"Performance Culture" the Private Equity way

Throughout the 1990s, the world's leading Private Equity firms consistently generated mouth-watering returns for their investors.

In the last couple of years returns have suffered. The Private Equity sector has not been immune to the turmoil on the world's stock markets, and subsequent near-paralysis of IPOs.

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But the fact remains that the Private Equity sector has consistently delivered higher returns than the FTSE (see Figure 1, below) - and for investors in the leading Private Equity funds annual returns of 50 or even 100% have not been uncommon.

Figure 1.
PE Firm Returns FTSE All-Share
3 yrs 13% 0.4%
5 yrs 15.7% 7.3%
10 yrs 17.4% 11.6%

How do they do it?

We drew on our experiences working with many of the world's leading Private Equity players, helping them evaluate possible investments, and working with the management of the companies they own to help increase their value. We looked at over 2000 transactions from the last 10 years, and the management practices of two dozen of the leading firms.

The answer is easy to say and hard to do - the leading Private Equity companies systematically create a "performance culture" in the businesses they own. Management and employees come to work each day determined to do everything they can to increase the equity value of the business. Nothing is allowed to get in the way of making the business more successful and more valuable.

Underpinning this "performance culture" are 5 basic management disciplines. There is nothing particularly unique to the Private Equity sector about these - indeed, on the face of it, virtually all can be adopted by a quoted company or subsidiary. What may be special to the leading Private Equity firms is the rigour and single-mindedness with which they apply them.

The five disciplines are :

* Hire managers who act like owners
* Define a clear 3-5 year "investment thesis"
* Make capital work hard
* Measure only what drives value
* Make the centre an active shareholder

Some sacred cows slaughtered

As we looked into the drivers of success within Private Equity we found three popular conceptions to be untrue :

1. Private Equity is a license to print money. As described above, the leading Private Equity firms have consistently generated high returns. But only the leading firms. As with quoted companies (in fact to an even greater extent), there is a wide spectrum of performance among Private Equity players. Across a multi-year period the bottom-performing quartile of Private Equity companies actually lost money for their investors, and the second and third quartiles generated only modest returns. It is only among the top quartile of performers where exceptional returns are consistently found - companies like(among others) Permira (formerly Schroder Ventures), EQT, Texas Pacific Group and Bain Capital (despite the shared name there are no formal links between Bain Capital the Private Equity investor and Bain & Company the consulting firm).

2. Private Equity firms make all their money through applying financial leverage to the businesses they buy. It is certainly true that on average Private-Equity owned companies have higher financial gearing than do their quoted competitors - typically up to twice the level of debt. Close attention to the financial structure of a business, and an ability to assess risk and match it with the appropriate financial intstrument have long been hallmarks of the Private Equity sector, and do in part explain the returns. But the days are long gone when the key to success in Private Equity was to obtain proprietary access to a business with stable cash flows, gear it to the hilt and stand back to let management generate the earnings to pay down the debt. As the Private Equity sector itself has become increasingly competitive across the 1990s, the leading players have had to rely more and more for their success on their ability to add value to the underlying business. Recent Bain analysis suggests that in the future as much as 80% of Private Equity returns will come from real performance improvement, rather than (or in addition to) value created through financial structuring.

3. Private Equity players succeed through running the businesses they own into the ground. Whilst it is certainly true that a Private Equity owner will typically take an aggressive approach to reducing costs and appraising new investment, it is almost always the case that the leading firms also look to put the businesses they own onto a solid growth trajectory. This is not due to any philanthropy on their part - since the Private Equity owner only realizes a return when they come to sell the business, common sense dictates that they will get more at this point if the business has sound operations and attractive future prospects. In fact, paradoxically, Private Equity owners often increase investment in a business, particularly where the previous owner may have regarded it as peripheral and therefore starved it of cash or talent.

Hire managers who act like owners

The most important item on the Private Equity owner's agenda is finding the right leadership team to drive the business.

Of course they look for individuals with the right skills and track record. But they also place a heavy emphasis on individuals with the right attitude : people who are prepared to think and act "like owners", and who genuinely want to make a difference not just manage the status quo.

In many cases, the Private Equity buyer will stick with incumbent mangement - who, assuming they have the required "owner" attitude very often find themselves liberated by the change of parent.

