Author: Pažitková Martina
Source: Trend, 8.5.2008, No. 18, page 38

It is Friday evening and about twenty relatives spend it in a restaurant, which is obviously much fancier than necessary. Maybe that’s to make the guests forget about the exorbitant prices.
One of the group orders a salad, but the waiter brings four. In a while, he brings a bottle of wine that nobody ordered. The place is noisy, it is impossible to talk to those sitting at the far end of the table and everybody thinks that the others made the order. Because nobody wants to spoil the evening with a confrontation, all keep silent. Anyway, if they split the bill twenty equal parts, it will not be any real burden on any one of the diners.
That’s how it works in big companies. Small shareholders will hardly ever consistently monitor what the executive director gets incentives for. Everybody cares about stock movement, at most. If they did it, it would be almost impossible for them to contact other shareholders and persuade them that they are right.
Collective logic. Such is the explanation of the bill-splitting principle in a publicly marketable company according to Logic of Life by Tim Harford. He thinks it is obvious that if the waiter was pulling a wallet straight out of somebody’s pocket, that person would immediately react. But which shareholder cares about payments that regularly go on the accounts of retired directors for “consultancy services”?
In a company with one big shareholder, the bill-splitting principle does not work, says Harford. It is just like at a family dinner which is paid for by extremely stingy father-in-law. If he watches for every order like a bulldog, nobody will dare to ask the waiter to bring an expensive bottle of champagne.
Stricter monitoring and changes in human behaviour that are shown by Harford’s principle of bill-splitting are only one from many reasons why companies in the hands of private equity investors get along better than other comparable companies. They gain the majority in the companies they invest in.. They use mostly their own funds and in some cases the money of their associate partners. Therefore, the pressure to be effective is higher than in joint-stock companies where many people have very small stakes.
Ernst & Young examined a hundred of the biggest Western European and American companies which were left by a private equity investor in 2006. At the time of exit, these companies were in the USA of about one billion (I DON’T UNDERSTAND EXACTLY WHAT THIS MEANS,) and in Europe of about 700 million dollar higher value than at the time of acquisition. In 2006 the market capitalization of American companies administered by PE investors grew by 33 % while of the publicly marketable companies only by 11 %. In Europe it was 23:15 ratio in the same category.
Invest your own money. The bill-splitting principle doesn’t work, either, in the Slovak private equity Penta group. Although for business it uses also foreign funds, Penta invests the money of its owners into other companies. Their motivation to maximize profit is, naturally, very strong. They can transfer it on the managers of particular investments, too, because by setting up responsibilities and evaluative criteria they de facto become co-owners.
Eduard Maták, Penta’s investment director, is responsible for several projects. Besides Alphamedical laboratories also for buying up meat processing plants in Central Europe and for Dôvera insurance company. If he finds out during project evaluations that the company lost 300 million crowns, he calculates that he worked for free all the time and will owe the company a lot. His share on any result is 10 %. Maták explains that this is why most of the people who could do this job prefer to sit in a bank with a fixed salary.
Somebody could simply state that companies in the hands of PE investors get along better because they are run by ambitious and autocratic businessmen with iron discipline and zero social feeling. They are the kind of people who, figuratively speaking, cannot live without business risk. Even if this statement might be right, it will never fully answer the question: What is the cause of above-average growth of companies that come under the control of PE investors?
The first step toward company evaluation and its future successful sale is a comprehensive analysis, says Rastislav Velič, the Arca Capital private equity group’s project manager in Slovakia. Their core tasks are to find a starting company with an idea, which does not have enough funding money, pour money into it, set up managerial processes in it and sell it as a viable and running company within three years.
With this objective Arca Capital bought the Czech company Bio-Skin last year, in which they invested one million Euro. At that time, the company had patented the production of a skin-cover that is used for treatment of skin injuries. Arca even kept the original management in the Czech company, which is not a very common action among private equity investors. The managers managing the company before acquisition usually remain minority owners, at most.
In such cases, the risk capital makes use of a gap when banks do not want to provide credits to start-up companies. PE investors have enough money and in comparison with banks they have better possibilities to evaluate business ideas and risks. That is why some of them do not refuse start-ups and sometimes even search for them. Although they can come off as losers, potential gains from later sales have exceptional potential.
