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Private equity, private lives
The private equity boom is breathtaking. It's not just making
investors rich - the wave of deals is changing the mindset of
corporate managers everywhere. Fortune reports.
By Geoffrey Colvin and Ram Charan
November 27 2006: 1:07 PM EST
(Fortune Magazine) -- If you want to get to the bottom of today's
historic boom in private equity, just follow Tom von Krannichfeldt
around.
You've probably never heard of him or the company he leads, AZ
Electronic Materials. Carlyle Group, one of the major private-equity
firms, bought AZ from Swiss chemical company Clariant a couple of
years ago for $415 million and brought von Krannichfeldt out of
retirement to run it; he'd spent his career in big public chemical
companies.
Being private, AZ doesn't get much media attention, and of course it
doesn't release financial data. But industry experts say it seems to
be doing extremely well. More important, the way von Krannichfeldt
and his team manage AZ from offices around the world - and the way
other CEOs run their newly private outfits - holds the real key to
how private equity is reshaping business.
The headlines about private equity have focused on the dollars
rushing in. Kohlberg Kravis Roberts proposes buying Vivendi for $50
billion, a record-sized deal that would have been unthinkable just a
year ago. Blackstone Group announces that it's raising a $20 billion
fund, the biggest ever. Private-equity firms already own a growing
stable of America's most famous companies - Hertz, Neiman Marcus and
Toys "R" Us, among others.
A big year for buyouts
With investors pouring in money and firms joining forces in club
deals, only a handful of giant companies are now out of reach of a
private-equity buyout. Wall Streeters speculate that other elephants
like Texas Instruments (Charts), Dell (Charts), and even Home Depot
(Charts) (market capitalization: $77 billion) could be targets.
But few observers appreciate that the private-equity phenomenon is
about more than just big bucks. Yes, private-equity deals are making
investors rich. In the 12 months through last June, investments in
PE firms returned 22.5 percent, vs. 6.6 percent for the S&P 500,
says Thomson Financial.
Over the past ten years, the score is 11.4 percent a year vs. 6.6
percent; over the past 20 years, 14.2 percent vs. 9.8 percent. Those
are significant differences, and some critics charge that huge fees
and sweetheart deals with management are siphoning value from public
shareholders.
Inside private equity
Yet there is another side to this story. The little-discussed heart
of the matter: There are management strategies and techniques that
enable PE-owned firms to produce stunning results that others can't
match. These successful practices have long seemed shrouded by the "private"
in private equity. But they needn't be.
Look inside the companies owned by major private-equity firms, talk
to the executives who run them, and you'll find a distinctive way of
managing that's sharply different from what goes on in most publicly
traded companies or most private companies under conventional
ownership. Investigation shows why privately held firms - at least
if they're owned by one of the major buyout shops - have important
advantages over competitors, and why they're regrading the playing
field in several industries. Many of the lessons apply to virtually
any organization.
The differences begin at the most fundamental level, with new
objectives. Private-equity firms want to buy companies for their
portfolio, fix them, grow them and sell them in three to five years.
The eventual buyer could be another company in the portfolio
company's industry, another private-equity firm or the public,
through an IPO. The holding period is occasionally less than a year
or as long as ten years. But always the goal from day one is to sell
the company at a profit.
Facing a goal like that changes a manager's mindset - usually in
positive ways. No longer seeing a corporate future that stretches
indefinitely into the distance, executives realize that they gain
nothing by resisting change: With the exit looming, driving change
is their only hope.
"Everybody in the company knows you're on a sprint to do well," says
von Krannichfeldt. "It's not this mindset of working for a company
that's been there for 100 years and will continue for another 100
years. I find this much more intense than a public company."
Pay is a whole different concept in PE-owned companies. Don't come
to play unless you're prepared to put significant skin in the game.
While public companies talk a lot about aligning executive pay with
performance, they typically award stock options and restricted stock
on top of already substantial pay packages, giving executives lots
to gain but little to lose.
And in big companies those options reflect the fortunes of the
overall corporation, not the specific business a manager is running.
By contrast, private-equity firms make the game much more serious.
Not only is a far larger share of executive pay tied to the
performance of an executive's business, but top managers may also be
required to put a major chunk of their own money into the deal.
At Dunkin' Brands (home of Dunkin' Donuts), which is co-owned by
private-equity firms Bain Capital, Carlyle, and Thomas H. Lee
Partners, CEO Jon Luther says, "I insisted that all officers invest
personally. Management has a substantial amount of their personal
money in this. It makes a huge difference in the 40 officers of the
company when they show up for work" they have an ownership mentality
rather than a corporate mentality." Luther says the resulting
difference in behavior is clear: "There's now a very different
discipline in how you spend money," he explains. "If it doesn't grow
the business, why would you do it?"
