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The 80/20 rule applies to much in business. Does 80 percent of your sales come from 20 percent of your sales force?

Yes. Absolutely.

Maybe. It is definitely disproportionate.

No. We have a fairly balanced sales team.

No idea. Good question!

Why Do Private Equity Firms Underachieve Their Planned ROI  

By Gary Cokins, Global Product Marketing Manager, SAS Institute Inc.

Research studies reveal that only a minority of investments in acquired companies achieve their targeted financial Return on Investment (ROI). Explanations include poor strategy execution and inadequate marketing and sales function tactics to grow sales profitably. Private equity firms are emerging as significant players in the capital markets. They are increasingly deploying the various improvement methodologies of enterprise performance management mounted on an integrated enterprise information platform. Can integrating enterprise performance management solutions resolve solve the underachieved ROI problem?

There is a sea change occurring in how the capital markets allocate financial capital to organizations to fuel growth and prosperity. Private equity funds and investment banks are displacing public capital markets managed by international stock exchanges.1 Firms like these that invest in acquisitions only, achieve their end-goal by raising the market value of their acquired companies. Acquiring organizations are called capital market firms. Their ultimate financial gain is realized from the buy-sell spread when they divest each investment.

But there is a problem. Research studies reveal that only a minority achieve their targeted financial return on investment (ROI). One study reported that less than half of mergers achieve their goal.2 Why such poor results? Do they over-plan, but under-execute their economic value creation activities? Widespread adoption of the performance management framework may provide a solution, but will the emergence of private equity funds accelerate the application of performance management methodologies?3

In this article, I will initially describe a basic primer about capital markets and what has created the growth in private equity firms. I will conclude with …

Who Are the Participants in Capital Markets?
In order to understand why private equity funds are sprouting globally, here is a basic primer about capital markets.4 There are three capital markets that profit-oriented organizations can tap to fuel their growth:
  1. Public Capital Markets
    These are the stock exchanges, such as the New York and London Stock Exchanges, where individuals like you and I as well as investment managers of mutual and pension funds and university endowments can invest along with others in publicly traded companies. Investors will always bear some risk, but broad participation by constant buyers and sellers typically moderates turbulence in stock price changes. Stock exchanges are also where new companies raise funding through initial public offerings (IPOs).

  3. Internal Capital Markets
    This is where operating divisions within a parent company, such as Procter & Gamble, are provided cash by senior executives at the parent’s headquarters. In effect, divisions compete for the parent’s limited funding by submitting proposals supported by justifications that estimate the financial returns they can generate from the funds. In short, this is how financial resources are allocated within a conglomerate.

  5. Private Capital Markets
    This is the emerging player. You may recognize the four major types of participants as angels (primarily individuals), venture capitalists (investors betting on entrepreneurs), private equity funds and hedge funds. One differentiator of private capital markets is they are not burdened by compliance with government and public stock exchange regulations and laws.

From these descriptions, you can see that managers of private capital markets are freer to identify investment opportunities and flexibly shift funds in those directions. As a result, they can more quickly produce higher financial returns than public and internal markets. Consequently, they are attracting insurance, university endowment and retirement pension fund managers to supply them with capital. Global liquidity available for investing is at record-high levels5 and managers are chasing the highest risk-adjusted returns.

What Is Creating the Emergence of Private Equity Funds
The emergence of private equity funds is being stimulated by the governance shortcomings of the other two types of capital markets.

Public capital markets will always be appealing to both investors and companies seeking funding. This is partly because a substantial pool of global financial savings is available, but more importantly, because investments are highly liquid. That is, investors can easily enter and exit with their cash savings. And this efficiency with pooled, risk-shared and liquid investments creates broad diversification that translates into a minimal extra price premium to purchase an equity position.

