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.

Private equity funds do not necessarily acquire glamorous growth companies but often older ones in mundane industries. Similar to a hospital patient in an intensive care unit, companies acquired by private equity fund managers have one purpose: to have their financial health improved and then be sold. However, the stakes and risks are large. In contrast to public and internal capital markets, with private equity funds, an investor's capital is locked up until the sale of the company - or until its parts are broken up and sold individually. There is a price premium for an illiquid investment, which places additional pressure on private equity fund managers to produce a high yield at the time of sale. (Because these acquired companies upon exit are frequently purchased by publicly owned companies, these assets are basically returned to the public capital markets. The intensive care patient is returned to the traditional business model.)

Why Will Private Equity Funds Turbocharge the Adoption of Performance Management?

One question you may be asking is this: What actions do private equity funds take that produce incrementally higher financial value in such short periods of time? The answer is simple. The managers of the private equity funds do three things:

  1. They hire talented senior executives to transform the acquired businesses.
  2. They have relatively higher performance targets and higher investment hurdle rates.
  3. They equip these executives with the technology and tools that constitute and support the performance management suite of methodologies.

The third item is where the turbocharging is occurring. Both the private equity managers and their hired guns who operate the businesses - who have compensation reward packages tightly linked to improved financial and nonfinancial performance goals - are adopting progressive managerial methods. These include strategy maps, customized balanced scorecards, advanced managerial accounting systems to accurately measure and manage product and customer profitability and future value, rolling financial forecasts, customer relationship management systems, analytics-powered business intelligence tools for better employee decision-making and much more. All of these are mounted on an integrated enterprise information platform.
To be clear, the boards of directors of companies listed in public capital markets are not ignoring performance management. They are making the transition from a ceremonial role to a new era of activist boards that more seriously accept their corporate governance responsibilities to represent shareholders.

Today, a building contractor would never manually excavate a foundation with shovels; they equip their employees with industrial-strength power tools. The same goes for most companies - at least those aware of the shortcomings of spreadsheets and other nonintegrated information systems that are limited in supporting control, analysis and decision-making.

References:

1. In 2006, private equity funds accounted for 35 percent of global acquisitions, which was double the prior 10-year average of 17 percent (PricewaterhouseCoopers study).
2. To learn the basics about the performance management framework, read "The Tipping Point for Performance Management" at http://www.dmreview.com/article_sub.cfm?articleId=1027292.
3. For more information, Google Professor Jayanth R. Varma, Indian Institute of Management, Ahmedabad, India, who inspired this article.
4. See http://usmarket.seekingalpha.com/article/22629.