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Published: January 30, 2012


Seven Value Creation Lessons from Private Equity

3. Operate as though time is money. Consistent with the imperative to generate cash quickly to pay down debt is the mantra among private equity firms that “time is money.” There is a bias for action captured most vividly in the 100-day program that PE firms invariably impose on portfolio companies during the first few months of ownership. PE firms have little appetite for the socialization and consensus building common at many large public companies — private equity firms and their management teams feel a sense of urgency and rapidly make decisions to change.

Granted, portfolio company executives are extraordinarily empowered and have close working relationships with their actively involved boards. They do not need to navigate layers of oversight or appease external stakeholders. Still, public company executives could learn a lot from the private equity firm’s need for speed. Waiting carries an opportunity cost that too many public companies inadvertently and unfortunately pay.

4. Apply a long-term lens. Private equity firms act with speed but without forsaking rigorous analysis and thoughtful debate. They typically have three to five years to invest their fund, providing time to carefully assess potential targets and develop an investment thesis. PE firms then have a window of about 10 years to exit these deals and return the proceeds to investors. Despite the occasional claim to the contrary, PE firms do not tend to “flip” investments.

After realizing the short-term cost benefit of eliminating low-value activities, the general partners can afford to invest in the long-term value creation potential of the companies they acquire. In fact, that is the only way they will secure their targeted returns upon exit — by convincing a buyer that they have positioned the company for future growth and profitability.

The best private equity firms not only cut costs but also invest in the highest-potential ideas for creating core value. The art and science of making these judicious choices is a capability that public companies can develop.

5. Assemble the right team. PE general partners intuitively understand that strong, effective leadership is critical to the success of their investment — in fact, they sometimes invest in a company based on the strength of its management talent. The assessment of talent begins as soon as due diligence commences and intensifies after closing. Once decisions are made, they are swiftly executed. One-third of portfolio company CEOs exit in the first 100 days, and two-thirds are replaced during the first four years. A private equity firm will act assertively to put the right CEO and management team in place, and may well draw on its own in-house experts or external network to fill talent gaps.

Talent management continues beyond the first few months after the acquisition and extends well beyond the C-suite. Pressured to do more with less, PE firms must continually reassess individuals in middle as well as top management positions and quickly remove or replace low performers. These same talent management tenets can apply to public companies.

6. Link pay and performance. The CEO and senior managers at a private equity portfolio company are deeply invested in the performance of their business — their fortunes soar when the business succeeds and suffer when it fails to achieve objectives. PE firms pay modest base salaries to their portfolio company managers, but add in highly variable and annual bonuses based on company and individual performance, plus a long-term incentive compensation package tied to the returns realized upon exit. This package typically takes the form of stock and options, which can be generous, especially for CEOs. A 2009 study in the Journal of Economic Perspectives of 43 leveraged buyouts pegged the median CEO’s stake in the equity upside at 5.4 percent, whereas the management team collectively received 16 percent of company stock.

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