The Private Equity Edge: How Private Equity Players and the World's Top Companies Build Value and Wealth

THE PRIVATE EQUITY EDGE How Private Equity Players and the World’s Top Companies Build Value and Wealth

ARTHUR B. LAFFER WILLIAM J. HASS SHEPHERD G. PRYOR, IV

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Copyright © 2009 by Arthur B. Laffer, William J. Hass, and Shepherd G. Pryor, IV. All rights reserved. Except as permitted under the United States Copyright Act of 1976, no part of this publication may be reproduced or distributed in any form or by any means, or stored in a database or retrieval system, without the prior written permission of the publisher. ISBN: 978-0-07-164292-7 MHID: 0-07-164292-7 The material in this eBook also appears in the print version of this title: ISBN: 978-0-07-159078-5, MHID: 0-07-159078-1. All trademarks are trademarks of their respective owners. Rather than put a trademark symbol after every occurrence of a trademarked name, we use names in an editorial fashion only, and to the benefit of the trademark owner, with no intention of infringement of the trademark. Where such designations appear in this book, they have been printed with initial caps. McGraw-Hill eBooks are available at special quantity discounts to use as premiums and sales promotions, or for use in corporate training programs. To contact a representative please visit the Contact Us page at www.mhprofessional.com. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is sold with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional person should be sought. —From a declaration of principles jointly adopted by a committee of the American Bar Association and a committee of publishers. TERMS OF USE This is a copyrighted work and The McGraw-Hill Companies, Inc. (“McGraw-Hill”) and its licensors reserve all rights in and to the work. Use of this work is subject to these terms. Except as permitted under the Copyright Act of 1976 and the right to store and retrieve one copy of the work, you may not decompile, disassemble, reverse engineer, reproduce, modify, create derivative works based upon, transmit, distribute, disseminate, sell, publish or sublicense the work or any part of it without McGraw-Hill’s prior co sent. You may use the work for your own noncommercial and personal use; any other use of the work is strictly prohibited. Your right to use the work may be terminated if you fail to comply with these terms. THE WORK IS PROVIDED “AS IS.” McGRAW-HILL AND ITS LICENSORS MAKE NO GUARANTEES OR WARRANTIES AS TO THE ACCURACY, ADEQUACY OR COMPLETENESS OF OR RESULTS TO BE OBTAINED FROM USING THE WORK, INCLUDING ANY INFORMATION THAT CAN BE ACCESSED THROUGH THE WORK VIA HYPERLINK OR OTHERWISE, AND EXPRESSLY DISCLAIM ANY WARRANTY, EXPRESS OR IMPLIED, INCLUDING BUT NOT LIMITED TO IMPLIED WARRANTIES OF MERCHANTABILITY OR FITNESS FOR A PARTICULAR PURPOSE. McGraw-Hill and its licensors do not warrant or guarantee that the functions contained in the work will meet your requirements or that its operation will be uninterrupted or error free. Neither McGraw-Hill nor its licensors shall be liable to you or anyone else for any inaccuracy, error or omission, regardless of cause, in the work or for any damages resulting therefrom. McGraw-Hill has no responsibility for the content of any information accessed through the work. Under no circumstances shall McGraw-Hill and/or its licensors be liable for any indirect, incidental, special, punitive, consequential or similar damages that result from the use of or inability to use the work, even if any of them has been advised of the possibility of such damages. This limitation of liability shall apply to any claim or cause whatsoever whether such claim or cause arises in contract, tort or otherwise.

This book is dedicated to our families. May they grow and prosper in our global economy in both good times and bad. May they act sooner and dig deeper.

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CONTENTS

Foreword by Stephen Moore vii Preface: Clearly Focused Goals and Metrics Matter! xi Introduction: How Value Builders Create Value and Wealth and Reduce Risk xvii PART ONE

DIG DEEPER Chapter 1

Value: Rules of Thumb: Simplistic, Usable, and Often Wrong 3 Chapter 2

Wealth, Tax Rates, and Income: Leaders Who Dig Deeper Can Change the World 47 Chapter 3

Risk: Life Is Not a Straight Line—The World Is Not Normal 79 Chapter 4

Incentives: Value-Based Executive Compensation Leads the Way 123 Chapter 5

Scenarios: Options and Alternatives Can Add Value 159 v

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PART TWO

ACT SOONER: FACILITATED BY DIGGING DEEPER Chapter 6

Speed: The Race Is to the Swift 193 Chapter 7

Renewal: Continuous Emphasis on Value and Customer Discipline Is Critical 223 Chapter 8

Inflection Points: Act on Insights from the Fundamental Drivers 251 Chapter 9

Experimentation and Innovation: Action Accelerates Learning 291 Chapter 10

Summary and Conclusions: Insight and Action Give Private Equity the Edge 319 Appendix 1: The Health and Wealth of Our Nation in 2007 (With an Occasional Peek Ahead) 327 Appendix 2: Digging Deeper into Tax Rate Cuts and Tax Revenue Appendix 3: Digging Deeper into Corporate Value Audits 365 Appendix 4: Digging Deeper on Top Value Builders 387 Bibliography 393 Acknowledgments Index 399

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This is a groundbreaking book. The Private Equity Edge combines the experience of the three coauthors—my friend and pioneering economist Arthur Laffer and two experienced corporate value consultants, Bill Hass and Shep Pryor. The book brings new insights and techniques to any decision maker who desires to build wealth and economic value. It provides an insider’s perspective on the challenges that private equity and other top value builders face to promote value-building change. Read this book and learn from it! Buy another one as a gift for a decision maker you respect. Creating value drives the capitalistic free-market economy that has been raising the standard of living all over the world. As business and government leaders, we need to get everyone on the same page and spread the word. Few of our leading policymakers understand the contributions of the private equity revolution. Congress wants to add new taxes on private equity at a time when this industry’s value-added transactions are most direly needed. Private equity financing has provided lift-off and transition capital for scores of American companies that today are household names—including Target/ Mervyns, Macy’s/Federated, Hertz, and Dunkin’ Donuts. Over the last 50 years we have learned a great deal from our economic successes and failures. Despite the tremendous human capital created, our educational system has failed to adequately teach our people how our economy really works and the importance of creating economic value. While there is general agreement on some concepts, we still have a long way to go. This book can help spread these important concepts about value and help you navigate in these changing times. The chapters provide behind-the-scenes stories and insights from private equity value builders and value losers. The stories show how difficult it is to get decision makers moving in the same vii

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direction. We also see how the “people effect” creates uncertainty in markets. Appendix 1, “The Heath and Wealth of Our Nation in 2007,” provides a mosaic history and perspective on the U.S. economy in terms of corporate profits, political leadership, and macroeconomic factors over the last 50 years. We can all learn from the lessons of the past. Yes, we do have economic ups and downs. Just look at the trends—but some people never do. The powerful impact of tax rates on all economic activity, corporate value, national wealth, and international capital flows is a pivotal lesson. People respond to incentives. Our U.S. economy is becoming less competitive because our tax rates are high relative to the rest of the world. We can reverse the trend if we cut capital gains tax rates or eliminate them altogether to restore our competitiveness. Most American voters are unaware of this fact. The time to act is now. The U.S. economy has ridden a tax-rate roller coaster since the inception of corporate income tax laws. Politics frequently gets in the way of value creation. Every time Congress decides to “pay” for new programs by increasing tax rates, Congress piles on the taxes, which eventually stifle the economy. The only solution is to reduce the marginal tax rates. Experience shows that increasing tax rates in periods of economic stress is absolutely the wrong prescription for growth and job creation. Our global competitors have learned that a flat tax is better than a progressive tax system that penalizes people who create value. Let’s get smart and avoid the mistakes of the tax-rate roller coaster of the past. This book has lessons that we all should have learned and shared from a common understanding of the data. Many politicians ignore the facts and disagree on what the data says. If government is doing its job as our national economy gets bigger and smarter, shouldn’t everyone benefit from greater economies of scale, so that taxes take a smaller bite out of everyone’s wallet? Many politicians just keep getting it wrong. There is a strong parallel in the corporate world. Private equity players set value building as the overarching goal. However, value building as a goal is not well understood and is often controversial. Creating value provides economic benefits to customers, employees, and shareholders. CEOs of public companies must serve the conflicting needs of these constituencies. In their efforts to boil the job of value building down to its essential and simplest elements,

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many CEOs use simplistic rules of thumb such as earnings per share growth or accounting multiples to measure their progress. The result is that many public companies do not build or communicate sustainable long-term corporate value. These CEOs get lost along the way by failing to communicate that capital, like other resources, has a cost. Top value builders set high goals and deliver better returns on capital. They think in terms of lean, continuous improvement and find ways to improve the return to providers of capital. The stories in this book highlight the “people effect” and the difficult discussions that take place behind the scenes, when major decisions related to value, wealth, and risk are made. The authors do a great job of bringing new light to the age-old question of what it takes to create value and wealth. Set high goals, dig a bit deeper than your competition, and take action! Keep the economy and your company growing with the framework used by successful private equity players. Stephen Moore Senior Economics Writer The Wall Street Journal

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PREFACE

Clearly Focused Goals and Metrics Matter!

Perfect data and perfect models do not exist in the study of economics, corporate performance, management, leadership, or business strategy because they all involve people and their expectations. In the fog of rapid decision making, all facts cannot be known, and leaders often rely on rules of thumb that have served them in the past. Top value builders understand rules of thumb but dig deeper than their peers. Digging deeper with a passion for action gives private equity the edge. Private equity helps make public markets more efficient. Successful private equity funds have grown tremendously over the last decade as a result of returns greater than their public peers. But how do the successful ones outperform their peers? This is the question we set out to answer. Lower marginal tax rates on capital gains and income provides private equity players with the incentive to take greater risk. A long-term value focus and the disciplined goal of providing their limited partners a return significantly above the after-tax cost of capital has attracted trillions of dollars to this alternative asset class. Private equity players use value-based incentives that force sustainable change. With billions of dollars of capital at their disposal, they take advantage of the short-term inefficiencies and volatility of public markets. They promote dramatic operational change in the companies they acquire. They use better metrics to judge performance and risk. They take advantage of the globalization of markets. They respond to macroeconomic trends. All these actions work together to give successful private equity players an edge over their public peers. Many of their techniques are open to anyone who accepts value creation as the overarching goal. Because time is limited and the world is constantly changing, leaders often forget to look at the impact their past decisions had on results as they look to the future. After the fact, academics and xi

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business and political analysts dissect and theorize about which factors work and which factors do not. Our interdisciplinary valuebased study and perspective on corporate strategy, corporate profits, political leadership, and macroeconomic factors over the last 50 years should be of great interest to all. Political leaders can especially benefit from the perspective of corporate decision makers on the impact of government intervention and their unintended consequences on the wealth and risk of the nation. For example, we have recently learned a lesson on the importance of using the right goals and metrics in managing the monetary base of the U. S. monetary system. While the Fed was attempting to keep inflation under control, it failed to maintain the monetary base needed to keep the global economy growing. Although there is plenty of blame to go around, the Fed mismanaged the monetary base and promoted a credit crunch that led to a major economic crisis. See Figure P.1. The annotations and the major deviations from the monetary base trend line speak for themselves. The Fed must walk the ridgeline between its conflicting goals of promoting growth, which might risk inflation, and avoiding inflation, which might choke off growth. The art and science is to manage the level of the monetary base to stay on the narrow path that promotes safe growth. Likewise, in the corporate world, top private equity players give their portfolio companies just enough cash to build value.

Figure P.1 Critical actions on the monetary base Source: FRED® (St. Louis Federal Reserve Bank); commentary by the authors.

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In the pages that follow we expose myths and discuss current research and truths about private equity, valuation, wealth creation, strategy, and economics that will help any decision maker gain new insights for creating value and reducing risk. For example: not every private equity deal makes money. There are winners and losers in private equity too! Private equity players are human and make mistakes. Those who develop an edge learn a bit better than others. They increase their odds of success as well as the ability to attract larger pools of capital. Likewise, in the public sector, the monetary authorities must manage the monetary base in response to changes in the supply of and demand for dollars. Failure to respond to an increase in the demand for money caused a credit crunch beginning in 2007 that seized up credit markets and dropped expectations about corporate future cash flows. Value and wealth around the globe were destroyed. We discuss some basic principles that top value builders employ: Markets allocate resources. We know of no better way to build wealth than to think of decisions in economic terms. Economic thought requires digging deep into the data. However, the insights from understanding the fundamentals produce better decisions. Regulation that distorts market behavior always has unintended consequences. Business is the economic engine of our free-market system. A business must earn a reasonable return on capital to survive and take risk. So why overtax the best value builders? Common goals are critical. Large committees and boards composed of individuals with different ideologies and multiple goals are slow to act, and they achieve less than those with a common goal. Smaller private equity boards focused on value give their portfolio companies a clear edge. Markets work but have bubbles. Short-term and long-term changes can be anticipated by digging deeper and applying disciplined thinking. Markets are like forces of nature— overpowering and uncontrollable. Fear and greed and the “people effect” are unpredictable elements. Precise timing is difficult. Top value builders understand how markets work—just a little bit better than their peers. As a result,

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when they are successful, they make more timely decisions to reduce long-term risk and create value. They consider many factors: the people effect, supply-and-demand shifts, and alternative options and scenarios. It is better to learn how to prosper within markets than to fight against them. Solid frameworks based on fundamentals are better than rules of thumb. Personal experience is a great teacher. However, experience is most valuable when crystallized into a framework. Better frameworks help people focus on the fundamental causes instead of simplistic rules of thumb. Frameworks that ignore changes in the cost of capital and demand for money will give inaccurate signals. Incentives work. People are motivated to take action that will provide benefits for them. After-tax cash flow is the best fundamental way to evaluate incentives and disincentives. Timing and metrics matter. People will wait for benefits only if they are compensated for the risk and the time value of money. An understanding of how economic metrics, such as discounted cash flow, differ from generally accepted accounting principles (GAAP) is critical to valuation. The difference is critical and provides the value-building edge to those who understand it. Individuals have their own preferences and goals. Markets are composed of many individuals, all acting to maximize their own benefit or wealth. For every buyer there is a seller, so different perceptions and ideas about the future abound. Bubbles and busts will occur. Private equity players have incentives to take action and bear risks that many public company leaders try to avoid. Top value builders have a better understanding when fear and greed are distorting markets. They act sooner to control downside risks. Other supply-side principles. Regulation and government intervention can both help and hurt value and wealth building. Finding the right balance is critical to business and economic growth. Multiple factors are usually in play, distorting our view of the future. It pays to be on the lookout for the unexpected and unintended consequences of regulation! There are always unintended consequences.

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As we put this book to press, the global economy was facing economic crisis and prolonged recession. Successful private equity players will adapt and grow. Private equity went through a tremendous boom in 2005 and 2006 and a clear slowdown of megadeals in the second half of 2007. Yet most private equity deals stay out of the headlines. As long as the incentives exist, different forms of private equity will come into play to meet changing market needs. Acting sooner is the key to their success. Private equity buyouts of larger “performing” public companies shifted into special “distressed” situations as market risk and return changed. When new but risky technology again offers high returns, venture capital will reappear. As long as private equity keeps its focus on value building and produces high returns, private equity will continue to grow and control greater amounts of capital, unless the government changes taxes to kill their incentive to create value. Competition for capital eventually keeps returns in line with risk. Opportunities present themselves to those who learn lessons of the past and understand and act on market fundamentals better than their peers. It is clear that top private equity players: • • • • • • • • • •

Demand a high return on capital for the risks they take, Take more risks than public companies in funding new technologies and turning around distressed companies, Promote value-building changes in the companies they buy, Use more leverage when debt is on sale, Buy good companies when the market price is below their intrinsic value, Lock in value increases when the market correctly values or overvalues their investments, Say no when asked to continue funding low-return projects, Act with speed and knowledge, Make and learn from mistakes, but don’t bet the farm, and Are longer-term investors, not traders.

Good luck to all who accept building value as the goal. Dig deeper and act sooner! Arthur, Bill, and Shep

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INTRODUCTION

How Value Builders Create Value and Wealth and Reduce Risk

We wrote The Private Equity Edge as a wake-up call for business leaders and their management teams. Difficult times are upon us, and readers need the approaches in this book more than ever. Any decision maker in either the public or the private sector can gain new insights into creating value and wealth from the examples of successful private equity players and the world’s best value builders. Throughout the book, we speak with one voice, as each of us has had significant experience in the corporate, public, and not-for profit sectors. Our experience, and the lessons we have learned as change agents introducing new ideas, reinforce the importance of digging deeper and acting sooner to all organizations—a notion that we underscore throughout this book. Strong parallels exist among thinking, planning, and decision making at the national policy level and within individual companies. At both levels, leaders must consider how other people will react to the changes in plans and directives that result from their decisions. Leaders call others to action under conditions of uncertainty. To be most effective, value builders must communicate their frameworks, their decisions, and the reasons behind their decisions in simple terms. We can learn from top value builders. These individuals are not afraid to communicate their focus on value building as their overarching goal. On the other hand, a national political focus on dividing the economic pie and a lack of focus on growing it push aside any clear goals and fog our national agenda. Unfortunately, in recent years the terms “value building” and “shareholder value” have lost favor in some corporate suites. The volatility of stock prices has confused the issue of corporate value as traders can move the price of any stock by 10 to 40 percent in a xvii

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week or even a day. Many large public companies have been bullied by various activist groups to drop or mute the terms. This has occurred just as some companies were opening up to shareholders and doing more to educate them on what the companies were doing to benefit shareholders. Large public corporations and now the largest private equity players are feeling the political heat of differences in ideologies and economics. Creating profits, wealth, and value is unfortunately viewed by some activists as greed and an unnecessary goal of a capitalistic economy. Companies that cave in to pressures from activists or fail to build shareholder value continue to find themselves as takeover targets. Given the success of private equity, many public corporations are reasserting their commitment to shareholder value. While leaders in both sectors may wish that the process of making decisions and producing value-building change could be made easy, that is only a wish. Simple may be good for communication, but simplistic falls short in decision making. Why? The first cut at solving significant problems frequently relies on many simplifying assumptions; the solution that is produced may only work as a special case or for a very limited time, if at all. Surprisingly, after digging deeper and using more realistic assumptions, the core solution may be one simple idea. Yet, discovering great, simple ideas sometimes requires enormously complicated and complex thought. Do we have to write anything more than E ⫽ mc 2 to make our point?1 Top private equity players and top corporate value builders—referred to as “top value builders” throughout this book—communicate that a company’s intrinsic economic value is a function of the cash-generating capacity of its business and its cost of capital. But the forecast of generating cash—both short and long term—is not simple or obvious. Traders buffet the price of a stock on the news of the hour. Generally accepted accounting principles (GAAP) accounting disclosures subordinate cash flow to GAAP-based earnings per share. Management groups are reluctant to give long-term guidance. Cost of capital is not commonly understood. Far too many corporate directors and decision makers use outdated or simplistic rules of thumb, leading to value destruction. Leaders and managers who involve others and expend the effort to dig deeper find the payoff in acting sooner.

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Value builders understand and focus sharply on economic value. Digging by value builders may also reduce the risk (increase the certainty) of outcomes and help to avoid unintended consequences. Even without dramatic new solutions, the reduction of risk may add value. Macroeconomics—if one gets it right—is far more important to corporate value and investment performance than most professionals think. Monetary policy and tax policy affect investor and consumer behavior and have significant effects on interest rates, inflation, real growth, and the level of the stock market. Corporate debt and home mortgage debt are tax deductible, so changes in interest rates and tax rates can produce dramatic effects. Professionals who recognize and act on these economic signals create wealth and value while reducing risk. When our leaders get economics wrong, people are hurt, and sometimes they are hurt very badly. For example, in 2007 and early 2008 inadequate money supply growth contributed to the credit crunch that eventually produced the 2008 global economic crisis, trashing the stock markets around the world. With stock prices depressed well below intrinsic value, private equity funds with cash planned to start buying again.

SUCCESSFUL PRIVATE EQUITY PLAYERS BUILD VALUE Private equity players focus on economic value. This simple focus gives them a significant edge over many public companies. Private equity funds range in size from under $10 million to multiple billions of dollars. It is hard to group them as one asset class, so we focus on the top value builders in the category. A private equity fund has some characteristics in common with closed-end mutual funds. Investment styles vary widely across the universe of private equity funds. Private equity funds are currently unregulated and usually structured as limited partnerships. A private equity firm or partnership serves as a general partner. Limited partners—mostly institutional investors and wealthy individuals—provide commitments for specific amounts of capital. The general partner has a limited time to invest the funds, usually about 5 years, and an agreed upon time to return capital to investors, usually over 10 to 12 years. As soon as the general partners have arranged commitments for all

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funds committed to the partnership, they typically start new funds. This is especially true if they produce good results. That is a big if! If they succeed in producing high rates of return (over 20 percent per year), they are usually able to gather additional commitments and build multiple funds. However, those who are not successful may be required to return money to their investors before the original commitments have been invested. The data on private equity funds’ performance are limited, because private equity funds are not required to report results and returns publicly. Some private equity funds voluntarily make performance reports available. It will be a surprise to many readers that research on a large sample of funds with assets of over $5 million, for the period 1980 through 2001, concluded that average private equity returns (after fees paid to the general partners) did not exceed those of the S&P 500.2 The research also concluded that better-performing fund managers are likely to raise larger follow-on funds than those who underperform. Fund returns improve with experience of the fund manager or general partner. Performance also depends upon the market cycle and timing of purchases, with better returns likely on funds started when markets are undervalued, rather than at market peaks. However, additional research in 2007 confirms that the average private equity fund does not outperform the S&P 500. Since many new funds are started at market peaks, they typically underperform the S&P averages. Better-performing funds or successful private equity players typically have better skill in improving operating performance and better deal flow because of their strong reputations. According to University of Chicago professor and private equity researcher Dr. Steven Kaplan, “The 2005 study findings still hold, but our research efforts are limited by incomplete data. There may be a selection bias on those that choose to report. Yet the research seems to indicate that when private equity funds get more money the returns seem to go down.”3 The ideal private equity investment typically has been a middle market, undermanaged company with reasonably steady cash flows that can be acquired for less than intrinsic value, financed through additional debt, and upgraded through significant improvements in operations, “change management,” or strategy. Ideally the company would be sold back to the public or to another private equity firm at a cash profit and a high internal rate of return

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(over 20 percent) within three to eight years. However, because of the tremendous popularity and increase in funds flowing to private equity players, the styles and target investments vary widely. Blackstone is a well-known large private equity management firm that went public in June 2007. At the time of its public offering, the Blackstone players had managed five general private equity funds and one fund specialized in media and communications. Blackstone was a relatively new business, started in 1987 with only $400,000 in capital. As of March 1, 2007, it managed a fund with capital commitments exceeding $18 billion. According to its offering memorandum, Blackstone pursues a wide variety of transactions involving leveraged buyouts of both seasoned and start-up companies, as well as turnarounds and industry consolidation opportunities, real estate, and more. Its 2007 offering memorandum—available to all on the Internet—gives the reader an inside view of one of the largest and most successful private equity funds, in addition to the returns available to the general partners in these firms.4 Not surprisingly, Blackstone’s share price traded well below its initial offering price throughout 2008. Private equity firms make no bones about their focus on value. The private equity fund Sun Capital, a player in the market for distressed companies, stated publicly that its business is about both buying and selling companies to create significant wealth for its partners.5 Public companies should listen to advice from this owner of 57 companies. It typically owns companies for five years before selling them and reinvesting the capital in new ventures. Private equity funds and players are very diverse. Their investments range from venture capital, to management and leveraged buyouts, to special (frequently distressed) situations and real estate. Private equity firms also differ in style. Some demand control, while others will join with investment partners on an acquisition. Some focus on buying and selling companies; others hold their portfolio companies for the long term. Some choose to take their returns in the form of high dividends, while others reinvest heavily and take their returns on exit.6 In discussing these diverse groups, we generalize where it is meaningful. We also frequently identify specific transactions, many of which are management or leveraged buyouts, to illustrate our points. One asset category, venture capital, is a particular focus in Chapter 9. Throughout our discussion, “top

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value builders” in private equity are considered to be those in the top quartile of performance. A study presented at the World Economic Forum in January 2008 begins to develop a new fact base and shed new light on the growing global impact of private equity. Key findings of the landmark report include7: • The impact of private equity is global and accelerating. From 1970 through 2007 the total value invested (debt and equity) in private equity buyouts with high leverage globally was over $3.6 trillion. About 75 percent or $2.7 trillion in transactions took place between 2001 and 2007.8 • The study identified 21,397 transactions from 1970 to 2007, more than 40 percent of which took place since January 1, 2004. • Buyouts occur in all markets, including declining markets and in high-growth, high-tech industries. • Only 6 percent of private equity buyouts end in bankruptcy or a similar restructuring, which is lower than defaults by comparable companies with corporate junk bonds. • Only 12 percent of transactions were “flipped” within two years, with the majority, 58 percent of investments, held for more than five years. • Innovation, as measured by patent activity of a sample of 495 firms worldwide, seems more focused on core technologies, but does not change in quality after a private equity transaction. • Employment in buyout companies declines following the transaction for four to five years, but on average there is only a cumulative 7 percent difference compared to a control group. Yet buyout companies have more greenfield—totally new—job creation, and after four to five years employment trends seem similar to those of the control group. • Governance differences are based on ownership. A study of 142 buyouts in the United Kingdom from 1998 to 2003 shows that after a private equity buyout, the board size

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was significantly reduced, as well as the participation of outside directors who did not represent a significant owner. • Contrary to popular belief, most private equity transactions take place outside the United States. • By 2005, approximately 2 percent of the nongovernment workers in the United States were employed by companies that received an investment from private equity. • The growing impact of private equity is receiving increased attention from politicians, unions, and investors. Despite the 2007–2008 credit crunch and forecasts of a prolonged recession, industry watchers expect successful private equity funds to grow as an asset class, because the funds often achieve their goals of outperforming public market alternatives, and private equity represents only a small portion of managed funds. There are a variety of other top value builders beyond the world of private equity in the corporate and public sectors. Consider the individual inventor of an idea or service that takes the world by storm or the world-class athlete or actress who inspires others and earns millions of dollars per year in the process from royalties and commercial endorsements. In this book we refer to other value builders who have created tremendous value and wealth through better decisions. These include national leaders like Ronald Reagan and corporate value builders like Best Buy, John Deere, Southwest Airlines, Toyota, and Walgreens. The plans and directives issued by any leader can be converted into action only by the people who are directly affected by the plans and directives. Anticipating the outcomes of this conversion requires understanding two effects. The first is the “numbers effect,” which can usually be computed directly. The second, the “people effect,” often counteracts the numbers effect. This will come to life in Chapter 2 in our discussion of the Laffer Curve and the challenge of promoting new ideas and change, and it remains a major theme throughout the book. People make things happen in a predictable way most of the time, but getting the prediction right can be challenging. People respond to incentives and disincentives. Successful value building and prediction require a good understanding of the

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incentives and disincentives that are at work, both in and around the company. Life is not easy for value builders. Conflicting ideologies, theories, metrics, and frameworks abound. Interesting stories highlight how the “people effect” is sometimes very difficult for leaders to understand. In other cases, leaders unfortunately refuse to change course, mostly through fear of being penalized for being wrong, but in some cases because they are so invested in their own ways of doing things that they cannot change. “It worked in the past. I have believed it for so long, it must be true.”9 This occurs despite available frameworks that more accurately predict the “people effect.” People have biases and preferences; as a result, they predictably over- or underreact to events. This fact helps to explain market bubbles and recessions. Unfortunately for investors, predicting exactly how much and in what direction people will overreact is difficult. There are many misguided decision-making theories used by leaders. These range from rules of thumb to elaborate economic frameworks. Some seek to explain the interaction between the numbers and people effects and the final results. Some frameworks merely assume away much of the impact, prompting business and political leaders to merely “hope beyond hope” or pray for luck that the outcomes will be positive. Clearly, hope is a wish and not a strategy. Such practices have resisted frequent and thorough debunking.10 In our effort to clear away the fog and clutter and distinguish between good and bad, we draw on lessons from the art and science of economics. The result will better explain wealth creation in the uncertain but interconnected world around us. In The Private Equity Edge we argue that people (citizens and employees) definitely respond to the incentives, plans, and directives set forth by their leaders. Leaders are, however, frequently disappointed with the responses. This dissatisfaction typically arises when the results and actions are not what the leaders anticipate. When this occurs, the problem is not that the affected people are somehow wrong; the problem is with the decision makers’ frameworks, communication methods, metrics, and expectations and the questions they ask. Top value builders who think more deeply successfully act sooner, ask the right questions, and are better at anticipating the reactions of those people whom they seek to

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influence. Better metrics and frameworks and realistic expectations make for better decisions, better leaders, and better results. What is wealth? What is risk? Wealth and risk are defined differently by different people. This causes much of the confusion in communicating plans and desired actions at any level in any organization. The definition of these terms determines how progress and wealth creation are measured in the world around us. In this book we define risk and wealth consistently with the economic concepts most frequently used in business and government. Because measurement is always relative to some standard, the measurement of both wealth and risk must also be relative to a standard. In today’s investment and corporate worlds, the return of the S&P 500 stock index is a widely used benchmark. Value builders provide economic returns better than the S&P 500 index over a long period of time, typically over several business cycles. Successful private equity funds have done this; unsuccessful ones have not. We define value in business and wealth in business and government as economic value, that is, the measured capacity to produce cash income. Gross domestic product, or GDP, is the technical measure for government. These measures of economic value can be expressed in both constant and current dollars. When we look long term (over five years), the difference between constant and current dollars can be significant. Value builders are focused on long-term horizons and trends, usually spanning three to eight years. They are not overly concerned with quarterly fluctuations in earnings per share or gross domestic product, which they consider noise around the trend. As a result value builders focus on what we call “intrinsic value.” Value builders are not traders. They are in it for the longer term. Traders influence stock prices in the short term. Top value builders are aware of the impact traders can have on current stock price, but they look beyond it. Top value builders seek to boost returns by taking advantage of the three- to six-year up-anddown cycles of bull and bear markets. They buy when stocks are on sale. For the purpose of this book we define the “intrinsic value” or warranted value of a business as the reasonable or “expected” present value of a business’s future cash flows discounted at a rate appropriate for the risk of the business.11 There are various derivations of this discounted cash flow (DCF) technique. Some theorists

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and academics would hold the discount rate constant and account for risk in the variance of the cash flows. Academics and practitioners continue to debate and argue over the “best discount rate.” In either case, the choice of a discount rate may not be as important to the decision as the forecast of expected after-tax cash flows. The key is using a forward-looking estimate of future cash flows to better communicate a business case and selecting a “reasonable” discount rate to provide a return to capital. The leaders of far too many public corporations worship earnings per share (EPS) and pay lip service to value building. They continue to talk to analysts in “EPSspeak” and set bonus compensation based on achieving quarterly earnings per share targets. Different people will have different views on the expected future after-tax cash flows and, as a result, different estimates of intrinsic value. We believe this is a great way to provide meaningful dialogue about the expected cash flow of various plans and alternatives under different scenarios. While providing some insights on a selection among newer discounted cash flow techniques, we encourage readers to dig deeper to find the discounted cash flow technique that serves their needs best. For those who are uncertain about which discount rate to use, we suggest that you test your decisions against a range of discount rates to determine if the choice of the discount rate makes a difference in the decision. The suggested range of nominal rates can be bounded at the low end by the 10-year U.S. Treasury note yield typically referred to as the “risk-free” rate and the expected rate of return on a portfolio of stocks such as the S&P 500 at the midrange. The high range of the discount rate may be the hurdle rate for the investor or the owner. In many successful private equity funds, alternative investments are targeted to return 20 to 30 percent or more, forcing value-building leaders in portfolio companies to propose only those high-return projects that are projected to build value over a five-year span. This wide range of discount rates is simple to understand but is not simplistic, as we will see in the chapters that follow. We define risk in business and government as the potential for future variations in the expected amounts of cash income after tax cash flow. In particular, we think of risk as the chance that the outcome will fall short of projected values, so that risk can be thought

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of as the “probability” of a loss or a shortfall. If we accept a broader context, it is necessary to recognize that there are risks that go beyond mere variations in cash income. History demonstrates that catastrophic events can occur, causing total losses. This broader context of risk is discussed in Chapter 3. Many people talk about and try to manage economic value, wealth, and risk without numbers. Top value builders improve communication and action by quantifying both wealth and risk by digging deeper into the relevant data. They ask: “How much?” Quantification, while never perfect, forces greater discipline and enhances communication. Focus on risk promotes long-term thinking and a better understanding and communication of alternative courses of action. We all learn from experience. Rather than providing specific decision rules for current and future value builders, our intent is to shed light on the experiences and thought processes that inspire confidence and that will encourage every value builder or decision maker to ask the questions that will inspire his or her people to dig deeper. This confidence will help all leaders act sooner and reduce risk. Business and political leaders must cope with the hard fact that over the long term, competition erodes the advantage of even great strategies. As a result, performance of both corporations and countries “regresses to the mean,” if not worse, over time. (Consider how General Motors, Xerox, Circuit City, and even the Roman Empire, Japan, and others reverted from great to good and then on to damaged goods.) Notice the risk that the U.S. economy could follow the same pathway if the wrong policies are put into place. We could be at a peak in our national prominence right now! Top value builders recognize the difficulty of formulating “brilliant strategies.” What they use is not strokes of genius, but better methods of continuously renewing and revising their ongoing strategies and goals to meet the ever-changing needs of dynamic markets. Yes, nations need to renew strategies, too! Also, as every businessperson knows, the wrong strategies on a national level can have a devastating impact on business as well. It takes people to implement value-building strategies, and people must be motivated with the right incentives to do the right things. Mistakes are made in many ways. Clearly, miscalculating the numbers effect of decisions creates one class of errors. More

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frequently, though, leaders can get past the numbers effect but are confounded by the people effect. Leaders often fail to understand how the people they lead or influence will react. We have witnessed many good and bad decisions made over the course of our collective 100 plus years of observing and participating in business and government. We distill some of the wisdom gained from trying to improve or change some of these decisions and trying to live with others. What we have to say will come as a surprise to many of our readers and will resonate well with most. For example: not all taxrate changes are the same; small changes in incentives and metrics matter; how leaders deal with resistance to change is critical; and, top private equity players who are in the top 1 percent of taxpayers are in the group that pays about 40 percent of the total federal tax burden.12 The intent is to provide a fresh perspective based on the facts and years of observing the behavior of decision makers and results at the corporate, national, and international levels. While new perspectives are sometimes controversial, change and new ideas are necessary for survival and progress. Top value builders focus on being realistic about the past, yet positive and realistic about the future. Our goal, as well as that of everyone who reads this book, is to promote behavior that creates wealth and reduces risk. This book is written for decision makers who are seeking to apply a deeper, practical understanding of the new interconnected world of business and economics, as well as the professionals who work with them. Former secretary of the treasury and state under Ronald Reagan, George Schultz, made the point clearly when he frequently quoted General Nathan Bedford Forrest of Civil War fame: “Get thar fustest with the mostest!”13

THE BOOK Private equity has a clear edge. Its edge is based on smart people motivated by the right incentives that promote digging deeper and acting sooner. These are concepts that many companies can employ. Digging deeper can provide new insights that anyone can use to make better choices on the corporate, national, and international levels. When leaders dig deeper, they act sooner to create wealth and reduce risk. The world’s top value builders set the example.

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The Private Equity Edge is divided into three parts. • Part One, based on research and anecdotal evidence, demonstrates how digging deeper provides new insights to create wealth and reduce risk. It explores cases of both success and failure. • Part Two emphasizes that acting sooner provides a competitive advantage and accelerates learning. Learning, in turn, enhances competitive advantage, and sustainable competitive advantage enhances value and wealth, while reducing risk. • Appendixes 1, 2, 3, and 4 contain graphic examples of digging deeper. Each chapter contains a few stories to highlight the interplay among people who influence decisions. Exact quotes on these stories are sometimes hard to come by—even from the story’s participants. We supplement these stories with research studies, case examples, interviews, and our own experience. Part 1: Dig Deeper Why dig deeper? Digging enables acting sooner—The quest is to better understand alternatives and develop insights before making major decisions. Top value builders make their decisions with great conviction. The ones that get it right base their conviction on experience, great analysis, and digging deeper for new insights. Digging helps bring you luck! Or as Justin Dart, the late chairman and founder of Dart Drug, would say “The harder I work, the luckier I get!” Chapter 1: Value Corporations exist to bring people and capital together to create wealth and reduce risk. Private equity sometimes does both those things just a bit better. It is a matter of degree. Top value builders, both public and private, learn from experience. In Chapter 1 we focus on uncovering a variety of corporate myths that frequently misguide leaders and thus negatively affect individual companies, their shareholders, and employees. We explore how top value

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builders look at topics such as price-earnings ratios, how important quarterly earnings per share targets are to the stock market, and whether six or eight times earnings before interest, taxes, depreciation, and amortization (EBITDA) is a good, but simplistic, measure of corporate value. Private equity players focus on value and avoid overemphasis on EPS or “EPS-speak.” It’s just that simple. Said another way, we tell the truth about the links among earnings per share, GAAP accounting, and intrinsic value and the problems that those links create for many public companies. Using the wrong metrics and frameworks causes leaders to make bad decisions, some of which have cost shareholders billions. For example, monetary missteps in 2008 helped to put the entire economy into a downward spiral. S. I. Hayakawa noted: If you treat variables as constants, your thoughts will be all confused, no matter how hard you think! We introduce the concept of capitalized economic profit to help explain the recent growth in private equity. Chapter 2: Wealth, Tax Rates, and Income People in free markets don’t work, consume, or invest to pay taxes. In Chapter 2 we focus on uncovering some of the impacts of taxes and big picture macroeconomic principles of value and wealth. Tax benefits from capital gain-related compensation, combined with the willingness to use leverage, give private equity players an edge. If these incentives are removed, the incentive to create wealth and economic growth may also vanish. Political changes are often better documented than corporate stories. In politics there are always two or more sides to every story. We use the great renewal and economic turnaround that occurred during the Reagan presidency as an example of the drama of conflicting interpretations of data and misconceptions of economic theory. Top value builders set clear goals and have common frameworks. Politicians have their own biases, passions, and methods of communication that are often in conflict with others. When old theories fail to explain the data, new and better theories emerge. We examine supply-side economics and why higher tax rates often do not result in higher tax revenue, but always result in less of the taxed activity. Not all tax rate cuts are the same. Taxes and tax rates can act as powerful disincentives or incentives.

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We examine the success of Reaganomics and the failures of more traditional Keynesian approaches to creating national wealth. The ideas that were finally communicated to the public were simple: “Cutting tax rates makes people more willing to work, because they keep more money, on the margin.” This “back of a napkin” description was simple and powerful. After-tax cash flow is the main driver of wealth and the economy. While supply-side thinking was considered radical “voodoo economics” 30 years ago, it has gained its place in mainstream economic thought. Outside the United States, more taxing authorities are thinking “flat tax” than ever before. Lower tax rates spreading around the world are helping to stimulate global growth, but the United States is falling behind. Chapter 3: Risk Risk is a fact of life. Public corporations are required to disclose their risks annually. Private equity firms are structured to look at risk differently. In Chapter 3 we provide perspectives on incorporating risk into decision makers’ analyses. Thinking about risk without including an assessment of both magnitude and probabilities can result in misunderstanding. Although leaders would like the experts to tell them exactly what to do, the world of the future is not subject to absolute certainty. In fact, research on stock market booms and busts shows the world is not statistically normal. Examples from the investment and corporate sectors demonstrate that major errors occur when leaders communicate risks poorly, ignore risk, or confuse the short term and long term. Top value builders structure their organizations to use risk to their advantage. High leverage and use of separate legal entities by private equity firms allow them to concentrate risk at the business unit level. This forces private equity portfolio company executives to manage and control risks better than most. Chapter 4: Incentives Incentives matter. In Chapter 4 we investigate the importance of the right incentives and more unintended consequences caused by the people effect. Private equity incentive plans require management to have risk of loss as well as a share of long-term gains in value.

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Public corporations can learn from the success of private equity firms and the mistakes of politicians. Politicians lack a common framework that connects their incentives to wealth creation. There is no direct downside for a politician making bad decisions or passing bad legislation until the next election. Public company executive pay controversies often highlight a “disconnect” between present-day incentive systems and producing value for shareholders. The debate has pushed stock options out of favor. Pay is the arithmetic. What is needed is a better understanding of the entire framework of incentives and the impact of incentives on all employees, not just the top team. When people are paid to do the wrong things—and they often are—no one should be surprised to find that they do the wrong things. Top value builders tie executive pay to value-building performance. Financial transparency and nonfinancial incentives help create a value-building culture. Private equity incentives and compensation help attract the best talent for value building. Chapter 5: Scenarios Looking and thinking ahead are important to building wealth and reducing risk. Top value builders evaluate long-term alternatives and cash flow scenarios for value creation. In Chapter 5 we examine the importance of understanding the significance of decisions for alternative futures. Putting future scenarios down on paper forces everyone to dig a little deeper to prepare for future action. Since the future is not known with certainty, preparation for a variety of alternative futures helps leaders choose better strategies. Private equity players intuitively use the concept of “real options” in determining the value of acquisitions. Size and timing of portfolio acquisitions affect private equity returns. Scenarios help determine how best to deploy cash. Top value builders do not hold excess cash balances. They put cash to work. We explore why share repurchases are growing relative to dividends as a means of returning excess cash to shareholders. Some people consider that private equity purchase of public companies represents the ultimate in stock buybacks. Private equity players look at options differently and can often realize more value than strategic public buyers.

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Part 2: Act Sooner Part 2 of the book provides examples of acting sooner. Given better insights and experience, top value builders are able to make better choices for wealth-creating actions sooner than those who drift with the flow. Private equity players make critical long-term decisions, but they break the long term into comprehensible three- to eightyear segments. As a result they stay focused and say no to marginal investments and most of the distractions that face their public company peers. Chapter 6: Speed The Google age is here. Top value builders use speed to their advantage. Speed of decision making is accelerated in private equity firms’ small hands-on board structure. In Chapter 6, we share stories that emphasize that fast trumps slow. Cycle times in all industries are shrinking to Internet time. Financial and intellectual capital move across borders with Internet speed. The wake-up call is sounded daily in the press. Acting sooner can save thousands on an individual level, millions on a company level, and billions or trillions on a national level. In this chapter we demonstrate that speed is of the essence in the interconnected global economy. Structural changes make markets work faster than ever before. But speed is dangerous if you don’t have the right framework and facts. Failure by the Federal Reserve to adjust the money supply to control imbalances in supply and demand for money has precipitated recessions and bouts of inflation more than once. Chapter 7: Renewal Inertia can and does kill great companies. In Chapter 7, we show that even great companies must change or risk fading back to average. No company, economy, or individual is exempt from the need to change. Companies that were labeled as “great” well into the 1990s performed little better than average in subsequent years. “If it ain’t broke, don’t fix it” does not work in corporate strategy. Examples of once great companies like Gillette and Circuit City are contrasted with Walgreens and Procter & Gamble. Top value builders think in terms of three- to eight-year value cycles and

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promote continuous change. The failures of designated great companies Circuit City and Fannie Mae are a wake-up call for all leaders and investors. A focus on what the customer wants and employee education on how to build value are critical to renewal. Chapter 8: Inflection Points In Chapter 8, we argue that action accelerates the learning process through feedback. Crisis is a powerful learning tool. Top value builders understand and identify inflection points. Calling the turning point—just a little bit better than others—in any market can make an investor rich beyond anyone’s dreams. Clearly, such predictions are also very difficult to make. Monitoring the right metrics is critical. Understanding the fundamental forces that will ultimately cause an inflection point—or an abrupt change in the trend—gives leaders the ability to plan for the change. Early action can create wealth and reduce risk. We examine interest rates, stock prices, foreign exchange rates, and oil prices.We find dual goals like those of the Fed—promoting growth while containing inflation—often cause problems. Government policy makers can make a very big difference. Unfortunately, they often look at the wrong indicators, or just make mistakes based on the wrong framework. For example, the 2007 and 2008 actions of the Fed created a slowdown in 2008 that resulted in a global economic meltdown. Chapter 9: Experimentation and Innovation Venture capital is the class of private equity that focuses on experimentation and innovation. Experiments help build wealth and reduce risk. In Chapter 9 we argue that venture capital is the experimental and innovative branch of private equity. Without experimentation and learning from experience, most companies would never be able to develop the skills and courage needed to increase their value and build true wealth. Value-building experiments are critical. Failing on small projects can be cheap tuition for a thoughtful company. “Failing cheap” while “avoiding death” can build valuable experience that allows

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for quick action in the future. “Failing expensive” is not acceptable to top value builders. Even top value builders make mistakes. They learn from them and keep trying. They monitor the components of value of portfolio companies and say no when returns fall below the cost of capital. Top value builders view their businesses as portfolios of investments. They never bet the farm on an unproven experiment. Chapter 10: Summary and Conclusions In Chapter 10 we provide a short conclusion and summary. These points include digging deeper to develop understanding and insight and taking action sooner to learn faster. Top value builders can act with speed because they use the best combination of analytics, people, and incentives to their advantage. The key to continued corporate and national success is involving more people in continuous renewal. Top value builders avoid inertia by responding to changes in the interconnected global marketplace. Top value builders have a passion for change. They adapt to change far better than their slower-moving peers. Appendixes 1, 2, 3, and 4 Are Graphic Examples of Digging Deeper • Appendix 1 contains an insightful 50-year mosaic history of U.S. economic policy and results under different political leaders. The influence of the different leaders and macroeconomic policies on our combined national health and wealth has ranged from good to bad, based on the impact of their policies on the four pillars of macroeconomics. • Appendix 2 provides background on the Laffer Curve framework and commentary on how it explains tax impacts at the state, national, and international levels. • Appendix 3 investigates the history, development, concepts, and use of value audits. • Appendix 4 lists top private equity funds and the relative long-term performance of top corporate value builders.

