Lessons from Private Equity Any Company Can Use

Orit Gadiesh, Hugh Macarthur

• Publisher: Harvard Business Review Press
• Year: 2008
• Print ISBN: 9781422124956
• eBook ISBN: 9781422156322
• Topic: Business
• Subtopic: Business Strategy
• Index: Business

Private equity firms are snapping up brand-name companies and assembling portfolios that make them immense global conglomerates. They're often able to maximize investor value far more successfully than traditional public companies. How do PE firms become such powerhouses? Learn how, in Lessons from Private Equity Any Company Can Use. Bain chairman Orit Gadiesh and partner Hugh MacArthur use the concise, actionable format of a memo to lay out the five disciplines that PE firms use to attain their edge:· Invest with a thesis using a specific, appropriate 3-5-year goal· Create a blueprint for change--a road map for initiatives that will generate the most value for your company within that time frame· Measure only what matters--such as cash, key market intelligence, and critical operating data· Hire, motivate, and retain hungry managers--people who think like owners· Make equity sweat--by making cash scarce, and forcing managers to redeploy underperforming capital in productive directionsThis is the PE formulate for unleashing a company's true potential.

Define the Full Potential

The PE game has changed, and here is how.

The way PE funds made money in the 1980s, and for most of the 1990s, was relatively simple. They used networks of contacts to source proprietary deals. Next, they loaded these assets up with debt, sometimes up to 90 percent of the capital structure, thus keeping the equity check needed to buy the business very modest. Over time, as these assets threw off cash, the debt was paid down. Eventually the assets were sold—often for a higher multiple of earnings before interest, taxes, depreciation, and amortization (EBITDA, a measure often used as a proxy for cash flow from operations)—in rising markets. The combination of low entry prices, lots of leverage, and higher exit multiples produced a “perfect storm” of good results: high IRRs and cash-on-cash returns.

For better than a decade, this model was a money machine—but no more. Today, the truly outstanding PE firms have replaced passive stewardship with a hands-on approach to building value in their portfolio companies. Why? Mainly because the engine that generated all those great returns in the past has been sputtering for some time. Almost all properties of more than $100 million in total enterprise value are now sold at auction by aggressive investment banks. The high PE returns of the 1980s attracted an avalanche of new funds—and competition. Today, it is all but impossible to buy assets at a discount to potential value. And we have recently observed that while the debt markets in the 2003–2007 period helped produce spectacular returns by allowing debt multiple levels to increase to amounts not seen since the late 1980s, the future debt cycle will almost assuredly be less friendly than during the past few years.

So at the beginning of this new day in PE, there is really only one way to swim against competitive currents and cyclical market conditions: creating operating value. Increasing the cash flow (and hence the value) of acquired companies is the process that the best PE firms are vigorously pursuing to keep generating attractive returns. Shifting gears as soon as a deal is completed, they use a systematic approach to collaborate with management and spot, stage, lead, measure, and profit from strategic and operational improvements.

They get richly rewarded for that systematic approach. Our experience shows that PE deal makers who in the first year of ownership actively plan and launch initiatives using a reliable and repeatable process, earn a cash-on-cash return on their investment that is better than 2.5 times the average industry return.

That fact brings us to the main theme of this section: the starting point for this strong performance begins with defining the full potential of the business in question.

How do PE players accomplish this, and how might it translate into a context outside of PE ownership?

The PE Approach to Defining the Full Potential

The first thing that the best PE firms do is to develop a clear understanding of where and how a business makes money and why they’d want to own it. They conduct a rigorous and dispassionate due diligence, building an objective fact base of the business and its industry. This might be called a “strategic” due diligence, for reasons that will become clear shortly. Typically, they focus on at least five things:⁷

• Derived demand analysis (What are the true underlying drivers, how are they changing, and how will they affect demand?)
• Customer analysis (What are this business’s customers going to do?)
• Competitive analysis (What are this business’s competitors doing, and how does it stack up against this business?)
• Environmental analysis (Are there technological, regulatory, or other issues or trends that may affect future performance positively or negatively?)
• Microeconomic analysis (How does this business really make money and where?)

