadership. Dominant market share in a locale provided scale economies for local call centers and pools of alarm technicians and installers. So GTCR quickly established a single-minded investment thesis for SecurityLink: Pursue rapid growth in carefully targeted regional markets. This strategy created immediate opportunities to rework the balance sheet of the company. First, GTCR released capital by selling a third of SecurityLink's offices-those lying outside the target markets. Then it refocused capital previously tied up in serving the dealer and mass-market channels on building direct sales capabilities in the traget regions. By homing in on a fewer markets, the company was also able to dramatically reduce costs, cutting more than 1,000 sales and service jobs. The result is that SecurityLink rapidly transformed itself from a loss maker into a highly profitable company, generating close to $100 million of pro forma pretax earnings in less than a year.

3. Incentive structure

(1) Private equity portfolio manager

Private equity fund managers have earned extremely attractive rewards, with little up-front investment. As compensation for taking the initiative in raising money, managing investments, and marketing their benefits, they have structured agreements so that a large portion of the gross returns flows to them : typically a fee of about 1.5% to 2% of asset under management, plus, subject to achieving a minimum rate of return of investors, 20% of all fund profits. Fund profits are mostly realized via capital gains on the sale of portfolio businesses.

(2) Operating manager

As more outfits are coming from taking an increasingly active, hands-really-on managerial role in the businesses they acquire, private equity firms recruit operating managers with proven talent. But not like public companies that allow top excutives to leave with large exit packages despite poor performance, the private equity firms offer large rewards to the operating managers for company outperformance without contractual protections for executive underperformance. At the same time, equity stake held by the operating managers of private equity firms are typically much larger than in public companies and the private equity firms ask them to invest their own money to ensure their commitment and motivation. In return, the operating managers may receive larger rewards linked to profits when the business is sold.

4. Buy-and-Sell vs. Buy-and-Keep

(1) What is the strategy of private equity firms

The private equity firms' standard strategy is buying businesses and then, after steering them through a transition of rapid performance improvement, selling them. This strategy is a combination of business and investment-portfolio management and the core of private equity's success.

(2) When Buy-and-Sell strategy is used

Buy-and-Sell strategy is ideally suited when, in order to realize a one-time, short- to medium-term value-creation opportunity, buyers must take outright ownership and control. Such an opportunity most often arises when a busienss hasn't been aggressively managed and so is underperforming. It can also be found with businesses that are undervalued because their potential isn't really apparent. In those cases, once the changes necessary to acheive the uplift in value have been made-usually over a period of two to six years-it makes sense for the owner to sell the business and move on to new opportunities.

(3) Why Buy-and-Sell strategy is pursued

Because all businesses in a private equity portfolio will soon be sold, the acquired companies remain in the spotlight and under constant pressure to perform. In cotrast, a business unit that has been part of a public company's portfolio for some time and has performed adequately, if not spectacularly, generally doesn't get priority attention from senior management. In addition, because every investment made by a private equity fund in a business must be liquidated within the life of the fund, it is possible to precisely measure cash return on those investments. That makes it easy to create incentives for fund managers and for the executives running the businesses that are directly linked to the cash value received by fund investors. That is not the case with business unit managers or even for corporate managers in a public company. Furthermore, because private equity firms buy only to sell, they are not seduced by the often alluring possibity of finding ways to share costs, capabilities or customers among their busineses. Their management is lean and focused, and avoids the waste of time and money that corporate centers, when responsible for a number of loosely related businesses and wishing to justify their retention in the portfolio, often incur in a vain quest for synergy. Finally, the relatively rapid turnover of businesses required by the limited life of a fund means that private equity firms gain know-how fast.

(4) Whether to buy-and-sell or buy-and-keep

Some diversified public companies, like General Electronics, focus, as do private equity fund, on making good acquisitions and exerting a positive influence on their management. The important difference is that where private equity funds buy with the intention to sell, diversified public companies typically buy with the intentions to keep. If recent history is any indicator-private equity firms are growing while conglomerates have dwindled in number-the private equity fund may have the more successful strategy.


Refererences :

"Private Equity's Long View" by Walter Kiechel III
"If Private Equity Sized Up Your Business" by Robert C. Pozen
"The Strategic Secret of Private Equity" by Felix Barber and Michael Goold
"Value Acceleration : Lessons from Private-Equity Masters" by Paul Rogers, Tom Holland, and Dan Haas

Members :
Moh, Kunwook (Coaching)
Moon, Hyung-Gyu (Editing)
Roh, Hye Ryung (Researching)
Choi, Insook (Writing)

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