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NOTES 1. When Einstein formulated his theory of relativity, it did not contradict Newton’s laws of physics, as some thought. Rather, it exposed the limits of Newtonian physics. Within the new and broader framework of relativity, Newton’s physics was a special case. 2. Steve Kaplan and Antoinette Schoar, “Private Equity Performance: Returns, Persistence and Capital Flows,” Journal of Finance, vol. LX, no. 4, August 2005. 3. Ibid., and conversations with Steve Kaplan in November 2006. See additional research on private equity returns: Mark Anson, “Performance Measurement in Private Equity: Another Look,” Journal of Private Equity, vol. 10, no. 3, Summer 2007, p. 7. 4. Form S-1 Blackstone Group LP, filed with the SEC on March 22, 2007. Blackstone’s stock price has declined since its IPO. Some believe Blackstone’s leaders picked the perfect time to monetize their investment, again demonstrating the skill of a top private equity firm. 5. Jim Jordan, “Fazoli’s Sold to Private Firm,” Lexington Herald Leader, October 21, 2006, p. A1. 6. For a study of the style of large private equity sponsors, see “Private Equity: Tracking the Largest Sponsors,” Moody’s Investors Service, January 2008. 7. “Globalization of Alternative Investments,” Working Papers, vol. 1, The Global Economic Impact of Private Equity Report 2008, World Economic Forum, Geneva Switzerland, 2008, p. iii. This is the first of a series of white papers that begin to unlock the secrets of private equity. 8. Ibid., pp. vii–x. 9. Various forms of fallacious reasoning continue in the business community: two that come to mind are false Bayesians, where the cart is before the horse and the belief in outcomes dictates the chosen probabilities (e.g., “I’ve believed it for so long that it must be true”), and “post hoc ergo propter hoc,” finding causation where it is not warranted. (e.g., “The economy recovered after the New Deal, so the New Deal must have caused the recovery”). 10. In 1975 Steven Kerr, then a finance professor at USC with one of our authors and as a colleague and later chief knowledge officer of both GE and Goldman Sachs, wrote a famous paper decrying the practice of “rewarding A while hoping for B.” See Steven Kerr, “On the Folly of Rewarding A, While Hoping for B,” The Academy of Management Journal, vol. 18, no. 4, December 1975, pp. 769–783. (An excellent example is politicians’ idea to tax the rich and subsidize the poor, hoping for less poverty. A corporate example is awarding stock options based on sales targets and expecting the stock price to increase.) 11. See William J. Hass and Shepherd G. Pryor IV, Board Perspectives: Building Value through Strategy, Risk Assessment and Renewal, CCH, Inc., Chicago, 2006, pp. 107–108. 12. See Appendix 2 for more detail on tax rates and tax revenues. 13. Brian Steel Wills, A Battle from the Start: The Life of Nathan Bedford Forrest. New York: HarperCollins, 1992). The supposed quote by General Forrest is: “Git thar fustest with the mostest men.” Wills, the biographer, says, “Although he never uttered the famous statement in this form, it has come to symbolize his life.” The more likely quote is “Well, I got there first with the most men.”

PART ONE

Dig Deeper

Private equity players and other top value builders dig deeper to understand the intrinsic value of their operations and the risks that they face. They consider a broad range of options and use better metrics and incentives to guide the activities of their people. They enhance the value-building process with constant communication and reinforcement. These players go beyond traditional metrics and rules of thumb that may produce decisions that destroy value. By analyzing macroeconomic factors, we find that these techniques work in all phases of the business cycle. Even in distressed markets, such as developed in 2008, the methods discussed can be used to build value and wealth.

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CHAPTER 1

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

I

n 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. 3

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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

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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 lowermargin supply businesses dropped Home Depot’s overall margins and real return on assets.1 Although generally accepted accounting principles (GAAP) 2 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.”3 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 CEOfriendly 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

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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.4 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.5 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

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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.6 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 waterrelated companies worked perfectly for the process. These companies had steady cash flow, were often undervalued, and had hard assets that could be financed.

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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.7 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.8 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

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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

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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. Communication styles vary widely as well. Some management groups disclose their estimates of future earnings per share (EPS) in the spirit of transparency. Some give point estimates, some give ranges. Some, with a strong sense of precision, refuse to make public forecasts because they know they are most likely to be

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wrong. Better analysts know the problems of GAAP accounting and have developed better measures of performance. However, the SEC rules regiment public company reporting and require reconciliations back to GAAP whenever “non-GAAP measures” are used.9 Unfortunately, many accepted accounting principles and rules deviate from economic measures that would be more representative of the true economics of the business. In addition, because historic financial statements are not restated to reflect changes in accounting principles that occur over time, it is extremely difficult to consistently track the historic record of any given company. Overall, accounting statements fail to serve as an accurate barometer of performance.10 The most advanced analysts and top value builders use discounted cash flow (DCF) models to value both public and private stocks. The better ones do their homework, and dig deeper into what drives cash flow and how they can influence management to improve it. Corporate buyers and successful private equity players look for opportunities to grow cash flow and intrinsic value. Some techniques are better than others. Everyone can dig a bit deeper to improve their understanding of cash flow drivers and their techniques of dealing with the dynamics of the market.

INTRINSIC VALUE FRAMEWORKS: THEORY VERSUS CURRENT PRACTICE

A central concept of finance is that the value of an asset is the discounted present value of the asset’s future after-tax cash flow. We call this intrinsic value. Current practice includes a wide variety of new and old techniques based on discounted cash flow. Research shows that short-term stock prices trade in ranges of plus or minus 50 percent of intrinsic value. Morningstar and a growing number of independent researchers regularly compute intrinsic value (or “fair value”) on public and private companies. Warren Buffett understands the concept of intrinsic value. According to Warren: “Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.” Buffett continues: “The calculation of intrinsic (Continued)

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value, though, is not so simple. As our definition suggests, intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised. Two people looking at the same set of facts, moreover—and this would apply even to Charlie [Munger] and me—will almost inevitably come up with at least slightly different intrinsic value figures.”11 The sometimes dramatic disparity between a company’s stock price and the intrinsic value that is computed by management or potential private equity buyers is clearly a driving force that promotes private equity buyouts. It can also create stress between management and shareholders. For example: Morningstar’s and other estimates of “fair value” suggest Home Depot was selling below fair value at the time of Nardelli’s ouster. Had Nardelli been flexible on his pay and able to communicate his strategy and its potential impact on intrinsic or long-term share value to the board and shareholders, he might still be heading Home Depot. In June 2007 after Nardelli’s ouster, Home Depot management gave a strong signal that it felt its shares were undervalued, as it announced its plans for a $22.5 billion share repurchase. After the completion of the stock repurchase on August 31, Home Depot’s stock continued its downward trend throughout 2007. In another example, the CEO of TXU Corp. claimed the public market failed to understand the long-term value of its strategy. As a result, Blackstone and other private equity firms bought this electric utility below its intrinsic value and took it private for $31.8 billion in the largest private equity deal in the United States during 2007. Intrinsic value is often in the eye of the beholder.

Informed people make serious money by trading on the weaknesses of GAAP. Some accounting changes move the market in the short term but do not change the long-term intrinsic value. However, the intrinsic value will likely eventually converge with the average long-term share price. Given the availability of accounting information on all public companies and the increasing need for online access to independent quantitative analysis, the demand for automated discounted cash flow and intrinsic valuation models has grown. In addition, the global research settlement reached between major brokerage

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houses and Elliot Spitzer, former N.Y. attorney general, mandated more independent research. Corporate cash flow is difficult for outsiders to predict. However, financial reports can be improved to highlight environmental factors and trends in cash flow growth that might affect stock market prices. To meet the demand, a variety of “fair value” or “intrinsic value” information providers and vendors have grown significantly. These providers serve institutional, private equity, corporate, and individual investors. They typically have roots in Modigliani and Miller’s view of the firm as a series of discounted cash flow projects.12 Providers of valuation models based on discounted cash flow and their products are noted in Appendix 3. Despite the differences in the intrinsic value vendors’ models, approaches, and assumptions, the models are founded on the basic principle of finance: the value of a company or business unit is the discounted present value of the cash that is expected to be generated over time. The discount rate (the cost of capital) typically reflects the risk of the cash flow stream. Debate continues regarding how to “project the cash flow stream” or the future economic value (for “EVA, economic value added, as promoted by Stern-Stewart & Co.”) and how those values correlate to stock prices. Selecting which discount rate to use is also steeped in debate. Al Rappaport’s Creating Shareholder Value,13 published in 1986 and revised in 1998, Bennett Stewart’s Quest for Value14 (1991), McKinsey’s (Tom Copeland) Valuation15 (1995), and Bart Madden’s CFROI Valuation16 (1999) all set the stage for the adoption of shareholder value as a goal by a wide range of business executives. While many executives and public companies have become advocates for maximizing shareholder value, some publicly soften this goal in the face of pressure from employee and community groups. Unfettered by special interest groups, successful private equity firms have adopted these techniques and have refined them into an art and science geared toward creating value through buying, improving, and selling companies. The availability of these models places a variety of discounted cash flow and intrinsic valuation and analysis techniques only a few clicks away from any investor or analyst interested in digging deeper into the intrinsic value range of any public or private company. Macroeconomic versions also value the overall market on an

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internally consistent basis. The modeling capabilities and the increasing computational skill of savvy value builders and analysts, combined with adept market operators, bring the use of DCF valuation and sensitivity analysis out of the strictly theoretical realm. These factors may be at a tipping point so that these types of analysis are becoming standard practice.

VALUE ESTIMATES CAN DIFFER WIDELY What were they thinking when they combined AOL and Time Warner? Mergers that fail can destroy tremendous value quickly. In January 2000 AOL and Time Warner tied the knot; at that time it was the largest merger in corporate history. Time Warner had been frustrated in its desire to be perceived as a “new economy company.” Efforts at pushing into the digital economy had been slow. Progress was made more difficult by the squabbles between internal fiefdoms. Its share price stagnated. Meanwhile, AOL strategists could see that they had the golden opportunity, because of their astronomical stock price, to buy any company they wished. At the same time, they were concerned that their string of good luck could only go so far. Expanding the subscriber base was becoming progressively more difficult. AOL would need content and other services to pump through its pipeline to the subscribers. And so, the two companies found each other.17 Differences in culture, inability to execute the ambitious plans, and fights in the executive office ultimately disappointed shareholders, and the value of the company collapsed from a high of $58.51 per share to a low of $8.60 per share.18 The result was the jettisoning of both the CEOs who had sold the deal to their respective boards and shareholders. The deal of the century became the widely heralded “worst deal ever.” Thanks to a new twist in GAAP accounting called goodwill impairment, AOL Time Warner had the distinction of reporting a quarterly loss of $54 billion, another world record, in the second quarter of 2002.19 Because the acquisition was for stock, and not blockbuster bank debt, the impact of the implosion was felt mainly by the stockholders of the company. Would digging deeper have saved these two companies a lot of heartache? Strategy is an important component of any successful merger. In addition, missing the operating numbers in the first year

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of a major merger speaks volumes about the lack of adequate analysis at the beginning and failure to understand the magnitude of the challenges of execution, including getting people moving in the same direction. Steve Case ultimately accepted the blame for the failure. “[Steve] Case learned Time Warner’s notorious culture of fiefdoms the hard way, as multibillion-dollar businesses bristled at the idea of working with their new AOL masters.”20 Both sides underestimated the people effect.

WHAT DRIVES THE GROWTH OF PRIVATE EQUITY BUYOUTS? It was late 2002. The pension fund’s investment committee chairman made his report: “Here is the bottom line. Our investment committee analysis indicates that there is little opportunity to achieve our target returns, if we limit investment to traditional large or mid-cap stocks. Those private equity funds keep promising that they can outperform a portfolio of public company stocks. They have had great success in acquiring and growing a diversified portfolio of small and mid-cap companies. They argue that diversification into private equity will balance our total portfolio. I move we increase our allocation to the three ‘best performing’ recommended private equity funds from 1.5% to 3.0% of our overall portfolio over the next 6 months. . . . Thank you for the second! Are there any questions? . . . It appears we are unanimous!” Thus, another institutional investor doubled its pension fund investment in large successful private equity funds, despite the pension fund managers’ desire to support domestic labor union activists. Typically there would be considerable discussion over such a change in policy. Past performance is no guarantee of future performance, but the private equity fund managers were promising to deliver more value than institutional investors believed they could get in public markets. Billions of dollars flowed into funds that had favorable track records. New funds were started by those who saw new opportunities while others did not. Reported earnings were down, but the anticipated Bush tax cuts and low interest rates that were designed to stimulate the economy could have a positive impact. Our country had been attacked on 9/11/2001. We were at

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war but, unless a loved one was personally involved, it did not seem like it. Accounting scandals and government reaction with the passage of Sarbanes-Oxley filled the newspapers. Successful private equity players knew it was a great time to buy low, but few others knew it; 2002 was a year of great uncertainty. The tremendous growth in the private equity markets from 2003 through mid-2007, around 70 percent per year,21 was a result of the confluence of several factors. Many of the factors created awareness, made top talent more available, or gave participants in the markets the tools to get started. One factor made it all work: the public markets had fallen into disarray with the fall of the dot-coms and were dramatically undervaluing the stocks of many public companies: Institutional investors in search of diversification and higher returns had experienced great returns with several large private equity funds and were ready to invest more. Private equity investments had gained credibility as acceptable investments. • After healthy returns in the 1990s, investors were told by many an industry pundit that earnings growth and stock returns to public company investors would no longer be in the double digits. In 2002–2003 Bill Gross, PIMCO’s bond guru and well-known stock watcher, was predicting a bearish 5,000 Dow Jones Industrial Average (DJIA).22 At the same time, private equity was still touting returns in the double digits and had only slightly reduced its targeted returns of 20–30 percent.23 • Successful private equity players considered many companies in the market undervalued as they looked beyond GAAP earnings to cash flow. Analysts who failed to dig into cash flow forecasts undervalued the stocks. • Access to the public capital markets was no longer the answer for smaller companies. The high cost of implementing Sarbanes-Oxley (SOX) might take millions off the bottom line for years. Many CEOs also welcomed the opportunity to avoid SOX scrutiny and cost.24 It no longer made sense for some slow-growth companies to be public if they could not grow beyond $250–$500 million in •

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sales. Going private was justified on the basis of cost reduction. A new wave of liquidity was beginning to flow as low interest rates and new nonbank lenders appeared on the scene. With lower interest rates, the cost of high leverage was reduced. Cash flow valuations of companies increased. At the same time, lenders were far more willing to lend. As competition among lenders continued to heat up, “covenant-lite transactions” began to appear, substantially reducing borrowers’ risk of default and giving them added flexibility to operate their businesses.25 A growing group of experienced managers and professional advisors learned how to acquire and boost the returns of low-return companies over the last cycle and were looking to make their mark and boost their personal wealth through management and performance fees. They were comfortable with debt and high leverage. A small group of well-experienced private equity players with a network could start their own fund. If one could borrow at 6 percent and had a good chance of earning 10 or 11 percent, they were ready to roll the dice. It was just that easy. At least, it was just that easy at the time. Private equity investors and their lenders became convinced that economic prosperity and reduced volatility in the economy justified higher leverage. Public market investors experienced volatility on their computer screens, with prices changing throughout the day. Public companies continued to shun leverage because of its impact on the volatility of reported earnings. In essence, this provided an arbitrage opportunity between public and private markets. Private equity buyers could take a company private and then take advantage of the benefits that cheaply priced leverage could provide.26 Private equity players and investors became aware of the tax benefits that could be arranged in private equity transactions. Many of these focused on fashioning fund management compensation to occur as capital gains, which are taxed at significantly lower rates than ordinary

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income. This potential for extra after-tax compensation became highly controversial in mid-2007, as Blackstone Group registered for an $8 billion initial public offering (IPO), and news items surfaced, quoting wealthy individuals who claimed that they and other private equity players paid lower tax rates than their butlers. Because it was easier to pay lower tax rates, it became easier to accumulate wealth. (Note that many journalists omitted the word “rates” in many of the news reports. Wealthy people do pay more tax dollars.) • Low-cost manufacturing and outsourcing were rapidly taking hold. Many private equity players had traveled to China and had developed contacts there. They could see that many target companies could be downsized and some functions outsourced to produce greater cash flow. Outsourcing was a new twist that made some deals hard to resist. China and other Asian countries had improving infrastructure, and quality was improving. Private equity owners, out of the media spotlight, were more aggressive about the use of international outsourcing solutions and could move more quickly than public companies to adapt to new market conditions. • A generation of bright and aggressive managers had been dashed on the rocks of the dot-com bust. Some of the fortunate were flush with cash and looking for another exciting experience. Others were hoping for one more chance at an entrepreneurial home run. Both groups gravitated to private equity. Of all these factors, what created the tipping point? How did some of the most successful private equity players know it was a good time to buy? With years of experience digging deeper into the macroeconomic drivers and stock prices, Arthur Laffer found an answer at the national level: Capitalized Economic Profits (CEP). Laffer Associates’ formulation of Capitalized Economic Profits is a new and better way to look at corporate earnings from a national macroeconomic perspective. Their analysis shows that, in essence, stocks had been a veritable bargain throughout the period from 2002 to 2007. No wonder stock prices continued to climb, and

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no wonder private equity has experienced such a boom! It’s just that simple, but not simplistic. This undervaluation effectively underwrote the decisions of private equity buyers, even though they occasionally had to pay premiums over existing stock prices to do so. But there is more. Successful professionals who use priceearnings ratios know their weaknesses: •

• •

•

• •

Price-earnings ratios rely on historic earnings, while investors price assets on expected earnings, well into the future. GAAP rules change, and recent changes have made reported earnings significantly more conservative. Changes in GAAP rules are picked up in the year of the change and later but are not reflected in past financial statements, thus distorting any trend analysis. Price-earnings ratios fail to account for interest-rate changes, and interest rates do matter to most investors to a great degree. Price-earnings ratios ignore changes in marginal personal tax rates. Price-earnings ratios fail to recognize the difference between C corporations and S corporations.

Successful private equity players and other top value builders look beyond price-earnings ratios to an economic profit or discounted cash flow approach to understand market values. Public stocks were clearly on sale. Laffer Associates uses its version of “Capitalized Economic Profits” to measure the over- or undervaluation of the overall market. In 2002 and 2003 and every year since then (at least through 2008), the CEP signaled that the market was significantly undervalued by as much as 50 percent. This represented a tremendous value gap, a fantastic bargain and buying opportunity for private equity. Laffer’s CEP is constructed by capitalizing the national income and product accounts (NIPA) economic profit data. This involves dividing NIPA profits by the yield on the 10-year Treasury note.27 Compared with other macro market measures such as Tobin’s Q28 and Greenspan’s Federal Reserve valuation model,29 Laffer’s CEP

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model has provided more accurate and timely signals of over- and undervaluation. See Figures A1.5d and A1.5e. The Capitalized Economic Profit decision rule outperformed the Tobin’s Q rule in seven out of the ten periods, and it outperformed the Fed Model rule six out of six times. Using a Capitalized Economic Profit model digs deeper into economics, providing better results. As we discuss later in this chapter, digging deeper to develop intrinsic value models for valuing companies outperforms results based on GAAP accounting models as well.

MORE STOCK MARKET MYTHS AND THE LINK BETWEEN INTRINSIC CORPORATE VALUE AND STOCK MARKET PRICES Board members of small and mid-cap public companies are often confused by the stock market and the price of their stock. It is not unusual to hear conversations like the following: “Our stock is really in the tank. What’s wrong with the market? We felt pretty good in 2000 when it peaked at $45 per share, but we can’t seem to get our price above $20. Our quarterly earnings are up, and we have cut back on advertising and capital spending to show an upward EPS trend. We met expectations, but our stock dropped. Wasn’t our recent acquisition of our weakest competitor accretive? Can anyone in this room tell me what those ‘idiot short sellers’ are talking about? The market and those analysts really don’t understand. . . . What’s that you say?We don’t have analyst coverage anymore? How can that be? No wonder all those other companies wanted to backdate their stock options.” Small and mid-cap public companies historically have been the best targets for private equity buyers. As the custodians of corporate value, corporate directors seek to drive corporate value. But many business leaders lack clear definitions of corporate value and methods to measure value. Valueoriented goals help to push thinking, acting, and oversight beyond trial and error and rules of thumb. While successful private equity players concentrate on value, many directors of public companies have a lot to learn. At the October 2006 National Association of Corporate Directors annual conference in Washington D.C., a major theme and of great interest to the 700 corporate directors who attended was “driving long-term

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value.” Each of the related panel discussions brought out useful approaches and ideas that are consistent with producing long-term corporate value. Most, if not all, of the speakers rightly lamented the pressure to focus on short-term results, often at the expense of developing sustainable, long-term value. Several of the speakers cited a growing concern that hedge funds, wielding a great deal of power through ownership concentration, might demand changes for short-term results and then take their profits and leave the companies in worse shape than when they found them. Private equity firms are known for more of a long-term view and in early 2007 were gobbling up undervalued public companies of all sizes at a record pace. By March 19, 2007, over $500 billion in corporate takeovers had been announced, 30 percent above the comparable figure for 2006, another record year for takeovers.30 Private equity and mezzanine financings (subordinated debt and preferred stock) topped $100 billion in the first quarter of 2007.31 These highly leveraged deals—sometimes carrying nine times as much debt as equity—were funded by a variety of institutional lenders. Banks had also become willing to provide “covenant-lite” financing, a structure that limits the ability of the banks to call defaults based on the financial condition of the borrower.32 After mid-2007, the bond market began to reject covenant-lite financings, even with upward price adjustments. In a number of notable cases, underwriting banks had to retain large portions of the financings, pending later distribution. Credit markets continued to tighten through 2007, ending the flow of multibillion-dollar buyouts that had made headlines earlier in the year. Issues related to driving long-term value are among the great governance issues that corporate decision makers currently face. Although much has been done to articulate the problem, the purpose of this section is to set forth a coherent framework that business leaders can use to help identify what builds value and what destroys it. Our goals here are to assist all leaders in digging deeper into the basic but often misunderstood concept of intrinsic value: 1. Clearing the air of some myths of the stock market and corporate value. 2. Commenting on the current state of financial theory and practice regarding corporate value.

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3. Providing a graphic method to clearly communicate those business units and products that are adding value and those destroying value. 4. Suggesting steps that successful private equity investors, directors, and management may take to improve the focus on value creation (as opposed to relying on old-fashioned variance analysis and short-term accounting earnings). Myth 1. EPS growth, price-earnings ratios, accounting profits, and other shortcut measures such as multiples of EBITDA (earnings before interest, taxes, depreciation, and amortization) provide a clear path toward corporate value for boards and management to follow, removing the need to understand the way the stock market works or to separately evaluate intrinsic corporate value. Unfortunately, each of the above measures provides us with only one side of the necessary equation. While these measures typically have the desired level of simplicity, they are also simplistic. They rarely track value for an individual company in a statistically meaningful way and thus leave directors and management victim to either manipulation by those who stand to gain from “hitting the numbers,” or by the outcome of “shooting at the wrong target.” In particular, companies that have settled on one such measure to the exclusion of all others have frequently veered off course, sometimes with disastrous results and consequences for value and wealth. For example, management must be aware of rule-of-thumb measures of value like EBITDA multiples. These measures are often used by investment bankers to benchmark and communicate acquisition prices. However, to stay out of trouble, the user must understand their limited range of usefulness. A particular multiple can only relate to corporate value at a point when the full context of growth, quality, and sustainability of the EBITDA is understood. Successful investors know that accounting numbers are backward looking, while market prices are forward looking. We know of no simple EBITDA-based model that is broadly applicable.33 While accounting helps us understand current performance and is sometimes a good predictor of future performance, we are always cautioned that past performance is no guarantee of future performance. In addition, most businesspeople can cite cases in which long term value-building programs have been terminated or

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modified to enable a company to meet a quarterly estimate of earnings per share. Myth 2. The market is swayed by the short-term thinking of some of its participants and believes that “the bottom line”each quarter is all that counts. While a particular investor class, such as hedge funds or day traders, may be thought to see value only in short-term results, the market will ultimately penalize any company that sacrifices sustainable long-term results on the altar of short-term, bottom line performance. Successful private equity players focus on a three- to eight-year value-building horizon. They are acutely aware of shortterm results but focus on long-term value.34 While individual investors can have great influence over management decisions, it is the aggregate market that prices the stock. Joel Stern identifies a class of investors that he has called “lead steers.” He says: “If you want to know where a herd of cattle is heading, you need not interview every steer in the herd, just the lead steer.”35 Prices are determined “at the margin” by the actions of these investors. But there is a seeming paradox. No one “lead steer” sets the price; the market sets the price. Time and again, companies that have pursued short-term strategies and somehow fooled the market for a while find their stock harshly treated when the day of reckoning comes. Are private equity players often the lead steer? You decide. Miscues occur frequently between analysts and management regarding what the market expects, primarily because short-term measurements are available and easily quantifiable. Long-term performance takes time to unfold and does not make good copy for news headlines or analysts’ reports. For this reason, many enlightened public company CEOs, such as CDW’s John Edwardson, welcome the opportunity to go private with the help of private equity: “Frankly, I'm looking forward to being the CEO of a privately owned company.”36 Myth 2.5. Growth always creates value. Growth in sales and market share may be compelling targets for CEOs and business unit management. However, growth can destroy value when it is achieved by cutting margins or overinvesting.

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Nardelli did grow Home Depot; however, investors did not believe there would be a future cash payoff. For some companies growth may erode value! For example, companies that are not earning their cost of capital on new growth initiatives are eroding value. All too often we see companies growing economically unprofitable businesses or maintaining investments in marginal return businesses just to avoid the negatives associated with closing them down. Private equity players do not have patience for unprofitable growth. They shut it down. Myth 3. The market is irrational and doesn’t understand companies or intrinsic value. The researchers of the market clearly report otherwise. While the market seems to understand companies very well on average, many company leaders and management have widespread difficulty understanding what the market really expects from them. In Figure 1.1, the ideal transparent flow of information would be from the company’s operations to the investors. This ideal flow

Investors

Analysts

Ideal

Actual

Actual

CEO Ideal Operations

Figure 1.1 Ideal information flow occurs in private equity, rarely in public

markets Source: Copyright © 2007, Board Resources. Reprinted with permission.

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closely represents private equity but not traditional public companies. Armed with a clearer understanding of the ability of the company to produce cash and therefore economic or intrinsic value, investors will value the company properly. The feedback loop from investors back to the operations of the company sends signals to help management allocate capital effectively within the company. Investors are interested to hear from management that capital is allocated more aggressively to highly profitable Division A, while capital is to be withdrawn from Division B that is not earning its cost of capital. Unfortunately, many leaders hide this information from investors and employees for fear their competitors will take advantage of the facts or their employees will defect. As a result, their public stock may get tagged with a conglomerate discount.37 Going one step further, some misguided leaders even hide the facts from themselves and fail to understand the true economics of each of their business units. Unfortunately, many leaders believe that a high degree of transparency is not practical for complex businesses. Thus the smaller inner loop of communication between CEO and analysts prevails, and important people are left out. Transparency suffers. Stock analysts who try to dig deeper communicate with the CEO and the CFO through the quarterly conference calls and GAAP mandated filings with the SEC. The management’s discussion and analysis (MD&A) section from the 10K and 10Q reports provides the framework, and the communicators focus on the recent changes and explanations for GAAP as well as some non-GAAP numbers. Like the classic childhood game of “telephone,” limited strategic commentary is further interpreted, filtered, confused, and eventually provided to the investing public and employees. They frequently miss value-building changes. The discussion is usually myopically focused on the details of the quarterly accounting results. “EPS-speak” is frequently the vernacular of the analyst calls. Broader issues, such as the risks the company faces, are required to be “disclosed” by the SEC. The list of risks can quickly become so diffuse that the business appears to have so many risks that no investor in his right mind would invest and employees cannot prioritize actions. The readers of the reports assume that the “kitchen sink” listing of risks is meaningless, and they consequently ignore them.

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Both independent and “sell side” analysts use the data from these conversations to populate their widely varying valuation models. Feedback from the analysts goes back to the CEO in the form of more questions, and the analyst estimates earnings per share. This dynamic has contributed to the short-term quarterly earnings per share focus that overly concerns most board members. It represents the worst impact of the people effect, when decision makers find themselves making obviously bad decisions to satisfy an ill-defined group of market participants who supposedly define the stock price. Recently, and for a variety of reasons including government disclosure rules, many companies have stopped giving earnings per share guidance, recognizing that the process may not have been providing useful information. Unsurprisingly, private equity firms, by virtue of their investment agreements and governance structure, manage to make the operations of portfolio companies more transparent to their owners. Their information exchange is more like the ideal as shown in Figure 1.1. Private equity owners sit on boards, frequently visit their portfolio companies, and educate management on value metrics and the importance of future cash flow. Because the reporting is direct and focused on issues of corporate value, the private equity owner/investors spend more time finding creative ways to enhance the value of their investee companies. They may transfer executives among portfolio companies. They may recommend proven operations or marketing consultants. In some cases, the private equity group may buy a company because it already has on board a talented and experienced executive around whom they hope to build a successful business. Better information flow promotes better and faster decisions to build value.

FINANCE THEORY AND PRACTICE HELP BUILD UNDERSTANDING OF CORPORATE VALUE RANGES The good news is that the growing body of financial theory does help link the price of the stock to management actions and intrinsic value. According to financial theory and growing practice, the total enterprise value of a corporation should be equal to the net present value of all of the expected after-tax free cash flows produced by the

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company, discounted at an appropriate rate. That discount rate is the rate that takes into account the risk of the investment and the returns available on alternative investments available to the investors. Total enterprise value is the total market value of all the claims on the company, both debt and equity. Make no mistake; growing numbers of investors, particularly large sophisticated investors and analysts, do use discounted cash flow techniques to value their investments. While they ask management about earnings per share each quarter, meeting the next quarterly earnings per share target plays only a tiny but direct role in valuation under financial theory and practice. The clamor for meeting short-term targets serves two main purposes—both related to judgments about the people within the company: Trust: testing the reliability of information provided by management. • Trend prediction: developing a feel for long-term expectable cash flow performance and the ability of the corporate team to produce sustainable results. •

Both of these judgments involve disciplined attention to current and expected numbers and the people who produce them. The quantified results are then used by wiser investors in their financial valuation models to produce reasonable ranges of value. After a session of being peppered with questions by young analysts and financial experts, it is not surprising that a CEO would be loath to return to the same forum without “meeting the guidance.” Hence, it is not a surprise that the CEO may be strongly prompted to turn the focus to quarterly targets and further to fashion internal compensation programs to push in the same direction. However, these quarterly targets often provide the wrong signals. Why? The analysts want to see up-trends in sustainable longterm cash flow and value, not one-time increases in quarterly accounting results. Yet, the apparent demand for false precision by analysts leads many CEOs to revert to the short term. A short-term focus on earnings per share may cause value-destroying actions such as cutting important marketing programs, failing to defend the business from competitor actions, failing to compensate the best people for valuable contributions, or cutting research budgets on high-payoff projects.

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Finance and accounting differ in one fundamental way that is crucial to the issue of valuation. Accounting is inherently focused on past performance, precision of numbers, generally accepted accounting principles, and history, while finance is focused on opportunity cost of capital, expected ranges of future cash flow, and risk. The difference causes confusion and mistakes that erode value.38 In conversations with management, many private equity players emphasize growing EBITDA, a surrogate or shortcut for cash flow. This “one number” focus is similar to the public market analysts’ focus on earnings per share. The real interest is in long-term value and sustainable levels of cash flow, not short-term achievements that will fade quickly in the future. As long-term players, the private equity investors are most concerned with the price at the time when they are ready to buy or sell, with a long-term gain in mind. The successful ones may use EBITDA as a shortcut to estimate cash flow, but they will focus on the ability to improve free cash flow when it comes to valuing businesses for purchase or sale. Despite the problems with using EBITDA multiples in valuation, they play a useful role in understanding leveraged buyouts (LBOs). The amount of senior debt that can be arranged in an LBO is frequently determined as a multiple of EBITDA. This is a good example of an accounting measure being useful for the analysis of credit capacity, but only of limited use as a shortcut for valuing equity. They are useful for special credit decisions.39 There are various useful financial valuation methodologies provided by or championed by consultants and academics that overcome the problems of accounting rules of thumb. They all incorporate some form of estimating and discounting future expected cash flows. These models rely on numerous assumptions about risk and the value of alternative investments. Their output is generally a reasonable range of estimated intrinsic values of a company’s stock. While these methods or estimates of intrinsic value are available on the Internet to virtually all public companies, directors and management frequently despair at the seeming complexity and lack of precision. To avoid the pain, corporate decision makers often revert to the comfort and false precision of simplistic rules of thumb and shortcut measurements to estimate value (e.g., priceearnings and EBITDA multiples). They downplay the need to understand the after-tax cost of capital at their own peril.

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When major decisions are to be made, it is wise to doublecheck the probable outcome of the decision with more than one value or decision model. This is how top value builders gain experience and learn which models work best. By digging deeper, companies can take advantage of improved valuation methodologies. Through testing and experimenting with better models, management can use the models to better allocate capital and set internal performance targets that are more likely to build value. Research shows that it is not unusual for a company that moves from accounting-based performance measurement to value-based performance measurement to discover that a third of their previous decisions on business unit values and capital allocations were wrong.40

MISUSE OF PRICE-EARNINGS RATIOS IS STILL WIDESPREAD—CONSOLIDATION HIDES THE FACTS Historically, misuse of price-earnings ratios has periodically led to major investor losses. In the 1960s corporate conglomerates emerged and became the darlings of the stock market. They were basically companies that operated as holding companies, with diverse arrays of subsidiaries. Defying industry classifications, these clusters of companies had tentacles into everything. The supposed magic of conglomerates was in synergy and diversification. The real magic was in the false signals that accounting earnings reports produced. At the time, the stock market was enamored with earnings per share growth. (Sound familiar?) Companies with dramatic earnings per share growth suddenly found that they had high price-earnings ratios. If one digs a little deeper into the math, it becomes obvious that a high price-earnings ratio company can increase its earnings per share by acquiring, for stock, a low price-earnings ratio company. In the investment climate of the time, some companies found the formula: buy a low priceearnings company, tout the new earnings per share to the investors, buy another, cheer to the investors, and continue. With growing earnings per share and enough confusion in the financial statements, investors bid up the stock to an even higher price-earnings ratio, enhancing the earnings per share effect of the next acquisition.

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Unfortunately, the formula was an accounting illusion. Priceearnings ratios are a result more than economic drivers. They are more indicators of growth than anything else. Some investors would naively invert the price-earnings ratio and interpret it as a cost of capital. This approach led investors to the false notion that a company with a high price-earnings ratio had a low cost of capital. That further seemed to justify the purchase of companies with low price-earnings ratios. It looked like a free lunch. What was really going on here? The price-earnings ratio is mostly an indicator of expectations of future growth in earnings. Think of two identical companies with a stock price of $20. If each company earns $2.00 per share, then each would have a price-earnings ratio of 10 ($20/$2). Now let one company announce that it has invented a better mousetrap and its profits and cash flow are expected to grow much faster in the future. It clearly makes sense that investors would bid up the price of that company’s stock. Because current earnings are still the same, the price-earnings ratio would rise. As a result, the stock with the higher price-earnings ratio will be the one with the higher growth expectations. Back in the conglomerate days (1960s and 1970s) investors were set up for a big fall. The conglomerate with the high priceearnings ratio was expected by the market to have high growth in earnings, and for some time, it was able to show consistent growth through “accretive” acquisitions, those that were bought at a lower price-earnings ratio than that of the purchaser’s stock. Now, each time the conglomerate bought a company with a low price-earnings ratio, it pushed up its reported EPS, but it also bought a slowergrowing company. This was repeated with each acquisition. Over time, the conglomerate became a hodge-podge of slow-growing companies, but it was tied to an investor expectation that earnings would continue to grow rapidly. As in every unstable system, a minor event ultimately topples the house of cards. When investors awoke to the underlying truth that the growth was coming from an accounting artifact, and not from real operations, the predictable collapse in conglomerate stocks occurred. GAAP itself creates additional problems, reducing the value of using price-earnings ratios. The rules do not require that companies restate their historic financial statements to reflect changes that are

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made in accounting principles. The definition of earnings for individual companies changes over time and may not be consistent across companies or industries. Unfortunately, glimmers of the price-earnings ratio error continue to recur in the markets, particularly among individual investors. Some more recent examples include BankOne in the 1980s and 1990s and, yes, Home Depot in the 2000s.

VALUE BUILDERS DETERMINE WHERE VALUE IS ADDED Using internal data and value-oriented analysis, a company can analyze its operations by product, division, or geography. The results can be graphically represented in a way that differentiates between units that add to corporate value and those that reduce it. The painful aspect of the exercise is that the analysis must follow one of the available discounted cash flow oriented valuation methodologies closely enough so that the important judgments are made correctly, such as choosing a cost of capital. Corporate decision makers who are trying to build value do not need to be experts in the computations, but they must commission knowledgeable providers, whether employees or consultants. To be successful, decision makers must judge the results of the analysis and the reliability of different models. Only when they truly believe the output will they be willing to make decisions consistent with the output of the models.

THE INTRINSIC VALUE WATERFALL TELLS MUCH MORE Consider the following graphical presentation that should be made available to corporate leadership and the board annually. The intrinsic value waterfall in Figure 1.2 is a graphic example of the way many successful private equity players and other value builders mentally deconstruct the value of a company. Each strategic business unit, product line, or customer segment of the company has been subjected to a valuation analysis. The units have been plotted in the order of their contribution to corporate value. In the example, divisions 1 through 4 contribute to the value of the

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Figure 1.2 The value waterfall distinguishes between value creators and value destroyers Source: Copyright © 2008 Board Resources, reprinted with permission. Adapted from William J. Hass and Shepherd G. Pryor IV, Building Value through Strategy, Risk Assessment, and Renewal, Chicago: CCH Inc., 2006.

company. Divisions 5, 6, and 7 detract from corporate value because they do not earn their cost of capital. The value analysis is not subject to the major flaw of traditional accounting variance analysis that is frequently used in operating division reviews and presented to the board. Accounting variance analysis is dependent on the operating units’ business plans and prior year performance. Unfortunately, these are not usually linked to corporate value. The leadership message is often short term: “Hit these targets and do better than last year, and you will get your bonus in January.” A common flaw appears when business units that are destroying corporate value are depicted by the variance analysis to be “performing above plan.” When this happens, the analysis shown to the board may erroneously seem favorable, and the managers of the units may be inappropriately awarded incentive pay. A more important strategic flaw in variance analysis is that it fails to look at the value of broader long-term opportunities and risks that face every business. Recall that value is created by looking forward, not backward. Variance analysis is a prisoner of history. It fails to force thinking beyond the current year, immediate

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practice, or the existing business model. Top value builders constantly apply disciplined strategic thinking about opportunities and risks. Using mental models like the value waterfall helps them develop ideas on how value will be created in the future. Focusing on intrinsic value at both the corporate and strategic business unit (SBU) levels produces far better insights and results. The value waterfall analysis forces everyone to dig a bit deeper and go beyond the “improve 10 percent over last year” approach to identify which units are adding and which are actually reducing corporate value. Attention can then be focused on those units where changes might enhance the overall worth of the company. The value waterfall presents in one picture the sum total of the company’s beliefs about its strategies and plans reaching into the long-term future. The basis for the analysis can be as simple as values based on accounting multiples attached to SBU cash flows. However, that method of valuation is crude and subject to many flaws of its own, including hidden assumptions about the arbitrary choice of the multiple. Thus it is not recommended. The first step, then, is to choose a discounted cash flow approach. Then, with some disciplined digging and thinking about alternative outcomes, internal analysts and planners can produce a value waterfall with ranges of outcome, incorporating risk into the analysis. Only by experimenting with more robust models and learning from the results can decision makers learn which valuation models work best over time across business units. See the shaded lines in Figure 1.3. An annual value analysis or “value audit” (See Appendix 3) is the best approach and one that is critical for top value builders. When this analysis is conducted in conjunction with the annual business plan, it can help corporate decision makers avoid mistakes in capital allocation among the business units. Using this approach, even in a rough form and in the absence of heavy analytical artillery, leaders should be able to do a better job of building corporate value. Without this discipline, they are left to chasing earnings per share guidance numbers and using price-earnings ratios as a shortcut to understanding value. Value audits are within reach of every business. In fact, many companies and ESOPs are required to conduct value audits annually for compliance purposes. Bart Madden, an early proponent of discounted cash flow valuation, is

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Figure 1.3 The value waterfall with risk ranges distinguishes between value creators and value destroyers Source: Copyright © 2008 Board Resources, reprinted with permission. Adapted from William J. Hass and Shepherd G. Pryor IV, Building Value through Strategy, Risk Assessment, and Renewal, Chicago: CCH Inc., 2006.

calling for private investors and perhaps the SEC to require each public company to disclose (1) its methods for measuring value, (2) historical value drivers, and (3) value creation statements for each business unit.41 Top value builders understand that building value basically requires understanding value. Value is built when, over time, operating units provide a return to the corporate parent and its investors in excess of the cost of capital. When such a unit grows and meets realistic estimates of sustainable growth, the contribution to corporate value increases further, and the stock price trend should be favorable, despite occasional ups and downs. Effective performance measures take these factors of value creation into account. The performance measures must help decision makers answer these questions: •

Is the operating unit expected to return free cash flow above its cost of capital over the long term?

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Is the unit growing? What new investment is required? • Is the free cash flow stream sustainable? • Will the business unit be worth more or less (than it is today) five years from now? •

Thinking about these questions in the context of one or more of a company’s business units should quickly convince decision makers that these answers do not pop out of the accounting system and that they cannot just be put on autopilot with simplistic formulas. However, cash flow, investment, and asset growth can be quantified and tracked. The more elusive question about future cash flows can be discussed and business judgment can be applied. Estimates can be made as to whether the business unit strategy and action plans will produce the desired performance, be sustainable, and provide the necessary cash flow and margins over time. The internal financial staff can provide inputs on these questions for senior management and the board. The typical financial staff of a company should now have the skill to work with basic cash flow models. If more refined calculations are needed, outside consultants and investment bankers are prepared to provide them. As we will see in Chapter 4, top value builder Bob Lane, CEO and chairman of John Deere, inserted cost of capital discipline into the company culture by charging each operating unit a simple 1 percent per month on its net assets. This simple charge is not simplistic. While it was easy for unit managers to employ, it fit within a broader incentive system that transformed Deere’s performance, changing the focus from accounting variance analysis to financial value building.

TOP VALUE BUILDERS ARE NOT LIMITED BY GAAP Private equity funds, as opposed to public companies, do not have the “protections” offered by SEC restrictions on public company reporting. Fortunately for them, private equity investors are generally sophisticated enough to determine the best metrics of performance for their companies. Communication can be much more direct and more productive between management and private equity owners.

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Public corporate directors need not be accounting experts, but they often need assistance in converting GAAP numbers to valueoriented metrics. Top value builders are knowledgeable in finance and in extracting value-oriented information from financial reports. They are also more adept at helping management design reporting systems that assist in tracking the key value-building processes. They run realistic cash flow models and ensure that everyone involved understands the cost of capital discipline.

CREATION OF INTRINSIC VALUE AND WEALTH MEASURES IS NOT ROCKET SCIENCE; IT’S NOT ARITHMETIC EITHER As mentioned earlier, there are various vendors that handle the rocket science parts of valuation and can provide empirical data on how their models perform. For advanced players, who need a higher degree of accuracy, these inputs may be crucial. Fund managers with billions of dollars at stake are concerned about the smallest errors that can give them a big advantage over other investors. For corporate decision makers, introducing a cost of capital is the first step to creating value. Their measurement techniques can afford to be less exacting. The simpler approaches that are effective must still be in general (directional) agreement with more sophisticated and accurate discounted cash flow techniques available today. Successful private equity players and investors use an array of methods to determine value. Because they are not willing to rely on a stock price, they must develop shortcuts and proxies for measuring the value of their companies. Those who have an independent, robust valuation of operating companies are in the best position to negotiate with the public stockholders when either buying or selling a portfolio company. Notably, effective private equity owners have trained themselves to find opportunities in both buying and selling companies. This distinguishes them from many public corporations, where the incentives are to build through acquisitions and only rarely divest. In the typical public company, divestiture is seen as a response to failure, not as an opportunity to take profits from a successful past effort. The advice from financial experts is the same in both

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markets: owners should always know the value of their assets and operations, and thus be prepared to buy or sell when opportunities arise. One of the early corporate value builders was Don Kelly, CEO of 1970s holding company Swift & Company/Esmark. He partnered with KKR in the first billion-dollar buyout of Beatrice Foods. Kelly often said, even before joining the private equity world, “Every one of our businesses is for sale.”

