corporate governance and value creation - private equity style

Corporate Governance and Value Creation: Private Equity StylePrivate Equity Style

November 2009

Fir M GeenenFir M. GeenenSohail Malad

3580 Carmel Mountain Road, Suite 460 • San Diego, CA 92130 • P: 858-764-4500 • E: [email protected]

Corporate Governance and Value Creation: Private Equity Style

According to studies published by Bain & Company and leading academicresearchers, private equity firms have exceeded the returns provided by the top quartileof the S&P 500 by 25% to 50% depending on the length of time measured1. Whataspects of private equity investing are responsible for this return premium? While there isno doubt that optimizing capital structure with increased leverage will continue to be alever used in private equity it would be a mistake to attribute private equity’s success to

Introduction

lever used in private equity, it would be a mistake to attribute private equity s success tofinancial engineering alone. According to a McKinsey study, 63% of private equity’ssuperior returns relative to market returns come from operational outperformance2. Thismeans that while capital structure plays some role in returns, the greater majority ofreturns are an outcome of specific actions taken by private equity firms.

In this paper, Harlingwood will deconstruct the private equity investment approach toreveal insights which can be applied to value creation in public equity. We will begin withempirical data to demonstrate how private equity has been successful. Then review thep p q yprivate equity process through the stages of due diligence, strategic review andgovernance to show how, in each phase, private equity firms differentiate themselves frompassive investors in creating value. We focus on how the private equity approach togovernance provides a catalyst for value creation.

Private Equity PerformancePerformance data for private equity firms is difficult to obtain as firms are not requiredPerformance data for private equity firms is difficult to obtain as firms are not requiredto publicly disclose performance. Depending on the sample set and time period, resultsindicate that well established private equity firms provide superior returns relative to themarket1. Furthermore, data confirms the outperformance provided by the private equityfirms was sustained over long periods of time and did not exhibit the year over yearvariances seen in the broader market. Leading private equity firms have provided greaterreturns with less volatility perhaps explaining the merits of private equity as a long terminvestment 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

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Looking beyond investment returns, an Ernst & Young LLP (“E&Y”) study examines privateequity from a holistic standpoint to evaluate company performance relative to peer publiccompanies. In 2007, the enterprise value (“EV”) of the 100 largest global private equityexits grew at a compounded annual growth rate of double their public companycounterparts4. This outperformance spanned across deal sizes, geography and industrysectors. Furthermore, private equity portfolio companies exceeded EBITDA growth of publiccompany peers by 60%. Finally in what E&Y describes as a measure of employeeproductivity, EBITDA per employee, private equity companies yielded a 50% premiumcompared to public companies. An interesting corollary to this last metric is from 2000 to2003 it was found that companies purchased by private equity firms created anadditional 600,000 jobs5. This defies the notion that private equity firms realize valuethrough “slash and burn” tactics.

Compound Annual Growth Rate, Public vs. Private Equity: 2007

30%

0%

10%

20%

CAGR

The illustrative point is private equity firms have shown an ability to leverage assets inmore productive ways than public company peers.

Moreover, an August 2009 study by the Stanford Graduate School of Business revealsthat 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 operationalimprovements realized disappear within one to two years6. This is a troubling statistic forthe public company manager as it alludes to something endemic to the public companystructure that erodes value. What is it about private equity ownership that results ingreater operational discipline? Why are private equity investors rewarded with returns thatpublic company stakeholders find elusive? To answer this question we start at thebeginning of the private equity process: due diligence.

Since we cannot delve into all components of due diligence, we highlight the onesignificant aspect that differentiates private equity investing from that of public equity -access to information. Prior to the passing of Regulation Full Disclosure (“Reg FD”) inOctober of 2000, it was possible for privileged institutional investors to receiveinformation not generally available to the broader market. As a result, companies arerequired to provide the same information to all investors, effectively closing theinformation gap separating large investors from smaller investors. Reg FD instituted certaindisclosure requirements providing a minimum bar of information to be disclosed, which

i d d h d Th f hil R FD h

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some companies exceed and others do not. Therefore, while Reg FD may havesucceeded in leveling the playing field in terms of information disclosed, it did notequalize the quality or distribution of information. This interchange between the qualityand distribution of information remains a key challenge to public equity investing7.


Public company investors have to rely on haphazard access to information and varying degrees of qualityR

ichn

ess

SEC FilingsShareholder

interviewsAnalyst

coverage

In private equity the barriers to quality and accessible information are reduced In order

varying degrees of qualityR

Road shows

Media outlets

Press release

Reach

In private equity, the barriers to quality and accessible information are reduced. In orderto attract capital, management must be receptive to a comprehensive review of allinformation and make themselves available to answer questions. The opaqueness thatfrustrates public equity investors and may even result in dubious practices to acquireinformation is unnecessary. A comprehensive due diligence process reveals more thandata, it allows skilled investors to review all assets to assess investment risk andopportunity.

