Read an Excerpt
The MASTERS of PRIVATE EQUITY and VENTURE CAPITALManagement Lessons from the Pioneers of Private Investing
By ROBERT A. FINKEL DAVID GREISING
McGraw-HillCopyright © 2010 Robert Finkel and David Greising
All right reserved.
Chapter OneMETHOD OVER MAGIC: THE DRIVERS BEHIND PRIVATE-EQUITY PERFORMANCE
Steven N. Kaplan Neubauer Family Professor of Entrepreneurship and Finance University of Chicago Booth School of Business
More than two decades of research and writing have established Steve Kaplan as a thought leader on the role of private equity in the economy and society. Tracking the industry through economic cycles, Kaplan identifies methods and tools that private-equity investors use to consistently improve performance. Kaplan also debunks the notion that private-equity investment leads to outsized layoffs at portfolio companies, and finds no evidence to support contentions that private-equity firms benefit from access to privileged information when making investment decisions.
The strong track record of private-equity firms, Kaplan finds, results from a combination of techniques. They use equity compensation and leverage to align management with efforts to increase efficiencies. They make changes in firm governance that lead to better oversight and decisions. Finally, private-equity firms increasingly bring industry and operating experience to help improve their companies.
* * *
The investment firms that we once called "leveraged-buyout firms" today are called "private-equity firms," but the rebranding has not changed the basics of what these firms do. They use modest doses of their own investment capital, backed by outside debt, to buy companies and attempt to improve their performance. Proponents of leveraged buyouts argue that private-equity firms improve the operations of the companies they buy and create economic value by applying financial, governance, and operational engineering to their portfolio companies. Others argue quite the opposite. Private-equity firms, these people say, take advantage of tax breaks and superior information but do not create any operational value. Moreover, critics sometimes argue that private-equity activity relies on market timing—and market mispricing—between debt and equity markets.
I largely agree with the private-equity proponents. Overall, private-equity firms create economic value by improving management incentives, providing better governance oversight, and, increasingly, providing advice on cost cuts or strategic improvements. This sort of operational engineering—the use of management techniques and tactics to enhance firm performance—is a thematic focus of this book. The empirical evidence from academic research leads to the clear conclusion that these changes lead to operating improvements and add value, on average. That said, it also appears to be the case that market timing matters and in some instances leads to negative results. From time to time, in the late 1980s and most recently from 2005 to 2007, plentiful availability of very aggressive debt financing allows private-equity investors to finance large public-to-private buyouts. And the record on those transactions, particularly post-1980s, is mixed.
The stereotype of the private-equity investor as a mercurial taskmaster prone to squeezing out costs, firing management, and flipping companies is at least in part a legacy of the frenzied leveraged-buyout boom of the 1980s. Leveraged-buyout activity mushroomed in that decade and culminated with the $25 billion buyout of RJR Nabisco in early 1989. Shortly thereafter, the junk bond market crashed. A number of high-profile leveraged buyouts resulted in default and bankruptcy, and leveraged buyouts of public companies—taking them private—virtually disappeared by the early 1990s.
While leveraged buyouts of public companies were relatively scarce in the 1990s and early 2000s, private-equity firms continued to buy private companies and divisions. In the mid-2000s, public-to-private deals reappeared when the United States led the world's rediscovery of a second private-equity boom. Then, in 2006 and 2007, pension funds, university endowments, and other institutional investors were among those who committed a record amount of capital to private equity, both in nominal terms and as a fraction of the overall stock market. Private-equity commitments and transactions rivaled, and in some respects overtook, the activity of the first wave in the late 1980s; however, in 2008, with the turmoil in the debt markets, private-equity transactions declined markedly again as they had in the late 1980s.
The Rising Tide of Private Equity
We can track the ebb and flow in the popularity of private equity by measuring the amount of capital committed to private-equity funds over the years. Nominal dollars committed each year to U.S. private-equity funds have increased exponentially since private equity achieved its first big wave of growth during the 1980s. In a quarter century, the scale of commitments to private equity grew from $0.2 billion in 1980 to over $200 billion in 2007, meaning commitments that year were a thousand times greater than the total in 1980.
