The tension between financial markets and management is evident for all executives. Should they follow financial or rather managerial objectives? Should they listen to investors or preferably their fellow managers (Davis 2008)? More than ever, finding the right balance is crucial for any manager and, in particular, in times of crisis when severe restructuring may be necessary. Against this background, what can publicly listed companies can learn from private equity?
The Lure and Limitations of Private Equity as a Source of Learning
Private equity as a specific form of governance may offer relevant insights. It constitutes a particular approach in combining financial and managerial perspectives. True value creation in private equity stems from superior strategic foresight, coupled with an entrepreneurial approach to execution – a lesson from which both private equity firms and as public companies can learn. In particular, the publicly listed firm can maximize value creation by embracing a virtual buyout, i.e. implementing what private equity does best while building on its inherent advantages.
For our purpose, we define private equity as a financing mode whose ‘capital involved has been raised privately and will not be deployed by investing in publicly traded securities' (Cheffins and Armour 2007, 5). Furthermore, '(t)heir primary owners are not households but large institutions and entrepreneurs that designate agents to manage and monitor on their behalf and bind those agents with large equity interests and contracts governing the use and distribution of cash' (Jensen 1989, 117).
Research shows that whereas some private equity deals have performed impressively, others have failed miserably, both for investors and the companies involved. At asset level, conclusive evidence is lacking as to the overall performance of private equity being better than any other asset class (Moskowitz and Vissing-Jorgensen 2002; Phalippou and Gottschalg 2007). Furthermore, performance of private equity is highly cyclical (Gottschalg 2007; Kaplan 2007) with different types of investors achieving different returns (Lerner, Schoar et al. 2007).
Research at portfolio firm level is equally indecisive. Some studies indicate that firms owned by private equity funds perform better than publicly traded firms, even when assuming that public firms too are leveraged (Gottschalg 2007). Others conclude that firms formerly owned by private equity firms perform better in IPOs but returns worsen over time compared to others (Cao and Lerner 2006). For all these performance studies, the limitations are obvious: they invariably depend on the selection of the time span and performance metrics.
Ultimately, there seems to be only one valid indicator for performance. While value creation among deals differs widely – leaving some few deals with superior returns while many others report marginal or even negative returns (Kaplan and Schoar 2005) – there seems to be high consistency in the performance of fund managers (Kaplan and Schoar 2005; Kaplan 2007). This could be seen as strong evidence for the existence of a strategic alpha, i.e. a specific set of managerial competencies to derive value beyond financial arbitrage and engineering.
Private Equity Performance Revisited – Seeking the Strategic Alpha
An international exploratory study on value creation in private equity based on interviews with 25 private equity executives and managers of their portfolio companies provided a glimpse into what constitutes the strategic alpha of high performing private equity investments (Hilb 2008). The core of successful value creation is what we call the entrepreneurial strategizing mindset, which combines a strong value creation perspective (strategic) with an owner mentality of execution and aspiration (entrepreneurial), bundled with a strong competence to apply it. We define mindset as a mental model that 'refers to the knowledge structures that top managers use to make strategic decisions' (e.g. Huff 1982). A mindset provides the management with a perspective on how to interpret information and translate it into action (Prahalad and Bettis 1986).
The best-in-class private equity investors are able to translate their entrepreneurial strategizing mindset along four value dimensions to overcome basic value creation challenges: Give direction through aligned option thinking, strengthen discipline through meritocracy-based empowerment, foster capital view through operationalized cash focus and share capacity through core competence complementation.
Give direction – aligned option thinking
Our research shows that great deals are based on a clearly defined plan that takes an outside-in view on strategic options, a specific approach to strategizing (e.g. Kogut and Kulatilaka 2001; Grundy 2004). Given the inherently limited duration of any private equity investment, the exit options have to be laid out right from the beginning. This focus on ownership options provides an additional level of strategic thinking which, in most publicly listed firms, is not in place by definition. They rather focus on solely strategic positioning. At the same time, the views of the management and owner lead to organizational alignment (Floyd and Lane 2000) resulting in a positive impact on performance (Powell 1992).
Strengthen discipline – meritocracy-based empowerment
In the most successful deals, the investors succeed in creating a culture of meritocracy which sends out a clear signal: The only criterion that counts is performance. The elimination of politics and a sense of accountability ignite managerial energy and make managerial behavior entrepreneurial in the truest sense: Motivated, ambitious and empowered. The positive impact of empowerment is crucial (Conger and Kanungo 1988).
