The Private Equity Edge: How Private Equity Players and the World's Top Companies Build Value and Wealth

Journal

PREFACE

Clearly Focused Goals

and Metrics Matter!

Perfect data and perfect models do not exist in the study of economics, corporate performance, management, leadership, or business strategy because they all involve people and their expectations. In the fog of rapid decision making, all facts cannot be known, and leaders often rely on rules of thumb that have served them in the past. Top value builders understand rules of thumb but dig deeper than their peers. Digging deeper with a passion for action gives private equity the edge.

Private equity helps make public markets more efficient. Successful private equity funds have grown tremendously over the last decade as a result of returns greater than their public peers. But how do the successful ones outperform their peers? This is the question we set out to answer.

Lower marginal tax rates on capital gains and income provides private equity players with the incentive to take greater risk. A long-term value focus and the disciplined goal of providing their limited partners a return significantly above the after-tax cost of capital has attracted trillions of dollars to this alternative asset class. Private equity players use value-based incentives that force sustainable change. With billions of dollars of capital at their disposal, they take advantage of the short-term inefficiencies and volatility of public markets. They promote dramatic operational change in the companies they acquire. They use better metrics to judge performance and risk. They take advantage of the globalization of markets. They respond to macroeconomic trends. All these actions work together to give successful private equity players an edge over their public peers. Many of their techniques are open to anyone who accepts value creation as the overarching goal.

Because time is limited and the world is constantly changing, leaders often forget to look at the impact their past decisions had on results as they look to the future. After the fact, academics and business and political analysts dissect and theorize about which factors work and which factors do not. Our interdisciplinary value-based study and perspective on corporate strategy, corporate profits, political leadership, and macroeconomic factors over the last 50 years should be of great interest to all. Political leaders can especially benefit from the perspective of corporate decision makers on the impact of government intervention and their unintended consequences on the wealth and risk of the nation.

For example, we have recently learned a lesson on the importance of using the right goals and metrics in managing the monetary base of the U. S. monetary system. While the Fed was attempting to keep inflation under control, it failed to maintain the monetary base needed to keep the global economy growing. Although there is plenty of blame to go around, the Fed mismanaged the monetary base and promoted a credit crunch that led to a major economic crisis. See Figure P.1.

The annotations and the major deviations from the monetary base trend line speak for themselves. The Fed must walk the ridgeline between its conflicting goals of promoting growth, which might risk inflation, and avoiding inflation, which might choke off growth. The art and science is to manage the level of the monetary base to stay on the narrow path that promotes safe growth. Likewise, in the corporate world, top private equity players give their portfolio companies just enough cash to build value.

Figure P.1 Critical actions on the monetary base

Source: FRED® (St. Louis Federal Reserve Bank); commentary by the authors.

In the pages that follow we expose myths and discuss current research and truths about private equity, valuation, wealth creation, strategy, and economics that will help any decision maker gain new insights for creating value and reducing risk. For example: not every private equity deal makes money. There are winners and losers in private equity too! Private equity players are human and make mistakes. Those who develop an edge learn a bit better than others. They increase their odds of success as well as the ability to attract larger pools of capital. Likewise, in the public sector, the monetary authorities must manage the monetary base in response to changes in the supply of and demand for dollars. Failure to respond to an increase in the demand for money caused a credit crunch beginning in 2007 that seized up credit markets and dropped expectations about corporate future cash flows. Value and wealth around the globe were destroyed.

We discuss some basic principles that top value builders employ:

Markets allocate resources. We know of no better way to build wealth than to think of decisions in economic terms. Economic thought requires digging deep into the data. However, the insights from understanding the fundamentals produce better decisions. Regulation that distorts market behavior always has unintended consequences. Business is the economic engine of our free-market system. A business must earn a reasonable return on capital to survive and take risk. So why overtax the best value builders?

Common goals are critical. Large committees and boards composed of individuals with different ideologies and multiple goals are slow to act, and they achieve less than those with a common goal. Smaller private equity boards focused on value give their portfolio companies a clear edge.

