One of our portfolio company CEOs sent me a really interesting comparison of the PE business model with the public company business model. “What private-equity strategy planners can teach public companies” By Matt Fitzpatrick, Karl Keliner, and Ron Williams (Link Here) is a ringing endorsement for several value creation techniques that PE managers employ. Matt Fitzpatrick is a partner in McKinsey’s New York office, where Karl Keliner is a senior partner. Ron Williams is the former chairman and CEO of Aetna; a Director on the boards of American Express, Boeing, and Johnson & Johnson and an adviser to private equity firm Clayton, Dubilier & Rice.
The authors point out those PE managers cannot afford to underperform or else they lose access to follow on funding. This is contrasted to the public markets where it seems like the managers are often paid handsomely for failing and then leaving to “spend more time with their families. The authors also see PE firms pursuing distinctly different value creation strategies. The public managers have to adopt strategies that will work quarter by quarter to appease institutional investors and support stock prices. PE managers have to adopt strategies that will enhance value over a 7-10 year period. One thing the article does not say but is also a distinctive difference is the alignment of rewards. PE managers usually invest meaningful capital at closing which is augmented by option programs tied to an exit and realization at a multiple of the original investment. It is not unusual for that option program not to kick in until the limited partners have received 2.0-2.5x cash on cash return at which point the management team’s options accrue. In a public company the strike price for the option is usually trading price at time of grant. Misalignment should not occur in the PE model but it is fairly common for public managers to exercise options and sell the underlying stock based on short term achievements even though the long term trend may be otherwise.
PE Professional Are Good Strategists
The authors like the 100 day planning process that almost all PE firms employ immediately after they have acquired a company. Here is their contrast: “During the 100-day planning process, private-equity firms are more active than public companies in considering the furthest horizons of strategic planning. Public companies often focus on nearer-term objectives, including existing baseline products and emerging product lines, though longer-term bets can help to create significant longer-term value. Typically, private equity firms more actively identify and emphasize strategic planning’s third horizon, including new markets and products and diligently makes tactical bets on it. For example, when PE firm Clayton Dubilier & Rice (CD&R) acquired PharMEDium for $900 million, in 2014, it hadn’t previously invested in outpatient care. But managers identified this as a major growth opportunity and made a calculated bet that paid off handsomely. CD&R ultimately sold the business for $2.6 billion.”
PE Managers May Have More Freedom to Allocate Capital
The authors also point out that Public Companies face more intense competition for capital. Managing EPS often means using cash for stock buy backs and shareholders seeking yield are highly focused on the public company dividend policy. The PE managers often look at capital allocation at the Fund level and tend to feed winners and starve losers without third party influence. In fact, most PE organizational documents limit the concentration of capital in any one investment to not more than 15-20% of the portfolio. The governance model for PE portfolio companies also helps rational capital allocation because each business unit has its own advisory board comprised of PE professionals and outsiders who can bring industry knowledge and tactical experience on matters like pricing and operational excellence. These Advisors usually invest a meaningful amount of their own capital at closing and are highly aligned to the performance of the portfolio company. There is often no comparable governance model in the public sphere even in cases where the company has unrelated business units.
PE Managers Are Highly Skilled at M&A
The McKinsey report also notes that Private Equity focuses its people on making M&A a competitive advantage. The ability to conceive and execute a value enhancing acquisition is difficult and fraught with “first time” risks. When you are buying and integrating across a portfolio of companies with the same PE teams leading all the deals and supporting management you tend to see better outcomes than the public model where a business unit manager is supported by internal corporate development teams and outside advisors who are often not aligned in their compensation to the final outcomes. The authors also make the point that PE managers are not just good at buying but they are often excellent sellers as well.
It is pretty typical for PE managers to collaborate with portfolio company managers plan during the first 100 days for how they are going to add value and enhance the attractiveness of a portfolio company in the M&A markets. While exit strategy does not trump business strategy, it often compliments it. The selling part of the PE model is also where management and the PE owners align. A realization, cash on cash return above target thresholds, gives both owner and manager the same pay day. The PE model also allows leveraged dividends when cash generators can refinance at low interest rates. There are many times when the market is not right for a sale because there is improvement in process but a leveraged dividend could make complete sense. The low interest rate environment encourages our industry to look at returning capital when it can.
The PE Model Focuses On Cash Flow
While it seems to be a distinction without a difference, there is a huge contrast between a business model where you maximize cash flow to pay down debt and a model where you manage to create earnings. It is true that it is usually hard to have cash flow without earnings but it is almost impossible to convert earnings to cash flow when the shareholders want it all back. By having a guillotine of debt hanging over your head each day, you learn to maximize cash flow by managing working capital, watching expenses and augmenting earnings through pricing and vendor management. As I have written in the past, debt is an insistent mistress and quite jealous of attention to anything other than her needs which means covenant compliance and speedy amortization.
While our public markets are the bedrock of American capitalism, the private equity industry is making a strong statement for why its business model may be better suited to longer term value creation.
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Rob McCreary, Chairman
October 20, 2016