Foster capital view – operationalized cash focus
The successful private equity-owned firms manage to introduce a simple yet powerful equity perspective into the organization which stresses the importance of cash. This allows employees at all levels to concentrate on a simple concept and work decisively towards a common goal without being distracted by complex financial concepts that may even confuse executives. The most successful investors, however, not only manage to define sound financial indicators but also succeed in translating these objectives into operational KPIs that set clear and achievable targets for every level of management. In that sense, they apply a combination of what Simons (1994) calls a diagnostic control system and a boundary system which sets limits on opportunity seeking.
Share capacity – core competence complementation
The most successful deals are characterized by an open assessment of the existing competencies and a targeted selection of capabilities to be infused into the target firm. Infusion can come in different forms, be it by a competence-based selection of directors and managers or by targeted advisory on specific topics. They value the importance of competencies to business success and hence, see the value of core competencies, a capability that is central to a firm's value-generating activities (Andrews 1971; Prahalad and Hamel 1990).
The Virtual Buyout – a Structured Approach to Bringing the Strategic Alpha into the Public Company
These considerations lead us back to the original question: To what extent and how can publicly listed firms benefit from insights of successful private equity? This is where the virtual buyout enters the scene.
The virtual buyout is a transformation process in which a publicly listed firm embraces the successful, and for the particular case, relevant approaches of private equity to maximize its value creation, while leveraging its inherent advantages. In doing so, the virtual buyout aims at combining the advantages of both the private and public company ownership models.
As is the case with private equity, there is no one-fits-all approach to a virtual buyout. The major challenge is to develop a virtual buyout concept that fits the company's needs and helps achieve its value creation targets. A structured four-step approach can help with that aspect by defining four distinct roles.
Coach: Establish entrepreneurial strategizing mindset for virtual buyouts
The key to unlocking the full potential of a virtual buyout is the entrepreneurial strategizing mindset. Strategic foresight combined with an entrepreneurial mentality to execute with aspiration and pragmatism depends on the personality of the manager, but not only. Managerial autonomy and positive pressures combined with a rewarding incentive structure can unleash this mindset in most managers and board members.
Creator: Identify need for virtual buyout contribution
As with traditional buyouts, the company needs to know what they are really seeking to achieve through a virtual buyout. Are they primarily looking for greater direction, discipline, capital view or capacity? That decision depends on knowing precisely the strengths and weaknesses of the organization.
Craftsman: Translate needs into virtual buyout approaches
As in any buyout, the structural elements alone cannot guarantee value creation, but are an important ingredient. The objective is to create an environment that imposes positive pressures. A set of approaches along the four value dimensions can be applied to emulate the private equity environment in that respect:
Negotiate a virtual contract with shareholders: The board needs to engage in an active dialogue with the shareholders on the ownership strategy. It needs to view itself as the shareholders’ investment committee, constantly challenging the ownership strategy.
Ensure the competitive strategy follows the ownership strategy: In contrast to traditional corporate strategizing, the starting point in a virtual buyout must always be the ownership strategy. The different options then provide the framework for developing the competitive strategy.
Install objective-hunting teams: It is crucial to break down the strategic plan into clearly defined and achievable objectives that individuals and teams commit to. They need autonomy in execution, but also clear guidance.
Promise long-term pay perspectives: Employees should feel they are part of an ambitious yet rewarding venture. This can be achieved by linking the incentive system directly to the outcome of the strategic plan in a given period of time.
Foster capital view
Take on virtual debt: Even if the company (wisely) decides not to fully leverage its capital structure, it may consider introducing a virtual debt that motivates achieving ambitious targets for cash generation.
Install back-to-basics metrics: Metrics are crucial to any virtual buyout. Yet, companies should strive to set simple cash targets supported by easy-to-understand operational KPIs instead of defining complicated metrics that only finance experts understand.
Add competence to your board: The board is key in identifying and filling competence gaps within the organization. A thorough assessment of strengths and weaknesses in the leadership team helps identify lacking competencies that are needed to challenge and actively support the development of ownership and competitive strategies.
