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So what exactly is private equity?

By Jonathan J. Ariel - posted Tuesday, 3 June 2008


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.

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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.

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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.

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Lessons from Private Equity Any Company Can Use (Memo to the CEO) by Orit Gadiesh and Hugh Macarthur Harvard Business School Press (February 2008) (136 pages) $25.



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About the Author

Jonathan J. Ariel is an economist and financial analyst. He holds a MBA from the Australian Graduate School of Management. He can be contacted at jonathan@chinamail.com.

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