Given the large increase in the market value of firms over this period, it is appropriate to measure committed capital as a percentage of the total value of the U.S. stock market. The data suggest that private-equity commitments are cyclical, tracking in part the ups and downs in the way the investment sectors performed. Commitments increased in the 1980s, peaked in 1988, declined in the early 1990s, and increased through the late 1990s. They peaked in 1998, declined again in the early 2000s, and then began climbing in 2003. By 2006 and 2007, private-equity commitments appeared extremely high by historical standards, exceeding 1% of the value of the U.S. stock market. Perhaps not merely by coincidence, many large private-equity buyouts occurred during those two years, and an inordinate number of those deals seemed to run into financial trouble in fairly short order.
One caveat to this observation is that many of the large U.S. private-equity firms have only recently become global in scope. Foreign investments by U.S. private-equity firms were much smaller 20 years ago, so the comparisons are not exactly apples to apples. Even so, the trends are clear, and, if the past record is any indication, the recent poor results of private-equity funds that began to be reported in 2008 seem likely to affect investor commitments to private-equity funds, which likely will find it difficult to raise new capital, at least until investment returns begin to improve.
The Levers of Performance
While commitments to private-equity firms have ebbed and flowed over the years, the improvement in operating results of companies bought by private-equity firms has been consistent across time and geographies. Private-equity firms improve firm performance, and maximize their investment returns, by engineering changes to the financial, governance, and operational aspects of the companies they buy. Private-equity investors also appear to take advantage of market timing—and market mispricing—between debt and equity markets, particularly when they take publicly owned companies private.
Equity participation by management is a key tool affecting performance. Private-equity firms typically give the management teams of portfolio companies a large equity upside through stock and options—a practice that was unusual among public firms in the early 1980s. Private-equity firms typically also require management to make a meaningful investment in the company. This is designed to align management with the private-equity investors to give management not only a significant upside but a significant downside as well. Moreover, because the companies are private, management's equity is illiquid—that is, management cannot sell its equity or exercise its options until the value is proved by an exit transaction. This illiquidity reduces management's incentive to manipulate short-term performance.
To illustrate the continued importance of equity stakes, my colleague Per Stromberg and I collected information on 43 leveraged buyouts in the United States from 1996 to 2004 with a median transaction value of over $300 million. In a little more than half of these deals, the private-equity firm was taking a public company private. After the deals closed, management ownership was substantial. The chief executive officer received 5.4% of the equity upside—both in stock and options—while the management team as a whole got 16%. These magnitudes have not changed much since I first studied them in the 1980s. Even though stock- and option-based compensation has become more widely used in public firms since the 1980s, management's ownership percentages—and management's upside—remain greater in leveraged buyouts than in public companies.
The second key ingredient is leverage, the borrowing that is done in connection with the transaction. Leverage creates pressure on managers not to waste money, because they must make interest and principal payments. In the United States, and in many other countries, leverage also potentially increases firm value through the tax deductibility of interest. On the flip side, if leverage is too high, the inflexibility of the required payments increases the chance of costly financial distress. This contrasts with the flexibility of payments on equity: Dividends and the like can be reduced or eliminated as market conditions change. Because the very inflexibility of leverage is itself a motivating factor, private-equity firms in a sense impose discipline on their firms' managers by virtue of the fact that they impose higher levels of debt on the companies they acquire.
A third technique, what I call governance engineering, refers to the greater involvement of private-equity investors in the governance of their portfolio companies compared to the directors of public companies. Private-equity portfolio company boards are smaller than comparable public company boards and meet more frequently, around 12 formal meetings per year and many more informal contacts. We can infer, too, that the pressure on management increases because private-equity firms have established a willingness to replace poorly performing managers. Viral Acharya and Conor Kehoe report that one-third of chief executive officers of these firms are replaced in the first 100 days, while two-thirds are replaced at some point over a four-year period. Financial and governance engineering were common by the late 1980s and have remained as common features of private-equity portfolio companies ever since.
Today, most large private-equity firms have added another type of activity that we call operational engineering. This refers to industry and operating expertise that they apply to add value to their investments, and this book seeks to redress the relative lack of attention that this particular aspect of private-equity investment has received. Indeed, most top private-equity firms are now organized around industries. In addition to hiring dealmakers with financial engineering skills, private-equity firms now often hire professionals with operating backgrounds and an industry focus. For example, Lou Gerstner, the former chief executive officer of RJR Nabisco and IBM, was affiliated with The Carlyle Group, while Jack Welch, the former chief executive officer of General Electric, is affiliated with Clayton, Dubilier & Rice. Most top private-equity firms also make use of internal or external consulting groups.
