So what exactly is private equity?

The term private equity conjures up a wide array of images in the public’s mind. Most images tend to focus on a cabal of nefarious and mind-blowingly wealthy Wall Street suits, scheming in secret and salivating (like a pack of wolves) at the prospect of plundering untold riches from a hapless enterprise under their superior financial deliberation.

So exactly what is private equity? And given it has proven to be such a successful wealth generating vehicle, what drives its success?

PE refers to equity investments in companies that are not publicly listed. These investments are distinguished by their transformational, value-added and (very) actively managed shareholding.

PE firms generally make their money through one of three ways: an initial public offering, a sale or a merger of the company or a recapitalisation. Unlisted securities may be sold to (individual) investors or sold to a private equity consortium, which pools contributions from individual investors to build a capital fund.

In Australia the best known organisation owned by a PE firm is the retailer, Myer, which was unhinged from the Coles Myer juggernaut for $1.4 billion in June 2007 by PE titans TPG and its Asian investment arm, Newbridge Capital. In the United States, the most celebrated recent example of a firm bought by a PE firm, in this case Towerbrook Partners is high-end shoe maker, Jimmy Choo in February 2007.

In Lessons from Private Equity Any Company Can Use, Bain & Company’s Chairman, Orit Gadiesh and Partner, Hugh MacArthur, use the concise, dot point format of a memo to spell out the five disciplines that drive PE firms to create and retain their edge.

The book answers questions like: just how do PE firms maximise investor value far, far more successfully than traditional publicly listed companies? How can PE recruited managers create more value for shareholders? How can they give more opportunities (be it jobs, promotions or financial incentives) to staff? The book answers these questions by listing examples, including Crown Castle, an owner operator of wireless infrastructure that PE firm Berkshire Partners bought into, and in time sold, yielding Berkshire a ten fold return on its investment.

This short book (a mere 136 pages) outlines the steps undertaken by PE firms to create or unlock value in targeted acquisitions. It does not so much as celebrate PE firms per se, as it promotes the PE approach. For instance, it bellows that the first priority of every CEO must be to increase the value of the firm. While the authors don’t say so, they hint that many managers of publicly listed organisations have a host of other priorities. These include maintaining the status quo. The success however of the PE approach rests on directly rewarding all those staff that can help realise the PE dream of value maximisation.

The steps involved in creating value include:

The full potential
This involves studying the business and constantly reappraising its full potential. This mandates a focus on a handful of core initiatives, say between three and five. A splendid example of how such strategic behaviour was implemented is well illustrated by reflecting on a period of Mr Peter Brabeck-Letmathe’s time as CEO of Swiss multinational Nestlé.

Developing a blueprint for change
This is a road map for initiatives that will generate the most value for a company within a set period of time. The blueprint defines the key details that comprise the strategic plan: the who, what, where, when and how. The strategic plan is tasked with turning the core initiatives into measurable results.

Accelerate performance
Once priorities are set and mapped, the overriding goal becomes to accelerate the performance of the company. This involves driving organisational change around key initiatives by sculpting the firm to the blueprint, and matching key personnel to core initiatives.

Harness the talent
Hire, motivate, train and retain hungry managers. Secure people who think and act like owners. Understand that money is not the sole motivator. Public firms can emulate PE pay conditions by rewarding staff in proportion to their (individual) success, by measuring their results and by torching long standing value destroying institutions, like in house bureaucracies.

The authors don’t limit corporate reform to management and staff but also scream for a more proactive board. Boards should be more decisive and more efficient in helping CEO’s generate value. The first step to achieve this end is to appoint the right board. Easy to say, but not easy to execute. What many boards sorely miss are folk who actually understand the industry as well as the strengths and weaknesses of the management team. Also missing presumably, are board members that can act with conviction when required.

Make equity sweat
By making cash scarce and forcing managers to redeploy underperforming capital in more productive directions. This involves a warm embrace of so-called LBO (leveraged buy out) economics, which in part means getting the firm comfortable with ever increasing mountains of debt. The CEO must identify the amount of cash needed for future acquisitions; for working capital; for sales generation and for future capital expenditure. All balance sheet items are examined for their contribution to the firm. Unproductive and non core assets must be considered for conversion into sources of funding. For example, think airlines that own their aircraft as opposed to leasing the same.