But Private Equity leaders will also act quickly to replace managers who fail to deliver, or who are judged inadequate to the challenge. While many public companies are tempted to hold on to underperformers in the hope that things will improve, Private Equity firms tend to act decisively and speedily to replace them.

To find the right talent, Private Equity firms cast the net broadly, often well beyond the industry in which a specific business competes. Increasingly, they also supplement the executive team with a formal Board structure, including heavy-hitting non-Executive directors again selected both for their expertise and attitude.

As an example, when Scandinavia's EQT recently acquired Duni AB (a $700 million, Swedish-based supplier of food-presentation products and services), EQT looked outside the food industry for experts to run the company. The former head of Shell Sweden (Hans Von Uthmann) became CEO, and the former head of Whirlpool Europe (Mikael Nordin) was named COO. The same reasoning applied to board appointments: EQT specifically went outside the industry to stack the Duni board with experts in turnarounds, branding, and the management of highly-leveraged companies. The chairman named by EQT, for instance, was Goran Lundberg, the former executive vice president of Asea Brown Boveri and a specialist in corporate restructuring. In addition, EQT appointed to the board the CEO of Absolut Vodka, one of the world's most successful brands, and the former CEO of Swedish Match, who had led two buyouts and understood the change in culture required to succeed.

Define a clear 3-5 year "investment thesis"

Central to any Private Equity investment is the "investment thesis" - a succinct point of view on how the business will achieve a significant increase in value during the period it is owned.

The "investment thesis" is used both to make the initial decision on whether to buy the business, and then to align the leadership team around a common vision of how to take it forward.

Three elements characterize an effective "investment thesis". First, it typically has a 3-5 year timeframe - the period for which, generally speaking, a Private Equity owner expects to hold the business - and, not entirely coincidentally, the natural investment cycle in many businesses. This contrasts with the strategic planning process inside many quoted companies which, despite paying lip-service to a multi-year view, is often in truth focused on creating the next year's financial budget. The 3-5 year timeframe also provides the Private Equity owner with a definitive end-point. For many quoted companies, the implicit assumption is that they will continue to own a business indefinitely.

Second, the investment thesis adopts a "Full Potential" mindset - it focuses on what the business could really be capable of, rather than seeking to meet an arbitrary growth target imposed from the Head Office, or achieve "last year's earnings plus x%".

Third, it is simple, and focuses disproportionate attention on the two or three initiatives that will be truly critical to achieving the increase in value, so that resources can be differentially allocated to ensure that these succeed.

Successful "investment theses" come in many forms. For convenience, they can be grouped into three broad categories, although many combine elements of each category. The three categories are strategic, operational, and financial.

An example of a strategic investment thesis is the turnaround of contact lens maker Wesley Jessen, a company Bain Capital bought from Schering-Plough in 1995. Over the years, Wesley Jessen had been a leader in specialty contact lenses-primarily coloured lenses and toric lenses used to correct astigmatism. But in the early 1990s, its search for growth caused it to expand into the mass market, where it found itself competing head-to-head against two 800-pound gorillas, Johnson & Johnson and Bausch & Lomb. Although sales remained strong, Wesley Jesse's profits had fallen, to the point where it had moved into loss and had a perilously low cash position.

Bain Capital's investment thesis for Wesley Jessen was simple - reposition the business in the specialty segment, and invest to achieve clear leadership within it. As part of this, the business was refocused around meeting the needs of the core specialty customers - eye doctors. Wesley Jessen deleted its mass-market product lines. The factory built to produce standard lenses was retooled to make specialty lenses. The company stopped serving unprofitable customers such as high-volume retail optometry chains, and began outinvesting its competitors in the specialty market. Wesley Jessen cut spending on advertising and promotion, and reduced costs to reflect the newly streamlined product range, eliminating many positions including several levels of management in manufacturing. It simultaneously expanded the product range in specialty lenses and made selective acquisitions to bolster its leadership position in that core market.

The change in strategy proved to be a resounding success. On the strength of its turnaround, Wesley Jessen completed a successful initial public offering in 1997, creating a 45-fold return on equity for its investors in less than two years.

Texas Pacific Group (TPG)'s 1993 purchase of Continental Airlines was based on an entirely different thesis - that under new ownership (and with a new management team) Continental would be able to achieve a dramatic improvement operationally. One of the ten largest airlines in the US, Continental had filed for protection from its creditors twice in the previous nine years. By 1992, annual sales were a respectable $5.4 billion, but net income was only $125 million.