Markets work but have bubbles. Short-term and long-term changes can be anticipated by digging deeper and applying disciplined thinking. Markets are like forces of nature—overpowering and uncontrollable. Fear and greed and the people effect are unpredictable elements. Precise timing is difficult. Top value builders understand how markets work—just a little bit better than their peers. As a result, when they are successful, they make more timely decisions to reduce long-term risk and create value. They consider many factors: the people effect, supply-and-demand shifts, and alternative options and scenarios. It is better to learn how to prosper within markets than to fight against them.

Solid frameworks based on fundamentals are better than rules of thumb. Personal experience is a great teacher. However, experience is most valuable when crystallized into a framework. Better frameworks help people focus on the fundamental causes instead of simplistic rules of thumb. Frameworks that ignore changes in the cost of capital and demand for money will give inaccurate signals.

Incentives work. People are motivated to take action that will provide benefits for them. After-tax cash flow is the best fundamental way to evaluate incentives and disincentives.

Timing and metrics matter. People will wait for benefits only if they are compensated for the risk and the time value of money. An understanding of how economic metrics, such as discounted cash flow, differ from generally accepted accounting principles (GAAP) is critical to valuation. The difference is critical and provides the value-building edge to those who understand it.

Individuals have their own preferences and goals. Markets are composed of many individuals, all acting to maximize their own benefit or wealth. For every buyer there is a seller, so different perceptions and ideas about the future abound. Bubbles and busts will occur. Private equity players have incentives to take action and bear risks that many public company leaders try to avoid. Top value builders have a better understanding when fear and greed are distorting markets. They act sooner to control downside risks.

Other supply-side principles. Regulation and government intervention can both help and hurt value and wealth building. Finding the right balance is critical to business and economic growth. Multiple factors are usually in play, distorting our view of the future. It pays to be on the lookout for the unexpected and unintended consequences of regulation! There are always unintended consequences.

As we put this book to press, the global economy was facing economic crisis and prolonged recession. Successful private equity players will adapt and grow. Private equity went through a tremendous boom in 2005 and 2006 and a clear slowdown of megadeals in the second half of 2007. Yet most private equity deals stay out of the headlines. As long as the incentives exist, different forms of private equity will come into play to meet changing market needs. Acting sooner is the key to their success. Private equity buyouts of larger performing public companies shifted into special distressed situations as market risk and return changed. When new but risky technology again offers high returns, venture capital will reappear. As long as private equity keeps its focus on value building and produces high returns, private equity will continue to grow and control greater amounts of capital, unless the government changes taxes to kill their incentive to create value.

Competition for capital eventually keeps returns in line with risk. Opportunities present themselves to those who learn lessons of the past and understand and act on market fundamentals better than their peers. It is clear that top private equity players:

• Demand a high return on capital for the risks they take,

• Take more risks than public companies in funding new technologies and turning around distressed companies,

• Promote value-building changes in the companies they buy,

• Use more leverage when debt is on sale,

• Buy good companies when the market price is below their intrinsic value,

• Lock in value increases when the market correctly values or overvalues their investments,

• Say no when asked to continue funding low-return projects,

• Act with speed and knowledge,

• Make and learn from mistakes, but don’t bet the farm, and

• Are longer-term investors, not traders.

Good luck to all who accept building value as the goal.

Dig deeper and act sooner!

Arthur, Bill, and Shep

INTRODUCTION

How Value Builders Create Value

and Wealth and Reduce Risk

We wrote The Private Equity Edge as a wake-up call for business leaders and their management teams. Difficult times are upon us, and readers need the approaches in this book more than ever. Any decision maker in either the public or the private sector can gain new insights into creating value and wealth from the examples of successful private equity players and the world’s best value builders.