The greater the debt to equity ratio, the greater the focus a manager will have on the most valuable opportunities for the firm, rather than those opportunities that bring home a pedestrian return. The board’s goal is to have the management team treat cash as an incredibly scarce resource indeed.

Foster a results oriented mind set
This demands an unwavering focus on cash and earnings driven by the five disciplines mentioned above, and requires a repeatable formula: repeatable within one activity and also across a host of activities. This is the key to realising profits in investment after investment by savvy PE investors.

The book concludes by exclaiming that Nestlé’s recent success is due to its PE mindset. Hallmarks of that success include the following:

• market capitalisation increased three and a half times to SF200 billion between 1998 and 2008;
• US$3 billion worth of cost saving was realised by closing or selling more than 200 factories;
• sales innovation gathered steam across all divisions; and
• proactive customer communication strategies were employed, meaning less TV advertisements and more new media was utilised.

Gadiesh’s (sensible) invocation for a PE mindset, be it in publicly listed companies or in firms devoured by PE firms, does not mean that PE deals are always successful in turning around an acquisition; sometimes acquisitions do in fact go sour.

Business Week, on April 14 reported the story of Freescale Semiconductor, a PE buy out that went very much pear shaped.

Back in 2006, a band of private equity firms - comprising Blackstone Group, Carlyle Group, TPG, and Permira Advisers - decided to buy Freescale Semiconductor, of Austin, Texas. Their interest was piqued by Freescale’s CEO, Michel Mayer who had resurrected the chipmaker from near death after it was spun-off from Motorola a few years earlier, sending the company's stock price soaring.

Soon after the buy out, the firm which makes semiconductors for mobile phones, telecom equipment and cars, resembled one big, fat, juicy and acidic lemon. Sales started oozing away just months after the deal's close. Freescale's biggest customer, former parent Motorola, cut orders, and Freescale wasn't able to add enough new customers to offset the shortfall. Revenues for 2007 tanked 10 per cent (to US$5.7 billion), even as the industry's cantered by 5 per cent.

Business Week noted that none of this would have been so dire had Freescale remained a publicly traded company which was light on debt. But Freescale's new owners - as is the wont of PE firms - saddled it with US$9.5 billion to pay for the deal. And naturally pay themselves. Now the company must find US$375 million in interest payments every half year.

Following a US accounting rule change in the (northern) autumn of 2007, PE consortium members must mark down the value of an investment in any quarter it drops. Freescale's new owners (a syndicate that includes insurer AIG and Singapore’s Government Investment Corporation) recently wrote down their US$7 billion equity stake by a whopping US$1 billion.

Freescale was in good company. Kohlberg Kravis Roberts, another big name in the PE galaxy, purchased chipmaker NXP Semiconductors (previously the semiconductor unit of Royal Philips Electronics) in 2006. Recently KKR marked down its value by 14 per cent. Bonds of First Data, a $27 billion KKR investment has seen its value take a 16 per cent haircut. And it was only bought last September!

The new owners replaced Freescale’s CEO, Michel Mayer with Richard M. Beyer, formerly of California chipmaker Intersil. As a former officer in the United States Marine Corps when serving his PE masters, Beyer will no doubt be mindful of the Corps’ motto, Semper Fi (always faithful). Faithful to creating value is, after all, what everyone’s hoping for. Everyone, from the investment bankers - hoping for a handsome return on their investment -all the way to the junior office clerks - who pray their jobs are not at risk.

In addition to the hard nosed economic and financial principles outlined by Gadiesh, an essential - but inevitably random - component in any PE investment, or for that matter, any of life’s endeavours, be it marrying well, winning on the horses or even getting a good table at a restaurant, is luck. And luck can be either good or bad. Luck is one thing you sure can’t plan for.

It’s telling that Freescale was bought by the Blackstone-led consortium only after a short scuffle with another PE consortium that included KKR, Apax Partners and Bain Capital.

And who said losing a fight must be considered as bad luck?