Governance Engineering

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Theoretical Framework

In this part, the literature concerning value-creation methods by private equity firms in buyouts is explored. The actions suggested in the literature are organized under four main themes and are summarized in a table at the end of this section.
The literature on private equity suggests a variety of methods to how private equity firms can add value to their portfolio companies. In this section, the authors organize the differ-ent methods for value creation suggested by current literature into four main themes: gov-ernance engineering, financial engineering, operational engineering, and strategic redirection. The first three themes were suggested by Kaplan as the main sources for value enhancement (Jensen et al., 2006). Many other authors have also argued for different aspects of value creation that could be classified under these themes. Corporate governance was suggested as a cor-ner stone in value creation by many studies (e.g., Millson & Ward, 2005; Nisar, 2005; Jen-sen et al., 2006). Other issues related to financial structure and operation were also widely discussed in the literature (e.g., Rogers et al., 2002; Arundale, 2004; Jensen et al., 2006). The fourth theme has emerged from several articles (e.g., Rogers et al., 2002; Lieber, 2004; Zong, 2005) since strategic redirection also leads to value creation by the private equity firms.
The authors base their review around these themes as each presents a different dimension of value creation. Furthermore, these four themes capture the vast amount of methods and tools for value creation suggested in the literature. Each theme is discussed extensively, in-cluding key concepts, methods and tools for value creation used by private equity firms as explored in the literature. Though the authors organize the methods for value creation un-der the four themes, they can also complement each other and somewhat overlap. Some is-sues may relate to more than one theme. For instance, the change in capital structure, which is a part of financial engineering, may also have consequences for governance engi-neering and operational engineering. Therefore, these four themes should be viewed as part of an interactive process, leading to value creation.
The review starts with governance engineering, as it has received much attention in the lit-erature and it is one of the major sources of value creation by private equity firms. Finan-cial engineering follows with a discussion of the financial aspects and their effects on the portfolio companies. Operational engineering is presented next, followed by strategic ad-vices. Finally, the main issues of each theme are summarized in a table at the end of the section in order to ease the reader with reviewing different aspects of value creation.

The theme “governance engineering” refers to the strengthening of corporate governance of portfolio companies. Eun & Resnick (2007) define corporate governance as “the economic, legal, and institutional framework in which corporate control and cash flow rights are distributed among shareholders, managers, and other stakeholders of the company” (Eun & Resnick, 2007, p. 78). In that sense, corporate governance is an attempt to protect shareholders’ rights by develop-ing mechanisms to deal with the agency problem.

Agency problem

The essence of the agency problem is the separation of ownership and control. The prob-lem is studied under the agency theory, which is the analysis of the conflicts between man-agers and shareholders. Agency theory has received much attention in the economics litera-ture (Jensen, 1986). Jensen and Meckling (1976) define the agency relationship as a contract between at least two persons, a principal and an agent. In the context of a corporation, the firm’s owner – the principal engage the managers – the agent, to perform some service on behalf of him, which includes entrusting the agent with residual control to run the com-pany. However, the principal can never assure himself that the agent will do what benefits the principal the most. By assuming that both parties in the relationship are utility maxi-mizes, it is believed that the agent instead of acting on the principal’s interest, will act upon his own interests first.
According to Arnold (2005), one of the main sources of the agency problem is the asymmet-ric information between the finance providers and the managers. Finance providers do not always have direct access to internal information of the company, which may cause them additional risk. For example, managers may spend money on projects that have much high-er risk than what is acceptable to the investors. This scenario is referred to as moral hazard.
Another issue that may cause conflicts of interests is the distribution of profits to share-holders. According to Jensen (1986), payouts to shareholders reduce managers’ power, as resources outflow from the organization. Further, managers are keen on managing larger firms. Retaining profits increases the size of the firm and thus, enhances their power.
A particular form of the agency problem brought forward by Jensen (1986) is what he called, the “free cash flow” problem. Jensen (1986) explains that companies with ample cash flow find themselves having more cash than what is needed to undertake profitable in-vestments. It is then a duty of mangers to distribute the free cash amount to the sharehold-ers. Unfortunately, mangers of these cash-rich companies are tempted to retain the cash and in many cases, waste money on low-return projects. The unproductive use of cash will eventually cause the destruction of the firm value. Eun & Resnick (2007) further argue that the free cash flow problem tends to be more serious in those firms at mature stage with li-mited growth opportunities. Meanwhile, the targets of buyout investments are usually well-established firms in mature industries.
Another form of the agency problem is the under-investment behavior. Investors of public companies and financial analysts tend to overemphasize quarterly performance (Zong, 2005). The pressure to show profitability in the short-run causes managers being reluctant to invest in projects that only generate profits in the long run. Although these projects may add tremendous values to the company, they require a large investment and sometimes show a negative cash flow in the current period, which investors will not be happy about. Such under-investment behavior is likely to result in losses of shareholder wealth.
No matter which form that the agency problem may take, the main issue pointed out by Jensen (Jensen et al., 2006) is the absence of active investors. According to Jensen, mangers left unchecked and unmonitored by investors were the cause of massive inefficiencies across corporate America in the late 1960s and 1970s. Many attempts to restructure defec-tive corporations took place in the U.S. in the later periods, in which leveraged buyout (LBO)³ and private equity contributed an important part. Jensen believes that there is po-tential for large value gains from strengthening corporate governance and compares the emergence of private equity with the “rebirth of new active investors” (Jensen et al., 2006, p.11). Other authors researching on private equity firms (e.g., Rogers et al., 2002; Zong, 2005; Heel & Kehoe, 2005; Wright, 2006) also advocate corporate governance as the traditional way for value creation by private equity firms.
Numerous ways to cope with the agency problem in the particular context of leveraged buyout and private equity have been proposed. In addition to interest alignment, other ob-jectives of corporate governance are to ensure the transparency of managerial activities and to have a proactive management ownership (Zong, 2005). These three objectives can be obtained simultaneously by employing several mechanisms.

