THE past weeks have witnessed turbulent and sometimes disappointing times for the large private equity firms. Organisations such as KKR, TPG, CVC Capital partners, the Blackstone Group and Cerberus have found it increasingly difficult to find and execute the value creating acquisitions that have dominated the M&A landscape in the last 15 months.
In the year-to-date, private equity driven acquisitions have accounted for over 25 per cent of global M&A deals and almost 35 per cent of the deals in the US.
However, in recent times, the rising cost of debt and increasing uncertainty in capital markets has made it difficult for buyout firms to access the so-called "covenant lite" debt needed to fuel highly leveraged takeovers.
So is this the end of the road for private equity or just the interval before the second act?
While the recent volatility has impacted some of the impending and rumoured deals (recent reports suggest that Cadbury Schweppes's planned disposal of its beverages activities may be impacted by the fall-off of PE activity), PE firms have had an impressive two years.
Notable PE-backed deals included TXU, Freescale Semiconductor, Chrysler, Canadian Telecoms Group BCE, Hilton Hotels and the Myer group in Australia. On the other hand, PE has not had it all its own way with Qantas, Sainsburys and Coles escaping the claws of cashed-up buyout funds.
However, it would be unwise and premature to write off the private equity industry. While increasing interest rates have made debt more expensive, recent stock market shocks have made some firms more attractive as acquisition targets.
In the rapidly overheating markets of the early months of 2007, PE firms were finding it increasingly difficult to capture value in the quoted company market.
The recent downturn in stock prices may, ironically, expose some interesting value opportunities.
As institutional investors turn away from riskier hedge fund type investments, they may look to well managed PE firms to generate the returns they need.
While the research indicates that not all PE-backed deals create long-term value, the evidence suggests that well-managed PE funds (that do not overpay for the firms they buy) generate superior returns to investors. So how do they achieve this and what can CEOs/CFOs learn from private equity?
>> Well managed execution trumps elegant strategy
PE firms focus on the key value drivers and as such they are prepared to sacrifice the temptations of prolonged strategic introspection for improvements in net operating cashflows.
These improvements typically include growing the top line, improving operating margins, sweating the assets and reducing the cost of capital using tax efficient debt.
This does not mean that PE firms are obsessed with cutting costs but rather that they understand the scarce and costly nature of capital and ration it accordingly.
Not for them expensive downtown corporate headquarters or state of the art 10-year IT and supply chain management projects.
>> Employ sophisticated and engaged board members
Typically, the boards of PE-backed organisations are filled with a smaller number of experienced and engaged industry experts.
PE firms understand the need for boards that are informed, sophisticated and aligned with the value creation goals of the acquired firm.
PE pays its so-called part-time non-executives well including equity participation, but in return they are expected to support management in finding opportunities for growth and driving the all important net operating cash flows.
>> Don't overpay - due diligence is not just about risks but the value opportunity
PE firms use due diligence to gain real insights into the potential of the target firms.
As such, the focus is very often on benchmarking costs, processes, revenues and other value drivers against industry medians to get some appreciation of the size of the improvement opportunity.
In carrying this out, PE will usually retain strategy consulting and big four advisers who have detailed industry knowledge and can offer the insightful comparisons needed to fully asses the target.
In addition, PE executives are wary of the winners paradox (the winner in a tender is often the one who has overestimated the value most).
They expect to lose deals on a regular basis and do not force completion rates just to justify the bid fees incurred. The ability to walk away and sacrifice sunk costs is a key element of the patient informed bidders' strategy.
>> Focus on value drivers and net operating cash flows
The burden of debt combined with interest cover covenants forces PE firms to focus on the real value drivers.
As such, they are strong advocates of managing for value and are prepared to sacrifice short-term earnings for sustained and strong net operating cash flows.
They are often miserly with scarce and increasingly expensive capital and make extensive use of techniques such as Cash Flow Return on Investment (CFROI) to manage performance and identify underperforming divisions and business units.
PE executives are quick to sell off non-core assets and will recycle capital into brand building where they feel it can drive topline growth. The burden of debt reinforces the primacy of cash flow and concentrates the mind.
>> Align management rewards with performance objectives
While the popular media would have us believe that the executives in PE-acquired firms lead a charmed life, the reality is that many are serial buyout executives that have worked with PE firms on previous deals.
Life as a CEO or CFO in a PE-owned firm is not for the faint-hearted.
The base salaries are often quite modest but the executives are encouraged to take equity positions in the acquired firm and they typically have performance contracts that are highly geared.
As such, PE firms put in place incentives schemes that encourage managers to behave like owners and they drive these down to the key front-line executives.
>> Agility and speed matter in a world of creative destruction
Whether the factories are designed to produce a single product over its short life or whether the use of subcontractors can drive flexibility in costs, executives are keenly aware of the need to embrace Schumpeter's so-called "creative destruction". Schumpeter was an Austrian economist who advocated innovation and change in economics.
The increasing pace of change and the need for firms to continually re-invent themselves has driven many executives to the wisdom of "building it to last".
For private equity, speed and agility are a source of competitive advantage and this informs not just their drive to run the business in real time - they are increasingly causing us to question the long cycle times that characterise the management processes of many firms.
For PE firms, "good enough is good enough" and they focus on reducing the decision-making cycle while pushing implementation of projects based on fact-based decision-making driven by the governing objective - to maximise the net operating cash class.
Over 25 years ago, Reinhold Messner turned the world of mountaineering on its head when in quick succession he climbed Everest solo without oxygen, and then went on to climb all 14,800-metre peaks using little more than the contents of a single rug sack.
At the time, mountaineering in the Himalayas was dominated by large scale siege tactics where teams took months and literally hundreds of sherpas and climbers to get a handful of "climbers" to the summit.
Like traditional mountain climbers laying siege to Everest, firms increasingly rely on a phalanx of teams, consultants, workshop processes and resources to implement decisions.
By contrast, PE firms have embraced speed and agility and this allows them to release value quickly and exploit short windows of opportunity.
The recent tribulations in the capital markets may cause some PE firms to retreat from the mountain but past experience tells us that they are capable of making a hasty retreat with their funds intact and will be back to push for the summit again.
The writer is a former director of the Asia Pacific Chartered Institute of Management Accountants (CIMA). For more information about CIMA, please visit www.cimaglobal.com
