Since 2001, private equity firms have invested around $2 trillion (around Rs98.6 trillion) to acquire or take stakes in some 11,000 companies around the world. The current credit environment may have slowed private equity investment this year, but the industry’s footprint and influence remain enormous. Private equity’s unique blend of risks, rewards, challenges and opportunities has changed the way many people think about effectively operating a business.
Illustration: Jayachandran / Mint
What can all businesses learn from the private equity experience? Below are 10 lessons that can be learnt from private equity, drawn from Spencer Stuart’s experience and discussions with leaders in private equity:
• Have an engaged and knowledgeable board: Of all the advantages of private capital, one of those most often cited is the strength and focus of the board of directors. In portfolio company boards, outside directors typically provide valuable operational, functional or industry expertise and can serve as mentors to the chief executive officer, or CEO. Portfolio company directors also have significant equity stakes in their companies. This, private equity executives say, aligns directors with shareholders and the management team, and increases their focus on performance. Ultimately, boards and private equity investors are partners, and this translates into a high level of accountability.
In the case of venture/growth, it is equally important to define the growth plan along with key milestones.
• Develop a clear and compelling plan for changing the business: In most cases, portfolio companies must be strategically transformed and restructured to reach the level of profitable growth required to accomplish the exit strategy, whether it is selling the company or taking it public. What works is investing in an intensive “outside-in session” with management after the transaction closes. This ensures that all agree on a set of facts and data, and together define what full potential is for the business. This can then be converted into a blueprint that details who’s responsible for what and how fast.
• Align equity holders and the management team around business objectives: Portfolio company CEOs and their top executives typically have a significant amount of personal wealth tied up in the portfolio company. As a result, their interests are closely aligned with the interests of shareholders and they have an incentive to accelerate the rate of change. With both management and directors heavily invested in the company, a true partnership develops between the CEO and the board. This leads to great communication about what’s going on in the company, sooner rather than later.
• Be diligent about cash-flow management: “Cash is king” at portfolio companies, so finding new sources of revenue and controlling costs are top priorities for their CEOs. A key player in this effort is the chief financial officer, or CFO, who typically has a commanding role in improving cash flow and driving value. In fact, CFOs are in the best position to challenge a CEO on whether he can do more.
In venture/growth, it is important for CFOs to have a keen, forward-looking view on burn rate, working capital and hence, capital calls from investors.
• Focus on growth and building value: The private equity environment allows its leaders to focus the organization on a few clear objectives aimed at value creation. In addition, the relationship between the board and management creates a culture of accountability for performance. The performance demand on the CEO is also more direct in private equity. While a public company director might present a concern indirectly in the form of CEO coaching, portfolio company directors are more likely to be direct.
• Act decisively: Management teams and boards of portfolio companies are analytical—ideas are presented and evaluated based on their potential impact on income or cash flow—and important decisions can be made without involving layers of management or external stakeholders. Board members, particularly those from the private equity investor, speak frequently with the management, helping streamline decision making. What could be more powerful than a CEO reflecting on an idea with his or her top shareholder who owns 70% or more of the company?
• Plan for the longer term: Quarterly financial reporting is a fact of life for public companies and will likely continue to be. With this focus on quarterly results, however, the public environment can be hypercritical in the short term and less strategically oriented. The finite time frame for achieving an exit strategy, typically three-five years, gives structure to portfolio company plans and encourages risk-taking that may pay off over the medium- to longer-term. Private equity tends to have a greater appetite for risk, making it easier for portfolio companies to make dramatic moves or embark on fundamental changes in strategy.
• Cultivate a sense of urgency: In a portfolio company, the leverage and alignment of management incentives with company performance combine to create a “burning platform for change”. This burning platform encourages an action-oriented culture, with a bias towards making decisions. In buyout situations, the higher debt level creates a crisis. There’s not as much room for error when one has a leveraged balance sheet, so it makes management very proactive and creates an atmosphere that encourages people to make decisions and act.
In venture/growth, while it may not be a leveraged situation, the rapidly evolving market context demands the same kind of urgency.
• Draw on expert advisers: When they are looking for investment opportunities or need advice during the due diligence process, private equity firms tap their networks of operating executives, advisory board members and board directors of other portfolio companies as resources. When a challenge arises or a portfolio company needs help opening a new door, the CEO and board members are able to reach out across the family of portfolio companies to find the expertise they need.
• Back the initial team but be willing to make changes when necessary: Many private capital firms invest in companies based on the strength of the management team. Others parachute trusted leaders into new investments or those that are struggling. Regardless of their approach, private equity firms recognize the critical importance of strong, effective leadership to the success of their investments.
As the primary shareholder, a private capital firm can also move quickly to replace an executive when necessary without having to worry about the reactions of analysts or the public. They are able to tap their CEO networks or bring in an executive-in-waiting if they need to make a change or supplement the existing team. Still, removing an executive in a private equity environment is not done lightly. There is always a sincere attempt to be as supportive as possible but if the problem is clear, there’s no inertia about making a change.
Portfolio companies enjoy a number of advantages when it comes to building efficient, high-growth businesses, including their ownership and compensation models, fewer competing distractions and the power of leverage. And while public companies will not be free any time soon from governance rules or the demands of a larger pool of stakeholders, private equity’s profit focus can be adapted to the public environment by including a robust and engaged board of directors.
A strong board that works effectively with the CEO to set strategy and holds the CEO accountable for results is essential to the success of any company, public or private. Attracting the very best directors begins with an effective nominating process. Wise boards will want to foresee where the company is headed and take advantage of natural attrition to recruit directors with the expertise required to help the company respond to the new challenges and opportunities it will face.
• A culture of urgency: In the absence of the high debt levels under which most portfolio companies operate, a public company CEO has to create a culture that is decisive and action-oriented. To do this, the CEO needs to work with the board and management to create a partnership based on performance.
• A talent assessment process that identifies and develops outstanding leaders: A primary responsibility of the board and CEO is to ensure that the company has succession-planning and assessment processes in place. Times of change, such as a major strategy shift or change in organizational structure, are natural opportunities to reflect on the strength of the management team, determine whether the right people are in each role and identify leadership gaps.
Naturally, private equity leaders are proud of their success in turning around troubled companies and improving the performance of others, thus creating value for their investors, their management team and their companies. These 10 lessons from their experience suggest ways that all companies might perform at higher levels.
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The article is based on a paper written by Spencer Stuart consultants Catherine Bright, Jonathan Visbal and Nick Young, who lead the firm’s private equity practice in Europe, global technology, communications and media practice and the private equity practice in North America, respectively, with inputs from Anjali Bansal. Bansal, who heads the India practice of Spencer Stuart, an executive search consulting firm, is based in the firm’s Mumbai office.