Private equity firms make their living acquiring organizations, building them to greatness, and selling them to reap the rewards of growth and success. Learn how private equity focuses on building value, measuring performance, managing risk, renewing, and experimenting to build high growth and successful organizations.
3. Building Value
Understand after tax costs of capital and use
appropriate valuation methodologies
Evaluate units that and add and subtract from value
Value is built when over time operating units provide
a turn to the corporate parent and its investors in
excess of the cost of capital
4. Performance Measures
Is the operating unit expected to return free cash flow
above its cost of capital over the long term?
Is the unit growing? What new investment is required?
Is the free cash flow stream sustainable?
Will the business unit be worth more or less five years from
now?
5. Managing Risk
Magnitude and probability
Use risk to your advantage
Use high leverage and separate legal entities
6. Risk Reducing Activities
1. Performing extensive due diligence to understand and quantify all the risks.
2. Limiting financial covenants whenever possible to provide maximum flexibility
3. Involving the right experts in the decisions and on the boards of their portfolio
companies
4. Making the tough decisions early, such as:
a) Changing management when results are not meeting expectations
b) Solving labor and benefit problems through tough fact based negotiation
5. Refusing to throw good money after bad by limiting investments in outmoded
business models
6. Extracting cash from all investments as quickly as possible to limit risk and
produce a high return on their capital
7. Having an exit strategy at all times that will maximize returns in the face of a
variety of risks
8. Compartmentalizing risk among business entities to ensure survival of some part
of the fund.
8. Scenarios
Have an exit strategy and outsiders viewpoint
Buy with an end in mind – run scenarios to determine when to buy
and sell
Use small boards (3-7) of outsiders and experts to help advise and
guide business units
Evaluate long term alternatives and cash flow scenarios
for value creation
Size and timing of portfolio acquisitions affect private
equity returns
Do not hold excess cash balances
9. Renewal
Once great companies regress to the mean (or
disappear)
Winning strategies aren’t forever
The environment changes
Employees need continuous education in value
Disciplined thinking and action is lost without digging
deeper
10. Experimentation
Use a portfolio approach to experiment and learn
Focus on doing what you know
Private equity is focused and good at saying no
Fail cheap while avoiding death
Business units will fail, use failures to learn
Never bet the farm, but do take managed risks