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(originally published by Booz & Company)


Seven Value Creation Lessons from Private Equity

What top-tier PE firms can teach public companies about creating and sustaining value over time.

Companies are in business to create value for their stakeholders, a pursuit that occupies countless hours in boardrooms and executive suites around the world. A select number of companies get it right — they set the correct value creation course and sustain it over time. But many do not. Some companies cannot find the right strategic path; others cannot execute their strategy. Still others execute well for a while but then lose their way. And another group of organizations become so exhausted by rounds of business transformation (that is, cost cutting) that they lack the stamina to search for additional ways to secure and sustain value.

For public companies, these challenges are intensified by quarterly reporting requirements, governance rules meant to drive accountability and transparency, and the demands of a vastly larger and more vocal group of stakeholders. Private equity firms, however, enjoy a number of natural advantages when it comes to building efficient, high-growth businesses, including a built-in platform for change (for example, a predetermined exit within 10 years), tightly aligned ownership and compensation models, and fewer institutional loyalties and competing distractions. But despite these distinctions, the best practices of top-tier PE firms still provide powerful and broadly applicable lessons. Public companies can adapt the following seven imperatives from private equity to build a value creation regimen.

1. Focus relentlessly on value. To attract continued investment from limited partners and earn the generous fees for which they are renowned, private equity firms have to maintain a laser-like focus on value creation, beyond simple financial engineering and severe cost cutting. More and more PE deals feature substantive operational improvements that result from the application of deep industry and functional expertise. Private equity firms are in the trenches at their portfolio companies, investing in core operations as often as they are cutting extraneous costs.

Private equity firms’ focus on core value begins with due diligence. General partners carefully choose each target company and explicitly define how they will create incremental value and by when. This assessment does not stop after the acquisition — they periodically evaluate the value creation potential of their portfolio companies and quickly exit those that are flagging to free up funds for more remunerative investments.

That can often mean exiting entire lines of business that are not drawing on the company’s core strengths and differentiating capabilities. Public companies should try to apply a similarly objective and dispassionate lens to their portfolio of businesses by assessing first their financial performance, and then the degree to which each employs mutually reinforcing capabilities that cross business unit lines and distinguish the enterprise as a whole.

2. Remember that cash is king. Private equity firms typically finance 60 to 80 percent of an acquisition with debt. This high-leverage model instills a focus and sense of urgency in PE firms to liberate and generate cash as expeditiously as possible. To improve cash flow, PE firms tightly manage their receivables and payables, reduce their inventories, and scrutinize discretionary expenses. To preserve cash, they delay or altogether cancel lower-value discretionary projects or expenses, investing only in those initiatives and resources (including talent) that contribute significant value.

Public companies can take a page from the PE playbook and develop a similar performance improvement plan. Although the specifics will vary from company to company, any such plan will focus on increasing profits and improving capital efficiency.

Public company leaders should start with a blank slate and then objectively and systematically rebuild the company’s cost structure, justifying every expense and resource. First, management needs to categorize each activity as “must have” (it fulfills a legal, regulatory, or fiduciary requirement, or is required to “keep the lights on”), “smart to have” (it provides differentiating capabilities that allow the company to outperform its competitors), or “nice to have” (everything else). The next step is to eliminate low-value, discretionary work. And the final step is to optimize the remaining high-value or mandatory work.

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