Private lessons

Private lessons

Gone are the days when investors could count on earning outsized returns simply by re-engineering an acquisition's balance sheets.

  • min read


Private lessons

The world's leading private equity firms have consistently delivered internal rates of return of 50% to 100% over the past decade. In Canada, recent successes include Shoppers Drug Mart, where private equity investors garnered stock price gains of five times over a three-year period, and Moore Wallace, whose stock grew by a factor of four in less than three years. Today, private equity investors are vying for controlling stakes in both Air Canada and Bombardier Recreational Products. Institutional investors such as the Canada Pension Plan, Ontario Teachers' and Ontario Municipal Employees Retirement System have increased their fund commitments to private equity.

But gone are the days when investors could count on earning outsized returns simply by re-engineering an acquisition's balance sheet. Increasingly, the way private equity investors grow profits and stock price is by improving the performance of the underlying operations they own, as well as through financial structuring. The question beckons: how much of their approach could apply to publicly traded corporations?

Bain & Co. studied more than 2,000 private equity transactions over the past 10 years, and we've come to this conclusion: although these firms do create value through financial engineering, the secret to the top performers' success lies in the rigour of the managerial discipline they exert and the performance culture they engender. How do they do it? They focus on accelerating growth in their businesses' value through just one or two key initiatives. They narrow their sights to widen profits. Specifically:

1. They clearly define their investment thesis and its time frame to fruition;

2. They hire managers who act like owners;

3. They focus management teams and their employees rigorously on just a few measures of success;

4. They make their capital work hard—and retire, sell or otherwise redeploy underperforming assets quickly;

5. They make the centre an active shareholder.

Define a three-to-five-year investment thesis
The first thing private equity firms do when they acquire a business is to 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 many corporations, under pressure 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."

The medium-term view allows private equity firms to out-invest competitors with short- and long-term views in whatever industry or business they happen to be. Shoppers Drug Mart's shareholders, for example, are benefiting from an intense effort to upgrade the shopping experience and build up the network of stores more aggressively than at any point in the past 10 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 in terms of attitude.

Few CEOs received more coverage for a take-charge approach than Robert Burton, when he took over at Moore Corp. in late 2000. Two years later, after a threefold increase in stock price, Burton left Moore—and has left behind a strong team of experienced managers who have now acquired Wallace Computer Services and pushed the stock price up a further 40%.

In one-half to three-quarters of cases, private equity players 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.

Focus on a few measures
Top private equity 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. And they 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.

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.

Make capital work hard
On average, private equity 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 the 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.

Make the centre 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 private equity firms, where corporate staffs view themselves as active shareholders, obligated to make investment decisions with a complete lack of sentimentality.

Private equity 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 James Coulter, founding partner of private equity firm Texas Pacific Group.

This past May, Burton announced the formation of a private equity fund that will focus on turnarounds. Not surprisingly, Burton Management Group plans to manage the day-to-day operations of the companies in which it invests.

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 good news for corporations is these disciplines travel. A few publicly traded companies, like Montreal-based Power Corp., have long managed their businesses with the rigour of private-equity firms—and with great success.

We believe these five management disciplines explain much of the success of the leading private-equity firms. And public company executives can adopt them to reap significantly greater returns.

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 centre is adding to the value of my business—not destroying it?

Pierre Lavallée is a vice-president with Bain & Co. in Toronto. Paul Rogers, based in London, directs Bain's organization practice. A version of this article appeared in Harvard Business Review, June 2002.



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