Board of directors

Size and structure of the board

The first step is to appoint an independent board of directors. Jensen points out that the size of the board is relatively small under the private equity governance system (Jensen et al., 2006). Private equity firms typically appoint a general partner(s) to represent them on the board (Rogers et al, 2002). The rest of the board may be made up of the company’s largest shareholders (Jensen et al., 2006). Further, Kaplan suggests that private equity firms welcome industry experts to the management board to assist the portfolio companies in their development (Jensen et al., 2006). The interviews with 27 buyout experts by Millson & Ward (2005) affirm that having non-executive board representation is seen to be crucial by private equity firms. Further, Jensen strongly supports splitting the jobs of the CEO and the board chairman (Jensen et al., 2006).
The appointed general partner goes beyond the role of an administrator by adopting a hands-on approach to the management of the portfolio companies on behalf of the private equity firm. The general partner is responsible for all aspects that lead to value advance-ment of the portfolio companies. The scope of the general partner’s work ranges from de-veloping long-term strategies, crafting business plans, to designing an incentive system and having ongoing dialogue with management on operational and strategic issues (Rogers et al. 2002; Zong 2005).
As mentioned earlier, private equity firms often involve the company’s largest owners in the board of directors (Jensen et al., 2006). The lesson drawn from the private equity indus-try is to let shareholders actively participate in the management process. Controlling share-holders are encouraged to question and influence managers’ decisions, make key compen-sation, and directly get involved in hiring and firing managers (Rogers et al., 2002; Zong, 2005).

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Board meetings and contact with the management

According to Jensen, there are significant differences in the kinds of discussions taking place in the board meetings of public companies and those of private-equity backed com-panies. In pricing the deal, the buyout principals go through a due diligence process, which enables them and the managers of the target company to learn more about the business. An extensive knowledge of the business is believed to raise the quality of those discussions, compared to public companies. Jensen further observes that there are a lot of conflicts and disagreements during public board meetings. Decisions are often made by voting. And due to disagreements, business issues that come up are ended up with no vote and are never re-solved. The board of private-equity backed companies, instead, intensively discuss the is-sues, generally reach agreement and every body is happy at the end of the day (Jensen et al., 2006).
To keep their detailed specific knowledge of the business, its customers, suppliers, com-petitors, employees, and so on, staying up to date, Jensen supports a close contact to be maintained between the board and the managers (Jensen et al., 2006). Feldberg, a Senior Adviser at Morgan Stanley, notices that directors representing private equity firms meet with the CEO and other members of management every couple of weeks for years. The meetings will typically address operational and strategic issues (Jensen et al., 2006).

The management team

Hoesterey reveals that the management team can benefit from the wide knowledge and ex-perience of those employed the private equity firm. In some extreme cases, the private eq-uity firm can decide to change the entire management team (Jensen et al., 2006). Heel & Kehoe (2005), however, suggest that replacing a management team should be done at the early stage of the investment. Berg & Gottschalg (2004) refer to this process as removing managerial inefficiencies.

