Arthur B. Laffer, Ph.D., servedas one of President RonaldReagan’s chief economic advisersin the 1970s and 1980s.His supply-side theories helpedtrigger the global tax-cuttingmovement of the 1980s. Laffer is on The WallStreet Journal’s Gallery of the Greatest PeopleWho Influenced Our Daily Business and wasreferred to as one of the “century’s greatestminds” in Time magazine. Inventor of the“Laffer Curve,” he serves on various publicand private boards and is the recipient oftwo Graham & Dodd awards and the AdamSmith award.
William J. Hass, CTP, is CEOof the strategy and turnaroundfirm TeamWork Technologies.He previously served as chairmanof the Turnaround ManagementAssociation and was apartner of accounting giant Ernst & Young.He is a certified turnaround professional.
Shepherd G. Pryor IV is a consultant,corporate director, andeducator on the subject of corporatevalue. He has served onthe boards of four corporationsand was formerly corporatebanking leader at Wells Fargo Bank.

THE PRIVATE EQUITY EDGE

How Private Equity Players and the World’s Top Companies Build Value and WealthBy ARTHUR B. LAFFER WILLIAM J. HASS SHEPHERD G. PRYOR, IV

The McGraw-Hill Companies, Inc.

Copyright © 2009 Arthur B. Laffer, William J. Hass, and Shepherd G. Pryor, IV
All right reserved.
ISBN: 978-0-07-159078-5

Contents

Chapter One

Value Rules of Thumb: Simplistic, Usable, and Often Wrong

In today’s interconnected and global economy, much of what goes on behind the closed doors of a boardroom is too sensitive to be shared with the public. Here is a classic example of what might happen on any public board.

The boardroom was filled with an uneasy quiet. Then one director spoke: “Our CEO needs to go. We can’t continue without taking action. We can’t ignore the employees, the shareholders, and the share price any longer. His pay package for the first five years of over $100 million without any increase in our stock price has made our board a target of activist groups. Is there any way we can get him to accept a pay cut and better tie his compensation to the stock price?”

A second director chimes in: “We all thought he was the right guy, but he continues to pursue a strategy that analysts say will kill the company. A third director comments: “My partners in our private equity fund would have my head for that kind of payday, given the stock decline and market share loss relative to the other major competitors in our industry.”

Several public company CEOs became the poster children for what was considered wrong with many big public corporations: excessive CEO pay for poor stock performance. Many were not surprised to see CEOs of public companies resigning to join private equity firms in order to run large portfolio companies.

The time was ripe for mistakes to be made. Public companies had to compete with private equity firms when seeking CEO talent. In an effort to simplify the process of hiring and overseeing their CEOs, some public company boards chose simplistic solutions that ultimately failed, sometimes catastrophically. Private equity firms, overseeing CEOs in their portfolio companies, could take a different tack. Rather than lure CEOs with high salaries with the soft landing of generous severance packages, the private companies required that CEOs share in the risk. CEOs would have to actively invest in their companies and accept modest salaries. However, if they were successful, their incentives could change their lives.

WHAT DO PUBLIC COMPANY BOARDS MISS?

In public companies, when things do not go right, they spur headlines. For example, in January 2007, Bob Nardelli resigned as CEO of Home Depot. As he departed, he was heavily criticized in the media. A few months later he was named CEO of Chrysler by its private equity fund owner. We expect that Mr. Nardelli’s experience will be vastly different in his new situation.

The Nardelli story is not unique. Many companies have suffered misfires, especially when a bold strategy has been employed to change corporate culture and performance. At the end of the day, Home Depot failed to meet shareholder expectations for continued growth in real cash flow returns and size. As a result, investors lost faith in Home Depot’s ability to create future cash flows. Home Depot’s stock price languished relative to its rival, Lowes. Nardelli did not find a way to communicate the value of his strategy to the market and stock analysts in terms they could translate into expectations about future cash flow. His focus on accounting metrics—sales growth and earnings per share—and his tendency to dismiss the importance of stock price and shareholder wealth, as well as his handsome “nothing at risk” compensation package (except for his stock ownership), made him a very independent, some have said “arrogant,” CEO.

