Follow private equity practices, avoid being bought out: Pozen

Follow private equity practices, avoid being bought out: Pozen

The spectre of private equity and the prospect of being snapped up, stripped down, and sold at a colossal profit, all in the name of maximizing value—has shaken traditional managers to the core.

But the best strategy for warding off the buyout pirates, who have been gobbling up and restructuring ever larger companies in recent years, may be to think, act, and manage just like them.

So says Robert Pozen, chairman of the Boston money management firm MFS Investment Management. In a provocative essay in this month’s edition of Harvard Business Review, Pozen contends that the private equity industry— those buyout and hedge funds that have been playing a growing role in the economy—can offer lessons in “value enhancement" to managers and directors of public corporations.

Among the lessons are the importance of running tighter operations and dangling richer incentives. That means reducing cash on the balance sheet and taking on more debt to gain tax advantages. It also means aligning a company’s operating plan, executive rewards, and director appointments to the lodestone of shareholder return.

“Directors of public companies would do well to step back and look with cool eyes at how the top private equity firms have produced such high returns," Pozen wrote. “This is not to suggest that directors of public companies should adopt every strategy or process employed profitably by private equity funds. Some fund managers engage in unsavoury practices that should not be emulated, such as charging excessive transaction fees and ‘flipping’ acquired companies." But businesses intent on staying independent, controlling their destinies, and reaping the benefits of their growth should understand and use private equity techniques, Pozen said.

His preemption advice is especially timely in a year when buyout firms have been acquiring and reshaping companies, such as Chrysler Llc., TXU Corp., and First Data Corp., with multibillion-dollar market values.

Merger and acquisition volume has totalled $3.98 trillion (Rs156.8 trillion) so far in 2007, according to the Thomson Financial research firm in New York. That’s more than the $3.62 trillion total for all of 2006, the busiest year for buyouts since the technology-driven boom of the late 1990s.

Pozen outlined five practices that private equity fund managers employ to unlock value in the companies they buy:

Once buyout portfolio companies have enough cash on hand to cover emergencies, they return as much of the rest as possible to shareholders through dividends or stock buybacks. “You have to be very careful you don’t have cash in your pocket that’s burning a hole," Pozen said in an interview.

Private equity-owned companies typically increase their ratio of debt to equity, lowering their tax exposure and their cost of capital. Public companies, by contrast, remain “overly cautious" about taking on debt, said Pozen.

Sometimes that means spending money smartly, as the buyout giant Kohlberg Kravis Roberts & Co. did on innovative television advertising after it acquired the Duracell battery company in the late 1980s. More often it means controlling costs, eschewing corporate jets or lavish dining rooms and focusing operations squarely on profit growth.

Executive compensation at buyout portfolio companies is weighted toward stock, creating strong incentives to boost value. Pozen cited a study by the McKinsey & Co. consulting firm showing that top executives are given rewards equivalent to 15-20% percent of their companies’ equity.

The goal, said Pozen, is to recruit directors who are experienced in a company’s industry sector, can lend expertise, and are more oriented toward seizing “upside opportunities" than avoiding downside risks.

To evaluate such practices, he proposed that public companies begin with role-playing exercises, letting their risk-averse managers recast themselves as buyout buccaneers.

“I’m suggesting that companies put together a SWAT team that looks at everything in their operations," and says, “‘There are no sacred cows’." Pozen said. “This would be a simulation of what a more shareholder value-oriented company would look like."