Private-equity firms use their industry and operating knowledge to identify attractive investments, to develop value creation plans for those investments, and to implement the value creation plans. A plan might include elements of cost-cutting opportunities and productivity improvements, strategic changes or repositioning, and acquisition opportunities, as well as management changes and upgrades. The operating partners of these firms can enhance the implementation of such plans by sharing their real-world experience with portfolio company management, offering unique perspectives that aid in the execution of plans and help to enhance results.
Impact on Cash Flow
As far back as the 1980s, when I first studied the impact of private equity on the operating performance of companies, I found that the operating performance of companies improved after they were purchased through leveraged buyouts. For U.S. public-to-private deals in the 1980s, the ratio of operating income to sales increased by 10 to 20%, both in absolute terms and relative to industry peers. The ratio of cash flow (operating income less capital expenditures) to sales increased by roughly 40% among public companies acquired and taken private by private-equity firms. The ratio of capital expenditures to sales declined. These changes coincide with large increases in firm value, again both in absolute terms and relative to industry peers.
Most post-1980s empirical work on private equity and leverage buyouts has focused on buyouts in Europe, largely because of data availability. Consistent with U.S. results during the 1980s, this work finds that leveraged buyouts are associated with significant operating and productivity improvements in the United Kingdom, in France, and in Sweden. In a 2007 paper, the economists Douglas Cumming, Don Siegel, and Mike Wright summarized the research in the United States and Europe and concluded that there "is a general consensus across different methodologies, measures, and time periods regarding a key stylized fact: LBOs, and especially management buyouts, enhance performance and have a salient effect on work practices."
There has been one exception to the largely uniform positive operating results: more recent public-to-private deals. In a study looking at U.S. public-to-private transactions completed from 1990 to 2006, Edie Hotchkiss and colleagues found modest increases in operating and cash flow margins—smaller increases, in fact, than those found in the 1980s, both in the United States and Europe. At the same time, Hotchkiss found high investor returns at the portfolio company level. Acharya and Kehoe found similar results for public-to-private deals in the United Kingdom. These results suggest that post-1980s public-to-private transactions may differ from those of the 1980s and from leveraged buyouts overall.
Impact on Jobs
Critics of leveraged buyouts often argue that these transactions benefit private-equity investors at the expense of employees, who suffer job and wage cuts. Such reductions would be consistent—and, arguably, expected—with the productivity and operating improvements that private-equity firms' portfolio companies achieve. Even so, the political implications of economic gains achieved in this manner would be more negative. For example, the Service Employees International Union, in a 2007 report, questioned the effects of private equity on both job destruction and the quality of those jobs.
Whatever the reputation of private-equity firms as job cutters, the actual employment track record at companies purchased by private-equity firms differs from the slash-and-burn stereotype in the popular press. When I studied U.S. public-to-private buyouts in the 1980s, I found actual employment increases post-buyout, though they were less than for other firms in the same industry. Steve Davis and coauthors, in subsequent research that examined data through 2005, found similar results: employment at leveraged-buyout firms increased, but at a slower rate than at other firms in the same industry during the same time period. Davis' research also found, meanwhile, that firms purchased in leveraged buyouts also experienced smaller employment growth in the time period prior to the buyout transaction. The relative employment declines were concentrated in retail businesses, and there actually was little difference in employment in the manufacturing sector. In new establishments, employment in companies owned by private-equity firms actually increased at a faster pace than in those controlled by non-buyout firms.
Overall, then, the evidence suggests that employment grows at firms that experience leveraged buyouts, but at a slower rate than at other similar firms. These findings are not consistent with concerns over job destruction, but neither are they consistent with the opposite position that firms owned by private industry experience especially strong employment growth. I view the empirical evidence on employment as largely consistent with a view that private-equity portfolio companies create economic value by operating more efficiently. As a group, companies controlled by private-equity firms do not cut jobs willy-nilly, but neither are they likely to add unusually to payrolls, even as business grows, because of their emphasis on bottom-line efficiency.
Excerpted from The MASTERS of PRIVATE EQUITY and VENTURE CAPITAL by ROBERT A. FINKEL DAVID GREISING Copyright © 2010 by Robert Finkel and David Greising. Excerpted by permission of McGraw-Hill. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.