Corporate Governance and Value Creation:

Private Equity Style Private Equity Style

November 2009
Fir M Geenen Fir M. Geenen
Sohail Malad
3580 Carmel Mountain Road, Suite 460 San Diego, CA 92130 P: 858-764-4500 E: info@harlingwood.com
www.harlingwood.com
Corporate Governance and Value
Creation: Private Equity Style
According to studies published by Bain & Company and leading academic
researchers, private equity firms have exceeded the returns provided by the top quartile
of the S&P 500 by 25% to 50% depending on the length of time measured
1
. What
aspects of private equity investing are responsible for this return premium? While there is
no doubt that optimizing capital structure with increased leverage will continue to be a
lever used in private equity it would be a mistake to attribute private equitys success to
Introduction
lever used in private equity, it would be a mistake to attribute private equity s success to
financial engineering alone. According to a McKinsey study, 63% of private equitys
superior returns relative to market returns come from operational outperformance
2
. This
means that while capital structure plays some role in returns, the greater majority of
returns are an outcome of specific actions taken by private equity firms.
In this paper, Harlingwood will deconstruct the private equity investment approach to
reveal insights which can be applied to value creation in public equity. We will begin with
empirical data to demonstrate how private equity has been successful. Then review the p p q y
private equity process through the stages of due diligence, strategic review and
governance to show how, in each phase, private equity firms differentiate themselves from
passive investors in creating value. We focus on how the private equity approach to
governance provides a catalyst for value creation.
Private Equity Performance
Performance data for private equity firms is difficult to obtain as firms are not required Performance data for private equity firms is difficult to obtain as firms are not required
to publicly disclose performance. Depending on the sample set and time period, results
indicate that well established private equity firms provide superior returns relative to the
market
1
. Furthermore, data confirms the outperformance provided by the private equity
firms was sustained over long periods of time and did not exhibit the year over year
variances seen in the broader market. Leading private equity firms have provided greater
returns with less volatility perhaps explaining the merits of private equity as a long term
investment strategy.
Fund Type 1 Year 3 Year 5 Year 10 Year 20 Year
Small Buyouts
48.3 8.9 2.4 7.2 26.3
Venture Economics US Private Equity Performance Index Returns (%)
3
Med Buyouts
34.2 8.6 0.2 10.2 17.9
All Private Equity
27.0 11.3 -0.8 12.4 14.3
S&P 500
10.2 14.7 -3.1 7.7 11.2
1
Corporate Governance and Value
Creation: Private Equity Style
Looking beyond investment returns, an Ernst & Young LLP (E&Y) study examines private
equity from a holistic standpoint to evaluate company performance relative to peer public
companies. In 2007, the enterprise value (EV) of the 100 largest global private equity
exits grew at a compounded annual growth rate of double their public company
counterparts
4
. This outperformance spanned across deal sizes, geography and industry
sectors. Furthermore, private equity portfolio companies exceeded EBITDA growth of public
company peers by 60%. Finally in what E&Y describes as a measure of employee
productivity, EBITDA per employee, private equity companies yielded a 50% premium
compared to public companies. An interesting corollary to this last metric is from 2000 to
2003 it was found that companies purchased by private equity firms created an
additional 600,000 jobs
5
. This defies the notion that private equity firms realize value
through slash and burn tactics.
Compound Annual Growth Rate, Public vs. Private Equity: 2007
30%
0%
10%
20%
C
A
G
R
The illustrative point is private equity firms have shown an ability to leverage assets in
more productive ways than public company peers.
Moreover, an August 2009 study by the Stanford Graduate School of Business reveals
that once private equity held companies revert back to public ownership any operational
EV EBITDA EBITDA/Employee
Private Equity Public Equity
Due Diligence
that once private equity held companies revert back to public ownership any operational
improvements realized disappear within one to two years
6
. This is a troubling statistic for
the public company manager as it alludes to something endemic to the public company
structure that erodes value. What is it about private equity ownership that results in
greater operational discipline? Why are private equity investors rewarded with returns that
public company stakeholders find elusive? To answer this question we start at the
beginning of the private equity process: due diligence.
Since we cannot delve into all components of due diligence, we highlight the one
significant aspect that differentiates private equity investing from that of public equity -
access to information. Prior to the passing of Regulation Full Disclosure (Reg FD) in
October of 2000, it was possible for privileged institutional investors to receive
information not generally available to the broader market. As a result, companies are
required to provide the same information to all investors, effectively closing the
information gap separating large investors from smaller investors. Reg FD instituted certain
disclosure requirements providing a minimum bar of information to be disclosed, which
i d d h d Th f hil R FD h
2
some companies exceed and others do not. Therefore, while Reg FD may have
succeeded in leveling the playing field in terms of information disclosed, it did not
equalize the quality or distribution of information. This interchange between the quality
and distribution of information remains a key challenge to public equity investing
7
.