A shortcoming of public capital markets is that investment managers may behave impatiently and be somewhat fickle in choosing which stocks to buy and sell. Examples are the dot-com bust of 2000 and former US Federal Reserve Chairman Alan Greenspan’s famous warning of ‘irrational exuberance.’ An impediment to full attainment of profit potential is the legal separation of a company’s ownership from its management. Investment managers rarely have access to internal managerial information that the company’s managers have. Yet, at the extreme, we observe young, recently minted MBAs at investment banking firms pressuring and influencing accomplished executives to make decisions favoring short-term financial results when relatively better decisions could result in much higher long-term financial outcomes. Finally, because recent Enron-like scandals have inspired regulatory burdens such as the Sarbanes-Oxley Act, publicly owned companies incur significant out-of-pocket expenses for regulatory compliance.

Internal capital markets can yield better financial performance because the executive leadership has access to internal information, marketing plans, return on investment analysis and projections. On the downside, however, similar to public capital markets, internal capital markets also impede the ability to attain full profit potential and maximize a company’s market value. But the explanation is for a different reason: ‘Corporate socialism.’ What I mean by this is that executives tend to patiently tolerate underperforming operating divisions. Further, they may be reluctant to starve an old colleague heading a division of his or her capital requests even though a sober and objective assessment would recommend it. Politics and personal favoritism are present. Strong divisions often subsidize weak ones.

In addition, executives tend to tolerate inefficiencies and waste that privately owned companies would be more ruthless to address and remove. They tend to universally apply standard performance measures that are not tailored to the unique traits of a division’s industry. In short, some publicly owned company executives are simply too slow at restructuring or divesting a division that is not living up to its full potential.

Private Capital Markets Are Free of the Shortcomings of Public and Internal Capital Markets
It is because private capital markets are not subject to the anchors and burdens of public and capital markets that they are capable of relatively higher performance. With a ‘Barbarians at the Gate’ reputation, private capital managers reject internal capital allocation ‘socialism’ in unleashing higher financial value from the tangible and intangible assets of their acquisitions. Within the four types of private capital market participants, private equity funds, such as the Blackstone Group and the Carlyle Group, are relatively more aggressive than angels and venture capitalists. Private equity funds always have an exit plan. In contrast, angels and venture capitalists are interested in helping the young companies they are funding to successfully blossom as a business, such as Yahoo! and Google

With this ‘buy low and sell high’ approach to investing, private equity funds have one goal: To transform and turn around the acquired company. In other words, the objective of a private equity firm can be summed up as follows: Buy a pig (or some pigs) with other peoples’ money, spend a few years covering it with lipstick and starving it so it has a more elegant figure and then sell the pig at a profit to someone who thinks it is Miss Universe. The key to the process is to be able to generate enough cash to pay for renting the ‘other peoples’ money’ while at the same time being able to afford all the lipstick. There is nothing inherently evil in this process. The point is that the owners of a business managed in such a way appear to have little concern for the business’ long-term success or even its continued existence after it is sold. Their goal is to pay for the interest and lipstick until they can sell the pig at a profit. Performance Management aims at long-term sustained shareholder wealth creation.

Private equity funds do not necessarily acquire glamorous growth companies, but often, older ones in mundane industries. Similar to a hospital patient in an intensive care unit, companies acquired by private equity fund managers have one purpose: To have their financial health improved and then be sold. However, the stakes and risks are large. In contrast to public and internal capital markets, with private equity funds, an investor’s capital is locked up until the sale of the company – or until its parts are broken up and sold individually. There is a price premium for an illiquid investment, which places additional pressure on private equity fund managers to produce a high yield at the time of sale. (Because these acquired companies upon exit are frequently purchased by publicly owned companies, these assets are basically returned to the public capital markets. The intensive care patient is returned to the traditional business model.)

Five Value-Capture Action Categories to Realize Results
What actions do private equity funds take that produce incrementally higher financial value in such short periods of time? The answer is simple. The managers of the private equity funds do three things:
  1. They hire talented senior executives to transform the acquired businesses.