Another effect: People just try harder. At Genpact, an outsourcing
company that had been part of General Electric (Charts) and is now
owned by General Atlantic, Oak Hill Capital Partners, and GE, CEO
Pramod Bhasin sees the difference every day: "We are owners, so you
fight harder for targets, fight harder to see where else you can go,
stretch yourself more" - even more, he says, than at GE, where he
spent 25 years.
Freedom to pay
Private-equity firms don't always bring in star outside managers to
run the companies they buy. In fact, they much prefer to buy a
company with strong management in place, as Luther was at Dunkin'
and Bhasin was at Genpact. "The strong preference is to use the
talent in the company," says General Atlantic chairman Steven
Denning. "You want to back a superb management team and liberate
them."
But if PE owners decide that they need to bring in an outsider, they
hold a valuable advantage over public companies: No one will know
how much they've paid. Public companies have to report executive pay
in SEC filings. Private companies don't.
In this era of outrage at grossly overpaid executives, any public
company that paid, say, a $20 million signing bonus or offered a
package with a potential nine-figure payout would be pilloried by
governance activists and the press. But the reality is that some
executives are worth that kind of money, and when private-equity
firms offer it - as they do - no one knows.
As a result, they can raid companies that are legendary executive-training
academies, using mammoth pay packages to lure away their most
valuable assets in today's economy: their best managers. Exhibit A
is General Electric superstar David Calhoun, who quit to head newly
private VNU for a package that could be worth more than $100 million.
(A person close to VNU says Calhoun "put a substantial part of his
own net worth" into the company as part of the deal.)
Another GE star, Paul Bossidy, recently left the company to join
Cerberus, a major private-equity firm. Procter & Gamble chief A.G.
Lafley says, "We've lost a half-dozen people" to private equity.
Home Depot has also lost a couple.
The trend has changed the high-stakes game of executive recruiting.
"Top candidates are no longer waiting around to be recruited to a
public company," explains über-headhunter Gerard Roche of Heidrick &
Struggles. "Instead they're jumping to a private-equity firm and
watching for the right opportunity to become a CEO. It wasn't like
this ten years ago."
Fewer restraints
Freedom to pay is just one example of an advantage that many PE
veterans consider critical: general freedom from the pressures of
the stock market, media and Wall Street analysts. Remember, these
companies have strong incentives to act quickly - but acting quickly
often produces volatile quarterly earnings, which Wall Street
doesn't like.
Making a big new investment or taking a write-off for a plant
closing may be the best thing for the business, but many public
companies hesitate because such actions could cause the stock to
tank. PE-owned firms don't have to worry about it. "In private
equity, you don't need to go from quarter to quarter," says von
Krannichfeldt. "You can take write-offs, you can make investments
that aren't accretive in year one or year two. It's a very different
dynamic."
One often hears that freedom from public markets carries another
boon for privately held companies - no more compliance with Sarbanes-Oxley
or the many other regulations on public firms.
But PE executives say that supposed advantage isn't such a big deal.
After all, the companies may be reentering the public markets in
just a few years. "It's not about accounting compliance," says
Luther. "We treat ourselves like we're public."
What makes a huge difference is the release of managerial time from
trying to placate and massage the public markets. Talking to
shareholders, analysts and the media may be important jobs for a
public-company CEO, but they're massive distractions from the
company's operations. In practice, a public-company CEO is lucky if
he spends 60 percent of his time actually running the place. In a
PE-owned firm those distractions disappear, and the CEO is free to
spend close to 100 percent of his time focused on the business.
Increased managerial attention comes to many PE-owned companies in
another way as well. Several of these companies were initially parts
of much larger outfits where they were not central to the mission.
The parent firm focused top-management time and corporate resources
elsewhere, which not only was bad for the stepchildren financially
but also demoralized the managers.
"I used to joke that I had to fly to London to beg for attention,"
says CEO Luther, recalling when Dunkin' was part of giant Allied
Domecq, which Pernod Ricard later bought. "Now it's just a 20-minute
ride downtown" to Bain Capital's office in Boston. Genpact's Pramod
Bhasin adds, "We weren't a strategic business for GE. Our whole
intention was to be able to offer our services to the broad market."
leadership and performance measurement
Much of that attention in PE-owned companies comes from a source
that makes some public-company CEOs uncomfortable: the board.