SUMMARY AND CONCLUSIONS Top value builders pursue common themes. They are more involved in long-term thinking about future business unit value and cash flow than in the last quarter’s financials. They focus on the simple but not simplistic value-building models that include a cost of capital. Successful private equity firms have small active boards for each of their portfolio companies. They demand higher returns on capital. The boards consist of about five to seven experienced directors with operational and finance backgrounds. Relevant experience and capability are the most important attributes of members of these boards. Private equity boards are more likely to be deeply involved in business unit issues than their counterparts on larger public boards. Private equity funds usually own a portfolio of separate, smaller businesses, each with a separate board. A public company of comparable size typically merges the operations into corporate divisions, with a significant loss of transparency. The board loses its understanding of the business units. Most astute observers of public boards will agree that many are too large and too distant from the business units to influence the business strategy and creation of value. Unfortunately, many public company directors do not understand how to measure or build value and consequently demand less performance than top value builders. Because oversight of corporate strategy is typically the province of the entire board, strategic conversations with such boards may become diffuse and one-sided, lacking any productive focus on value. Management describes, more than discusses, its strategies. In these board conversations, challenging questions on business unit strategy, operations, and value are rare.

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Top value builders in public companies take courageous steps that involve altering the compensation plans and pushing back against analysts who clamor for guidance in precise, micromanaging detail. However, if the discipline of discounted cash flow is followed, the road to greater value creation will bear fruits for all involved, because: • •

•

•

• •

The investors and analysts will see the results of more focused fundamental performance. Management will be driven to produce what the investors really want: returns on capital. This leads to growth in intrinsic value that is competitive with alternative investments. Leadership and the board will be assured that the company is not being pressured by short-term holders, thereby hurting the long-term intrinsic value. The board and the leadership team will be less concerned about a takeover engineered by dissident activist investors desiring to buy and “flip” the company. A value-building strategy will be communicated and upgraded continually by the new value-building process. Cost of capital will become integral to the company culture.

There are at least five common steps that top value builders take. While these are more commonly pursued at private portfolio companies, they can be readily employed in any public company. 1. Set higher standards. Top value builders forge common goals between the management team and the board and focus incentives on building long-term value. Their approaches are matched to the level of capability and sophistication of their organizations, but they incorporate the disciplines of cash flow and cost of capital. 2. Develop and communicate performance measures based on value. Top value builders develop value-oriented measures that are accepted by both management and the board. They go far beyond EPS-speak and GAAP metrics. The measures are frequently used to evaluate the business units. They analyze the impact that major risks and opportunities,

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both macroeconomic and competitive, will have on the value of the business units. 3. Monitor and provide feedback from the right performance measures. Top value builders track value-based performance measures at the board level at least quarterly. They have unit level management explain the underlying changes to the board each quarter, and they ensure that the CEO is reinforcing the use of value-building measures throughout the organization. 4. Adjust behavior based on the performance measures. Top value builders require near-term turnaround action plans on value-destroying or underperforming units. Throughout their organizations, they constantly realign compensation plans to produce increases in unit value. 5. Adjust standards and directions. Top value builders are extremely proactive. They do not wait for problems before developing solutions. They actively experiment with value-based measures and ways to improve them. They revisit the standards and directions annually at the board level and make incremental improvements to reflect new insights. They develop scenarios to test the value of alternative strategies and prepare for future uncertainties.

NOTES 1. While the supply business acquisitions were accretive to EPS and Nardelli hoped to boost the price-earnings (P/E) ratio, they had no strong synergies with the core business and hurt the stock price. This is a trap awaiting nearly every public company and a recipe for a declining P/E ratio as the growth prospects of the overall business are hurt by the purchase of the low-growth subsidiaries. 2. GAAP is generally accepted accounting principles, the body of principles and rules that govern financial reporting. U.S. GAAP refers to the principles and rules used in the United States, which differ from GAAP in use in other parts of the world, such as in the Eurozone. In this book, when we refer to accounting or accounting principles, the reader can assume that these are within GAAP. 3. Stephen Taub, “Nardelli Resigns from Home Depot: The Controversial Chairman Has Drawn Heat for His Huge Pay

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7.

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Packages and for the Way He Handled Last Year’s Annual Meeting,” Today in Finance, January 3, 2007. See: CFO.com, http://www.cfo.com/article.cfm/8486274/c_8484720. Form 8-K Home Depot, June 20, 2007. The Home Depot Completes Sale of HD Supply at: http://ir.homedepot .com/releaseDetail.cfm?ReleaseID=262344. http://www.sec.gov/Archives/edgar/data/318025/0000950150-99000620.txt. Vivendi bought 95.7 percent of the stock of US Filter in April 1999 for $5.5 billion, following up with a short-form merger for total control. Fractal events are events that are in the range of possibility but have such a low expected probability that their occurrence comes as a big surprise. One view of financial risk is the potential for future variations in the expected amounts of cash income and also in the shape of the probability distribution of expected outcomes. Considering the outer edges of the frequency distribution can be critically important, for it is there that miracles and disaster lurk. Some plans or projects have limited ranges; others do not. Consider this: An option holder can lose his premium, but a short seller can lose an unlimited amount. We may think of statistical populations as being adequately described by averages, medians, modes. However, think of the net worth of 1000 random people. Now put Bill Gates in the room, and the normal statistics would be so distorted, we would be lost, without digging deeper. Adjusted for splits, US Filter’s stock peaked at $43.75 on October 3, 1997, later falling to $11.50 by October 8, 1998. The stock lost 74 percent of its value. Source: ATIVO Research. Companies use GAAP to communicate to stockholders. In fact, SEC regulations strongly dissuade management from using non-GAAP financial measures. Regulation G requires that any non-GAAP measures that are used in the reporting be prominently highlighted and reconciled back to GAAP. However, the rule sometimes persuades management to withhold useful information, rather than provide the reconciling details. It is hard to believe that we continue to find professional stock analysts using sales multiples within industry groups to pick stocks. Private equity players are known for their use of earnings before interest, taxes, depreciation, and amortization (EBITDA) multiples as a rough approximation of value and a tool for disciplining management. An Owner’s Manual, originally produced in June 1996 by Warren E. Buffett, as updated on www.berkshirehathaway.com.

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12. Franco Modigliani and Merton H. Miller, “Dividend Policy, Growth and the Valuation of Shares,” Journal of Business, October 1961. 13. Alfred Rappaport, Creating Shareholder Value: A Guide for Managers and Investors (New York: The Free Press, 1986, 1998r). 14. G. Bennett Stewart III, The Quest for Value: A Guide for Senior Managers (New York: HarperCollins, 1991). 15. Tom Copeland, Tim Koller, and Jack Murrin, Valuation: Measuring and Managing the Value of Companies, (New York: John Wiley & Sons, 1995, 1996r). 16. Bart Madden, Cash Flow Return on Investment: CFROI Valuation (Oxford, UK: Butterworth, Heinemann, 1999). 17. Alec Klein, Stealing Time: Steve Case, Jerry Levin, and the Collapse of AOL Time Warner (New York: Simon & Schuster Paperbacks, 2003), pp. 68–78. 18. “AOL and Time Warner Executives Accused of Pocketing Nearly $1 Billion,” UC Newsroom, May 14, 2003, University of California.edu. See: http://www.universityofcalifornia.edu/ news/article/5311. 19. AOL Time Warner Inc., 10Q Report, second quarter 2002, dated August 14, 2002, p. 35. “Upon adoption of FAS 142 in the first quarter of 2002, AOL Time Warner recorded a one-time, noncash charge of approximately $54 billion to reduce the carrying value of its goodwill. Such charge is nonoperational in nature and is reflected as a cumulative effect of accounting change in the accompanying consolidated statement of operations. In calculating the impairment charge, the fair value of the impaired reporting units underlying the segments were estimated using either a discounted cash flow methodology, recent comparable transactions or a combination thereof.” 20. Jim Hu, “Case Accepts Blame for AOL-Time Warner Debacle,” CNET News.com, published on ZDNet News: January 12, 2005. 21. Charles Uhrig, “Recent Trends in the Mergers & Acquisitions and Private Equity Markets,” presentation, August 31, 2007, at the University of Florida. 22. Bill Gross has been tagged as a perennial bear. See: Arthur B. Laffer and Marc A. Miles, “Equity Valuation: Whom Do You Trust?” Laffer Associates, August 21, 2002; and Arthur B. Laffer and Marc A. Miles, “Five Factors Distorting P/E Comparisons over Time,” San Diego: Laffer Associates, March 19, 2003. Perennial bears are occasionally right.

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23. With long-term stock returns at somewhere around 10–11 percent, private equity must take significant risk to expect to generate 20–30 percent returns. The risks are generally either from very high leverage, which is used by the larger private equity players on large acquisitions, or from very high operating risk generated by transformations of smaller acquisitions. Private equity venture capital investments represent an even more extreme case of high-risk start-ups. Source: Interview with Joe Mansueto, founder, chairman, and CEO of Morningstar, Inc. February 15, 2008. 24. Interestingly, the much maligned Section 404 of Sarbanes-Oxley required that public companies undertake tedious and expensive analyses of their internal control environments, but, having done so, management should understand the internal workings much better, dramatically reducing uncertainty and adding new insight. SOX was not enough to prevent bank failures. 25. At their peak, covenant-lite loans were even used in highly leveraged acquisitions. With no substantive covenants, the banks would not be able to react until a payment default, normally the last event before collapse of the borrower. Thus, the banks had basically given away all the flexibility to the borrowers. Not surprisingly, this practice came to a screeching halt during the credit crunch that followed the subprime mortgage crisis in 2007. 26. For more on this perspective, see Lewis A. Sanders, “Capital Markets Outlook,” Alliance Bernstein Investments, May 2007. 27. Rather than use reported GAAP earnings of the S&P 500 companies, Laffer and his team at Laffer Associates tracked the S&P 500 prices against data from the national income and product accounts (NIPA), compiled by the Bureau of Economic Analysis (BEA). From the NIPA data they used a more stable, broader, and more reliable series of reported after-tax profits from national tax returns. The IRS data were better indicators of the broad economy and economic profits than GAAP earnings. Corporate financial statements had also become particularly distorted in the “tech bubble.” Many companies ultimately restated their financials downward. The source of basic data matters. Using the more reliable tax return measure of economic profits, the price to earnings ratio (P/E) of the market indicated a “strong buy” opportunity, while the measured price-earnings ratios using the depressed GAAP profits of the S&P 500 following September 11, 2001, indicated the market was overvalued and signaled a “sell.” The less distorted economic profits from the NIPA data were used to generate a market price-earnings

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ratio that is compared with a GAAP-generated market price-earnings ratio of the S&P 500. This comparison is shown in Appendix 1, Figure A1.5. The data clearly show that the NIPA adjusted priceearnings ratio of the market was dramatically down, while the GAAP price-earnings ratios were climbing during the period from 2002 through 2007. 28. The origin of the Q ratio is the following article: James Tobin, “A General Equilibrium Approach to Monetary Theory,” Journal of Money, Credit, and Banking. vol. 1, 1969, pp. 15–29. Tobin’s Q ratio was the ratio of the market value of a company’s assets, which is considered to be the sum of the market values of the company’s debt and equity, and the replacement value of the assets. The idea is that a ratio over 1 would imply that it would be more costly to purchase the company at market than to build a competing entity, and thus the company might be overvalued. A Q ratio below 1 indicates that it would be cheaper to buy the company than to replace it, implying that the company is overvalued. Like any model, the Q ratio model can be grossly overused. Its numerator is based on market values, which are derived from investors’ evaluation of the long-term future. The denominator is based on the current replacement of the assets, which says nothing about the future. The model ignores the value of intangible assets and activities. It also ignores interest rates. 29. The following description is from http://www.greenwichfinancial .com/wm24.htm: “One valuation model, nicknamed the ‘Fed Model,’ zeroes in on the relationship of stock prices and interest rates. . . . The Fed Model compares the interest rates on the US Treasury 10 Year Note (now 4.16% [in 2003]) with the one year forward earnings yield on the S&P 500 Index (simply the reciprocal of the forward price to earnings ratio, it is currently about 5.4% according to stock analysts on Wall Street, or 4.5% in the opinion of market strategists and economists). (Source: http://news .morningstar.com/doc/article/0,1,104110,00.html, 4/6/2004, article by Mark Sellers). Overvaluation of stocks would occur when the yield of the Treasury note exceeds the forward earnings yield on stocks.” Like the Q ratio model, the Fed model was designed to look at the aggregate market. The Fed model overlooks volatility of the market. (See also: www.TopValueBuilders.com Web site for “Equity Valuation: Whom Do You Trust?” by Arthur B. Laffer and Marc A. Miles, August 21, 2002.)

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30. See the following Web site: http://www.lastdata.com/NewsFiles/ Stocks_in_U.S._Rise_on_Takeovers%3B_Triad,_ServiceMaster_Shares_ Lead_Advance.html. 31. One source, http://www.srr.com/files/Publication/0008c2ba-d571409a-8025-039ab19774af/Presentation/PublicationAttachment/ 9bd8e6cc-5f1f-4017-8b51-184d4c91c470/Financing%20Overview_ Spring%202007.pdf, claims that private equity and mezzanine financing was $102.6 billion in the first quarter of 2007. 32. Loan covenants help to offset risk. Combining high leverage with a weak covenant structure dramatically increases the risks of bank loans. This competitive trend was accepted by many of the arranging banks, as they were increasingly able to securitize their loan positions, selling the loan risk to nonbank purchasers. As it has played out in the markets, cov-lite died a timely death with the credit crunch that toppled the mortgage market. With banks as the only buyers of bank loan paper, normal standards were quickly reimposed. 33. Valuation professionals are discouraged from using rules of thumb in their formal reports. EBITDA is a non-GAAP measure, intended to be a high-level measure of cash production by a company. It is supposedly more insulated from accounting shenanigans than the net income line. Nevertheless, many companies in the early 2000s found ways to manipulate this high-level number. Growth characteristics, capital intensity, and industry structure must be clearly understood to avoid error when using EBITDA multiples to compare companies. For more discussion about estimating corporate value using historical accounting statements and the problems that an analyst encounters, see: Alfred Rappaport, Creating Shareholder Value: A Guide for Managers and Investors (New York: The Free Press, 1986, 1998r). 34. Consider this. Even a trader has to sell her stock to another participant in the market to realize any gain. Unless the market is populated by “greater fools” or is temporarily following false signals, the trader will not be benefited by pressuring a company to focus on short-term results at the expense of sustainable long-term results. Society loses. Boards and management should be wary of pressure from any investor to take actions to produce short-term results at the expense of long-term value. The market ultimately reacts to the impact on intinsic value. Outsiders sometimes see longer-term value problems when management is focused on short-term window dressing.

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35. G. Bennett Stewart III, The Quest for Value: A Guide for Senior Managers (New York: HarperCollins, 1991), pp. 40–41. 36. Mike Hughlett and Becky Yerak, “CDW Chief Glad to Go Private: Sale to Shift Focus from Quarterly Profit to Long-Term Growth,” Chicago Tribune, May 31, 2007, from: http://www.chicagotribune .com/technology/chi-thur_cdw00531may31,1,7195267.story?coll= chi-techtopheds-hed&ctrack=1&cset=true. 37. Conglomerate discounts result when investors and analysts cannot understand the strategies and cash flows of business units. The numerous and diverse business units make it difficult for analysts to analyze and forecast future cash flows. Private equity firms keep portfolio companies separate to avoid this confusion. 38. The best example is the flaw in using price-earnings ratios as a performance measure. As we have seen in macroeconomic analysis of market trends, the denominator, earnings, is an accounting measure, arising from historic results of past actions and GAAP conventions. The numerator, price, is observable in the market but it is based entirely on investor and trader expectations and projections about the future cash flow and risk. Even if forward forecasts of GAAP earnings per share are used, price-earnings ratios are at best a simplistic, shorthand way to look at the more complex process of market valuation. 39. EBITDA multiples are useful in certain contexts: • EBITDA multiples may be used to simplify contract terms for a sale (although investors choose the multiple only after a deeper analysis). Ultimately, the real prices, “the Ps,” are heavily and creatively negotiated by the successful value builders with an eye on future cash flows, not the widely touted EBITDA multiples. • EBITDA plays a special role in leveraged buyouts. Lenders focus on EBITDA because, if a default occurs, they can force the cash that EBITDA represents to be used to pay down debt and thus enhance their recovery of principal. This is yet another example of an accounting method being useful for the analysis of credit capacity, but only of limited use as a shortcut for valuing equity. 40. Rawley Thomas and Laure Edwards, “How Holt Methods Work: For Good Decisions, Determine Business Value More Accurately,” Corporate Cashflow (Atlanta: Argus Business, September 1993). 41. Bartley J. Madden, “For Better Corporate Governance, the Shareholder Value Review,” Journal of Applied Corporate Finance, vol. 19, no. 1, Winter 2007, pp. 102–114.

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CHAPTER 2

Wealth, Tax Rates, and Income Leaders Who Dig Deeper Can Change the World

“Hell! It’s more than I thought we could get!” said the president after negotiating with Congress, and upon the passage of his tax bill, “This on top of the budget victory is the greatest pol win in a half century.”1 Value-building change is extremely difficult without a common framework and goal.

RONALD REAGAN AND HIS ADVISORS HAD DIFFERENT MENTAL MODELS President Ronald Reagan took office at time when the Cold War was in full throttle. The U.S. economy was faltering. Things were really bad. “Trust but verify” applied to international diplomacy. By the end of his time in office, Reagan had “outspent” the Soviets, contributing to their demise and leading to the destruction of the Berlin Wall. Domestically, his greatest success came from “Reaganomics,” the cluster of economic policies that successfully led to a sustained boom through the 1980s and beyond, despite a chorus of naysayers and critics along the way. Like many advisors to CEOs, Arthur Laffer and a band of other advisors played a critical role in helping Reagan, the nation’s “CEO,” formulate his economic policy vision and stick to it. Laffer’s conversations with Reagan began years before Reagan’s election. Reagan showed a willingness to dig deeper into 47

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economics. After his two terms as governor of California and his failed bid for the 1976 Republican presidential nomination, which he lost to then incumbent President Ford, Reagan arranged a series of luncheons with a young economics professor, Arthur Laffer. The luncheons conducted at the Beverly Wilshire between 1976 and 1980 were instrumental in giving Ronald Reagan the knowledge and confidence to push for substantial tax rate cuts that became the cornerstone of Reaganomics and allowed free enterprise capitalism to triumph.

REAGAN WAS AN ENTHUSIASTIC LEARNER Arthur Laffer recalls: “Reagan really probed with questions. He felt he could have done better as governor of California. He was passionate about the need for a major tax cut and gradually gathered the facts and understanding that would later give him the conviction to resist the pressure to further delay a major federal tax cut. He believed in the incentives and the ‘people effect’ that a reduction in tax rates would provide. Although several ‘intellectual’ detractors considered Reagan a detached ‘amiable dunce,’ he did dig far below the surface on topics he considered to be priorities. Reagan understood but went beyond the hard numbers that accountants suggested would be needed to balance the budget. Reagan studied and understood the history of the Harding-Coolidge and Kennedy tax cuts.” Leaders who attempt turnarounds live in a world of controversy and conflict. They frequently must trade short-term pain for long-term gain. The 1970s was a period of stagflation and deep economic distress for the United States. The Carter administration found and later left behind a general malaise and inability to make any economic progress. In his “malaise speech” President Carter said: “The erosion of our confidence in the future is threatening to destroy the social and the political fabric of America. . . . The symptoms of this crisis of the American spirit are all around us. For the first time in the history of our country a majority of our people believe that the next five years will be worse than the past five years.” 2 In total, the old Keynesian economic policies had not been conducive to growth of the economy, which was on the verge of a recession. The Reagan administration arrived in the White House with a critical

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need to turn the economy around, promote growth, and generate a recovery. Looking back over the decade, the public still felt the sting of wage and price controls, devaluation of the dollar, tax surcharges, lines at the gasoline pumps, a recession in the mid-1970s, and no hint of improvement to come. Inflation was a global problem. The United States was ready for a change. Reagan had a bold four-point plan that few believed or understood because of its magnitude. He was trying to change the “business model” of the United States economy from one of “liberal giveaways” for the poor to one that would increase the nation’s total economic wealth by providing “incentives” to all people for working, increasing the size of the nation’s economic pie. As an actor Reagan had personal experience with high marginal tax rates. He observed that after making one or two successful motion pictures in the same tax year, a successful actor would face the prospect of receiving only six cents after tax on every dollar earned on the next picture. Deferring the picture until the next year or turning down the project was clearly the sensible thing to do. When the star did not work, the result was to put a crew of 40 to 70 support people out of work.3 Reagan’s top reform priority was a major tax rate cut. When Reagan raised the issue of cutting tax rates, resistance to change came from all directions. The pressure to use existing, politically acceptable methods came from Democrats, media pundits, the academic community, and eventually members of his own party and many of his own advisors. Fortunately, he had the confidence to stick with his key priority. The final result was real change in the U.S. economy and the world. This was not a temporary Band-Aid approach, but a true change in the business model for government. Reagan’s approach was consistent with supply-side economics. Although Reagan claims he was not a supply-sider,4 he would cast aside many of the obsolete and inadequate theories of Keynesian economics, such as the Phillips Curve and the preoccupation with a balanced budget. However, the depth to which government computer models were rooted in Keynesian economic assumptions created a pervasive preoccupation with the budget deficit and was a significant factor that slowed the process and made the transition more difficult for Reagan to achieve.

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Reagan ran his failed 1976 primary campaign based on a $90 billion tax rate cut proposal. However, when asked how he would fund it he replied with a simple answer: “Cut waste, abuse, and fraud.” A more limited but ultimately successful form of this tax rate cut proposal would later become law in August 1981 and be named after supporters Kemp and Roth.5 The idea of a major tax cut had been around for years, spearheaded in the early 1970s by former football player and congressional leader Jack Kemp. Kemp’s proposals gained little or no traction with Republicans or Democrats at first. As the economy of the 1970s worsened and Reagan campaigned, introducing tax rate cuts into the debate, the issue struck a note of accord with the average American that was totally unexpected by the Democrats. The promise of new hope and California’s success with Proposition 13 helped put Ronald Reagan into office in 1981 as the 40th president of the United States, but politics requires compromise. If there had to be a cut in tax rates, the political process of concessions would press for the cuts to be phased in over time. That condition was required to get even Republican support. One compromise had occurred earlier to get Bill Roth to become the bill’s Senate cosponsor. Instead of being a one-time 30 percent cut in tax rates, it became 10 percent per year for three years. Shortly after the election, in 1981, Ronald Reagan made an additional “phase-in concession,” much to the dismay of Arthur Laffer. Reagan clearly felt the phase-in was one of many concessions needed to gain support from both parties. He did not realize it would be the major issue it would become. In his speech accepting the Republican presidential nomination in July 1980, Reagan stated: “I have long advocated a 30 percent reduction in income tax rates over a period of three years.” By then, he had accepted the need for the tax rate cuts, but would stick with a phase-in implementation plan.

THE BIRTH OF REAGAN’S TAX RATE CUTS The intellectual roots of tax cuts and supply-side economics are centuries old. The decline of the Roman Empire is attributed by some historians to persistent high taxes. Bruce Bartlett wrote in his 1981 book Reaganomics, “In many respects, supply-side economics is nothing more than . . . Say’s law of markets rediscovered.”6 French

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economist Say had placed the economic importance of stimulating supply of goods and services above demand. Say was even more specific on government taxes, stating in 1834, “It is the aim of good government to stimulate production, of bad government to encourage consumption.”7 Several things happened in the 1970s that boosted supply-side thinking and a growing understanding of the rationale for tax cuts: Application of Keynesian economics consistently failed to resolve the stagflation. • Declining respect for Keynesian economics in the 1970s was accelerated by monetarist thinking, often attributed to monetarist Milton Friedman, who won the Nobel Prize in 1976. • Economists developed more evidence and insights that monetary policy, inflation, and taxation were linked. • Proposition 13 in California sent a powerful message that voters wanted tax cuts to force cuts in government spending, awakening many Republicans who had previously favored program spending cuts to balance the budget. •

In 1968, Robert Mundell, who would later win the 1999 Nobel Prize, and Arthur Laffer began a dialogue at the University of Chicago. Their interest in international monetary policy led them to believe that stagflation was a result of moving away from the gold standard. They developed a two-prong strategy to end stagflation. “Laffer and Mundell said: First, monetary growth needed to be sharply tightened, preferably by targeting the price of gold and reestablishing a de facto gold standard. Second, tax rates needed to be cut in order to restore incentives and increase the demand for money.”8 Their thinking eventually led Laffer to organize a 1974 conference sponsored by the American Enterprise Institute. At this conference on worldwide inflation, Washington policy makers learned from Mundell, Laffer, and others the principles that would later be called “supply-side economics” by some and “voodoo economics” by others. Jude Wanniski, then an editorial writer for the Wall Street Journal, was in the audience. He was hooked on the concepts and wrote the first of several editorials explaining the

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Laffer-Mundell world view. Those editorials and other Wanniski publications would eventually put the Laffer Curve concept and “Time to Cut Taxes” in print and give it wide distribution.9 Also in 1974, Arthur Laffer and Jude Wanniski convinced Congressman Jack Kemp to convert his complex sponsored proposals on taxes to include a 30 percent cut in maximum incremental tax rates. Kemp had resisted until he had separate conversations with Nobel economist Milton Friedman on the subject. After some searching through the Senate to find a cosponsor, they connected with Senator Bill Roth from Delaware. Roth resisted a one-time cut, afraid that there would be a large first-year deficit resulting from the cut. The necessary compromise to keep Roth’s support was to break the program into three separate 10 percent reductions in the tax rates. This was a compromise with unintended consequences. Finally an agreement was in place among the advisors and the legislators, but the program fell short when Reagan failed to win the Republican presidential nomination in 1976. Gerald Ford, the winner, went on to lose the election to Jimmy Carter. In September 1977, the Republican National Committee unanimously endorsed the plan of Jack Kemp.10 From 1976 through 1980 Laffer consulted and coached Reagan to fully familiarize Reagan on the economic issues. Throughout Carter’s administration, the economy sagged, making tax reform even more critical for the future. Leading up to the election, the plan was to phase in the tax cuts relatively quickly: 10 percent just after the election (in December 1980), 10 percent on the day Reagan would take office (February 1981), and a final 10 percent in another six months (August 1981), essentially all completed in under 12 months. Date Changes Can Have Big Impacts By election time in 1980, though, Reagan was forced to make further concessions. The cuts were set at 10 percent/10 percent/10 percent, and the timing was stretched out over three years. Then again to gain broader support in the Congress, the initial tax rate cut was reduced to 5 percent, but the critical indexing of tax brackets to inflation was added. The final form, the Economic Recovery Tax Act (ERTA) of 1981, would schedule the tax cuts of 5 percent/ 10 percent/10 percent to occur in October 1981, July 1982, and July

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1983. This meant that taxpayers would have a cumulative effective tax rate cut of only 1.25 percent in tax year 1981, 10 percent by tax year 1982, 19 percent by tax year 1983, and 23 percent by tax year 1984.11 The time to complete the tax rate cuts had been dramatically drawn out. These seemingly small concessions in the timing of the tax rate cuts are what delayed the “Reaganomics” economic recovery until 1983 and precipitated the great controversy and conflict in the White House in 1981 and 1982. The controversy continued! While most people would agree that tax rate cuts do not work until they take effect, after the second tax rate cut in the series, Republican Senate leader Bob Dole led a charge to kill off the third cut, scheduled for mid-1983. Fortunately, that effort failed, and the economy and stock markets took off on one of the longest bull markets in history. The economic growth in the free world that followed is recognized as one of the key factors that put an end to the Cold War and the fall of the USSR, leading Arthur Laffer to reaffirm his belief: “You don’t win wars with guns, you win wars with economics.” Arthur believed that the inherent logic of supply-side economics dictated that the tax rate cuts should be made quickly, or else participants in the economy would just defer their income, and the economy would recover even more slowly. Except for Laffer, no one wanted to step forward and champion the issue. As a former union president, Reagan had learned to be an excellent negotiator, but he understood that concessions were necessary. At the time the phase-in compromise was agreed on, candidate and presidential hopeful Ronald Reagan did not know the impact of that decision. Later he would learn that “acting sooner” could have saved billions, removed controversy, and reduced economic pain for millions of people. Reagan’s interactive luncheons with Laffer in the 1970s had made a difference in Reagan’s understanding of macroeconomics. His interest in tax rate cuts was strongly supported by Laffer’s then controversial supply-side view. By the time of the 1980 Republican presidential primary, Reagan was much better prepared and more confident on how he would fund his proposed 30 percent acrossthe-board tax rate cut. When Reagan was asked: “How will you fund it?” Reagan replied most emphatically, “What do you mean how will we fund it? A tax rate cut will not be a revenue loser for

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long. It will promote economic growth and actually produce more tax revenue as people get back to work!” Ronald Reagan was an unusual leader who took the initiative to reinforce his own beliefs and took the time to learn by digging deeper into the relationships between economics and taxes. Reagan’s prior experience, which included a bachelor’s degree in economics and sociology, helped him learn, understand, and clearly communicate the significant difference between a “tax cut” and “a tax rate cut.” This subtle difference confuses many people and, without digging deeper, is very tough for even educated leaders to understand, and it is seemingly impossible for others. Digging deeper makes sense on a national and state government macroeconomic level just as it does on the corporate microeconomic level. History shows that complex concepts can be conveyed on a dinner napkin. But it takes willing listeners, patience, passion, tireless repetition, and storytelling to make a difference. As many of us have learned over time, many politicians are not known as willing listeners. The Michigan congressman who was to become Reagan’s budget director, David Stockman, was not motivated to dig deeper into taxes. While Stockman was not trained in economics, he sought a theory of “how the world works,” initially embracing supply-side economics as a means for achieving Reagan’s 1980 seemingly conflicting campaign promises of reducing waste, increasing defense spending, cutting tax rates, and balancing the budget, all at the same time. Most conventional economic and political thinkers of the time did not believe that Reagan’s promises could be fulfilled. Many of the leading Democrats considered him “only an actor,” not a threat and surely the weakest of the Republican candidates as well as the least likely to get elected in the 1980 race for president. This pressure would later push Stockman to favor trading away the tax rate cuts.

TIMING OF TAX RATE CUTS MATTERS During that difficult economic period leading up to mid-1981, Arthur Laffer constantly, as an economic advisor to Reagan, made strong arguments: for maximum effectiveness, the tax rate cuts must be implemented at one time, or it would result in a delay in economic recovery. A three-year phase-in would cause major

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problems. He repeatedly emphasized his belief that phasing in successive 10 percent per year cuts in marginal tax rates in 1981, 1982, and 1983 would defer any significant enhancement in tax revenues until after the final cut in rates in 1983. In testimony before the House Ways and Means Committee in the 97th Congress (first session), Laffer tended to be conservative and said it could take 10 years for the Reagan tax cut to pay for itself.12 His line of reasoning was repeated hundreds of times in 1981 as confidence in Reagan’s tax-reform package was questioned and the economy remained in the doldrums. Arthur’s story later appeared in print in a December 1981 Barron’s article after Stockman’s insider doubt of Reagan’s tax rate cut program surfaced in November 1981 in the December Atlantic Monthly. 13,14 The logic was clear; people are smart. Consider the “people effect.” Laffer reasoned and argued that taxpayers would plan and defer their income until 1983 to receive maximum advantage from the tax rate reductions. As a result, 1981 and 1982 would be great years for high-income taxpayers to take losses. These taxpayers would push income into 1983 or 1984, where income would be burdened by the lowest tax rates. Laffer passionately argued that the economic recovery would be delayed because the tax cuts were phased in. Reagan believed this was so and, in his communications to the public, cautioned the people of the United States that the improvements would not be immediate but “would take time.” While most of the president’s other close advisors understood Laffer’s arguments, none were prepared to support compressing the timeline on the tax rate cuts to a single event. They understood the logic, but they just didn’t believe the plan would work. At the same time, Laffer could not prove that the plan would work, as there were only two historical examples of major tax rate cuts: Harding/Coolidge and Kennedy. Fortunately, both yielded good results, but the economic record was cluttered with the impact of other events and market forces.

THE REAGAN TAX CUTS WERE DELAYED BY THE MISINFORMED In August 1981, after much behind-the-scenes drama as just described, President Ronald Reagan signed into law the Economic Recovery Tax Act (ERTA, also known as Kemp-Roth). ERTA slashed

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marginal earned income tax rates by 25 percent across the board over a three-year period. This was significantly below the original goal to reduce rates by 30 percent in about nine months. The highest marginal tax rate on “unearned” income dropped to 50 percent from 70 percent immediately—the Broadhead Amendment—and the tax rate on capital gains also fell immediately from 28 percent to 20 percent. The bill has had dramatic long-term impact because it also indexed the tax brackets for inflation, providing future relief to taxpayers who had been harshly penalized by bracket creep during the stagflation years of the 1970s.

EFFECTIVE LEADERS OVERCOME CONFLICT In November 1980 Ronald Reagan was elected president. Before the January 20 inauguration, the newly appointed head of the Office of Management of the Budget (OMB), Stockman, started working on the budget and became convinced that there was a big hole that could not be covered without a huge deficit. His views were conditioned by a basic ideology which included a passion for cutting costs and waste in government above all else. The Keynesian-based budget models helped him press for budget cuts, because they frequently projected future tax revenues that never materialized and gave little or no room for assuming any positive economic results from tax rate reductions. Stockman quickly forgot Reagan’s campaign promises and went back to the old way of thinking: cutting federal spending programs to balance the budget. (The corporate analog is focusing strategy on a cost cutting and placing no emphasis on innovation, experimentation, and building revenues.) Stockman’s fixation on cost cutting basically ignored any hope for any impact from the revenue side of the equation. Stockman’s intense fixation on the annual budget undermined Reagan’s whole concept of tax rate cuts eventually paying for themselves and eventually reducing the deficit. This was the idea that Reagan carefully understood, studied, finally accepted, and made a priority in his economic recovery plan. In Reagan’s February 5, 1981 address to the nation, two charts were used. The first chart showed Stockman’s $80 billion deficit. The second chart showed that after some time the “people effect” of the tax reduction would boost economic growth and increase tax

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revenue, resulting in a balanced budget in around 1983 or 1984. Despite President Reagan’s confidence in his proposed tax rate cuts and his practical way with words, not many politicians believed in the second chart. Stockman referred to it as the “rosy scenario.”15 Except for Laffer, not even the majority of Reagan’s very own staff believed it. Why didn’t Reagan merely push past his staff and Stockman and go with the tax cut? It was not that easy. Let’s go behind the scenes. Reagan was a movie hero. He was a natural charismatic leader, but putting together a cabinet of advisors proved more like running a zoo.16 Reagan’s ideas to turn around the economy were bold but unproven. To him his reform package seemed more like common sense than supply-side economics.17 Many cabinet members valued spending cuts more than the tax rate reductions. Then Vice President Bush, who had campaigned against Reagan in the 1979 Republican primary, called Reagan’s economic reform program “voodoo economics.” Jim Baker, George H. W. Bush’s primary campaign manager and chief of staff of the Reagan cabinet, eventually came to believe in supply-side economics, but was originally skeptical. George Schultz was chairman of Reagan’s Economic Policy Advisory Board until he became secretary of state in July 1982. Formerly a cabinet member, advisor to Presidents Nixon and Ford, and dean of the University of Chicago Graduate School of Business, he was one of the few high-level supporters of Laffer’s vision of the tax rate cuts. President Reagan encouraged debate among his cabinet officials, yet after listening, he would make his own decisions. The open debate would often result in raised voices and a rare consensus. High-ranking cabinet members and their more traditional advisors were convinced that Reagan just “did not get it” as the economy plunged into recession in 1981–1982. One can imagine the confusion on Reagan’s economic plan among the advisors, many of whom had little formal training in economics. The opinions were diverse and in conflict: “It must be a phase-in, or Congress will never buy it.” • “How do we know it will work? If we do a phase-in and something goes wrong, we can stop the process before too much damage is done.” •

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“The budget is the only issue; we should be cutting the budget to repair the deficit, not cutting taxes.” • “We must ‘feed the beast’; federal programs will never be cut; we dare not put those at risk, or again, Congress will never buy it.” •

Unfortunately, all of these lines of reasoning focused on budget and arithmetic “numbers effects.” Even those who had believed in the logic that cutting tax rates would ultimately boost tax revenue in the long run were still concerned that it might not work. Two of the players were at opposite ends of the spectrum. Arthur Laffer, chief economic advisor and Reagan’s close friend, had argued throughout his many meetings with Reagan since the 1970s that tax rate cuts would lead to economic growth and would eventually be self-funding. Stockman, head of OMB, although not a trained economist, constantly questioned Laffer’s economic wisdom and continually pressed for budget cuts. Stockman’s commitment to cutting the budget and reducing fraud, waste, and abuse became his primary commitment when considering the tax rate changes. Stockman thought tax rate cuts were great campaign rhetoric but only a “Trojan horse” that might help get Reagan elected and would eventually be traded away to get budget cuts. Baker, Darman, and Dole initially echoed Stockman’s concerns. The growing criticism of Reagan’s plans was both public and private. Fortunately, Reagan was a true believer in tax reform. Only President Reagan, Arthur Laffer, Reagan’s speechwriters, and a few of the people in the Treasury Department had remained committed to supply-side economic principles. Stockman secretly thought they were all telling lies like “typical politicians” to gain political advantage. Many of the others just didn’t believe that a tax rate reduction would lead to an increase in tax revenues and that “Reaganomics” would actually work. It was a time of great controversy. One by one, then Vice President Bush and other presidential advisors, Dole, Baker, and Darman, all lined up in the Stockman camp. All were afraid of the prospect of supporting a new idea that they believed would fail. The typical formula for dealing with deficits was to cut and tighten the nuts and bolts of the budget and throw on more taxes to close the gap. In this case, though, Laffer

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had reinforced the conviction and personal experience of Ronald Reagan the man, the former governor, and the former actor. Laffer, though, had his supporters. By 1981, all the evidence was available and in print. George Gilder (1981), Jude Wanniski (1978), and Bruce Bartlett (1981) had written extensively in support of the supply-side principles. This was not a political contest; this was a matter of the cold hard facts of the “new” supply-side economics and data, but it was clearly a new and yet not widely accepted view or model of “how the world works.”18 Stockman’s budget models did not reflect this new thinking. The debate raged on. In the minds of critics, there were real risks that the supply-side fix would not work. The classic view that tax rate cuts produce deficits and deficits produce inflation was widely held and ingrained in many. On the other hand, the stagflation of the 1970s had proven that the best Keynesian minds could not explain or fix the economic problems that were holding the economy back. National economic outcomes involve the decisions of millions of people, and the incentives in the system are the drivers of the outcomes. Economists debated and disagreed widely on just how the changes in the economy might play out. The supply-siders clearly indicated that a tax cut could and would eventually save the day. However, it would take time to work. As the recession deepened in 1981–1982, it was time for real decisions to be made. The Keynesian economic policy tools of the past had burned out. They simply did not explain the economic results of the 1970s. They consisted of a variety of short-term Band-Aids, treating symptoms, but with no real understanding of the underlying causes of the problems. The paradigm followed by politicians was one of compromise and hair splitting. Since the 1960s, a downturn in the economy would produce increases in unemployment. The response would be to increase government spending and raise tax rates, with the hope that the increase in spending would return the economy to health and that the increased tax rates would keep the program from producing deficits. Unfortunately, this became a one-way street, culminating in the dramatic inflation of the late 1970s. Volcker’s monetary policy had come forward in the late 1970s to alleviate problems associated with the meltdown of the gold standard and the end of fixed exchange rates, but measurement issues

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and controversy over lag times still clouded the record. The times called for a better diagnosis of the problems and untried solutions. No politician wanted to be out on a limb championing a cut in tax rates, causing a huge deficit, and then being pilloried in the press and skewered by the opposition when he was found to be wrong. Most seemed to think it was better to take a low profile and “safe” course of action. This attitude hung like a thick fog in the Oval Office.

INTRIGUE—WHAT REALLY CAUSED THE 1981–1982 RECESSION?

Stockman, Baker, Darman, and Dole were among those calling for the delayed phase-in of the Reagan tax rate reductions. The economy was “tanking.” In the White House, it was tough. It was frustrating. They all wanted to blame Paul Volcker for tight money and say that that was the problem. Instead, it was the delay of the tax rate cuts that caused the recession. But only a limited few would believe it. In a typical, unfortunate governmental compromise, a new policy was tacked onto the back of a correct policy that had not had time to produce results. The delaying action canceled out the value of the tax rate cuts and exacerbated the problems. In 1979, Paul Volcker, chairman of the Federal Reserve Board, had embarked on a bold and appropriate program of monetary restraint, which would have set the economy free of inflation. By tuning the money supply through a “price rule” to stabilize commodity prices, Volcker was essentially balancing the demand and supply of money in the economy. The two-pronged solution about which Mundell and Laffer had written in the early 1970s was being tested and was working. First, monetary growth needed to be sharply tightened. Volcker had put that in place, and now, in 1981, tax rates were being cut in order to restore incentives and increase the demand for money. Keynesians resisted the logic and debated the results. History vindicates the decision to cut the tax rates, but the timing of the cuts was flawed.

Stockman originally hoped that the announcement of Reagan’s tax rate cuts and better control of monetary policy would provide the solution. He thought market expectations about the future would produce a huge bull market beginning in April 1981,

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but by May it had not materialized. It looked like inflation would continue. The projections coming from the models in the “nonpartisan” Congressional Budget Office (CBO) predicted continuing deficits through 1984.19 The drama heightened after President Reagan was shot by John Wayne Hinckley on March 30, 1981, barely two months into his term.20 After surgery and a fairly rapid recovery, there sat President Reagan, recovering from nearly fatal wounds, his normal aura of optimism greatly dimmed. He had become mortal only 70 days after his inauguration. Many felt that the economy was in a tailspin, and his chorus of advisors was clearly singing off-key to different tunes. Arthur Laffer recalls: “The interpersonal dynamics were really tough. The president, George Schultz, and I were the only ones who really believed the tax cut would eventually stimulate growth in tax revenues. Fortunately the president did not weaken to the pressure of other ‘deficit obsessed’ advisors. This is despite continuing bad press, personal attacks, a major recession, and the stress of being shot.” When advisors and legislative leaders failed to come together to clearly support the tax rate cuts, Reagan took to the airwaves for public approval. As governor of California, Reagan had used this approach, forcing politicians to respond to the people’s cry for tax relief. President Reagan appeared on network television in April 1981 to rally support for tax rate cuts, fiscal controls, and balanced budgets. The public acceptance of Reagan’s message was overwhelming. Phone calls and letters flooded into Congress. Meanwhile Stockman continued to work against Reagan’s main priority. In May 1981, an overly confident Stockman proposed a plan for Social Security against overwhelming opposition from Democrats. He pressed for Reagan to go on TV and say that without change, the Social Security system would go bankrupt, but the White House advisors and the president disagreed. Stockman reverted to old-time political trading to get closer to the $41 billon in budget cuts he considered necessary. Despite all his efforts he only got $35.1 billion in cuts and lost credibility with many important government officials in the process. Stockman’s role in the argument shows how bitter the controversy finally became. His behind the scene actions became public in

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November 1981, when his series of periodic “off-the- record” conversations with Washington Post reporter William Greider were published in the December 1981 Atlantic Monthly.21 The result was that Stockman was “taken to the woodshed” by President Reagan for publicly airing his skepticism about many administration programs. Stockman apologized to Reagan and claimed a breach of faith by William Greider. Reagan did not fire Stockman despite the pressure to do so by many in his inner circle. After that episode Stockman was banished from the inner circle, serving in a perfunctory role until he took a position on Wall Street in 1986.22 According to Reagan: “He was one of the first on our team to begin clamoring for a tax increase, long before the tax cuts had had a chance to begin working their effect into the economy.”23 Reagan understood that political inertia would make it extremely difficult and time consuming to cut specific programs. In the president’s mind budget cuts were secondary in priority. His vision was for reducing tax rates and increasing defense spending to boost the economy and the position of the United States in the world. The core of the program would remain intact. However, it would contain the flaw that Laffer had argued against, the phase-in. Stockman would not be able to trade away the tax rate cuts, nor would he waste resources battling for more programmatic cuts, but the phase-in of the tax rate cuts remained. What Stockman failed to understand is how people respond to tax rate changes that are announced but not yet in effect. The bull market that Stockman had predicted in April 1981 finally took hold, but not until the final phase of the tax rate cuts went into effect in 1983. Just as Laffer had argued, the economy would remain in recession until taxpayers could take advantage of the full cuts in tax rates. At last, the supply-side predictions anticipated and discussed by Arthur Laffer and Ronald Reagan, dating back to the mid-1970s, were paying off. The rest is history. The story is still the subject of politically charged debate. But the facts tell us that the tax rate cuts, once they finally went into effect, triggered the beginning of one of the greatest economic expansions in the history of the U.S. economy. Had the three-year phase-in of the tax cuts been faster, the pain and the length of the 1981–1982 recession might have been reduced. See Appendix 1 for a graphic history of the dramatic change in results after 1983.

