Understanding Firms - A Managers Model of the Firm

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Ask about examples of people who succeeded wildly within the boundaries of the organization. Strive to understand what it was they did that made them rising stars in the organization.

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Was it their initiative and innovative thinking? Was it their ability to rally support? Are the walls covered in stories or photos of customers and employees? The absence of those artifacts says something as well. How does the firm celebrate? What does it celebrate? How frequently does it celebrate?

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Are there quarterly town hall meetings? Does the firm get together when new sales records or big customer orders are achieved? Is the concept of quality present in the culture? Do employees take pride in their work and the output of their firm? Are there formal quality initiatives in place, including Six Sigma or Lean?

Are there regular opportunities to interact with top executives including the CEO? Is employee input sought for new initiatives including strategy? Are the leadership roles filled with individuals who have been promoted from within? Does the firm tend to hire from the outside for senior roles? How does the organization innovate? Ask for specific examples. Be certain to explore what happens when innovation initiatives fail.

How are big decisions made? Do executives encourage decision-making at lower levels of the organization? Is cross-functional collaboration encouraged? Again, ask for examples. If you are hired into a new organization in a senior leadership role, respect the culture and heritage of the firm, even if the firm is struggling. Connect the change initiative to the core cause, purpose and values of the firm. Higher taxes greatly reduce the attractiveness of public companies as a vehicle for buying businesses and selling them after increasing their value.

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  • Public companies in Europe once faced a similar tax barrier, but in roughly the past five years, it has been eliminated in most European countries. Note that two tax issues have been the subject of public scrutiny in the United States. The first—whether publicly traded private equity management firms should be treated like private partnerships or like public companies for tax purposes—is closely related to the issue we raise. Despite the hurdles, some public companies have in fact successfully developed a buy-to-sell business model.

    Those restrictions make such structures unattractive as vehicles for competing with private equity, at least for large buyouts in the United States. With the removal of the tax disincentives across Europe, a few new publicly quoted buyout players have emerged. The largest are two French companies, Wendel and Eurazeo. Both have achieved strong returns on their buyout investments. In the United States, where private companies can elect, like private partnerships, not to be subject to corporate tax, Platinum Equity has become one of the fastest-growing private companies in the country by competing to buy out subsidiaries of public companies.

    The emergence of public companies competing with private equity in the market to buy, transform, and sell businesses could benefit investors substantially. In compensation for these terms, investors should expect a high rate of return. However, though some private equity firms have achieved excellent returns for their investors, over the long term the average net return fund investors have made on U. Private equity fund managers, meanwhile, have earned extremely attractive rewards, with little up-front investment. Public companies pursuing a buy-to-sell strategy, which are traded daily on the stock market and answerable to stockholders, might provide a better deal for investors.

    From where might a significant number of publicly traded competitors to private equity emerge? Their investors would be wary. Also, few corporate managers would slip easily into a more investment-management-oriented role. Private equity partners typically are former investment bankers and like to trade. Most top corporate managers are former business unit heads and like to manage. Public financial firms, however, may find it easier to follow a buy-to-sell strategy.

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    More investment companies may convert to a private equity management style, as Wendel and Eurazeo did. More private equity firms may decide, as U. More experienced investment banks may follow the lead of Macquarie Bank, which created Macquarie Capital Alliance Group, a company traded on the Australian Securities Exchange that focuses on buy-to-sell opportunities. In addition, some experienced private equity managers may decide to raise public money for a buyout fund through an IPO.

    Examples of alternatives to profit maximisation

    A strategy of flexible ownership could have wider appeal to large industrial and service companies than buying to sell. Under such an approach, a company holds on to businesses for as long as it can add significant value by improving their performance and fueling growth. The company is equally willing to dispose of those businesses once that is no longer clearly the case.

    A decision to sell or spin off a business is viewed as the culmination of a successful transformation, not the result of some previous strategic error. A decision to sell or spin off a business is viewed as the culmination of a successful transformation, not the result of a strategic error. Take General Electric.

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    • The company has demonstrated over the years that corporate management can indeed add value to a diversified set of businesses. Indeed, with its fabled management skills, GE is probably better equipped to correct operational underperformance than private equity firms are. To realize the benefits of flexible ownership for its investors, though, GE would need to be vigilant about the risk of keeping businesses after corporate management could no longer contribute any substantial value. GE would of course have to pay corporate capital gains taxes on frequent business disposals.