Throughout the book, we speak with one voice, as each of us has had significant experience in the corporate, public, and not-for profit sectors. Our experience, and the lessons we have learned as change agents introducing new ideas, reinforce the importance of digging deeper and acting sooner to all organizations—a notion that we underscore throughout this book. Strong parallels exist among thinking, planning, and decision making at the national policy level and within individual companies. At both levels, leaders must consider how other people will react to the changes in plans and directives that result from their decisions. Leaders call others to action under conditions of uncertainty. To be most effective, value builders must communicate their frameworks, their decisions, and the reasons behind their decisions in simple terms. We can learn from top value builders. These individuals are not afraid to communicate their focus on value building as their overarching goal. On the other hand, a national political focus on dividing the economic pie and a lack of focus on growing it push aside any clear goals and fog our national agenda.

Unfortunately, in recent years the terms value building and shareholder value have lost favor in some corporate suites. The volatility of stock prices has confused the issue of corporate value as traders can move the price of any stock by 10 to 40 percent in a week or even a day. Many large public companies have been bullied by various activist groups to drop or mute the terms. This has occurred just as some companies were opening up to shareholders and doing more to educate them on what the companies were doing to benefit shareholders. Large public corporations and now the largest private equity players are feeling the political heat of differences in ideologies and economics. Creating profits, wealth, and value is unfortunately viewed by some activists as greed and an unnecessary goal of a capitalistic economy. Companies that cave in to pressures from activists or fail to build shareholder value continue to find themselves as takeover targets. Given the success of private equity, many public corporations are reasserting their commitment to shareholder value.

While leaders in both sectors may wish that the process of making decisions and producing value-building change could be made easy, that is only a wish. Simple may be good for communication, but simplistic falls short in decision making. Why? The first cut at solving significant problems frequently relies on many simplifying assumptions; the solution that is produced may only work as a special case or for a very limited time, if at all. Surprisingly, after digging deeper and using more realistic assumptions, the core solution may be one simple idea. Yet, discovering great, simple ideas sometimes requires enormously complicated and complex thought. Do we have to write anything more than E = mc² to make our point?¹

Top private equity players and top corporate value builders—referred to as "top value builders" throughout this book—communicate that a company’s intrinsic economic value is a function of the cash-generating capacity of its business and its cost of capital. But the forecast of generating cash—both short and long term—is not simple or obvious. Traders buffet the price of a stock on the news of the hour. Generally accepted accounting principles (GAAP) accounting disclosures subordinate cash flow to GAAP-based earnings per share. Management groups are reluctant to give long-term guidance. Cost of capital is not commonly understood. Far too many corporate directors and decision makers use outdated or simplistic rules of thumb, leading to value destruction. Leaders and managers who involve others and expend the effort to dig deeper find the payoff in acting sooner. Value builders understand and focus sharply on economic value. Digging by value builders may also reduce the risk (increase the certainty) of outcomes and help to avoid unintended consequences. Even without dramatic new solutions, the reduction of risk may add value.

Macroeconomics—if one gets it right—is far more important to corporate value and investment performance than most professionals think. Monetary policy and tax policy affect investor and consumer behavior and have significant effects on interest rates, inflation, real growth, and the level of the stock market. Corporate debt and home mortgage debt are tax deductible, so changes in interest rates and tax rates can produce dramatic effects. Professionals who recognize and act on these economic signals create wealth and value while reducing risk. When our leaders get economics wrong, people are hurt, and sometimes they are hurt very badly. For example, in 2007 and early 2008 inadequate money supply growth contributed to the credit crunch that eventually produced the 2008 global economic crisis, trashing the stock markets around the world. With stock prices depressed well below intrinsic value, private equity funds with cash planned to start buying again.

