An Inside Look at Private Equity

by JT McGee

BusinessWeek ran a fantastic article in the most recent edition, giving readers an inside look into what actually happens on the ground when a private equity firm takes over a company for restructuring.

The article cites incredible improvements. Here’s a concrete example:

On-time delivery ran at 72 percent before Monomoy bought the plant; so far for 2012 it’s at 96 percent.

Another part of the article explains my fascination with smaller companies. The article notes the available opportunity in small firms relative to larger companies:

With larger companies they found more capital chasing fewer deals, and the market tended to be more efficient. By “efficient,” read: harder to make money in. On the lower end of the middle market, however—companies bringing in $100 million to $150 million in revenue—they could double, triple, and sometimes even quadruple Ebitda (earnings before interest, taxes, depreciation, and amortization).

The market for these companies is huge. The article says there are as many as 150,000 businesses with revenues of $100 to $150 million in North America alone. Not at all public – most are private, and even more are smaller subsidiaries of larger companies. As an individual investor constrained to the fewer smaller businesses of this size on the public markets, I drool over the opportunity present in private markets.

The end of the article shows the extent to which private equity companies master true operational efficiency:

We walk past the electrical-box assembly station. A broom leans against a machine. Above it, a shadow board, painted to show where tools belong, reveals an outline where the broom should hang

What Private Equity Really Is

So private equity isn’t just a chop shop for companies? Nope. Monomoy Capital Partners might not be a major player like Bain Capital, a subsidiary of Bain & Company, a management consulting firm turned private equity super-star with presidential candidate Mitt Romney, but private equity is private equity. And while Bain Capital may be back in the news in part because of Mitt Romney’s tax rate, it’s not just another activist investing chop shop looking to suck cash out of acquired firms.

While many of the acquisitions are financed heavily, often dangerously, the magic is still in the operations. From Bain to Monomoy, the value-add is in refining processes – making a business more efficient from top to bottom. Moving a company’s cost of capital from 10% annually to 5% is a major win, but it’s not nearly as accretive to future earnings as real, substantial change to operations. Anyone can play with financing, but it takes real, creative decision-making and strategy to refine operations.

A Must Read Piece

I barely touched on summarizing this beast of an article. It’s an excellent write-up, one which explains in-depth the steps private equity firms take to make money by buying, improving, and reselling companies. As the debate about private equity’s corporate raiders and Wall Street’s gamblers takes to the mainstream, it’s nice to see a publication actually do some digging to see if the high-level view of private equity aligns with what really happens when the boots hit the ground.

Take a look: My Week at Private Equity Bootcamp

{ 6 comments… read them below or add one }

Darwin's Money April 29, 2012 at 22:54

As an avid reader of businessweek AND a Lean Six Sigma proponent (working on a Green Belt now), I think they could have done more to outline the LSS mantra and list out more examples of successes. Virtually all large companies adopted the methodology a decade or more ago and yes, many small companies haven’t. So, it was a neat narrative on all the efficiencies to be gained from small companies.

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JT McGee April 30, 2012 at 10:25

Yeah, it was mostly a human interest piece in so far as the steps taken to ensure a better outcome. However, to that extent, it was very valuable in showing how efficiency isn’t always financial, and much of it can come from operations. Counter to what we hear, it sounds as though the workers were quite happy with the changes and new ownership.

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101 Centavos April 30, 2012 at 06:14

Neat article. Perhaps a little focus on the shop-floor level reporting and information systems would have been interesting too. At the pace of an acquisition every 2 or 3 years, our operations team finds that this is a consistent failing in the acquired companies, failure to effectively utilize their ERP systems. Going from 72% OTP (or less) to our standard 95% is more of a function of data and date maintenance, and accountability.

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JT McGee April 30, 2012 at 10:28

It really is incredible what can be done with a little bit of data from a whole lot of testing. I do find it surprising that companies can see such incredible change in EBITDA (I guess they’re low margin businesses?) from simple operational changes.

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PK April 30, 2012 at 10:55

Hmm… from reading most newspapers and watching the news I thought private equity was when a bunch of dudes (fat + smoking cigars) wheel in barrels of money, buy a company, load it with debt, and pawn it back on an unsuspecting, cheering stock market?

I’ll have to rethink all of my assumptions!

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JT McGee May 1, 2012 at 10:12

Yeah, that’s exactly what private equity does. All the time. It’s also bad for America, bad for the public securities market, and, when combined with high frequency trading, it obviously ruins the market for everyone.

Sigh. Living in a world where people don’t understand personal finance is bad enough. Living in a world where people who don’t understand personal finance think their opinion on institutional finance should carry weight is even worse.

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