PE firms then set an equity target value for a point in time that is generally three to five years out, based on their due diligence findings, their reading of the full potential of the business and the planned financial structure. The target is based, too, on the assumption that they will be successful at injecting new thinking into the company if required, and that they will be able to partner with management in steering the company toward embracing required changes.

In this era of intense competition, PE firms need to find a reason to pay more than competing strategic and financial buyers. The only compelling reason to pay more than the next bidder is the discovery that the microeconomics of the business can be better than conventional wisdom would imply.

Conversely, the best PE firms are acutely attuned to any red flags that might persuade them to bow out of the process. Like you, PE deal makers are busy; they can’t spend their time on low-probability bets. Meanwhile, they are well aware that in most cases, there’s someone out there who will overpay for this asset, in part because not everyone is conducting a comparable strategic due diligence. The attitude is, “If someone wants to overpay, fine; it’s just not going to be us!”

Top PE buyers never assume that they know everything about the business that they are looking at or the industry it is in. They are also aware that every business and industry is a moving target. So even if they know something about the company or industry at hand, they ask endless questions. (Advance knowledge can certainly lead to sharper questions at the outset, but there is always plenty of homework still to be done.) They live by the motto “In God we trust. All others bring data.”

Good investors put little faith in the offering books that are put together for companies that are on the block. These books are compiled mainly based on market research reports and analysts’ reports, which in turn are largely informed by off-the-shelf data. For example, these books rarely look deeply into the demand drivers that industry growth will depend on in the future. Those preparing them usually just take historical growth rates and tweak them a bit using management estimates of future growth and the readily available market research reports. Obviously, market research reports can be, and often are, wrong. It certainly makes no sense to double-check offering books with the same sources used by the bankers who put them together in the first place!

Instead, the best PE buyers do their own homework. They and their advisers drill deeply into the key drivers of demand and how they might behave in the future. They interview the key decision makers in the customer base, making sure they cover a majority of the target company’s revenues. They approach suppliers the same way, looking at costs. They always analyze the competition (where possible, they interview competitors) and dig out information relating to their strategy, operations, cost position, technological sophistication, financial situation, and so on.

What are smart buyers looking for? They are looking to determine what the full potential of the business is and what it could be worth in three to five years. This becomes their target equity value. At the same time, they are looking to identify the few key initiatives that should be emphasized to reach that full potential. Planning to do a dozen things simultaneously usually turns into a recipe for disappointment. Instead, the PE buyer focuses on three to five critical initiatives—and also makes it clear what the company is not going to do. This process helps ensure the business does not waste time, money, and management bandwidth on the wrong issues. In our experience, the discipline of not doing things can preserve tremendous value. Therefore, identifying the full potential path early is critical.

Of paramount interest to most PE buyers is the time frame to reach full potential. While the key initiatives on their short list typically range from immediate to longer-term impact, many PE buyers adopt a three- to five-year time horizon for their full potential plan to materialize—which corresponds with their average anticipated length of overall investment in the company. There are PE players whose time frame is somewhat longer; these players may well invest in even longer-term initiatives. And as CEOs like Peter Brabeck will point out quite graphically, the returns available to companies purposed to sustain a business—for example, to breed and raise cows and sustain a dairy for the long term—will be different from those aimed to acquire and resell—to buy a few cows, milk them hard, and send them to the slaughterhouse.

But smart PE owners, too, must think about sustainability. Because they will be selling the business to another buyer at some point, they need to ensure that the company they have invested in has a sustainable wealth creation platform. Without it, the next set of owners doing their strategic due diligence (be they private owners or public markets) will likely sniff out future value deterioration, which could devastate the seller’s returns.

So, three to five years might be the starting point (and the point at which most things are reasonably actionable for most companies), but it is by no means the end point.

There are examples of companies in both the United States and Europe that are on their fourth or fifth successive private equity owner—with each owner making good returns upon exit. Take, for example, French plumbing supply group Frans Bonhomme SA, which has been bought and sold four times in eleven years—each time for a profit. In such cases, the next PE firm often continues implementing what the previous one started, making substantial changes only if they think they can add further value. True, PE firms sell. But they must sell because they have to repatriate capital to their limited partners—that is part of their business model. It has nothing to do with the validity of the portfolio company business model they’ve created. In fact, the nice thing about PE firms cashing out is that it shows us how they did in a very tangible way.

