Much has been written about private equity over the years from executive recruiters to consultants. Many have pontificated on what makes private equity acquisitions successful and what dynamics of private equity create value. Many have discussed the elements of the private equity model, the role of the CEO, and the pro’s and con’s of private equity investment. In all my readings, I have not observed an article written from the inside perspective of the Chief Executive.
Most external observers perceive PE in a negative manner as firms that buy companies, increase debt, cut costs, have limited tolerance, fire employees and then sell for great profit. From the inside perspective, I believe the fundamental nature of the PE investment is, in most cases, value added: however, the fact that most companies acquired by PE require some type of transformation, the outsider views the PE firm as a destroyer of value, turning the company upside-down. The fact is that most PE acquired companies lack effective process, efficient methods of operation, strong management teams, or adequate working capital. The objective to realize value often requires significant change in people, process, product and the balance sheet. To the outside observer, these changes are perceived as negative; however, to the insider, these changes are mandatory to make the company stronger and, hence, more valuable. In the end, PE firms are extraordinary at sustainable value creation, especially when they team-up with strong management.
While PE firms are great value creators, and provide the best example for effective business management, they do have limitations that need to be balanced with strong internal operational management teams. The first limitation of PE firms can be the focus on quantitative methodology. Over emphasis on quantitative analysis and measurement can negate the importance of human resources and the need for employee motivation. Effective PE CEO’s provide a counterbalance and compliment the PE firm. These CEO’s are inspirational operational leaders that motivate employees with a strong sense of purpose and passion.
A second limitation of the PE firm can be the focus on improving short-term financial measures and operational infrastructure. The requirement for immediate results can limit attention to strategic positioning and long-range plans. Effective PE CEO’s understands the need to build long-range strategic plans that create a sustainable competitive advantage and serve as a blueprint for short-term tactical action plans.
A third limitation of PE firms can be tolerance both in terms of time to create results and the magnitude of results. Moreover, if management does not clearly explain “why” results are not achieved on time and on budget, the lack of tolerance may increase and the relationship may be strained. The strong PE CEO consistently communicates well, perceives the PE firm as a valuable strategic partner and serves as the eyes/ears to the marketplace.
To me, despite these limitations, the PE model generally brings strong business rigor and value to each acquisition. From an inside CEO perspective, I believe there are four key principles that embody the value-added PE model and guide the effective PE CEO.
The first principle of the PE model is “buy to sell”. To me, as an inside Chief Executive, this is the most fundamental principle. As a PE firm considers acquiring an enterprise, the firm is simultaneously validating a profitable exit. Therefore, the first principle always considers a start and a finish with clear objectives and a finite timeline. Value is realized, and monetized, once the sale is complete; therefore, in addition to buying, the focus is also on selling at the right time and right place. The effective PE CEO understands the balance between long-range mission, vision and values and the requirement for short-term, fast-paced, action-oriented performance. The focus almost always has to be on working toward the sale without disrupting the daily workflow or jeopardizing the future vision. The challenge, complexity and balance become more intense as the process of selling actually gets underway. Most CEO’s will only have experience leading a going concern and never lead a challenged enterprise with the mandate to sell at a targeted IRR. Appreciation, knowledge and experience of the “buy-to-sell” principle are a distinguishing, and fundamental, characteristic of the effective PE CEO. Jack Welch, when he taught GE students at the Croton-on-Hudson campus, always discussed the tension between long-range strategy and short-range performance. When his students asked which is more important, he answered, “You need to do both simultaneously and well”. This is the challenge of the buy-to-sell principle… deliver near-term results in the context of a long-term vision.
In between buying and selling, a second significant principle emerges, which is the mandate for “rapid value creation”. Value may be created through organic growth, bolt-on acquisitions, operational improvement, product/service improvement and management teams. It seems straightforward, but the added pressure of a definitive, compressed time-line to get up to speed quickly and deliver results consistently is a challenge. Most CEO’s are P&L focused with specific attention on revenue and margin. The rapid value creation principle focuses on the objective to achieve a 20-30% IRR in 4 to 5 years. The very concept of IRR requires the enterprise produce annual incremental cash flow over the historical run rate within an accelerated time frame. The same value of cash flow produced in a shorter time period delivers a higher IRR. Therefore, rapid value creation principle requires an acute sense of urgency throughout the organization with a focus on cash flow. Speed can be a competitive advantage, however, in a PE company, the principle of “rapid value creation”, requires speed for success. The successful PE CEO must be a holistic leader looking far beyond just the P&L to achieve extreme value in a compressed timeframe.
The third principle, “intense financial rigor” is the hallmark of PE – This principle requires an internal team well versed in all elements of financial analysis, financial tracking, and most important, financial success. The effective PE CEO understands the intense focus on financial rigor and the value that is created with a strong financial discipline across the P&L, balance sheet and statement of cash flow. If IRR represents the measure of annual cash flow over time, then it is critical to ultimately ensure cash targets are achieved. An additional, and important, financial concept that is unique to PE and critical to success is the measurement of total enterprise value (TEV). In a public company value measures are different and focus is on net income, earnings per share and market capitalization. In a PE portfolio company TEV – Debt = Equity, so, it is important to have a specific plan to improve TEV and reduce debt. The TEV key financial indicator is determined through a multiple of EBITDA. In addition to the quantitative progression of EBITDA, professionalizing a poorly run company and improving the overall reputation in the marketplace may add significant qualitative value and increase the multiple. The effective PE CEO understands this equation and builds a plan of action to improve EBITDA and increase the multiple to optimize TEV.
A forth-significant principle is the “Compressed Governance” structure. In a public company the shareholders are represented by a Board of Directors with a fiduciary responsibility to represent the best interest of the shareholders through governance and guidance. In a family/founder company, the board is mostly represented by family members generally looking to preserve the estate and pass ownership on to the next generation. In a PE portfolio company, the partners of the PE firm usually take on the role of Chairman and several Board Director positions. The PE firm is both shareholder and board member, providing direct governance and guidance. This structure delivers a more intense, more challenging interaction with the Board of Directors. The effective PE CEO must listen and be inclusive while maintaining focus and delivering results. When the plan is clear and expectations are achieved, the process is seamless; however, if performance drops and the vector to the sale off-track, the PE CEO may find limited tolerance and additional intervention from the sponsor. In addition, the PE CEO must be an open and honest communicator with strong values and integrity… anything less will create issues for both the CEO and the PE sponsor.
In general, despite negative public perception, the PE acquired company is better managed under a more rigorous and analytical PE model. It is critical to the overall success of the enterprise, to have an experience Chief Executive that understands the PE model and can bring vision, passion, operational focus and employee inspiration to the team. Without extraordinary transformation leadership inside the company, the great efforts from the PE sponsor outside the company are likely to fall short of expectations.
Paul Block is the ex-Chairman and CEO of Merisant Company (makers of Equal and Whole Earth Sweetener). He has been a CEO for over 14 years with Sara Lee Coffee & Tea, Merisant Company and SVP Worldwide. He resides in Westport, Connecticut with his wife Trish and four children.