SUCCESSFUL PRIVATE EQUITY PLAYERS

BUILD VALUE

Private equity players focus on economic value. This simple focus gives them a significant edge over many public companies. Private equity funds range in size from under $10 million to multiple billions of dollars. It is hard to group them as one asset class, so we focus on the top value builders in the category. A private equity fund has some characteristics in common with closed-end mutual funds. Investment styles vary widely across the universe of private equity funds. Private equity funds are currently unregulated and usually structured as limited partnerships. A private equity firm or partnership serves as a general partner. Limited partners—mostly institutional investors and wealthy individuals—provide commitments for specific amounts of capital. The general partner has a limited time to invest the funds, usually about 5 years, and an agreed upon time to return capital to investors, usually over 10 to 12 years. As soon as the general partners have arranged commitments for all funds committed to the partnership, they typically start new funds. This is especially true if they produce good results. That is a big if! If they succeed in producing high rates of return (over 20 percent per year), they are usually able to gather additional commitments and build multiple funds. However, those who are not successful may be required to return money to their investors before the original commitments have been invested. The data on private equity funds’ performance are limited, because private equity funds are not required to report results and returns publicly. Some private equity funds voluntarily make performance reports available. It will be a surprise to many readers that research on a large sample of funds with assets of over $5 million, for the period 1980 through 2001, concluded that average private equity returns (after fees paid to the general partners) did not exceed those of the S&P 500.²

The research also concluded that better-performing fund managers are likely to raise larger follow-on funds than those who underperform. Fund returns improve with experience of the fund manager or general partner. Performance also depends upon the market cycle and timing of purchases, with better returns likely on funds started when markets are undervalued, rather than at market peaks. However, additional research in 2007 confirms that the average private equity fund does not outperform the S&P 500. Since many new funds are started at market peaks, they typically under-perform the S&P averages. Better-performing funds or successful private equity players typically have better skill in improving operating performance and better deal flow because of their strong reputations. According to University of Chicago professor and private equity researcher Dr. Steven Kaplan, The 2005 study findings still hold, but our research efforts are limited by incomplete data. There may be a selection bias on those that choose to report. Yet the research seems to indicate that when private equity funds get more money the returns seem to go down.³

The ideal private equity investment typically has been a middle market, undermanaged company with reasonably steady cash flows that can be acquired for less than intrinsic value, financed through additional debt, and upgraded through significant improvements in operations, change management, or strategy. Ideally the company would be sold back to the public or to another private equity firm at a cash profit and a high internal rate of return (over 20 percent) within three to eight years. However, because of the tremendous popularity and increase in funds flowing to private equity players, the styles and target investments vary widely.

Blackstone is a well-known large private equity management firm that went public in June 2007. At the time of its public offering, the Blackstone players had managed five general private equity funds and one fund specialized in media and communications. Blackstone was a relatively new business, started in 1987 with only $400,000 in capital. As of March 1, 2007, it managed a fund with capital commitments exceeding $18 billion. According to its offering memorandum, Blackstone pursues a wide variety of transactions involving leveraged buyouts of both seasoned and start-up companies, as well as turnarounds and industry consolidation opportunities, real estate, and more. Its 2007 offering memorandum—available to all on the Internet—gives the reader an inside view of one of the largest and most successful private equity funds, in addition to the returns available to the general partners in these firms.⁴ Not surprisingly, Blackstone’s share price traded well below its initial offering price throughout 2008.

Private equity firms make no bones about their focus on value. The private equity fund Sun Capital, a player in the market for distressed companies, stated publicly that its business is about both buying and selling companies to create significant wealth for its partners.⁵ Public companies should listen to advice from this owner of 57 companies. It typically owns companies for five years before selling them and reinvesting the capital in new ventures.

Private equity funds and players are very diverse. Their investments range from venture capital, to management and leveraged buyouts, to special (frequently distressed) situations and real estate. Private equity firms also differ in style. Some demand control, while others will join with investment partners on an acquisition. Some focus on buying and selling companies; others hold their portfolio companies for the long term. Some choose to take their returns in the form of high dividends, while others reinvest heavily and take their returns on exit.⁶ In discussing these diverse groups, we generalize where it is meaningful. We also frequently identify specific transactions, many of which are management or leveraged buyouts, to illustrate our points. One asset category, venture capital, is a particular focus in Chapter 9. Throughout our discussion, top value builders in private equity are considered to be those in the top quartile of performance.