Corporate Governance and Value
Creation: Private Equity Style
Public company investors
have to rely on haphazard
access to information and
varying degrees of quality
R
i
c
h
n
e
s
s
SEC
Filings
Shareholder
interviews
Analyst
coverage
In private equity the barriers to quality and accessible information are reduced In order
varying degrees of quality
R
Road
shows
Media
outlets
Press
release
Reach
In private equity, the barriers to quality and accessible information are reduced. In order
to attract capital, management must be receptive to a comprehensive review of all
information and make themselves available to answer questions. The opaqueness that
frustrates public equity investors and may even result in dubious practices to acquire
information is unnecessary. A comprehensive due diligence process reveals more than
data, it allows skilled investors to review all assets to assess investment risk and
opportunity.
Since private equity firms are privy to internal information, they can review data with a p q y p y , y
critical eye. For example, with access to an organizations database, an experienced
analyst can examine product costing and margins, can review customer profitability and
identify trends which may speak to customer retention risk. These are examples of a
detailed layer of information that the public equity investor does not benefit from, yet
may be critical to an investment decision. With greater access to information, private
equity investors go deeper and dedicate more man hours on research, ultimately leading
to a better understanding of investment risk and the necessary premium required to
compensate for invested capital.
In 2006, the average premium paid by private equity investors to purchase a publicly
traded company (a Go Private transaction) was approximately 28%
8
. Typically, private
equity firms target at least a 15-20% annual internal rate of return. How do private
equity firms achieve this return in such a short period of time?
Private equity firms take great care in designing and executing a strategic blueprint that
Strategic Roadmap
Private equity firms take great care in designing and executing a strategic blueprint that
views each business unit relative to its current contribution and perceived potential.
During the due diligence period, private equity investors work with management, industry
experts and consultants to formulate a detailed plan that specifies all elements of the
strategy relative to time. The strategic plan is not a separate plan that runs parallel to
the business as usual or budget plan, but is the exclusive plan that relies on all
constituents for its success. Once approved, the plan is communicated to all levels of the
organization so stakeholders understand their role in implementation. This atmosphere of
accountability and leadership is a key ingredient to target realization
3
accountability and leadership is a key ingredient to target realization.
Corporate Governance and Value
Creation: Private Equity Style
Value creation often comes from margin improvement. According to a study by Kaplan
and Schoar, mature private equity firms create value for portfolio companies through
initiatives that substantially improve margins. In contrast, based on a 2008 study by
Acharya, Kehoe, and Reyner only 36% of public company boards rate themselves as
focused and successful with cost reduction plans
9
. This statistic is telling in that it
suggests that the public company CEO may be less inclined to cut costs than he or she
is in finding and funding growth. In time, management can lose its ability to approach the
business from a perspective that identifies cost saving opportunities Private equity firms business from a perspective that identifies cost saving opportunities. Private equity firms
can provide objective insight that can help management reformulate an existing business.
Increasingly, active-oriented public equity investors are making the choice to narrow
information asymmetry and influence strategy by signing non-disclosure agreements that
restrict trading. The increasing frequency of public equity investors trading liquidity for
access and a voice is indicative of the value that a private equity approach provides.
Harlingwood believes that even with access to the same level of information it will be
hard for public equity investors to replicate the private equity value creation model. It is hard for public equity investors to replicate the private equity value creation model. It is
not just information asymmetry that distinguishes the two approaches; it is how the
private equity firm engages corporate leadership in synthesizing the information, financing
the opportunity and mitigating the investment risk with intense focus on implementation
of the strategic plan.
Governance
Depending on the context, corporate governance can encompass everything from Depending on the context, corporate governance can encompass everything from
executive compensation to regulatory compliance. We narrow the scope of governance to
address the critical differentiator between public and private equity owned firms - board
level stewardship. The private equity board member allocates significantly more time than
his public equity counterpart in governing for value. This greater oversight combined with
appropriate risk management, capital allocation and an alignment of incentives directly
impacts value creation.
Surveys show that a private equity partner spends two to three days a week of their time
on a single investment during the initial investment phase and about one to two days a
week during the holding period. McKinsey research has shown the average private equity
director spends three times the amount of time in their role (fifty-four days versus
nineteen days annually) relative to his public equity counterpart
10
. This metric does not
include non-director private equity staff who also allocates their time to investment
success. The reason for the wide disparity in allocated time relates to ownership. Most
public company boards are comprised of management from other companies or retired
managers who do not have a material financial stake in company performance. In
contrast private equity boards are typically comprised of private equity representatives contrast, private equity boards are typically comprised of private equity representatives
with either a large ownership interest or a compensation incentive tied to the amount of
value created by their efforts. Private equity directors are supported by internal teams
who evaluate and analyze, with a critical eye, management presentations and board
materials. The relative difference between private and public equity boards is highlighted
by a McKinsey survey which queried directors who served in both capacities and have
rated private equity boards to be far more effective than their public company
counterparts
11
.