  2. They have relatively higher performance targets and higher investment hurdle rates.

  3. They equip these executives with the technology and tools that constitute and support the Performance Management suite of methodologies.

The third item is where the private equities display their competence deploying the power of business intelligence and performance management technologies. Both the private equity managers and their hired guns who operate the businesses – who have compensation reward packages tightly linked to improved financial and non-financial performance goals – are adopting progressive managerial methods.

Realizing actual economic value from mergers and acquisitions (M&A) is a ‘high stakes juggling act.’6 So many things must be correctly executed to maximize the potential economic value. But problems arise such as the disruptions from executive and employee turnover and from poor strategy execution – both the modified business strategy and the M&A integration strategy.

Figure x displays five value-capture action categories that each contribute to lifting shareholder value from an enterprise’s initial conditions. Although this figure describes opportunities for an M&A deal, it can be applied to any existing commercial organization.

Figure x: Value Capture Opportunities

Employees fear that the majority of the value lift will come from the third arrow – operating expense savings – which is perceived as code for employee layoffs. How can all five of the arrows generate the lift?
How Can Performance Management Methodologies Unlock Potential Value
There is confusion about what performance management (PM) at the enterprise level is; and PM is too often narrowly described as just visual dashboard measures and better financial reporting. It is much broader. PM is the integration of multiple managerial methodologies (e.g., customer relationship management, a balanced scorecard, Six Sigma) with an emphasis on analytics of all flavors, and particularly risk management and predictive analytics. PM’s methodologies themselves are not new; but organizations tend to independently implement each of them sequentially, often using disconnected spreadsheet tools rather than formal and proven information technologies. True PM deploys the power of business intelligence (BI) to enable decision-making.

Although there are interdependencies of PM across all five value-capture categories, different PM methodologies play a prominent role in each category:

  • Integration Strategy and Management
    The heavy lifting is done in the next four categories to the right in Figure 1, but in this first category the main PM methodology is human capital management (HCM). Employees, like information, can be a powerful intangible asset to lift ROI. A robust HCM system is not just an automated personnel database, but is much more powerful in aiding employee selection and retention. For example, an analytics-powered HCM system can quantify historical employee turnover and apply statistical correlations from that history to the existing work force to rank-order predict the most-to-least likely next employee to resign and therefore enable management interventions. Both the employer and employee benefit. With an aging work force approaching retirement at many companies, an HCM system becomes essential.

  • Revenue Growth
    Several PM methodologies are engaged here:
    • Enterprise Risk Management (ERM)
      ERM goes beyond just monitoring the traditional three pillars of market risk, credit risk and operational risk. ERM also formally manages an organization’s risk appetite with its risk exposure.

    • Business Strategy Management and Execution David Norton, the co-author with Professor Robert S. Kaplan of The Balanced Scorecard book series, has stated that nine out of 10 companies fail to successfully implement their business strategy.7 PM addresses this with the integration of:
      1. Strategy maps

      2. Scorecards (for strategic objectives and their associated key performance indicators [KPIs] with targets)

      3. Dashboards (to cascade downward all measurements for operational actions
        Incentives; and

      4. Analytics (to drill down to examine problem areas plus predict future outcomes).

    • Price Optimization
      Pricing is too critical to be just a ‘thumb-in-the-air’ intuitive feel for what price the market will bear. PM tools that optimize pricing include price elasticity analysis of consumer demand. This is incorporated into scalable forecasting and optimization routines that determine profit and volume maximizing price-point for example for each retail stock keeping unit (SKU) at a store specific level.

    • Product, Service-Line, Channel and Customer Profitability
      Profit is calculated as sales minus costs, but few managerial accounting systems properly trace and assign consumed resource expenses into costs; they rely on antiquated broadly averaged cost allocations that distort true costs and profits. Traditional costing practices mask and hide costs of a product or service as a lump sum. PM’s inclusion of activity-based cost (ABC) principles resolves these deficiencies. It is critical to have visibility and transparency of the contributing elements of costs – with accuracy – and to understand the many layers of profit margins.

