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Column

Robert H. Rock
Chairman and Publisher
Directors & Boards

What Can We Learn from Private Equity?
A lot — especially about how PE firms approach the governance of their investments.

By Robert H. Rock

The value of mergers and acquisitions has soared, up almost 50 percent from last year’s record amount. An increasing number of these deals involve private equity (PE) firms. During the last takeover boom in 2000, PE accounted for 1 in 25 deals; so far this year, it’s 1 in 3. In the first half of 2007, PE raised a quarter of a trillion dollars; 15 years ago, the figure was $10 billion. PE now drives the financial markets, and the heads of these firms are the new kings of Wall Street.

Over the past five years I have voted three times as a director to sell the company to a PE firm. At the time, the price paid for these companies, bid up during an exhaustive auction process, seemed very full. But within a few years, the new owners had extracted a tidy profit, and in one case an outright killing.

How did they accomplish this? They upgraded management, raised performance expectations, tied rewards to performance, instilled a sense of urgency, cut costs, pared unprofitable operations, grew those parts where returns were highest, capitalized on low interest rates and relatively loose covenants, and imposed the discipline of leverage. In addition, these PE firms revamped the board of directors, often inserting a strong outside chairman, and instituted rigorous oversight processes that helped bring about these superior results.

In an article in the November 27, 2006, Wall Street Journal, Don Gogel, CEO of the highly successful PE firm Clayton, Dubilier & Rice (http://www.cdr-inc.com), spotlights the structural advantages of private equity, including “a better governance model than public companies.” He asserts: “It is extremely difficult for public company CEOs and their management teams to focus and execute long-term strategies that require fundamental changes in business practices at the same time as they are responding to the cacophony of their many, multiple constituencies.”

PE owners are usually tough taskmasters, but as the one and only taskmaster they can give clear instructions, enabling management to spend their time creating a healthy business. Many public company CEOs complain that they spend so much time with a broad range of stakeholders that they have little time left for the business.

Gogel underscores that PE firms recruit directors with industry and functional expertise specifically relevant to the needs of the business. Their firsthand knowledge enables them to add value to operating reviews and strategic discussions, and enables board meetings to dig deeply into how the company can compete successfully in its marketplaces.

In Gogel’s words, “Board meetings are issue-oriented, not show-and-tell.” The directors are focused on controlling the business and are engaged in building its future. In a public company, some of these experts would not qualify as independent directors and thus would be excluded from serving on important board committees, including audit, compensation, and nominating.

Life is not much fun in a public company with the media, activist investors, and politicians breathing down their backs. No wonder many CEOs embrace a PE offer when it comes knocking. They can rid themselves of many of a public company’s time-consuming hassles, such as “checking-the-boxes” compliance, and they can make a bundle in a subsequent sale or going-public transaction.

Since 2003, PE has benefited from almost ideal conditions, namely low interest rates, plenty of liquidity, and rising asset prices. However, these conditions can change in a hurry. The 1980s’ PE boom (or boomlet, by today’s standards) came to a halt in the face of rising interest rates and a slumping economy, and the same conditions may bring an end to this one.

However, for now PE remains vigorous, and public companies can learn a lot from these firms’ management philosophy, particularly their corporate governance.

Robert H. Rock is chairman and publisher of Directors & Boards. He is a director of several publicly traded companies and nonprofit organizations. He can be contacted at rrock@directorsandboards.com.