Chapter 3: The Strategic Power of Private Equity
To address the issue of what drives the strategic power of PE
funds and understand what is behind the phenomenal returns of the major PE
funds, albeit the early negative returns we touched on when we explained the
J-curve phenomenon in Chapter 1, I tried to take ground on two articles
recently released on the September 2007 «Harvard Business Review».
These articles are totally independent one from the other, yet I kept asking
myself whether the first could feed the latter and reciprocally and found out
after thought that these two articles combined will form an excellent source of
knowledge for our current issue.
Indeed, the first article named «The Strategic Secret of
Private Equity» is dealing with the strategies Private Equity firms deploy
to achieve high returns on investments, the latter named «Rules to Acquire
By» depicts a methodology to abide by for groups of companies and
corporations seeking to expand and grow using external acquisitions. Obviously,
the basic common ground between these two articles is the fact that both
Private Equity funds and Corporate groups are engaged in a permanent process of
external acquisitions. Yet, their in-house alchemy differs and so are their
returns and successes.
Through the analysis of both cited articles, I will attempt in
this chapter to give an insight about the «strategic power» of
Private Equity funds by comparing them to common corporations and private
groups. The fact is that usually, corporate groups are also constantly
involving in acquisitions processes. So by comparing the respective practice of
PE funds and Corporate groups when dealing with acquisitions, we will give an
insight on what drives the dynamics of both toward success or failure, and try
to find out if one category could learn from the other.
In the first cited article, Felix Barber and Michael Goold, both
directors at the «Ashridge Strategic Management Centre» in London,
attempt to give a strategic insight on the powerful «Secret» Private
Equity firms use and in some cases probably abuse to dramatically increase the
value of their investments.
The question is why Private Equity firms achieve high growth and
correlated high returns in the businesses they acquire whereas Corporate groups
barely digest their acquisitions and wait a long term before experiencing
acceptable returns?
Many well known reasons could answer this question (Barber and
Goold, 2007):
- Both Private Equity firms' Managers and Portfolio Businesses
Operating Managers receive high incentives,
- An aggressive use of leverage and debt which provide both
financing and tax advantages,
- A clear focus on cash flows and margins improvements,
- A freedom from restrictive public companies regulations being
private and often closely held entities.
But the fundamental reason behind Private Equity skyrocketing
growth and returns is something else. The driver for such encountered successes
is more mechanical and less financial than usual practitioners could observe.
Indeed, Private Equity industry thrived in the mid-way between «pure
financial investment firms» and «pure operational management
businesses». This pivotal position to refer to a mechanical term
makes the major reason for Private Equity blurring success. Let's just think
about this a few moments. Is there another type of investor that holds this
strategic position amid the financial and business community? In my opinion,
the answer is obviously negative.
The authors qualify this phenomenon as Private Equity funds
«standard practice of buying businesses and then, after steering them
through a transition of rapid performance improvement, selling them. That
strategy, which embodies a combination of business and investment-portfolio
management, is at the core of Private Equity's success». The Venn diagram
here after presented, reveals the «Hybrid Nature» of Private Equity
firms.
Investment Portfolio Management Firms
Operational Management Businesses
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Private Equity Firms
However, this «Buy-to-Sell» strategy could not be fully
implemented by Corporate groups that acquire businesses with the intention to
integrate them into their core operations creating synergies for a long term
run. In the meanwhile, and as Private Equity track records show, the
«Buy-to-Sell» strategy is perfectly matching when the purpose of the
investment is to make a one-shot, short to medium term value creation.
For that, buyers must take the ownership and control of a target
company, often one that hasn't been aggressively managed and so is currently
underperforming or an undervalued business with potentials not yet apparent. In
such cases, after the changes necessary to achieve transformations and drive up
the firm value have been implemented (usually around 5 years), it makes sense
for the buyer to sell out the business and turn over to new opportunities
following the same line fashion.
In fact, records also show that Corporate groups, usually public
companies, still holding to their acquisitions even after value creation
changes and transformations occurred, are somewhat diluting the terminal value
and final return of their investments by forgiving to sell out businesses at
the apex of their value.
Both practices are indeed justified by the different ways Private
Equity funds and Corporate groups work and also by the manner their respective
shareholders perceive their buying activities.
First, PE funds are obligated by their shareholders to sell out
the portfolio businesses and liquidate the entire assets of a fund within its
lifetime; therefore acquired businesses remain under pressure to perform.
Whereas as Corporate groups shareholders expect long term synergies (sometimes
in vain!) and operational integration that will sustain the total shareholders
value in the future, the businesses belonging to their portfolios don't get
immediate attention from top management whether they are well or under
performing and thus reflexes to immediately restructure, sell out or take on
other strategic actions are not triggered in a timely manner as do Private
Equity funds, always on the hot spot.
This in turn leads to another reason for the insolent performance
of the Private Equity industry. Because, Private Equity structure requires a
rapid turnover of businesses due to the limited life of the funds, the result
is that PE funds gain strong and fast knowledge of buying, transforming and
selling businesses that few Corporate groups develop. Perhaps the nature of
Private Equity top managers has also something to do with that, whereas Private
Equity partners as former investment bankers are keener to trade, most
Corporate groups top mangers have operational and line background and are so
more comfortable to manage that to buy and sell.
