THE global credit crunch has left its mark on private equity deal volume. But the way private equity funds respond to massive market and economic uncertainties is instructive. Now more than ever, PE funds are sticking with their winning recipe, which enables them to generate big returns from dramatic improvements in operations.
The results speak for themselves: the top 25 per cent of US private equity funds raised between 1969 and 2006 have earned internal rates of return of 36 per cent on average, through good times and bad. That's close to 10 points higher than the equivalent S&P 500 top quartile.
Private equity masters follow a basic set of disciplines that any senior executive can employ for similar results. Some of these lessons will sound familiar. Some may appear obvious. However, in our view, they are not being applied rigorously by businesses around the world. It is easier to do "fine" than to do the best a company can do. This pervasive disease of satisfactory underperformance can be cured by applying some key PE lessons.
> Define full potential
Top PE firms generate high returns primarily by creating operating value. They start by building an objective fact base. They scrutinise demand, customers, competition, environmental trends and the details of how money is actually made. Only then do they pursue a few core initiatives to reach full potential.
After Bain Capital and Charlesbank Capital Partners bought Sealy Corp, for instance, they probed every corner of Sealy's business. They learned that product differentiation, not complexity, was the real margin problem.
Shelving plans to expand mid-priced offerings, Sealy instead redesigned its core mattress line, shifting away from a costly, two-sided design to a "no-flip" technology and concentrating on premium price points. Result: the new mattress design improved Ebitda by 22 per cent.
> Develop the blueprint
PE blueprints are about action. They turn the few core initiatives into results, choreographing actions from standing start to the finish line.
Newbridge Capital used this approach to transform Korea First Bank from a bankrupt industrial creditor into a world-class financial institution. The key step was converting Korea First?fs costly institutional branch structure into a network to serve retail customers.
Mapping a plan to consolidate into a handful of large-scale branches, Newbridge closed some locations, and removed back-office functions from the rest, refocusing them on customer sales. Result: bottom-line improvement of $50 million within a year.
> Accelerate performance
Top PE firms mold the organisation to the blueprint, use a rigorous programme, and monitor a few key metrics.
Such urgency helped CVC Asia Pacific and CCMP Capital reinvigorate Singapore Yellow Pages (SYP). With an 87 per cent market share, the telephone directory publisher had grown complacent and had seen its revenues slide 40 per cent. Advertisers were defecting, along with demoralised sales staff. Revamping advertising sales, the firms began tracking customer retention rates, the cross-sale of products and new account sign-ups. They also introduced incentive-heavy compensation for top performers. Result: they realised a gain exceeding 2.6 times their investment in an IPO less than a year after the purchase.
> Harness talent
Top PE firms create the right incentives for employees to act like owners, and they assemble decisive and efficient boards.
So do some smart companies. Nestle, for instance, introduced short-term bonuses paid out against clearly defined targets, increased the variable part of its compensation package, and moved 1,400 people into long-term incentive plans so that key managers became shareholders. Result: Nestle?fs new motivational tools helped it deliver total shareholder returns exceeding 15 per cent annually since 1996, more than twice the industry average.
> Make equity sweat
Top PE firms embrace leverage. This is perhaps one of the toughest PE disciplines to adopt, and one that CEOs and their boards should consider carefully, especially when credit is tightening. But CEOs, too, should get comfortable with leverage. Scarce cash compels managers to manage working capital aggressively, discipline capital expenditures, and work the balance sheet hard.
DLJ Merchant Banking purchased Mueller Water Products - a US maker of fire hydrants, high-pressure valves, and fittings - from Tyco International. The $938 million price included just $231 million of equity. Closing uncompetitive foundries and establishing leaner manufacturing methods freed up cash to fund growth in the core businesses and establish a presence in China. Result: Five years later, Walter Industries bought Mueller for $1.9 billion, earning DLJ a 4.6 times return on its equity.
> Foster a result-oriented mindset
This lesson is about creating repeatable processes that spur performance improvements again and again.
Nike has achieved such PE-like repeatability. Beginning as a basketball shoe company, it has become a lifestyle company. Nike revisits a formula with each sport - from running to volleyball to soccer to golf and now cricket. Nike first establishes a leading position in athletic shoes, then launches a clothing line endorsed by the sport's top athletes. This category expansion forges new distribution channels and locks in suppliers, enabling broader global distribution. Result: "Swoosh"-branded products have become nearly ubiquitous.
If you are not the clear-cut market leader in your industry, you can't afford to ignore how the best PE firms are transforming the business landscape. Even if you are the clear-cut leader, our research has shown that such companies oftentimes perform below their true, full potential, and examining the full measure of these lessons can benefit them greatly.
Orit Gadiesh, chairman, Bain & Company, is an expert on management and corporate strategy.
Hugh MacArthur, partner, Bain & Company, is the leader of the firm's Global Private Equity Practice.
Suvir Varma, partner, leads the firm's South-east Asia Practice
