Reasons why Private equity firms have been able to create superior returns

Fortune has a quite good article about the reasons why Private Equity firms have been able to create superior returns for their investors. According to the article the main reasons are that Private Equity firms are able to :

• attract and keep the world's best managers,
• focus them extraordinarily well
• provide them with strong incentives
• free them from distractions
• give them all the help they can use
• let them do what they can do

As it is obvious it is therefore mainly the alignment of interest between owners and managers combined with empowerment of the managerial role that creates an environment that enables the manager to focus (almost) solely on creating value for the owners of the firm.

With regards to the superior returns we will of course briefly forget such issues as survivorship bias with regards to PE-returns and the higher systematic risk of PE-investments which could explain the superior performance;)

Nevertheless, the following presents some excerpts from the article:

Look inside the companies owned by major private-equity firms, talk to the executives who run them, and you'll find a distinctive way of managing that's sharply different from what goes on in most publicly traded companies or most private companies under conventional ownership. Investigation shows why privately held firms - at least if they're owned by one of the major buyout shops - have important advantages over competitors, and why they're regrading the playing field in several industries. Many of the lessons apply to virtually any organization.

The differences begin at the most fundamental level, with new objectives. Private-equity firms want to buy companies for their portfolio, fix them, grow them and sell them in three to five years. The eventual buyer could be another company in the portfolio company's industry, another private-equity firm or the public, through an IPO. The holding period is occasionally less than a year or as long as ten years. But always the goal from day one is to sell the company at a profit.

Facing a goal like that changes a manager's mindset - usually in positive ways. No longer seeing a corporate future that stretches indefinitely into the distance, executives realize that they gain nothing by resisting change: With the exit looming, driving change is their only hope.

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Pay is a whole different concept in PE-owned companies. Don't come to play unless you're prepared to put significant skin in the game. While public companies talk a lot about aligning executive pay with performance, they typically award stock options and restricted stock on top of already substantial pay packages, giving executives lots to gain but little to lose.

And in big companies those options reflect the fortunes of the overall corporation, not the specific business a manager is running. By contrast, private-equity firms make the game much more serious. Not only is a far larger share of executive pay tied to the performance of an executive's business, but top managers may also be required to put a major chunk of their own money into the deal.

At Dunkin' Brands (home of Dunkin' Donuts), which is co-owned by private-equity firms Bain Capital, Carlyle, and Thomas H. Lee Partners, CEO Jon Luther says, "I insisted that all officers invest personally. Management has a substantial amount of their personal money in this. It makes a huge difference in the 40 officers of the company when they show up for work" they have an ownership mentality rather than a corporate mentality." Luther says the resulting difference in behavior is clear: "There's now a very different discipline in how you spend money," he explains. "If it doesn't grow the business, why would you do it?"

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Private-equity firms don't always bring in star outside managers to run the companies they buy. In fact, they much prefer to buy a company with strong management in place, as Luther was at Dunkin' and Bhasin was at Genpact. "The strong preference is to use the talent in the company," says General Atlantic chairman Steven Denning. "You want to back a superb management team and liberate them."

But if PE owners decide that they need to bring in an outsider, they hold a valuable advantage over public companies: No one will know how much they've paid. Public companies have to report executive pay in SEC filings.

Private companies don't. In this era of outrage at grossly overpaid executives, any public company that paid, say, a $20 million signing bonus or offered a package with a potential nine-figure payout would be pilloried by governance activists and the press. But the reality is that some executives are worth that kind of money, and when private-equity firms offer it - as they do - no one knows.

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The trend has changed the high-stakes game of executive recruiting. "Top candidates are no longer waiting around to be recruited to a public company," explains über-headhunter Gerard Roche of Heidrick & Struggles. "Instead they're jumping to a private-equity firm and watching for the right opportunity to become a CEO. It wasn't like this ten years ago."

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Freedom to pay is just one example of an advantage that many PE veterans consider critical: general freedom from the pressures of the stock market, media and Wall Street analysts. Remember, these companies have strong incentives to act quickly - but acting quickly often produces volatile quarterly earnings, which Wall Street doesn't like.

Making a big new investment or taking a write-off for a plant closing may be the best thing for the business, but many public companies hesitate because such actions could cause the stock to tank.

PE-owned firms don't have to worry about it. "In private equity, you don't need to go from quarter to quarter," says von Krannichfeldt. "You can take write-offs, you can make investments that aren't accretive in year one or year two. It's a very different dynamic."

One often hears that freedom from public markets carries another boon for privately held companies - no more compliance with Sarbanes-Oxley or the many other regulations on public firms.

But PE executives say that supposed advantage isn't such a big deal. After all, the companies may be reentering the public markets in just a few years. "It's not about accounting compliance," says Luther. "We treat ourselves like we're public."

What makes a huge difference is the release of managerial time from trying to placate and massage the public markets. Talking to shareholders, analysts and the media may be important jobs for a public-company CEO, but they're massive distractions from the company's operations. In practice, a public-company CEO is lucky if he spends 60 percent of his time actually running the place. In a PE-owned firm those distractions disappear, and the CEO is free to spend close to 100 percent of his time focused on the business.

Increased managerial attention comes to many PE-owned companies in another way as well. Several of these companies were initially parts of much larger outfits where they were not central to the mission. The parent firm focused top-management time and corporate resources elsewhere, which not only was bad for the stepchildren financially but also demoralized the managers.

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Much of that attention in PE-owned companies comes from a source that makes some public-company CEOs uncomfortable: the board. Because they're corporations, even privately held companies must by law have boards of directors. But the
boards of PE-owned companies are fundamentally different from the public boards that are the focus of governance activists. They're typically smaller and consist only of representatives of the PE owners plus industry experts whose explicit job is to help management create and execute strategy; many directors fulfill both roles. "The board is far more involved in assisting the company," says General Atlantic's Denning.

Besides furnishing heavy-hitting directors, large PE firms also bring a world of connections to the companies they own. "Our three partners are able to connect us with people we otherwise couldn't meet," says Luther of Dunkin'. "For example, the Carlyle folks introduced us to one of their investors in Taiwan, and we soon had an agreement for 100 Dunkin' Donuts stores there."

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Clarity is a running theme in why PE-owned companies on average perform so well. They suffer no confusion about the role of the board, who's ultimately in charge (the PE firm is), and the eventual goal. They benefit also from a clear view of what they're managing along the way: It's cash.

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Public companies often get caught up in disagreements over what to measure - earnings per share, return on equity, Ebitda, return on net assets. PE-owned firms generally bypass that debate. They're managed for cash, the ultimate business reality.

However a few caveats still exists:

Warren Buffett has criticized private-equity firms as "deal flippers" uninterested in building long-term value. Some firms extract exorbitant fees from their portfolio companies.

Continued abuses could attract federal regulation; the Justice Department is already investigating possible collusion in bidding for companies. This industry is filled with some of the world's smartest people; now it needs leadership to start self-policing to make such intrusions unnecessary.

But a longer-term threat to the private-equity industry could be a development that would actually be good news for the economy. Consider: The most fundamental question raised by today's private-equity boom is, Why can't public companies do all these things themselves?