Nardelli had significant experience in acquisitions from his years at General Electric. As a strategic business unit (SBU) head, however, he did not gain experience dealing directly with stockholders. It was clear that he acquired building supply businesses to boost Home Depot’s sales growth and earnings, but at what price? Nardelli spent over $7 billion on the acquisition of builder supply businesses when home building was booming, thereby changing the focus of the company. The acquisition of the lower-margin supply businesses dropped Home Depot’s overall margins and real return on assets. Although generally accepted accounting principles (GAAP) earnings increased, the price-earnings multiple dropped. Apparently, these accounting metrics were not those which the market considered important to share price. Under Nardelli, Home Depot lost market share and growth opportunities to Lowes in the higher-margin core retail business. Consumers complained that stores were messy and that customer service had declined. Lowes had taken the lead in quality and service. Home Depot seemed to have lost its focus and hurt its intrinsic value.

The day Mr. Nardelli’s resignation was reported in the press, the business press reflected doubt about the future of Home Depot’s cash flow and growth. “Nardelli has also drawn heat for his huge pay packages and for the way he handled last year’s annual meeting. Under his guidance, Home Depot has lost market share to rival Lowes Cos. while its stock has fallen 7.9 percent.”

In brief, Home Depot’s board was correct to finally ask Bob Nardelli to take a pay cut. His apparent superior pay negotiation skills and stated belief that “Share price is one measure of corporate performance I [Nardelli] could not control” are examples of selective oversight. Being selective on only the facts that are CEO-friendly is typical of the interchange between CEOs and the boards of many companies with underperforming stock prices.

A mission-critical part of the CEO’s job is to convince the board, shareholders, employees, and suppliers that the current strategies will result in building long-term shareholder “intrinsic” value. Communicating thoroughly is often neglected by “autocratic CEOs.” Nardelli had great discipline and a vision for Home Depot, but without a clear understanding of what would build Home Depot’s intrinsic value (i.e., using the wrong metrics), he was doomed to failure. He did not communicate the intrinsic value or the potential cash flow of his strategy.

Despite the doubling of sales and earnings at Home Depot over the previous five years, Nardelli failed to communicate to his board and shareholders how his planned acquisition strategies would make Home Depot a more valuable long-term investment. Nardelli’s apparent hubris in dealing with people and communicating with Wall Street was a weakness, possibly uncovered in GE’s succession planning process.

Enter a value builder. In June 2007 Nardelli’s successor, Frank Blake, took steps to recognize the importance of returning cash to shareholders. After a much needed strategic review, Home Depot announced on June 19, 2007, that it would sell the builder supply business for $10.3 billion to a private equity group and use the sale proceeds and other funds to repurchase 30 percent of Home Depot’s outstanding stock for $22.5 billion. However, things changed. By August 2007, housing slowed further and debt markets were suffering from a reassessment of risk. The $10.3 billion deal was in danger of collapse. To get the deal done, Home Depot dropped the price to $8.5 billion, a 17.5 percent decline from the price agreed upon less than three months before. Home Depot also had to guarantee $1 billion of the debt and retain 12.5 percent of the equity in the supply spin-off. Fortunately for Home Depot shareholders, Home Depot management stood firm on its $22.5 billion share buyback.

The tools exist to explain how strategy leads to long-term intrinsic value creation. CEOs must understand how to use these tools to communicate to the shareholders and the investment community. Without clear and thorough communication among all parties—management and the analysts, analysts and the current and potential shareholders, management and employees—investors are likely to make the wrong assumptions about future value, real growth, and cash flow. Most CEOs know that their stock price will suffer whenever they fail to meet the expectations of the market. Communicating realistic expectations about the long-term future growth in cash flows is a priority for all top value builders. Many CEOs act as though they believe the rules do not apply to them. They are the first to communicate in terms of earnings per share but complain that the market is irrational and does not understand performance. Those who ignore cash flow and cost of capital and fail to understand the nature of value eventually are surprised.