When considering new investment opportunities it is, according to Penta’s investment director Maták, very important to avoid stale thinking that is to a large extent spread over industry.. “When we were buying Paroplynový cyklus in 2003, we were surprised how herd-like some strategic players behaved,” says about the time when nobody counted on significantly increasing energy prices. Today it is common to use steam gas for heating.
Obesity and moths. To create a value in a company is possible without any difficult managerial interventions into the company structure. The water and sewage works of Northern Moravia was not a publicly marketable company, but they had many scattered owners. Those were individual villages that had just one objective – to have water and sewage systems within reach.
A typical feature of PE investors’ thinking is that they do not care about the role of companies in the society, but view them as generators of cash flow. From this point of view, cash and assets create the value. In the waterworks, Penta introduced financial restructuring. Instead of own capital they pumped a bank debt into the company, by which they changed the ratio of cash-flow items. They increased the debt and the free cash was paid out as superdividends. If some of the original shareholders wanted to do something similar themselves, they would not probably be able to get the cash. Penta sold the whole network to a strategic investor after more than two years. Including disbursed dividends, they earned four billion crowns.
Sometimes it is enough when PE investors play with money and they can earn kingly sums, but in most cases they have to revitalize the company before they sell it profitably. The faster and more effectively they do so, the better. Before the strict eye of a manager prescribes a cleansing and slimming cure, the company has to undergo a systematic check-up. When he discovers breathlessness, tapeworm in the colon and threatening nervous collapse, he will throw out the outdated production line and reduce the electricity expenses.
New managers, who are usually appointed by PE investors, send redundant employees away without a wink. That is what is usually viewed as the most visible feature of measures taken by PE groups. “We go into business to earn money, not to employ people,” says Velič. He knows that reducing staff is not a favored step and points out that if there is unhealthy overemployment, after a time the company will cease to exist anyway. Exaggerated social feeling should not be a part of the picture, he says.
The results of an Ernst & Young study do not confirm that private equity invested into a company means a permanent employment decrease. Eighty per cent of U.S. companies included in the survey reported no changes or increase in the number of employees in the period of time between acquisition and sale. In Great Britain, France and Germany, where the most of the surveyed European companies come from, the number of employees was increasing by five percent yearly. Concerning the reference group of publicly marketable companies, the increase was about 3 per cent per year. Redundancies are common in the recuperative phase, but as soon as the company rebounds, employment rates increase. Most of the companies that need reconstruction look like hundred-year-old houses with plenty of accumulated trifles. The person who collected them would never throw them away. But if a young couple moves in, they probably would. New owners usually find old relics useless.
During so-called asset stripping, the company gets rid of burdening side activities. That’s usually true if there are no such synergies between them which can save money and be used for generating cash-flow. For instance, the ZSNP company producing aluminum in Žiar nad Hronom had at the time of privatization in 2002 eleven different types of unrelated productions. Alloy casting and plastic tube production used to be in one place. Penta sold unimportant operations to strategic investors found in Norway and Sweden. So the value of ZSNP increased. In 2006, the company achieved a profit of 1.1 billion crowns; four years ago it reported a loss of 2.5 billion.
When a profit is not a profit. Even managers of private equity investors can make mistakes. For instance, they can be lured by a good price to the extent that they wrongly anticipate trends in the industry, in which the purchased company conducts business. That was true of Penta acquiring the bankrupting garment company Ozeta in 2004. They wanted to get rid of unnecessary activities and restructure the company. At last they had to close down almost all the company’s establishments for persistent losses. “We had wrongly anticipated the industry development. The whole project might be unprofitable, but Ozeta is not the thing we want to be proud of,” admits Maták.
Errant anticipation of external factors can be blamed for the failure of the Fenzin company project. Arca Capital wanted to build a galvanizing plant in Humenné. “We already had the building permit, but then zinc prices started to rise quickly and we were in danger of falling demand.” In addition, they could not compete with big players in the business who had hedged prices for about a year. It was clear that they had to withdraw. They immediately cast a net and found a Norwegian investor, to whom they profitably sold the company.
Velič is more sorry for what he has not than what he has done. A few years ago Arca Capital was considering purchase of shares in the ČEZ company. It was a static deal, which means that the group was supposed to invest money into buying share of a company, in which it would not have majority and would not have any decision rights. “The philosophy of the deal was completely beyond us, but sometimes I am sorry when I bethink of the time when the share were sold for one hundred crowns. Today they cost ten times more.”