Why private equity works

Australian Financial Review, January 15, 2007

Recent controversy over a proposed Private Equity supported management buy-out of Alinta raises a number of legitimate questions about conflict of interest at the Board and senior management levels. At a more fundamental level, it should be a wake-up call for shareholders and Directors around Australia.

Quite clearly it is not appropriate to have Directors - whose primary role is to act independently in the best interests of shareholders - involved in a takeover bid whether private equity backed or not.

But if one looks at the simple logic of most private equity acquisitions a more fundamental question arises. And it goes well beyond Alinta.

Private equity makes it's money by offering shareholders significantly more than the company's current valuation, and then quickly making the company worth even more.

So why does (recently stepped down) Alinta chief executive and Director Bob Browning thinks he can make Alinta worth more under private ownership than as a listed company?

There can be little doubt that many Australian senior managers see private equity offering superior access to capital, better leverage and greater managerial freedom.

But sooner or later shareholders are going to start asking Boards and management why they are not delivering what private equity can deliver. And how they are going to lift their games. It's time to make harder decisions, faster.

Leverage alone does not explain the differences, and it's not that executives in PE-owned companies are any smarter than their corporate counterparts. They are more effectively motivated. Unlike general or division managers in publicly listed companies, managers in heavily leveraged PE-owned companies are continually required to ask “where am I going to get the cash from this month?”

This is known as the “discipline of debt” and it's not until you have experienced it that you can truly understand how it feels.

But with increasing shareholder interest there'll soon be motivation aplenty for Australia's senior managers and the question “how?” will become much more pressing.

Four key lessons can be learned from the way private equity operates.

Lessons one is align your portfolio. Why does Qantas maintain its own in-flight catering business? Or own Jetstar? Or absorb significant capital on ventures like Startrack Express? Each business may well be profitable, and without the discipline of debt that may be enough for the Directors and management of a public company - for the time being.

Private equity will ask “is this the most profitable use of my capital today?” Is there not a more 'natural' owner?” If so, Qantas' capital should (and most likely will) be deployed quickly elsewhere under any future PE ownership arrangements.

Lesson two is about aligning management incentives. Corporates typically treat incentive systems (share options, etc.) as a retention tool you need to pay to get and keep the best people. PE treats them as a performance management tool. Shareholders are becoming increasingly irate about pay awards to executives in companies with free-falling share prices. But they are also reluctant to reward successful management to the same extent as their PE counterparts. They can't have it both ways.

Lesson three is focus on operational effectiveness and efficiency. Even if you have your portfolio as close as possible to perfectly aligned, the only way to combat PE's leverage advantage is by improving the effectiveness and efficiency of your operations.

Most corporate managers have convinced themselves of the myth that it is not possible to deliver both rapid and sustainable improvements in efficiency and effectiveness. They avoid pushing hard and allow their people the time to 'learn by making mistakes'. They are afraid that giving “too much” direction - and support from people who have done this many times before - will disempower their people.

PE houses don't muck around with such niceties. They simply stimulate people to want to deliver fast results and then drive them to deliver fast.

Lesson four is make 'people decisions' harder and faster. It is possible to deliver the value this year, and train people for ongoing results and have everyone feel empowered.

Private equity has raised the bar. It can be done. It's time Australia's Board rooms started capturing untapped value for their shareholders. Today.

Published in the Australian Financial Review
By Alasdair Johnston, January 15, 2007

Back to top | Back to Home