Home Depot’s shares continued to decline through 2007 and into 2008, as the subprime crisis hit homebuilders and consumer confidence. Only time will tell if and when Home Depot’s stock will recover. No doubt, Mr. Nardelli’s options were worth much less at the end of 2007 than when he resigned.

THINGS WORK UNTIL THEY DON’T; CRISIS IS STILL THE BEST TEACHER

Dick Heckmann became CEO of United States Filter in 1990 and later arranged for the sale of the company to Jean Marie Messier’s Vivendi in 1999 for about $6 billion. During the period, US Filter grew rapidly, completing over 215 acquisitions by the time of the sale. It was a classic “roll-up” company. To speed up the integration after an acquisition, Heckmann would say: “Always shoot the lead elephant.” Once the former leader of the new subsidiary was gone, the rest of the managers would quickly take their cues from their new bosses.

Heckmann had a commonsense approach to business and tremendous motivation to build the business. “Always be the lead dog. The view for every other dog never changes.” He loved simplicity; keep it simple: “Never say ‘boo-boo’ when ‘boo’ will do.”

The approach if not the personality was the same in France, as entrepreneur Jean Marie Messier was rolling up an even larger empire of water treatment and related companies as a division of Vivendi. Jean Marie Messier was a very classy operator and a huge success in France, following his departure as a senior partner of Lazard Frères.

Although both entrepreneurs operated public companies, they pursued versions of a private equity, Capitalized Economic Profit model. The first step was to issue debt at attractive rates. The proceeds of the debt would be used to buy companies. Those companies would be brought into the corporate fold and acculturated. Once the assimilation process was completed, a public offering would follow, which would pay down the debt. Then it would be back to step one. With the exception of using a public offering in place of raising a new private equity fund, the approach was straight from the private equity handbook. The economics of water-related companies worked perfectly for the process. These companies had steady cash flow, were often undervalued, and had hard assets that could be financed.

So, why did US Filter not just continue to fight its way toward being the global “lead dog”? Things happen along the way. Unforeseeable “fractal events” occur, bringing with them dramatic impact. The impacts may be positive or negative, depending on luck and how a company’s strategy is aligned. US Filter’s strategy was simple. It was based on planning to take advantage of the run of good fortune, with cash flows staying predictable and additional capital being available whenever needed. When the negative “unexpected” fractal events occurred, they had a major impact on the way people viewed the world. The change took its toll on a once successful business model.

Arthur Laffer personally experienced the power of fractal events, right alongside Heckmann. He was a director of US Filter at the time. Also a director of MasTec, Laffer had the good fortune to watch his investments in these companies increase by factors of as much as 40 to 60 times his purchase price. As his options matured, he would borrow to buy the stocks, building up his holdings, but also building up his debt. His was clearly an undiversified “fractal focused” strategy. It would either win big or lose big.

Few parties last forever, and this one came to a close in the fall of 1998, after the 1997 Thai baht crisis triggered the “Asian Contagion” and was later compounded by the August 1998 collapse of the Russian ruble. The stock price of US Filter fell by 74 percent, and MasTec’s stock lost 76 percent of its value. The drop in the stock prices breached Laffer’s loan covenants. He called the banks and went in to visit them. Since he had other resources and income generating capability, he was able to show them how he would pay back the loans over time. Yet he was panicked. This was not supposed to happen to a wise investor. Fortunately, the bullet went right by him. The bankers were impressed with his forthrightness, saying that they had never had a customer come in with such a straightforward explanation. Later the market recovered. During the crisis, though, he had the feeling of living in cold water. He then understood the meaning of a negative fractal event personally.