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Despite all the resistance, why was Reagan able to push the tax rate plan through? Reagan had personally experienced the effect of obscene marginal tax rates while he was in the movie industry. Laffer had the passion to dig deeper into the depths of the data and economic reasoning. Laffer had some very influential people—Friedman and Mundell—to think through the alternatives and test ideas. They discarded Keynesian myths and sought to understand how the economy would react to tax rate cuts based on the few previous examples of “tax rate” cuts that existed. The Kennedy and Coolidge tax rate cuts held valuable and crucial lessons for the United States, if only other leaders could be convinced to set aside their politics and preconceptions. The role of monetary policy, and the “price rule” that Volcker had implemented, was a critical element that was not well understood. Top value builders dig deep enough into the data to improve their understanding of how people react to economic incentives, such as tax rate cuts. Fortunately for the free world, President Reagan was a value builder.

COMMUNICATING CLEAR GOALS AND PRIORITIES IS CRITICAL TO SUCCESS Clear goals and priorities are important. Reagan’s four-point program for economic recovery had to be prioritized for the short and long term. It included cutting tax rates, controlling the money supply to control inflation, building the nation’s defenses to challenge the Russians, and reducing government spending. As in many complex organizations, the multiple goals seemed to be in conflict. The common wisdom then was to focus on a simplistic goal, short-term budget cuts. Reagan had a long-term vision that put economic growth and national defense ahead of obsession over the budget deficit. Reaganomics worked miracles. The United States won the Cold War as a result of economics, not guns. Its basic concept was simple, but not simplistic: provide incentives for growth. Supporting the supply-side message with facts, Arthur Laffer explained why balancing the budget is not the key factor in a turnaround. In fact, obsession with balancing the budget may be completely counterproductive. Putting America back to work, building

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the national defense, and beating the Soviets were Reagan’s priorities and his overarching long-term goals. Many leaders have self-doubt, but Reagan used his doubts to dig deeper to push himself to improve. Reagan was schooled as an economist and a sociologist, but his personal experiences as an actor, a union leader, and later a spokesperson and motivational speaker for General Electric provided him with a powerful ability to understand and communicate to all audiences. His communication techniques worked well for him as governor of California and as president. Reagan believed that he could have done a better job as governor of California. Although he became the oldest president to take office at 70, Reagan kept searching for ways to improve. Timing matters for politicians. The third year of a four-year term of office is sacrosanct. A politician must perform flawlessly and save ammunition to get reelected. Fortunately for Reagan, the economy began to turn around just as he promised in 1983, leading to the longest run of economic growth in U.S. history. He was reelected in 1984 for a second term by a record margin in a huge Republican victory. The people spoke!

YOU CAN’T “BUDGET CUT” YOUR WAY TO WEALTH In the long run, a successful economy should result in a balanced budget. Government exists in the United States to serve people, not to serve accounting balances. It is only common sense that the security of the country and the welfare of the public should not be sacrificed to some sort of accounting rule like balancing the budget. We might never have fought in WWI or WWII if the accountants ruled. Both wars put the nation deep in debt but eventually helped protect our future and build tremendous wealth for the people of the United States.

MYTH: A BALANCED BUDGET IS ALWAYS BEST FOR THE NATION It is always better for the economy to have low unemployment, low interest rates, and high economic growth to create wealth rather than forcing a balanced budget in the short term!24 Individuals

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are used to the idea that they can borrow to buy a house early in their careers. They create a deficit, which is made up over time. Similarly, governments may find from time to time that promoting long-term growth will require a short-term deficit. (See Appendix 1, Figure A1.9.) National leaders should not automatically defer to economists or accountants on decisions. But it would be just as dangerous to not listen to strong advisors who have a true comprehension of reality and the data to back it up. Yet the debate continues to this day on how and when to balance the budget. Crisis is usually needed to change opinions, but that is not necessary if the correct metrics are used. Arguments continue about how to choose the right metric for deficits and the budget. It is not a meaningful comparison to cite a “record budget deficit” in dollars if the deficit is a smaller percentage of national income or smaller in inflation-adjusted terms. However, the facts are frequently distorted by politicians and the press who are seeking to win arguments or make headlines instead of seeking a viable way to measure the economy.

POLICY MISTAKES CAUSE STOCK MARKET CRASHES

Unfortunately, growth comes in fits and starts. Many of us baby boomers recall that despite the success of Reaganomics, the stock market crashed in October 1987. After the boom of the Roaring Twenties we had the great depression. After the prosperity of the 1960s we had stagflation in the 1970s. When we look at the data, we see that policy mistakes have been made that caused or contributed to significant declines in wealth and value. The boom of the 1990s was followed by the recession of 2001. Chapter 8 addresses some of these examples. Top value builders dig into the data. They communicate priorities clearly, and they recognize that arrogance limits communication. They do not allow accountants or economists to run things. “Budget czars” are typically accountants. A country cannot budget-cut its way to wealth! Leaders must take care of customers in the short term or there will not be a long term. Long-term vision is critical to counteract short-term thinking among the leadership team.

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Major decisions in government are made long before the votes are taken. Individual votes are gathered in the back rooms and through hundreds of personal discussions. The focus on people who can swing the majority of votes is intense, and concessions usually need to be made, but unintended consequences of those concessions may negate the original intent of the needed change. Clear initiatives frequently get clouded or watered down, and facts get lost in negotiations because of a perceived need to find common ground among disputed facts. The parallel in the corporate world is when CEOs push their long-term strategic goals aside in favor of short-term earnings per share goals, ceding their decision authority to outside analysts and traders. As a result of the great Reagan economic experiment and the supply-side innovations that it used, politicians should have learned that marginal tax rates have a major effect on behavior at all levels. Low marginal tax rates—especially the top rates—help promote the economic growth that affects the wealth of people at all economic levels. Even a reduction of corporate taxes rates helps the poor. Despite the data, political advisors of both parties fail to understand the data and look for different explanations. They dig deeper sometimes for the wrong reasons, not always for truth, but to support their personal points of view or a political agenda. They often forget about enlarging the size of the “wealth pie” because they spend all their time arguing how the pie should be split.

SIMPLE BACK-OF-NAPKIN CONCEPTS TAKE TIME TO TAKE HOLD Arthur Laffer began using the concept of the Laffer Curve in his macroeconomic classes in the very early 1970s at the University of Chicago. But the Laffer Curve did not gain wide public awareness until 1978. Jude Wanniski told the story of how the Laffer Curve got its name in a 1978 article in The Public Interest titled “Taxes, Revenues, and the ‘Laffer Curve.’” At the time, Wanniski was an associate editor of the Wall Street Journal. In December 1974 Wanniski had been invited to have dinner with Arthur Laffer (then a professor at the University of Chicago), Don Rumsfeld,25 and Dick Cheney26 at the Two Continents Restaurant in the Washington Hotel in

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Washington, D.C. While discussing President Ford’s “WIN” (whip inflation now) proposal for tax increases, Arthur supposedly grabbed his napkin and a pen and sketched a curve on the napkin illustrating the trade-off between tax rates and tax revenues. Wanniski named the trade-off “the Laffer Curve,” and the title stuck. The Laffer Curve itself does not specify whether a particular tax rate cut will raise or lower tax revenues. Revenue responses to a tax rate change will depend upon the tax system in place, the time period being considered, the ease of moving into underground (nonreported, thus nontaxed) activities, the level of tax rates already in place, the prevalence of legal and accounting-driven tax loopholes, and the motivation of the people affected. If the existing tax rate is too high—in the “prohibitive range” shown in Figure A2.1—then a tax rate cut would result in increased tax revenues. The people effect of the tax cut would clearly outweigh the numbers effect. Over the past 100 years, in the United States there have been five major periods of historic tax rate cuts: the Harding/Coolidge rate cuts of the mid-1920s, the Kennedy rate cuts of the mid-1960s, the Reagan rate cuts of the early 1980s, the Clinton rate cuts in the mid-1990s, and the George W. Bush rate cuts in 2002. Each of these periods of tax rate cuts was remarkably successful in terms of virtually any public policy metric. (See Appendix 2 for a deep dive on tax rates.) The political lesson that should have been learned way back in 1981 is that a presidential administration must seek balance. It will lose if it tries to eliminate basic programs, curtail the services that government should provide, or slice and cut out broadly popular programs.27 There is a constant tug-of-war over resources. A good example is recorded in Reagan: A Life in Letters. In 1983, Reagan responded to Laffer’s questioning of Reagan’s support of a 5 cent tax on gasoline (4 cents for highways and bridges and 1 cent for mass transit). In his letter Reagan wrote: “I realize it is a tax and yet I would never have held still for that as part of a tax package simply to raise revenues.” He went on to explain his approach for a supposedly short-term tax. “I agreed to the tax as purely a user fee for the purpose of restoring the [transportation] system and that it would expire once that was done. If I’m still around I’ll see that it does.” In the 2003 publication,

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the author notes that Congress never allowed the gasoline tax to expire, and had even added to it since then.28

CHANGE HAPPENS IN FITS AND STARTS WITH EXPERIMENTS

If this all makes perfect sense, why is it so hard to convey these concepts to many political leaders? The road to wealth creation has many ups and downs. When measuring the nation’s wealth by looking at the stock market, it is easy to get distracted by short-term changes. Because the market values of stocks are based on future expectations, values can change radically whenever expectations change. Even experts disagree until there are rock-solid data to prove a principle or theory. It sometimes takes decades to get points across. Although supply-side concepts are now widely accepted, supplyside economics was derided by critics as “voodoo economics” for years. The epithet is still being used by some who try to politicize supply-side economics. They do not accept the fact that it has become part of the mainstream (while they have not!).

THE STORY IN THE STATES: TAX RATES AFFECT STATE WEALTH AND MIGRATION California has an extremely progressive tax structure which lends itself to classic Laffer Curve types of analyses. During periods of tax rate increases and economic slowdowns, the state’s budget office almost always overestimates revenues because it fails to take into account the economic feedback or people effects incorporated in the Laffer Curve analysis (the people effect). Likewise, the state’s budget office also consistently underestimates revenues by wide margins during periods of tax rate cuts and economic expansion. The consistency and size of the misestimates are quite striking when the data are plotted. Budget directors often fail to anticipate the people effect. Figure 2.1 demonstrates that the California state budget directors consistently fail to take the people effect into consideration. While it is difficult to estimate the people effect, that does not justify ignoring it. For example, in 2001–2002 the tax rate was increased and budget revenues were overestimated by $13 billion, or 20 percent.

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California General Fund Revenue (Plus Transfers): Forecast versus Actual (in billions of dollars) $85

$85 Current and upcoming year revenue forecast Actual revenues

$75

May 2003 revision January 2003 budget

$65

Pete Wilson’s tax increases

$55

Temporary tax increases removed

$65

$55

Wow! a 20 Percent error

$45

$75

$45

$35

$35 Overforecasted revenues

$25

Underforecasted revenues

Overforecasted revenues

$25

87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 Year of January budget forecast for current and upcoming fiscal year Revenue estimates as of

Actual

January 2001 May 2001 January 2002 May 2002 January 2003 May 2003

2000–2001 revenues 2001–2002 revenues 2002–2003 revenues 2003–2004 revenues

$76.9 $79.4

$78.0 $74.8

$77.1 $79.3

$73.8 $78.6

$73.1 $69.2

$70.8 $70.9

$77.6 $66.1 $70.9

Figure 2.1 California budget directors fail to anticipate people effect

properly Source: Arthur B. Laffer, “The Laffer Curve: Past, Present, and Future,” Laffer Associates research paper, January 6, 2004.

They used arithmetic but apparently did not consider the people effect.29 In the wake of 9/11/01 and the recession that followed, 2003 was a unique period in state history given the degree to which the states, almost without exception, all experienced budget difficulties, so it does provide a good opportunity for comparison. As you might expect in this illustrative example, those states with high rates of taxation had greater problems than those states with lower tax rates. California, New Jersey, and New York, three large states

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with relatively high tax rates, were among those states with the largest budget deficit gaps.

STATE TAX RATES AFFECT STATE ECONOMIC HEALTH Over the years, Laffer Associates has chronicled the relationship between tax rates and economic performance at the state level. This relationship is more fully explored in the Laffer Associates State Competitive Environment model. As you might expect, the 10 states rated best by the model have outperformed the bottom 10 states in each category examined. Using a proprietary methodology, Laffer Associates computes an overall ranking for each state according to the impact that state taxes have on corporations and individuals. One factor, the incentive rate for a state, represents the value of a dollar produced, after passing it through the state’s major taxes. This incentive rate is combined with a measure of the trend of the taxes in the given state. Thus the best state would have low and falling taxes, and the worst would have high and rising tax impacts. Figure 2.2 compares as of 2005 the 10 best states and the 10 worst states, based on personal income tax rates and 10 years of economic performance history from 1995 to 2005. The measurement includes income growth, employment growth, unemployment, and population growth. The 10 best states have outperformed the bottom 10 states in each category examined. Notably, this is a dynamic analysis, which takes trends into account. A given state that makes significant changes can improve its ratings from one year to the next.

THE LAFFER CURVE APPLIES INTERNATIONALLY The flat tax revolution has accelerated globally, with flat tax regimes increasing from 3 in 1987 to 18 in 2007.30 Despite decades of criticism as a short-term fad, the growing number of regimes is producing more evidence of the efficacy of flat taxes. When Russia and other large Eastern European nations adopted flat taxes, opponents had to concede that flat tax regimes

Lower Taxes, Higher Growth: Personal Income Tax Rates (PIT) versus 10-Year Economic Performance, 1995 to 2005 (current tax rate versus performance between 1995 and 2005, unless otherwise noted)

Top PIT rate*

Gross state product growth

Personal income growth

Personal income per capita growth

Population growth

Net domestic in-migration as a % of population

Nonfarm payroll employment growth

Unemployment rate, 2005

Alaska Florida Nevada New Hampshire South Dekota Tennessee Texas Washington Wyoming

0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%

72.7% 94.2% 122.1% 75.9% 71.8% 64.4% 95.5% 73.5% 102.6%

53.3% 79.1% 120.8% 75.6% 70.5% 64.4% 86.4% 71.5% 83.5%

39.6% 46.4% 44.6% 55.2% 62.1% 46.9% 54.6% 49.5% 74.8%

9.8% 22.4% 52.7% 13.2% 5.2% 11.9% 20.6% 14.7% 5.0%

⫺3.9% 8.9% 20.5% 6.0% ⫺1.8% 4.3% 2.1% 3.1% ⫺2.0%

18.2% 30.2% 55.7% 17.7% 13.5% 9.8% 21.3% 18.4% 19.9%

6.8% 3.8% 4.1% 3.6% 3.9% 5.6% 5.3% 5.5% 3.6%

9 states with no PIT**

0.00%

85.8%

78.3%

52.6%

17.3%

4.1%

22.7%

4.7%

9 states with highest marginal PIT rate**

9.45%

65.0%

61.2%

50.0%

7.4%

ⴚ2.2%

12.4%

4.8%

Hawaii Maine Ohio New Jersey Vermont Rhode Island Oregon California New York

8.25% 8.50% 8.88% 8.97% 9.50% 9.90% 10.25% 10.30% 10.50%

48.3% 58.1% 47.8% 59.0% 69.7% 73.3% 83.2% 80.1% 65.4%

47.2% 64.9% 47.7% 63.1% 67.9% 64.7% 64.7% 74.7% 55.5%

38.1% 55.2% 44.4% 51.2% 58.7% 55.7% 44.0% 53.3% 49.6%

6.5% 6.3% 2.3% 7.9% 5.8% 5.8% 14.3% 14.0% 3.9%

⫺6.5% 3.7% ⫺2.8% ⫺4.2% 1.0% ⫺1.9% 4.7% ⫺3.5% ⫺10.1%

13.0% 13.6% 4.0% 12.3% 13.0% 11.7% 17.0% 19.0% 8.1%

2.8% 4.8% 5.9% 4.4% 3.5% 5.0% 6.2% 5.4% 5.0%

*Highest marginal state and local personal income tax rate imposed as of 1/1/06 using the tax rate of each state’s largest city as a proxy for the local tax. The effect of the deductibility of federal taxes from state tax liability is included where applicable. New Hampshire and Tennessee tax dividend and interest income only. While Hawaii and North Carolina both impose the same top rate. Hawaii is included in this “nine highest” category due to a much lower top bracket. **Equal weighted averages.

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Figure 2.2 State taxes and regulations affect economic health Source: Copyright 2008 Laffer Associates, reprinted with permission.

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were feasible, but they rationalized that tax reform worked only in transition economies. Those criticisms are contradicted by Hong Kong, one of the world’s most robust economies, where flat taxes have been in force since 1947. In addition, Iceland now demonstrates that a country with a stable modern democracy can also usher in flat taxes. None of the flat tax nations have returned to a discriminatory (“progressive”) rate structure. The most recent threats to single-rate regimes came in Russia in April 2007, but lawmakers overwhelmingly rejected a proposal to return to a progressive system. (Almost one-third of Forbes’s 226 billionaires live in Moscow.) Notwithstanding faulty analysis from the International Monetary Fund (IMF), the flat tax seems remarkably resilient. Even the IMF writers recognize, “the number of countries adopting flat tax reforms, in which the single income tax rate chosen is low, is likely to increase over the years.”31 The favorable facts are there: “The experience in Russia . . . reduction in top marginal rates from 20% and 30% to 13% [flat], was followed by an increase in real revenues from the [personal income tax] of nearly one-quarter.”32 Despite this success, the IMF continues to speculate that some future “significant fiscal strains” may cause some countries to abandon the flat tax approach.33 In general, countries that have implemented the flat tax have enjoyed rapid economic growth and healthy revenue increases. While the flat tax has a growing level of support, it is not a cureall for every economic ill. To maximize the economic benefits of tax reform, a nation should have the rule of law, property rights, sound money, limited government, and low levels of regulation. In such an environment, a flat tax ensures that the tax code will not be an obstacle to growth. In a country such as Russia, as long as people worry about arbitrary expropriation by the government, flat taxes alone will not be enough to guarantee that citizens feel confident about investing in the nation’s future. This will dampen the realization of the potential benefits of the Russian flat tax. More nations will adopt flat income taxes, likely choosing low income tax rates. Countries with flat tax systems will probably shift to lower rates to keep competitive. The global shift to flat taxes means more growth in more nations. A flat tax does not guarantee

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robust economic performance, but it does mean that the tax code will be less of an impediment to productive activity.

SUMMARY AND CONCLUSIONS Need we say more about tax rates and tax revenue? Despite the evidence and the growth in application of Laffer Curve concepts, many politicians are reluctant to even experiment with tax rate reductions to promote wealth creation. As we discuss in Chapter 4, politicians have little incentive to change. Most political bodies, including those in the United States, are not maximizing their ability to create wealth. By providing better incentives to their citizens and eliminating disincentives from high tax rates, they could increase wealth. Much of the world still lives in the “prohibitive range” of the Laffer Curve. The global growth of flat taxes is a step in the right direction. Since the invention of governments, people have acted to avoid high tax rates. People even migrate over the long run to reduce their tax burdens. Remember that “tea party” in Boston around 1776! In this chapter we describe some of the complex issues and people problems that effective leaders learn to deal with to improve economic health and performance. As a result of their leadership, economic growth leads to increases in individual and corporate wealth. The United States from 1983 to 2007 is a perfect example of tremendous wealth creation despite a few bumps in the road. People in free markets do not work, consume, or invest just to pay taxes. In politics continuing misunderstandings of big-picture macroeconomic principles often lead to reductions in national wealth and value. Top value builders find ways to get people to work toward the same goals, despite enormous difficulties and ideological differences. In the 1980s, convincing top decision makers to adopt new thinking on wealth creation for the U.S. economy was a major challenge. The great renewal that occurred during the Reagan presidency was an example of how top value builders persist and make a difference. This story clearly demonstrates the drama of conflicting interpretations of data and misconceptions about economic theory. To create wealth, leaders must dig deeper and communicate well to resolve conflicts. Some of the conflicts arise because many

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politicians choose their facts to justify their points of view or political agendas. Real change happens erratically. When old theories fail to provide solutions, new theories emerge. Supply-side economics emerged when Keynesian and monetarist methods fell short. The Laffer Curve explained why higher tax rates do not automatically result in higher tax revenue, but always result in less of the taxed activity. Taxes and tax rates create powerful incentives and disincentives. While multiple examples of productive tax policies exist, the passion of many politicians makes them blind to change and causes them to make obvious blunders that cost their economies billions and erode individual opportunity and incentives. Reaganomics was consistent with supply-side economic thinking. The ideas that were finally communicated to the public were simple: “Cutting marginal tax rates makes people more willing to work, because, on the margin, they keep more money. More people working can mean more tax revenues. The payers of taxes and those who depend on government expenditures both benefit.” This back-of-a-napkin description was simple and powerful. The digging that led to the justification of the decision was not. It took years to get the message across, yet many political and public leaders still fail to understand the true drivers of wealth in national economics. The concept is misinterpreted by many. It is not only how the pie gets divided that matters. True wealth creation involves placing the highest priority on reducing the disincentives and setting tax rates to make the pie bigger. Top value builders marshal support for increasing the size of the pie. While supply-side thinking was considered radical “voodoo economics” 30 years ago, it has gained its place in mainstream economic thought. Supply-side thinking also offers new approaches and solutions to corporate problems.

NOTES 1. Douglas Brinkley, ed., The Reagan Diaries (New York: HarperCollins, 2007), pp. 21,34. 2. Jimmy Carter speech: “Energy and the National Goals—A Crisis of Confidence, July 15, 1979. http://www.millercenter.virginia.edu/ scripps/digitalarchive/speeches/spe_1979_0715_carter.

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3. An American Life: Ronald Reagan, the Autobiography (New York: Simon & Schuster, 1990), p. 231. 4. Ibid. 5. The Kemp-Roth Tax Cut [officially the Economic Recovery Tax Act of 1981 (ERTA), Pub. L. No. 97-34, 95 Stat. 172 (August 13, 1981)]. 6. Bruce Bartlett, Reaganomics: Supply-Side Economics in Action, 2nd ed. (New York: Morrow/Quill, 1981). 7. Jean-Baptise Say, A Treatise on Political Economy, 6th American edition (Philadelphia: Grigg & Elliott, 1834). 8. Bruce Bartlett, “Supply-Side Economics: ‘Voodoo Economics’ or Lasting Contribution?” Laffer Associates, November 11, 2003, p. 11. 9. Jude Wanniski, editorial, Wall Street Journal, December 11, 1974. 10. From: http://www.wanniski.com/showarticle.asp?articleid=5125, accessed on December 30, 2007. 11. Arthur B. Laffer, “The Laffer Curve: Past, Present, and Future,” Laffer Associates, 2004. 12. Bruce Bartlett, “Supply-Side Economics: ‘Voodoo Economics’ or Lasting Contribution?” Laffer Associates, November 11, 2003, p. 15. 13. Kathryn M. Welling, “An Interview with Arthur Laffer,” Barron’s, December 21, 1981. 14. William Greider, “The Education of David Stockman,” Atlantic Monthly, December 1981. 15. David Stockman, The Triumph of Politics: Why the Reagan Revolution Failed (New York: Harper & Row, 1986). Stockman publicly denounced the White House “false promises” of 1984 (p. 380). He criticized Reagan for not balancing the budget. 16. Dinesh D’Souza, Ronald Reagan: How an Ordinary Man Became an Extraordinary Leader (New York: The Free Press, 1997), p. 101. 17. An American Life: Ronald Reagan, the Autobiography (New York: Simon & Shuster, 1990), p. 232. 18. Jude Wanniski, The Way the World Works: How Economies Fail—and Succeed (New York: Basic Books, 1978). 19. Note: Even today, the process of producing budgetary estimates is biased against any assumptions about economic growth in response to changes in tax rules. The CBO gets its revenue estimates from the Joint Committee on Taxation. “In providing conventional estimates, the Joint Committee staff assumes that a proposal will not change total income and therefore holds Gross National Product (“GNP”) fixed. The use of fixed economic assumptions does not prevent the

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20.

21.

22.

23.

24. 25. 26.

27. 28.

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Joint Committee staff from taking into account possible shifts in economic activity across sectors or markets and/or changes in the timing of such activity in response to the proposed tax change, so long as GNP remains unaffected.” Source: http://www.house.gov/ jct/revhist.htm, accessed on December 20, 2007. The national atmosphere was even crazier. The day of the shooting, General Alexander Haig, secretary of state, appeared on network TV telling everyone not to worry, because he was “in charge.” The nation stood aghast. Even the secretary of state seemed to be so stressed that he forgot the constitutional provisions for presidential succession in times of crisis. See: “The Day Reagan Was Shot: Fears of a Soviet Plot,” CBS News.com, April 24, 2001. http://www.cbsnews .com/stories/2001/04/23/60II/main287292 .shtml, accessed on February 12, 2008. William Greider, “The Education of David Stockman,” Atlantic Monthly, December 1981. The publication was in the hands of the Washington politicians in mid-November and created quite a stir. The author claimed Stockman’s “off-the–record” comments pertained to the Washington Post only. Damage control continued for years. Dinesh D’Souza, Ronald Reagan: How an Ordinary Man Became an Extraordinary Leader (New York: The Free Press, 1997), p. 97. An American Life: Ronald Reagan, the Autobiography (New York: Simon & Schuster, 1990), p. 314. In addition, in 1986, Stockman published The Triumph of Politics: Why the Reagan Revolution Failed (New York: Harper & Row, 1986), criticizing the Reagan revolution and predicting huge economic problems in the future, which did not materialize. In his book, Stockman commented that Alan Greenspan was not a supply-sider and that he felt that Greenspan was on his (Stockman’s) side (p. 86). Kathryn M. Welling, “An Interview with Arthur Laffer,” Barron’s, December 21, 1981. Then chief of staff to President Gerald Ford. Then Donald Rumsfeld’s deputy and Arthur Laffer’s former classmate at Yale. Kathryn M. Welling, “An Interview with Arthur Laffer,” Barron’s, December 21, 1981, paraphrased from the interview. Kiron K. Skinner, Annelise Anderson, and Martin Anderson, eds., Reagan: A Life in Letters (New York: Simon & Schuster, 2003), pp 315–316.

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29. In 2007 the middle class in California continued to vote with its feet. An exodus of over 1,400,000 occurred over the past 10 years as middle-class Californians relocated to other states. The tax base is very narrow. In 2004, 43 percent of personal income taxes were paid by the top 1 percent of earners. At the beginning of 2008, the state of California faced a one-year projected budget gap of $14 billion. See IBD staff, “California’s Huge Deficit Forces Day of Reckoning on Politicians,” Investor’s Business Daily, January 9, 2008. 30. Adapted with permission from Daniel J. Mitchell, “The Global Flat Tax Revolution,” Laffer Associates, June 19, 2007. 31. John Norregaard and Tehmina S. Khan, “Tax Policy: Recent Trends and Coming Challenges,” IMF working paper 07/274, December 1, 2007, p. 51. 32. Ibid, p. 27. 33. Ibid, p. 51.

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CHAPTER 3

Risk Life Is Not a Straight Line— The World Is Not Normal

“The Board has made its decision. We failed to meet our EBITDA targets in each of the last 18 months. There will be no money to fund the losses. There will be no bonuses this year. We will need to postpone that new machine purchase. We are on our own now. “We need to make some drastic changes, now! I know it’s tough, but you need to think about reapproaching the union on self-funding its retiree medical plan. We have not controlled that risk in the opinion of our owners. “Oh, something else; I am the first to go. The new CEO has great experience with companies like this. Maybe he can do a better job with the union. I will help with a short transition next week.” These were the words used as the former CEO delivered the bad news to his management team. Private equity fund representatives typically control the board and compensation policy. Private equity owners take on risk and live on the edge. They are reluctant to fund losers. Many public boards are much slower to act and are likely to fund underperforming divisions for years. But that may be changing. CEO turnover in public companies is way up. As we learned in Chapter 2, you often need simple language to explain a new concept. In this chapter we use our right brain, the creative side, to demonstrate how others have used a quick graphic communication to coax their audience to dig a bit deeper. Good ideas can often be sketched and communicated on the back of a 79

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napkin, but the essence is “good,” not “simplistic.” The concept behind private equity investments is clear: outline the available ways to reduce and control risk, increase the cash flow, pay down debt, and the value of the business will increase over a few years. The goal is usually simple enough to sketch in a few seconds. “When I first took the position, I asked to see the company’s policies on risk management. True to form, they were amazingly well written, thorough to a fault, and so dense and detailed, no one person could grasp the program to any level of depth. I told the staff: ‘This looks great, but how does anyone use it?’ Sure enough, the company had spent untold resources producing another bookshelf stuffer. I changed the process; I wanted four or five areas of risk that were truly critical for the company. Management should be talking about those regularly. The way we had analyzed the risks in the company, we would be lucky to get a handful of the thousands of risks from the policy manual in front of top management before we would be updating the book for the next year.” These were the approximate remarks by Motorola’s new VP internal auditor as he looked back at his experience in the position after six months on the job.1

PRIVATE EQUITY FIRMS ARE STRUCTURED TO LOOK AT RISK DIFFERENTLY Every public corporation must disclose risks in its annual Form 10K report to shareholders. Many stop the thinking there. The SarbanesOxley Act of 2002 required that each company adopt a framework for assessing risk. This put many companies into the same mode that produced the Motorola risk management tomes. Resources were committed to defining every pocket of risk in an organization, and tracking discrepancies became a critical effort to avoid the dreaded “material weaknesses” that could send the CFO and the CEO to accounting purgatory. The teeth in the law were focused on the accuracy of GAAP financial statements. Public companies have spent billions over the last few years on risk identification. However, given the complexity of the interconnected global economy, they will never eliminate risk. However, from the standpoint of running the business, many of these efforts did not enhance the stockholders’ value. In essence, they

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tried to arrest the risk of reporting and accounting, but in doing so, many derailed forward progress and innovation in the business. After all, if that was the mandate, then essentially freezing the business in time and reducing innovation would do the most to control the risk. While many CEOs complained that the risk identification efforts were a nuisance, some valiant and more effective CEOs attempted to get everyone in their organizations to understand and help control risk. This required unique approaches, and it required convincing middle management and employees to look past the negative context that was spreading around the “Section 404” work that had been mandated by Sarbanes-Oxley. From 2002 through 2005, while public companies were bogging down in their efforts to comply with the new laws, private equity companies were rapidly building their investment fund war chests and continuing to build their portfolios of businesses. In 2005, the level of announced leveraged buyout deals topped $100 billion. This activity exploded in 2006 with the total nearing $400 billion.2 In 2007, private equity played by different rules and reaped significant benefits. While the managers of public corporations had to spend a significant part of their day checking the boxes required by SEC tracking and reporting processes, private equity bosses could spend their day trying to figure out which companies could be taken private and which companies would be more valuable after the economy returned to full strength. Risk in a public corporation had to be disclosed and discussed. This prompted many boards of public companies to view risk as something to avoid, but risk in a private company represented an opportunity to add value. So we began to see the emergence of two distinct approaches toward risk. Public companies usually consist of a number of strategic business units that are overseen by boards at the very top. Board members bring diverse skills and backgrounds to bear on great problems of their great companies, but they have little ability to get far into the details of key business units or their strategies. At that level, risk is a “four-letter word.” Board members are likely to ask, “What are the risks?” whenever change in strategy or tactics is brought to their attention. Much of their time in the 2002–2005 era was devoted to ensuring the integrity of the governance processes and financial statements—and trying to avoid risk.

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Private equity companies usually consist of a portfolio of investments in separate legal entities, similar in size to the strategic business units (SBUs) of larger public companies. Each portfolio company is then similar to a single strategic business unit, overseen by its own financial and operational board.3 Board members bring skills that are very specific to the needs of each such business unit. They are able to reach deep into the business detail of the single unit. At that level, risk is a companion to return. Meaningful conversations about controlling business risk as part of business strategy are possible in these boards, and they think in terms of alternatives and value-building change. In recent years, even larger public corporations have been taken over by private equity owners. These examples will provide a laboratory for evaluating whether the increased flexibility of private equity and the more constructive attitude toward business risk actually allow private equity to more successfully build corporate value. Various models and techniques have been developed over time for managing risk. Risk comes from the changing business environment and competitors. The speed of change will not disappear. As markets evolve, companies will continue to face unknowns and will develop more questions than answers. The search for the right decision model or business model is really a search for a model that can be adapted to the environment and used wisely by the decision makers. Those who try to put risk management on autopilot will suffer.

AMARANTH: HOW MUCH RISK CAN YOU BEAR? All business school students hear that risk and return go together. Today’s MBAs learn about alpha and beta.4 This does not mean that taking any and every risk will automatically produce return. It merely means that an investor must be offered additional return to coax that investor to put his or her money at greater risk. It is just a matter of understanding the alternatives and options that the investor has. New tools such as real options help to better quantify the risks of different alternatives. We discuss real options in more detail in Chapter 5.

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In practice, though, thinking about risk can get confusing. A simple analytical framework for understanding risk has two dimensions: likelihood and magnitude. Both must be taken into account. A certain event may have a low probability of occurrence, but a very high cost if it does occur. The rational decision might be to avoid exposure to the risk altogether, given the potentially disastrous consequences. However, people who have put themselves in the position of taking such a risk over an extended period of time, without any loss, may come to believe that the low probability means that the costly event will never occur. This seems to have happened to the managers of Amaranth, the $8 billion hedge fund that lost $2 billion within a few weeks. In the summer of 2006, Amaranth speculated on future prices of natural gas, at one point “controlling 40 percent of the wintermonth contracts traded on the New York Mercantile Exchange.”5 This position represented 5 percent of the nation’s annual gas consumption. Officials at the exchange at one point ordered Amaranth to reduce its holdings. Instead, Amaranth bought contracts on another exchange. The fund collapsed in September 2006, when prices moved against it.6 “Former Amaranth trader Shane Lee, testifying before the [Senate] panel . . . agreed that Amaranth’s trading volume was large, but did not deem it ‘excessive.’”7 It seems that constant exposure to risk can dull the protective senses that we think we possess as businesspeople. Amaranth’s perceived likelihood of a loss was tiny, because managers were emotionally convinced that gas prices would continue to rise. Of course, with their level of participation in the market, the upward price signals were possibly becoming a self-fulfilling prophecy. How could gas prices decline in such an energy-hungry world? Admittedly, though, at their trading volume, the magnitude of the problem that resulted from a decline in gas prices was fatal. Risk management requires more disciplined thought than feeling. For those who live on the edge, risk management involves hard statistical analysis and stress testing on a frequent basis— sometimes even hourly or daily as conditions change. Thinking about the data and the prudence of taking such a risk as Amaranth did was a critical misstep at Amaranth. The events that occurred will always highlight the possibility that one bad event could

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destroy a fund. Thoughtful analysis, at the time of the transactions, though, could also have revealed that one bad event could spell disaster. Alternatives, such as trading lower amounts and containing the magnitude of the risk, were readily available. Only “feeling the risk,” or, that is, basking in the euphoria of having beat the odds for some period of time while reaping enormous returns, could dull the sensibility of the fund managers to think that there really was little or no risk at all.

LONG-TERM CAPITAL MANAGEMENT Are we that smart or just lucky? When half the people in your conference room have been considered for or won Nobel Prizes, it is admittedly tough to be humble and second-guess your successes. However, even geniuses can be pulled off target when a string of successes leads to new opportunities. After a wonderful run of eye-popping returns, the managers of Long-Term Capital Management (LTCM) had proven that their smarts really worked. The problem was that fame gave them a chance to scale up an activity that works only when you can keep it secret and small. At one point LTCM had $100 billion of assets and $1 trillion of national derivative exposure.8 Myron Scholes, Nobel laureate, Robert C. Merton, Nobel laureate, and John Meriwether changed their winning strategy in order to accommodate the flood of investment capital that was thrust at them in the late 1990s. The fund “had already started straying from the pure academic strategy, taking hyper-risky bets on the direction of bond prices rather than just on market ‘mistakes’—much to the dismay of Scholes.”9 Armed with all the analytical horsepower that genius could muster, they marched down the dark road, taking risks that they could have screened out. However, screening out the risk might have meant turning their backs on some of the offered capital. Remember that a 2 percent management fee on $1 billion is $20 million per year received by the fund manager whether the investors win or lose. After the crash of LTCM the players gave their own account of what caused the downfall. “They had been done in, they argued, by an unforeseeable event—a perfect storm such as strikes once in a hundred years. . . . People caught in such financial cataclysms

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typically feel singularly unlucky, but financial history is replete with examples of ‘fat tails’—unusual and extreme price swings that, based on a reading of previous prices, would have seemed implausible.”10 Roger Lowenstein, in his book When Genius Failed, put the blame on the fund’s partners, who knew enough about both markets and statistics to be more careful: “A man driving a car at thirty miles an hour may blame the road if he skids on a patch of ice; a man driving at a hundred miles an hour may not.”11 John Meriwether finally conceded that the firm’s “whole approach was fundamentally flawed. . . . We believed that diversity meant safety—it worked in 1994 and 1987, but it failed us. Although high leverage doesn’t necessarily mean too much risk, we did have too much leverage.”12 In his Wall Street Journal article, Gregory Zuckerman concluded: “Despite sophisticated trading models mapping past behavior of securities prices, the firm’s brain traders had little understanding of human behavior. Such as: Investors often bail out in a panic.”13 This points to the need to go beyond the statistics of past market behavior and include the psychology of the people effect. At the foundation, investors are people. The people effect adds to the uncertainty in financial markets, reminding us that the numbers alone are never enough.

PERFECT STORMS ARE MORE FREQUENT THAN EVER BEFORE

Since the 2000 movie The Perfect Storm, the term has been used by an increasing number of business leaders in describing the reason for financial distress. A recent example, “sub-prime lending,” got tagged (with unfortunate foresight) by Washington Mutual CEO Kerry Killinger at a Lehman Brothers conference.14 Other industry CEOs, including the CEO of Countrywide Financial and a variety of other lenders, have used similar terms. We guess they need to learn to build a more storm-resistant ship or know when to stay out of the water. (Interestingly, all three were taken over or in bankruptcy.) In Chapter 8 we explore getting a better sense of the economy and when storms are a serious concern. It is sometimes better to carry an umbrella—just in case. Maybe we can blame global warming on this too!

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FAT TAILS CAUGHT AMARANTH AND LONG-TERM CAPITAL OFF GUARD If you look at the risks that both Amaranth and Long-Term Capital faced, they are in the category of “outliers.” These are risk events that are very unlikely to occur, but the impact of the event is greatly different from the expected outcome. In thinking about statistics, most of us think in terms of randomly distributed outcomes. Those are the examples we have seen in textbooks and read about in scholarly articles as the bell-shaped “normal” distributions. However, in the financial markets, many outcomes are serially connected and not random or independent. Reality rarely reflects the book-perfect “bell-shaped distribution curves” typical of a stable process. Hedge funds15 and financial institutions are usually working with such high leverage that a small change in the markets is all they need to make a lot of money. However, the sword is double-edged. A big change in a market value may push a financial institution into failure. Witness the financial failures of 2008. Human nature is very interesting. If a state lottery tells members of the public that they can bet $1 and possibly win $150 million, the line often will stretch around the block, even though there is a disclosure that the odds of winning the prize are astronomical, say, 300 million to 1. Go to the line and interview the participants, and you will hear them confidently predict that they will win. On the other hand, tell the public that there is a 1 percent chance that a teenage driver will have a serious wreck within a year, and the drivers will ignore it. Interview them, and they will tell you the odds are infinitesimal. (“It can’t happen to me.”) Yet the insurance companies know that they must charge the teenage driver a significantly higher premium for the greater risk of accidents.

FRACTAL BEHAVIOR OF MARKETS AND SCALABILITY Most people have heard about 100-year rainstorms. Some have experienced them directly. Even among professional investors, success makes it easy to rule out the outlier event. Yet, like a 100-year rainstorm, the havoc it can bring will definitely be remembered by those who are affected.

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Fortunes have been made and lost in the markets over the years, and a great deal of time and money continually goes into efforts to better understand how markets function. In particular, traders pay richly for the opportunity to cement even the slightest advantage over other market participants. Many have found such an advantage, in various ways, and become fabulously rich. Others have been bounced out of the markets, as their trading strategies failed on one unanticipated event. We note here that different types of market participants have different roles, and what can be found in a study of the markets will have different meaning and importance for various types of players. Market-timing risk, for example, is of less importance to a corporate decision maker whose job is to build value in his company. Actual transactions with the markets are limited for many companies. At the other end of the spectrum, hedge fund operators, who are highly active short-term traders, constantly focus on timing and short-term moves in the markets. A debate on the nature of markets has been simmering in the background for years, but has been rising to the surface more recently. In markets, it seems that the 100-year floods occur more frequently than one would have thought based on standard financial models. The debate centers on the use of the Gaussian16 “normal” statistical frequency distribution. Critics attack market theories that are based on the assumption (or finding) that stock price changes, for example, follow a pattern that is like the typical bell-shaped curve, or formally known as “Gaussian normal.” Such theories would predict that dramatic price swings would be extremely unlikely to occur and that the larger the change, the more unlikely its occurrence would be. Benoit Mandelbrot, the mathematician of “fractal geometry” fame, points out: “The seemingly improbable happens all the time in financial markets.” He notes that “standard theories” would have estimated that the odds of the August 31, 1998, market collapse, following the Russian ruble crisis, would make it a 1-in-20 million event, something a daily trader would not expect to see in 100,000 years. And, strikingly, the market failure in July 2002 was a 1-in-4 trillion event. Both these events paled in comparison to the market break in 1987, which would have been estimated to have odds of less than 1 in 1050 (yes, that’s a 1 followed by 50 zeroes)—far from anyone’s concept of a likely event.17 In 2008 we saw another series of similar improbable events.

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Much of the criticism is pointed at the random walk model, which is familiar to business school students. The claims that emerge from the model are that price changes are random, independent of the past, and form a Gaussian normal distribution. While these notions are highly useful for computation, critics such as Mandelbrot violently object, saying that the randomness may have some validity (which arises from the vigorous efforts of all the players in the markets), but the idea of independence from the past and normal distribution are both contradicted by reality.18 These criticisms are certainly more than a shot across the bow of those who would use modern financial models and proclaim that they provide certainty, or ability to predict the future. As discussed before, Long-Term Capital Management seems to have fallen prey to the 1-in-20 million events of 1998. The lesson, though, is not to abandon theory for some level of “practical” anarchy; it is to understand that markets are not “normal.” Values do change, sometimes dramatically and suddenly. Mandelbrot has sought to model financial markets without relying on the historical independence and Gaussian normality that he criticizes in the standard financial models. His models use the concepts of scalability associated with his fractal geometry. He notes that wild swings that might occur over a short period of time (a day, a week, a month) are not dampened by lengthening the period. Thus the patterns are scalable, making the record of stock prices, for instance, over a month look similar to those of a five-year period. Thus the wild swings will not go away and cannot be easily diversified away. He criticizes the standard academic models for assuming these outliers away, as a trade-off for remaining mathematically concise. However, he argues that these models have sacrificed their grip on reality because of these trade-offs. He offers multifractal models, combining prices and time, along with a concept of “trading time” as a potential method of dealing with the problems in current theories.19 The surprises that Mandelbrot has found in the data translate into real-world risks for private equity investors. Successful private equity players look beyond the numbers and think about the risks that may be lurking beyond the scope of the valuation models that merely spit out prices for acquisitions. For example: airlines in the United States did not consider terrorism a real risk until it occurred.

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The Army Corps of Engineers was unable to convince politicians of the risk of a levee collapse in New Orleans until it occurred. Both had precedents in other countries, but decision makers assumed it could not happen here! Historically, theoreticians have modeled various aspects of reality, first by making the most limiting assumptions and experiencing large errors in the predictions that the models produce. The models are then tuned as the assumptions are relaxed or eliminated, with the effort being to reduce the errors and thus increase the usefulness of the models. The search for “general” theories leads to occasional breakthroughs that may allow whole classes of assumptions to be revised. The volatility in markets in recent years has put increasing stress on the financial models used by market participants. As the debate continues about which direction financial theory should take, it is likely that modern financial theory— typified by the capital asset pricing model and beta—may be later viewed as limited to special cases where the limiting assumptions create less of a problem. The analogy in physics is Newtonian physics, which serves us perfectly well as long as we avoid operating at the speed of light or in the atomic realm. There, the broader approaches of general relativity and quantum physics are more useful. In the meantime, market participants will be plagued with the destructive volatility that can appear with surprising speed in any financial market.20

UNDERSTANDING THAT INTRINSIC VALUE IS GOOD FOR STOCK ANALYSTS AND MANAGEMENT

The questions for analysts are how to produce an “outsider’s” forecast of future cash flows and what discount rate to use so as to predict stock price movements. The issue for corporate manager “insiders” is to develop and execute the strategies that will produce the highest sustainable cash flows with acceptable levels of risk. Both need navigation tools to help them along the way. Some tools are complex, yet some tools can be surprisingly simple. Traders and some of their favorite authors are critical of both analysts and insiders. Traders are concerned about price movements (Continued)

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rather than price levels, and they are more interested in the path taken by the market prices toward intrinsic value than in assurances that the two will ultimately agree. Given the volatility of news events, which through their psychological impact on market participants can further magnify their impact on market prices, these issues can dominate the thoughts of traders. A twitch in the markets can spell ruin for ill-placed traders. However, none of this should indicate that analysts or corporate managers should abandon their quest to understand and produce estimates of intrinsic value and trends. The advanced forms of DCF-based value analysis focus on stock price levels rather than on stock price changes. They recognize that markets have momentum and can sometimes follow a trend long after it should have been abandoned, leading to the possibility of overshooting and stark corrections. This means, consistent with the critics of modern financial theory, that stock price changes are not independent, hence not Gaussian normal. Stock price level models are able to signal when the entire market is out of line with reality. Many such models indicated a high degree of risk and sounded the warning bells just prior to 2000. After the bubble burst in 2001, these same models were consistent with conclusions based on capitalized economic profits and indicated that the market was significantly undervalued from mid-2002 forward for at least five years.

