When a consortium of private equity firms teamed up with Edgar Bronfman Jr. to acquire the Warner Music Group for $2.6 billion in 2004, it looked as if they were in for a rough ride. The music industry was in the doldrums: Sales were slipping badly, while the cost of signing and marketing artists was climbing, and digital piracy was rampant. Yet, in less than two years, WMG management and the buyout partners had dramatically lifted the company's earnings, by reining in costs, tapping into digital distribution and bundling music and other content. The new owners had so transformed the company that they were able to take WMG public-and watch the stock rise until their equity stake, combined with dividends, was worth more than three times their initial investment.
"To succeed in the new environment, private equity owners must stop thinking like investors and start acting like company owners."
- Chris Bierly
The turnaround at Warner Music came straight out of a new playbook that is helping private equity investors earn strong returns, at a time when buyouts have never been bigger or bolder. As deal prices and the cost of debt rise, private equity firms can no longer count on leverage and financial maneuvers to deliver outsized gains. Consider a hypothetical acquisition made in 2000 in a company that grew earnings at the same rate as the overall economy for the next five years. The company would have nearly tripled its equity value-with most of that gain resulting from a more favorable price-to-earnings multiple. By contrast, if multiples revert to historic norms, an investment made today with similar performance would struggle to earn back the investors' original stake.
To succeed in this environment, private equity firms need a different formula. As soon as a deal closes, they must stop thinking like investors and start acting like company owners intent on making their business more valuable. The new owner-activists follow a disciplined process for staging, accelerating, and profiting from breakthrough operational improvements. And it's one that corporate acquirers would do well to adopt.
Develop a blueprint for success. Private equity investors already begin with a clear understanding of how a target makes money and why they'd want to own it. But activists don't mistake an investment thesis for a detailed strategy. They quickly engage with management to zero in on the most attractive opportunities, gather data to test their viability and develop strategic objectives and financial targets. They then develop a detailed operational blueprint that determines what gets done, with which resources, in what order and by whom.
At a company we'll call Home Wares Corp., a two-day workshop allowed its new private equity owners to refine the company's focus and set the pace of change. Among the key initiatives identified was a sequence of moves to penetrate the mass-market channel, win more business from cornerstone accounts and ratchet up the supply chain capabilities. Within a year, Home Wares squeezed 30 days out of the nearly six-month order cycle. Within two years, Home Wares' sales of dedicated lines to mass merchandisers rose by more than 20-fold. Soon after, the company went public, with an IPO valued at four times the private equity group's initial investment.
Track the right measures and stay nimble. Activist firms monitor progress toward operational goals before it shows up in the financial results. Experienced activists focus on a few key measures-an operational "dashboard"-that can be understood throughout the organization.
Getting the metrics right was the cornerstone of Singapore Yellow Pages' post-acquisition revitalization. Guided by interviews to assess customers' needs, the private equity owners and management set concrete revenue and growth targets for each of a dozen clusters of high-priority accounts. The company raised the number of clients each sales rep served, set specific guidelines for how many calls or visits were needed to close a sale and rewarded top performers for hitting the ambitious targets. The objective performance measures provided a reliable report card on whether the turnaround plan was on track. Confirmation came within a year, when the private equity owners were able to sell off a portion of their holdings in a stock offering that locked in a gain equal to 2.6 times their initial investment.
Build future growth into the exit plan. Activist owners defy a common knock against private equity investors: Rather than stripping value for a quick sale, they seed new growth opportunities for the next set of owners to harvest. They don't hesitate to invest in R&D projects, new technology, acquisitions or expansions-even if they may bear fruit only years after the sale. Such early owner activism primes the asset's eventual sale by ensuring that the company has a prosperous path forward. Our experience shows that deal makers who actively launch initiatives in this way during their first year of ownership outperform the private equity industry's average return on investment by a margin of better than two-and-a-half to one.
Corporate managers have long borrowed avidly from the private equity deal-making tool kit. They would do well to watch and learn as this new wave of private equity activists applies the discipline and urgency that have made them world-class acquirers to the challenge of becoming first-rate value creators.
Chris Bierly, a partner in Bain & Company's Boston office, has extensive experience in working with private equity firms and their portfolio companies. Graham Elton, a partner in Bain's London office, is a leader in the firm's European Private Equity Practice. Chul-Joon Park, a partner in Bain's Seoul office, co-directs the firm's Asian Private Equity Practice. You can read more on the new hands-on approach private equity owners take to increase the value of acquisitions in the Bain Brief "Private Equity's Road Map to Profits."