Private equity, private lives
The private equity boom is breathtaking. It's not just making investors rich - the wave of deals is changing the mindset of corporate managers everywhere. Fortune reports.
(Fortune Magazine) -- If you want to get to the bottom of today's historic boom in private equity, just follow Tom von Krannichfeldt around.
You've probably never heard of him or the company he leads, AZ Electronic Materials. Carlyle Group, one of the major private-equity firms, bought AZ from Swiss chemical company Clariant a couple of years ago for $415 million and brought von Krannichfeldt out of retirement to run it; he'd spent his career in big public chemical companies.
Being private, AZ doesn't get much media attention, and of course it doesn't release financial data. But industry experts say it seems to be doing extremely well. More important, the way von Krannichfeldt and his team manage AZ from offices around the world - and the way other CEOs run their newly private outfits - holds the real key to how private equity is reshaping business.
The headlines about private equity have focused on the dollars rushing in. Kohlberg Kravis Roberts proposes buying Vivendi for $50 billion, a record-sized deal that would have been unthinkable just a year ago. Blackstone Group announces that it's raising a $20 billion fund, the biggest ever. Private-equity firms already own a growing stable of America's most famous companies - Hertz, Neiman Marcus and Toys "R" Us, among others.
With investors pouring in money and firms joining forces in club deals, only a handful of giant companies are now out of reach of a private-equity buyout. Wall Streeters speculate that other elephants like Texas Instruments (Charts), Dell (Charts), and even Home Depot (Charts) (market capitalization: $77 billion) could be targets.
But few observers appreciate that the private-equity phenomenon is about more than just big bucks. Yes, private-equity deals are making investors rich. In the 12 months through last June, investments in PE firms returned 22.5 percent, vs. 6.6 percent for the S&P 500, says Thomson Financial.
Over the past ten years, the score is 11.4 percent a year vs. 6.6 percent; over the past 20 years, 14.2 percent vs. 9.8 percent. Those are significant differences, and some critics charge that huge fees and sweetheart deals with management are siphoning value from public shareholders.
Inside private equity
Yet there is another side to this story. The little-discussed heart of the matter: There are management strategies and techniques that enable PE-owned firms to produce stunning results that others can't match. These successful practices have long seemed shrouded by the "private" in private equity. But they needn't be.
Look inside the companies owned by major private-equity firms, talk to the executives who run them, and you'll find a distinctive way of managing that's sharply different from what goes on in most publicly traded companies or most private companies under conventional ownership. Investigation shows why privately held firms - at least if they're owned by one of the major buyout shops - have important advantages over competitors, and why they're regrading the playing field in several industries. Many of the lessons apply to virtually any organization.
The differences begin at the most fundamental level, with new objectives. Private-equity firms want to buy companies for their portfolio, fix them, grow them and sell them in three to five years. The eventual buyer could be another company in the portfolio company's industry, another private-equity firm or the public, through an IPO. The holding period is occasionally less than a year or as long as ten years. But always the goal from day one is to sell the company at a profit.
Facing a goal like that changes a manager's mindset - usually in positive ways. No longer seeing a corporate future that stretches indefinitely into the distance, executives realize that they gain nothing by resisting change: With the exit looming, driving change is their only hope.
"Everybody in the company knows you're on a sprint to do well," says von Krannichfeldt. "It's not this mindset of working for a company that's been there for 100 years and will continue for another 100 years. I find this much more intense than a public company."
Pay is a whole different concept in PE-owned companies. Don't come to play unless you're prepared to put significant skin in the game. While public companies talk a lot about aligning executive pay with performance, they typically award stock options and restricted stock on top of already substantial pay packages, giving executives lots to gain but little to lose.
And in big companies those options reflect the fortunes of the overall corporation, not the specific business a manager is running. By contrast, private-equity firms make the game much more serious. Not only is a far larger share of executive pay tied to the performance of an executive's business, but top managers may also be required to put a major chunk of their own money into the deal.
At Dunkin' Brands (home of Dunkin' Donuts), which is co-owned by private-equity firms Bain Capital, Carlyle, and Thomas H. Lee Partners, CEO Jon Luther says, "I insisted that all officers invest personally. Management has a substantial amount of their personal money in this. It makes a huge difference in the 40 officers of the company when they show up for work" they have an ownership mentality rather than a corporate mentality." Luther says the resulting difference in behavior is clear: "There's now a very different discipline in how you spend money," he explains. "If it doesn't grow the business, why would you do it?"
