What ails the public-company ownership model? For generations, public ownership was unassailable as the right way to promote the best management of a company's short-term performance and long-term health. As a worldwide equity culture blossomed during the second half of the last century, the evidence appeared everywhere: mutually owned companies demutualized, family- or employee-owned businesses undertook IPOs, and governments privatized state-held enterprises to capture the long-term value created by the capital market approach to governance.
Not so today. More than half of all CFOs say they would cut a project with a positive net present value to hit a short-term earnings target set by the market.1 Private equity firms are raising capital at a record pace, acquiring businesses, and in many cases creating tremendous value for themselves and their investors. And corporate boards of directors, which are meant to manage for the long term, are getting sucked into short-term issues, such as compliance. Family-controlled companies (or those influenced by families with a substantial stake) have often performed better than companies that are fully publicly owned—particularly in Asia.
At a McKinsey CFO forum in London during the summer, a panel of experts dug into the current trends in value creation, varied approaches to ownership, and the governance implications for both public and private companies. The panelists were Kurt W. Bock, CFO at the publicly listed German chemical company BASF; Johannes P. Huth, managing director and head of European operations at Kohlberg Kravis Roberts (KKR); David Pitt-Watson, chief executive of Hermes Focus Funds (Europe's leading shareholder activist fund); and Lennart Sundén, president and CEO of Sanitec, a private-equity-owned company. (See Panelist Profiles.) The panel discussion was moderated by Richard Dobbs, a partner in McKinsey's London office. What follows is an abridged version of the roundtable debate.
Richard Dobbs: Johannes, let's start with you. How do private equity firms create value?
Johannes Huth: There has really been a change in how private equity firms have generated value over the past 30 years. In the 1980s private equity firms generated value simply by being able to buy companies relatively cheaply and later selling them at a better price. In the 1990s a lot of value was generated through what you could broadly call financial engineering. Today the markets are fairly efficiently priced, and financial engineering is no longer a differentiating factor. Everyone can do it, and everyone has the same tools.
So the way that private equity creates value today is by fundamentally changing businesses and driving growth. We can do that by making sure that management is a significant participant in value creation and by maintaining our focus. If you run a large conglomerate, there is always one business that isn't a priority in terms of capital allocation, but we can run every one of our businesses as a priority and dedicate the necessary capital to them. We're probably also better at corporate governance than a public company. When we acquire a business, we spend a lot of time on due diligence so that when we sit on the board, we have a detailed understanding of what the company does. That enables us to be very good sparring partners for the management team in further driving value.
Richard Dobbs: Lennart, you have worked at a listed company in the past. You are now the CEO at a private-equity-owned company. What differences have you seen between the two models as you've moved from one to the other?
Lennart Sundén: The two models are actually considerably different, but more so around implementation than around strategy. There really aren't any shortcuts to developing a business; you have to do what is right in the industry. But how to go about it—developing the business plan, deciding on the value creation program, and making decisions while under way—these things are quite different.
In a private equity context, for example, we can make decisions very quickly. We don't have to wait for the next planned board meeting, we don't need to communicate anything to a wide range of investors, and we don't need to tell competitors anything if we don't want to—just a very short communication between the owner and management and it's done. That makes it a very competitive model compared with larger public companies, where the board may be coming in on a more infrequent basis and a lot of time is spent meeting all the requirements that listed companies face today.
Richard Dobbs: And what about long-term value generation?
Lennart Sundén: It's true that private equity funds are temporary owners of a business; that's their model. But if we expect to generate good value when we sell that business either to the stock market or to another acquirer, we have to remember that those potential acquirers will only pay for something that they believe will have value in the long term. So if we haven't invested in research and development, if we haven't invested in marketing, if we basically have stripped a business of its future growth opportunities, we won't get paid for that business when we sell it. The only way that we can actually create something that will have value is if we do invest in that future growth, and I really fundamentally believe in that.
Richard Dobbs: Kurt, many of the players in your industry are private equity owned, but you are listed. How do Lennart and Johannes's comments resonate with your experience?
Kurt Bock: In the chemical industry, the difference between a private equity company and a publicly quoted company is rather small, at least in terms of management's approach. The major difference is that as a large group with about €50 billion in annual sales, we certainly look at the synergies between our businesses, compared with private equity, where they have separate investments and they look at every separate investment on its own. The consequence for us is that whenever we realize that a business no longer fits in our organization, we sell it off. In that sense, we also feed the private equity industry.
