Lessons from Private Equity | MacArthur & Gadiesh

Published in: 2008

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Hugh MacArthur and Orit Gadiesh, at Bain & Company, shows six techniques that owners and business leaders can apply to increase the value of their companies. These are: (1) defining the company’s full potential, (2) developing a change plan, (3) putting the plan to work, (4) using existing talent, (5) equity should be sweating and (6) creating a results-oriented culture.

OK IS NOT GOOD ENOUGH. MacArthur and Gadiesh say that many companies suffer from “satisfactory underperformance”. Where the result is completely okay and the owners as well as management are satisfied. But performing below capacity is not okay; shareholders receive less return from their investment, the company receives a lower value than possible and the management as well as employees receive lower remuneration than is possible. It is the management’s most important task to increase the value of the company.

DEFINE THE COMPANY’s FULL POTENTIAL. To increase profits and stock market valuation, a leader must make strategic choices based on a clear picture of the company’s full potential. To do that, you have to start by building an objective fact base. To analyze demand, customers, competition, environmental trends and map how the company actually makes money. With that, you can determine the company’s true potential and based on that, initiate a few, usually 3-5, key initiatives to take the company there. No company can succeed when it divides its resources among too many initiatives.

DEVELOP A PLAN OR CHANGE. Management develops a plan for how the core initiatives will be implemented. The plan for change must be clear and feasible with emphasis on measurable measures. The plan should describe the whole process from start to end. Thereafter, the organization is shaped according to the plan and the execution is carefully monitored through set measurement values. The private equity companies then design incentive programs to get the management to think and act as owners. Often there is great inherent talent already in the organization, which is simply not motivated in the right way or given the right chances before. In addition, it is of great importance to put together an appropriate board.

EQUITY SHOULD BE SWEATING. To maximize a company’s potential, owners as well as management must be comfortable with financial leverage. This requires management to manage working capital aggressively and to have high discipline regarding investments. Assets or divisions that cannot deliver good returns should be sold or shut down. Free capital is then redistributed to more productive areas of use.

GEAR UP TO STRENGTHEN THE CASH FLOW. A higher debt / equity ratio helps to strengthen management’s focus and ensures that they see money as a scarce resource. If a typical PE company needs $100 for growth, they often finance the sum with $70 of debt and $30 of equity. Then they focus on cash generation, which they can use to either pay off the debt or invest in additional cash-generating projects.

CREATE A RESULT ORIENTED CULTURE. The goal is to create a result oriented and long-term oriented culture. Think out methods that prevent the management from going back to old ruts once they have reached the finish line. A high level of indebtedness also makes it difficult for management to become comfortable and relax.

FOCUS ON EBITDA. PE companies generally use EBITDA as a measure of cash flow. EBITDA will cover debt amortization and interest payments, working capital requirements for growth and investments for maintenance as well as growth. Say a company has $125 in EBITDA of which $50 is used for amortization and interest. Let’s further assume that working capital as a percentage of sales is 30% and that next year’s sales growth budget is $100. The growth thus requires an additional $30 in working capital. Then say the capex need is $10. In total, this business requires an additional $ 90 and has $ 125 in EBITDA to finance this with.

WORKING CAPITAL IS EASIEST TO MANAGE. The bank decides on the interest cost and the amortization rate. The nature of the business controls capex levels – it is possible to hold back for a year, but if you neglect the maintenance, reality will quickly catch up. However, management has control over, and may in the short-term influence, the business’s working capital needs. Working capital can – if managed efficiently – decrease without impairing operations. Say that the working capital requirement in the example above could be reduced to 20% of sales through better inventory management, receivables and accounts payable. That savings would increase cash generation from $35 to $45, equivalent to 29%, simply by changing internal procedures.

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