    • Customer Value Management
      To determine the value of a customer, marketing staffs have traditionally relied on basic customer recency, frequency and monetary spend data (the RFM triad). That data is not enough. Today, there is a much greater need for customer intelligence that measures psycho-demographic information of customers as well as to apply Customer Lifetime Value (CLV) metrics to answer the key questions, ‘What types of customer microsegments should we retain, grow, acquire and win back? Which types should we not? How much should we spend with differentiated deals or offers on each microsegment so we don’t risk over-spending on loyal customers or under-spending on marginally loyal customers who may defect to a competitor?’ The more powerful and scalable PM technologies answer these questions and enable the ultimate microsegmentation – to the individual customer or consumer.

    Maximizing ROI is not accomplished by just growing sales, but rather by growing sales ‘profitably.’ That is, ‘smart’ revenue growth rather than growth at any cost.

  • Operating Expense Savings
    The recent popular improvement initiatives of Six Sigma and lean management help the work force learn ‘how’ to think (and PM provides more reliable and useful data for them, such as ABC information). But PM provides information for ‘where’ to think. PM brings focus. Improved productivity from business process improvements will reduce expenses, but there are diminishing limits, and breakthrough innovations stimulated by PM information will inevitably be required. Warranty and service parts expenses are often loosely managed and PM addresses these with analytics that quickly detect minor problems before they escalate into major ones. PM also facilitates sourcing with supplier management and consolidation tools.

  • Asset Efficiency
    For product-based companies, a large portion of their working capital is inventory. PM’s solution to reduce inventories leverages statistically based forecasts (updated periodically with demand history and potential influencing factors) to reduce uncertainty so a company can more confidently match its supply with demand. The objective is to minimize stockouts, shortages and surplus unsold items. The resulting right-time and right-amount inventories increase inventory turnover rates that in turn improve the financial gross margin return on investment (GMROI).

  • For fixed assets, a growing portion of an organization’s expense structure is its information technology expenses, and PM supports managing these infrastructure expenses with IT value management reporting and planning systems of technology capacity and usage as well as their associated workforce requirements.
  • Cost of Capital Reduction
    The cost of capital has two components:
    1. The amount required and

    2. Its composite rate. PM methodologies contribute to reducing both.

    PM’s ‘more with less’ productivity actions optimize the ‘amount’ of assets and resources required to fulfill customer orders and meet strategic initiatives. For banks this means better control of their capital reserves. PM provides risk mitigation and reduced earnings volatility through powerful predictive analytics to reduce the cost of capital ‘rate.’

Performance Management’s Bonus Methodology – Rolling Financial Forecasts
Capital market organizations hate surprises. PM cannot prevent surprises from fraud, ethics violations or unexpected financial re-statements (but PM’s analytics can provide earlier warnings). A surprise that PM can reduce for capital market firms is an earlier alert that their acquired company will ‘miss their numbers.’ Today, the annual budget is arguably outdated as a financial control instrument in part because it is obsolete soon after being published. But worse, the annual budget is criticized for not effectively allocating resources to their highest returns. PM addresses these shortcomings by shifting the accountants’ mentality from negotiating the next fiscal year’s incremental percent spending changes with managers to a more logical approach. This approach models resource capacity planning, staffing levels and supplier spending.

Imagine producing a budget twelve times a year. That is a nightmare for the accountants. Budgets are financial translations of non-financial operations. PM tools combine future volume-based demand drivers (e. g. sales projections) with funding for strategic initiatives. Since sales forecasts are constantly updated and because a strategy is dynamic, not static, then with constant adjustments various PM methodologies automate the translation of operations into rolling financial forecasts.

