Will Private Equity Funds Turbocharge Applying Performance Management?

Performance Management - From Managing to Improving

Information Management Online, April 5, 2007

Gary Cokins

In case you have not noticed, there is a sea change occurring in how the capital markets allocate financial capital to organizations to fuel growth and prosperity. Private equity funds are displacing public capital markets managed by international stock exchanges.¹ Widespread adoption of the performance management framework is increasing, but will the emergence of private equity funds accelerate the application of performance management methodologies?²

Who are the Participants in Capital Markets?

In order to understand why private equity funds are sprouting globally, here is a basic primer about capital markets.³ There are three capital markets that profit-oriented organizations can tap to fuel their growth:

1. Public capital markets - These are the stock exchanges, such as the New York and London Stock Exchanges, where individuals like you and I as well as investment managers of mutual and pension funds and university endowments can invest along with others in publicly traded companies. Investors will always bear some risk, but broad participation by constant buyers and sellers typically moderates turbulence in stock price changes. Stock exchanges are also where new companies raise funding through initial public offerings (IPOs)
2. Internal capital markets - This is where operating divisions within a parent company, such as Procter & Gamble, are provided cash by senior executives at the parent's headquarters. In effect, divisions compete for the parent's limited funding by submitting proposals supported by justifications that estimate the financial returns they can generate from the funds. In short, this how financial resources are allocated within a conglomerate.
3. Private capital markets - This is the emerging player. You may recognize the four major types of participants as angels (primarily individuals), venture capitalists (investors betting on entrepreneurs), private equity funds and hedge funds. One differentiator of private capital markets is they are not burdened by compliance with government and public stock exchange regulations and laws.

From these descriptions, you can see that managers of private capital markets are freer to identify investment opportunities and flexibly shift funds in those directions. As a result, they can more quickly produce higher financial returns than public and internal markets. Consequently, they are attracting insurance, university endowment and retirement pension fund managers to supply them with capital. Global liquidity available for investing is at record-high levels,⁴ and managers are chasing the highest risk-adjusted returns.

What is Creating the Emergence of Private Equity Funds?

The emergence of private equity funds is being stimulated by the governance shortcomings of the other two types of capital markets.

Public capital markets will always be appealing to both investors and companies seeking funding. This is partly because a substantial pool of global financial savings is available but, more importantly, because investments are highly liquid. That is, investors can easily enter and exit with their cash savings. And this efficiency with pooled, risk-shared and liquid investments creates broad diversification that translates into a minimal extra price premium to purchase an equity position.

A shortcoming of public capital markets is that investment managers may behave impatiently and be somewhat fickle in choosing which stocks to buy and sell. Examples are the dot-com bust of 2000 and former U.S. Federal Reserve Chairman Alan Greenspan's famous warning of "irrational exuberance." An impediment to full attainment of profit potential is the legal separation of a company's ownership from its management. Investment managers rarely have access to internal managerial information that the company's managers have. Yet, at the extreme, we observe young, recently minted MBAs at investment banking firms pressuring and influencing accomplished executives to make decisions favoring short-term financial results when relatively better decisions could result in much higher long-term financial outcomes. Finally, because recent Enron-like scandals have inspired regulatory burdens such as the Sarbanes-Oxley Act, publicly owned companies incur significant out-of-pocket expenses for regulatory compliance.

Internal capital markets can yield better financial performance because the executive leadership has access to internal information, marketing plans, return on investment analysis and projections. On the downside, however, similar to public capital markets, internal capital markets also impede the ability to attain full profit potential and maximize a company's market value. But the explanation is for a different reason: "corporate socialism." What I mean by this is that executives tend to patiently tolerate underperforming operating divisions. Further, they may be reluctant to starve an old colleague heading a division of his or her capital requests even though a sober and objective assessment would recommend it. Politics and personal favoritism are present. Strong divisions often subsidize weak ones.

In addition, executives tend to tolerate inefficiencies and fat that privately owned companies would be more ruthless to address and remove. They tend to universally apply standard performance measures that are not tailored to the unique traits of a division's industry. In short, some publicly owned company executives are simply too slow at restructuring or divesting a division that is not living up to its full potential.

Private Capital Markets are Free of the Shortcomings Public and Internal Capital Markets

It is because private capital markets are not subject to the anchors and burdens of public and capital markets that they are capable of relatively higher performance. With a "Barbarians at the Gate" reputation, private capital managers reject internal capital allocation "socialism" in unleashing higher financial value from the tangible and intangible assets of their acquisitions. Within the four types of private capital market participants, private equity funds, such as the Blackstone Group and the Carlyle Group, are relatively more aggressive than angels and venture capitalists. With a "buy low and sell high" approach to investing, private equity funds have one goal: to transform and turn around the acquired company. Note that they always have an exit plan. In contrast, angels and venture capitalists are interested in helping the young companies they are funding to successfully blossom as a business, such as Yahoo! and Google.

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