Richard Dobbs: So the relationship between the public and private models has become symbiotic, in a way?
Kurt Bock: At least in the sense of healthy competition, yes. Private equity has helped tremendously to make our industry more disciplined, particularly around corporate performance and health. We in the chemical industry were always talking about good health and forgetting about good short-term performance. Only in the past ten years has the industry faced up to the fact that it has to deliver more to its investors. In BASF's case, we have restructured quite dramatically and over the past three years have earned a significant premium on cost of capital. Also, the time we spend making difficult decisions has shortened dramatically over the past five to ten years. Today managers realize that they either get it done or they're out.
We should remember, though, that private equity companies can also mismanage a business. Sometimes they do seem to walk on water, and some investors today are extremely comfortable with private equity investors. Some banks, for example, really throw money at private equity firms as if they know how to do this better than anybody else. That's a very strange development when people who work in private equity often have a reputation for being more capable of running a business than people who have industry-specific experience in management.
Richard Dobbs: Johannes, to follow up on Kurt's earlier point, do public market investors look at business in the same way as private equity investors?
Johannes Huth: No. The two are fundamentally different. A public market investor might reason that if one business is trading at 10 times earnings and a similar one is trading at 15, then the former is undervalued and the investor should buy the undervalued stock and then trade up. That's not the way private equity investors look at a business. We look at the latter business and reason that while it's trading at 15 times earnings, if we take out some costs, maybe restructure something here, sell something there, we can get this business really at an implied value of 10 times, and that's much better. So we look at it, really, from an industry perspective, and I think that's why we are much closer to the way that some of the better-run companies are. If you ask what's our role model, it isn't Goldman Sachs. It's much more like GE: we want to be a very good manager of businesses.
Richard Dobbs: Let me just throw out this question: what motivates the board members of private companies compared with public ones?
Lennart Sundén: I think it comes down to the involvement of board members. Family owners are very involved, and if they have the multigenerational perspective, they are often ever more so. In a public company, board members are a little more come and go. There may be a few replacements every year, and there are always some who are less informed. And while in most cases they make the effort to really be informed, they are inevitably a bit less into the business than the others. In the private-equity-owned firms that I have been involved in, the board members are very, very informed and follow the business closely, partly because they often have a substantial stake in it.
Johannes Huth: Yes, I agree. In private equity, the people who sit on the board are the ones who have actually acquired the business, and when you acquire a business you tend to go through three to four months of very intensive due diligence to understand it better. So when you join the board, you've already spent an extensive and very intensive period of time learning the business and working with the management team to develop a business plan. You've talked to the CEO, yes, but you've probably also gone two or three levels down and visited a branch manager here or gone to a foreign country and visited the manager there. And, of course, we have our remuneration tied directly to how a business performs, so we are very interested in making sure it does well. Those mechanisms are in place to make sure that you pay attention—but they may not exist in the larger public businesses.
Kurt Bock: I would add that it's really important for a board member to have an intrinsic motivation to do the right things. At BASF we support that by making compensation heavily dependent on the company's success in the marketplace, so that managers and employees alike are highly motivated to make the company better every single day, both from a company and a personal point of view. Indeed, we have the same compensation matrix across the entire company, so we have about 1,000 people who are members of our stock option program. Even the bonus payment for our workers in Germany is paid on the same matrix as our board compensation, and this is all very transparent, so people can really understand what they will get if we achieve a certain return on capital or premium on the cost of capital.
Richard Dobbs: So, David, you have been an investor in both private equity and directly in public markets. What's the key difference between the two ownership models?
David Pitt-Watson: I think the point Johannes made is key, actually, about the way different owners behave. You can have a public company that behaves as if it were private; it's extremely well run, it's financing itself properly, and yet it's public. The difference Johannes would note is that with private equity, if you're not well run the owner is going to be on top of you immediately. Private equity investors will make sure that you're running yourself correctly. They will identify companies that are really underperforming, see how they can be improved, invest in them, and incentivize management to do the right thing.
As someone who's interested in the public equity side, I would say, "Gosh! I would really like public equity companies to be run that way." In contrast, I would observe that what most public equity funds do, as Johannes reminds us, is buy and sell shares—they don't actually take an awful lot of care about how it is that they own companies. And I would say, "My goodness, we seem to be losing an awful lot of value from public markets if a private equity firm can take over a company at a premium, incentivize itself, and then turn around and make almost as good a return in five years' time as you would have made in public equity."
