Call it heartless, but private equity has changed corporations

Private equity makes for an easy target. Much of the targeting is self-inflicted, thanks to the large compensation packages that private equity professionals receive on account of the 2-and-20 model – 2% management fee on assets and 20% on returns over a hurdle rate – combined with the mediocre performance of many private equity funds.

The enormous fortunes made by private equity fund managers as a result, and the preferential tax treatment of these, have caused considerable derision and envy. Despite this, it is important to acknowledge the beneficial impact that private equity has had over the past four decades on how companies are managed.

On the 40th anniversary of KKR, arguably the pioneer in the private equity space, there was an interesting interview with the firm’s founder, Henry Kravis . It is worth reading and I will use it as a provocation for the rest of my article.

Repair business

It is important to remember that private equity is essentially in the repair business. They take over companies that they believe are poorly managed. After removing them from the public eye, they turn these companies around in a relatively short period of time, usually between two to six years. After the turnaround, the company is sold at a much higher value, based on its revised performance and future prospects. The delta change in valuation within a tight time horizon results in a large upside for the private equity fund. This opportunity exists only because many companies were not run well from a profit perspective.

You have to dig deep into the interview to discern the KKR model for turnarounds. In its simplest form, this consists of getting the right team in place and setting the appropriate metrics on which the team will be held accountable. In addition, the model identifies the strategic thrusts needed to rejuvenate the business: brand, supply chain, etc.

It is only after such analysis, I suspect, that the team and the metrics are put in place. This ensures that appropriate talent with the required competency is hired and the right metrics to track turnaround progress are laid out. The aggressive use of debt and financial engineering, which has historically been a feature of private equity, seems to be currently de-emphasised as liquidity has tightened.

Interestingly, KKR appears to accept that it is now in a low-growth environment in the advanced world. To create value in such a sluggish setting, the focus is on delivering single-digit sales growth and double-digit earnings jumps. Fundamentally, regardless of how much stakeholder chatter there is in the interview, this is the private equity model. It is what private equity has uniquely brought to the table: the single-minded running of the company, not as manager but as if it were your own.

The unwavering attention given to profits and returns can be seen in Karvis’s observations at the end about environmental, social and corporate governance. “We also saved an enormous amount of money on costs,” he notes.

All about profits

Private equity, essentially speaking, resolves the agency problem that arises in public corporations from the owner and manager having different incentives. Owners wish to maximise profits and managers are expected to act in the owners’ (and shareholders’) best interests. Managers often don’t do so. Private equity aggressively rewards its operating managers for the turnaround by sharing the value created on exit.

Private equity's uncompromising attention to profitability has now seeped into large public corporations, especially those based in the United States. And, as an unintended consequence, compensation for chief executives have gone up dramatically.

Companies such as Coca Cola and Pepsi have learned to live with flat, or even declining revenues due to the tepid economic milieu and currency fluctuations. Yet they are still able to increase profits. In a recent quarter, for example, Coke’s revenues were down 3% while profits were up 19%. This despite more being spent on advertising, which is the lifeblood of a consumer brand that sells carbonated sugar water.

Indra Nooyi, who helms Pepsi, reiterated the reality in a recent Harvard Business Review article. “We have to do two things as a company: keep our top line growing in the mid-single digits, and grow our bottom line faster than the top," she observed. "...The culture needed to change. We had to eliminate redundancies. We had to slim down to reinvest in R&D, advertising and marketing, and in new capabilities.”

Private equity's effect on corporations, if you wish to be charitable, the improvement in returns, at least in the case of Coke and Pepsi, are coming from reducing costs that do not create value for customers. Some of the savings are kept to enhance the long-term sustainability of the business through increased investments in research and development and marketing.

The remaining cash generated is for the shareholders. Of course, there is a limit to this type of performance improvement. But if companies are flabby, and many are, it is hard to argue against it.

On the other hand, if you wish to be unkind, private equity is clearly heartless, what with the relentless spotlight on margin improvement. This leads me to end with my favourite story from this high finance world. At a party of one of these fund managers, authors Kurt Vonnegut and Joseph Heller are the guests. Kurt tells his friend Joseph, that the host has made more money in one day than Joseph Heller has from the entire royalties of his bestseller, Catch 22. Heller says:

“yes, but I have something he will never have… Enough!”

Nirmalya Kumar is Member-Group Executive Council at Tata Sons and Visiting Professor of Marketing at London Business School. His Twitter handle is @ProfKumar. This article is written in his personal capacity.