Borrowing from the private equity playbook
February 07, 2007
Companies aren't just swimming in cash; they're almost drowning.
To survive the downturn at the start of the decade, corporations drastically reduced costs and improved productivity. When the economy rebounded, corporate profits quickly followed. Most of these profits have gone straight to the balance sheet.
A cash mountain used to be considered a good thing-savings for a rainy day or a war chest for acquisitions. Today, it's a mixed blessing. For one thing, profitably emptying a war chest isn't as easy as it once was. As private equity firms hunt for big deals and bid up prices, strategic buyers are effectively being priced out of the market. But keeping the cash in the bank isn't an option. Not only does it generate embarrassingly low returns, but the same private equity firms that are driving up acquisition prices could view that cash as a reason to target a company. And with private equity firms now able to complete transactions of $50 billion or more, few companies are off limits. Giving that cash back to shareholders as a dividend isn't a very attractive alternative, either, because it signals that management has run out of promising growth ideas, a fact that will inevitably lead to lower share price. Of course, companies can always pay off debt, but these days, most companies are underleveraged.
So, like it or not, acquisition is really the only good option. But, to exercise that option effectively, would-be buyers are going to have to take a few leaves from the private equity playbook. To begin with, they're going to have to spend much more time looking at potential deals. Research shows that for every deal a private equity firm completes, it actively pursues 2, appraises 4 and screens 40. Corporate buyers cast smaller nets: Most would struggle to come up with more than 4 or 5 targets in the M&A pipeline.
Companies experienced in small deals must now be prepared to use their cash mountains to take on much larger acquisitions. With their strong balance sheets, they should be able to borrow heavily in advance of transactions, then use proceeds from subsequent divestitures to pay down debt quickly. In this regard, the advent of private equity firms is actually a blessing, because they're prepared to acquire businesses that commercial buyers won't touch. As a result, the market for companies is much more liquid than before, making it easier to execute mega-acquisitions contingent on subsequent smaller divestitures.
Making acquisitions has always been tough, but in today's market, with private equity players competing for many deals, success is even harder. But it's often the only way to effectively use cash on hand. The smartest companies will incorporate private equity firms' best practices in order to hunt more like them and will take advantage of the liquidity they create in order to hunt with them.
Michael C. Mankins is a partner in the San Francisco office of Bain & Company. This article is adapted from a longer version, ""Borrowing from the PE Playbook," which appeared in "Breakthrough Ideas for 2007" in Harvard Business Review in February.