For public-company managers, the big issue is that if you're running a company and you have a bunch of so-called owners who aren't actually owners at all—they're traders—how do you respond to them? Forinvestors, the question is how they create the advantages of private equity oversight while maintaining public-company ownership. Intriguingly, of course, the way over this problem is to recognize that we're all getting our funds from exactly the same places; we're all trying to make decent returns with the savings of people who are saving for their pensions, for their life insurance over 20, 30, 40 years. Of course, we have to be interested in the short term, but actually we need to be paying our pensions in 30 years. It seems to me that if public equity managers could say, "We will do all the things that we would if we were under private equity—indeed we can be much longer term than private equity can possibly be"—then that would be a better model than the one that we have right now. Too often, companies in the current model feel they have to respond to the short-term pressures of share price and analysts.
Richard Dobbs: Kurt, does that difference between owners and traders show up differently among different types of investors? What's your experience, especially with hedge funds?
Kurt Bock: Our experience so far with the hedge fund managers has been positive because most of them are really value investors, who are fundamentally interested in the development of the company. However, in one recent unsolicited takeover, we came across very, very short-term arbitrageurs for the first time, and they're a totally different type of animal. They clearly couldn't care less about our long-term emphasis on innovation. When we explained why our proposal to the target's shareholders was better than the management's proposal, they listened politely, but they just wanted us to pay more money, full stop. With those people, you really can't have an intelligent discussion about the company. Those who care, they want to be strategically convinced, and they want management to deliver. So it's all about credibility, and credibility is the result of years of hard work to deliver what you promised, and that is important from the investor's point of view.
Richard Dobbs: On another topic, what do you each think about the way to measure a business's performance and its health? How do you think about balancing the two?
Lennart Sundén: In a highly leveraged company, one would follow different indicators than in a listed company with a normal balance sheet. On a daily or monthly basis, you measure cash flow, covenants, and the fulfillment of initiatives, for example. Then you follow the growth plans or the restructuring plans over a couple of years to see how the company performs on a monthly basis—to see that the company actually delivers on what it has promised. Reporting on those things is very tight in my present environment, whereas the public reporting for a listed company might just have a few lines mentioning that there are projects going on.
David Pitt-Watson: Like every other investor, we're trying to invest long-term insurance and pension money, so we put it in companies that we think will give us a long-term return. We'd obviously like them to be maximizing that return, which underpins all sorts of familiar financial disciplines. We're hugely prepared to take on individual risks in companies because we are investing in 3,000 of them. If a risk looks sensible we would love to back it, but we need to understand what the risk is. We want people to be properly incentivized to do the right thing. We want clarity of strategy. We want, for example, to know that a company is the best owner of the businesses in its portfolio, that it is competitive in the market, and that its organization is constantly being renewed to face new challenges. We want companies to behave in a way that is sustainable—partly because they will attract regulation if they don't, and partly because we're representing literally millions upon millions of pensioners, and it makes very little sense for us to be encouraging companies to do unsustainable or unethical things. So these are the sort of measures that we look for. Frankly, we get very worried about companies that use "fiddleable" accounting measures like EPS as the basis for driving themselves forward.
Richard Dobbs: Johannes, what kinds of performance indicators does KKR look for?
Johannes Huth: Measurement systems and performance indicators are very important, and we pay a lot of attention to them when we actually enter a business. This goes beyond the monthly P&L cash flow and balance sheets, to include the kinds of metrics that will give us some visibility into the future. That metric could be understanding customer behavior or it could be a measure of our own performance in a related area. For example, we own a business that makes machinery for plastics, and one of the things we look at is how BASF does in sales of plastics, because that's a leading indicator. If there's a lot more sold, customers will need more machines; therefore we know roughly what to expect. We develop these measurements as part of the acquisition process and then implement them once we take ownership. Clearly, we're very cash flow driven, rather than earnings driven, because for the first few years we have to repay the loans we take on to buy a business. So we have rolling daily cash flow forecasts in every business, and with today's technology, that's quite possible to implement in pretty much any business. Yet again and again we're amazed at how unsophisticated some of the cash-flow-monitoring mechanisms are, even in large businesses. 
About the Author
Richard Dobbs is a partner in McKinsey's London office.
This article was first published in the Autumn 2006 issue of McKinsey on Finance.
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