Define a 3-5 Year
Investment Thesis
The first thing PE firms do when they acquire a business is
define an investment thesis they believe will pay off in the medium
term. They take a three-to-five year view, the amount of time they
expect to hold the company. This differs from competing pressures
at many corporations to hold a short-term view to meet quarterly or
annual shareholder expectations, and, simultaneously a long-term
view that says, "We'll own this company forever." Rather, PE firms
create a policy that states how they will make the business more
valuable and realize benefits for owners before they exit the
business. A good thesis is extraordinarily simple, and provides a
much clearer basis for action than the typical financial target of
"last year's earnings plus x%" that most public companies use. The
fact that PE firms take this medium-term view allows them to
out-invest competitors with short and long-term views in whatever
industry or business they happen to be.
Consider the simple investment thesis that Bain Capital used for
contact lens maker Wesley Jessen, a company it bought from
Schering-Plough in 1995. Over the years, Wesley Jessen had been a
leader in specialty contact lenses (primarily colored lenses and
toric lenses used to correct astigmatism). But in the early 1990s,
it strayed into competing head-to-head in the mass market against
two 800-pound gorillas, Johnson & Johnson and Bausch & Lomb
and wound up in a perilous cash position.
When Bain Capital acquired Wesley Jessen, it brought in a new
management team to pursue a back-to-basics thesis: Return to the
core specialty-lens business, and focus on core customers-eye
doctors. A 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
out-investing its competitors in the specialty market. Wesley
Jessen cut spending on advertising and promotion, and eliminated
many positions, including several levels of management in
manufacturing. It simultaneously expanded its product range in
specialty lenses and made selective acquisitions to bolster its
leadership position in that core market.
The investment thesis proved 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.
Hire Managers Who Act
Like Owners
The management disciplines imposed by private-equity firms
require a certain type of executive; one predisposed to act as an
owner, not an administrator. They go for top talent, but they
define that talent not only in terms of skills and track record but
also attitude. PE firms hire for this specific profile, and they
motivate their hires by giving them equity in the company they are
running-so they truly become owners. Then the firms establish
nonexecutive board governance for each portfolio company and give
the board members equity too, thus aligning all interests around
the disciplines.
To find the right talent, PE firms reach wide, looking well
beyond the scope of their personal contacts. In one-half to
three-quarters of cases, they appoint key executives from outside
the company. They seek managers who, however experienced, are
hungry for success and relish the challenge of transforming a
company. PE firms also find ways to hold onto talent: They retain
great CEOs by bringing them back into the fund or appointing them
to newly acquired portfolio companies.
Focus
on a Few Measures
Top PE firms steadfastly resist measurement mania. They zero in
on a few financial indicators: Those that most clearly reveal a
company's progress in increasing its value.
PE 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 return 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 James Coulter,
founding partner of U.S. private-equity firm 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."
PE firms put teeth in their measures by tying the equity portion
of their managers' compensation to the results of the managers'
units, effectively making these executives owners. Often,
management teams own 10% to 20% of the total equity in their
businesses, through either direct investment or borrowings from the
PE firm. Public company executives may believe they're doing the
same thing when they grant options to their line managers, but
they're usually not. Those arrangements typically give managers a
stake in the parent company, not the unit. But there are ways for
public companies to structure compensation as PE firms do. For
instance, bonuses tied directly to the unit's performance, not the
entire company, can be increased as a proportion of overall
compensation, with an offsetting decrease in cash compensation.
Make Capital Work
Hard
On average, PE firms finance about 60% of their assets with
debt, far more than the 40% typical at public companies. The high
debt-to-equity ratio helps strengthen managers' focus on cash as a
scarce resource. But PE firms also make capital work harder,
looking at balance sheets not as static indicators of performance
but as dynamic tools for growth. They expect all capital deployed
in the business to earn strong returns; if it underperforms, they
quickly redeploy it. This often means cutting pieces out of the
business.
Consider how the U.S. firm GTCR Golder Rauner redeployed capital
to turn around its SecurityLink unit. GTCR quickly established a
single-minded investment thesis for the security systems company:
Pursue rapid growth in carefully targeted regional markets, because
regional market share, not national, was the key to profitability.
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 shifted capital previously tied up in serving
dealer and mass-market channels, which were less profitable, and
refocused it on building direct sales capabilities in the target
regions. By focusing on fewer markets, the company was also able to
dramatically reduce costs, cutting more than 1,000 sales and
service jobs. The result? SecurityLink transformed itself from a
loss maker to generate close to $100 million of pro forma pretax
earnings in less than a year. GTCR next sold SecurityLink to alarm
giant ADT, growing its investors' $135 million initial equity
investment to $586 million in just 13 months.
Make the Center an
Active Shareholder
As public companies grow, headquarters' role tends to shift
toward administration, becoming in essence, mere employers. This
isn't so at successful PE firms, where corporate staffs view
themselves as active shareholders, obligated to make investment
decisions with a complete lack of sentimentality. PE firms maintain
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.
PE 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 centers are extremely lean. According to
analysis conducted by Bain & Company, the average PE firm has
just five head office employees per billion dollars of capital
managed (the combined value of debt and equity), one-fourth the
number at a typical corporate headquarters.
A Powerful Agenda
Private equity firms increasingly are tackling operational
improvements and revenue opportunities to add value to the
businesses they own. And they are achieving success by focusing on
a straightforward, powerful, set of managerial disciplines that
direct both what happens, and who makes it happen. The action
agenda includes clearly defining a company's investment thesis;
tracking its progress via a few key metrics; and quickly
redeploying capital that underperforms. The people agenda is
twofold: PE firm partners view their own role at the center of a
portfolio of companies as that of dispassionate
shareholder-willing, themselves, to exit and redeploy cash if
businesses underperform. However, these same partners hire managers
for each company with a bias for their company's odds of
success-who have the skill and will to succeed. The center incents
them to do so.
The good news for corporations is these disciplines travel. A
few publicly traded companies, like General Electric and
Montreal-based Power Corporation, have long managed their
businesses with the rigor of private-equity firms-and with great
success. More recently, companies like UK conglomerate GUS PLC are
adopting the disciplines and getting results. Recounts GUS Group
Chief Executive John Peace: "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 realized 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." With GUS's share price rising 75% since January
2000, in a declining market, some investors must feel that their
order's fulfilled.
Questions for Monday
Morning
- What are the two to three things that are critical to driving a
significant increase in the value of my business over the next
three years?
- Where is my capital earning a good return-and where isn't
it?
- Do we measure only what drives value?
- Do my top team think and act like owners?
- What is the evidence that my center is adding value-not
destroying it?
Paul Rogers is a Bain director based in London and a leader
in the firm's organization and strategy practices. Tom Holland, a
director based in San Francisco, and Dan Haas, a vice president in
Boston, help lead Bain's global private equity practice. Bain's
change management practice director Stan Pace and manager Alan
Hirzel assisted with this article, which is based on a feature the
authors published in Harvard Business Review, June 1, 2002,
entitled: "Value Acceleration: Lessons from Private-Equity
Masters."
