Understanding the success of private equity

“Never invest in what you don’t understand”. That was the advice of David A. Novak in a fascinating discussion with London Business School’s Professor Florin Vasvari at the most recent Summit Series event, held earlier this year. In a conversation that spanned the relative benefits of private versus public capital, the evolution of the industry in Europe and the opportunity for ‘solution capital’, Clayton Dubilier & Rice’s (CD&R) Co-President provided a wealth of insight into how private equity drives value creation through the release of strategic capital and partnering with management teams.

Mr Novak has worked in private equity for close to 30 years, with most of that time at CD&R. He is responsible for the company’s European business, having led the storied firm’s expansion across the Atlantic in the late 1990s. He sits on both the firm’s Investment and Executive committees, while also overseeing CD&R’s international, investor relations and external affairs activities.

Mr Novak gave an impressive account of the success of private equity firms over the past three decades, noting their efficient capital structures and the specific mix of debt and equity PE firms use to finance their operations and drive growth. Getting the mix of debt and equity right, focusing on operational improvement and working closely with management teams to agree on strategy and tactics are, Mr Novak stressed, fundamental to the success of the private equity value proposition.

In response to Professor Vasvari’s question about the changes Mr Novak had seen in the industry over the past 30 years, Mr Novak remarked on an earlier conversation the two men had had where Professor Vasvari revealed the growth in the number and popularity of private equity classes he taught at London Business School.

Seventeen years ago, Professor Vasvari taught a single class on private equity. Now he teaches six. This, Mr Novak said, reflected the growth in private equity markets over a similar timeframe.

“We’ve seen a similar growth in the private capital industry which has grown from less than one trillion dollars of capital to more than eight trillion dollars today. And if you think which companies operate in the private capital space, that too has also grown considerably,” said Mr Novak.

“If I think back to when I joined CD&R in 1997, we numbered about 20 people and little more than half of those were investment professionals with the rest support staff. Today we employ close to 300 people in New York and London.”

In the 1990s Mr Novak said the industry was mostly engaged in small investment partnerships, “a few people trying to find businesses to invest in, improve the business and then sell it on”.

“Today I would describe the private equity market as being its own capital market, with its own ownership and governance models. We’ve seen a big transition that has spurred a lot of growth for the industry.”

How do the advantages of the private equity governance model, asked Professor Vasvari, play into the volatile global market environment that we see today, and how can private equity contribute to businesses and economies differently, than one sees with public equity?

If one were to examine capital flows over a period of time, there is clear evidence that as the private equity market has grown, unsurprisingly the number of public companies has declined. Mr Novak said there are a number of key reasons why this should be so, including growing short-termism in public markets.

“First of all, notwithstanding what you might read in the media, public capital is not long-term. If you look at the trading behaviors of the public investors, you can see that the average hold of the stock is less than a year.

“The other thing that has evolved with public capital is the common approach to forecasts. There is consensus on earnings for the year and what has happened is that a lot of companies go through considerable effort to come up with a forecast, and the worst thing they could do is miss that forecast.” said Mr Novak.

“What has resulted from this approach I believe is that, often, management teams of public companies don’t wish to take any risk. Furthermore, I believe they are very reticent to take long-term investment decisions that by definition have unpredictable outcomes. Thus, public company investment is not that long term, and in the UK in particular there is a focus on dividends so instead of investing cash into growth, you’re returning it to shareholders.”

Other areas of principal difference between private and public equity concern governance and incentives. While Mr. Novak noted that there are good governance measures in the UK public market and that public boards spend considerable time on governance, time spent doesn’t always translate into action.

“I believe the good thing about private equity is that it’s a small group of people who are there for a longer period of time and they can sit around a table and speak with their management teams about value creation. In my view, this is something one cannot do in a public investment arena principally because there is not the same alignment between the public board members and the management team.”

This, says Mr Novak, goes to another area of difference between public and private capital: alignment of incentives. He believes the flexibility private equity has in terms of incentivising management teams, versus the rigidity often seen in public compensation committees is one of the key tools in private equity toolkit, aligning compensation on long-term value creation objectives.

Mr. Novak believes the relationship the firm has with management teams is a key point of difference for CD&R. This is down to the firm’s focus on partnership transactions: situations in which CD&R invests alongside an existing owner, “not buying from them but becoming their partner”. In fact, close to 60% of the firm’s investments have followed this model.

Mr. Novak outlined that in these situations several key characteristics repeat, “often there is a problem that needs to be solved, or an opportunity that the owner needs help realising”. He said that while these processes are often longer in gestation, CD&R has found that, “our operating capability and industry expertise positions us to best help the owner solve the problem or realise the opportunity. And I believe the longer process helps drive conviction, build trust and cement confidence in each other.”

Which brings us back to the opening quote of this article, the advice from Mr. Novak to ‘never invest in what you don’t understand.” For CD&R it seems that ‘partnership’ investments are the key to ensuring this. These kinds of investment require time to really understand the problem you’re deploying capital to solve, and to find the answer as to whether you really “have the right to play”.

As Mr. Novak, pithily put it, “over the long run we are prepared to take a little more process risk to, on average, get much better outcomes.”

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