Incentive mechanism

The board of directors have many tools at its disposal to align manager’s interest with those of the owners. In their study of sixty buyout deals done by eleven leading private equity firms, Heel & Kehoe (2005) find out that the most successful deals involved establishing a proper performance-based incentive program. Significant changes in performance-based incentives are often cited by famous researchers and practitioners as a conventional way to better align the interest of managers with that of shareholders (Gregory, 2000; Jensen et al., 2006). The incentives can take different forms but the most common ones are pay-for-performance incentives and share options. The successful deal partners in Heel & Kehoe’s study (2005) reported to have a system of rewards equalling 15-20 percent of the total eq-uity, depending on the firm performance. With share options, management has the right to buy ownership stake in the company at a stated (i.e., exercise) price some time in the future (Fabozzi & Peterson, 2003). An important feature of these incentives is to replace cash payment with equity grant. By doing so, managers’ interest is more closely tied to the inter-est of the owners (Gregory, 2000).
In addition to equity grant, private equity firms often require managers to make significant investment in the business (Heel & Kehoe, 2005; Jensen et al., 2006). According to Kaplan, the rationale behind this is to create both upside and downside for managers. Managers should not only be rewarded for improved performance but must also share losses result-ing from poor performance. By contributing their own money to the company, managers are as likely to gain as to lose depending on the firm’s performance. To a great extent, managers are motivated to run the business in a way to maximize shareholder value, not to destruct their own wealth (Jensen et al., 2006).
Regarding the scope of the incentive program, Moon – Managing Director and founding partner of Metalmark – stresses the importance of giving incentives to the right people. Eq-uity grant should not be limited to the CEOs or top managers. “Equity should be pushed as deep into the organizations as there are people who move the needle” (Jensen et al., 2006, p.23).
Another issue in structuring the compensation is the liquidity of the equity ownership. Kaplan emphasizes that it is insufficient to provide managers with significant equity. More importantly, management’s equity must be made illiquid until the increase in value is proved. In another way, managers can not sell stocks or exercise options until they have created value to the company (Jensen et al., 2006). Millson & Ward (2005) reveal that the right to exercise share options should be conditional upon meeting performance targets or only be enforceable after a specified time period.

Due diligence

Another mechanism to monitor mangers’ conduct is to carry out a transparent due dili-gence. It is particularly important to perform the due diligence in the early stages of the in-vestment. Heel & Kehoe (2005) reveal that the best-performing deal partners devote half of their time on the company during the first 100 days and meet almost daily with top ex-ecutives. According to Jensen (Jensen et al., 2006), the due diligence process unearths in-formation about the company and enables private equity firms to learn about the business. In that sense, Moon emphasizes that the due diligence helps to minimize the information gap that causes the agency problem (Jensen et al., 2006).

Reporting and Performance indicators

Millson & Ward (2005) find out that dedicated private equity firms have a high need for ac-cess to monthly management accounts, weekly review of sales and margins, and frequent meetings with managers and visits to the company site.
Finally, private equity firms establish an appropriate set of indicators to track the com-pany’s performance. 92 percent of the best-performing deals examined by Heel & Kehoe (2005) implemented such a performance management system.
Top private equity firms in the study by Rogers et al. (2002) reported to zero in on few fi-nancial indicators that most revealed the company’s progress in enhancing its value. These firms believed that a broad array of measures complicated rather than clarified the discus-sions and hindered rather than speeded up actions. Their most commonly-used measures were cash flow ratios and return on invested capital (ROIC). Rogers et al. (2002) argue that private equity firms prefer to track cash rather than earnings because earnings can be ma-nipulated. Zong (2005) agrees with the focus on cash. She further explains that it is the high portion of debts in buyout deals making cash a scarce resource to private equity firms. Therefore, they tend to watch cash more closely. The reasoning for using ROIC, as ex-plained by Rogers et al. (2002), is to reflect actual returns on the money put into the busi-ness.
Together with corporate governance, private equity firms can capitalize on their financial skills to improve the firm’s performance. The next section synthesizes value-adding activi-ties within the scope of Finance.

Table of Contents
1 Introduction
1.1 Background
1.2 Problem Discussion
1.3 Purpose
1.4 Delimitations
2 Research Design
2.1 Methodology
2.2 Research Approach
2.3 Literature Review
3 Theoretical Framework
3.1 Governance Engineering
3.2 Financial Engineering
3.3 Operational Engineering
3.4 Strategic Redirection
3.5 Summary of Value-Creation Methods
4 Method
4.1 Company Selection
4.2 Data Collection
4.3 Data presentation and analysis
4.4 Method evaluation
5 Empirical Findings
5.1 Private Equity A
5.2 Private Equity B
5.3 Private Equity C
5.4 Private Equity D
5.5 Private Equity E
6 Analysis
6.1 Target companies and Investment criteria
6.2 Governance Engineering
6.3 Financial Engineering
6.4 Operational Engineering
6.5 Strategic Redrection
6.6 Timeframe
7 Conclusions
7.1 Reflections on the Study
7.2 Further Research
References