4
Corporate Governance and Value
Creation: Private Equity Style
Effectiveness: Public Equity Boards vs. Private Equity Boards
Survey of Directors on 1-5 Scale (1 = Least Effective, 5 = Most Effective)
5
Source: McKinsey
interview with 20
Directors serving in
both public and
private companies
over past 5 years
with enterprise value
greater $500 million
2
3
4
0
1
Overall
Effectiveness
Strategic
Leadership
Performance Mgmt Development /
Mgmt Succession
Stakeholder Mgmt
Private Equity Boards Public Equity Boards
A critical aspect of board stewardship is the oversight provided in the capital allocation
process. The significance of capital allocation is emphasized by Warren Buffet who has
said, I really have only two jobs. One is to attract and keep outstanding managers to
run our various operations. The other is capital allocation
1
. Private equity firms view
capital allocation as more than a budgeting exercise, as every dollar invested in the
company has to exceed what the dollar could earn in the pockets of its owners. This is
i di i i b bli i h fli i b
Private Equity Boards Public Equity Boards
an important distinction between public equity where an agency conflict exists between
owners and their managers who may be incentivized to grow the business even if the
resulting return does not exceed the cost of capital. When it comes to using capital to
grow the business, private equity investors are emphatic that investments provide a return
in excess of the companys true cost of capital and map to the strategic value creation
plan. Often due to the use of leverage in private equity financing there is built in
protection from imprudent capital allocation decisions as cash is needed to service debt.
Capital Allocation Approach & Ownership Capital Allocation Approach & Ownership
Owner vs. Non-Owner
Strategically sound, part of value
creation blueprint
Meet financial target, i.e. revenue, EPS
Near-term path to return realization Increase organizational influence
Return > WACC Protect year over year budget
5
Return > WACC Protect year over year budget
Corporate Governance and Value
Creation: Private Equity Style
Private equity firms ensure agency conflict between owners and management is mitigated
by providing management with considerable ownership. According to Oyer and Leslie, on
average, private equity firms provide the CEO two times the equity relative to the public
company, but with a 9.6% lower salary and a 12.7% variable pay share
6
. Since private
equity compensation is largely delivered based on exit value, there is little management
incentive to make decisions that improve short term results at the expense of long term
value creation. Compensation is engineered to ensure that the owners objective for high
asset value matches that of management. In order to track management progress, private g g p g , p
equity firms are skilled in finding the right metrics to assess managements ability. With
detailed expectations and milestones laid out in a formal strategic plan, there is less
subjectivity when it comes to determining success or failure. In the event of non-
performance, private equity investors are typically much quicker to insist on operational
or management changes. Concentrated ownership provides for consistent directives that
drive accountability and ensure management and investor are aligned. As a result, private
equity management is not afforded the same latitude as their public equity peers for
subpar performance.
Public Equity Private Equity
Director Commitment
Average of 19 days per
year. Typically one of
Average of 54 days per
year. Core function. Part
f j b & i d
The table below highlights the aforementioned aspects that differentiate private equity
boards from their public company counterparts when it comes to corporate stewardship.
Director Commitment year. Typically one of
many responsibilities.
of job & incented to
invest time.
Risk Profile
Avoidance. Focus on
compliance (i.e. SOX)
Manage. Risk versus
return trade-off.
Capital Allocation
Part of overall
budgeting process
Cost of capital hurdle with
near-term realization.
Salaries bonuses often
Incentives
Salaries, bonuses often
tied to accounting
measured EPS.
Tied to value creation
Management Execution
Quarter to quarter
earnings. GAAP-based
metrics.
Execution of long-term
strategic plan. Focused
on value creation.
Performance Oversight Shareholder motivated Plan realization/execution
Ultimately, private equity investors succeed because they are viewed by management as
facilitators that provide capital and an abundance of experience when it comes to
strategy realization. Many of the traits described are associated with activist public
equity investors. However, the chief differentiator is that activism implies that these
investors act more as agitators for value versus collaborators for value. In consequence,
activists can be viewed as a minority with a disgruntled view, outnumbered and
handicapped when it comes to providing other critical aspects of governance. Private
l ll b h l h
6
equity style governance requires collaboration with management to implement the aspects
of corporate stewardship that enable superior value creation.
Corporate Governance and Value
Creation: Private Equity Style
Conclusion
This paper highlights what Harlingwood considers critical facets of the private equity
approach that when applied to public equity investments will yield greater returns. To
successfully pursue the value journey, public directors and private equity investors must
monitor progress along three major themes:
(1) Comprehensive knowledge of opportunities and risks across all business units and p g pp
product lines.
(2) Go beyond simplistic EPS metrics to value-based metrics that drive cash
flow, improve portfolio value and reduce risk. These include return on invested
capital, customer retention, customer value, growth, market size and market share
trends, to name just a few.
(3) In order to be effective at monitoring for improved value, public company directors
and private equity investors must be verywell preparedand highly engaged to ensure
the appropriate alignment of all constituents such that all constituents are focused on
h i f di bl d i bl l the creation of predictable and sustainable value.
The private equity model is compelling and will appeal to corporate leaders who are
looking at creating, executing, and overseeing a strategic plan designed for value
creation.
7
Corporate Governance and Value
Creation: Private Equity Style
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2.
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E t & Y LLP H d P i t E it I t C t V l ? A Gl b l St d f 2007 E it
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9
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10.
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11.
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8