Recently, there have been more opportunities to see articles about private equity funds, or PE funds.
Sometimes I read articles that introduce them as “management professionals.”
It is true that they play a role in bringing in external capital and talent, organizing management structures, and supporting company growth, and funds can also serve as important recipients in business successions or corporate carve-outs.
However, there is something I think we must not forget when reading such articles.
Funds have an exit, but the company continues after that.
Funds are also in a position of being entrusted with capital
From here on, I will focus primarily on buyout funds that acquire control of companies.
For a fund, increasing the value of an acquired company and recovering the investment is important.
This is because the fund itself is entrusted with capital by investors and is expected to provide returns. Most of the capital used by the fund for acquisitions is also money entrusted by investors.
Such funds are generally premised on making investments and recovering them within a certain period.
They acquire a company, get involved in management, and increase the stock value.
Then, ultimately, they recover the investment through means such as selling the shares to another company or selling them after an IPO, and return the results to the investors.
Therefore, it is natural to think about how to sell the acquired company at the highest possible price. The acquisition price and the holding period also affect the investment results.
Growing the company and returning returns to investors.
These two things must be balanced.
Increasing profits to sell at a high price
One of the important factors for selling a company at a high price is increasing profits.
(I will omit the detailed indicators used for corporate valuation in this article.)
Of course, the sale price is not determined solely by profit.
Future growth potential, business stability, market conditions, and attractiveness from the buyer’s perspective also have an impact. However, the fact that the ability to generate profit is important remains unchanged.
To increase profits, broadly speaking, you either increase sales or reduce expenses.
If it is difficult to increase sales, you reduce expenses. In other words, cost-cutting.
Reviewing wasteful spending and improving inefficient operations is necessary.
On the other hand, some of the items recorded as expenses also include those that support future growth.
Recruitment and training of personnel.
Research and development.
Development of management systems to support daily operations.
If you suppress these, immediate profits may improve.
However, the impact of that might only become visible several years later.
Are you cutting into the power to generate future profits just to increase current profits?
I think it is necessary to look not just at the result of having reduced costs, but also at what was reduced.
Who pays back the debt for the acquisition?
Another important point when considering investment returns is the amount of equity capital used for the acquisition.
Part of the acquisition funds is covered by borrowing from banks and the like. This is so-called LBO financing. By utilizing debt, the fund aims to keep the total investment amount down and increase the return on that investment.
Most of the fund’s capital referred to here is also money entrusted by investors.
The operating company side usually also makes a certain investment, but they are not bearing all of the acquisition funds themselves.
Meanwhile, the operating company side earns management fees for running the fund and performance fees based on investment results. In other words, it is a mechanism where managing investors’ capital and returning profits also leads to their own revenue.
However, using debt does not guarantee success.
If the business does not proceed as expected, the repayment burden becomes heavy, and there is a risk of losing the invested capital.
And the source of repayment for that debt is basically the cash generated by the acquired company.
The business of the acquired company supports the funds raised for the acquisition.
Although there are differences in the detailed mechanisms, this point must be understood.
When a fund sells its stake to recover its investment, existing debt may be repaid or refinanced. Therefore, the same loan does not necessarily remain. Even so, there are cases where the target company continues to operate while carrying debt.
A shareholder recovering their investment is not the same as the company being relieved of its repayment burden.
Driving management as a shareholder
The source of the power to advance these measures is control as a shareholder.
The fund acquires a majority of voting rights and exerts strong influence over management policies and the execution of measures through the appointment of management teams and other means. Investment managers from the fund’s management company are sometimes dispatched as directors.
They are in a position to move the company, not just advise from the outside.
With this power, it is sometimes possible to execute reforms that had previously stalled.
It is also possible to accelerate management decisions, bring in necessary talent, and promote growth investments.
On the other hand, what remains in the company changes depending on what is prioritized.
Is the focus on profits during the holding period or the sale price?
Or is it on leaving behind talent and systems that allow the company to grow after the sale?
Sometimes both can be achieved. Creating a company with future potential can also lead to a higher sale price.
However, measures that show results in a short period (a few years) and measures that require a long time to show results are not always evaluated in the same way.
Investment success and management success
If the buyer is another fund, management aimed at investment recovery begins again under the next shareholder. The next fund may also support new growth.
On the other hand, it is the management team and employees remaining in the company who must deal with changing policies and goals every time the shareholder changes.
Who decides what should be protected even when shareholders change?
The management team also has that responsibility.
However, one cannot ignore the time horizon on which shareholders, who have strong influence over the appointment and evaluation of management, seek results.
I do not intend to deny the act of returning profits to investors itself.
That is a role the fund must fulfill, and in the process, the company may become stronger. I also believe that funds play a significant role from the perspective of capital circulation.
However, I do wonder if it is appropriate to call investment success management success. It was sold at a high price.
A sufficient return was provided to investors.
That is a result as an investment.
Beyond that, what kind of talent has been nurtured in the company, what kind of business foundation remains, and how much capacity is left for the next growth?
If we are to consider the results of management, shouldn’t we think that far?
If the essence of management lies in sustaining and growing a company with a long-term perspective,
are PE funds not so much ‘management professionals’ as they are ‘professionals in corporate value enhancement and investment recovery within the holding period’?
I believe that being an investment professional and being a management professional are not necessarily the same thing.
Funds have an exit, but companies continue after that.
In that process, who keeps an eye on the long-term growth of the company?
What, after all, is true management?