What can we learn from Private Equity?

Historically, there has been the misperception that Private Equity makes its money by cost-cutting and asset stripping, not investing in the business and having a short-term focus. However the recent downturn in the economy has made it apparent that to survive private equity firms need to do more than concentrate on transactions but they need to focus on the running of the businesses in which they have invested to ensure good returns, especially as they are likely to hold these companies for a longer period of time.

So what are the more successful private equity firms doing and how can businesses learn from these successes. The following key practices were discussed at a recent meeting of the PARC (Performance and Reward Centre) led by Lisa Stone of HgCapital.

·         Focus on growth

·         Medium to long-term focus

·         Plans and priorities

·         Focus on people

·         Effective Boards

·         Alignment of incentives

In this blog I am going to highlight how reward strategies can support Private Equity businesses with their turnaround agenda.

HgCapital data has shown how for every pound invested twice as much value comes from revenue growth than from margin (ie reducing costs). With Private Equity the time horizon to drive more growth is likely to be around the five-year mark. Where growth is required revenue would normally be the highest weighting in the short term incentive plans (50% based on Revenue, 25% on profit and 25% on other targets would be quite common).

Strategic metrics which align to the business plan and are cascaded and owned by the management team are also important to ensure that the strategy is clear, accountable and measurable. Therefore key indicators such as Net Promoter Score (Customer Satisfaction) or sales conversion rates could also be included in the incentive plans.

In times of change the incentive measures are often changed annually to react more tactically to the new strategy and business plan.

Private Equity firms normally appoint non-executive directors but they are entirely dependent upon the management team and continued engagement of the staff. This requires a particular focus on people and in particular employee engagement. If your business has implemented metrics to monitor employee engagement then consider included these metrics in the management incentive plans.

As with most companies the remuneration packages of the Private Equity boards will comprise of base salary at the market rate for the industry and bonuses of around 100% for the CEO and 60-70% for the CFO. As mentioned above the bonus plans are likely to be tactical and linked to the critical criteria of the business plan for that particular year.

Equity plans will most likely be two-fold; plans which receive the executives own investment (usually at about 1 x salary) and those which are provided by the Company. For a CEO the equity provided by the Company is likely to vest over the planned investment period and pay out only where there is a successful exit from Private Equity status. The value of the equity provided to the CEO at the end of the investment period will vary considerably but is generally distributed to the top 20 executives with the CEO perhaps receiving 5% of the value of the business and the CFO receiving 2%. Of course Private Equity deals are generally highly leveraged and therefore there is the risk of the Executives losing their own investments as well as the potential upside.

The two biggest contrasts between Private Equity and PLCs are with the short-term and long-term incentive plans and using these to support delivery against the business plan.

The focus on the bonus plan being tactically used with a few measures which change each year – rather than the desire within PLC for a balance of financial measures and continuity in their bonus design.

With the equity plans it would be very difficult to persuade the Rem Co and the shareholders that a single event should be the criteria for vesting rather than market related performance criteria such as EPS.

So although there is much to learn from the success stories within the Private Equity arena there must also be a recognition that Corporate PLC needs to align to shareholder interests which are much different to those of the senior executive team.