A study presented at the World Economic Forum in January 2008 begins to develop a new fact base and shed new light on the growing global impact of private equity. Key findings of the landmark report include⁷:

• The impact of private equity is global and accelerating. From 1970 through 2007 the total value invested (debt and equity) in private equity buyouts with high leverage globally was over $3.6 trillion. About 75 percent or $2.7 trillion in transactions took place between 2001 and 2007.⁸

• The study identified 21,397 transactions from 1970 to 2007, more than 40 percent of which took place since January 1, 2004.

• Buyouts occur in all markets, including declining markets and in high-growth, high-tech industries.

• Only 6 percent of private equity buyouts end in bankruptcy or a similar restructuring, which is lower than defaults by comparable companies with corporate junk bonds.

• Only 12 percent of transactions were flipped within two years, with the majority, 58 percent of investments, held for more than five years.

• Innovation, as measured by patent activity of a sample of 495 firms worldwide, seems more focused on core technologies, but does not change in quality after a private equity transaction.

• Employment in buyout companies declines following the transaction for four to five years, but on average there is only a cumulative 7 percent difference compared to a control group. Yet buyout companies have more greenfield—totally new—job creation, and after four to five years employment trends seem similar to those of the control group.

• Governance differences are based on ownership. A study of 142 buyouts in the United Kingdom from 1998 to 2003 shows that after a private equity buyout, the board size was significantly reduced, as well as the participation of outside directors who did not represent a significant owner.

• Contrary to popular belief, most private equity transactions take place outside the United States.

• By 2005, approximately 2 percent of the nongovernment workers in the United States were employed by companies that received an investment from private equity.

• The growing impact of private equity is receiving increased attention from politicians, unions, and investors.

Despite the 2007–2008 credit crunch and forecasts of a prolonged recession, industry watchers expect successful private equity funds to grow as an asset class, because the funds often achieve their goals of outperforming public market alternatives, and private equity represents only a small portion of managed funds.

There are a variety of other top value builders beyond the world of private equity in the corporate and public sectors. Consider the individual inventor of an idea or service that takes the world by storm or the world-class athlete or actress who inspires others and earns millions of dollars per year in the process from royalties and commercial endorsements. In this book we refer to other value builders who have created tremendous value and wealth through better decisions. These include national leaders like Ronald Reagan and corporate value builders like Best Buy, John Deere, Southwest Airlines, Toyota, and Walgreens.

The plans and directives issued by any leader can be converted into action only by the people who are directly affected by the plans and directives. Anticipating the outcomes of this conversion requires understanding two effects. The first is the numbers effect, which can usually be computed directly. The second, the people effect, often counteracts the numbers effect. This will come to life in Chapter 2 in our discussion of the Laffer Curve and the challenge of promoting new ideas and change, and it remains a major theme throughout the book. People make things happen in a predictable way most of the time, but getting the prediction right can be challenging. People respond to incentives and disincentives. Successful value building and prediction require a good understanding of the incentives and disincentives that are at work, both in and around the company.

Life is not easy for value builders. Conflicting ideologies, theories, metrics, and frameworks abound. Interesting stories highlight how the people effect is sometimes very difficult for leaders to understand. In other cases, leaders unfortunately refuse to change course, mostly through fear of being penalized for being wrong, but in some cases because they are so invested in their own ways of doing things that they cannot change. It worked in the past. I have believed it for so long, it must be true.⁹ This occurs despite available frameworks that more accurately predict the people effect. People have biases and preferences; as a result, they predictably over- or underreact to events. This fact helps to explain market bubbles and recessions.

Unfortunately for investors, predicting exactly how much and in what direction people will overreact is difficult. There are many misguided decision-making theories used by leaders. These range from rules of thumb to elaborate economic frameworks. Some seek to explain the interaction between the numbers and people effects and the final results. Some frameworks merely assume away much of the impact, prompting business and political leaders to merely hope beyond hope or pray for luck that the outcomes will be positive. Clearly, hope is a wish and not a strategy. Such practices have resisted frequent and thorough debunking.¹⁰ In our effort to clear away the fog and clutter and distinguish between good and bad, we draw on lessons from the art and science of economics. The result will better explain wealth creation in the uncertain but interconnected world around us.