Since private equity firms are privy to internal information, they can review data with ap q y p y , ycritical eye. For example, with access to an organization’s database, an experiencedanalyst can examine product costing and margins, can review customer profitability andidentify trends which may speak to customer retention risk. These are examples of adetailed layer of information that the public equity investor does not benefit from, yetmay be critical to an investment decision. With greater access to information, privateequity investors go deeper and dedicate more man hours on research, ultimately leadingto a better understanding of investment risk and the necessary premium required tocompensate for invested capital.

In 2006, the average premium paid by private equity investors to purchase a publiclytraded company (a “Go Private” transaction) was approximately 28%8. Typically, privateequity firms target at least a 15-20% annual internal rate of return. How do privateequity 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 thatviews each business unit relative to its current contribution and perceived potential.During the due diligence period, private equity investors work with management, industryexperts and consultants to formulate a detailed plan that specifies all elements of thestrategy relative to time. The strategic plan is not a separate plan that runs parallel tothe “business as usual” or budget plan, but is the exclusive plan that relies on allconstituents for its success. Once approved, the plan is communicated to all levels of theorganization so stakeholders understand their role in implementation. This atmosphere ofaccountability and leadership is a key ingredient to target realization

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accountability and leadership is a key ingredient to target realization.


Value creation often comes from margin improvement. According to a study by Kaplanand Schoar, mature private equity firms create value for portfolio companies throughinitiatives that substantially improve margins. In contrast, based on a 2008 study byAcharya, Kehoe, and Reyner only 36% of public company boards rate themselves asfocused and successful with cost reduction plans9. This statistic is telling in that itsuggests that the public company CEO may be less inclined to cut costs than he or sheis in finding and funding growth. In time, management can lose its ability to approach thebusiness from a perspective that identifies cost saving opportunities Private equity firmsbusiness from a perspective that identifies cost saving opportunities. Private equity firmscan provide objective insight that can help management reformulate an existing business.

Increasingly, active-oriented public equity investors are making the choice to narrowinformation asymmetry and influence strategy by signing non-disclosure agreements thatrestrict trading. The increasing frequency of public equity investors trading liquidity foraccess 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 behard for public equity investors to replicate the private equity value creation model. It ishard for public equity investors to replicate the private equity value creation model. It isnot just information asymmetry that distinguishes the two approaches; it is how theprivate equity firm engages corporate leadership in synthesizing the information, financingthe opportunity and mitigating the investment risk with intense focus on implementationof the strategic plan.

GovernanceDepending on the context, corporate governance can encompass everything fromDepending on the context, corporate governance can encompass everything fromexecutive compensation to regulatory compliance. We narrow the scope of governance toaddress the critical differentiator between public and private equity owned firms - boardlevel stewardship. The private equity board member allocates significantly more time thanhis public equity counterpart in governing for value. This greater oversight combined withappropriate risk management, capital allocation and an alignment of incentives directlyimpacts value creation.

Surveys show that a private equity partner spends two to three days a week of their timeon a single investment during the initial investment phase and about one to two days aweek during the holding period. McKinsey research has shown the average private equitydirector spends three times the amount of time in their role (fifty-four days versusnineteen days annually) relative to his public equity counterpart10. This metric does notinclude non-director private equity staff who also allocates their time to investmentsuccess. The reason for the wide disparity in allocated time relates to ownership. Mostpublic company boards are comprised of management from other companies or retiredmanagers who do not have a material financial stake in company performance. Incontrast private equity boards are typically comprised of private equity representativescontrast, private equity boards are typically comprised of private equity representativeswith either a large ownership interest or a compensation incentive tied to the amount ofvalue created by their efforts. Private equity directors are supported by internal teamswho evaluate and analyze, with a critical eye, management presentations and boardmaterials. The relative difference between private and public equity boards is highlightedby a McKinsey survey which queried directors who served in both capacities and haverated private equity boards to be far more effective than their public companycounterparts11.

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Effectiveness: Public Equity Boards vs. Private Equity BoardsSurvey of Directors on 1-5 Scale (1 = Least Effective, 5 = Most Effective)

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Source: McKinsey interview with 20 Directors serving in both public and private companies over past 5 years with enterprise value greater $500 million2

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 allocationprocess. The significance of capital allocation is emphasized by Warren Buffet who hassaid, “… I really have only two jobs. One is to attract and keep outstanding managers torun our various operations. The other is capital allocation1.” Private equity firms viewcapital allocation as more than a “budgeting” exercise, as every dollar invested in thecompany 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 betweenowners and their managers who may be incentivized to grow the business even if theresulting return does not exceed the cost of capital. When it comes to using capital togrow the business, private equity investors are emphatic that investments provide a returnin excess of the company’s true cost of capital and map to the strategic value creationplan. Often due to the use of leverage in private equity financing there is built inprotection from imprudent capital allocation decisions as cash is needed to service debt.