For Example?

One case in point involves the Sealy Corporation, the mattress maker that was purchased in 1997 by an investment group led by Bain Capital and Charlesbank Capital Partners.⁸ Together with Sealy’s management, the two PE firms assembled a team to launch an appraisal of the company’s competitive position, prioritize opportunities to improve performance, and develop a detailed road map to guide implementation. The team probed every corner of Sealy’s business and challenged every assumption. This involved reviewing Sealy’s growth record and underlying trends; analyzing its cost structure and drivers of increasing costs; closely examining competitors’ performance and products; interviewing and segmenting both customers (retail) and consumers; and for each segment, determining its product and service requirements.

What did they discover under the mattress? A lot of unexpected, actionable facts:

• Sealy had a cost disadvantage, and its sales mix had shifted toward the less profitable portions of its product line. As a result, Sealy’s profit margin was declining while its main competitors’ margins were improving.
• Although the complexity of Sealy’s product line was increasing, this was not the primary driver of the company’s cost problem. While complexity generated some additional costs, product differentiation was critical to support high retail and manufacturer margins.
• Retail floor space for selling mattresses was highly constrained, and the best opportunity to boost profits lay in trading up slots to higher price points.
• Sealy had a particularly low share in smaller accounts. Yet this segment offered higher margins and faster growth than Sealy’s typical customers. This was a pleasant surprise as management had not fully appreciated the profitability of higher-end, mom-and-pop stores and therefore had not honed an operating model for cost-effectively serving them.

As a result of this rigorous assessment of Sealy’s true full potential, the two PE firms set a valuecreation target of five times their equity investment. To reach that target, they zeroed in on a few crucial initiatives.

One of the key initiatives was a complete redesign of Sealy’s core Posturepedic mattress line. Critically, Sealy shifted away from a costly, two-sided design that allowed mattress owners to do something most didn’t bother to: flip their mattresses. Instead, Sealy designed a new and improved “no flip” mattress whose technology improved Sealy’s margins and leapfrogged the technology of its chief rival, Simmons, which had been selling a one-sided mattress for years. Three other major initiatives that sprang from Sealy’s fullpotential assessment involved account planning strategies and tools, pricing, and manufacturing changes to reduce material yield loss.

This rigorous assessment also revealed what Sealy should not do. For example, before the sale, Sealy’s management team had mapped out a plan to increase revenues by its volume of mid-priced mattresses. A detailed product profitability analysis convinced Sealy management that concentrating on higher price points would raise profitability and reward its retailers most. This was accomplished in two ways: by focusing the redesign of Sealy’s core mattress line on the targeted price points; and by developing decision-making tools that would assist sales reps in maximizing the profitability of each account’s merchandising mix.

The key growth and cost-cutting initiatives increased EBITDA by more than 50 percent over three years.

Defining the company’s full potential, including a target value and a short list of key initiatives, is only the preamble to the down-in-the-trenches activities that come in the blueprint-development phase (as described in the next section). But before we leave our Sealy case study behind, it is worth fast-forwarding to reveal how the story turned out. In 2004, Sealy’s owners sold the company to Kohlberg Kravis Roberts & Company (KKR), netting a better than fivefold return on equity. KKR willingly paid this price because of the strength of the full-potential plan and clear momentum in results already banked. Under KKR ownership, Sealy continued to grow EBITDA and reap the benefits of the full-potential program.

Your Approach to Defining the Company ’s Full Potential

How does this full-potential exercise apply to a public or private company?

Obviously, to the extent that you are in the acquisitions game, you would benefit from being among the best-informed bidders at the table. But our focus here is ...

Table of contents

• Cover
• Copyright
• Publisher’s Note: Memo to the CEO
• Introducing the Private Equity Advantage
• What Is Going On in Private Equity?
• How Can PE Lessons Apply to You?
• Define the Full Potential
• Develop the Blueprint
• Accelerate Performance
• Harness the Talent
• Make Equity Sweat
• Foster a Results-Oriented Mind-set
• Conclusion
• Lessons
• Notes
• About the Authors