Another effect: People just try harder. At Genpact, an outsourcing company that had been part of General Electric (Charts) and is now owned by General Atlantic, Oak Hill Capital Partners, and GE, CEO Pramod Bhasin sees the difference every day: "We are owners, so you fight harder for targets, fight harder to see where else you can go, stretch yourself more" - even more, he says, than at GE, where he spent 25 years.
Freedom to pay
Private-equity firms don't always bring in star outside managers to run the companies they buy. In fact, they much prefer to buy a company with strong management in place, as Luther was at Dunkin' and Bhasin was at Genpact. "The strong preference is to use the talent in the company," says General Atlantic chairman Steven Denning. "You want to back a superb management team and liberate them."
But if PE owners decide that they need to bring in an outsider, they hold a valuable advantage over public companies: No one will know how much they've paid. Public companies have to report executive pay in SEC filings. Private companies don't.
In this era of outrage at grossly overpaid executives, any public company that paid, say, a $20 million signing bonus or offered a package with a potential nine-figure payout would be pilloried by governance activists and the press. But the reality is that some executives are worth that kind of money, and when private-equity firms offer it - as they do - no one knows.
As a result, they can raid companies that are legendary executive-training academies, using mammoth pay packages to lure away their most valuable assets in today's economy: their best managers. Exhibit A is General Electric superstar David Calhoun, who quit to head newly private VNU for a package that could be worth more than $100 million. (A person close to VNU says Calhoun "put a substantial part of his own net worth" into the company as part of the deal.)
Another GE star, Paul Bossidy, recently left the company to join Cerberus, a major private-equity firm. Procter & Gamble chief A.G. Lafley says, "We've lost a half-dozen people" to private equity. Home Depot has also lost a couple.
The trend has changed the high-stakes game of executive recruiting. "Top candidates are no longer waiting around to be recruited to a public company," explains über-headhunter Gerard Roche of Heidrick & Struggles. "Instead they're jumping to a private-equity firm and watching for the right opportunity to become a CEO. It wasn't like this ten years ago."
Freedom to pay is just one example of an advantage that many PE veterans consider critical: general freedom from the pressures of the stock market, media and Wall Street analysts. Remember, these companies have strong incentives to act quickly - but acting quickly often produces volatile quarterly earnings, which Wall Street doesn't like.
Making a big new investment or taking a write-off for a plant closing may be the best thing for the business, but many public companies hesitate because such actions could cause the stock to tank. PE-owned firms don't have to worry about it. "In private equity, you don't need to go from quarter to quarter," says von Krannichfeldt. "You can take write-offs, you can make investments that aren't accretive in year one or year two. It's a very different dynamic."
One often hears that freedom from public markets carries another boon for privately held companies - no more compliance with Sarbanes-Oxley or the many other regulations on public firms.
But PE executives say that supposed advantage isn't such a big deal. After all, the companies may be reentering the public markets in just a few years. "It's not about accounting compliance," says Luther. "We treat ourselves like we're public."
What makes a huge difference is the release of managerial time from trying to placate and massage the public markets. Talking to shareholders, analysts and the media may be important jobs for a public-company CEO, but they're massive distractions from the company's operations. In practice, a public-company CEO is lucky if he spends 60 percent of his time actually running the place. In a PE-owned firm those distractions disappear, and the CEO is free to spend close to 100 percent of his time focused on the business.
Increased managerial attention comes to many PE-owned companies in another way as well. Several of these companies were initially parts of much larger outfits where they were not central to the mission. The parent firm focused top-management time and corporate resources elsewhere, which not only was bad for the stepchildren financially but also demoralized the managers.
"I used to joke that I had to fly to London to beg for attention," says CEO Luther, recalling when Dunkin' was part of giant Allied Domecq, which Pernod Ricard later bought. "Now it's just a 20-minute ride downtown" to Bain Capital's office in Boston. Genpact's Pramod Bhasin adds, "We weren't a strategic business for GE. Our whole intention was to be able to offer our services to the broad market."
leadership and performance measurement
Much of that attention in PE-owned companies comes from a source that makes some public-company CEOs uncomfortable: the board. Because they're corporations, even privately held companies must by law have boards of directors.
