Private Equity: The New Normal
Klaas begins the session with several powerful slides and describes how many companies tend to go the private equity route. There is a dramatic growth in the number of active private capital type firms and large rise from 1998-2000, 2004-2006, and 2014-2015. An estimate of $1 Billion in capital is raised every year. Obviously the buyout portion is usually most relevant to the CFO audience.
Most privately backed companies seem to do well over time with the exception of Venture Capital. Private Equity firms target ~20% on average and Klaas explains that this tends to be a bifurcated space. Klaas informs the audience that PE firms tend not to report when things aren’t going to well so the numbers may be biased. Today in private equity people look for operational value add. Leverage tends to magnify returns. Smart people adjust for this with a risk adjustment. Generally speaking, if you want to leverage your business you need an asset heavy business. Typical time that a private equity firm holds on to a business averages about 4-5 years.
A lot of CFOs are turned over by going to a PE firm, something to think about if you are in the ballpark to get acquired by a PE firm,”
Klaas remarks before turning it over to the panelists. He then asks, “From a broad industry perspective, where do you guys see the market going? What does the landscape look like? What kind of firms are people looking for?”
David responds first, pointing out how much money exists in private equity, and that leads to an ongoing number of private equity deals happening. “They are big firms, sophisticated people; they have a lot of money to put to work. They need to look for bigger and better targets to make that happen,” David highlights.
He then discusses how private equity models everything at an incredible level of detail. PE firms want to understand what the operational model will be for several years of the investment thesis. He suggests that you will want to deploy enough capital and start going after bigger assets that you can leverage. This becomes more relevant for CFOs in middle market companies because that is where a lot of the activity is.
Next, he defines how the role of CFO and leadership within PE is different than what he sees in that of AT&T or Cox. The role is not for everybody – at the end of 4 years, he was only one from the original top senior leadership team pre carve out from AT&T.
As for industries, David believes the trend is going to be across all industries, and PE firms are very opportunistic, what they go after will change over time. The general characteristics of having enough cash flow, having assets you can leverage, and having operational improvement is what is important. “It’s a formula on the financing side, and private equity is excellent at it. It’s not for the faint of heart in staying ahead of the cash flow and servicing your debt and trying to produce that return,” David advises.
“It is very intense, and you get more help from your PE partners than you ever thought possible! And they don’t miss anything- they are smart people. They’ve seen a lot, they understand patterns, they don’t miss things.”
Evan agrees that the prevalence of private equity is not going away and will probably accelerate. He believes this for two reasons. One, private equity money needs to be put to work, and two, there are more and more targets because of the increase in quarterly scrutiny by Wall Street, specifically activist investors. Second, he thinks activist investors are precipitating companies- either selling themselves or selling divisions.
Showing the benefits of going private for a period, Evan talks about how it takes you out of the scrutiny of Wall Street and quarterly earnings sales reports giving you an opportunity to do some heavy lifting. He describes how being taken out of the public eye makes it easier for restructuring. “I think there is a place for PE firms to add significant value to companies in all industries,” Evan concludes.
David supplements Evan’s point by expressing that while you do not have to prepare quarterly earnings, you are dealing with daily reporting and cash flow at a much more detailed level. Some may look at it as having an activist shareholder in a much more transparent environment. Evan agrees with David, “It is very intense, and you get more help from your PE partners than you ever thought possible!” David adds, “And they don’t miss anything- they are smart people. They’ve seen a lot, they understand patterns, they don’t miss things.”
“What do you think are your best skills that you bring to the table as you go through that transition?” Klaas asks, noting how Evan has now been through the entire cycle. “If you think through that, you’ve been a ninja of different skill sets, dealing with various people.” Evan responds, “You have to have the ability to change and react to whomever your current audience is.” When HD Supply was a part of Home Depot, a Fortune 20 company, they never had to question the ability to meet financial obligations. When the private equity deal went through, HD Supply suddenly had six billion in debt on its balance sheet, and that changed my role. Now I had to communicate with vendors, landlords, and business partners, convincing them that we could meet our financial obligations. That carried an enormous amount of time and effort.
As for timeline and growth, Evan clarifies that private equity firms want to see that you are going to make changes. Their goal is to grow shareholder value in a medium term about 3-5 years. “You have to be on board and be their partner,” Evan suggests, “Help them identify where the opportunities lie, whether it’s selling noncore assets, restructuring, reductions in force, or growth in acquisitions in other areas.” He emphasizes that while some of these decisions are not popular, you have to be able to make them and move fast.
He also tells the audience they have to be ready for the exit strategy from private to public. In 3-5 years you have to be prepared for the IPO, which can be difficult because during the transition the board is mixed with independent directors. They don’t always get along, and it’s the CEO and CFO’s job to manage that dynamic. “You have to have the right mindset and personality; I think it’s fun.”Evan declares.
David offers a CEO’s perspective in what he looks for from a CFO in this job, “It’s the toughest job in the company because it is extremely broad-based if done well.” He thinks the CFO plays such an important role with the credibility of the company to the PE firm. “It’s a night and weekends job,” David reveals, “You’ve got to have a positive attitude and just keep doing the job. It is a critical role.”
Klaas steers the discussion toward governance by asking, “What are the dynamics that go on at the board meeting when you have to trade off growth in a company versus generating cash for your shareholders?”
David talked about how even with a nine-member board, there is one or two key decision makers that own the deal for the PE firm. The alignment with that person or couple of people is critically important. He described how in the first few years it was straight forward to stay aligned because of the pre-deal modeling and strategy development. “Divergence starts when you get into longer term growth questions not contemplated in the original deal thesis,”David articulated that what might be winning to you is different from what the PE firm wants, and you have to make that clear and come to an agreement on the path forward.
Contrasting private equity with public boards, Evan describes how private equity boards push you to grow the top line and everything is about cash and profitability, whereas public boards don’t want you to go too far out on a limb. But that PE firms are also superb at balancing that with looking long term. “These folks are smart people, they are going to make good business decisions looking out over their investment horizon,” he reiterates.
Klaas: “If you think back to the start of your transactions, what are the three things you would have done differently? What would you recommend to the audience?
Evan jokes that he’d prefer not to be quite that “levered”, but then admits they didn’t have much control over that, giving credit to the PE firms for helping them navigate through that. His advice, “I would have tried to move quicker than we did and be more aggressive on what we thought was the right answer.”
David leads to the softer, more corporate people issues that are less top of mind for many PE firms. Explaining that by trying not to be combative with the PE team, there were things that he backed off on as a CEO that could have made the company run more effectively.
“Private Equity companies tend to value senior management but undervalue the workforce under senior management,” Evan adds, “They have the attitude they are plug and play.” This can lead to issues with keeping good people motivated and creating cash incentive plans because private equity discriminates on whom they give equity.
Chris White, Market Leader and EVP of Savills Studley, asks the panelists about what to expect in the first 100 days of private equity?
Evan stresses the importance of understanding expectations- Get all the players together and decide on one way of conducting communication and reporting. Create a framework or strategy over the horizon of private equity ownership and make sure everyone is rowing in the same direction.
David emphasizes the value of building credibility. Over communicating and calling more meetings than you think necessary builds confidence in the first 100 days and private equity firms will then let you run your business and they will support it.
Alan Sollenberger, CAO of HD Supply, closes the program with, “What are the most positive aspects from your experience?”
David thinks he is likely to spend the rest of his career in the private equity environment because the focus and motivation is very clear. Private equity is very pure in its objectives from his business perspective. Evan prefers to work in a public company environment but greatly values the experience with private equity because you learn so much from working with the people in these firms.