As long-term participants in the markets, the private equity players and the corporate managers are the ones who build value. They are the engine under the hood. Their lesson is to avoid situations in which the fractal event will endanger their long-term survival. Successful private equity funds have the scale to employ or engage the expert resources necessary for deep digging to get the hard data with facts. They learn and use better—but still imperfect—models to understand the real economics and risks. They do everything possible to control the risk of their investments and make big bets on their superior knowledge. They can afford to concentrate their investments. Those with only average knowledge should diversify their investments. Naturally, good and bad luck in terms of fractal events can affect the best or worst decisions.

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Common private equity practices that help control risk include: 1. Performing extensive due diligence to understand and quantify all the risks. 2. Limiting financial covenants whenever possible to provide maximum flexibility. 3. Involving the right experts in the decisions and on the boards of their portfolio companies. 4. Making the tough decisions early, such as: a. Changing management when results are not meeting expectations. b. Solving labor and benefit problems through tough factbased negotiations. 5. Refusing to throw good money after bad by limiting investments in outmoded business models. 6. Extracting cash from all investments as quickly as possible to limit risk and produce a high return on their capital. 7. Having an exit strategy at all times that will maximize returns in the face of a variety of risks. 8. Compartmentalizing risk among business entities to ensure survival of some part of the fund. In this context, understanding risk requires more than the mean and a probability or frequency distribution. It requires an understanding of the shape of the fractiles (quartiles, quintiles, etc.). Considering the outer edges of the frequency distribution can be critically important, for it is there that miracles and disaster lurk. Consistent with this approach is the idea of diversifying a group of high-risk, high-return activities as the way to produce value. Many private equity players do just that. They are protected from a total loss or blowout so long as the portfolio assets are independent. At the same time, they can and do take advantage of the runaway success of any one unit. Successful investors like Warren Buffett and private equity firms take on businesses that they understand well. Most private investments are typically midmarket companies that the public markets have ignored. This includes smaller underperforming or

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distressed companies that can be acquired at a discount, thereby reducing the risk. These players further reduce their risk by digging deeper into each acquisition opportunity. They have investment models that work for them. Warren Buffet has found that he does best if he buys only businesses he can understand. They must have both a profitable business model and management that his people skills tell him will produce results. Buying undervalued assets at a discount is a skill he uses to his advantage. Combining skill and a bit of luck along the way never hurts. Warren Buffett seems to learn from his mistakes better than most. The outcomes of some plans or projects have limited ranges; others do not. Consider this: an option holder can lose his premium, but a short seller can lose an unlimited amount. Think of the net worth of 1,000 random people. Now put Bill Gates in the room, and the normal statistics would be so distorted that we would be lost without digging deeper. Predictability is very limited when the statistical character of the data wanders off the “normal” path. Put together a series of unfavorable events, and your risk of failure increases. Success in the face of the unpredictable requires different approaches, such as scenario analysis. Scenario planning is a useful tool to explore the long-shot events on both the upside and the downside. Because the process highlights a variety of outcomes, it can enhance awareness of both the risk and the rewards and prepare leaders for the unplanned event that may happen. Successful private equity players make copious use of scenarios for estimating potential risks and better timing of decisions, as well as for contingency planning. We talk more about scenarios in Chapter 5.

THE FED OVERREACTS TO Y2K PREDICTIONS

In the months leading up to the feared “millennium,” two dates took on special prominence: September 9, 1999 (9/9/99), and January 1, 2000 (1/1/00). Both dates related to potential computer glitches. The first (on 9/9/99) would occur because computers had been set to protect themselves from a crash that older programming languages (Continued)

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could cause. The protection would shut down a machine that used a date that looked like “9999.” The second (on 1/1/00) would occur because programmers had adopted a two-digit date standard to offset costs and increase the speed of computing. This system would fail when the year rolled over from “99” to “00” because computers would be confused over what year it was. The big implication of these potential problems was that the financial system might shut down as a result of its dependency on computers. Fueled by a tidal wave of media pressure, businesses and government girded for the impact. The Fed took this risk very seriously and decided to flood the banking system with reserves, ahead of each critical date and in anticipation of a problem, so that no liquidity crisis could develop. Unfortunately, those reserves constitute a major portion of the “monetary base” that our economy can quickly and efficiently convert into other forms of money in much larger amounts. Because this excess supply of liquidity was injected into the economy before there was any spike in the demand for money, much of this new money found its way into the stock market. The Fed had not considered the risk of having too much money in the system, or of correcting such an overage too late. Instead, all the attention was focused on the problems that would follow if there was not enough money in the system. Predictably, the tsunami of cash flowing into the market “floated all boats,” pushing up the stock indexes to all-time highs. However, while Alan Greenspan spent a great deal of time blaming the market for “irrational exuberance” for fueling higher prices, it is more likely that the Fed itself caused or at least fueled the problem. In this case, the Fed paid little or no attention to the people effect that would result from a huge infusion of cash into the monetary system. It also demonstrates that acting in advance of an expected crisis can cause an unexpected and unintended crisis of a different sort. By focusing on the outlier or fractal (a Y2K meltdown) and taking action, the Fed disrupted the normally expected path of the market economy. When a Y2K banking crisis did not occur, the Fed attempted a rapid pullback of the money supply, reversing its impact on the stock market. The market meltdown of 2000 could have been anticipated.21

AIRLINES AND AUTOMAKERS HAVE BIG RISKS The greatest risk for corporations is their strategic or business risk, which includes regulatory and operations risks. Errors in the big decisions about corporate direction can be by far the most ruinous.

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In many cases, the risks of the big decisions are overlooked, and the results of the decisions become baked into the framework of the industry over time.22 Private equity players limit these risks by focusing their investments in smaller separate legal entities where possible. They then execute dramatic changes needed to reduce these risks by altering the business model of each entity. Both the airline and automotive industries failed to understand the basic risk of change and the compounding impact of sequential events. After building a complex system over a 30–40 year period, their leadership was affronted by change, not energized by it. GM famously sneered at Toyotas when they were first introduced. The airline majors, no doubt, sneered at discount airlines. The combination of skyrocketing fuel prices and a new breed of successful competitors like Southwest put the airlines near the brink of bankruptcy. The extended decline in travel prompted by the 9/11 attacks eventually pushed all the majors except American Airlines into bankruptcy. A perfect storm had struck. An unexpected “series of events” caused their near death. Unfortunately for the domestic players in both industries, they had both avoided current cost increases for decades by accepting ever-increasing future obligations for pension and medical benefits. These legacy costs are manageable only while an industry is experiencing growth and profitability. When a downturn occurs, the impact of the benefits costs can mushroom, particularly when retirees begin to outnumber active employees. For the airline industries, the “perfect storm” above did not need to have very high winds. The major players were already heavily burdened by benefit obligations. For the auto industry, a puff of wind was all it took to send it into a tailspin, given the overwhelming burden of its benefit costs. The U.S. airline industry was heavily capital-intensive with high fixed costs. After its deregulation in the 1980s, profitability depended on filling planes with passengers, and the airlines embarked on a decades-long price war without reshaping their underlying business model to enable them to survive a price war. True, the majors did accomplish major cost cutting through adopting hub-and-spokes patterns of travel, achieving an advantage. However, they never changed their preference for fixed costs and capital intensity as a way to drive down total costs. Unfortunately,

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this approach becomes a total failure if passenger traffic declines and fuel prices spike. After years of deregulation, by 2001, operating margins were razor thin. Most of the industry was loaded with fixed costs, inflexible, and vulnerable to two risks: (1) declines in passenger traffic and (2) increases in fuel costs. The American auto industry has been in gradual decline for the past 30 years, as foreign manufacturers have found ways to build cars in the United States with better cost structures, greater attention to customer preference, and more flexibility. Legacy costs, inflexibility, and rigid relations between management and unions have all converged to suffocate the U.S. auto industry in a sea of selfimposed problems. The U.S. auto parts suppliers failed, not by one event but a series of events that gradually took their toll. Seeing the potential for failure, dramatic negotiations between labor and management have resulted in reducing the legacy burden on Ford, GM, and Chrysler. Private equity investors at Cerberus Capital Management bought a variety of auto parts suppliers and, later, Chrysler. Its approach was to add management talent, force changes, and alter the business models of these faltering companies to reflect competitive realities in the interconnected global economy. Unfortunately, an entire industry can get caught up in solving the wrong problems. When industries are in consolidation, the players find themselves pressed to cut costs in an effort to shore up their short-term survivability. They need ways to quickly prioritize the risks that they face so that they can focus not just on the urgent, but on the important issues as well. Many turn to consultants for help. Some turn to private equity for capital and a second chance at life. Legendary private equity investor Wilbur Ross bought up troubled and bankrupt steel companies, restructured labor agreements and plant configurations, and sold them to a foreign industry consolidator, Mitalsteel, at a huge profit. He then invested in troubled coal mines, followed by auto suppliers, and later distressed subprime lenders. His ability to buy low and restructure underperforming industries has created billions in wealth for him and his investors. Although such restructuring is painful and dislocates thousands of people, these actions also have saved thousands of jobs. Ross comments: “What private equity brings to the party is a new set of eyes, a dispassionate view. Because they’re not a publicly reporting company, they’re not tied to quarterly this, that, and the

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other thinking. They can afford to take write-offs and measures that might be hurtful if they were publicly traded.”23

A SIMPLE MATRIX CAN ASSIST COMMUNICATION ABOUT RISK The world is not as simple as a two-by-two matrix, but even the dimmest flashlight is useful in total darkness. Frequently, the use of a simple analysis can break through the clutter and provide impetus for real solutions. In the wake of Sarbanes-Oxley, everyone talks about better transparency, but most companies shudder at disclosing risk. A simple two-by-two or three-by-three risk matrix provides a great deal more transparency and insight than the two to six pages of risks described in the 10K or proxy materials of public companies. Any number of consultants can help a management team prepare a simple risk matrix like the one shown in Figure 3.1. A risk matrix can be

Figure 3.1 A simple risk matrix helps identify and prioritize key risks Source: © 2005 Board Resources. William J. Hass and Shepherd G. Pryor IV, Building Value through Strategy, Risk Assessment, and Renewal, Chicago: CCH, Inc., 2006.

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sketched in a few minutes in a meeting by a presenter or a facilitator. The value in using the framework is in provoking the questions about risks that the group has identified. Group discussions can then produce new insights and bring intuition, experience, and judgment into the conversation to supplement the raw data. A laundry list of risks may fulfill an SEC compliance need, but companies need to make decisions about the risks that they face. The risk matrix provides a quick framework to support decisions and communicate the issues to management or board members. Individual risks are plotted on a rough scale of both their possible impact and likelihood. In the example, Risk B is very significant for the company. It is foreseeable and would have a high impact. Thus management should place it high on the priority list of risks to deal with. Should the risk be insured, transferred, accepted? This may depend on the value that is associated with accepting the risk. In some situations, there is no value to accepting such a risk, and it quickly becomes obvious that the risk should be eliminated, if possible. The framework is useful because it helps to distinguish between risky activities that have little impact, such as Risk D, and those such as Risks A and B that could spell disaster. In the discussion about volatility and outliers, some of the risks that were discussed would appear at the extreme upper left corner of the risk matrix. Should they be ignored? Not if we learn the lessons from Amaranth and Long-Term Capital Management. Some “low probability” events are bound to happen on occasion. These events can be taken into account in the planning process through the use of scenarios.

COSO PROVIDES A FRAMEWORK (USED BY AUDITORS) FOR UNDERSTANDING RISK COSO, the Committee of Sponsoring Organizations of the Treadway Commission, created a risk management framework that has been adopted by many public companies in their effort to comply with Sarbanes-Oxley. It is frequently represented by a cube that breaks the company’s activities into discrete segments for analysis. The risks are looked at individually, and various control mechanisms are put in place to mitigate the potential impact of the risks. While this approach

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is effective in finding and defining internal risks, particularly those that can affect financial reporting, the process is not a substitute for a global view of the risks that a company faces.24 Ultimately, risks must be judged at the top of the corporate pyramid. Only at that level can the impact of the risks on the overall company be evaluated.

FORGET THE PROBABILITIES: TELL ME IF IT WILL RAIN OR SNOW! We live in a world of sound bites and accelerating amounts of information and misinformation. We elect public officials partly based on their ability to communicate ideas in simple terms. Executives demand simplicity, but their subordinates deal in complexity. Down in the trenches, the detail is often the most important aspect of the work. At top management levels, confident, quick decision making is highly valued, but success often depends on execution in the field. In many companies a huge gulf develops between decision making and action. The CEO may become frustrated with the results yet continues to look for easy answers, despite feedback from the field. Alternatively, he or she could ignore the estimates from the field. While decision making is never perfect in any organization, successful private equity players engage experienced experts and get it right more often than entrenched management teams that often ignore an outsider’s view. In the private equity world, the outsider’s view gets more than a casual hearing. It seems to make a big difference in situations of deep distress, as well as in mature and emerging businesses. Like it or not, most business decisions must be made under uncertain conditions, but there is always an opportunity for new data or experience. Data flow faster to everyone, faster than ever before. However, today’s changing global environments make digging deeper more important than ever before. Projections are not facts; they are made of assumptions, estimates, and even guesses. All involve interpreting data and assessing risk. Companies that develop an internal language to discuss new data and evaluate risk are better equipped to deal in the interconnected global business world of the future. In this context digging deeper is not an effort to

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guess the outcome, but an effort to understand the range of likely outcomes, given many of the uncontrollable factors. Creating scenarios and running simulations of the various possible outcomes can give a management team a better understanding of how the company will perform in its uncertain environment. Without this understanding, every outcome may be off target. When budgets are considered to be absolute, they result in a downward spiral of criticism and reconciliation to budgeted numbers. Variance analysis becomes the “sport of kings” at the board meetings, and progress slows down. On the other hand, with a probabilistic approach, only those aspects of financial outcomes that are truly surprising need explaining. Separately the spurious noise that may drown out the signal is paramount. The simplest version of this approach is to construct multiple versions of the business plan. For example, in a cyclical market, there may be a Plan A for “business as usual” and a Plan B that will be used if there is a downturn. On a more sophisticated level, a company can construct an entire array of scenarios and plans to provide it with ongoing flexibility to enable it to adjust to possible changes in the business environment. John Deere undertakes a version of this by setting performance targets for different phases of the business cycle.25 Incorporating risk and probabilities into the planning and into the discussion of the business should be valuable. As a communication device, annotating projections with clearly stated ranges and probabilities can help bring a common understanding to a disparate group of decision makers. Successful private equity players outline the alternatives, the returns, and the odds. For example, if a portfolio company is choosing whether to undertake a risky product launch, the decision makers will want to consider more than just the expected outcome of the launch. Think of the questions: What is the downside? Have we considered the risks? Which risks can we control? What will happen if our lead competitor responds aggressively? For example, Figure 3.2 shows that Project A has an 85 percent probability of producing a breakeven or positive net present value, which would indicate that the project is likely to earn at least its required rate of return. (There is also a 5 percent probability of a loss

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Figure 3.2 A napkin can be used to explain probabilities of project risk

of $10 and a 10 percent probability of losing $5, so that the likelihood of a loss is only 15 percent.) In order to better communicate the background to the decision makers, analysts can provide simple probability distributions of different levels of outcomes. As an example, if a board member is shown that the project will have a favorable outcome with an 85 percent probability, then most board members would find the project acceptable. On the other hand, a project with a 40 percent probability of success would be much less likely to be approved. Interestingly, each of these two projects might have the same expected value. Without communicating risk with some estimate of probabilities, the projects would look identical to the casual observer. Yet someone—somewhere—in the organization might know the truth about or be able to better assess the relative risks. Naturally numbers can be adjusted to show almost anything. The purpose here is to use probability as a discussion point to dig deeper into the true economics and risk. Remember that “O-ring” failure on the space shuttle Challenger? This was not another “fat tail” event. It was a management failure. Engineers failed to specify a material for the “O-ring”

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that would maintain its elasticity at colder than normal temperatures. Management failed to specify the range of performance required. Despite all the experiments and PowerPoint presentations, it took a catastrophic failure before NASA learned about Orings and how damage to heat shield tiles might occur. Nobel laureate (physics, 1965) Richard Feynman was appointed to a presidential commission that was convened to determine the cause of the Challenger explosion. In the meetings, he dramatically demonstrated the problem with the O-ring by soaking the material in a glass of ice water. He was able to convince the panel that the material had lost crucial elasticity because of the outdoor air temperature at the time of the launch. The O-ring was ultimately tagged as the cause of the disaster.26 The point is that top-level decision makers can be much more effective if they change the “sound bite” standard of communication with their divisional executives and dig a bit deeper into the business of their companies. Quantification and understanding of the upsides and downsides and, when possible, probabilities will help to better communicate both the opportunities to build corporate value and the risks of destroying it. Stultifying PowerPoint presentations do not always communicate. One of the best known examples of the successful use of disciplined statistical techniques in management is Six Sigma. Made popular by Motorola and General Electric, this method has become widely emulated as a way to control manufacturing and service processes. While Six Sigma may require a corporate transformation for some companies, there are many steps that companies can take short of adopting Six Sigma that would help them enhance their long-term survival.

WHAT IS THE RANGE OF VALUES? As everyone knows, few things in this world can be known with absolute certainty. Yet most people believe that quarterly and annual financial statements and accountant reports are clear blackand-white absolute fact. Anyone familiar with accounting in a large or small public company can tell you that even in the absence of fraud, the accounting numbers, such as earnings per share (EPS), are based on many assumptions and are not as precise as the

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printed black-and-white reports make them seem. So what is the big deal when a company misses an analyst estimate by a penny? To traders an EPS miss means a great deal because it sets off a whole wave of people effects. That is why a stock price may change 5, 10, or even 50 percent in any given day, week, or month. To long-term investors and private equity players, a small change in EPS may not change their opinion on a company at all, as they are in the game for the long-term intrinsic value. In fact, every number found on GAAP financial statements (including the date) is an estimate. GAAP is a set of accounting rules sometimes applied differently by different companies over time. When valuing a company, investment professionals need to dig far below the surface of the accounting numbers and assumptions to begin to understand value and put “comparable companies” on the same basis before making comparisons. Some of the better approaches described in Appendix 3 make these adjustments.27 Successful private equity players and other value builders are concerned with significant changes that affect value over the long term. They look for things that can change corporate value significantly: 30, 50, or 100 percent or more. Timing does matter to success in creating value from the buying and selling of businesses.

KNOWING WHAT YOU DON’T KNOW ABOUT RISK AND VALUE

In his book The Black Swan: The Impact of the Highly Improbable, author and former trader Nassim Taleb, based on work done by Benoit Mandelbrot, argues against the ability to foresee the future and the annual planning ritual, and decries many of the Gaussian-based theories of modern finance. He argues vehemently in response to the growth of modern portfolio theory: “. . . it is contagion that determines the fate of a theory in social science, not its validity.”28 Taleb may be right on the contagion part, but it is human nature to anchor to some beliefs and some frameworks that explain the average uncertainties if not the “black swans” that are totally unexpected. In 2008 a veritable flock of black swans flew over the world’s financial markets. So if value of an asset is a function of its future cash flows and no one can know the future with absolute certainty, it only follows that (Continued)

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no one can know the “value” of an asset with absolute or perfect certainty. The best we can do is guess or estimate better than the next person. Financial markets have risk. Market movements are often unexpected by most participants until they happen. Taleb and others before him have noted: “. . . removing the 10 biggest one-day moves from the U.S. stock market over the past 50 years, we see a huge difference in returns—and yet conventional finance sees these one-day jumps as mere anomalies.”29 Many analysts ignore the outliers at their own peril. Successful private equity players and other value builders learn from personal experience that risk does not always behave according to traditional Gaussian or normal statistics. They try to understand risk better than others in the market and attempt to buy low and sell high, a task that Taleb would consider arrogant and destined to eventually fail.

So what is the wisdom of private equity on risk? Private equity players do their homework better than the next guy. Cerberus, for example, is known to throw “massive resources” at the due diligence process when making an offer on a target company. It is not unusual for Cerberus to put a 35-person team of operations professionals, investment bankers, and outside professionals through a 24/7, 35day process that yields thousands of pages of spreadsheet analysis to model downside risk. “Cerberus buys companies that look extremely risky, assumes the worst will happen, and plans accordingly.”30 It finds ways to dig deeper to understand and control its risks. Cerberus believes it can make a difference in the troubled automotive industry and has made some major bets in acquiring a majority interest in General Motors Acceptance Corp. from GM and a variety of auto parts makers. Its highly publicized $7.4 billion acquisition of 80.1 percent of unprofitable Chrysler Group was an even bolder move. Chrysler’s three attempted turnarounds in the last 20 years may have permitted it to survive but not without tremendous losses. But Cerberus is a bargain hunter. Did it buy low? Consider that Daimler’s much heralded takeover of Chrysler in 1998 cost Daimler $36 billon plus years of losses, further aggravated by the 2001–2002 recession. As a public company Daimler

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was pressured by shareholders to give up on its turnaround efforts and sold Chrysler at a loss. It’s a strange world. In a similar fashion Home Depot was pressured to sell the contractor supply business that Bob Nardelli, now chairman of Chrysler, had acquired. Still Cerberus has accepted huge risks in the form of billions of dollars of liabilities for Chrysler’s retiree medical and pension benefits. Controlling those risks will be the job of an experienced team of automotive executives, plus Bob Nardelli of GE and Home Depot fame. Cerberus chairman John Snow (secretary of the treasury, 2003–2006) said in a 2007 interview: “We don’t think about next quarter. We don’t think about what analysts have to say about us. We care very much about producing long-term results [spelled V-A-L-U-E] for investors.”31

PRIVATE EQUITY TAKES RISKS, SOMETIMES ENDING IN BIG LOSSES

Wickes Furniture Company was a furniture retailer with 37 stores, based in Wheeling, Illinois. Wickes had been struggling in the cyclical furniture retail business for over 20 years. In 2002, Wickes was acquired out of receivership by Sun Capital Partners, a private equity player that specialized in distressed investments. The undisclosed price has been estimated at about $75 million. After benefiting from a strong housing market from 2003 to 2006, Wickes expanded as the housing market collapsed in 2007. While Sun injected funds into Wickes to keep it operating through October, in December Sun refused to provide more funds without an agreement from vendors to defer past due payments Wickes’ inventory purchases.32 Wickes filed for bankruptcy on February 4, 2007, to obtain protection from creditors and attempt a sale to perhaps another private equity firm with a greater risk tolerance. No doubt, Sun will survive because it knew when to say “no” to avoid further losses.33 Many of the private equity transactions booked in 2006 and 2007 will fail because of the changes in the markets in 2008. Successful private equity players will find opportunities in the changed markets and will recover.

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IF YOU THINK REALLY LONG TERM, WHY HOLD BONDS? Looking at the risk and return of stocks relative to bonds over any 10-year period (including a starting point after the crash in 1929), we find that stocks have always outperformed bonds. Introduce taxes on dividends and interest, and the relative return becomes even more impressive. Yes, the stock market has ups and downs, but it has always pressed forward. Private equity players have a long-term (three- to eight-year) holding period that can work to their advantage, eliminating the short-term pressure that faces public companies. The implication from the data is that no investor with a true long-term time horizon (for example, pension funds, insurance portfolios, and major foundations) should invest in fixed income securities. The overwhelming evidence from a century of history points to an all-equity portfolio. Segments of investors with shorter-term horizons and needs for liquidity hold bonds.

ACCOUNTING ISSUES DIVERT ATTENTION FROM FOCUSING ON RISK Dennis Chookaszian, chairman of FASAC (Financial Accounting Standards Advisory Council), warns that the convergence process between U.S. and international accounting standards faces not just resistance but tremendous technical hurdles. Blending principlesbased and rules-based systems will take far longer than many expect.34 While some public companies try to move away from the EPS focus, others point to the fact that “people” will create their own EPS estimates from financial statements just as they have created an industry that provides information based on reporting and tracking EPS estimates from a variety of analysts. The Sarbanes-Oxley revolution and GAAP accounting combined with tightened disclosure rules have reduced the amount of discretion that management has to “engineer” earnings per share, when reporting its quarterly EPS, to the penny. As a result, public companies will report more quarterly EPS outcomes that miss— both above and below—management guidance or analyst estimates. Reported EPS for most companies will be more conservative but also more volatile than ever before. How to measure and manage risk in this new highly volatile market is a new frontier.

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IMPROVE COMMUNICATION WITH A NAPKIN SKETCH While we decry the simplistic approach, we strongly champion the discipline of digging to bedrock and finding the simple underlying truth and a meaningful framework. Once found, the underlying answer can be communicated in a most straightforward manner. However, universal acceptance is not always the immediate outcome. The simple truth frequently contradicts well-established theories and beliefs. What is needed is not better thought processes but better communication with others in the field. It is always surprising how fundamental ideas can be communicated on the back of an envelope or on a napkin. Most businesspeople have witnessed a brainstorm, the output of which found its way onto a tablecloth, a napkin, or the first available piece of paper. Private equity players are uniquely situated to have productive communication with the CEOs and top-level managers of their portfolio companies. Successful private equity players are not micromanagers. They are deal makers who have a specific goal of value creation. With few distractions from probing regulators, the conversations focus on strategy and value. We construct one hypothetical conversation below based on observations in a variety of real-world situations: Private equity owner: Well, Mr. CEO, thank you for the presentation of your budget. The $100 million EBITDA that you have projected will provide a good base for the business. However, you must understand that our expectations are a little more aggressive than your old bosses in the public company that previously owned your division. Before we made our bid on your company, we did our homework. When we bought your company, we thought we made it very clear that you should develop a plan to double your sustainable annual EBITDA within five years. If you succeed, you can be wealthy. Here, look at this napkin (Figure 3.3). Tell me the four things you will change to double EBITDA to $200 million in four to six years and control risk. For instance in our last portfolio company, it looked something like this. . . .

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Figure 3.3 You can communicate the essence of a plan on a napkin

The EBITDA at the end of four or five years must double, plus or minus 20 percent. The plus or minus depends on how much debt you can pay down over the next three years and how you have positioned the company for future growth. Oh, by the way, DON’T EXPECT US TO FINANCE YOUR AQUISITION PLANS unless there is a huge payoff. CEO: If our projected product launches are all favorable, and if . . . Private equity owner: Whoa! Let’s not rely on external events over which we have no control. I’m interested in what you and your team will do to meet the targets. You must identify and control those risks. Leave luck out of this and come back to me with a real plan, and don’t be shy about including some real changes in the business. You must be flexible and adapt to meet the EBITDA goal while paying down debt. You really need to show an understanding of how interest rates will affect the slowdown in housing and how that will affect all the players in your industry. You also need to convince me that your people are committed to change!

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Later that month . . . CEO: When I left, I was concerned that my team members might just bog down like they used to when headquarters would say, “Not enough,” to all of our plans. But, when I mentioned the part about our own ownership and the getting wealthy part, I think I got their attention. Here is our plan: 1. We agree to increase the leverage in the company even more to give us tax shelter and boost your equity returns. The proceeds will give us the flexibility to undertake the acquisitions that are part of the plan. 2. We will sell our underperforming division in the next three months. The employees have been trying to put together a deal for the last five years. We have not paid attention to them in the past. The unit is a drag on management and has delivered poor returns over the last seven years. We hoped it would turn around. Hope is not a strategy. Can you help us get the employees the financing they need? 3. Once we have that business out of the way, though, we are in a great position to acquire a West Coast outlet that will boost our core business. The company I have in mind is a distribution center with a full transportation network that it has built up over the past 20 years. It considers itself an orphan division from the parent holding company and is open to an offer. I will get this done in the next 12 months despite the fact that we have been considering it for three years. 4. The whole team is energized. All the members realize that decisions will be made that make our business more valuable. For once we all feel like we are in the same boat with the owners. We now feel like we are in the driver’s seat and can actually do something that will make a big difference. So, make that range of four- or five-year EBITDA values double or $240 million plus or minus 20 percent. My team is 95 percent confident we

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can make it happen regardless of our competition because the market is growing, and we can adjust everything in our plans to make the EBITDA goal. 5. We will need to be flexible in responding to new insights, but we have all the incentives we need to make that EBITDA goal. We will advise you if we see any new risk to that new goal at our bimonthly board meeting. Private equity owner: That’s great! We like to see that level of confidence in our portfolio company plans. We hoped you would agree that the risks are low. As long as the market grows, you should do just fine, and that’s why we purchased your division from that sleepy conglomerate.

DATA WITHOUT ANALYSIS ARE NOT INFORMATION (E.G., TRENDS AND SCATTER) The onset of computers gave us the ability to store more and more data. The promise was that we would have better information and better analysis. However, data without analysis are not information. The modern world thrives on information, but we live in an endless sea of raw data. The news media thrust their stories on us, much of which is irrelevant and distracting noise. E-mail is awash with spam and excess communication about inconsequential issues and events. Despite the clutter and the difficulty of dealing with the data explosion, it remains crucial to find ways to manage the data and to turn them into information. Digging deeper into the data does not mean storing them, or transporting them, or distributing them to others. The real meaning comes from finding trends, ranges, and patterns, using the data to anticipate outcomes and evaluating results. The critical issue is presenting the data in a way that helps the reader increase his or her understanding of the facts and the implications of the data. All of us can improve our methods of presenting data to others. For some examples, take a look at the daily newspapers to see how differently data are presented on the financial, weather, and sports pages. Communication on risk is one of the greatest

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challenges that businesses face. Risk is a complicated subject. People are accustomed to looking at data presented in a variety of ways. Books have been written on how to communicate through words, graphs, charts, and tables. Top value builders dig below traditional PowerPoint presentations to understand the true underlying causes and undisclosed assumptions.35

BANKERS ARE FORCED INTO A HIGHER LEVEL OF RISK SOPHISTICATION WITH BASEL II

In 1988, the Basel I Accords were entered into by most of the world’s central banks. The agreements ushered in a global regime of regulation built around the concept of risk-based capital allocation. Before the Accords bank capital ratios were inconsistent from country to country. Critics argued for a “level playing field” for banks. The concern was that undercapitalized banks from some nations (German and Japan at the time) were using their low equity ratios to justify ruinous pricing that was considered damaging to the safety and soundness of the global financial system. Basel I required that banks risk-weight their asset portfolios to determine capital requirements. This focused banks on their returns on equity and on the riskiness of their portfolios. Now it is time for Basel II. The stated goals are to make capital allocation even more risk-sensitive and to separately quantify and provide capital for both credit and operational risks. The new process was designed to make more use of banks’ internal risk-rating and risk-weighting systems. These systems currently feed into the calculations of bank reserves. Under the new system, the calculations will have greater impact, as they will also affect the determination of required bank capital.36 Protecting banks’ capital adequacy is a fundamental goal of bank regulation. The capital requirements must be set high enough to enable survival of the banking system in the event of unexpected financial disasters. Bank directors and managers are now required to think in terms of probabilities. The recent chaos in the global banking industry makes it clear that Basel II was not a cure-all. Regulation will never eliminate risk from the banking industry. However, we should expect even more vigorous bank regulation in the future.

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HEDGE FUNDS FORCE DEVELOPMENT OF NEW RISK MEASURES The tremendous growth of hedge funds, which attempt to improve risk and return by investing in an unusual diversity of assets, has brought new meaning to the words “risk metrics.” The rise of hedge funds parallels the tremendous growth in private equity and has contributed to it. As wealthy investors sought out higher returns and diversification, record low default and interest rates made potential hedge fund returns very attractive. Wealthy investors flocked to hedge funds. Hedge funds can be thought of as a unique class of unregulated mutual funds. They have a wide range of styles, investment strategies, and asset classes ranging from commodities to stocks and bonds. They typically have one trait in common and that is the use of leverage and the ability to change trading strategies without regulation. Like private equity they have high performance incentives including a 1–2 percent management fee and a 20 percent bonus for performance over stated benchmarks like the S&P 500. There are literarily thousands hedge funds. One source claims to have information on 16,500 funds.37 Many are registered “offshore” for tax and regulatory reasons. Hedge funds are believed to be “self-regulated” as investors are limited to a maximum of 499 individuals who must qualify as “accredited investors.”38

SIMPLE REMEDIES CAN BE COUNTERPRODUCTIVE

Because of the tremendous growth in hedge funds and private equity in 2006 and 2007, there appeared a high risk that tax laws would become more focused on capital gains of private equity and that regulation would be imposed on hedge funds. Former Fed chairman Alan Greenspan put it into perspective when he said: “Any governmental restrictions on fund investment behavior (that’s what regulation does) would curtail the risk taking that is integral to the contributions of hedge funds to the global economy, and especially to the economy of the United States. Why would we wish to inhibit the pollinating bees of Wall Street?”39 By late 2007, the initial efforts to turn the tax laws against these investors had failed. The tax laws were not changed. The political (Continued)

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rhetoric exceeded the ability of legislators to increase taxes on the “carried interest” of private equity funds, and hedge fund regulation did not increase. No doubt private equity and hedge fund players lobbied hard and made the point that they have a role in making markets more efficient. Most of their investors are institutional investors, including public pension funds and nonprofits that welcome aggressive management and innovative ideas to improve the risk–return characteristics of their portfolios.

Performance of hedge funds varies as widely as their styles. Based on a now outdated but widely quoted study of a large sample of hedge fund (self-reported) data from 1988 to 1995, hedge funds consistently outperform mutual funds but not market indexes. We believe the study is outdated because it did not address up and down market cycles, may ignore the possibility of survivor bias, and does not reflect the performance of the huge number of new hedge funds started and shut down in the last five years.40 Hedge fund performance metrics focus on relative return and risk, but new risk metrics are needed because hedge fund returns by their nature are not normally distributed. Reporting is not required by government regulation, but many funds do report to some source. For example, Morningstar monitors over 3,000 hedge funds.41 Typically reported is the style of the fund and the year-todate (YTD), three-year, and five-year internal rate of return (IRR) performance of the fund relative to the S&P 500 in a category. Risk metrics designed to describe non-normal returns include skewness (asymmetry), kurtosis (flatness), Sharp ratio, Sortino ratio, positive months, negative months, and worst months as well as maximum drawdown in dollars.

WHAT DOES IT TAKE TO SUCCEED AS A HEDGE FUND? Successful hedge funds are built on a foundation of four main elements: 1. Scale. Most of the positions taken by hedge funds are essentially bets on small inconsistencies they find in

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markets. A huge amount of money must be put at risk for a big payoff to occur. Scale is also important in that it justifies the resources necessary to perform analysis. 2. Hard analysis. Real resources must be devoted to analyzing each position to a great depth. If the analysis does not go down to bedrock, it is probably too superficial, given the risks. Without good input, no model will produce the right answers. 3. Good model. The model used must realistically track what the market will do, given the assumptions that are being made. Without a good decision model, even the best data will not help. 4. Luck. Most hedge fund “bets” include real risks that cannot be abated. If a fractal event occurs and overwhelms both the data and the model, losses will occur. Hedge funds and their managers have reputations close to those of medieval magicians. Despite a popular notion that they can do no wrong, they do take real risks, and some bet wrong. When inflection points occur,42 the news media usually surface the names of the unfortunate—those whose bets turned against them.

COMMON USE OF FINANCIAL DERIVATIVES IS GROWING Chicago has been a center for financial derivatives because of its experience in commodity markets. The wide variety of derivatives available in the interconnected global economy continues to grow.43 They range from simple commodity and stock-based options (puts and calls) to the most sophisticated interest rate and foreign exchange instruments. Electronic trading and risk analysis have made these risk management tools a growth industry. “Credit derivatives fill a natural void that existed previously in a company’s ability to shift its credit risk Additionally, they appeal to a wide range of players. Moreover, as new products are realized, new players are apt to emerge as well, and changes in rankings are to be seen.” 44 While many believe the risk in the interconnected global economy has been reduced through free trade and less regulation, many of these newer financial derivatives have not been tested in the

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high-leverage market we found in 2007.45 Some private equity funds combine financial engineering involving the use of multiple derivatives with high leverage. While the results will take years to analyze and understand, some investors are questioning the logic of high-leverage and high-risk businesses.46 A lesson from the past: Banks have a history of underestimating the credit risk of new products. These mistakes have typically mushroomed into banking crises of various sizes. Products in this notable rogues list include foreign exchange trading, standby letters of credit, interest rate swaps, floor plan loans, lending against petroleum reserves, “daylight” overdrafts, subprime auto lending, and others. Today’s list includes subprime mortgages and a full array of credit derivatives. Different from the past, the credit derivatives are primarily designed to transfer credit risk. In the previous crises, the banks stubbed their own toes by lending too much, or made loans based on the wrong assumptions, and they bore the brunt of the problems. Somewhere in the future there will be a crisis based on a broad sweeping failure of a class of credit derivatives (for example, collateralized mortgage obligations [CMOs] or collateralized loan obligations [CLOs]). We have already seen chapter one of this drama, with the big question arising from the investors who have bought these instruments and thus absorbed risk from the banks: “Who is minding the store?” Because the instruments allow the banks to off-load the risk to others, the banks have the opportunity to “let the market decide,” which really means that no one will decide on the credit risk, or the value of the underlying collateral. Market participants have lulled themselves into a false sense of security more than once, believing that credit ratings from Moody’s or S&P will suffice for credit judgment. Holders of CMOs and mortgages in 2007 found out otherwise. Stay tuned for more surprises as these derivative products teach us all more in the coming years and CPAs learn to incorporate them into GAAP accounting. Unfortunately, these complex financial engineering strategies frequently cannot be explained on the back of a napkin or understood by those who invest millions! Their performance is certainly too early to call and clearly outside the scope of this book as the “wisdom” is not yet proven. Hopefully, market participants are investing only enough to experiment with the newest derivative

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strategies and learn from experience without killing the fund or the economy. The gyrations and increased volatility in the financial markets of late 2007 and 2008 influenced by the boom in credit derivatives of 2006 and 2007 are a concern to many, as were the Amaranth and Long-Term Capital failures. Experiments of the financial kind do have risks, as we will see in Chapter 9. That’s why they are called experiments.

A FINAL WARNING ABOUT RISK For all the quantitative methods that have been developed in an effort to understand and control risk, markets continue to have risks that are more tied to the participants than to the numbers. It is the people who react to the numbers, and those people and their decisions move the markets and create further risks for everyone involved. Risk will continue to be about uncertainty, variability, and the entirely unknown. Author Michael Mauboussin said: “We really don’t know how markets aggregate information and what it means for stock market efficiency. Our concept of risk remains incomplete, although we do know that the standard measure of risk is wrong.”47 He does argue against rules of thumb without digging deeper to understand their embedded assumptions. For example: price-earnings ratios are not stationary because of constant changes in macroeconomic variables, such as growth, inflation, taxes, and risk appetites of markets and the structure of the economy.48 What we don’t know, we don’t know, but we can clear some of the fog and find ways to protect ourselves, even from the entirely unknown. Successful private equity players seem to control risk better than do public equity players. Is it discipline or luck? You decide.

SUMMARY AND CONCLUSIONS Private equity is more competent at controlling risk. Risk is a fact of life. Public corporations are required to disclose their risks annually in their annual 10K reports. Private equity firms are structured to look at risk differently. Portfolio companies are separate legal entities. They dig deeper to understand the potential risks in portfolio

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companies before they place their bets. After the acquisitions, they monitor performance against plans to control risk. They look for companies with the potential for steady and healthy cash flows and a spread between the return of the business and its cost of capital. Viewing the magnitude and likelihood of risk makes it more comprehensible. Risk can be incorporated into any analysis. Thinking about risk without including an assessment of both magnitude and probabilities can result in even greater misunderstanding. Although business and political leaders would like the experts to tell them exactly what to do, the world of the future is not subject to absolute certainty. Good luck and bad luck play a role in every decision. Errors in judging risk can be costly. Top value builders deal with risk differently; they dig deeper to understand it! Yet many decision makers sometimes overreact to expert input about risk. Successful private equity players and other top value builders are generally independent long-term thinkers, not short-term traders. Yet market psychology and the people factor bring an interesting twist to interpreting numbers. Effective leaders realize that it is easier to destroy than it is to create value. Recall the missteps that were made by leaders who tried to anticipate problems of Y2K and missed the O-ring problem on the space shuttle. Many misunderstand risk. Examples from the investment and corporate sectors demonstrate that major errors occur when leaders communicate risks poorly, ignore risk, confuse the short and long term, or ignore the impact of serial events. Amaranth and Long-Term Capital Management were victimized as much from assuming away certain types of risk as from the “serial risk events” that hurt them. Airline and auto companies painted themselves into strategic corners of inflexibility. When conditions changed even slowly, they could not.49 Scenarios are necessary in a world of uncertainty. Examining events, trends, and their potential impact on ranges of value and wealth is key to assessing the best course of action. Further, a nagging issue for decision makers is that risk events at the extreme ends of predicted ranges seem to be more common nowadays. Combining high levels of debt with risky businesses brings a new level of risk to private equity. We inspected the problem of “fat tails and fractals” to demonstrate how leaders incorporate them into their thinking and their risk reduction initiatives. Standard formulas don’t work; you need to simulate alternate scenarios.

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Focused risk taking can enhance returns. Top value builders structure their organizations to use risk to their advantage and control the risks in their investments. High leverage and use of separate legal entities by private equity firms allow them to isolate and concentrate risk at the business unit level. This forces their executives to anticipate and manage risks better than many public companies.

NOTES 1. Paraphrased story told in panel discussion by Motorola’s internal auditor at KPMG Audit Committee Institute, Milwaukee, WI, November 2006. 2. Serena Ng, Tom Lauricella, and Michael Aneiro, “Market’s Jitters Stir Some Fears for Buyout Boom, Takeover-Related Debt Gets Chilly Reception, Hearing ‘Wake-Up Call,’” The Wall Street Journal, Midwest Edition, June 28, 2007, p. 1. 3. Smaller units have the advantage of flexibility and adaptability. The metaphor of Sir Francis Drake dueling with the Spanish Armada comes to mind in comparing private equity and public corporations. The larger corporations have generally lost their capacity to change direction quickly, while the smaller competitors can push forward, seeking opportunities, or retreat from markets quickly when adverse conditions develop. The typical private equity portfolio company of the past has been smaller in size than most public companies. As a result, changes in strategy are much easier to make than in larger public companies. This flexibility has huge competitive advantages in niche markets and changing market conditions! 4. Alpha is a measure of return above the market average, and beta is a measure of risk relative to the market. 5. David Ivanovich, “Natural Gas Gambling: A Senate Report Says the Failed Hedge Fund Amaranth Advisors’ Speculation May Have Cost the Public Billions in Higher Bills,” Houston Chronicle, June 26, 2007, from: http://www.chron.com/disp/story.mpl/business/ 4919847.html. 6. Ibid. 7. Ibid. 8. Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management (New York: Random House, 2000), p. 200.

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9. Benot Mandelbrot and Richard L. Hudson, The (Mis)Behavior of Markets: A Fractal View of Risk, Ruin, and Reward (New York: Basic Books, 2004), p. 106. 10. Ibid, Lowenstein, pp. 228–229. 11. Ibid, Lowenstein, p. 228. 12. Gregory Zuckerman, “Long-Term Capital Chief Acknowledges Flawed Tactics,” The Wall Street Journal, Eastern Edition, August 21, 2000, p. C.1. 13. Ibid. 14. Laurie Kulikowski, “WaMu Chief Warns of ‘Perfect Storm,’” TheStreet.com, accessed September 10, 2007, from: http://www.thestreet.com/s/wamu-chief-warns-of-perfectstorm/newsanalysis/wallstreet/10378726.html?puc=_tscrss&. WaMu (Washington Mutual) was taken over by J.P. Morgan amid the 2008 global economic crisis. 15. Both Amaranth and LTCM were hedge funds. The distinctions between hedge funds and private equity are often confused. We discuss them here as they both avoid many of the required disclosures of public companies when it comes to risk and return. Both are prevented from marketing to unaccredited public investors, and they both use high leverage to boost returns to equity. A main distinction is that hedge funds typically act as traders of publicly available assets (stocks, bonds, foreign exchange), while private equity firms are investors, typically buying up to 100 percent equity in companies. 16. A Gaussian normal distribution refers to the bell-shaped frequency distribution curve that describes events that are independent and randomly distributed about an average value. A great convenience arises in such data, because it has been shown that characteristics of random samples of such data can lead to accurate predictions about the entire data set. When the data points are not independent and random, the Gaussian normal distribution does not arise, the math does not apply, and the conclusions that can be drawn from random samples about the entire data set begin to break down. Early work on stock prices indicated that changes in prices were random, implying that the math of Gaussian normal distributions could be applied. Much of modern finance theory makes use of this assumption. More recently, the work of many researchers, including Benoit Mandelbrot, has contested both the independence and the nature of the randomness of the data. These researchers claim at a minimum that modern finance theory overuses the Gaussian normal

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21. 22.

