If Private Equity Sized Up Your Business
By Robert C. Pozen
The Idea in Brief
Private equity funds' outsize returns to shareholders have many public company managers asking, "If they can get that kind of performance out of a company, why can't we?"
Some counter that private equity's enviable returns come from suspect tactics (think collusive deals, excessive leverage, or overpriced IPOs). But Pozen disagrees. Top private equity funds excel, he maintains, because they use rigorous management practices that many public companies don't. For example, private equity funds keep idle cash to a minimum, create operating plans specifically designed to increase shareholder value, and tie executives' compensation to actual increases in value.
Not all private equity practices lend themselves to public companies. But savvy firms are taking the best pages from the private equity playbook. IBM, for instance, saw its share price jump 3.5% on the day it announced it would use its cash plus new borrowings to buy back $15 billion (10%) of its outstanding shares.
The Idea in Practice
Pozen suggests these practices for matching private equity funds' impressive returns:
Keep Idle Cash to a Minimum
Instead of hoarding excess cash, return it to shareholders by raising cash dividends. Companies that did this on average outperformed the market by over 4% in the year the dividends were raised. And firms that started paying cash dividends for the first time on average outperformed the market by over 5% in that initial year.
Take on More Debt
Increasing your company's debt-to-equity ratio can improve financial performance by substantially reducing the cost of capital. To discover the right ratio for your firm, analyze various combinations of debt and equity (including expected returns on equity and interest rates on debt) to identify the lowest after-tax cost of total capital.
Design Value-Enhancing Operating Plans
Develop operating plans designed to increase shareholder value. For example:
* Make astute judgments about where to cut back costs within existing units.
* Look closely at possible sales of non-core businesses.
* Invest to expand revenues; for instance, by opening new stores or increasing production capacity.
* Seek reasonably priced acquisitions that will consolidate your firm's market position or realize economies of scale. Monitor your operating plan's implementation closely based on appropriate performance indicators. If you fall behind plan, act decisively?by redrawing the plan, changing management, or reconfiguring investments
The Executive Compensation to Shareholder Value
Instead of distributing financial incentives broadly across the employee population, concentrate them on the small group of executives who are proven drivers of company performance. Grant stock options with an exercise price equal to fair market value at the time of grant. That way, you'll ensure that recipients will benefit if the company's share price rises but will not gain if the firm's share price plateaus or declines. Also, place conditions on exercise of options. At Schering Plough, for example, options aren't exercisable unless special earnings targets are met.
Act Like a Private Equity Board
Public company boards typically spent too little time on their companies' businesses to have optimal impact on performance. Instead, use the private equity model, by having directors spend 3-5 days per month on company business. Also limit their directorships in other organizations. Ensure that directors have extensive experience in your company's industry. Motivate them to create shareholder value by paying them a nominal annual fee but giving them substantial equity in your firm.
Robert C. Pozen is chairman of MFS Investment Management, a global money management firm. He is based in Boston.
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