Because they're corporations, even privately held companies must by
law have boards of directors.
But the boards of PE-owned companies are fundamentally different
from the public boards that are the focus of governance activists.
They're typically smaller and consist only of representatives of the
PE owners plus industry experts whose explicit job is to help
management create and execute strategy; many directors fulfill both
roles. "The board is far more involved in assisting the company,"
says General Atlantic's Denning.
Besides furnishing heavy-hitting directors, large PE firms also
bring a world of connections to the companies they own. "Our three
partners are able to connect us with people we otherwise couldn't
meet," says Luther of Dunkin'. "For example, the Carlyle folks
introduced us to one of their investors in Taiwan, and we soon had
an agreement for 100 Dunkin' Donuts stores there."
Pramod Bhasin says Genpact has received similar benefits from its
new owners: "Their access to markets, to people, to the right
headhunters, the right lawyers - that's a huge help to companies
that are newly independent, because without it, we'd have to swim
for it ourselves."
Clarity is a running theme in why PE-owned companies on average
perform so well. They suffer no confusion about the role of the
board, who's ultimately in charge (the PE firm is), and the eventual
goal. They benefit also from a clear view of what they're managing
along the way: It's cash.
Selling out: Media's 'private' affair
Public companies often get caught up in disagreements over what to
measure - earnings per share, return on equity, Ebitda, return on
net assets. PE-owned firms generally bypass that debate. They're
managed for cash, the ultimate business reality. "The focus on cash
flow is very intense," says von Krannichfeldt, "and most employees
who came from Clariant [AZ's previous, corporate owner] had never
seen that. As a consequence, what they'd done with regard to
controlling inventory or working capital wasn't terribly good, and
we could improve on that a lot."
These companies tend to be especially disciplined about how to reach
their cash goals. More than others, they insist on identifying the
measurements that are most important. Many companies call them key
performance indicators, or KPIs.
At AZ Electronic Materials, for example, CEO von Krannichfeldt uses
about 80 of them, covering all the critical areas - finances, growth,
productivity, quality, safety, market position. It's an agreed-upon
dashboard that he and Carlyle monitor continually.
Private vs. public
Combine all those factors and here's what private-equity firms have
figured out how to do: Attract and keep the world's best managers,
focus them extraordinarily well, provide strong incentives, free
them from distractions, give them all the help they can use and let
them do what they can do. No wonder these companies tend to be
outstanding performers.
If it all sounds too good to last, some people worry that it may be.
Private equity has become so large, powerful and successful that
some firms may be doing too much, too fast. PE-owned firms that go
public have generally outperformed the market, but in the past year
many have badly underperformed. Burger King (Charts), formerly owned
by PE firms including Texas Pacific Group, Bain Capital and Goldman
Sachs, has barely climbed back to its offering price after a steep
drop; and Sealy (Charts), taken public by KKR, is still down about
12 percent.
Warren Buffett has criticized private-equity firms as "deal flippers"
uninterested in building long-term value. Some firms extract
exorbitant fees from their portfolio companies.
Continued abuses could attract federal regulation; the Justice
Department is already investigating possible collusion in bidding
for companies. This industry is filled with some of the world's
smartest people; now it needs leadership to start self-policing to
make such intrusions unnecessary.
But a longer-term threat to the private-equity industry could be a
development that would actually be good news for the economy.
Consider: The most fundamental question raised by today's private-equity
boom is, Why can't public companies do all these things themselves?
In theory, they could and should. In other words, private equity's
success is built on advantages that public firms just haven't
figured out how to adopt yet. But the history of markets says that
they will figure it out eventually. When they do, their returns
should rise, slowly eroding private equity's ability to attract
capital. That would make life challenging for the PE industry, but
it also means that the world's capital would be more productive.
At least that's the theory. For now, private-equity firms probably
have many years of big opportunities ahead of them. Capital will
continue to be abundant. "The No. 1 reason" private equity is on
such a tear, says Carlyle Group's Allan Holt, "is the availability
of capital. It opens up a universe of possibilities."
Even higher interest rates won't necessarily scotch deals; rates are
just a cost to factor in. And most public companies will be slow to
adapt, creating plenty of chances for private equity to work its
magic.
The good news is that you don't have to wait for a PE firm to swoop
into your organization. By using private-equity strategies, you can
improve results and maybe even become as successful as these
companies are, starting right now.
Ram Charan, an advisor to Fortune 500 CEOs and boards, is author of
the forthcoming book "Know-How." He has consulted for AZ Electronic
Materials, Dunkin' Brands, and Genpact.
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