Heckmann had a similar experience, being fully invested at the same time in the late 1990s, but the sudden drop in the US Filter stock price also endangered the company and his personal wealth. He saw his successful efforts at building a company for the better part of a decade going up in smoke. The fractal event changed Heckmann, too. He became a different person, utterly dedicated to selling US Filter to cash out. US Filter was ultimately sold to Vivendi.

Jean Marie Messier was not so lucky. The market collapse of 2001–2002, another fractal event, led to a decline in Vivendi’s stock price, culminating in a spectacular collapse in mid-2002, which led to a bankruptcy, costing investors billions. Jean Marie Messier, once one of the French elite, was relentlessly attacked for the losses. The unfortunate aspect of the collapse is that Messier fell victim to the crisis, even while consistently pursuing the high-risk strategy that had been such a spectacular success and that was so applauded by those who had previously enjoyed the favorable returns. Apparently, those investors were not willing to accept the downside of high risk/high return strategies.

Private equity players typically follow the same high-leverage technique of rolling up acquisitions as Heckmann employed in building up US Filter. At the same time, Heckmann, a master of acquisitions, more recently has avoided tempting fate in his role as CEO of K2 by operating with lower levels of risk and debt. The fractal event of 1998 gave Heckmann the scare of his life. Unfortunately, Jean Marie Messier got more than a scare! For a time Messier lost his fortune and public respect. Crisis, when it is personal, is a powerful teacher.

Armed with the wisdom of experience, both Heckmann and Messier took their lessons to heart. They moved beyond the crises and on to other value-building activities. Different from the public equity markets, where prices can plummet far below intrinsic value, private equity investors are more realistic about the setbacks that can occur. They understand expected values and take risks that others shun.

Before their “near death” experiences, Nardelli, Heckmann, and Messier all pursued ambitious goals, but risk and value are very difficult to understand when the future is filled with uncertainty. Nardelli’s goals were sales and earnings growth, which worked well at GE. However, because he achieved those goals at the expense of producing cash flow, the stock market punished him at Home Depot. Heckmann and Messier pursued sales growth and accounting profit with a classic roll-up strategy. Both accepted the high risk of leverage in pursuit of those goals. For each of them there was a period during which the stock market favored their every move, but public stock prices can drop below intrinsic values because of market factors. Heckmann danced too close to the fire; however, after the 1997 Asian crisis hit, he had the wisdom to sell out. The music stopped for Messier when another major unforeseen event, the 9/11 attacks on the World Trade Center, dried up sources of new capital that were needed to finance prior acquisitions. The public stock market eventually understood the differences between the cash being produced and the accounting numbers, and Vivendi crashed. Public markets frequently overreact on both the upside and the downside, accentuating the highs and lows for individual stocks. This is another reason why private equity players have a long-term value- building edge.

EVERYONE HAS A DIFFERENT WAY TO VALUE THE MARKET AND INDIVIDUAL STOCKS

There is a substantial industry of stock analysts making earnings per share estimates and building valuation models that evaluate stock prices for the largest public companies. They try to find stock price anomalies and market inefficiencies. Unfortunately, not all public companies are covered. Thousands of analysts base much of their analysis on historic results at the corporate level. Many small and mid-cap companies are ignored by analysts, providing private equity investors with the opportunity to produce excess returns.

The best place to understand corporate performance and cash flow is at the strategic business unit (SBU) level. The best people to do it are members of SBU management. They understand the business unit challenges, the operating cash flows, and the amounts and type of cash investments needed to replace or enhance the asset base. Private equity players and other value builders understand cash flow and investment needs at the SBU level. Some public company CEOs miss the opportunity to understand and communicate this information to their directors and the market.

(Continues…)

Excerpted from THE PRIVATE EQUITY EDGEby ARTHUR B. LAFFER WILLIAM J. HASS SHEPHERD G. PRYOR, IV Copyright © 2009 by Arthur B. Laffer, William J. Hass, and Shepherd G. Pryor, IV. Excerpted by permission of The McGraw-Hill Companies, Inc.. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.