What can family companies, which typically flourish thanks to values and a long-term investment horizon, learn from private-equity investors? François de Visscher supplies some answers…
Private equity investors traditionally focus on aggressive return generation by taking a short-term approach to investing and managing companies before they exit. Family businesses have become prime targets for PE investors attracted in part by the low leverage, dependable long-term operating history and "brand" value.
This was evidenced in May this year when PAI Europe V, the largest PE fund ever raised in Europe was launched by PAI Partners to target family businesses.
The PE approach may seem the antithesis of a family business's desire to nurture the family's patient capital by safeguarding family values and pursuing longer-term returns. Yet owners or managers of family companies can learn from the investment approach of PE managers.
Think about the following questions: Does their aggressive, short-term return discipline enhance the long-term success of family firms? How would a family enterprise measure up as a potential investment? What PE management tools and discipline might be worth considering self-imposing?
Most importantly, is it possible to have the best of both worlds: the disciplined risk-taking/high rewards of the private equity world and the conservative, safer sustainable growth of a family firm?
PE investors generate investment returns in four different ways: operating performance, management discipline, effective governance and controlled exit strategy. Some of those investment tools are extremely useful for family businesses looking to generate long-term returns.
1. Operating performance
Operating performance by PE investors is typically achieved in three ways: operational excellence, effective use of capital and emphasis on cash-flow growth and return.
Optimising performance requires the most productive use of every operating asset of a family company: physical, human and financial. Outsourcing goods and services, web-based customer response systems, productivity maps for optimal plant utilisation are tools often imposed by PE firms to their portfolio companies.
Many family firms, because of their sales orientation, measure growth in the form of revenues. PE firms prefer to measure growth in terms of cash flow. Their cash-flow growth —not sales growth — creates value either at the time of exit or earlier to reinvest in expansion or acquisitions.
Upon exit, the historical and projected growth of cash flow will be a key value parameter for a potential buyer. Hence, every investment decision by a company is gauged by its short- and long-term impact on cash-flow growth.
The effective use of capital is probably where PE firms find the largest and fastest value-creation opportunities. Reducing the amount of capital the business uses has an exponential effect on shareholder value creation.
If a company has been generating $10 return on $100 capital invested, the PE investors may be able to generate the same return on $50 of capital by leasing assets currently owned (which frees up capital) and the effective use of leverage.
Private equity investors ultimately measure investment performance by the excess of ROI over the cost of capital. The less capital invested and the more return they can generate from operations, the more value they will create for shareholders.
In contrast, family businesses tend to be asset rich in accumulating capital, which often has a negative effect on return on capital employed. Therefore, return on capital to shareholders in the short term — be it through leasing, corporate spin-offs or partial share buybacks —is also an effective way for PE investors to generate superior shareholder return.
2. Management discipline
Management discipline is also a key driver of value creation for private equity investors. Such management discipline focuses on setting measurable goals for each manager, monitoring progress toward achieving those goals, and basing a portion of compensation on those accomplishments and the company's overall performance.
Accountability and compensation make for good management discipline in the eyes of a PE investor.
Each manager will be very clear about his or her responsibilities, what they are accountable for, how performance (or lack thereof) will be measured and how such performance will be rewarded.
Because PE investors have such emphasis on shareholder-value creation, management performance will often be measured by the shareholder value parameters. PE investors also may bring in experienced managers from the industry and in different functional areas to enhance best practices and set better benchmarks.
3. Effective governance
Effective governance for PE investors starts with effective manager information systems and management-reporting tools. PE investors emphasise efficient, timely and well-informed decision-making.
How is that reporting synthesised and what information is needed at each level of management? Often, PE firms use a management dashboard to monitor investment performance without becoming overwhelmed with unnecessary data.
PE firms have also mastered the use of outside board members. Recruiting outside directors and setting up appropriate board incentives are two key activities of a PE firms at the early stage of investment.
PE firms often structure the boards of their portfolio companies around a few committees, such as finance or strategy. The use of board committees helps expedite time-sensitive decisions without the need to convene the entire board.
4. Controlled exit strategy
Controlled exit strategy and the timing thereof dictate many PE investors' investment decisions. The shorter the investment period, the higher the expected returns will be.
They will measure the merits of any investment decision in the business, be it an acquisition, new equipment or a new sales branch, in terms of the impact of that investment on the flexibility of exit and the return that such investments will generate upon exit. Most PE firms look at a three- to seven-year exit.
Managing a family business with an eye toward a medium-term exit is a useful discipline even if such a medium-term exit is not actually contemplated. Families should manage their businesses, keeping in mind one of Steven Covey's seven habits of successful people: Begin with the end in mind.
While many of us in family companies are long-term investors, the tools we learn from private equity investors to manage our businesses better and to measure our performance in the short term allow us to achieve Covey's maxim.