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(originally published by Booz & Company)


Seven Value Creation Lessons from Private Equity

Top managers receive their annual performance bonus only if they achieve a handful of aggressive but realistic performance targets, unlike bonuses at public companies, which have become an expected part of overall compensation irrespective of performance. PE firms will reduce or even eliminate bonus payments if an operating company fails to achieve its targets.

Not only does management participate in the upside in a private equity operating company, but it also shares in the potential downside. CEOs and certain direct reports have real “skin in the game” in the form of a meaningful equity investment in the acquired company. Because this equity is essentially illiquid until the PE firm sells the company, it reinforces the alignment between top management’s agenda and that of the PE shareholders, reducing any temptation to manipulate short-term performance.

Although public companies may not be able to match the equity-based rewards of a successful PE venture, they can create a tighter link between management pay and performance, particularly over the long term. Companies can stimulate a high-performance culture by strengthening their individual performance measures and incentives to align them with true value creation. The first step is to reform the performance review process so that it truly distinguishes and rewards star talent.

7. Select stretch goals. As discussed, top private equity firms manage their portfolio companies by developing and paying rigorous attention to a select set of key and customized metrics. PE general partners quickly assess what matters in driving the success of an acquired company and then isolate these few measures and track them. They set clear, aggressive targets in a few critical areas and tie management compensation directly to those targets. PE firms watch cash more closely than earnings as a true barometer of financial performance and prefer to calculate return on invested capital rather than fuzzier measures such as return on capital employed.

Many public companies are already following the private equity example by developing “dashboards” that track the key measures of business performance and longer-term value creation. Ideally, companies want to create a virtuous circle of performance measurement and management. The vision and long-term strategy should drive a set of specific initiatives with explicit objectives. These initiatives and their financial implications should, in turn, drive annual plans and budgets.

There are reasons that those who can afford the extravagant management fees continue to invest in private equity — the evidence shows that the best of these firms create economic value again and again, by implementing real and sustainable operating and productivity improvements at their portfolio companies. Although public companies do not enjoy certain liberties that highly concentrated private ownership affords, their boards and executives can learn from the better practices of PE firms, adapting them to the realities and constraints of their own business model to create additional and lasting value.

Author Profiles:

  • Vinay Couto is a senior partner with Booz & Company in Chicago. He is the global leader of the firm’s organization and change leadership practice, focusing on global organization restructuring and turnaround programs in the automotive, consumer packaged goods, and retail industries.
  • Ashok Divakaran is a partner with Booz & Company in Chicago. He focuses on large-scale organizational restructuring strategies for multinational companies.
  • Deniz Caglar is a principal with Booz & Company in Chicago. He focuses on organizational design and transformation in the consumer packaged goods and retail industries.
  • Also contributing to this article was Booz & Company partner Harry Hawkes.


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