The Deal

Traveling disciplines

Private equity firms have generated enviable returns by emphasizing a few basics.

By Paul Rogers, Tom Holland and Dan Haas

Published on July 12, 2002
min read


Private equity firms have generated enviable returns by emphasizing a few basics. Leading private-equity firms have delivered internal rates of return at double the S&P 500's over the past decade, including tough times. Increasingly, they've achieved this by adding value to the underlying operations they own as well as through creative financial structuring. In experience with more than 2,000 private-equity transactions over 10 years, we've identified a handful of managerial disciplines PE firms use to add value to operations and engender a performance culture. They rigorously focus on accelerating growth in the value of their businesses by zeroing in on just one or two key initiatives. They create simple, focused measures to track progress. They make their assets work hard—often transforming fixed costs into variable. Finally, they hire for both skill and attitude, attracting hungry managers willing to accept compensation tied to results. The good news: These disciplines travel. And by following them public companies can reap significantly greater returns. The first step PE firms take when they acquire a business is to define an investment thesis they believe will pay off in 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 both a short-term view to meet quarterly or annual shareholder expectations, and a long-term view that says, "We'll own this company forever." PE firms create a policy statement of 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. But to achieve such simplicity often requires a good dose of strategic thinking and a lot of market, customer and competitor analysis to get it right. Otherwise you'll end up among the 75% of PE funds that post sub-optimal returns. Once they've narrowed their sights strategically, top PE firms steadfastly resist measurement mania. They zero in on those few financial indicators that most clearly reveal true progress in increasing value. PE firms watch cash more closely than earnings, knowing that cash remains a true barometer of financial performance while earnings can be manipulated. (Witness any of the current accounting scandals.) PE firms prefer to calculate return on invested capital, which indicates actual returns on money put into a business, rather than fuzzier measures like return on accounting capital employed. 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 PE 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 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 either through 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. Finally, PE firms make sure their assets work as hard as their people. 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. As a result, SecurityLink transformed itself from a loss maker to generating 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 a matter of months. GTCR's willingness to sell SecurityLink in short order, when a good offer suddenly came, reflects PE firms' view of themselves as active shareholders. "Every day you don't sell a portfolio company, you've made an implicit buy decision," Coulter says. Can corporations adopt such an unsentimental approach? A few publicly traded companies, like General Electric and Montreal-based Power Corp., have long managed their businesses with the rigor of PE firms—with great success. Others can, too. Paul Rogers is a Bain & Co. director in London who leads the firm's organization practice. Tom Holland is a director in San Francisco and Dan Haas a vice president in Boston; both are leaders in the firm's private equity practice.

Private equity firms have generated enviable returns by emphasizing a few basics.

Leading private-equity firms have delivered internal rates of return at double the S&P 500's over the past decade, including tough times. Increasingly, they've achieved this by adding value to the underlying operations they own as well as through creative financial structuring. In experience with more than 2,000 private-equity transactions over 10 years, we've identified a handful of managerial disciplines PE firms use to add value to operations and engender a performance culture. They rigorously focus on accelerating growth in the value of their businesses by zeroing in on just one or two key initiatives. They create simple, focused measures to track progress. They make their assets work hard—often transforming fixed costs into variable. Finally, they hire for both skill and attitude, attracting hungry managers willing to accept compensation tied to results.

The good news: These disciplines travel. And by following them public companies can reap significantly greater returns.

The first step PE firms take when they acquire a business is to define an investment thesis they believe will pay off in 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 both a short-term view to meet quarterly or annual shareholder expectations, and a long-term view that says, "We'll own this company forever."

PE firms create a policy statement of 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. But to achieve such simplicity often requires a good dose of strategic thinking and a lot of market, customer and competitor analysis to get it right. Otherwise you'll end up among the 75% of PE funds that post sub-optimal returns.

Once they've narrowed their sights strategically, top PE firms steadfastly resist measurement mania. They zero in on those few financial indicators that most clearly reveal true progress in increasing value. PE firms watch cash more closely than earnings, knowing that cash remains a true barometer of financial performance while earnings can be manipulated. (Witness any of the current accounting scandals.)

PE firms prefer to calculate return on invested capital, which indicates actual returns on money put into a business, rather than fuzzier measures like return on accounting capital employed. 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 PE 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 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 either through 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.

Finally, PE firms make sure their assets work as hard as their people. 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. As a result, SecurityLink transformed itself from a loss maker to generating 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 a matter of months.

GTCR's willingness to sell SecurityLink in short order, when a good offer suddenly came, reflects PE firms' view of themselves as active shareholders. "Every day you don't sell a portfolio company, you've made an implicit buy decision," Coulter says.

Can corporations adopt such an unsentimental approach? A few publicly traded companies, like General Electric and Montreal-based Power Corp., have long managed their businesses with the rigor of PE firms—with great success. Others can, too.

Paul Rogers is a Bain & Co. director in London who leads the firm's organization practice. Tom Holland is a director in San Francisco and Dan Haas a vice president in Boston; both are leaders in the firm's private equity practice.