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.