Harvard Business Review

Borrowing from the PE playbook

A cash mountain used to be considered a good thing—savings for a rainy day or a war chest for future acquisitions.

By Michael C. Mankins

Published on February 01, 2007
min read


To survive the economic downturn at the start of the decade, corporations took dramatic steps to reduce costs and improve productivity. As a result, their operating leverage skyrocketed, and when the economy rebounded, corporate profits quickly followed. Since the amount of capital required to sustain organic growth represents a small portion of the cash now coming in, most of these profits are going 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 future acquisitions. Today, it's a mixed blessing, and the possibilities for spending the cash wisely are much reduced. For one thing, profitably emptying a war chest isn't as easy as it once was. Private equity firms are hunting for big corporate deals and using their financial leverage to bid up the prices of acquisition targets—effectively pricing "strategic buyers" out of the market. But keeping the cash in the bank isn't an option. Not only does it generate embarrassingly low returns for investors, but it can make a company more attractive to PE firms. With those firms now able to complete transactions of $50 billion or more, this applies even to large corporations once considered immune to buyout. Industrial firms are the most susceptible, but no sector is off limits, as the privatization of SunGard (software and IT services) and HCA (health care) demonstrate. Giving the cash back to shareholders in the form of dividends isn't a very attractive alternative: It effectively signals that management has run out of promising new growth ideas, which will inevitably affect the share price. Some companies resort to share repurchases, but these create value only if the company is undervalued by investors—which is the exception, not the rule. Of course, companies can always use the cash to pay off debt. But since the after-tax cost of debt is lower than the cost of equity, paying off debt increases value only when a company is overleveraged—that is, has taken on so much debt that it is at risk of going under. In today's markets, most companies are underleveraged. So what can companies do to profitably rid themselves of this embarrassment of riches? Like it or not, acquisition really is the only option, but to exercise that option effectively, would—be buyers are going to have to take a few leaves from the PE playbook. To begin with, they're going to have to spend a lot more time looking at potential deals. PE firms create value in acquisitions by being very selective. Research shows that for every deal a PE firm completes, it screens 40, appraises four, and actively pursues two (see the exhibit "What Does It Take to Create $1 Billion in M&A Value?"). Corporate buyers cast smaller nets: Whereas PE firms reject 39 deals for every one they complete, most corporations would struggle to come up with more than four or five targets in the M&A pipeline. In addition to strengthening their M&A pipelines, companies experienced in making smaller deals should be prepared to leverage their cash mountains in order to acquire companies of equal or greater size. With their strong balance sheets, they should be able to borrow heavily in advance of transactions; they can then use the proceeds from divestitures within their portfolios and those of their acquisitions to pay down the debt quickly. In this regard, the advent of PE firms is actually a blessing, because they are 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 that are contingent on subsequent smaller divestitures. Finding profitable outlets for excess cash can be challenging. Making acquisitions has always been tough, but in today's market, as private equity players compete for many deals, success is even harder. The smartest companies will incorporate the best practices of PE firms 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 (michael.mankins@bain.com) is a partner in the San Francisco office of Bain & Company. Purchase the full text of this article from Harvard Business Online

To survive the economic downturn at the start of the decade, corporations took dramatic steps to reduce costs and improve productivity. As a result, their operating leverage skyrocketed, and when the economy rebounded, corporate profits quickly followed. Since the amount of capital required to sustain organic growth represents a small portion of the cash now coming in, most of these profits are going 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 future acquisitions. Today, it's a mixed blessing, and the possibilities for spending the cash wisely are much reduced. For one thing, profitably emptying a war chest isn't as easy as it once was. Private equity firms are hunting for big corporate deals and using their financial leverage to bid up the prices of acquisition targets—effectively pricing "strategic buyers" out of the market. But keeping the cash in the bank isn't an option. Not only does it generate embarrassingly low returns for investors, but it can make a company more attractive to PE firms. With those firms now able to complete transactions of $50 billion or more, this applies even to large corporations once considered immune to buyout. Industrial firms are the most susceptible, but no sector is off limits, as the privatization of SunGard (software and IT services) and HCA (health care) demonstrate.

Giving the cash back to shareholders in the form of dividends isn't a very attractive alternative: It effectively signals that management has run out of promising new growth ideas, which will inevitably affect the share price. Some companies resort to share repurchases, but these create value only if the company is undervalued by investors—which is the exception, not the rule. Of course, companies can always use the cash to pay off debt. But since the after-tax cost of debt is lower than the cost of equity, paying off debt increases value only when a company is overleveraged—that is, has taken on so much debt that it is at risk of going under. In today's markets, most companies are underleveraged.

So what can companies do to profitably rid themselves of this embarrassment of riches? Like it or not, acquisition really is the only option, but to exercise that option effectively, would—be buyers are going to have to take a few leaves from the PE playbook. To begin with, they're going to have to spend a lot more time looking at potential deals. PE firms create value in acquisitions by being very selective. Research shows that for every deal a PE firm completes, it screens 40, appraises four, and actively pursues two (see the exhibit "What Does It Take to Create $1 Billion in M&A Value?"). Corporate buyers cast smaller nets: Whereas PE firms reject 39 deals for every one they complete, most corporations would struggle to come up with more than four or five targets in the M&A pipeline.

In addition to strengthening their M&A pipelines, companies experienced in making smaller deals should be prepared to leverage their cash mountains in order to acquire companies of equal or greater size. With their strong balance sheets, they should be able to borrow heavily in advance of transactions; they can then use the proceeds from divestitures within their portfolios and those of their acquisitions to pay down the debt quickly. In this regard, the advent of PE firms is actually a blessing, because they are 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 that are contingent on subsequent smaller divestitures.

Finding profitable outlets for excess cash can be challenging. Making acquisitions has always been tough, but in today's market, as private equity players compete for many deals, success is even harder. The smartest companies will incorporate the best practices of PE firms 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 (michael.mankins@bain.com) is a partner in the San Francisco office of Bain & Company.

Purchase the full text of this article from Harvard Business Online