Capital Allocation Approach & OwnershipCapital 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

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Return > WACC Protect year over year budget


Private equity firms ensure agency conflict between owners and management is mitigatedby providing management with considerable ownership. According to Oyer and Leslie, onaverage, private equity firms provide the CEO two times the equity relative to the publiccompany, but with a 9.6% lower salary and a 12.7% variable pay share6. Since privateequity compensation is largely delivered based on exit value, there is little managementincentive to make decisions that improve short term results at the expense of long termvalue creation. Compensation is engineered to ensure that the owner’s objective for highasset value matches that of management. In order to track management progress, privateg g p g , pequity firms are skilled in finding the right metrics to assess management’s ability. Withdetailed expectations and milestones laid out in a formal strategic plan, there is lesssubjectivity when it comes to determining success or failure. In the event of non-performance, private equity investors are typically much quicker to insist on operationalor management changes. Concentrated ownership provides for consistent directives thatdrive accountability and ensure management and investor are aligned. As a result, privateequity management is not afforded the same latitude as their public equity peers forsubpar performance.

Public Equity Private Equity

Director CommitmentAverage 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 equityboards 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 ExecutionQuarter to quarter earnings. GAAP-basedmetrics.

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 asfacilitators that provide capital and an abundance of experience when it comes tostrategy realization. Many of the traits described are associated with “activist” publicequity investors. However, the chief differentiator is that activism implies that theseinvestors act more as agitators for value versus collaborators for value. In consequence,activists can be viewed as a minority with a disgruntled view, outnumbered andhandicapped when it comes to providing other critical aspects of governance. Private

l ll b h l h

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equity style governance requires collaboration with management to implement the aspectsof corporate stewardship that enable superior value creation.


ConclusionThis paper highlights what Harlingwood considers critical facets of the private equityapproach that when applied to public equity investments will yield greater returns. Tosuccessfully pursue the value journey, public directors and private equity investors mustmonitor progress along three major themes:

(1) Comprehensive knowledge of opportunities and risks across all business units andp g ppproduct lines.(2) Go beyond simplistic EPS metrics to value-based metrics that drive cashflow, improve portfolio value and reduce risk. These include return on investedcapital, customer retention, customer value, growth, market size and market sharetrends, to name just a few.(3) In order to be effective at monitoring for improved value, public company directorsand private equity investors must be verywell preparedand highly engaged to ensurethe appropriate alignment of all constituents such that all constituents are focused onh i f di bl d i bl lthe creation of predictable and sustainable value.

The private equity model is compelling and will appeal to corporate leaders who arelooking at creating, executing, and overseeing a strategic plan designed for valuecreation.

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1. Gadiesh, Orit. MacArthur, Hugh. “Lessons from Private Equity Any Company Can Use,” HarvardBusiness Press. 2008

2. Morgan Stanley. “Operational Improvement: The Key To Value Creation in Private Equity.” July 20093. Radler, Joshua. “Long Term Private Equity Performance Solid in Q3 2005, Short Term Returns Showed

Positive Fluctuation,” Thomson Venture Economics. January 30, 2005E 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

Selected References

4. Ernst & Young LLP. How do Private Equity Investors Create Value? A Global Study of 2007 Exits,Beyond the Credit Crunch.” 2008

5. AT Kearney. “Creating New Jobs and Value With Private Equity: All Companies Can Learn from theStrategies Employed by PE Firms.” 2007

6. Leslie, Phillip. Oyer, Paul. “Managerial Incentives and Value Creation: Evidence From Private Equity,”Stanford Graduate School of Business. August, 2009

7. Evans, Philip and Wurster, Thomas S. “Blown to Bits, How the New Economies of Information Transforms Strategy.” 2000

8. Hester, William. “Private Equity and Market Valuation: The Average Valuation of Takeover CandidatesSuggests Thinning Reward to Risk.” June 2007

9 Acharya Viral V Hahn Moritz Keheo Conor “Corporate Governance and Value Creation: Evidence9. Acharya, Viral V., Hahn, Moritz. Keheo, Conor. Corporate Governance and Value Creation: Evidencefrom Private Equity.” January 2, 2009

10. Heel, Joachim. Kehoe, Conor. “Why Some Private Equity Firms Do Better Than Others,” The McKinseyQuarterly. 2005

11. Acharya, Viral V., Keheo, Conor., Reyner, Michael. “The Voice of Experience: Public Versus PrivateEquity,” The McKinsey Quarterly. December 2008

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corporate governance and value creation - private equity style

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