But the boards of PE-owned companies are fundamentally different from the public boards that are the focus of governance activists. They're typically smaller and consist only of representatives of the PE owners plus industry experts whose explicit job is to help management create and execute strategy; many directors fulfill both roles. "The board is far more involved in assisting the company," says General Atlantic's Denning.
Besides furnishing heavy-hitting directors, large PE firms also bring a world of connections to the companies they own. "Our three partners are able to connect us with people we otherwise couldn't meet," says Luther of Dunkin'. "For example, the Carlyle folks introduced us to one of their investors in Taiwan, and we soon had an agreement for 100 Dunkin' Donuts stores there."
Pramod Bhasin says Genpact has received similar benefits from its new owners: "Their access to markets, to people, to the right headhunters, the right lawyers - that's a huge help to companies that are newly independent, because without it, we'd have to swim for it ourselves."
Clarity is a running theme in why PE-owned companies on average perform so well. They suffer no confusion about the role of the board, who's ultimately in charge (the PE firm is), and the eventual goal. They benefit also from a clear view of what they're managing along the way: It's cash.
Public companies often get caught up in disagreements over what to measure - earnings per share, return on equity, Ebitda, return on net assets. PE-owned firms generally bypass that debate. They're managed for cash, the ultimate business reality. "The focus on cash flow is very intense," says von Krannichfeldt, "and most employees who came from Clariant [AZ's previous, corporate owner] had never seen that. As a consequence, what they'd done with regard to controlling inventory or working capital wasn't terribly good, and we could improve on that a lot."
These companies tend to be especially disciplined about how to reach their cash goals. More than others, they insist on identifying the measurements that are most important. Many companies call them key performance indicators, or KPIs.
At AZ Electronic Materials, for example, CEO von Krannichfeldt uses about 80 of them, covering all the critical areas - finances, growth, productivity, quality, safety, market position. It's an agreed-upon dashboard that he and Carlyle monitor continually.
Private vs. public
Combine all those factors and here's what private-equity firms have figured out how to do: Attract and keep the world's best managers, focus them extraordinarily well, provide strong incentives, free them from distractions, give them all the help they can use and let them do what they can do. No wonder these companies tend to be outstanding performers.
If it all sounds too good to last, some people worry that it may be. Private equity has become so large, powerful and successful that some firms may be doing too much, too fast. PE-owned firms that go public have generally outperformed the market, but in the past year many have badly underperformed. Burger King (Charts), formerly owned by PE firms including Texas Pacific Group, Bain Capital and Goldman Sachs, has barely climbed back to its offering price after a steep drop; and Sealy (Charts), taken public by KKR, is still down about 12 percent.
Warren Buffett has criticized private-equity firms as "deal flippers" uninterested in building long-term value. Some firms extract exorbitant fees from their portfolio companies.
Continued abuses could attract federal regulation; the Justice Department is already investigating possible collusion in bidding for companies. This industry is filled with some of the world's smartest people; now it needs leadership to start self-policing to make such intrusions unnecessary.
But a longer-term threat to the private-equity industry could be a development that would actually be good news for the economy. Consider: The most fundamental question raised by today's private-equity boom is, Why can't public companies do all these things themselves?
In theory, they could and should. In other words, private equity's success is built on advantages that public firms just haven't figured out how to adopt yet. But the history of markets says that they will figure it out eventually. When they do, their returns should rise, slowly eroding private equity's ability to attract capital. That would make life challenging for the PE industry, but it also means that the world's capital would be more productive.
At least that's the theory. For now, private-equity firms probably have many years of big opportunities ahead of them. Capital will continue to be abundant. "The No. 1 reason" private equity is on such a tear, says Carlyle Group's Allan Holt, "is the availability of capital. It opens up a universe of possibilities."
Even higher interest rates won't necessarily scotch deals; rates are just a cost to factor in. And most public companies will be slow to adapt, creating plenty of chances for private equity to work its magic.
The good news is that you don't have to wait for a PE firm to swoop into your organization. By using private-equity strategies, you can improve results and maybe even become as successful as these companies are, starting right now.
Ram Charan, an advisor to Fortune 500 CEOs and boards, is author of the forthcoming book "Know-How." He has consulted for AZ Electronic Materials, Dunkin' Brands, and Genpact.
From the November 27, 2006 issue