January 5, 2009

Pre-Empting the Tactics of Private Equity May Be Best Way to Enhance Shareholder Value, Finds Booz & Company

Many publicly traded companies are outmaneuvered by private equity firms that ‎swoop in, buy them, and resell them at a premium—often after only a short ‎holding period. But public companies are not helpless, according to a Booz & ‎Company report that urges managements to use the tactics of private equity to ‎raise their share prices and make themselves less vulnerable.‎

The report, “Pre-Empting Private Equity: Six Ways to Enhance Value,” highlights ‎the steps companies can take, including shedding non-core parts of their ‎portfolios, rewarding shareholders with dividend increases and stock buybacks ‎and optimizing their capital structures.‎

“Pre-Empting Private Equity” is particularly timely given the economic ‎slowdown, which requires an increased emphasis on value enhancement. ‎

“The growth in this part of the world has been tremendous over the last few ‎years” said Ahmed Youssef, a Booz & Company principal in Dubai who ‎specializes in private equity and conglomerates. “But people aren't really thinking ‎about the practices that maximize value and assure sustainability. These practices ‎are critical in tough times"‎

It's one thing to be successful in an upturn, he added. You have to be able to ‎survive over time and across economic cycles.

The first thing a company needs to do to ward off unwanted attention from a ‎financial sponsor is to analyze its own portfolio of businesses. This means ‎mapping every business unit along two dimensions: strategic fit and economic ‎value. Management should set one of three strategies for its business units—‎invest, hold or divest. Divestment makes sense with business units that are ‎peripheral and that can command a high price in the market. General Electric’s ‎‎$11.6 billion sale of its plastics business in 2007 was an example of a non-core asset ‎sale.‎

The second lesson is to de-emphasize short-term results and manage for the long ‎term. Private equity companies typically have an easier time doing this because ‎they don’t have to answer to public-market stockholders. This is certainly true in ‎the United States, where there is intense pressure to meet quarterly numbers. But ‎several highly successful U.S. companies have found ways to resist short-term ‎thinking and focus on the long term. For instance, Google and Coca-Cola, risking ‎shareholders’ ire, have both abandoned the practice of providing quarterly ‎earnings guidance. The key, whether you are running a soft drink company in ‎Atlanta, a real estate investment company in Dubai or the national airline of ‎Tunisia, is to focus on the most intrinsic measures of value, not on accounting ‎earnings. ‎

The third lesson is about acquisition strategy, and turns an age-old financial ‎adage—buy low, sell high—on its ear. In fact, there is ample evidence that the best ‎acquisitions are those whose price was high but where the targets were growing ‎fast and were in areas adjacent to the acquirer. That is why Google wasn’t ‎necessarily overpaying when it paid $1.65 billion for YouTube a few years ago. It's ‎also why the seemingly high prices agreed to by private equity firms for “roll-‎ups”—acquisitions of companies in related industries—often end up seeming ‎reasonable in the long term. ‎

A separate study published several years ago supports the notion that pricey ‎acquisitions often work well. The investment bank UBS looked at 1,500 deals over ‎a 12-year period and compared the 500 that had ultimately driven the acquiring ‎company’s stock up the most with the 500 that had driven the acquiring ‎company’s stock down the most. UBS found that of the 500 best deals, the top ‎performers had enterprise value-to capital ratios of 3.5-to-1, while the worst had ‎enterprise value-to-capital ratios of only 2.8-to-1. ‎

The fourth lesson is to be unsentimental about low-growth businesses, and ‎manage their costs. This means pressing such businesses to be disciplined and ‎efficient, and identifying operational savings to bring more profit to the bottom ‎line.  Private equity firms excel at this sort of cost control, but some public ‎companies have proven to be good at it as well. For instance, in 2006, the U.S. food ‎company ConAgra set a goal of operating its businesses more efficiently. The next ‎year, even though its revenue only rose 4.8%, the company’s net profit jumped ‎‎43%. ConAgra achieved this improvement after an exhaustive internal analysis ‎helped it identify processes and expenditures that were not adding value. ‎

The fifth lesson is optimizing capital structure. How much leverage should a ‎company have? There is no cut-and-dried answer to this question; optimal debt ‎levels are a function of a company’s bargaining power, the opportunities it enjoys, ‎the threats it faces, and broader economic conditions. ‎

Optimal capital structure may well be different now than it was a year ago, before ‎the credit crunch hit. But knowing how to approach the question is a core ‎competence of private equity players; there will always be one willing to take ‎advantage of a company that hasn’t wrestled with question, and come up with an ‎intelligent answer, on its own.‎

The sixth and last lesson is to use cash to reward shareholders. Microsoft offers a ‎good example of how to do this. In 2004, with $56 billion in the bank and only a ‎few big investment opportunities, the software giant announced it would pay a ‎special one-time dividend of $3 a share, double its already doubled quarterly ‎dividend and initiate a $30 billion open-market share repurchase program. Its ‎financial executives did something big, just as all financial executives must do ‎something big or risk having a private equity firm come along and do it for them.