What Leads to the Unfulfilled Promises of ROI for Capital Market Firms
To be clear, the boards of directors of companies listed in public capital markets are not ignoring performance management. They are making the transition from a pre-Enron ceremonial role to a new era of activist boards that more seriously accept their corporate governance responsibilities to represent shareholders.

Capital market firms place high importance on executive leadership. And they should. From reading this article, you may conclude that the performance management methodologies are like cog gears, and the executives with the best-in-class technologies that support PM’s methodologies can just push or pull the levers and pulleys and watch the dials. To achieve superior results, executive leaders must exhibit vision and inspiration. That is what a work force responds to.

However, to fully achieve the highest potential in the right side of Figure 1 – Value of New Company – an enterprise cannot rely on a rudder-and-stick to get there. The executive team and their work force need integrated business intelligence and performance management software for those gears to mesh and revolve at faster speeds. The premier software technology not only integrates PM’s suite of methodologies, but its underlying architecture is on a common data platform and its compute power is optimized for analytics – particularly predictive analytics. The result and benefit is better, faster, cheaper – and smarter.

Today, a building contractor would never manually excavate a foundation with shovels; they equip their employees with industrial-strength power tools. The same goes for most companies – at least those aware of the shortcomings of spreadsheets and other nonintegrated information systems that are limited in supporting control, analysis and decision-making.

Enterprise resource planning (ERP) software is helping companies get operational control, but ERP software is not designed to transform transactional data into information needed for decision support. As the capital market firms influence (or demand) their acquired companies to adopt and integrate PM methodologies with their supporting technology, their desired ROI targets will be achieved and possibly surpassed.

1 In 2006, private equity funds accounted for 35 percent of global acquisitions, which was double the prior 10-year average of 17 percent (PricewaterhouseCoopers study).
2 Deloitte Research – Economist Unit M&A Survey (2007).
3 To learn the basics about the performance management framework, read “The Tipping Point for Performance Management” at http://www.dmreview.com/article_sub.cfm?articleId=1027292.
4 For more information, Google Professor Jayanth R. Varma, Indian Institute of Management, Ahmedabad, India, who inspired this article.
5 see http://usmarket.seekingalpha.com/article/22629
6 “Mergers and Acquisitions: What CFOs Should Consider Asking Before the Deal is Done;” March 18, 2008 webinar; Carol Bailey and Trevear Thomas, Deloitte Consulting LLP.
7 David Norton, co-author of “The Balanced Scorecard: Translating Strategy into Action” at the Balanced Scorecard Collaborative Summit on November 7, 2006.

Gary Cokins, CPIM, is Global Product Marketing Manager of Performance Management Solutions with SAS. He is an internationally recognized expert, speaker and author in advanced cost management and performance improvement systems. After earning an Industrial Engineering degree from Cornell University in 1971 and an MBA from Northwestern University Kellogg Graduate School of Management, Gary began his career as a Financial Controller and Operations Manager with FMC Corp. He worked 15 years as a Consultant at Deloitte, KPMG Peat Marwick and Electronic Data Systems (EDS), where he headed EDS’ Cost Management Consulting Services. Gary was the lead author of the acclaimed “An ABC Manager’s Primer” sponsored by the Institute of Management Accountants (IMA). His “Activity-Based Cost Management: An Executive’s Guide” recently ranked as the best-selling book of 151 titles on the topic. Gary’s other books include “Activity-Based Cost Management: Making it Work,” “Activity-Based Cost Management in Government”, and his latest work, “Performance Management: Finding the Missing Pieces to Close the Intelligence Gap.” He has served on committees of professional societies including CAM-I, AICPA, the Supply Chain Council, the American Society for Quality (ASQ) and the Institute of Management Accountants (IMA). Gary is a member of the editorial advisory board of the Journal of Cost Management. He is an Instructor for the IMA, the Institute of Industrial Engineers (IIE), and the Purchasing Management Association of Canada (PMAC). For article feedback, contact Gary at gary.cokins@sas.com

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