23.

24.

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formulation. At the extreme, they argue that modern finance theory is completely wrong. Mandelbrot and Hudson, p. 4. Ibid, p. 247. Ibid, pp. 208–222. New ideas sometimes take centuries to become mainstream In the third century BC the ancient Greeks had come to realize that the earth was round. Eratosthanes, armed with a stick and some knowledge about the way the sun, on one day each year, would shine directly down a well a few hundred miles south of him, was able to calculate the circumference of the earth with surprising accuracy. Unfortunately, these ideas met with resistance and were pushed aside for the next 1,500 years. Source: Simon Singh, Big Bang: The Origin of the Universe (New York: HarperCollins, 2004). There is more on this subject in Chapter 8 when we discuss inflection points. Examples of industry wisdom that later led to downfall: hub and spoke systems are the most efficient for airlines, automakers should be vertically integrated, department stores can be successful only in malls. Nanette Byrnes, “No Chapter 11 Here: The Investor Extraordinaire Speaks Out on the Cerberus Deal and How It Will Affect Automakers, Private Equity, and the Auto Market Overall,” Business Week, May 15, 2007, Newsmaker Q&A, http://www.businessweek .com/print/bwdaily/dnflash/content/may2007/db20070515_ 870543.htmAccessed January 7, 2008. For example, a particular risk might be found and mitigated by the purchase of a financial derivative. “The risk is gone,” the local manager says to herself. However, the local manager may not be in a position to judge counterparty risk, or concentrations. It is also likely that the local manager lacks the expertise to consider basis risk and some of the other arcane risks that may be hidden in derivative transactions. Interview with Bob Lane, chairman and CEO, Deere & Company, December 18, 2007. See more on the Deere’s planning process and incentive system in Chapter 4. Interview conducted by Bill Hass and Shep Pryor. Richard P. Feynman, Classic Feynman, Ralph Leighton, ed. (New York: W.W. Norton & Company, 2006), pp. 379–412. Economic value added (EVA) and cash flow return on investment (CFROI) are popular metrics that employ standardized methods of

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32. 33.

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translating GAAP financials into more insightful, value-oriented information that can be used for cross-company comparisons. Nassim Nicholas Taleb, The Black Swan (New York: Random House, 2007), p. 277. Ibid, p. 276. Katie Benner and Geoff Colvin,“Cerberus: Inside the Wall Street Powerhouse,” Fortune, August 20, 2007, vol. 156, no.4, pp. 38–39. “Chrysler Group to Be Sold for $7.4 Billion: Automaker Sells 80% to Cerberus, Ending Dreams of Creating Auto Giant,” MSN.com, www.msnbc.msn.com/id/18645179/-57k-cached-. Accessed November 2, 2007. Sandra M. Jones, “Without Buyer, Wickes Could Be Liquidated,” Chicago Tribune, February 6, 2008, Section 3, p. 3. James P. Miller, “Furniture Retailer Wickes Files for Chapter 11: Furniture Chain Mum on Fate of Its 37 Stores,” Chicagotribune.com, www.chicagotribune.com/business/chi-tue_wickesfeb05,0,2111031 .story, February 5, 2008. Accessed by S. G. Pryor on February 14, 2008. Interview with Dennis Chookaszian, September 4, 2007, conducted by Bill Hass and Shep Pryor. See Edward Tufte, The Visual Display of Quantitative Information (Cheshire, CT: Graphics Press, 2001), and Tufte’s blog at www.edwardtufte.com, which contains dialogue on the Challenger crisis and other insights on PowerPoint weaknesses. Full white paper is available at: http://www.bis.org/publ/bcbs128 .pdf: Basel Committee on Banking Supervision, International Convergence of Capital Measurement and Capital Standards, a revised framework, comprehensive version. EurekaHedge maintains a list of hedge funds and provides clients with information on the industry. See www.eurekaHedge.com. “Accredited investor” is defined by the SEC in Rule 501 of Regulation D, under the Securities Act of 1933. Accredited investors must have typically over $1 million in net worth or annual earnings of over $200,000 for the preceding two years with expectations of similar amounts in the current year. Congress is considering raising the minimums that accredited investors must possess to limit participation in hedge funds by less sophisticated investors. Alan Greenspan, The Age of Turbulence: Adventures in a New World (New York: Penguin Press, 2007).

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40. Carl Ackermann, Richard McEnally, and David Ravenscraft, “The Performance of Hedge Funds: Risk, Return, and Incentives,” The Journal of Finance, 1999. Cited by www.edge-fund.com. 41. Go to www.morningstar.com and click on “hedge funds.” 42. See Chapter 8 for more discussion of economic inflection points—the point at which an economic variable changes from an upward trend to a downward trend, or vice versa. 43. Ellen J. Silverman, “Market Risk—Credit Derivative Growth Surges by 106 Percent,” August 9, 2006. Source: http://www.riskcenter.com/ story.php?id=13317 accessed on September 4, 2007. 44. Ibid. 45. See Lewis A. Sanders, AllianceBernstein L.P. white paper, “The Last Risk Premium Standing,” May 2005. https://www.bernstein.com/ CmsObjectPC/pdfs/B45222_LastRiskPremium_LAS.pdf. 46. Peter Morici, “Con Men Create Crisis,” Providence Journal, August 27, 2007. Source: vindy.com, accessed on September 4, 2007: http://www .vindy.com/content/opinion/oped/369409823810566.php. 47. Michael J. Mauboussin, More Than You Know: Finding Financial Wisdom in Unconventional Places (New York: Columbia University Press, 2006), p. 207. 48. Ibid, p. 140. 49. Many models make use of simplifying assumptions. Statistical models frequently assume normal distributions of the data, even when the model builders are aware that the data are not normally distributed. Unfortunately, the real world impact can produce an extreme outcome, and it is more likely to happen when data are not “normal.”

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CHAPTER 4

Incentives Value-Based Executive Compensation Leads the Way

“W

elcome to the world of private equity. You have invested along with us, so we all have skin in the game. If we do well on this investment, you will be wealthy.” The new chairman of the board, one of the partners of the private equity fund, spoke softly to the management team. “We have a four- to five-year horizon for value creation. If you don’t perform, you will lose your investment and will be looking for a job. Our severance package is a maximum of one year’s salary. Once we agree on a plan, we will have monthly board meetings and a weekly conference call. Agreed? “Oh! By the way, we have an agreement from a hedge fund to leverage the company to four times its present level. We want you to be sure your plans include significant cash flow to pay down debt over the next four years as well as increase the company’s long-term value. We have negotiated minimum covenants on that debt, so you will need to monitor cash closely. There is no safety net. There will be no chance of a restructuring. The hedge fund is known as one that is not afraid to ‘loan to own.’” Private equity firms compensate management handsomely for creating value and paying down debt. Private equity owners and their representatives on the board call the shots much more effectively than members of most public company boards. Amfac is one of the first public companies to give shareholders a vote on 123

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CEO pay, but it is a nonbinding vote. A Hewlett Packard shareholders’ proxy proposal asked to have a substantial portion of executive pay “linked to demonstrable performance criteria,” but management and the board recommended against it.1 Months later the HP board reversed their position, after a majority of shareholders asked for change. HP now has an executive compensation plan that improves the link between pay and shareholder value performance. The world of executive compensation will never be the same. Yet questions remain: What incentives will work best in this new world? Who should be given incentives? What does private equity do better? Can these techniques be used in public companies? A positive trend is already occurring among public companies. Compensation experts are seeing public company compensation moving more toward the private equity model with greater emphasis on value creation and less on EPS growth.2

GOVERNMENT INTERVENTION HAS UNINTENDED CONSEQUENCES ON COMPENSATION Executive pay legislation is a classic example of the failure to understand the people effect. Much of the excessive CEO pay around the turn of the century was triggered by new rules in 1993 under which non-performance-related annual pay above $1million was no longer deductible for corporate income taxes.3 This change, which was created in an effort to stem the tide of rising CEO pay, caused rewriting of executive pay plans and prompted companies to increasingly turn to performance-based stock options and grants to avoid the loss of tax deductibility. Targeted pay levels did not decrease, as the market price for CEOs was clearly above the $1 million mark. The unplanned outcome was to make actual CEO pay much more volatile and unpredictable. The result was vastly more headlines decrying CEO pay, as the market surged into 2000. CEOs whose options paid off the best pushed the headline numbers far beyond any previous records. When the stock market crashed, these astronomical paydays came to represent the excesses of the 1990s, spawning new and even more vigorous criticisms.

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In 2006, new SEC rules were issued regarding the disclosure of executive pay. Along with a new accounting pronouncement, Financial Accounting Standard (FAS) 123R, which changed the accounting for certain types of executive pay, these rules were designed to put significantly more information about executive compensation in the hands of investors. The first proxy season to require the new disclosures was in the second quarter of 2007. SEC guidance was vague regarding the disclosures, despite hundreds of pages of instructions. At the end of the proxy season, the SEC sent out comment letters to 300 companies seeking further clarifications in the disclosures. This was considered a first blast of such letters, with more to follow. Clearly, the issue will take much iteration before the SEC is satisfied that the process is working properly. With these new external pressures, boards may find it easier to tame the compensation hunger of aggressive CEOs, with so many others looking over their shoulders. Example: As directors of a notfor-profit company, the directors of the New York Stock Exchange might have thought twice if the potential compensation outcomes for CEO Richard Grasso had been modeled and the details of his deferred compensation under various scenarios had been disclosed to the board each year. With that level of preparation, the directors would have been better prepared to respond to criticism of Mr. Grasso’s nine-figure accrued retirement and deferred compensation package. The disclosure and the criticism led to Mr. Grasso’s resignation and later litigation.4

MORE COMPANIES ARE GOING PRIVATE AND MOVING OFFSHORE The cost of Sarbanes-Oxley regulation for small and mid-cap public companies has unquestionably made going private more attractive. At the same time, the main benefit of going public, which had been access to greater amounts of capital, has faded in importance as the resources of private equity capital have grown so dramatically. This shift in the costs and benefits of maintaining public corporation status has provided a strong incentive for smaller companies to drop out of the public markets and for companies to defer going public until they reach a much greater size than they had in the past.

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The global calendar for initial public offerings (IPOs) from 2005 to 2007 showed a distinct shift, with many companies that had the choice electing to list their shares in London rather than in the United States. Foreign companies already listed in the United States also have choices. During 2007, 12.4 percent of all such foreign companies delisted their stocks from U.S. exchanges. In addition, four out of five of the foreign companies that raised capital through IPOs in the United States did so using Rule 144a offerings, which are not subject to Sarbanes-Oxley regulation.5 Other reasons prompt companies to elect offshore venues for headquarters. For example, Halliburton Corporation announced its intention to open a headquarters in Dubai in early 2007. In 2008 the company began to list the location of its corporate headquarters as Houston, Texas, and Dubai, United Arab Emirates.6 The public justification for this move was for the company decision makers to be closer to their customers. If the incorporation of the company is later formally transferred to Dubai, the move will allow Halliburton to be less transparent. It will also allow the principals to avoid the scrutiny that has followed the company as a result of their political connections with the Bush administration. Vice President Dick Cheney had been the CEO of Halliburton prior to becoming the vice president. These trends that show corporations considering leaving the United States clearly provide new examples of the unintended consequences of government regulation.

WHAT IMPACT WILL NEW COMPENSATION DISCLOSURE RULES HAVE? THE SEC INVESTIGATES! The reporting changes will keep executive compensation in the center ring for some time to come. Compensation committees will come to realize in many cases that they have been “rewarding A while hoping for B.”7 It will take time to learn what we don’t know. Compensation has been a corporate backwater for decades. There were as many legal and regulatory changes affecting executive compensation passed in the five years between 2002 and 2007 as in the 100 preceding years.8 The current climate is rife with conflict and biased information. Labor unions complain that some CEOs are making 300 to

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400 times the income of the average worker. Politicians and some stockholders clamor for lower pay for CEOs. Corporate governance advocates argue that boards are not minding the store on executive compensation. Boards in the public company spotlight are not willing to bet on untried players to fix ailing companies. Yet, CEOs are unwilling to change their employment and accept positions of extreme risk without commensurate expectations of high payoff. It is within this climate that the next crop of CEOs will have to negotiate their pay packages. Given that CEOs have a half-life of less than two years, there will be a great number of pay-for-performance experiments in the laboratory of public companies in the next few years. Each April, as public company reports are filed, CEO pay becomes a media football.9

TOP VALUE BUILDERS STRUCTURE INCENTIVES BETTER Public company CEOs are finding that the rewards can be much greater in private equity. Computer Discount Warehouse, renamed CDW Corporation, is a $7 billion provider of multibranded information technology products and services.10 CDW went private in October 2007. Now private, CDW no longer has to make the detailed CEO pay disclosures required of a public company. However, we can assume that CDW’s new owner, private equity firm Madison Dearborn Partners, plans to compensate CEO John Edwardson handsomely if CDW achieves a doubling of value. Months before the unsolicited offer from private equity, CDW had reorganized its sales staff, stalling its stock price. The board believed in the new organization, but the value had not yet expressed itself in quarterly performance figures or the stock price. However, because the board had just reviewed the strategy and intrinsic valuation of the company, it was able to negotiate a significant increase in the buyout price and was ready to sell to Madison Dearborn, not at the initial bid, but at $87.75 per share, closer to what it considered the intrinsic value. Both Edwardson and founder and former chairman Mike Kraszny were placed in a difficult situation by the unsolicited offer. Edwardson and the special committee of the board had to exclude CDW’s majority shareholder, Mike Kraszny, from the evaluation

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and negotiation process. Separately, Edwardson was not allowed to negotiate his compensation package with the new buyers until after the sale of the company was completed.11 While the debate continues to rage about public company CEO and executive compensation, private companies are able to go about their business and make decisions that they believe are the most productive. Rather than having to satisfy outside constituents that the salaries fit arbitrary criteria, the private equity owners can design the packages to fit each situation. They can give the strongest incentives to management, based on the value to be created. They base incentives on achieving the plan under which they bought the company.

SIMPLE BUT WRONG: WHY COMPENSATE A SALESPERSON ON GROSS SALES? Over the years, corporations have employed innumerable incentives to drive the activities of their people. At the grass roots, there is the choice of paying workers for piecework or paying by the hour. At the top, CEOs’ pay has been tied more directly to measures of shareholder value. The difficult job for management is to convert the incentives at each level of an organization so that all of the players are working toward a common goal of creating and enhancing long-term corporate value. For this effort to be successful, different metrics must be used for different units and activities within a company. The late Merton Miller, professor and Nobel laureate, would tell his students that this was the most difficult job for managers, creating the “kick structures,” that is, the incentive structures that would lead all the employees toward behaviors that would increase corporate value.12 In an effort to simplify this process, many companies limit the number of measures that are used to provide incentives at each level. Single measures are particularly dangerous because they almost always are subject to manipulation and gaming, either intended or unintended: •

“We pay our sales force a fixed percent of gross sales.” This time-honored and simple way of paying salespeople goes wrong almost immediately. Salespeople may find that

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selling the lowest-margin product gives them the highest commission. Management usually finds that multiple measures are necessary to provide incentives that promote all the desired activity. • “We compensate the unit manager on EBITDA.” This approach, common in private equity, sounds reasonable. However, private equity owners couple this incentive with the requirement of servicing high levels of debt, which disciplines executives to manage assets tightly. In many public companies the asset discipline may be missing, and EBITDA-based incentives go awry.13 Top value builders have learned that incentives must reach the right level of complexity to do the right job. They know that the inconvenience of implementing more focused incentives based on long-term value is worth the effort. The best practice is to pay incentives as a significant percentage of base pay and relate the incentives carefully to performance goals that build corporate value.

IS THERE SOMETHING WRONG WITH EXECUTIVE COMPENSATION? Private equity expert Professor Steven Kaplan, testifying before the U.S. House Committee on Financial Services in March 2007, said that, despite the staggering salaries of public company CEOs, most are actually paid according to market value and performance, and some may actually be underpaid. He told the committee that the “say on pay” bill that Congress was considering was not needed and might actually harm the economy. “There can be no doubt that the typical CEO in the U.S. is paid for performance. . . . It seems unlikely that CEOs who choose to go private and work for private equity investors would do so if they were so overpaid as public company CEOs. It is also worth pointing out that in hiring the CEOs at higher pay, the private equity investors cannot have felt the CEOs were overpaid.”14 The occasional exceptions to the rule have caused a furor among investors, media spokespeople, and legislators. Even compensation consultants have been critical. Frank Glassner, CEO, Compensation Design Group, has said: “How many compensation

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professionals, both internally and externally, tell their boss or client what they need to hear instead of what they want to hear? In reality—not very many.”15 Hopefully there are lessons that can be learned from the extreme examples. Before the 2006 SEC disclosure rules on executive compensation, there was no standard definition of total compensation or any requirement that it be disclosed to shareholders. Effective in 2007 for fiscal years ending on or after December 15, 2006, corporate proxy statements are required to include a total compensation table and a special section known as the compensation discussion and analysis (CD&A). This section must disclose and explain compensation of key executives, including salary, bonus, retirement plans, long-term incentives, and other perks such as use of cars and planes. Previously, significant executive compensation items, such as severance applicable in cases of change of control or termination, could be buried in SEC filings. Now, in the interest of transparency, this information must be disclosed in the proxy materials. Severance terms were brought to the attention of corporate directors in the wake of the Disney suit, where Michael Ovitz had been paid severance of $140 million after working as Disney’s president for only 14 months. In the ensuing lawsuits, the Disney directors were severely chastised for the quality of their judgment, but were not required to participate personally in funding the litigation settlement. Other directors took the lesson seriously. As we saw in Chapter 1, Bob Nardelli walked away from Home Depot with over $100 million in severance. Over a year earlier, he had asked the board to change his compensation program to be more attuned to earnings and sales growth than share price. As a result, corporate directors often now ask for preparation of a spreadsheet analysis with scenarios on what might happen to the CEO total compensation under various assumptions, both good and bad. Required corporate disclosures have more than tripled the size of key sections of some annual 10K and proxy materials over the last five years.16 Directors on compensation committees now do far more homework to understand the details of compensation plans than ever before.17 With increasing frequency, shareholder groups continue to call directors on the carpet for excessive CEO compensation not tied to

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shareholder results. A major criticism is that big pay mistakes are not reversible. Numerous cases of backdating of stock options surfaced in early 2007, further eroding credibility of the state of corporate governance. In cases this extreme, recovery of pay mistakes is sometimes possible. For example, after months of litigation with institutional stockholders, William McGuire, former CEO of UnitedHealth Group, finally settled. He agreed to forfeit over $600 million, mostly in stock options that the lawsuit claimed were illegally backdated.18 Shareholder efforts at exerting more direct influence over board activities have increased, notably the “say for pay” proposals which would call for a vote by shareholders on the CEO’s pay package. Another such effort would have shareholders play a more direct role in nominating board members. Some of these proposals strike at the heart of the present system of board governance, where the board holds certain authority on behalf of the stockholders and has the sole right to exercise it. Public directors support their decisions on compensation by engaging compensation consultants to dig deeper into peer group pay, better value metrics, and strategy issues. Many bridle at the high costs of the consulting, but it will take a significant amount of new effort to rebuild trust and confidence. This will require a period of calm, without new scandals like the backdated options. Yet, positive changes are taking place. Best practices for public companies suggest that justification of incentive compensation requires attention in at least three areas: 1. Understanding the market for talent in key areas. This helps the board ensure that peer group compensation incentives are periodically reviewed and understood. 2. Ensuring a link to the business strategy. This means that individuals who have the ability to influence the success of key strategies should have stronger performance incentives for accomplishing key business unit goals. The smaller size and more focused strategies of private equity portfolio companies are key differentiators in making incentive compensation more effective. 3. Frequent monitoring of value. This helps the board ensure that pay and performance are more closely aligned.

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The strong implication is that one size does not fit all companies and that multiple metrics are required. Compensation is an area in which private equity owners may be much more direct in matching pay and performance. They have no need to bury the details of executive compensation and no need to explain them to anyone except their own limited list of investors. Further, private equity players seem to have a greater focus on long-term value that makes increasing the market value of the business the overarching goal. Value building is typically the foundation of the major incentives available to the management teams of private equity companies. Unlike many public company plans, which provide liquidity to executives through stock or options, private equity incentives are usually not realizable until investor value is realized through a sale of the company. In comparison with private companies, the challenge for public companies is to find better methods of measuring the value of a business and its key business units, and to better control the timing of the payments to the management team. In the late 1990s and early 2000s, stock options seemed to be tied to long-term value and, as a result, grew in popularity. Later the cost of such programs to other stockholders came under scrutiny, adding to the controversy. Restricted share rights, shares of stock with vesting over time, were used as a replacement for stock options by many public companies after FAS 123R forced disclosure and recognition of the cost of options. Compensation consultants frequently argue that options are still appropriate for the CEO, who must deal with the vagaries of markets as well as make fundamental decisions about the company. However, they recommend using restricted share rights as incentives for management players below the CEO level.19 With new and more complete disclosures on executive compensation effective in 2007, compensation committees continue to seek out best practices. This search is designed to support their desire that executive pay be correlated to the creation of sustainable business value, not just quarterly earnings per share and other accounting results. The right performance metrics make a difference, and companies are using more “sophisticated analytics,” such as versions of our old friends cash flow return on investment (CFROI) and economic value added (EVA), from Chapter 1. These value-based metrics are finding their way into more boardrooms as directors of public companies look for better links to value than quarterly EPS growth.20

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MYTH: STOCK OPTIONS PROVIDE THE BEST INCENTIVE FOR PUBLIC COMPANIES

Stock option grants are clearly on the decline. However, some will survive because of their simplicity and leverage. Expensing of stock options was required by calendar year companies effective January 1, 2006. FAS 123R, new disclosure rules, and a renewed focus on corporate governance have been agents of change as they have forced compensation committees and corporate executives to dig deeper into other modes of long-term performance incentives. As a result, there is a renewed interest in more disciplined measurement, sharper goal setting, and aligning pay with performance. Corporate directors have discovered that stock option grants have several weaknesses: 1. Options do not reflect relative corporate or business unit performance and tend to reward even average performance. Favorable macroeconomic trends can bail management out. 2. Typical 10-year option length may be unrealistic for certain businesses. 3. Options seem to imply that everyone in the program affects value building to the same degree. 4. Options have no downside. Compensation committees and plan designers need to dig deeper to understand how stock options and other compensation tools support specific business unit strategies and long-term sustainable value creation. Research suggests that greater use of full-value shares, restricted share rights (RSRs), and stock appreciation rights (SARs) may be more effective than stock options alone in many situations.21 According to Mark Ubelhart, architect of human capital foresight and practice leader, value-based management, at Hewitt: “Stock option plans that index the strike price to industry performance can prevent awards for companies that underperform their industry, but they are not common. Total shareholder return (TSR) versus peer companies plans, known as TSR plans, have grown in prevalence. The growth of TSR plans is a result of their simplicity, the weakness of stock options, and the fact they have no need to set specific financial goals. “The heyday of value-based management and incentive compensation of the 1990s featuring EVA, CFROI, shareholder value added (SVA), and the like did have a lasting impact. Most companies do (Continued)

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consider cash flow, return on investment, and cost of capital in their decision making and incentive design in some manner. The new rules forcing expensing of options, greater disclosure, and improved corporate governance are revitalizing value-based principles that will compel more disciplined measurement, effective goal setting, and better alignment of pay with performance.”22

Most public corporate boards try to do the right thing but do not seem to have the time to gain the complete understanding and perform the detailed work needed to tie executive compensation to value-generating performance for shareholders. Four to six meetings per year—even with the support of outside compensation experts—may not be enough to build consensus and assures that compensation programs are both fair and effective when corporate goals are unclear and markets change. The state of the art of incentive compensation is changing. Rapid changes in the economy and in the legal and regulatory environment have further hampered companies’ ability to catch up. However, things may now be changing. Corporate compensation may be going through its own revolution, similar to the changes that occurred in other elements of corporate governance in the recent past.

WHY DID THE EXECUTIVE PAY MISHAPS OCCUR AT HOME DEPOT AND DISNEY? Big executive pay mistakes make the headlines. The mistakes also find their way into litigation and even congressional investigations. Directors at Home Depot apparently were not adequately informed, or they discounted Nardelli’s ability to collect millions in bonuses while Home Depot stock dropped and underperformed both the S&P and its key competitor, Lowes. Directors at Disney would have been loath to contradict CEO Michael Eisner when he was supporting the hiring of Michael Ovitz. Mr. Ovitz was a megaearner in his own right, running one of the most powerful talent agencies in the country, so that the terms of his contract would be rich to start. Naturally, such a player would want to be protected from the downside, should things not work out. From the board’s

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point of view, what’s not to work out? Ovitz was clearly Eisner’s top choice. It is easy to understand why the directors might not be highly motivated to pore over the severance provisions of his contract and run some scenarios. Severance payments in the case of termination probably were discounted as unlikely events, but when they took effect, the board looked both uninformed and overly generous with the shareholders’ money. The contrast between public companies and private equity continues. Excessive severance amounting to multiples of annual compensation is clearly something absent from the world of private equity. However, public company examples continue to mount up. As we saw in Chapter 1, Bob Nardelli walked away from Home Depot with over $100 million in severance. In November 2007, Merrill Lynch CEO Stan O’Neal left in dishonor with over $100 million in benefits despite presiding over multibillion-dollar losses related to the subprime mortgage market.23 They join the pantheon of the overpaid, who have made headlines and cast a shadow on the rest. Directors in large public companies have been paying attention to the public outcry and the bad publicity that can affect them as individuals as a result of compensation decisions that look reckless in hindsight. Changes are in the wind, and directors of other companies are spending much more time on compensation issues than they had in the past. Interestingly, private equity companies have far fewer problems in this area. They tell incoming CEOs that they will become wealthy if they succeed and that they will get little or no severance if they fail.

EFFECTIVE LEADERS SET MORE THAN GOALS, THEY SET MEANINGFUL GOALS TO BUILD VALUE Compensation must be tied to strategy, and strategy needs to reflect the company’s competitive situation. Yet many public corporations are still struggling to set the right goals. Is it sales growth, improving profit, or generating cash? Is it short-term EPS or long-term value? Private equity firms have the overarching goal of increasing eventual exit value. Their funds typically have a finite life. In Chapter 1 we explore corporate intrinsic value and the difficulty that public companies experience in both defining appropriate

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goals and adhering to the strategies to meet those goals. Given the constant pestering they receive from analysts who clamor for quarterly EPS targets to be met, they often get confused. Private equity has a clear advantage in its ability to avoid the distractions of the quarterly analyst confrontation. However, corporate value comes from not only the short- and medium-term strategies and actions; it is also built on the long-term strategic choices that are made by the company. In both public and private companies, it takes an extra dose of courage and conviction to make investments that will last for 10 to 20 years, or that will take several years to come to fruition. In some cases, the bold moves and the investments invite trouble from the public investors, and the short-term stock price drops. Until the payoffs from the investments begin to express themselves, a stock price may languish. Setting compensation in line with long-term corporate value unfortunately requires similar courage. Value-based compensation expert Mark Ubelhart says: “Pursuit of a shareholder-value-oriented compensation program often stretches the understanding of the likely participants. Indeed, some companies have allowed the concern for simplicity to stall the development of such programs. Others have reduced the focus of such programs to their most narrowly defined elements, which simplifies them but runs the risk of fostering myopic behavior.”24 Top value builders hold improving executive pay as a high priority.

DEERE INTENDS TO GROW VALUE WITH A SUSTAINABLE GREAT BUSINESS For Bob Lane, chairman and CEO of John Deere, it was all about changing the culture of Deere and “running a sustainable great business.” John Deere has expressed this on the front page of its annual report as a motto for each of the past six years: “Growing a business as great as our products.” According to Lane: “Most employees knew we had great products but they did not know we were not a great business. . . . It’s all about communicating what is needed to become a great business. In our cyclical industry it means earning at least a 12 percent return on capital in down years, 20 percent in midcycle, and 28 percent when the business is really good.”25

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What is a sustainable great business? According to Lane, “That means dramatically improving how we use our capital. In the past, we had worked in an expensive way. We did things with too many assets. We were margin-lean; now we have many more profitable products that customers think are really worth paying a substantial margin for [i.e. a price that yields John Deere an economic profit]. Incidentally, the concepts for creating real economic value on a sustainable basis came out of my education at the GSB (University of Chicago Graduate School of Business).”26

WAS KINDER AS GOOD TO HIS SHAREHOLDERS AS HE WAS TO HIMSELF? The judge felt that something was amiss. How could the CEO of Kinder-Morgan work for both the shareholders and himself in valuing the company buyout? A shareholder suit charged that management had proposed a value plan that projected a value at $190 per share by 2010. So, how could the Kinder-Morgan board approve a buyout of the company for only $107.50 per share? In a move that disturbed directors at Kinder-Morgan, as well as directors at other companies, Richard Kinder, CEO, allegedly negotiated the terms of a potential buyout of Kinder-Morgan on behalf of the company. Making matters worse, his alleged negotiations took place before notifying his board. “A respected, retired Delaware judge who was appointed to rule on one stage of the shareholder suits against Kinder and his partners criticized the CEO last year for his ‘stealthy’ ways and the ‘flawed process’ he oversaw.”27 Clearly, a large discrepancy between share value before the announcement ($84.41) and the value that Kinder had previously told his board could be achieved by a restructuring ($163 by 2010) provided motivation for the Kinder-Morgan transaction. In cases like this, boards are concerned that a CEO might be in a position to “steal” the company by retarding its progress and then negotiating a purchase at a bargain price with a friendly private equity partner, only to unveil the “grand strategy” after the transaction. Negotiations with the board produced a higher price of $107.50 for the shareholders, a 27 percent premium. The buyout group now had the opportunity to push the value to or beyond Kinder’s $163 per share.28

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Kinder, a former Enron executive, was credited as being the operating brains behind Enron before it fell under the trance of wrongdoing. He departed Enron in 1996 and purchased two pipelines that were being orphaned by changes in Enron’s strategic focus for $40 million. Kinder later built the business into a pair of publicly traded entities together worth some $27 billion.29 The outcome of the lawsuits between Kinder-Morgan’s former shareholders and Richard Kinder will continue to play out in the courts. This was yet another wake-up call. The impact on CEOs who wish to arrange buyouts that are motivated by large disagreements on value will play out in corporate boardrooms for years to come.30

GOING PRIVATE: A CASE OF CONFLICTING INCENTIVES “Five dollars per share? 31 How can we sell it for that when we took it public in the IPO for $10 per share? That was only 18 months ago. I think we have to ask for a higher price. At least the IPO price. . . . ” So began a conversation that would ultimately push the most independent member off the board of a profitable but out-of-favor public company. This board member was truly independent. He had been brought onto the board as a result of a chance encounter where the CEO had heard him speak at a conference. His logic and way of communicating resonated with the CEO. For some time the director had a good experience on the board. The company was interesting and growing. It was a “cash machine” almost like a bond. This company’s steady and growing cash flow was very appealing to private equity buyers. As a roll-up, though, it was out of favor in the public markets, and the stock price, after almost doubling, dropped to one-half of its fairly recent IPO price. A private equity buyer jumped on the opportunity. When the time came to decide between going private and remaining public, the different incentives of each of the parties suddenly came to the surface. Management was motivated by a very cheap price and, for the second time, a chance to gain wealth by working with the private equity firm. The prospective buyers were enthusiastic about the discounted price and the growth prospects for cash flow. The legal

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and investment banking professionals who were hired by the special committee of the board were motivated to “do a deal,” based on the structure of their compensation. Many of the directors had historical ties with the CEO and looked toward future opportunities that the continuing relationship might bring. The full-court press was on, with everyone pushing the independent director to go along with the deal as it was proposed. With no allies, the independent director held out for a higher price. However, pressure mounted, and in the end he could force only a small increase in the price and final terms. If the company had run scenarios and dug more deeply into the possible value of different courses of action, there may have been a more satisfactory outcome for the public shareholders. The new private equity owners would quickly resolve these conflicting incentives. Management and any remaining outside directors would be truly invested in increasing the value of the private company going forward. At all times, private equity owners pay attention to value and how to increase it. Conflicts over compensation in public companies will always develop because of the mix of people involved. Public companies can reduce eventual board conflict by establishing a common understanding and focusing on intrinsic value. If the board has a continuing and better understanding of intrinsic value, the conflicts resulting from an unsolicited bid will be kept to a minimum. Board conflicts that waste value have a short life under private equity owners. Directors of private equity portfolio companies are clearly more aligned when it comes to creating long-term value and the plans to build value.

IMPROVEMENTS CAN BE MADE TO EVERY COMPENSATION PLAN Public boards are the custodians of corporate value for their shareholders. Compensation consultants report that many boards are reluctant to change to value-based compensation, often because they get confused by the variety of alternative economic metrics. Yet they do strive for better performance-based compensation programs. But what is performance? As coauthors we continue to be amazed, given our observations and those of other experienced directors, that so many of the public shareholders’ representatives

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do not have a consistent and operational definition of performance and its link to corporate value. Disclosure of the current stock price and its trend over the last five years relative to a peer group and the S&P index is required by law in proxy materials but too rarely referred to in many board meetings. Far too many public directors and their CEOs remain fixated on quarterly EPS and fail to try to dig deeper to improve their understanding of the linkage of performance metrics to value. Naturally there are exceptions. For example, an unexpected tender offer will bring the issue of current stock price and intrinsic value into quick contrast and controversy. Many directors are not adequately compensated for their time. These directors find it difficult to devote the additional time needed on complex issues. Successful private equity firms typically assign staff to support the directors whom they place on boards.32 Experiments and gradual changes are made in public corporation compensation plans over time. However, when private equity takes over a company, the compensation plans are changed quickly and dramatically to focus on cash flow and long-term value rather than the public corporation’s preoccupation with quarterly EPS. Private equity promotes change, and refocusing the incentive compensation system is one area where the changes are dramatic and swift. Private equity owners are willing to pay portfolio company management extremely well, with compensation tied to increases in the value of the company. For example, a typical fund might have a goal of 20 percent return on investment. The incentive structure for management would be designed to accelerate the payoff for big success. It would work as follows: No payment for returns below 10 percent • A nominal share for returns of 10 to 20 percent • A payment of 20 percent of returns from 20 to 50 percent, and • A payment of 50 percent of returns over 50 percent. •

This type of progressive incentive program intensifies management’s focus on building value.33

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WHAT’S DIFFERENT WITH PRIVATE EQUITY?—SKIN IN THE GAME AND GOVERNANCE Private equity has a clear focus on value. Public companies frequently stress growth over value because CEO compensation and better perks often relate to corporate size. In the short term, private equity may use accounting-based metrics like EBITDA and cash flow to monitor performance. But the primary private equity incentive comes from value received on the sale of the business and the cash flow during the period of ownership, something pubic companies find difficult and elusive to measure. While the three- to five-year time horizons of private equity players may seem arbitrary, they do create a unique type of longerterm incentive. Public companies seem to have difficulty in paying bonuses only in years when value is realized. Instead, CEOs seem to be rewarded with incentives and bonuses, even as their companies fall into ruin. Private equity funds require that executives be meaningfully invested in their portfolio companies. The private equity investors want to know that concern for the company’s value is the number one thought on the mind of the CEO every day. Public company boards have historically had difficulty being direct with their CEOs, because in many cases, the CEO is the good friend who invited the directors onto the boards on which they serve. Private equity owners will probably never be nominated for “congeniality” awards, but they are effective at getting their portfolio company executives focused on corporate value as their main goal. According to William E. Conway, Jr., a founder of Carlyle Group in 1987, the hardest part of his job is dealing with compensation of highly talented people who frequently work around the clock: People in the private equity business make so much money, and yet I guess maybe they don’t find it satisfying. Or they think everything is relative and very little is absolute. If you think about people who are having a tough time, it’s somebody who’s working two jobs or two shifts and trying to make a car payment and put a kid through college. And yet in our business, you can have somebody who’s 28 years old who only got a $300,000 bonus and is crushed. I don’t think I’ve met anybody who said, “Boy, I’m overpaid!” One thing about private equity that makes it a great business is that you can do things in private and fix businesses, as opposed to

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having to report quarterly results or monthly numbers, and have them analyzed and somebody’s disappointed because this is 1 cent below that. In private equity you’re really saying, “What can I do today that’s going to make this business worth a lot more in five years?” not, “What can I do today that’s going to make it worth a lot more tomorrow?”34

FRANCHISE OPERATIONS SPREAD THE INCENTIVES OF OWNERSHIP Franchise systems offer an interesting parallel to private equity. They exist in a type of hybrid organization. They think like owners because they are owners. These systems create an odd juxtaposition between the owner/operators who run the franchises and the corporate employee/managers who run the franchisor company. Not surprisingly, the benefits, the risks, and the focus on value are strongest in the franchisee companies. In some franchise systems where the franchisees are large, such as in the heavy equipment industry, aggressive managers in the parent companies aspire to own franchises later in their careers. McDonald’s, PepsiCo, and Coca-Cola35 have made thousands of millionaires from the ranks of their franchisees over their long histories. For various reasons the concept of employee stock ownership plans (ESOPs) does not seem to work as well as the franchise model. It may be due to the value at risk and the ability to make a difference. Franchise owners typically have a significant investment, probably a sizable portion of their wealth, at risk and are in control of the operations. In the case of ESOPs, the typical employee/participant may have a much smaller portion of his or her wealth at risk, may view the investment as a gift from the company, and may have many more alternatives for employment than a franchise owner. Attempts to use employee stock ownership in troubled industries have not proved successful. United Airlines tried this tactic to get greater buy-in from its employees, but a prolonged bankruptcy resulted in disbanding the ESOP and created bad feelings among many employees. When an industry is in need of dramatic change, the private equity model of providing significant wealth for value creation and requiring that executives participate directly as real investors seems to simply work better than other models.

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SET BIG BOUNTIES FOR EXCEPTIONAL TEAM PERFORMANCE Corporate bonus programs fail to provide true value-based incentives when they pay for changes in the stock market that are completely unrelated to activities within the company. In fact, many such programs are rewarding average or even below-average performance when the market raises all prices. At the same time, such programs can penalize units at a time when they are far outperforming their peers both inside and outside the company. Successful internal team value building can be accomplished by putting big incentives on team performance and by measuring the performance through actions and outcomes that are controllable by the members of the team. For companies that are able to align the team goals with the corporate value-building goals, the payoff can be significant.

FINANCIAL TRANSPARENCY AND FREQUENT PAYOUTS TO RANK AND FILE BUILD DISCIPLINE

While CEOs should look beyond the annual results toward longterm value for wealth, many don’t. Whole Foods is one of the exceptions. The rank-and-file employees at Whole Foods see bonuses in their next paycheck when their team meets monthly goals. Every four weeks, each team of employees sees profit per labor hour for the team, as well as for every other team in the store.36 Management guru Gary Hamel, in looking for clues on best practice incentives in The Future of Management, finds a unique form of self-disciplined management in this differentiated supermarket chain. We agree with Hamel that the need for top-down discipline is minimized when several conditions are met: 1. First-line employees are provided with detailed financial results for their team and store on a daily and weekly basis. 2. Team members vote on new additions to their team, introducing a high degree of peer accountability and pressure to accept only people who they believe will contribute to the team’s success. (Continued)

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3. Team members have decision authority to do what is right for the customer and are accountable for profits. 4. The corporate culture forces a coupling between results, compensation, and recognition.37 In such a system, cash in the pay envelope may be the best longterm motivator. Rank-and-file stock ownership is a great motivator when a company is profitable and growing, as Whole Foods’ stock did up to January 2006.38 However, employee stock ownership can be a real drag on employee morale when the stock underperforms. Whole Foods deals with the dilemma between serving shareholder value and customer service in a unique way. Whole Foods’ mission statement describes the company as “a community working together to create value for other people.”39 Whole Foods sees increasing profit as a way to bring better food standards to the market but understands you can’t build stockholder value without servicing the community. During the 15 years from 1992 to 2007, Whole Foods’ stock price rose approximately 3000 percent, leaving other grocery providers in the dust. Going forward, the climb will be much steeper, because competitors have been awakened by Whole Foods’ past success. In addition, the entire industry has been affected by the global market crisis that developed in 2008.

INCENTIVES AND EMPLOYEE EDUCATION INFLUENCE CULTURE Our public education system does not do a good job of teaching business and economics to the average person. Consequently, educating the nation’s workforce on what builds value is left up to employers. This message should be emphasized in all corporations. The popularity of open book management is growing, but it is still far behind the curve. Top value builders Whole Foods and Best Buy are public company retailers that do an excellent job, as we will see in Chapter 7. More than one major corporation has attempted to educate its employees on the economics of their business. It is a very difficult thing to do and keep current. Economic education of employees takes years and requires a high degree of passion. Some companies do get it right. As part of his successful effort to rejuvenate Deere & Company, CEO Bob Lane reformulated the

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bonus structure. Incentives at Deere were historically dependent on commodity prices, creating a boom and bust payoff for employees that was unrelated to the efforts and successes of the company’s business units. As part of his passion to change the culture at Deere, Lane set up new short-term incentives, allowing payouts if a unit was doing well, even in a down year. In the boom years, the unit must perform much better for the payouts to continue.40 By setting clear financial goals aimed at producing “shareholder value added,” Lane pushed the understanding of corporate goals deep down into the operations of the company. Lane says that what is noteworthy is that “the concept of economic profits and how it’s applied is understood by thousands of managers, not [just] by a few financial people at the top.”41 Deere went far beyond Wall Street’s preoccupation with GAAP earnings per share.42 Deere evaluates and discloses each and every product on the basis of operating return on assets (OROA). It talks about the shareholder value added (SVA) for each of its product lines in presentations to Wall Street and in its annual report. For short-term incentives each Deere product line team must have a plan outlining how it will achieve a 12 percent return during low parts of the business cycle and 28 percent at the top of the cycle. Prior to setting these aggressive goals, Deere had never earned a return of more than 18 percent, even in the best years. This added twist to the goals, reflecting the reality of macroeconomic ups and downs, was a brilliant way to set the performance bar higher yet adjust for the business cycle. Deere educated thousands of its employees in economic value metrics. Deere took the complexity out of economic value by assigning a cost of capital of 1 percent per month to assets employed in each of its product lines. It clicked. This simplification made sense to employees who finally had a meaningful target. Employees now understand effective use of capital. The ratio of inventory to sales has decreased in every one of the last 30 quarters. Deere’s medium-term incentive bonuses are based on the absolute amounts of economic profit. They are placed in a four-year rolling accrual to avoid the boom and bust of many compensation plans. Plans that pay out huge amounts one year and take nothing back if the business collapses the next year encourage risk taking but do not build sustainable businesses. Deere’s accrued bonuses

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can be lost if results fall. For example, all the value created in the 1990s was lost in one year. Under Deere’s program, the motivation at each level is to keep up the performance over time. The short-term incentives are paid to operating employees whose product lines exceed quarterly economic income-based targets. For long-term incentives, Deere’s top 1,000 people own equity in the company. The top 40 managers participate in a plan that is 50 percent options and 50 percent restricted stock. They are rewarded when product line SVA’s are positive. According to Bob Lane: “It is not rocket science. . . SVA is like a scoreboard. You win the game on the field with effective use of capital and operating metrics.” Lane made it simple but not simplistic: “Improve returns on each product [and] then grow those products.” In our broader culture we frequently employ simple feedback and motivational methods. Think about how tips can motivate the average restaurant worker. Immediate feedback and incentives for better performance are important to producing results.

HIGH PERFORMERS MOVE BETWEEN ORGANIZATIONS, BOOSTING VALUE Leading edge research by human resource experts at Hewitt Associates indicates that high performers move between organizations and that these movements highly affect relative stock performance. “In spite of the current crisis in the financial markets, it is clear the constraint facing most companies is human rather than financial capital, and that this will be exacerbated in the future. It is also clear that while investors are learning more about executive compensation, they know next to nothing about the workforce attributes of the companies in which they invest. Hewitt found and quantified, in a metric called the talent quotient (TQ)—which simply tracks the flow of ‘pivotal employees’ into and out of companies. This is an intuitively appealing standardized measure of human capital performance that is predictive of subsequent financial performance. In a recent live meeting poll by the Human Capital Institute, 48 percent of the respondents indicated that leading companies will be reporting such metrics within two to three years. Executive compensation is just the tip of the iceberg.”43

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“Much like planned capital expenditures signal growth and return prospects, so does planned hiring.”44 In order to realize planned growth, companies must successfully develop a growing and competent workforce. Recruiting, training, and retention are crucial elements of a successful plan to increase the human capital of a company. Notably, incentive structures significantly affect the ability of a company to sustain and grow its human capital. Because of their incentive structures, successful private equity firms often attract the best and brightest.

