Private equity. The very term continues to evoke admiration, envy, and—in the hearts of many public company CEOs—fear. In recent years, private equity firms have pocketed huge—and controversial—sums, while stalking ever larger acquisition targets.
Indeed, the global value of private equity buyouts bigger than $1 billion grew from $28 billion in 2000 to $502 billion in 2006, according to Dealogic, a firm that tracks acquisitions.
Despite the private equity environment’s becoming more challenging amid rising interest rates and greater government scrutiny, that figure reached $501 billion in just the first half of 2007.
Private equity firms’ reputation for dramatically increasing the value of their investments has helped fuel this growth. Their ability to achieve high returns is typically attributed to a number of factors: high-powered incentives both for private equity portfolio managers and for the operating managers of businesses in the portfolio; the aggressive use of debt, which provides financing and tax advantages; a determined focus on cash flow and margin improvement; and freedom from restrictive public company regulations.
But the fundamental reason behind private equity’s growth and high rates of return is something that has received little attention, perhaps because it’s so obvious: the firms’ 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.
Public companies—which invariably acquire businesses with the intention of holding on to them and integrating them into their operations—can profitably learn or borrow from this buy-to-sell approach. To do so, they first need to understand just how private equity firms employ it so effectively.
The Private Equity Sweet Spot
Clearly, buying to sell can’t be an all-purpose strategy for public companies to adopt. It doesn’t make sense when an acquired business will benefit from important synergies with the buyer’s existing portfolio of businesses. It certainly isn’t the way for a company to profit from an acquisition whose main appeal is its prospects for long-term organic growth.
However, as private equity firms have shown, the strategy is ideally suited when, in order to realize a onetime, short- to medium-term value-creation opportunity, buyers must take outright ownership and control. Such an opportunity most often arises when a business hasn’t been aggressively managed and so is underperforming. It can also be found with businesses that are undervalued because their potential isn’t readily apparent. In those cases, once the changes necessary to achieve the uplift in value have been made—usually over a period of two to six years—it makes sense for the owner to sell the business and move on to new opportunities.
The benefits of buying to sell in such situations are plain—though, again, often overlooked. Consider an acquisition that quickly increases in value—generating an annual investor return of, say, 25% a year for the first three years—but subsequently earns a more modest if still healthy return of, say, 12% a year. A private equity firm that, following a buy-to-sell strategy, sells it after three years will garner a 25% annual return. A diversified public company that achieves identical operational performance with the acquired business—but, as is typical, has bought it as a long-term investment—will earn a return that gets closer to 12% the longer it owns the business. For the public company, holding on to the business once the value-creating changes have been made dilutes the final return.
In the early years of the current buyout boom, private equity firms prospered mainly by acquiring the noncore business units of large public companies. Under their previous owners, those businesses had often suffered from neglect, unsuitable performance targets, or other constraints. Even if well managed, such businesses may have lacked an independent track record because the parent company had integrated their operations with those of other units, making the businesses hard to value. Sales by public companies of unwanted business units were the most important category of large private equity buyouts until 2004, according to Dealogic, and the leading firms’ widely admired history of high investment returns comes largely from acquisitions of this type.
More recently, private equity firms—aiming for greater growth—have shifted their attention to the acquisition of entire public companies. This has created new challenges for private equity firms. In public companies, easily realized improvements in performance often have already been achieved through better corporate governance or the activism of hedge funds. For example, a hedge fund with a significant stake in a public company can, without having to buy the company outright, pressure the board into making valuable changes such as selling unnecessary assets or spinning off a noncore unit. If a public company needs to be taken private to improve its performance, the necessary changes are likely to test a private equity firm’s implementation skills far more than the acquisition of a business unit would.
When KKR and GS Capital Partners, the private equity arm of Goldman Sachs, acquired the Wincor Nixdorf unit from Siemens in 1999, they were able to work with the incumbent management and follow its plan to grow revenues and margins. In contrast, since taking Toys “R” Us private in 2005, KKR, Bain Capital, and Vornado Realty Trust have had to replace the entire top management team and develop a whole new strategy for the business.
Private Equity’s New Focus
Many also predict that financing large buyouts will become much more difficult, at least in the short term, if there is a cyclical rise in interest rates and cheap debt dries up. And it may become harder for firms to cash out of their investments by taking them public; given the current high volume of buyouts, the number of large IPOs could strain the stock markets’ ability to absorb new issues in a few years.
Even if the current private equity investment wave recedes, though, the distinct advantages of the buy-to-sell approach—and the lessons it offers public companies—will remain. For one thing, because all businesses in a private equity portfolio will soon be sold, they remain in the spotlight and under constant pressure to perform. In contrast, a business unit that has been part of a public company’s portfolio for some time and has performed adequately, if not spectacularly, generally doesn’t get priority attention from senior management. In addition, because every investment made by a private equity fund in a business must be liquidated within the life of the fund, it is possible to precisely measure cash returns on those investments. That makes it easy to create incentives for fund managers and for the executives running the businesses that are directly linked to the cash value received by fund investors. That is not the case with business unit managers or even for corporate managers in a public company.
Furthermore, because private equity firms buy only to sell, they are not seduced by the often alluring possibility of finding ways to share costs, capabilities, or customers among their businesses. Their management is lean and focused, and avoids the waste of time and money that corporate centers, when responsible for a number of loosely related businesses and wishing to justify their retention in the portfolio, often incur in a vain quest for synergy.
Finally, the relatively rapid turnover of businesses required by the limited life of a fund means that private equity firms gain know-how fast. Permira, one of the largest and most successful European private equity funds, made more than 30 substantial acquisitions and more than 20 disposals of independent businesses from 2001 to 2006. Few public companies develop this depth of experience in buying, transforming, and selling.
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