In The Private Equity Edge we argue that people (citizens and employees) definitely respond to the incentives, plans, and directives set forth by their leaders. Leaders are, however, frequently disappointed with the responses. This dissatisfaction typically arises when the results and actions are not what the leaders anticipate. When this occurs, the problem is not that the affected people are somehow wrong; the problem is with the decision makers’ frameworks, communication methods, metrics, and expectations and the questions they ask. Top value builders who think more deeply successfully act sooner, ask the right questions, and are better at anticipating the reactions of those people whom they seek to influence. Better metrics and frameworks and realistic expectations make for better decisions, better leaders, and better results.

What is wealth? What is risk? Wealth and risk are defined differently by different people. This causes much of the confusion in communicating plans and desired actions at any level in any organization. The definition of these terms determines how progress and wealth creation are measured in the world around us. In this book we define risk and wealth consistently with the economic concepts most frequently used in business and government. Because measurement is always relative to some standard, the measurement of both wealth and risk must also be relative to a standard. In today’s investment and corporate worlds, the return of the S&P 500 stock index is a widely used benchmark. Value builders provide economic returns better than the S&P 500 index over a long period of time, typically over several business cycles. Successful private equity funds have done this; unsuccessful ones have not.

We define value in business and wealth in business and government as economic value, that is, the measured capacity to produce cash income. Gross domestic product, or GDP, is the technical measure for government. These measures of economic value can be expressed in both constant and current dollars. When we look long term (over five years), the difference between constant and current dollars can be significant. Value builders are focused on long-term horizons and trends, usually spanning three to eight years. They are not overly concerned with quarterly fluctuations in earnings per share or gross domestic product, which they consider noise around the trend. As a result value builders focus on what we call intrinsic value. Value builders are not traders. They are in it for the longer term. Traders influence stock prices in the short term. Top value builders are aware of the impact traders can have on current stock price, but they look beyond it. Top value builders seek to boost returns by taking advantage of the three- to six-year up-and-down cycles of bull and bear markets. They buy when stocks are on sale.

For the purpose of this book we define the intrinsic value or warranted value of a business as the reasonable or expected present value of a business’s future cash flows discounted at a rate appropriate for the risk of the business.¹¹ There are various derivations of this discounted cash flow (DCF) technique. Some theorists and academics would hold the discount rate constant and account for risk in the variance of the cash flows. Academics and practitioners continue to debate and argue over the best discount rate. In either case, the choice of a discount rate may not be as important to the decision as the forecast of expected after-tax cash flows. The key is using a forward-looking estimate of future cash flows to better communicate a business case and selecting a reasonable discount rate to provide a return to capital. The leaders of far too many public corporations worship earnings per share (EPS) and pay lip service to value building. They continue to talk to analysts in EPS-speak and set bonus compensation based on achieving quarterly earnings per share targets.

Different people will have different views on the expected future after-tax cash flows and, as a result, different estimates of intrinsic value. We believe this is a great way to provide meaningful dialogue about the expected cash flow of various plans and alternatives under different scenarios. While providing some insights on a selection among newer discounted cash flow techniques, we encourage readers to dig deeper to find the discounted cash flow technique that serves their needs best. For those who are uncertain about which discount rate to use, we suggest that you test your decisions against a range of discount rates to determine if the choice of the discount rate makes a difference in the decision. The suggested range of nominal rates can be bounded at the low end by the 10-year U.S. Treasury note yield typically referred to as the risk-free rate and the expected rate of return on a portfolio of stocks such as the S&P 500 at the midrange. The high range of the discount rate may be the hurdle rate for the investor or the owner. In many successful private equity funds, alternative investments are targeted to return 20 to 30 percent or more, forcing value-building leaders in portfolio companies to propose only those high-return projects that are projected to build value over a five-year span. This wide range of discount rates is simple to understand but is not simplistic, as we will see in the chapters that follow.