The new team focused on improving customer yield, aircraft utilization and financial performance. They took rapid action to close unprofitable routes, shut down Continental's low-cost division (CALite) and reduce maintenance costs by $280 million (36%) - whilst actually improving safety. They addressed one of the primary customer complaints, moving Continental from consistently near the bottom of the "on-time departures" league table to consistently in the top three, by the simple expedient of incentivising front-line staff on this key measure. At the same time they built up the carrier's Houston, Newark and Cleveland hubs and upgraded the entire fleet. By the time TPG sold the company in 1998 it had realized an annual internal rate of return of 55% on the investment. In addition, despite more recent difficulties Contintental was left in a much stronger state than when they had bought it. The carrier was to go on to become one of only two US airlines to record positive profits every quarter until 11 September, and retained its strong performance near the top of the passenger charts.

TPG was also the acquirer of Punch Taverns, a chain of 1,470 UK pubs, in 1999. A few months 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 a hotly-contested and very public bid.

On this occasion, the investment thesis was dependent in large part on a creative approach to financing.
TPG paid for the pub estate with a £1.6 billion bridge loan, which it later refinanced by ring-fencing the rental income stream of its newly acquired properties, repackaging this cashflow as debt securities and selling them to fixed income investors. This saved TPG some £30 million in annual interest costs. It also created the platform for Punch to move on and make substantial operating improvements to the combined business. Punch tailored pub products and prices more closely to local markets, and it drove out costs from the supply chain, reinvesting some of the savings to drive growth. This combination 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 industry as a whole.

Make all capital work harder

The leading Private Equity firms take a rigorous approach to managing the capital tied up in the businesses they own. They work hard to understand where the capital is (for example by product, by channel, by customer segment, and by geography), and where it is and is not earning an acceptable return. Armed with this knowledge, they then act decisively to invest strongly where high returns are available, and to improve unacceptably low returns or, where necessary, re-deploy the capital.

An example is the US Private Equity firm GTCR Golder Rauner. GTCR bought SecurityLink, a $500 million firm that manufactures and installs security equipment for homes and commercial buildings. In its search for growth, SecurityLink had expanded into a number of US regions and across both dealer and direct sales and distribution channels. GTCR soon found that the capital returns were higher in regions where SecurityLink had high relative share, and through the direct rather than dealer channel. The new owner acted swiftly to exit regions where SecurityLink was weak, closing or selling a third of its offices and refocusing resources in the remaining areas onto the direct sales channel. SecurityLink was transformed from a loss-making business to generating close to $100 million of pro forma pretax earnings in less than a year. At this point GTCR next sold the business to alarm giant ADT, growing its investors' $135 million initial equity investment to $586 million in just 13 months.

Measure only what drives value

Top PE firms steadfastly resist measurement mania. They zero in on a few critical performance indicators - those that most clearly reflect a company's progress in increasing its value. They work hard not only to identify the few critical measures that really matter, but also to systematically collect and display these in an easy-to-absorb way - a concept sometimes known as the "Executive Dashboard", the analogy being the typical display a driver sees at the wheel of a car.

PE firms watch cash more closely than earnings, knowing even pre-Enron (et al) that over time cash remains the true barometer of financial performance, while earnings can be manipulated. "Cash is king; profit is for accountants," explains an executive at a major PE firm. 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. However, managers in PE firms are careful to avoid imposing one set of measures across their entire portfolios, preferring to tailor measures to each business held. "We use their metrics, not our metrics," says Jim Coulter, founding partner of Texas Pacific Group. "You have to use performance measures that make sense for the business unit itself rather than some preconceived notion from the corporate center."

Private Equity firms give their measures bite by tying the equity portion of their managers' compensation to the results of the businesses they lead - effectively encouraging them to act like owners by making them owners. Often, management teams own 10% to 20% of the total equity in their businesses, through either direct investment or borrowings from the Private Equity firm. A recent survey for a sample of Private Equity-owned businesses found that on average the Chief Executive held just over 6% of the equity, compared with around 1% before the businesses went private.

Public company executives may believe they're doing the same thing when they grant options to their line managers, but they're often not. Such arrangements typically give managers a stake in the parent company, not the business unit they lead.