NONFINANCIAL INCENTIVES CAN PRODUCE WONDERS IN BOTH PUBLIC AND PRIVATE SECTORS Top value builders like Whole Foods, Best Buy, and Nordstrom are known for frequent recognition of outstanding front-line employees’ performance. Their employees are people known for having a passion for customer service. It is clearly part of their culture. Money is not the only motivator. While attending college at the University of Illinois at Chicago (UIC), Bill Hass’s daughter, Veronica, and son, Charlie, were rarely impressed by the services and support provided by the tenured civil service employees who performed administrative duties at the university. After years of state budget cuts, civil service wages, while far above minimum wages, had not kept up with the cost of living in the Chicago area. The best people often left for better jobs in the private sector, and the remaining civil servants, while performing their jobs, fell into a routine. Many lacked a passion to serve student needs. Better incentives make all of the difference. With the correct incentives almost anyone can be great. With incorrect incentives everyone is likely to fail. It is not the people. It is how the people are motivated. After a new campus chancellor was appointed, Veronica returned from a nine-month internship at Walt Disney World, where she had learned about a variety of “nonfinancial” incentives that helped to inject passion into Disney employees. Disney employees, while not the highest paid, are taught how to treat the customers as “guests.” Veronica and Bill helped the Alumni Association through its alumni relations council and later the chancellor’s office pioneer a

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“WOW Award.” The WOW Award recognizes UIC employees who demonstrate exceptional service to the students and the university. To launch the program, UIC administrative leaders were invited to the local Nordstrom’s to observe, firsthand, how Nordstrom builds a spirit of exceptional customer service and makes daily “heroes” out of employees who make a difference. UIC’s WOW award is providing a daily incentive and reminder to improve student services by civil service and other UIC employees. Any employee can make a difference. Stories of employee heroics are being celebrated on a regular basis, thereby increasing UIC’s ranking among urban research universities.45 The awards are given monthly to employees who have demonstrated exceptional service by solving department problems or providing service to the student community. Winners are surprised at their workstations by the WOW patrols, who arrive with balloons and a certificate commemorating the award. Notice that the distribution of recognition rewards can be as important as the size of awards. Recognizing people for doing things right is a powerful incentive. Participating employees are better inspired to new heights of effort, and the passion to do a superior job has returned to many. A passion for service and value building can be contagious. Because of greater awareness in the university community, these people are often first on the list for a promotion. The power of creating a passion for customer service is also demonstrated in the past value creation success of public companies such as Whole Foods and Best Buy.

STATE AND LOCAL TAXES: A DISINCENTIVE TO STAY OR AN INCENTIVE TO MOVE High taxes cause migration of people and businesses between states. High-income taxpayers are migrating from California to Arizona and other states to avoid high state taxes. This was occurring before the housing bubble burst. The difference between taxes in California and in other states provides a good laboratory for studying the impact of state tax policy and state regulatory environment.

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Business owners look for incentives to locate new job-producing units. Not all states are the same, as Figure 2.2 in Chapter 2 demonstrates. Incentives work but need to be carefully balanced with the cost. State and local governments must compete effectively for business. That means that they must provide services and raise overall tax revenues, but the overall package must be sufficiently attractive to maintain a growing business community and tax base. States that overtax the companies that provide the wealth can go into longterm economic decline. The incentives for politicians to do the right thing are weak, because there is no consensus on a value- or wealth-based goal. It is clear that our elected officials have no common goal except doing what they “believe” is in the best interest of the voters who elected them. The lack of common goals leads to frequent decisions that may solve one problem but are likely to create others. Many elected officials ignore data that are in conflict with their personal ideology. They rarely think in terms of relative wealth-producing alternatives. Because they have terms of two to four years, they have no direct incentive to make long-term wealth-producing decisions. They often miss the importance of increasing the size of the pie over the long run and instead focus on dividing it up and spending it in the short run. The flawed incentives flow into public services. Schools are funded essentially by state and local taxes. The incentive systems for teachers in public schools are based on inputs to the process. Teachers are paid more for seniority and attainment of academic degrees. If the states want better outcomes, they should provide incentives for outcomes, such as test scores or attainment of degrees by students. Think about it. People vote with their feet. They have choices. For example, if parents are interested in education, they work hard to move into communities with the best schools, or they find a way to pay for private schools. Rather than ignore the issues, they get involved in the school system and their children’s education. They find a way to accomplish things that are important to them. Successful communities remain vibrant by addressing what they are willing to accept as performance standards for education. They give incentives to teachers to meet the performance standards. In these communities, the public stays involved.

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THE LOTTERY MODEL EXPLAINS SOME INCENTIVES The mathematically expected value of a $1 lottery ticket is something like 60 cents—not such a good deal. Why do people buy the tickets? When the payoff is large, they focus on what could be, not on the expected value. Golf pros struggle on the tour, actors wait on tables in restaurants, and rock bands languish away in malls and restaurants, all just to stay in the game because of what could be. Incentives that are designed to pay off handsomely for top players will continue to motivate people to strive to be in the select group as long as they see the payoff as a possible outcome. When incentives are watered down so that everyone participates, both the reward and the incentives may fail to inspire performance. The lottery has less appeal when the prize is only $10 million. When the prize increases to $200 million, many more people are motivated to participate when their odds of winning have not changed. The big lesson from the lottery is that big incentives paid to a few can have widespread impact on large groups of people. Despite all the media attention paid to “excessive CEO pay,” the high pay does rivet the attention of CEOs on the performance targets. Private equity has learned to pay the going rate to CEOs and get real performance in return.

SUMMARY AND CONCLUSIONS Incentives matter. In Chapter 4 we investigate the importance of the right incentives and the people effect. Supply-side economics is the economics of incentives. Private equity incentive plans are value based. They require management to have a risk of loss as well as a share of long-term gains in business value. Beyond the executive suite incentives make all the difference. Correct incentives produce great results, while incorrect incentives can lead to failure. It is not the people. It is how the people are motivated. Communication and culture make a difference. It is dangerous to judge all compensation plans based on those mistakes that make headlines. Public companies can learn from the successes of private equity and the mistakes of politicians. Government regulations—

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such as the million-dollar limit on CEO pay for tax deductibility, the SEC’s new compensation disclosure rules, and Sarbanes-Oxley— frequently have unintended consequences. Most politicians lack a framework that connects their incentives to wealth creation. There is no direct downside to a politician for making bad decisions or passing bad legislation. The sanctions come only from voters and can only be based on their distant perception, rather than facts. In California and other high-tax states, taxes and regulation serve as a disincentive to stay and an incentive for people and businesses to leave. Executive compensation can be improved by increasing its link to intrinsic value. Many public companies used stock options as simplistic solutions to complex problems, but the practice has become nearly obsolete. By contrast, private equity players tie incentives to cash flow and value three to six years out. Like their private equity bosses, the executives must wait until the incentives can be monetized in a sale or other transaction. Public company CEO incentive pay controversies highlight a “disconnect” between present-day incentive systems and producing value for shareholders. Pay is the arithmetic. What is needed is a better understanding of the entire framework of the link between pay and value creation. Without the right valuation tools and the right people, it is very hard for public board members to be objective and independent. The move to separate the jobs of CEO and board chairperson is clearly a move in the right direction. Unfortunately, while the separation of duties is gaining momentum, the pace of change is slow. In private equity portfolio companies, the board members are appointed by the private equity owners. This small difference can produce a huge difference in value-building results. Company culture, compensation plans, and executive incentives have a significant impact on all employees and shareholders, not just the top team. There are many opportunities to improve shareholder value through better incentives. We shudder to still see salespeople compensated on gross sales, regardless of profitability. Investors would be wise to really understand whether the CEO’s compensation is aligned with value building before investing. When it comes to value creation, successful private equity firms seem to do a better job of providing long-term value-based

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incentives than do most public companies. This is a result of several factors. Successful private equity players: Are very selective in choosing the members of portfolio company boards. Their directors understand that their mission is to oversee value building. • Refocus the portfolio company strategy on cash flow and value building over a three- to six-year period, not quarterly accounting EPS. • Encourage management to invest along with them so that management has “skin in the game.” The CEO and management team win or lose based on their ability to increase value. • Overcome management inertia and encourage needed changes in leadership, operations, strategy, and customer service. •

The cost and compliance pressures of Sarbanes-Oxley have enhanced this difference and made private equity buyouts more attractive to management groups that want to avoid the public spotlight.46 The most talented people vote with their feet. Top proven value-oriented CEOs are attracted to private equity because of the opportunity to build personal wealth while operating in a more business-friendly environment. Communication is critical. We touch on the importance of culture and attitude in relation to both financial and nonfinancial incentives. Winners tend to continually remind themselves that they are winners, and losers focus on the negative. The prophecy is usually self fulfilling but like other things can be taken too far. Education in ethical intrinsic value building should be part of every company’s culture-building process.

NOTES 1. From http://www.sec.gov/Archives/edgar/data/47217/ 000104746907000347/0001047469-07-000347.txt. 2. Interview with Don Delves, Delves Group, December 6, 2007. 3. IRC Section 162(m). The exceptions are commissions and performance-based pay under plans that have been approved by a compensation committee and by the stockholders.

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4. Krysten Crawford, “Spitzer Seeks $100M from Grasso: N.Y. Attorney General Announces Sweeping Lawsuit Seeking Return of Some of $187M Pay Package,” May 24, 2004, CNN Money.com, accessed October 10, 2008. 5. “The Other Market Crisis,” Wall Street Journal, December 10, 2007, p. A.18. 6. See Halliburton Company’s SEC Form 10-Q dated June 30, 2008. 7. Steven Kerr, “On the Folly of Rewarding A, While Hoping for B,” The Academy of Management Journal, vol. 18, no. 4, December 1975, pp. 769–783, doi:10.2307/255378. In 1975 Steven Kerr, then a finance professor, at USC and a colleague of Arthur Laffer and later chief knowledge officer of both GE and Goldman Sachs, inked this famous paper decrying the practice of “rewarding A while hoping for B.” An excellent example is politicians’ idea to tax the rich and subsidize the poor, hoping for less poverty. A corporate example is awarding stock options based on sales targets and expecting the stock price to increase. 8. Jeffrey M. Kanter of Frederic W. Cook & Co., Inc., “Executive Compensation: The New World,” presentation before Corporate Directors Institute, September 26, 2007, Oklahoma City University, Oklahoma City, Oklahoma. 9. Claudia Deutsche, interactive graphics at “New York Times Sunday Special Report on Executive Compensation,”April 6, 2007. See also the following examples of articles from the New York Times on the subject of executive compensation: “Putting Pay for Performance to the Test, April 8, 2007,” http://query .nytimes.com/gst/fullpage.html?res=9802E3D8173FF93BA35757C0A9619C8B63&sec=&spon= Jim Rutenberg, “Bush Tells Wall St. to Rethink Pay Practices,” published by NYTimes.com February 1, 2007. http://www.nytimes .com/2007/02/01/business/01bush.html Eric Dash, “Executive Pay: A Special Report, More Pieces, Still a Puzzle.” Published: April 8, 2007 http://www.nytimes.com/ 2007/04/08/business/yourmoney/08pay.html. Joseph Nocera, “January 2006: Disclosure Won’t Tame C.E.O.Pay,” published January 14, 2006, NYTimes.com. http://www .bmacewen.com/blog/pdf/NYT.2006.01.14.DisclosingCEOPay.pdf 10. CDW Corporation Form 10K for year ended December 31, 2006, filed with the SEC on March 1, 2007. 11. “What to Do When Private Equity Comes Calling,” panel discussion, Michelle L. Collins (panel moderator and a director of CDW), Ellen

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Carnahan, Richard P. Kiphart, Imad I. Qasim, National Association of Corporate Directors, Chicago chapter, October 11, 2007. Classroom experience with Professor Miller, 1972. Unfortunately, there are many businesses where EBITDA is possibly the worst measure to use. For example, any business that depends on heavy marketing expenses may see distortions when incentives are based on EBITDA. Management may dramatically decrease marketing expenses in the fourth quarter, thereby increasing EBITDA to meet the targets, and qualify for bonuses. Unfortunately, the next year’s performance suffers. However, the most serious weakness of compensation based on EBITDA alone is the failure of this metric to impute a cost for growing the asset base. Phil Rockrohr, “Why CEOs Aren’t Overpaid,”Chicago GSB Magazine, Summer/Fall 2007. Steven Kaplan is Neubauer Family Professor of Entrepreneurship and Finance at the University of Chicago Graduate School of Business. These findings are backed up by Kaplan’s research and by the research of others. For example, see: Xavier Gabaix and Augustin Landier, “Why Has CEO Pay Increased So Much?” MIT Department of Economics Working Paper No. 06-13, May 8, 2006. Available at SSRN: http://ssrn.com/abstract= 901826. Eric Gillin, staff reporter, TheStreet.com, “Meet the Street: Putting Executive Pay under the Microscope,” an interview with Frank Glassner, CEO, Compensation Design Group, February 12, 2002. http://www.thestreet.com/funds/meetthestreet/10008775.html? puc=_tscs, accesses January 18, 2008. As an example, the page count of compensation-related disclosure provided by Macy’s (formerly Federated Department Stores) went from 12 to 45 from 2006 to 2007. (See SEC proxy materials 2006 and 2007.) Directors also must educate themselves to understand the use of complex formulas such as Black-Scholes or the “binomial” model for estimating the value of options awarded as incentives. There is a general acknowledgment that the estimates are often wrong and subject to judgment; thus we can expect the rules in these areas to remain in flux for some time to come. Anonymous, “Ex-CEO to Return Millions: Recoveries Approach $1 Billion in UnitedHealth Backdating Case,” Chicago Tribune, December 7, 2007, p. 3-1. Options are asymmetrical, with little if any downside risk for the recipient. Having a huge upside payoff balanced by a relatively

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nominal potential for loss is only appropriate for members of management who can truly affect the stock price. For most companies, it is the CEO who makes the final decisions. At that level the potential payoff may give the CEO the added courage to make the tough decisions that are required. The problem with options is that they are valued and expensed at grant date. The actual realized value is not known until the options are exercised. Restricted share rights convey real value to the recipient, but the value can diminish if the stock price drops. This balances the incentives more than in the case of options and may provide consistently better incentive to promote corporate value at each level within an organization. Source: http://www.hewittassociates.com/_MetaBasicCMAssetCache_/Assets/Articles/Pay_for_Performance2.pdf. Frank H. Wagner and Mark J. Kazmierowski, “High-Technology Equity Programs: Powerful Forces for Change,” WorldatWork Journal, 1st Quarter 2006, pp. 42–51. Source: http://www.hewittassociates .com/_MetaBasicCMAssetCache_/Assets/Articles/HighTechnology%20Hewitt%201st%20Qtr% 20Jrnl%202006.pdf. Interview with Mark C. Ubelhart by Bill Hass and Shep Pryor, December 21, 2007. Walter Hamilton and Kathy M. Kristof, “Ex-Merrill Chief Wins for Losing: O’Neal Exits with 161.5 Million Despite Huge Subprime Write-Down,” Chicago Tribune, October 31, 2007, p. 3.1. Mark C. Ubelhart, “Encouraging Equity Excitement and the Creation of Value: Case Studies of Shareholder-Value Incentives,” American Compensation Association Journal, Autumn 1994. Interview with Bob Lane by Bill Hass and Shep Pryor, December 18, 2007. Patricia Houlihan, “2007 Distinguished Alumni Awards,” Chicago GSB Magazine, vol. 29, no. 3 Summer/Fall 2007, p. 41. Adam Lashinsky, senior writer, “Rich Kinder’s Bigger Slice,” Fortune.com, June 12 2007: 12:24 PM EDT http://money.cnn.com/ magazines/fortune/fortune_archive/2007/05/28/100034252/ index.htm. Ibid., Lashinsky. Ibid., Lashinsky. The Kinder-Morgan experience is not unusual. Independent board members are not automatically equipped to make judgments about corporate value. However, many directors have found themselves

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pressed to make such judgments very quickly in the context of a proposed transaction. Their only recourse is to retain investment bankers to analyze strategic alternatives and produce estimates of value ranges. But the investment bankers can make mistakes of their own. They often have incentives to reflect management’s view. While directors may be allowed to legally rely on such advice, they would all benefit from having an ongoing process to monitor the intrinsic value of their companies. This would allow them time to get comfortable with value methodologies and reasonable ranges to avoid being ambushed and forced to make a fast decision. In this story, the details and the facts have been disguised. The point remains valid. For example, a major company, with over $30 billion in market cap, paid its directors only 35,000 euros and demanded that they purchase stock. No stock or stock options were awarded to the board. Source: Panel Discussion, Turnaround & Restructuring Group Nuts and Bolts seminar sponsored by University of Chicago Graduate School of Business, January 18, 2008, Chicago. Patricia Houlihan, “Distinguished Alumni Awards,” Chicago GSB Magazine, vol. 29, no. 3, Summer/Fall 2007, p. 35. Coke and PepsiCo grew rapidly in their early years by selling bottling franchises to local entrepreneurs. Gary Hamel, The Future of Management (Boston: Harvard Business School Press, October 2007). See p. 73, “The importance of Open Book Management Is Amplified at Whole Foods.” Ibid. Adapted from Hamel, p. 75. See: Yahoo.com/finance, http://finance.yahoo.com/q/bc?s =WFMI&t=my&l=on&z=m&q=l&c= Ibid. Hamel, p. 75. Jia Lynn Yang, “Reenergizing an Old Company,” Fortune, October 15, 2007, p. 50. Ibid. Remainder of this section based on an interview with Bob Lane by Bill Hass and Shep Pryor, December 18, 2007. See also investor presentations at www.JohnDeere.com. Conversation with Mark Ubelhart, architect of human capital foresight and practice leader, value-based management, at Hewitt and Associates, December 21, 2007.

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44. Mark Ubelhart, “Exploring the Frontier,” Human Resources Magazine, July/August 2001, p. 63. 45. Go to http://www.uic.edu/homeindex/wowaward.shtml for more insight on this recognition-based nonfinancial employee incentive in the public and not-for-profit sectors. 46. Companies that become bogged down in the process of tightening up their internal processes may demonstrate to potential hostile suitors that the existing management team is not capable of meeting competitive standards.

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CHAPTER 5

Scenarios Options and Alternatives Can Add Value

“I’m glad we have that excess cash in these uncertain times, but we need to look at more scenarios. What is the impact on the value of each of our key business units if oil prices increase or decrease by 30 percent over the next five years? Let’s run the numbers again. I’m not sure that we have an adequate cushion to withstand dramatic changes like that. Our gross margin, earnings, and cash could be at risk. “With all these uncertainties, I’m reluctant to ask the board to consider a share repurchase in either case. What will the value look like if we’re unable to negotiate that new labor contract? Can we still generate a 15 percent return per year in years two, three, and four of our plan? What will happen if we take a strike? Should we sell those less profitable divisions and conduct a larger share buyback?” A few days later the chairman received a call from a private equity firm. “Can we meet for dinner? We ran some numbers and would like to discuss taking your company private.” After the meeting, the chairman murmured to himself: “Who do they think we are? Will they break us up? We can’t possibly reply to their offer in three days. We have several alternatives to evaluate! We are not prepared to respond. We should have done this value exercise last year!”

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Not many people would build or buy a new home without looking at several alternatives. New visualization technology allows an architect or broker to give you a virtual tour of the inside and outside of a variety of different home designs. Yet, most business plans examine only one course of action. Despite the future uncertainties, many companies do a poor job of examining alternative scenarios. Top value builders have a long-term plan to create value and constantly consider scenarios that might build more value. Running scenarios provides insights on whether to buy or to sell a business or a business unit. Effective strategies come from full, but never perfect, knowledge of how the company will interact with its customers, supply chain, and competitors. By building scenarios, management can explore how the company will fare in varying states of its environment. Inputs on macroeconomic trends, industry shifts, and competition can dramatically alter business value. Prepared management teams are those which have tested their business model under a full range of conditions. Successful private equity players run scenarios to determine if they can extract more value. Large share buybacks by public companies return cash to shareholders, thereby mimicking some of the value-building strategies of private equity.

TOP VALUE BUILDERS HAVE AN EXIT STRATEGY AND OUTSIDER’S VIEWPOINT Successful private equity players buy with an end in mind.1 They dig deep to identify a variety of ideas that could result in a significant increase in value. They run scenarios to determine when to buy and sell. They create value by monetizing their portfolios through transactions. Some use scenarios to test the sensitivity of crucial value drivers. For example, through such techniques as measuring gross margin at risk and cash flow at risk, they can relate changes in macroeconomic variables to the value of a portfolio company. Most public companies are different. They are reluctant to spin off divisions but sometimes resort to radical private-equity-like transactions to restore value. However, it usually takes a crisis and an outsider’s view to produce the dramatic changes typical of private equity players. For example, after a governance scandal that

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rocked Wall Street, Tyco, a diversified $40 billion company with 250,000 employees, was struggling to rebuild value. As a result of its governance crisis, management and the board were changed. Tyco’s diverse portfolio interests included health-care products, electronic connectors, security products and services, and industrial valves. Tyco’s new management was faced with several alternatives to restore value, including: 1. Continue with the multibusiness portfolio as it was. 2. Divest some segments and focus on a core business. 3. Liquidate the entire portfolio. After a thorough analysis of alternative scenarios, Tyco’s new CEO, Ed Breen, reconstituted the board and senior management team and decided to dramatically downsize the company through an aggressive divestiture and restructuring plan.2 The divestitures helped monetize and realize value from the array of businesses Tyco had acquired. The diverse businesses in the portfolio had radically different growth rates, capital needs, and human capital requirements. Limited public market disclosures of the holding company impeded its hopes for recognition of the value of its diverse business units. The way for Tyco to realize long-term value was through a business unit sale, patterned after private equity sale of portfolio companies. Top value builders often take steps to reduce corporate complexity when growth stagnates. For example, despite a drop of over 20 percent of its stock price from September to year end 2007, Walgreens has built value on a par with top American companies over the last 10 to 15 years. From 1975 to 2000 its stock price outpaced the market averages by 16 times. The stock price even outperformed much-touted General Electric by five times. In the 1970s Walgreens, “America’s corner store,” adopted a planning scenario that resulted in a major turnaround. CEO Cork Walgreen and his team studied the business and decided it had become too complicated. After examining multiple alternative scenarios for the future, they spun off Walgreen’s low-growth restaurant chain and other businesses and improved the appearance of its retail drug stores. The results were an outstanding record of value building.3 (See more on Walgreen’s relative success at building value in Chapter 7.)

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PUBLIC COMPANY BOARDS LIKE TO SLEEP AT NIGHT, SO THEY HOARD CASH: VALUE BUILDERS BUY BACK STOCK It was the first item on a crowded board agenda. The conversation began: “Thanks for your presentation. We will need to think about it,” said the CEO and chairman of a midmarket public company. The investment bankers shook hands as they made their way around the board table and exited the boardroom. “Let’s discuss their recommendations over lunch. . . . It was a bit unclear to me what they were saying. How about you, Arthur?” “I was really disappointed in their recommendations. The investment banker didn’t give very good guidance. A review of the current literature shows that a stock repurchase is always better than dividends as a method of returning excess cash to the shareholders! Let me show you the summary of the paper on the topic that I put together with one of my researchers. We reviewed every paper on the topic we could find. The result was clear; share repurchases are the way to go!”4 The board thanked the economist for his diligent effort but decided to ignore his expert advice. Although the board was more confused than ever, the clear majority of senior directors could sleep better with significant cash in the bank. Like many boards, this one functioned more like a social club than as the guardians of the shareholders’ value. Few of the outside directors were major shareholders. Reducing their personal risk and maintaining the status quo by holding cash was more appealing to them than pushing management to return unproductive cash to the shareholders. Private equity would put that cash to work or return it to the owners.5 In late 2007, many public companies became loaded with billions of dollars worth of excess cash as a result of growing profits in 2005, 2006, and 2007. Private equity has helped pry loose some of the excess cash. When directors disagree on the impact of economics and incentives, even after being presented with thoughtful analysis, it is tough to promote value-building change. It has taken a series of high-profile private equity takeovers to open the eyes of even the most highly experienced directors. The authors have served on and advised a variety of boards: public, private, and not-for-profit. Cash inevitably becomes a

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discussion point, especially when there is too little or too much. The discussions can really get interesting. Too little cash makes most directors nervous, and a cash crisis usually serves as a call to action. It is not unexpected that the “people effect” on cash is “more cash is better than less.” As a consequence, directors of public companies tend to prefer that their companies carry more cash on the balance sheet than needed. Many public company directors are reluctant to change until they see another cash-rich company struggling against a takeover attempt. The psychology of the people effect often overwhelms hard finance.

PUBLIC COMPANIES FINALLY GET IT—STOCK REPURCHASES ARE GREAT FOR RETURNING EXCESS CASH TO OWNERS

Examples of recent share repurchases by companies with excess cash abound. In 2007 share buybacks totaled billions of dollars and returned excess cash to shareholders. Yet practitioners are still debating the merits of share repurchases. Example: Wal-Mart finally got it in 2007! It was generating huge amounts of cash and finally buying back stock rather than trying to grow its domestic stores faster than warranted. Despite the ups and downs of markets, this should help boost its shares over the long run and bring its share price closer to intrinsic value. While share buybacks alone do not change intrinsic value, they split the value into two components, one that will be returned to the shareholders and one that will remain with the ongoing business. By returning capital to the shareholders, a share repurchase eliminates management’s incentive to wrongly invest the excess cash in low-return or high-risk projects. Many other recent examples exist: Amazon.com, Home Depot, Microsoft, and Sears Holdings are just the tip of the iceberg.

There is a growing, significant body of academic and professional literature on stock repurchases. Those who dig deep and spends the time and energy to familiarize themselves thoroughly with the topic will come to a number of conclusions—some pretty straightforward, yet others counterintuitive. What has become one of our firmly held views is that most public company boards of directors are woefully uninformed and misinformed about dividends and stock repurchases. Private equity again has an edge.

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Private equity portfolio company boards, which represent owners with significant value at risk, generally get it right. They do not hoard cash! They leverage up to get every aspect of the business, including capital, to work harder to improve value. A Major Share Repurchase Is Always Better Than Dividends for Shareholders The research literature generally and incorrectly assumes that boards of directors and managers of publicly owned corporations understand what they are doing when they initiate stock repurchase programs. This assumption is made implicitly by many researchers when they analyze various characteristics of corporations that do and do not repurchase their own stock (or pay dividends, for that matter). Researchers then incorrectly conclude from that analysis that those characteristics signal “best practices” for stock repurchases (as well as dividends). The threat of private equity raids has caused many companies with surplus cash to look more closely at repurchasing shares. The dilemma of whether to pay dividends or buy back stock was noted and discussed by our late friend and colleague Fischer Black in his 1976 paper. 6 Dividends and stock repurchases both have effectively the same balance sheet impact and therefore, from a company’s balance sheet perspective, are indistinguishable. Dividends and stock repurchases can be constructed both de jure and de facto to have the exact same characteristics as to timing, amounts, and stability. There are literally no intrinsic differences.7 Empirical researchers are applying updated metrics, such as real cash flow returns, to shed light on the comparison between share repurchases and dividends. One such question is whether there would be a significant difference in the impact on stock price from 5 or 10 years of increased dividends or a major share repurchase of the same present value. The real world issues of the economic return on alternative uses of cash and whether or not a company is selling below intrinsic value make this decision more complex. We would expect that a major share repurchase would pass any empirical test as a good idea for companies that have excess cash and few investment projects with expected returns above the cost of capital.

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Tax Treatment Matters for Shareholders and Benefits Private Equity Yes, taxes do matter. From the standpoint of shareholders, dividends have been and are taxed very differently from stock repurchases, except in the case of nontaxable shareholders where there are no tax differences. From the standpoint of corporations, neither stock repurchases nor dividends are tax deductible. The effect on a corporation’s tax liability is neutral. When it comes to individual shareholders, dividends have been and still are discriminated against by the tax codes vis-à-vis stock repurchases. This dividend disadvantage for shareholders goes well beyond tax considerations, but the tax considerations are huge. Because stock repurchases—not stock dividends—allow shareholders the choice of whether or not to sell, those shareholders can decide based on their own individual circumstances—tax or otherwise. Some shareholders may wish a greater payout than would be offered by dividends, and some less. Who knows? Individual shareholders may have different perceptions of the company’s prospects. Dividends allow for no self-selection. Stock repurchases do. Stock repurchases are clearly superior to dividends from the shareholder perspective. Throughout most of the recent past, dividends have been taxed at significantly higher rates than have capital gains. As a result, a shareholder receiving a certain amount either through dividends or through selling stock back to the company would never be worse off by selling the stock, even if the entire amount of the sale is taxed as capital gains. Only if the dividends were taxed at a rate below that of capital gains would it be possible that a dividend is preferable, purely on the basis of after-tax cash. Many experts agree capital gains taxes should be eliminated or at a minimum indexed for inflation. Selling shareholders, however, virtually never have their full sale taxed at capital gains tax rates because the tax basis for all shares is greater than zero. Thus, something less than 100 percent of the stock repurchase is taxable. In fact, because shareholders in a traded stock can buy and sell at will, it is unlikely that much of the sale price that results from a stock repurchase would on average

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represent taxable capital gains. Also, because of the self-selection process, sellers may well have losses or loss carry-forwards to offset any capital gains that might result. The individual shareholder’s capital gains tax liabilities from a stock repurchase will be smaller compared with the taxes on a comparable-sized dividend. Private equity players understand this critical difference and have built considerable value and wealth as a result.8 The existence of dividends, given tax laws and issues of selfselection, makes little or no sense when judged by the after-tax cash provided to the stockholders. This is another reason for the huge popularity and success of private equity funds among wealthy and taxpaying investors since they provide fund investors with returns in capital gains, not taxable dividends. Some additional observations follow: In the decade through 2003, aggregate stock repurchases and dividends were about equal. The Bush tax changes in 2003 reduced, but did not eliminate, the tax advantage of stock repurchases for investors. Stock repurchases have accelerated, particularly in 2007. The “dividend puzzle” remains: Why haven’t stock repurchases replaced dividends altogether?9 • Stock repurchases (and dividends) deplete a company’s cash and alter a company’s balance sheet; therefore, companies that are strapped for cash and highly leveraged probably should not engage in stock repurchases or dividends. Effective scenarios are needed to evaluate the degree of repurchase that will optimize the capital structure. Successful private equity firms live on the edge and seem to do this better than their public peers. • In an effort to avoid a takeover, companies occasionally enact stock repurchase programs, sometimes incurring significant debt. Not only does a stock repurchase make the target company’s balance sheet less attractive to the prospective acquirer, but those shareholders who value the company least may self-select and participate in the repurchase. This raises the bar for potential acquirers. • Stock repurchases have generally been found to raise the stock price of the company above where it otherwise •

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would have been. This effect may signal management’s (and directors’) more knowledgeable view that their company is undervalued. There have been, of course, many instances in which stock repurchases reflected management’s wishful thinking and were thus unsuccessful. This was especially prevalent from late 2000 through 2003, when companies hoped against hope to raise their stock price and would try almost anything to do so. Timing and market expectations matter. As we have seen in Chapter 1, successful private equity players take advantage of market ups and downs. The preponderance of evidence is that stock repurchases do raise stock prices for several reasons: In many cases stock repurchases are better for a company than increasing investments or acquiring other companies. This is especially true if the expected return from new investments or acquisitions—risk adjusted and after tax— is less than the average returns of the company itself. Not all companies should increase their growth. Stock repurchases are an excellent use of corporate funds when other uses are not compelling. The difficulty of producing value from public company acquisitions and mergers is well documented. • Stock repurchases remove some of the temptation from management to squander the balance sheet either through empire building or through excessive compensation. This, to our way of thinking, is good governance. Companies with excessive cash balances essentially give management carte blanche to retain low-return assets. Successful private equity firms remove this temptation from their portfolio companies. • There are several forms of stock repurchases currently in practice. The results from these different forms of stock repurchases vary widely. By far the least effective stock repurchase program is the open market repurchase program which allows management to pick and choose when to buy, at what price to buy, and how much to buy. These programs have been shown time and again to have •

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the least value impact on a company as compared to either a Dutch auction10 or a tender offer. The literature is clear that when a repurchase is warranted, it should be carried out by a tender offer of significant magnitude at a substantial premium to the going share price.11 An implication is that at times the market may underestimate the intrinsic value of a stock. Think about Warren Buffett’s success in building wealth from this factor alone. For example, in fall 2008 Buffett was buying into good companies like GE as their stocks dropped amid the global market meltdown. Value-building decision makers dig deeper and run scenarios to understand the intrinsic value in order to know when a tender offer can add value. After reviewing the literature on the subject, it appears that when a stock repurchase is carried out, it should be of a sufficient magnitude to put the company into effectively a zero net cash position or slightly in debt above its corporate target level of leverage. This is true, unless there is a significant planned high return use of cash, that is, acquisition or capital outlay.12 The return on cash is usually much lower than the return on other corporate assets. Getting a company’s net cash position (in excess of liquidity and transaction needs to run the business) as close to zero as possible is important and is something that successful private equity firms have clearly mastered through effective scenario analysis combined with cash management systems. Research continues in an effort to explain why the apparent optimal leverage ratio for public companies remains significantly lower than the same ratio for private equity portfolio companies. However, one strong hypothesis is that private equity firms with access to cash are able to react more quickly to avoid liquidity problems in a crisis, and thus require a far smaller safety margin of cash and equity than do most public companies.

CHANGING RETAIL LANDSCAPE DEMONSTRATES NEED FOR SCENARIOS AND RENEWAL We have all come to accept the volatility of retailing. Yet which changes produce sustainable long-term value? Store performance in the last few weeks of a calendar year usually determines the

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difference between success and failure for the whole year. Changing consumer tastes force a need for continuous reevaluation of merchandising methods, private label products, store format, and location. New technology, modern logistics, and better tracking of products force changes in operations, distribution, and buying patterns. These factors, combined with constant demographic changes and new competition for the consumer dollar, play havoc with the financial performance of retailers. The same factors affect retailers’ ability to grow and earn cash returns greater than their cost of capital. Major retailers live and die on their ability to provide the shopping experience and products that the consumer wants—at the right place, right price, and right time. Customer preferences shift from mall, to strip mall, to stand-alone stores and back again, demonstrating the importance of real estate in the retail mix. Unfortunately, balancing the cost and flexibility of store locations in suburban, urban, and rural locations distorts many a retailer’s balance sheet. Accounting treatment of leases is not uniform across retailers. Depending on their terms, lease obligations can appear as current expenses or capitalized assets on the balance sheet, or they can be buried in the footnotes. As a result, differences in lease accounting and real estate strategies often make it difficult to compare retailer performance. A 2007 study of retailer lease accounting concluded: “It is clear that excluding operating leases from the balance sheet causes a material distortion of the financial position of [retailers].”13 Proposed changes are in the wind for retailer lease accounting, but accounting changes are slow to catch up to economic reality. Effective metrics adjust for accounting inconsistencies. For example, a graphic presentation of “real cash flow return,” oriented toward value, makes such comparisons more insightful. Figure 5.1a graphically portrays the results of Target Corporation, a top value producer that continually renews itself. From 1995 onward, Target’s culture of customer-intimate design outperformed most retailers and the S&P 500. Target distanced itself from Kmart and other retailers that were slow to change and wandered into bankruptcy. Target is a prime example of successfully renewing a retailing operation and building value. Prior to its renaming in January 2000, Target was known as Dayton Hudson Department Stores. Target shed its culture of mall-based department stores by

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morphing into Target’s stand-alone retail store chain, while leaving behind its traditional mall-based department store foundation. Performance—as measured by real cash flow returns—in all years after 1995 exceeded Target’s real cost of capital by at least 200 basis points.14 To maintain its high returns and significant store and sales growth, Target sold both Mervyn’s and Marshall Field’s department stores in 2004. Target demonstrates the importance of successful and dramatic cultural change as well as disciplined attention to differences in business unit profitability and growth prospects of portfolio units. The payoff has been in Target’s ability to continually gain ground against Wal-Mart over the last decade. Target’s evolution is unusual for a public company. It emerged from a traditional slow-growth, mall-based department store culture. From there it pursued a successful retail concept: freestanding onefloor design-oriented and customer-appealing stores. Target’s unique focus on product design creates excitement for its customers as well as differentiating everyday products and its customer store experience from those of its competitors. Kohl’s produced tremendous value for shareholders with a similar model but did not have the burden of having to escape a mall-based culture. Figure 5.1b describes Wal-Mart’s growth and performance spurts over the last 15 years. To maintain this type of growth WalMart had to continuously renew and refine the business models of its business units. Speed bumps along the way included significant challenges by labor and Wal-Mart’s problems with its early attempts to grow its Sam’s Club discount store chain before it had proved the basic business model profitability of Sam’s Club. As a result, in the years 1991 to 1996, Wal-Mart’s failure to meet expectations for growth and declining profitability destroyed shareholder wealth. During this period Wal-Mart underperformed the S&P averages, despite earning real cash returns three to four percentage points above its cost of capital and that of Target. Despite its profitability and cash flow, Wal-Mart was out of favor and, except for its size, could have been a takeover target 1995–1996 because of its undervalued stock price. Tear it down and rebuild. For a retail giant, Wal-Mart demonstrated the dramatic continuous renewal needed to produce growth and shareholder value. It did this by reducing the drag from Sam’s

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Club, recently moving into groceries, and strengthening its position in international markets. As part of Wal-Mart’s continuous renewal and efforts to build value, older Wal-Mart stores in profitable markets were torn down and rebuilt as superstores. Many of these new superstores are open 24 hours a day and are clearly putting stress on the supermarket industry. From 1996 to 2001 Wal-Mart built relative value for its shareholders by outperforming the S&P 500 index as it restored its real cash returns back to the 11 percent level and reestablished a healthy growth rate. Wal-Mart’s 10-year “v”-shaped relative return line—5 years down and 5 years up—is illustrative of the 5-year value turnarounds executed by many top public companies. A major question is: how long can a company the size of WalMart keep growing without encountering even more value detractors. Wal-Mart is continually in the spotlight. Successful private equity players are likely to shun the limelight. They own thousands of small and midsized companies that are not targeted by unions or activists. Thus another clear private equity edge is the incentive and ability to capture the value through a sale and move on to another opportunity. Unlike private equity players, public companies generally must renew the same business, rather than switch to new projects. As the Wal-Mart chart shows, after building value and producing great performance for five years, Wal-Mart underperformed from 2002 to 2005, not unusual for a large public company. Change and renewal in large companies is difficult. As we have shown, even giants like Wal-Mart stumble. Private equity firms use scenarios to identify and purchase companies that stumble but can be fixed. They work their magic on finance, operations, and strategy and sell the company opportunistically when scenarios and their “industry expert boards” tell them the time is right. They also sell when the funds need to be returned to investors. Recall from Chapter 4 that private equity directors have more skin in the game than their public peers and are motivated to take some chips off the table periodically.15 Public company peers are typically limited in their ability to realize value in this way without splitting up the company. Public boards have little incentive to break up their business to produce value, but top value-building public companies do divest to produce value. McDonald’s spun out Chipotle. Target spun off department stores. Walgreens spun off

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13% 11% 9% 7% 5% 3% 1% –3% –5% 30% 20%

Real cash flow returns

Real asset growth

Real cost of capital

Real sales growth

10% 0% –10% –20% –30% Shareholder wealth relative to S&P 500, Year 2000 = 100

200% 100% 0% '88 '89 '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06

(a) Target Corp. Value Analysis

13% 11% 9% 7% 5% 3% 1% –3% –5%

Real cash flow returns

60%

Real asset growth

Real cost of capital

Real sales growth

40% 20% 0% –20% –40% Shareholder wealth relative to S&P 500, Year 2000 = 100

200% 100% 0% '88 '89 '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05 '06

(c) Federated/Macy’s Value Analysis Figure 5.1 Comparative value analysis of key

retailers highlights trends. Source: CharterMast Partners, LLP.

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13% 11% 9% 7% 5% 3% 1% –3% –5%

173

Real cash flow returns

Real asset growth

Real cost of capital

Real sales growth

20% 0% –20% –40% Shareholder wealth relative to S&P 500, Year 2000 = 100

200% 100% 0% '88 '89 '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05

(b) Wal-Mart Stores Value Analysis

13% 11% 9% 7% 5% 3% 1% –1% –3%

Real cash flow returns

Real asset growth

Real cost of capital

Real sales growth

20% 0% –20%

800%

Shareholder wealth relative to S&P 500, Year 2000 = 100

600% 400% 200% 0% '88 '89 '90 '91 '92 '93 '94 '95 '96 '97 '98 '99 '00 '01 '02 '03 '04 '05

(d) JC Penney Value Analysis Figure 5.1 Comparative value analysis of key

retailers highlights trends (Cont.)

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restaurants. GE spun off small appliances and plastics. Need we say more? Unfortunately, public company management teams usually have incentives that favor growing sales more than increasing value.16 Only time will tell how long Wal-Mart can perpetuate its continuous renewal efforts, grow, and remain the world’s largest retailer. The key ingredients are centralized fact-based information systems and state-of-the-art low-cost distribution, combined with face-to-face communication between stores and headquarters. These factors seem well aligned to enable Wal-Mart’s penurious yet customer-focused management culture to be consistently communicated to all. Repetition of “Everyday low prices” and “May I help you?” boosts communication to help satisfy both customers and shareholders. Sears was once at the top of its industry. After it faltered, it was taken over by successful billionaire hedge-fund player Edward Lampert, who owns about 49.6 percent of the stock.17 Industry analysts believe Lampert ran several scenarios before buying Sears and combining it with formerly bankrupt Kmart. Some believe he sees most of the value in the real estate and will focus on closing down or selling parts of the business that do not earn their cost of capital. Others believe that he may follow another scenario that permits experiments to find ways to fix the business. Rest assured that Lampert’s closest people are running scenarios on how to build value from this retail giant.18 In late January 2008, after share price dropped below $100 (50 percent of the $200 peak), Lampert announced a new structure that indentified five critical business areas. In February about 4 percent of Sears’ 5,000-person headquarters headcount was cut to reduce overhead in support functions.19 By fall 2008 Sears’ stock price had been hammered again and was trading in the $50s, reflecting the global economic meltdown. Lampert increased share buybacks.

SOFT-GOODS RETAILING MEANS CONSTANT REFOCUSING ON CONSUMER PREFERENCES Let’s now turn to historic performance profiles of two well-known department store turnarounds and the value renewal scenarios they represent. Figure 5.1c profiles the classic successful turnaround and

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renewal—five years of relative underperformance followed by five years of strong performance—at Federated Department Stores (now Macy’s).20 Federated owns Bloomingdales, Macy’s, Rich’s, Bullock’s, and Marshall Field’s (all except Bloomingdale’s were rebranded as Macy’s in 2006). Burdened by excessive debt resulting from the 1988 takeover by mall operator Robert Campeau, Federated Department Stores filed a Chapter 11 bankruptcy in January 1990. Here the private equity tactic of heavy leverage wiped out a great portion of the value of a public company.21 Campeau had bet the farm. The bankruptcy and restructuring process requires digging deep to understand and communicate to all stakeholders alternative scenarios to preserve the value of the bankrupt company. Many top private equity players have made fortunes restructuring distressed companies and bringing back jobs. Top value builders identify ways to force needed changes to restore value in distressed situations. Federated’s “merchant prince” department store culture had been resistant to change until Allen Questrom returned to Federated as chairman and CEO in 1990. Questrom is noted as a retail turnaround expert. Questrom is a fact-based decision maker and highly skilled customer-focused private label brand merchant. He required department managers to know their customers, merchandise, and competition intimately. A critical part of Questrom’s turnaround strategy in all of his successful renewal experiences was internal culture change and a renewed focus on the needs of the consumer, thus breaking with past practices.22 After multiple scenarios helped Questrom prove Federated’s viability and value as a company, it emerged from bankruptcy in 1992. Questrom then led Federated’s acquisition of Macy’s out of bankruptcy in 1994. In 1995 he added the acquisition of financially distressed California retailer Broadway Stores, Inc. Unlike Target, Federated did not abandon the department store concept, despite shrinking department store industry revenues. After years of losses, Questrom restored Federated’s profitability. Federated has continued to earn its cost of capital since Questrom’s departure in 1997, but it has not found the growth formula characteristic of the renewal successes at Target and WalMart. It is now seen as a department store industry consolidator

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making dramatic changes and taking advantage of economies of scale to rebrand famous chain store names to Macy’s. Will Federated’s dramatic rebranding strategy experiment work? Will Federated remain independent and public, or will it be taken private to execute a more radical restructuring strategy? Only time will tell which scenario will play out. Private equity players have certainly been watching Federated, now Macy’s, for an opportunity to buy low, restructure dramatically, and sell to realize the value they create.23 JC Penney’s first big—but only modestly successful—renewal scenario was in its strategy to break away from the pack of “allthings” department stores to specialize in soft goods.24 In the early 1980s, with a legacy of having been a Sears clone, this was no easy task. However, breaking away from an embedded strategy can be accomplished when management is truly committed to the strategy and does not backslide. A decade later, in the 1990s, the biggest challenge was a proliferation of well-merchandised specialty apparel and soft-goods retailers. In addition, Penney’s foray into a different market, through its 1997 acquisition of the Eckerd drugstore chain, caused management to lose focus. Recall that private equity firms also make portfolio acquisitions, but they keep them separate and accountable to separate boards and experts. Most experts in drug retailing are not experts in soft goods! Penney’s public board was no longer on the cutting edge. After posting cash flow returns well above its cost of capital from 1992 through 1995, Penney’s watched its stock plunge from over $50 per share to around $10 in 2000 (See Figure 5.1d) Eventually, after Penney’s stock price cratered, new management forced a redirection. With better focus as the foundation of a successful renewal effort, Penney’s sold off Eckerd in 2004 and conducted a major share buyback. Despite the difficulty in duplicating the success of the specialty retailers, Penney’s strategy called for positioning itself as a trendy, customer-focused retailer, providing extra value to its customers. And who was that new management? At age 60, Allen Questrom took on the even larger task of turning around JC Penney, proving that public companies can bring in experts when needed to produce success.25 Stan Eichelbaum, president of Marketing Developments Inc., a retail consulting firm, suggests that the lack of proven retail

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executives helped pave the way for private equity to move in on distressed retailers: “When Neiman Marcus was in trouble, [its private equity owners] called on Allen Questrom. When Barney’s was in trouble, they called on Allen Questrom. When Federated was in trouble, they called on Allen Questrom. And when JC Penney was in trouble, they had to call on Allen Questrom. . . . If that’s not a sign of a shortfall of talent, what is?”26 JC Penney, like many department stores, ran multiple scenarios, experimenting and struggling for years to find a survival and growth formula. Key factors cited by Allen Questrom in JC Penney’s 2000–2005 turnaround plan included familiar items: culture change, a refocus on higher-margin store brands, effective centralized merchandising systems, and closing unprofitable stores in its portfolio.27 Before presenting his 2000–2005 turnaround scenarios and plan, Questrom spent several months in two-way communication with frontline employees to gain input and support for change, while intensely studying Penney stores and the competition. This approach is characteristic of the grassroots-level communication that forms the basis of many successful turnarounds. It is also characteristic of the degree of digging and speed of change promoted by a new management installed by a new private equity owner.28 The mall-based department store industry continues to face challenges as most established mall-based retailers struggle to find profitable opportunities for growth while newer freestanding formats like Kohl’s continue to grow. Share buybacks have become a common financial maneuver among mall-based department stores to return cash to shareholders, reduce the number of shareholders, and raise reported earnings per share. The EPS change is arithmetic. As we saw in Chapters 1 and 2, arithmetic alone does not create value. Favorably cashing out of low-return businesses and businesses that are near a peak in their value does. While this appears to be a means of rewarding shareholders, it does not necessarily increase the intrinsic value of the underlying business, unless the shares are purchased at a significant discount to intrinsic value. Clearly, management’s role in this decision is to create value for the shareholders. In no way should management or the board seek to take advantage of the stockholders in any share

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repurchase. Scenarios are needed to understand the full impact of a share repurchase and the optimal capital structure. In many cases companies that pursue a share repurchase without an understanding of the impact on intrinsic value and the potential for dramatic changes in operations and strategy are left with little more than a higher debt burden.29 Scenarios help top value builders determine how and when to change.