We define risk in business and government as the potential for future variations in the expected amounts of cash income after tax cash flow. In particular, we think of risk as the chance that the outcome will fall short of projected values, so that risk can be thought of as the probability of a loss or a shortfall. If we accept a broader context, it is necessary to recognize that there are risks that go beyond mere variations in cash income. History demonstrates that catastrophic events can occur, causing total losses. This broader context of risk is discussed in Chapter 3. Many people talk about and try to manage economic value, wealth, and risk without numbers. Top value builders improve communication and action by quantifying both wealth and risk by digging deeper into the relevant data. They ask: How much? Quantification, while never perfect, forces greater discipline and enhances communication. Focus on risk promotes long-term thinking and a better understanding and communication of alternative courses of action.

We all learn from experience. Rather than providing specific decision rules for current and future value builders, our intent is to shed light on the experiences and thought processes that inspire confidence and that will encourage every value builder or decision maker to ask the questions that will inspire his or her people to dig deeper. This confidence will help all leaders act sooner and reduce risk.

Business and political leaders must cope with the hard fact that over the long term, competition erodes the advantage of even great strategies. As a result, performance of both corporations and countries regresses to the mean, if not worse, over time. (Consider how General Motors, Xerox, Circuit City, and even the Roman Empire, Japan, and others reverted from great to good and then on to damaged goods.) Notice the risk that the U.S. economy could follow the same pathway if the wrong policies are put into place. We could be at a peak in our national prominence right now! Top value builders recognize the difficulty of formulating brilliant strategies. What they use is not strokes of genius, but better methods of continuously renewing and revising their ongoing strategies and goals to meet the ever-changing needs of dynamic markets. Yes, nations need to renew strategies, too! Also, as every businessperson knows, the wrong strategies on a national level can have a devastating impact on business as well. It takes people to implement value-building strategies, and people must be motivated with the right incentives to do the right things.

Mistakes are made in many ways. Clearly, miscalculating the numbers effect of decisions creates one class of errors. More frequently, though, leaders can get past the numbers effect but are confounded by the people effect. Leaders often fail to understand how the people they lead or influence will react. We have witnessed many good and bad decisions made over the course of our collective 100 plus years of observing and participating in business and government. We distill some of the wisdom gained from trying to improve or change some of these decisions and trying to live with others. What we have to say will come as a surprise to many of our readers and will resonate well with most. For example: not all tax-rate changes are the same; small changes in incentives and metrics matter; how leaders deal with resistance to change is critical; and, top private equity players who are in the top 1 percent of taxpayers are in the group that pays about 40 percent of the total federal tax burden.¹² The intent is to provide a fresh perspective based on the facts and years of observing the behavior of decision makers and results at the corporate, national, and international levels.

While new perspectives are sometimes controversial, change and new ideas are necessary for survival and progress. Top value builders focus on being realistic about the past, yet positive and realistic about the future. Our goal, as well as that of everyone who reads this book, is to promote behavior that creates wealth and reduces risk. This book is written for decision makers who are seeking to apply a deeper, practical understanding of the new interconnected world of business and economics, as well as the professionals who work with them. Former secretary of the treasury and state under Ronald Reagan, George Schultz, made the point clearly when he frequently quoted General Nathan Bedford Forrest of Civil War fame: Get thar fustest with the mostest!¹³

THE BOOK

Private equity has a clear edge. Its edge is based on smart people motivated by the right incentives that promote digging deeper and acting sooner. These are concepts that many companies can employ. Digging deeper can provide new insights that anyone can use to make better choices on the corporate, national, and international levels. When leaders dig deeper, they act sooner to create wealth and reduce risk. The world’s top value builders set the example.

The Private Equity Edge is divided into three parts.

• Part One, based on research and anecdotal evidence, demonstrates how digging deeper provides new insights to create wealth and reduce risk. It explores cases of both success and failure.

• Part Two emphasizes that acting sooner provides a competitive advantage and accelerates learning. Learning, in turn, enhances competitive advantage, and sustainable competitive advantage enhances value and wealth, while reducing risk.

• Appendixes 1, 2, 3, and 4 contain graphic examples of digging deeper.