Now, after having discussed all these differences, the question
is what should Corporate groups do and change to narrow down if not overcome
the outperforming Private Equity industry?
The authors give a tangible answer by proposing two distinct
strategies:
1- Adopt the same Buy-to-Sell framework
2- Take on a Flexible Ownership strategy
Rapidly explained, the first point could be implemented by
overcoming a corporate culture of a «Buy-to-Keep» strategy embedded
in the nature of Corporate groups. It also requires that a Corporate group
develop new resources or shift them, hire new skills and change some of its
structures to adopt Private Equity oriented approach. This strategy should also
be explained to shareholders which beliefs can be qualified as somewhat
traditional; in that case, both the board and the top management need to argue
the new approach of the Corporate group portfolio of businesses. This can be
easily expressed but highly challenging to implement and achieve.
In contrary, the «Flexible Ownership» means that a
Corporate group could hold on acquired businesses as long as these can add
significant value by improving their performance and continuing their growth,
and then can dispose of them once it is no longer the case. In fact, if a
Corporate group decides to hold on to an acquired business, it can give it a
competitive advantage over Private Equity funds which must sometimes forgo
substantial over returns they could realize if they would keep on the
investment for a longer period of time. «Flexible Ownership» is
likely to lure most industrial and services holdings with fewer synergies
between subsidiaries, Corporate groups could keep businesses with potential
long term core synergies or transform and sell units with no longer more
synergies yet with a sustainable go-alone strategy. Following the
«Flexible Ownership», Corporate groups should also be wary about
keeping businesses after corporate top management could no longer contribute to
create more value. In a sense, the latter comment embodies the
«gauge» that indicates when and whether a business should be kept,
transformed or sold.
Taking ground on all what we explained here up, let's now find
out what the second article provides as insight for the present discussion.
This article deals with the outstanding success of Pitney Bowes, a US company
that experienced 70 external acquisitions in six years!!
Pitney Bowes is a US multinational firm specialized in providing
mail stream solutions that allow companies to improve and integrate all the
activities essential for business communication, the company operates in 130
countries with a current turnover of $5.7 billion.
The author, Bruce Nolop, an Executive Vice President and CFO of
the company, is arguing that success or failure from an external acquisition
process is due to the mere fact that some companies have figured out how to do
it right, and other don't.
The problematic laid out here is the fact that much recent
studies revealed that the «impulse to buy other businesses is a sign of
weakness, that corporate cultures don't mix, and the majority of acquisitions
simply fail». Yet, on the flip side, the records show that world's most
successful companies rely heavily on acquisitions to achieve their strategic
set of goals and objectives.
So the question is: who is right? As a part of an answer to this
question, Bruce Nolop tried to bring up and share the experience of his company
in the subject, through a fairly set of basic rules that could apply to most
companies.
Here are his key guidelines:
- Rule 1; Stick to Adjacent Spaces:
This approach means pursuing development on logical extensions of
a company's current business mix, which can be taken on incrementally.
- Rule 2; Bet on Portfolio Performance:
This rule emphasizes the fact to manage acquisitions as a
portfolio of investments introducing diversification and all the technical
rules applied to asset management in terms of risk analysis, liquidity and
expected returns.
- Rule 3; Get a Business Sponsor Involved:
Acquisitions processes should be sponsored by inside business
leaders who establish and maintain strong working relationships with the new
management teams to smooth their entry into the buyer culture and operating
procedures.
- Rule 4; Be Clear on How the Acquisition Should be
Judged: Distinguish between acquisitions that will perfectly fit
into a business or a market the buyer is already in, and acquisitions that
takes the buyer into a new business space or activity. Both types should be
treated and appraised differently, the second is naturally more difficult and
entails more risks that the first.
- Rule 5; Don't Shop When You Are Hungry:
On a strategic level, «Hungry» means that the business
is missing an element that the management feels it urgently needs. However,
this does not have to translate into impulsive acquisition.
In fact, whether or not this set of rules perfectly matches other
companies, the main lesson applies to all businesses: acquisitions should be
managed as a «process». As all business processes, this one should be
documented, practiced, improved and mastered. Said differently, it means laying
down the «complex chain of actions typically involved in an acquisition,
paying attention to what can go right or wrong at different stages,
standardizing effective approaches and tools, and continually improving these
approaches». «This aims to create more smart and efficient buyers,
discipline the unit managers about which companies should get into an
acquisition pipeline, and help keep away from apparent tempting deals that turn
out to be in fact disappointing. This also ensures that the acquisitions
completed would finally make more strategic, business and financial
sense».
Does this process-oriented acquisition strategy developed by
Pitney Bowes Company and here laid out answers to the previous question about
how could Corporate groups compete in the area with Private Equity firms? I'm
pretty much sure that readers will find out on their own.
In fact, although the majority of already known cases highlight a
segmentation of strategies for the Private Equity funds and the Corporate
groups, each one could learn from the other by adopting the outsider line of
work if and when the case appeals so.
Private Equity could hence benefit from a «Buy-to-Hold»
strategy for portfolio firms that still show high growth and more value
creation in a longer term (more than 5 or 6 years) to end up with a much high
profitable sell out of the business.
Corporate groups could in turn reap profits from a
«Buy-to-Sell» strategy and sell out or spin-off businesses that have
reached successful transformations in a limited time fashion, avoiding in the
same time to consider such «divestments» as «strategic
errors».
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