      We would argue that the tax constraints that discriminate against U. Nevertheless, even in the current U. For example, spinoffs, in which the owners of the parent company receive equity stakes in a newly independent entity, are not subject to the same constraints; after a spinoff, individual shareholders can sell stock in the new enterprise with no corporate capital gains tax payable. We have not found any large public companies in the industrial or service sector that explicitly pursue flexible ownership as a way to compete in the private equity sweet spot.

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      Although many companies go through periods of actively selling businesses, the purpose is usually to make an overly diversified portfolio more focused and synergistic, not to realize value from successfully completed performance enhancements. Managers need skills in investing both buying and selling and in improving operating management. The challenge is similar to that of a corporate restructuring—except that it must be repeated again and again. There is no return to business as usual after the draining work of a transformation is completed. Can you spot and correctly value businesses with improvement opportunities?

      For every deal a private equity firm closes, it may proactively screen dozens of potential targets. Many firms devote more capacity to this than to anything else. Private equity managers come from investment banking or strategy consulting, and often have line business experience as well. They use their extensive networks of business and financial connections, including potential bidding partners, to find new deals. Their skill at predicting cash flows makes it possible for them to work with high leverage but acceptable risk.

      A public company adopting a buy-to-sell strategy in at least part of its business portfolio needs to assess its capabilities in these areas and, if they are lacking, determine whether they could be acquired or developed. Do you have the skills and the experience to turn a poorly performing business into a star? Private equity firms typically excel at putting strong, highly motivated executive teams together. Sometimes that simply involves giving current managers better performance incentives and more autonomy than they have known under previous ownership.

      It may also entail hiring management talent from the competition. Good private equity firms also excel at identifying the one or two critical strategic levers that drive improved performance. They are renowned for excellent financial controls and for a relentless focus on enhancing the performance basics: revenue, operating margins, and cash flow. Plus, a governance structure that cuts out a layer of management—private equity partners play the role of both corporate management and the corporate board of directors—allows them to make big decisions fast.

      Over the course of many acquisitions, private equity firms build their experience with turnarounds and hone their techniques for improving revenues and margins. A public company needs to assess whether it has a similar track record and skills and, if so, whether key managers can be freed up to take on new transformation challenges.

      Note, however, that whereas some private equity firms have operating partners who focus on business performance improvement, most do not have strength and depth in operating management. This could be a trump card for a public company adopting a buy-to-sell strategy and competing with the private equity players.

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      Can you manage a steady stream of both acquisitions and disposals? They have a strong grasp of how many targets they need to evaluate for every bid and the probability that a bid will succeed. They have disciplined processes that prevent them from raising bids just to achieve an annual goal for investing in deals. At least as important, private equity firms are skilled at selling businesses, by finding buyers willing to pay a good price, for financial or strategic reasons, or by launching successful IPOs.

      In fact, private equity firms develop an exit strategy for each business during the acquisition process. Assumptions about exit price are probably the most important factor in their valuations of targets—and are continually monitored after deals close. A public company needs to assess not only its ability but also its willingness to become an expert at shedding healthy businesses. Both public companies and investment funds manage portfolios of equity investments, but they have very different approaches to deciding which businesses belong in them and why.

      Public companies can learn something from considering the broad array of common equity investment strategies available. A portfolio manager can take one of three approaches to creating value: simply make smart investments; invest in businesses and then influence their managers to produce better results; or invest and influence while looking to build synergies among portfolio businesses. A few diversified public companies, such as Berkshire Hathaway, seek to create shareholder value merely by making smart investment decisions.

      Even if you are the Sage of Omaha, that is a tall order. Index mutual funds, such as the Vanguard Index Fund, buy to keep, but they seek to match the market, not to beat it. Active mutual funds that do seek to beat the market, such as the Fidelity Magellan Fund, adopt a flexible ownership strategy. They buy shares in companies in which they expect a particular event, such as a merger or a breakup, to create shareholder value, and plan to sell out and take their profits once it occurs. Because they maintain liquidity for their investors, hedge funds and mutual funds cannot bid to take outright control of public companies or invest in private companies.

      This is where private equity funds, such as those managed by KKR, which are willing to sacrifice liquidity for investors, have an edge. Some diversified public companies, like General Electric, focus, as do private equity funds, on making good acquisitions and exerting a positive influence on their management. The important difference is that where private equity funds buy with the intention to sell, diversified public companies typically buy with the intention to keep.

      If recent history is any indicator—private equity firms are growing while conglomerates have dwindled in number—the private equity funds may have the more successful strategy. If you can comfortably answer yes to those three questions, you next need to consider what kind of portfolio strategy to pursue.