Each chapter contains a few stories to highlight the interplay among people who influence decisions. Exact quotes on these stories are sometimes hard to come by—even from the story’s participants. We supplement these stories with research studies, case examples, interviews, and our own experience.

Part 1: Dig Deeper

Why dig deeper? Digging enables acting sooner—The quest is to better understand alternatives and develop insights before making major decisions. Top value builders make their decisions with great conviction. The ones that get it right base their conviction on experience, great analysis, and digging deeper for new insights. Digging helps bring you luck! Or as Justin Dart, the late chairman and founder of Dart Drug, would say The harder I work, the luckier I get!

Chapter 1: Value

Corporations exist to bring people and capital together to create wealth and reduce risk. Private equity sometimes does both those things just a bit better. It is a matter of degree. Top value builders, both public and private, learn from experience. In Chapter 1 we focus on uncovering a variety of corporate myths that frequently misguide leaders and thus negatively affect individual companies, their shareholders, and employees. We explore how top value builders look at topics such as price-earnings ratios, how important quarterly earnings per share targets are to the stock market, and whether six or eight times earnings before interest, taxes, depreciation, and amortization (EBITDA) is a good, but simplistic, measure of corporate value.

Private equity players focus on value and avoid overemphasis on EPS or EPS-speak. It’s just that simple. Said another way, we tell the truth about the links among earnings per share, GAAP accounting, and intrinsic value and the problems that those links create for many public companies. Using the wrong metrics and frameworks causes leaders to make bad decisions, some of which have cost shareholders billions. For example, monetary missteps in 2008 helped to put the entire economy into a downward spiral. S. I. Hayakawa noted: If you treat variables as constants, your thoughts will be all confused, no matter how hard you think! We introduce the concept of capitalized economic profit to help explain the recent growth in private equity.

Chapter 2: Wealth, Tax Rates,

and Income

People in free markets don’t work, consume, or invest to pay taxes. In Chapter 2 we focus on uncovering some of the impacts of taxes and big picture macroeconomic principles of value and wealth. Tax benefits from capital gain-related compensation, combined with the willingness to use leverage, give private equity players an edge. If these incentives are removed, the incentive to create wealth and economic growth may also vanish.

Political changes are often better documented than corporate stories. In politics there are always two or more sides to every story. We use the great renewal and economic turnaround that occurred during the Reagan presidency as an example of the drama of conflicting interpretations of data and misconceptions of economic theory. Top value builders set clear goals and have common frameworks.

Politicians have their own biases, passions, and methods of communication that are often in conflict with others. When old theories fail to explain the data, new and better theories emerge. We examine supply-side economics and why higher tax rates often do not result in higher tax revenue, but always result in less of the taxed activity. Not all tax rate cuts are the same. Taxes and tax rates can act as powerful disincentives or incentives.

We examine the success of Reaganomics and the failures of more traditional Keynesian approaches to creating national wealth. The ideas that were finally communicated to the public were simple: Cutting tax rates makes people more willing to work, because they keep more money, on the margin. This back of a napkin description was simple and powerful. After-tax cash flow is the main driver of wealth and the economy.

While supply-side thinking was considered radical voodoo economics 30 years ago, it has gained its place in mainstream economic thought. Outside the United States, more taxing authorities are thinking flat tax than ever before. Lower tax rates spreading around the world are helping to stimulate global growth, but the United States is falling behind.

Chapter 3: Risk

Risk is a fact of life. Public corporations are required to disclose their risks annually. Private equity firms are structured to look at risk differently. In Chapter 3 we provide perspectives on incorporating risk into decision makers’ analyses. Thinking about risk without including an assessment of both magnitude and probabilities can result in misunderstanding. Although leaders would like the experts to tell them exactly what to do, the world of the future is not subject to absolute certainty. In fact, research on stock market booms and busts shows the world is not statistically normal.

Examples from the investment and corporate sectors demonstrate that major errors occur when leaders communicate risks poorly, ignore risk, or confuse the short term and long term. Top value builders structure their organizations to use risk to their advantage. High leverage and use of separate legal entities by private equity firms allow them to concentrate risk at the business unit level.