Make the centre an active shareholder

The leading Private Equity firms think of themselves as active shareholders, focused on helping the management team increase the value of their business whilst simultanteously holding them accountable. One part of this role is to make unsentimental, economically rational investment decisions, maintaining a willingness to swiftly sell or shut down a company if its performance falls too far behind plan or if the right opportunity knocks. "Every day you don't sell a portfolio company, you've made an implicit buy decision," says TPG's Coulter.

The focus is unblinkingly on performance, not synergy. Even though they may own 20-30 different businesses at any one time "We spend our time trying to improve the performance of each individual business - almost never on issues across businesses," says one private equity firm manager.

Private Equity firms are equally unsentimental in their approach to their headquarters' staffs, seeing them as part of their transaction costs. Although their portfolios may represent several billions in revenue, their corporate centres are extremely lean. According to Bain & Company analysis, the average Private Equity firm has just five head office employees per billion dollars of capital managed (the combined value of debt and equity), one-quarter the number at a typical corporate headquarters.

While the corporate centre might be lean, it is by no means passive. It used to be that the firms' partners saw themselves as buyers and sellers of companies, leaving day-to-day management to the management teams. Today, the leading Private Equity firms are increasingly adopting a more hands-on approach, typically appointing a senior partner to work day-to-day with the CEO of each business. What they avoid is lots of parallel communication between functional staff at HQ and counterparts in the businesses - through the simple expedient of not having a lot of functional staff at HQ in the first place.

Applying Private Equity Disciplines to Quoted companies

The management disciplines that underpin the leading Private Equity firms' success are highly transferable to quoted companies. The classic example is GE, which under Jack Welch's leadership adopted very similar disciplines with similarly impressive results.

A more recent example is the UK conglomerate GUS plc. When its share price hit the doldrums in the late-1990s, GUS plc's new managers, led by Chairman Sir Victor Blank and Group Chief Executive John Peace, recognized the need for a fundamental change in approach.

They rapidly refocused the group around a small number of attractive businesses. For each one, they instituted a review to determine the 3-5 year "investment thesis", and identify the two or three things that were critical to achieving the full potential value. They realigned the capital base of the company and exited peripheral businesses to release funds for investment in their core. They refocused measures away from earnings and onto value and away from purely short-term historic to a mix of historic and predictive. Most importantly, they refocused the role of the corporate center to concentrate on driving the performance of individual businesses rather than on searching for cross-business synergies. They also realigned and empowered the senior management teams in the businesses, bringing in new talent where necessary, and restructured incentives.

Although still relatively early days, GUS's results to date have been swift and impressive. GUS's share price has increased 50% in a market that has declined overall. Since December 1999, the company has moved from number 85 on the UK's FTSE index to number 42.

GUS Group Chief Executive John Peace comments "Investors were concerned that GUS was failing to manage major changes in the business-and they were right. We sat down and asked ourselves, is GUS really an unwieldy conglomerate, should it be broken up? Instead, we realised that there were a number of real jewels in GUS, genuine growth businesses that could provide a new focus for the group. Our role was to make sure that those businesses (delivered) to shareholders."

Monday morning 9am

The leading Private Equity firms have created sustained, exceptional returns for their investors by systematically instilling a "performance culture" in the businesses they own. They achieve this by rigorously applying five basic management disciplines, which can equally be applied by quoted companies.

To assess the extent to which your company has these disciplines already in place, we propose the "Monday morning 9am" test :


1. Does our top team think and act like owners?
2. Are we aligned around a common vision of how our business will achieve a significant increase in value over the next 3-5 years, and the two or three initiatives that will be most important to achieving it?
3. Are we clear where our capital is, where it is earning a good return-and where it isn't?
4. Do we have an effective "dashboard", measuring only what drives value and clearly presented to drive action?
5. What is the evidence that our corporate centre is adding value-not destroying it?


(Paul Rogers is a Director based in London, from where he leads Bain's worldwide organization practice and co-leads the UK strategy practice. Geoff Cullinan is a Director based in London responsible for the firm's European Private Equity consulting practice. Tom Shannon is a Director based in London with extensive experience of helping public companies apply Private Equity disciplines to improve performance.

Other contributors to the research on which this article is based include Tom Holland, a Director based in San Francisco; Dan Haas, a Vice President based in Boston; Simon Griffiths, a Vice President based in Stockholm; Stan Pace, a Director based in Dallas; and Alan Hirzel, a Manager based in London. This research was also featured in an article in the Harvard Business Review, June 1, 2002, entitled: "Value Acceleration: Lessons from the Private Equity Masters.")