Private equity. The very term continues to evoke admiration, envy, and-in the hearts of many public company CEO’s-fear. In recent years, private equity firms have pocketed huge-and controversial -sums, while stalking ever larger acquisition targets.
Private equity firms’ reputation for dramatically increasing the value of their investments has helped fuel this growth. Their ability to achieve high returns is typically attributed to a number of factors: high powered incentives both for private equity portfolio managers and for the operating managers of business in the portfolio; the aggressive use of debt, which provides financing and tax advantages; a determined focus on cash flow and margin improvement; and freedom from restrictive public companies regulations.
But the fundamental reason behind private equity’s growth and high rates of return is something that has received little attention, perhaps because it’s so obvious: the firms’ standard practice of buying businesses and then, after steering them through a transition of rapid performance improvement, selling them. That strategy which embodies a combination of business and investment-portfolio management, is at the core of private equity’s success.
Public companies-which invariably acquire businesses with the intention of holding on to them and integrating them into their operations-can profitably learn or borrow from this buy-to-sellaprroach- To do so, they first need to understand just how private equity firms employ it so effectively.
The Private Equity Sweet Spot.
Clearly, buying to sell can’t be an all-purpose strategy for public companies to adopt. It doesn’t make sense when an acquired business will benefit from important synergies with the buyer’s existing portfolio of businesses. It certainly is’t the way for a company to profit from an acquisition whose main appeal is its prospects for long term-organic growth.
However, as private equity firms have shown, the strategy is ideally suited when, in order to realize a onetime short- to medium-term value-creation opportunity, buyers must take outright ownership and control. Such an opportunity must often arises when a business hasn’t been aggressively managed and so is underperforming. It can also be found with businesses that are undervalued because their potential isn’t readily apparent. In those cases, once the changes necessary to achieve the uplift in value have been made-usually over a period of two to six years-it makes sense for the owner to sell the business and move on to new opportunities.