Concentrate on a few selective capacity building initiatives: The advisory power of the board should be utilized effectively by concentrating on a few strategic initiatives that clearly help solve the competencies gap and directly lead to value creation.
Conductor: Connect and coordinate virtual buyout approaches
The advantage of the virtual buyout over a traditional buyout is its long-term impact. Whereas the positive effects of a buyout are limited to the duration of the deal, a publicly listed firm can make the virtual buyout become part of its performance culture by embracing subsequent virtual buyouts. This requires the firm to constantly strive for improvement.
Conclusions – Value Creation beyond Virtual Buyouts
The virtual buyout approach shows that the ownership structure does not have to be a limitation to performance. Rather, it provides a structure that can be improved by emulating favorable elements of a different ownership structure. A certain mindset, however, is required to do so successfully: entrepreneurial strategizing.
The implications of these findings are not limited to publicly listed firms. Privately held companies and their investors can also learn from these lessons. They will only achieve superior returns in the long term if they recognize the limitations of their traditional approach and embrace a view that combines the best from both, the worlds of investment and management respectively. Furthermore, companies at different stages of their evolution need different impetus. There may well be a need for more public company components from time to time. For private companies this may even mean targeting a virtual IPO.
Allen, N. J. and J. P. Meyer (1990). "The measurement and antecedents of affective, continuance and normative commitment to the organization." Journal of Occupational Psychology 63: 1-18.
Andrews, K. (1971). "Personal values and corporate strategy." Harvard Business Review 49: 103-110.
Cao, J. and J. Lerner (2006). The performance of reverse leveraged buyouts. Harvard Business School Working Paper. Boston, MA, Harvard Business School.
Cheffins, B. and J. Armour (2007). The eclipse of private equity. ECGI Working Paper Series in Law. Brussels, European Corporate Governance Institute.
Conger, J. A. and R. N. Kanungo (1988). "The empowerment process: Integration theory and practice." Academy of Management Review 13(3): 471-482.
Davis (2008). Managed by the markets. New York, Oxford University Press.
Floyd, S. W. and P. J. Lane (2000). "Strategizing throughout the organization: Managing role conflict in strategic renewal." Academy of Management Review 25(1): 154-177.
Gottschalg, O. (2007). Private equity and leveraged buy-outs. Study. E. Parliament. Brussels, European Parliament.
Grundy, T. (2004). "Rejuvenating strategic management: The strategic option grid." Strategic Change 13: 111-123.
Hilb, M. (2008). Entrepreneurial Strategizing - Towards a better understanding of strategic value creation in buyouts. Singapore/Zurich, INSEAD/Roland Berger Strategy Consultants.
Huff, A. (1982). "Industry influences on strategy reformulation." Strategic Management Journal 3(119-131).
Jensen, M. (1989). "The eclipse of the public corporation." Harvard Business Review 67(September-October): 61-74.
Kaplan, S. (2007). "Private equity: Past, present, and future." Journal of Applied Corporate Finance 19(3): 8-16.
Kaplan, S. and A. Schoar (2005). "Private equity performance: Returns, persistence, and capital flows." Journal of Finance 60(4): 1791-1823.
Kogut, B. and N. Kulatilaka (2001). "Capabilities as real options." Organization Science 12(6): 744-758.
Lerner, J., A. Schoar, et al. (2007). "Smart institutions, foolish choices: The limited partner performance puzzle." Journal of Finance 62(2): 731-764.
Moskowitz, T. J. and A. Vissing-Jorgensen (2002). "The returns to entrepreneurial investment: A private equity premium puzzle." The American Economic Review 92(4): 745-778.
Phalippou, L. and O. Gottschalg (2007). The performance of private equity funds. University of Amsterdam Working Paper. Amsterdam, University of Amsterdam.
Powell, T. C. (1992). "Organizational alignment as competitive advantage." Strategic Management Journal 13: 119-134.
Prahalad, C. K. and R. A. Bettis (1986). "The dominant logic: A new linkage between diversity and performance." Strategic Management Journal 7: 485-501.
Prahalad, C. K. and G. Hamel (1990). "The core competence of the corporation." Harvard Business Review 68: 79-91.
Simons, R. (1994). Levers of control: How managers use innovative control systems to drive strategic renewal. Boston, MA, Harvard Business School Press.
This article appeared as a book chapter in 2012.