TOP VALUE BUILDERS RUN SCENARIOS AND USE EXPERT CONTINGENCY PLANS While scenarios help identify the best path among several alternatives, it takes action and people to move along the chosen path. As with any plan, there will be surprises along the way. In cases of crisis, the world’s top value builders usually are able to draw upon experts and have contingency plans if the original scenario does not materialize. In many public companies, plans are played out long after they have been judged as eroding value rather than building value. Private equity players sense when a new scenario and a new plan are needed to deal with an unexpected impact on value. In some very complex cases, that contingency is to restart with a new approach and gather more ground level and expert input.30 Occasionally it will take a new management team with a fresh perspective to execute a scenario with a different theme. Again private equity will follow or change to the course that has the best chance to build or recover value. Public peers would not be as willing to pursue a change from the originally planned path. Top value builders operate in industries in which experts can create value from decisions based on their experience. It is important to identify situations in which experts are most likely to add value.31 Many simple or routine situations, like the decision of where to locate a standardized fast-food franchise, can be defined by a set of rules requiring minimal judgment. More complicated situations that involve changing conditions or new experiments— such as designing a new fast-food format or system—may require specialized expertise to find a solution that adds value. In more complex situations that involve new and dynamic changes, such as how to counteract a new type of competitor, there may not be

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“optimal” solutions that produce value, even when using an “expert,” because no expertise exists for the specialized situation. Some business environments are chaotic, where everything is changing. An example might be operating a supplier to a distressed industry undergoing restructuring in a war zone. These situations are totally unpredictable and highly risky. These are often the situations in which investors like Wilbur Ross have built major wealth.32 In a Harvard Business Review article, researchers identify four contexts in which business decisions are made: simple, complicated, complex, and chaotic. Managers can lead effectively in each by identifying the context in which the decision is being made, remaining aware of warning signals, and avoiding inappropriate reactions.33 Top value builders adjust to the decision environment. Many public companies struggle when dealing with complex or chaotic situations in one of their business units. Private equity governance structures, with their greater control, involvement, and speed, are more adept at making better decisions in these higherrisk complex situations. They combine an expert perspective with an outsider view.

The Best Defense Is a Good Offense Corporate executives and directors are frequently concerned that their company has become ripe for a takeover attempt by private equity investors. A November 2007 Harvard Business Review article offered five basic questions that can help corporate leadership determine just how close they are to being replaced by private equity owners: 1. “Is there too much cash on the balance sheet? 2. Is the capital structure optimal? 3. Does the operating plan significantly increase shareholder value? 4. Is executive compensation tied closely enough to shareholder value? 5. Do directors devote enough time and have enough incentive to increase shareholder value?”34

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Companies can answer the questions by running scenarios. Management teams that run scenarios and share them with the board have a better chance of staying in control of the value-building process and have less risk of turning their companies over to private equity players. Real Options: A Tool to Evaluate Sequential Investment Strategies One of the more sophisticated analytical methods in the toolbox of digging deeper is “real options.” This method overcomes a weakness of discounted cash flow analysis by quantifying up front the value of choices that can be made after a project is initiated. Few public companies are “formally” using real options to evaluate major investment decisions because the concept of real options has not yet gained significant use and support. Using the method requires a great deal of discipline to dig deeper into understanding the data, alternative scenarios, and key assumptions. As the development of the technique and tools continues and the awareness spreads, this method of analysis should gain ground. A real option is a nonfinancial right to benefit from taking certain future actions. The “holder” of the option has the ability to not take the actions. Thus the holder of a real option has the choice to take certain future actions, if the actions are to her benefit, and no obligation to take those actions if there is no benefit. The quantification of real options ranges from simple identification of costs to accept or avoid to highly complex and analytical computations, using option valuation techniques.35 Successful private equity firms intuitively think through the value of their real options when they run acquisition scenarios. Evaluating their ability to control and improve intrinsic value is critical to their analysis. Private equity’s value edge comes from its ability to control future investments under a variety of future scenarios. When a private equity firm buys control of a company, it uses its ownership power to control the board. As previously discussed, the board of a private equity portfolio company is uniquely designed to bring expertise to the company. These more highly

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engaged boards typically monitor and control company cash flow and understand the true competitive environment more deeply than do their public director peers. By controlling a portfolio company, the private equity owners also control the real options within the company. Control premiums are thought to occur when companies are taken over at a price above their recent trading value. The control premium is often estimated at 15 to 20 percent, but it can be much larger. The value of a control premium arises from the ability that it confers on the buyer to make sweeping changes in corporate structure or strategy. Such a control premium can be considered to be the value of having control over the company’s real options. Discounted cash flow techniques, even when combined with sensitivity analysis and probability distributions of outcomes, reflect a “static view” of a decision. Strategy in today’s world must be dynamic. Multiple scenarios help visualize and communicate a range of future values. Real options provide evaluation tools, methodology, and frameworks to value various alternatives and future choices and express their value in a single dollar amount when investment decisions can be made sequentially. Evaluating the real options is the intuitive next step for private equity players. A crucial aspect of the technique is that it frequently uncovers hidden value in projects that might otherwise be rejected. As we have discussed, private equity players and a limited slice of top value builders in publicly owned companies have the discipline to change the course of investments once they have been made. This is different from the atmosphere that exists in many public companies, where the capital allocated to even multiyear projects is not reexamined. The real option technique promotes evaluating and structuring projects in stages. At each stage new information can be taken into account and directional or “go/no-go” investment decisions can be made. A full description of the real option methodology is beyond the scope of this book.36 A simple example will help explain the value of the concept and how intuitively it applies to the control over future investment exercised by top value builders. Authors Tom Copeland and Vladimir Antikarov argue that real options will be the primary method of evaluating sequential investment decisions within the next 10 years.37

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REAL OPTIONS CAN GIVE AN ADVANTAGE TO A BUYER WHO INVESTIGATES ALTERNATIVE SCENARIOS

Buyers who investigate alternative scenarios for real options can have an advantage. For example, a 10-year-old company has developed and tested a successful coffee house concept to compete with Starbucks. It has 10 locations and plans to accelerate its growth, but it needs significant cash to open 100 new locations over the next five years. A private equity firm is considering purchasing control of the company. The founders are prepared to give up control in exchange for the opportunity to be part of a major corporate success. The private equity firm could use the real option technique to evaluate alternative scenarios and outcomes to support its investment decision. In particular, the option would arise at a second stage, where the owners would decide whether to abandon further funding or modification of the growth plan to realize their intended value. Other evaluators, such as purchasers of stock in an initial public offering (IPO), would normally evaluate such a company as though the decision to launch the strategy could never be changed. These investors might view any future problems as probabilities, but not as choices with go/no-go decision options. By incorporating the value of the real option to control alternative scenarios in its analysis of the purchase price, the private equity firm would be able to justify buying the company at a higher price than an IPO would bring. Figure 5.2 shows how the real options evaluation would produce a higher expected enterprise value of the company, $35 million, compared with the outcome of a conventional analysis of only $12.5 million. Computations: A standard discounted cash flow analysis would assign probabilities to the three prospective outcomes. An overall expected value would then be computed from the combination of possible outcomes and probabilities (see Figure 5.2, Scenario A). The real options method takes into account the ability to make future decisions to continue or discontinue funding the project. Because the company will know more at a point in the future about the viability of the project and whether it will produce a high or low return, the future funding decision can be viewed as an option. In this case the private equity buyer is committed to one outcome and has ways to control or eliminate the others. Figure 5.2, Scenario B shows that the expected value, given this approach, is significantly higher. As a (Continued)

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Scenario A IPO Approach: Initial investment and uncertain outcomes; no options

Success 50% 50% Start project 50%

Failure 50% shutdown NPV = –30

183

Expected NPV (Prob*NPV) High return 25% 50% NPV = 100 50%

Scenario B Private Equity Approach: Option to avoid continued investment in low-return project

+$25.0 Success 50%

Low return 25% NPV = 10

50%

+2.5

High return only 50% NPV = 100

+$50.0

Start project 50%

–15.0 Expected (NPV) =

Expected NPV (Prob*NPV)

+$12.5

Failure 50% shutdown NPV = –30

–15.0 Expected (NPV) = +$35.0

Figure 5.2 Scenarios can discover hidden value (in millions of dollars) Notes: NPV ⫽ Net Present Value

(Probability) ⫻ (NPV) ⫽ Expected Value Source: Copyright © 2008 Board Resources, reprinted with permission.

result, the private equity firm may outbid the IPO alternative, and the new owners will use their control to maintain the discipline to realize the value.

Think about it. Private equity’s extreme focus on value gives its investors an edge when it comes to investment decisions. It prevents the funding of marginal investments. Once an operating company is part of a private equity portfolio, the owners help build value through investment decisions by directing and controlling: Strategic and operating decisions: new locations, production, pricing, and cost. • Choices of future investment amounts and timing, levels of acceptable risk, and desired rates of return. • The choice of when and how to disinvest assets or business units. • The choice of how to build on the foundation of a “platform” company. •

Smaller highly engaged private equity boards can “adjust the sails” to cope with the changing economic climate. Many public

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boards are typically much slower to act, relying on their CEO for strategies and operating decisions. These control points add to the private equity edge. Projections that extend beyond three to five years are sometimes distorted, as the effect of compounding may overstate longerterm results and the environment may change. By reserving the right to change course along the way, private equity owners maintain a position of significant flexibility over longer time horizons. This type of flexibility can also be built into the planning process by using a regress-to-the-mean approach when making assumptions about returns that are greater than normal. Realistically, few companies are able to maintain a significant advantage in their markets for prolonged periods of time. Experience shows that their returns ultimately regress toward the average performance of their peer group.38

SUMMARY AND CONCLUSIONS Looking and thinking ahead to understand cash flow is important to building wealth and reducing risk. Top value builders evaluate long-term scenarios for value creation. They understand the cash flow implications of the inevitable ups and downs of the economic cycles. In this chapter we examined the importance of scenarios in understanding the significance of alternative future outcomes. The discipline of thoroughly debated and written cash flow scenarios forces everyone to dig a little deeper to think and prepare for future action. Since the future is not known with certainty, preparation for a variety of alternative futures helps leaders choose better strategies and respond to surprises. Digging deeper and running after-tax cash flow scenarios in the eyes of the shareholder helps us understand why stock repurchases can be clearly superior to dividends from the shareholder perspective. Lower capital gains tax rates also point to the significant growth in private equity. Research continues to fuel the debate. Anyone can benefit from scenario analyses. Scenarios help determine if a large share repurchase is a wise move. We examined why share repurchases are growing relative to dividends as a means of returning excess cash to shareholders and why some boards resist the potential risk of reducing the “cash cushion.”

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Some believe that private equity purchases of public companies represent the ultimate in stock buybacks. Shareholders will find that share repurchases are clearly superior to dividends. Share repurchases give the shareholders the choice of when to realize their gains.39 The changing world of retailing demonstrates how effective scenarios can guide renewal. Decisions made today affect the future options of a company. We briefly examined real options as a means of valuing more complex alternatives. We explored how major retailers have faced notable forks in the road where strategic choice could have a dramatic impact on the value of the company. Retailers who fail to adapt to changing markets file for bankruptcy. The bankruptcy and restructuring process requires management to dig deep and justify the continuing value of the company with cash flow scenarios focused on value. However, the original stockholders rarely benefit from the lessons the company learns in a bankruptcy. Private equity players take big risks for big returns in distressed situations. When a public company leverages up to the maximum, it faces the threat of bankruptcy. Private equity firms live on the edge with high leverage, yet they have the edge over their public peers again with better access to capital, should a crisis develop. Successful private equity players control that risk by keeping their portfolio companies as separate legal entities with independent but highly leveraged capital structures. They take advantage of the lower tax rates on capital gains, and as a result, their view of risk is different from that of their public peers. Private equity players use scenarios to evaluate future options and can usually create higher value by eliminating investments in projects that produce only marginal cash flow returns. Their activities help allocate capital more efficiently in both public and private markets.

NOTES 1. As noted in the introduction, different private equity firms have different holding periods and strategies for their various funds. Their strategies are diverse. Some private equity funds are focused on buying and fixing distressed companies, others are focused on

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acquiring midsized high-cash-flow businesses they can expand, and still others specialize in real estate. “When to Break Up a Conglomerate: An Interview with Tyco International’s CFO,” The McKinsey Quarterly, November 29, 2007, http://www.mckinseyquarterly.com/article_abstract.aspx?ar=2057& l2=5&l3=5&srid=27&gp=1, accessed November 11, 2007. John U. Bacon, America’s Corner Store: Walgreens’ Prescription for Success (Hoboken, NJ: John Wiley & Sons, 2004), pp. 182–187. Also, see page 169 for the reference to the Jim Collins comparisons. Portions of this chapter are adapted from Arthur B. Laffer and Wayne Winegarden, “The Benefits and Costs from Implementing a Stock Repurchasing Strategy: A Survey and Summary,” Laffer Associates research paper, March 2006. The research paper cites over 100 sources. (See www.TopValueBuilders.com.) This story is based on actual experience. Yet the dividend versus share repurchase debate continues. In times of uncertainty and after a stock market crash, many individual investors and their investment advisors will suggest stocks of strong companies that are paying cash dividends of 5 percent or more as a hedge against market uncertainty. These stocks would, in our words, be selling below their intrinsic value. The dividend policy only reflects the confidence of the management to continue to generate strong cash flows despite an uncertain global economy. Jack L. Treynor and Fischer Black, “Corporate Investment Decisions,” in Modern Developments in Financial Management, Stewart C. Myers, ed. (New York: Praeger Publishers, 1977), pp. 310–327. Cited in Laffer and Weingarden. Laffer and Winegarden, “The Benefits and Costs from Implementing a Stock Repurchasing Strategy: A Survey and Summary.” A company with excess cash will find that the best way to return that cash to shareholders is through a share repurchase. The offer to repurchase gives a choice to investors. Nothing is imposed upon them. On the other hand, a one-time dividend imposes a tax liability on taxable shareholders, and cash is returned to all shareholders who might have to reinvest the proceeds. The more fundamental decision of whether to pay or not pay dividends in general is related to the life cycle of the company. Newer companies with high growth find that payment of dividends competes with the cash needs for growing the profitable business. More mature companies usually find that cash is produced regularly in excess of the amount needed for productive growth. This happens as growth becomes more difficult and less profitable.

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9. Raj Chetty and Emmanuel Saez, “Dividend Taxes and Corporate Behavior: Evidence from the 2003 Dividend Tax Cut,” The Quarterly Journal of Economics, vol. CXX, issue 3, August 2005, p. 796. 10. In a Dutch auction, buyers submit bids for certain quantities and prices. The seller accepts the number of bids necessary to sell the quantity offered, at the price necessary to sell the desired quantity. All buyers pay a common price equal to the lowest price of any of the accepted bids. 11. For more on this issue, see Arthur B. Laffer and Wayne Winegarden, “The Benefits and Costs from Implementing a Stock Repurchasing Strategy: A Survey and Summary,” Laffer Associates research paper, March 2006. (Available at: www.TopValueBuilders.com.) 12. Ibid. Note: Standard finance theory holds that for a given company, increases in leverage reduce the cost of capital as the tax shelter benefits of debt increase. However, the cost of equity rises with increases in leverage. This rising cost of equity offsets the tax shelter benefits so that, above a certain level of leverage, the total cost of capital rises. The expectation is that a corporation will find a capital structure that optimizes its mix of tax benefits and equity risk, likely at a point where the cost of capital is minimized for the company. Research continues on why the experienced levels of leverage differ greatly between public companies and portfolio companies of private equity owners. Candidate reasons include differences in risk preference, agency issues and incentives, legal barriers, access to capital when needed, and relative differences in ability to isolate the impact of a business unit failure. 13. Emily Chasan, “Retailers Seen Taking Lease Accounting HitStudy,” Reuters.com, June 12, 2007, http://www.reuters.com/ articlePrint?articleId=USN1230002220070612, accessed January 2, 2008. Charles Mulford, an accounting professor at Georgia Tech, headed a study to reconsider accounting for leases. The study applied the proposed rules pro forma to the 2006 earnings of retailers. On average, earnings from continuing operations of the 19 companies profiled would have been reduced by 5.3 percent. 14. For a more complete explanation of cash flow metrics, dig deeper: William J. Hass and Shepherd G. Pryor IV, Building Value through Strategy, Risk Assessment and Renewal (Chicago: CCH, 2006). Additional information is available on the Web at www.TopValueBuilders.com. 15. See also Robert C. Posen, “If Private Equity Sized Up Your Company,” Harvard Business Review, November 2007, pp. 78–87, HBR.org.

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16. As we discussed in Chapter 4, CEO compensation should rise with market value of the company rather than sales. 17. Sears Holdings Form DEF-14A, dated March 26, 2008, and filed with the SEC. 18. In a letter to his employees on November 29, 2007, Lampert wrote: “Retail is a fickle business. Nevertheless, like any other business, by focusing on the long term, making decisions based on facts and logic, and appreciating that all decisions are based on many possible future scenarios, companies can navigate the ups and downs of the economy and the stock market to create long term value for their shareholders. That is our focus, and our goal, at Sears Holdings. We will take the actions we believe are necessary to drive value over the long term and manage the business closely and opportunistically in the short term.” Todd Sullivan, Reuters Stock Buzz, November 30, 2007. Posted at: http://stockbuzz.us.reuters.com/post/show/118927. Accessed December 6, 2007. (Note: While running scenarios is crucial, the exercise must be followed up by engaging people to take the desired actions.) 19. “Sears to Cut 200 Staffers,” Sandra M. Jones, Chicago Tribune, February 13, 2008, Section 3, p. 1-5. See Chapter 9 for a value analysis of Sears Holdings. 20. In June 2007, Federated changed its corporate name to Macy’s, Inc. We refer to the company throughout this section as “Federated,” which was its corporate name during the time of most of the included facts. 21. The Federated transaction was private. Campeau was a real estate developer. In 1986 he bought and broke up Allied Stores, which included Brooks Brothers, Ann Taylor, and others. Federated was to be an encore performance, but he overpaid after a bidding war with Macy’s. Important point: private equity can make mistakes and overpay. 22. Allen Questrom was selected for Federated’s top job because of his previous well-documented turnaround leadership within Federated at Atlanta-based Rich’s and outside Federated in the 1989 turnaround of Dallas based Neiman-Marcus. Under his leadership, Rich’s went from Federated’s worst division to its most profitable division in four years. 23. “Macy’s Stock Rises on Report of Takeover Bid,” Reuters.com, July 18, 2007. See: http://www.reuters.com/. “Macy’s a Takeover Target by Private Equity Firms?” Money News.com, July 12, 2007. Available at: http://moneynews.newsmax .com/money/archives/st/2007/7/12/114617.cfm.

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24. Most readers will be surprised to know that JC Penney was a value creator from 1986 through 1993, while Federated reorganized in bankruptcy court, and the U.S. economy went through a recession from July 1990 through March 1991. 25. Allen Questrom returned after a two-year stint turning around Barneys New York, a public company that emerged from a Chapter 11 bankruptcy on January 28, 1999, after filing for protection under the Bankruptcy Code on January 10, 1996. Rumors also have suggested that he was being pursued by Ed Lampert to lead the even larger job at Sears in 2007/2008. 26. David Bodamer, “Private Equity Firms Likely Buyers for Lord & Taylor, Parisian,” Retail Traffic Magazine, January 19, 2006, at http://retailtrafficmag.com/news/lord_taylor_parisian/. Questrom continues to be a highly respected retail expert who has been tapped by private equity. 27. Tim Reason, “A Penney Saved: A Deft Turnaround Buys Time, but What’s in Store Long-Term for the Venerable Retailer?” CFO Magazine, December 1, 2004. 28. Ibid. 29. For additional profiles on other retailers, including Nordstrom’s, Sears, and Kmart, and specialty retailers such as Home Depot, Lowes, and Crate and Barrel, see William J. Hass and Shepherd G. Pryor IV, Building Value through Strategy, Risk Assessment and Renewal (Chicago: CCH, 2006). Additional information is available on the Web at: www.TopValueBuilders.com. 30. See also: David F. Snowden and Mary E. Boone, “A Leader’s Framework for Decision Making: Wise Executives Tailor Their Approach to Fit the Complexity of the Circumstances They Face,” Harvard Business Review, HBR.org, November 2007, pp. 69–76. 31. Ibid. 32. Notable fortunes have been built by private equity investors who are willing to take on distressed investments. However, they each pursue their individual strategies. Monoline insurer Ambac faltered as a result of its position in insuring hundreds of billions of dollars of collateralized securities. Two competing offers surfaced in early 2008. Warren Buffet, through Berkshire Hathaway, offered to take on the municipal insurance portfolio obligations for 150 percent of the premium revenue, an offer that was quickly rejected. Wilbur Ross, on the other hand, offered to go in as an investor. While the operational turnaround that Ross would have to undertake might produce greater wealth over time, there is clearly a difference in risk

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preference between these two approaches to “investing” in the monoline insurance industry. See: “Buffett’s Bailout Short on Takers: Hardball Terms Color Bond Reinsurance Plan,” by James P. Miller, Chicago Tribune, February 13, 2008, Section 3, p. 1. See also: “Has Wilbur Ross Lost His Mind? Reports that Ross will invest in the battered bond insurer Ambac have soothed investors. But the deal makes no sense, argues Roddy Boyd,” by Roddy Boyd, Fortune, CNNMoney.com, January 25, 2008, Ibid. Robert C. Posen, “If Private Equity Sized Up Your Business,” Harvard Business Review, November 2007. “The topic of real options applies the option valuation techniques to capital budgeting exercises in which a project is coupled with a put or call option.” See: Campbell R. Harvey, “Identifying Real Options,” white paper, Fuqua School of Business, Duke University, National Bureau of Economic Research, latest revision: December 30, 1999. Source: http://faculty.fuqua.duke.edu/~charvey/Teaching/BA456_ 2002/Identifying_real_options.htm, accessed January 18, 2008. The interested reader can consult a variety of sources such as Tom Copeland and Vladimir Antikarov, Real Options: A Practitioner’s Guide (Texere, New York: Monitor Group, 2001). Tom Copeland and Vladimir Antikarov, Real Options: A Practitioner’s Guide (Texere, New York: Monitor Group, 2001). Shepherd G. Pryor IV, William J. Hass, and Dennis N. Aust, “Inertia or Change? Try Continuous Renewal!” The Journal of Private Equity, vol 10, no. 2, Spring 2007, pp. 12–21. Research continues to test the separate impacts of dividends and share repurchase on intrinsic valuations of companies. The focus is on preferences and expectations of different investor segments that have varying available strategies to limit taxes. The hypotheses to be tested relate to how the various available tax strategies affect the buying and selling habits of the investor segment and thus affect the intrinsic value and how intrinsic value translates into stock prices. In addition to tax strategies, the testing will ask whether segments of investors prefer consistent high dividends over share repurchases as a way to manage agency risks, forcing management to consistently disgorge the firm’s annual excess operating cash flow which cannot be profitably reinvested significantly above the cost of capital. Additional research is needed to cover different business cycles and account for changes in tax rates and the changing mix of different types of institutional shareholders.

PART TWO

Act Sooner Facilitated by Digging Deeper

Part 2 of

The Private Equity Edge deals with acting sooner. Acting with speed gives private equity an edge. They know the clock is ticking for results. Given better insights, knowledge, and experience, top value builders are able to make better choices. They take wealthcreating actions sooner than those who are content with average returns. They dig deeper but balance digging with action. Top value builders understand that the future is uncertain and that good and bad things will happen along the way. Ideally, the combination of their digging and their speed of action allows them to identify and mitigate bad decisions and accelerate the execution of good decisions toward their value-building goals. They learn that the key to building value and wealth is to maintain forward motion and to become smarter along the way. Top value builders ask the right questions about their customers and their markets. They continually improve value by making many changes along the way. They build superior knowledge that allows the best ones to produce results far above public market averages. Successful private equity players do a far better job of building long-term value, compared with the average public-market company. Private equity players make critical long-term decisions, but they break the long term into comprehensible segments. They typically set aggressive EBITDA goals as a benchmark for value over a three- to five-year time horizon. As a result they stay focused and say no to most of the quarterly earnings per share (EPS) distractions that face their public company peers.

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Successful private equity players live in the reality of the present, but they have a realistic planning horizon and a value road map that is continually updated. They understand market shifts better than most. They understand, identify, and act on inflection points with greater precision than their slower-moving peers. Top value builders know that plans extending beyond five years should be viewed with caution because the actions of others can destroy even the best-laid plans. Successful private equity players “monetize” the value they create by knowing when to sell a business they have acquired and repositioned for the future. They create transparency of value for their investors through transactions that result in cash, providing much greater transparency than their public peers.

CHAPTER 6

Speed The Race Is to the Swift

“W

e have an offer to take the company private. We need to form an independent committee of the board to evaluate the value of strategic alternatives. We must have an answer in 60 days or less. It’s too bad their offer is below our intrinsic value. I think we can force them to increase their offer at least 15 to 20 percent. “Fortunately, the strategic review we just completed has provided all our managers and directors a new perspective on the intrinsic value of our business. The question we need to answer today is: Do we put the company in play, or wait and see what their offer might be? “Our first choice for an investment banker is already advising our private equity suitor and has a conflict.”

THE IMPORTANCE OF SPEED If there is one lesson to be learned from successful private equity players and other value builders, it is the speed at which they put plans into action. Before private equity firms bid on takeovers, they typically do extensive due diligence. Their bids are made on their belief that their ownership presence can be used to produce major change and a significant increase in value over three to eight years. Interestingly, that three- to eight-year exit planning horizon is typically the time that coincides with one full business cycle. 193

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Time is of the essence in these transactions. The bidder must see the opportunity and then must be able to act ahead of potential competitors. Frequently the opportunities themselves are fleeting, triggered by executive transitions, near insolvency, short-term economic events, or business errors that can temporarily damage the stock price of a target company. The “industry-smart” private equity buyer who has already done the homework may have a major advantage over potentially competing buyers. For example, in 1988 Henry Kravis, a principal of KKR, and Ross Johnson, CEO of RJR Nabisco, got into a bidding battle for control of the company. Ultimately, KKR prevailed with a bid of $25 billion, and ultimately, its investors made suitable returns on their investment in the takeover of RJR Nabisco. As an insider, Johnson had a strong advantage in the bidding process, because he knew the company intimately. Still, KKR, known for doing its homework, won the bid.1 In some cases, such as Ford Motor Company’s quick sale of Hertz, the goal of the private equity player to buy low and sell high is clearly demonstrated. Taking advantage of low interest rates and business cycle timing, as well as bringing specific change to the acquired companies, can produce tremendous value. Private equity firms find the status quo unacceptable and force a high degree and speed of change on the companies that they buy. Management players in most but not all public companies that compete as strategic buyers find the approach unacceptable and risky.2 This can give an advantage to the private equity firms. Public company buyers are concerned with the short-term impact on EPS and are typically slower to introduce change to the companies they acquire. Exceptions in the public company arena include ITW, Danaher, GE, and others, which introduce major changes to their acquired companies. Edith Hotchkiss, a finance professor at Boston College, has studied nearly 100 companies taken private by private equity firms in the most recent wave of buyouts for which post-buyout financial information is available. According to Professor Hotchkiss: “The operating performance of these firms is comparable to or slightly exceeds that of benchmark firms in similar industries. However, the gains from these transactions do not nearly reach the magnitude reported by earlier researchers for deals of the 1980s. Firms show improvement in their management of working capital, and the

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gains in operating performance are greater when the private equity sponsor has replaced the CEO at or soon after the time of the buyout.”3

SPEED MATTERS: HERTZ BUYOUT SPEEDS CHANGE AND YIELDS BILLIONS FOR PRIVATE EQUITY INVESTORS During their 11-month ownership of Hertz, a group of private equity investors including the Carlyle Group, Clayton, Dubilier & Rice, and an investment vehicle of Merrill Lynch changed management, made dramatic changes, and put over $3 billion in the pockets of their investors. Private equity players are known for their value discipline and ability to take advantage of crisis and distress situations. In 2003 Ford Motor Company felt the pressure of a recession and global competition. Bankruptcy rumors directed at Ford and GM circulated. To help ensure survival, Ford raised cash by eventually selling its Hertz car rental subsidiary to a group of private equity investors in late 2005.4 Hertz, under Ford Motor’s public ownership, was a sleepy, underperforming company. Rather than risk the time and distraction of conducting the sale through an initial public offering (IPO), Ford sold Hertz at a discount. The private equity investors and new management realized huge rewards when Hertz was taken public again only one year later. The $3 billion value increase was not entirely the result of the operational improvements by a new, more aggressive management:5 One-third of the value increase was a result of buying Hertz at a discount to its intrinsic value, resulting from Ford’s distress. Private equity firms are opportunistic. • One-third of the value improvement was market timing, as the entire market and economy improved during the year of ownership because of increases in travel demand. Private equity firms understood the importance of macroeconomic trends. • The remaining one-third of the value improvement was the result of new management’s operating changes. This •

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boost in value resulted from increased demand for construction equipment rentals and basic operating improvements that prior public owner management missed or had no great incentive to implement. Private equity firms make operating changes to improve value. According to Hertz’s CEO, “Ford could have gotten more money for it if Hertz had done what private equity did.”6 An open question is whether, had Ford’s survival not been the leading issue at the time, management would have gotten around to making the changes that could have enhanced Hertz’s value. It was answered in part with a comment on November 11, 2007, as a correction to the Hertz article that appeared in the New York Times on September 23, 2007. In the correction, former Hertz CEO (1977–1999) Frank A. Olsen commented that Hertz, in effect, used financial yardsticks like EBITDA and cash flow before the buyout, but those practices “have been expanded broadly.”7 This is exactly our point. While practically every public company looks at a wide variety of financial benchmarks like EBITDA, cash flow, and value, top value builders focus on intrinsic value-based metrics with a high degree of urgency and speed for change. Private equity incentive compensation is also a factor that encourages management to make rapid change. Private equity owners of Hertz installed a former Tenneco executive, Mark Frissora, as CEO and gave him great incentives to produce the value increase. In addition to his CEO salary near the $950,000 taxdeductible cap, he received stock options and other grants that became worth over $30 million one year after the IPO; not bad for one year of value building! Successful private equity players make changes much faster than do their public peers. As we saw with the Hertz example above, it usually takes a crisis to get the average public company to make needed dramatic changes (such as selling a marginally producing division) because of management’s concern about meeting quarterly EPS targets. Private equity’s focus on value forces change with dramatic speed as seen in the purchase of Chrysler. In mid2007, Daimler Benz sold Chrysler to private equity player Cerberus Capital Management, L.P. Daimler management felt strongly that the public company structure was inhibiting Daimler Benz from

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making the necessary dramatic improvements. Only time will tell if Cerberus is successful in changing Chrysler’s profit picture and establishing a sustainable business model. Cerberus did not waste time. Less than 90 days after the acquisition of Chrysler, the new private equity management team announced the elimination of four models and shifts at five assembly plants that were likely to reduce Chrysler’s 45,000 U.S. payroll by 12,000 jobs.8 While those cuts could have been made earlier by Daimler-Chrysler, industry observers noted that public companies are slow to admit defeat and “private equity responds much quicker than what we’ve seen from traditional manufacturers.”9 If a return to profitability is possible, Cerberus is the type of private equity firm up to the challenge. More cuts are almost certain as the auto industry faces extreme challenges amid the 2008 global economic crisis. Survival under fire requires an intensified focus on cash. Healthy companies that pay too much attention to growth or maintaining market position can lose focus on cash and become acquisition targets.

PRIVATE EQUITY PLAYERS USE THEIR NETWORKS TO SPEED DEALS Time is money. Closing profitable transactions is a skill that top value builders have developed through personal experiences and trial and error. Over several years they develop networks of professionals including legal, accounting, and industry operations experts whom they hire to perform due diligence and to facilitate the transactions. They have a draw on sources of capital in all forms. Capital providers are ready to make firm proposals after a few phone calls. They call on these contacts in their networks to deliver opinions in days or weeks, not months or years as may happen in most public companies. Once a deal is closed, the private equity players really get involved. Unlike many public boards of directors, they quickly develop an understanding of management’s true capability and critical systems, far beyond the due diligence that preceded the acquisition. When difficulties arise, they jump into daily monitoring of cash by business unit. They are not afraid to defer expenses

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or make tough decisions on benefit reductions if it is necessary to protect future value and conserve cash. Rather than wait for problems to become serious, successful private equity players get involved and stay involved, so that when a problem develops, they are prepared to act immediately. As we learned in Chapter 5, they run scenarios and update plans and projections as conditions change. They dig beyond monthly GAAP accounting statements and keep a close eye on cash flow and key cash flow drivers, including changes in competition, order backlog, accounts payable, accounts receivable, and inventories. Successful private equity players carefully monitor in real time the pluses and minuses of the business units and add additional expert resources whenever results deviate from plan. When results fall short of what is planned, the owners’ involvement is often unwelcome by management. Unlike public company boards, the private equity owners will not hesitate to replace management players who resist important value-enhancing change sought by the owners. A management that pushes back on change and key priorities may be immediately pushed aside. While successful private equity players organize themselves for speedy completion of transactions, they remain vigilant. Private equity firms do not dole out cash the way public companies do. Many restrict the expenditures on major projects, staging the payments and requiring that management meet important benchmarks before each payment is made. The more aggressive ones require portfolio companies to pay substantial dividends or repurchase stock in the first few years of ownership, potentially repaying all or most of their investment within three to four years.10 Acquisitive public companies such as General Electric and ITW (Illinois Tool Works) develop networks of experts similar to those of private equity firms. Private equity firms typically realize value by sale of businesses they acquire. Public companies usually do not. Public companies that acquire numerous businesses look for their improvements to be reflected in the stock price. Since most public companies do not disclose business unit results, they often suffer from the “conglomerate discount” and may find it difficult to produce the immediate value increases that are so transparent when private equity firms execute a sale. It takes a talented

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management team and consistent short-term results in a public company to communicate to stockholders the value of the changes made. This is why many private equity firms have been successful by purchasing conglomerates and then quickly breaking up the businesses, because the parts, treated properly, are worth more than the whole. Public companies that do not sell subsidiaries as readily as they acquire them are at risk of reaching an unmanageable mass. Subsidiaries can languish in the complexity of the corporate empire and drain value. Private equity firms treat each company they buy as an asset that will be developed and sold at a profit. Thus the private equity incentive is always to focus on the value of each company in the portfolio. They do so through their board interface with portfolio companies. Sara Lee was built into a major conglomerate by John Bryan and Steve McMillan, both known as jet-set deal makers. The company had so many business units, it was incomprehensible to analysts, and its stock price suffered from the typical “conglomerate discount.” Brenda Barns became CEO in 2005 and quickly moved to shed a variety of operating divisions in an effort to focus on food and related products. In order to shake things up and speed up the transformation, she moved the corporate headquarters from Chicago to an outer suburb, Downers Grove. Despite the speed of the transformation and her communication to the stockholders, Barnes found that many stockholders continued to clamor for even greater speed of change, greater returns, stock buybacks, and further cost cutting to unlock the intrinsic value that they thought still lay hidden within the company. “As of September [2007], Barnes was sticking to her long-term plan, confident that unifying Sara Lee would realize greater returns than a quick fix.”11 Barnes also stepped up efforts on transparency, presenting detailed overviews of each of the company’s businesses at the company’s annual meeting in September 2007.12 We would hypothesize that Sara Lee, as a private equity investment, would not find as much pressure on short-term results, but would be more supported in its effort to build long-term value. However, a private equity owner might push the deconglomeration of Sara Lee even more quickly and find an even more concentrated core to build on.

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SPEED TRUMPS SLOW: TOYOTA ADOPTS “LEAN THINKING”—OTHERS FOLLOW Most private equity investors have encouraged or mandated their portfolio companies to embrace lean thinking, a technique that focuses on providing what the customer values and eliminating waste. Lean thinking was pioneered by Toyota and has been copied by many. The speed that Toyota generated enabled it to create a competitive advantage by shortening the cycle time from design to market. For decades American auto manufacturers were comfortable with a five-year cycle time. Incremental changes helped keep costs down, while occasional style changes helped to prompt buyers to trade in, rather than continue as owners of obviously out-of-date cars. Toyota’s dramatic process improvements disrupted the auto industry by cutting the cycle time to three years, and even less, while improving quality. This move surfaced an even starker contrast among the attitudes of the manufacturers. The North American automotive manufacturers had relied on sales promotions and rebates to move product and to keep inventory in balance. This added to their production efficiencies in manufacturing, as the production schedules could remain steady and helped absorb their high levels of overhead. Toyota, on the other hand, made its adjustments by determining what the customers wanted, “pursued perfection,” and, through shorter cycle times, was able to produce cars with the style and features that were most desired by the consumers. What originally seemed to be only an upgrade in design/manufacturing speed became a major marketing advantage. The “lean thinking” that Toyota used to gain a long-term competitive advantage has become the standard that many manufacturing companies aspire to. By acting first and speeding ahead of its industry peers, Toyota gained a great advantage, which has allowed it to consistently gain market share over the past decade. Private equity players have identified the underperforming auto industry as a target for improvement. When they purchase a distressed auto parts manufacturer, they are quick to implement Toyota’s lean concepts and outsource select operations to add to the

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bottom line. As a result, they significantly enhance the creation of value.

GOVERNMENT BODIES CAN LEARN FROM PRIVATE EQUITY’S SPEED OF CHANGE Many consider government agencies to be classic examples of bureaucracy, resistance to change, and the antithesis of speed. The move to privatize government functions should be an eye-opener for everyone who pays taxes. Elimination of waste and lean thinking are gradually finding their way into government agencies.13 Privatization has been successful in reducing the cost of service in prisons, water works, and utilities around the world. Government agencies are afflicted with the silo effect that many corporations are learning to break down.14 Every organization can be improved. Private companies have the incentives to serve their customers better, faster, and cheaper than government agencies. Privatization of schools and toll roads is being discussed. Privatization of many support functions to our military may seem outrageously costly, but despite the reported high cost, private firms usually save taxpayers millions of dollars compared with government-run alternatives.

LARGE FAMILY-OWNED BUSINESSES CAN LEARN FROM PRIVATE EQUITY FUNDS Large family-owned businesses have been a target of private equity funds for years. Because they are slow to change, they typically sell at a discount. Private equity firms that acquire mature middlemarket family-owned businesses act quickly to make substantial changes that usually result in immediate improvements in value. Some family businesses use speed to their advantage. When in the early growth stage, the founding team makes speedy decisions. Problems develop later, under the leadership of second and third generations, as growth slows and markets change. Many large family businesses are conservative niche players, content with remaining private. Yet others are perched at the threshold of going public or otherwise taking advantage of opportunities for high growth.

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A distinguishing characteristic will be those who most quickly break through the limiting cultural barriers that can develop within family companies. Breaking out of the pack can provide a lead for a family business that may leave others far behind. The trick is finding ways to get past the intrafamily negotiation and on to business decision making and building value. Conflict over family wealth and the distribution of wealth typically slows decision making. As we frequently see in politics, disputes about how to distribute the nation’s wealth may push aside efforts to build wealth. This same problem occurs in multigeneration family businesses where there are often many interested parties who may have differing priorities and time horizons. Should the business be changed to increase value or preserved as is and value built through retention of earnings? Should the family members be given high dividends, at the expense of the future of the business? Should the business be liquidated and the proceeds reinvested in a diversified portfolio? What is the appropriate level of risk and financial leverage? All these questions have been answered in the affirmative by various family businesses in the past. Clearly, avoiding conflicts over family wealth is a critical step to refocusing on the business value and health. Author François de Visscher15 notes that a family holding company structure offers several benefits. It can enable the family to attract outside sources of capital to fund the operating business without affecting its other assets. It can also be used to smooth out the flow of cash from the business to family members. The holding company structure may also help in financing and developing the business. “Lenders who may not be interested in writing loans to the operating company may be happy to lend money to, say, the real estate entity. . . .” The holding company structure, which allows better control and isolation of different assets, “provides the ability to take bigger business risks without risking the family’s wealth.”16 In fact, several large family holding companies do operate as private equity funds. Applying the typical private equity fund compensation formula of paying a 2 percent management fee on assets plus 20 percent of gains would provide a formula for distribution of cash to the family, while creating an incentive for building value rather than harvesting value. Various family business experts note, “It’s no

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surprise that a family’s wealth may intensify conflict, but family members may not recognize that these conflicts can simmer beneath the surface for years,”17 Tips for speeding change and reducing future conflict in large family businesses also apply to business units of all types: •

•

•

•

•

Communicate clearly. • Family: Facilitate communication among family members. Create a family council or appoint a family ombudsman to field complaints. • Corporate: Make use of advisory boards and task forces to facilitate two-way communications with the parent company. Incentivize for value building. • Family: Build a common understanding of what creates value. • Corporate: Build an incentive structure that rewards building value. Clarify accountability and roles. • Family: Determine who will work in the business or sit on the board and who will not be directly involved in the business. Create strong, written policies for hiring, promotion, and succession. • Corporate: Clearly set expectations for financial performance and development of human resources. Obtain outside input. • Family: Allow for indirect involvement of family members. Family members can participate in an advisory board or a family council without having a formal position within the business. Use outside advisors. • Corporate: Where productive, use advisory boards for each business unit. Identify distinct business units. • Family: Separate family issues from business issues. When this is accomplished through the governance structure, it channels the energies of the family toward

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the right forum. The family vacation resort is not part of the business. • Corporate: Plan and run the business unit as a distinct unit. This can be accomplished through the internal planning and budgeting structure. The impact is to enhance local management’s ownership of the performance.18

TIMING MATTERS: ACTING SOONER CAN SAVE BILLIONS According to the acclaimed investor Warren Buffett, most public companies are slow thinking, resistant to change, and too smug to change. Buffett’s Berkshire Hathaway is a public company, but it is operated more like a private equity portfolio.19 Thoughtful managers and directors have all been through situations in which there was a fork in the road. Yogi Berra’s advice was, decide with speed: “When you come to a fork in the road, take it!” Unfortunately, as choices arise, they can be as confusing as Mr. Berra’s advice. When the decision is whether to maintain a known method or to abandon it for a new method, there are real issues to consider: • • • •

•

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How important is the decision to long-term intrinsic value? How long will it take to know for sure if it is the right decision? Will the new method increase value? If so, how much? Will it be costly, risky, and difficult to implement? If so, how much of the potential value of the switch will be eaten up in the transformation? Will sticking with the old method cause the company to fall behind competitors? If so, will the company ever be able to catch up? Will the company be betting the farm if it fails?

Successful private equity players make decisions quickly and move into transactions with great speed, but they always make sure they are not betting the farm.

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BOLD LEADERS USE CREATIVE DESTRUCTION TO FORCE CHANGE IN MATURE INDUSTRIES In the late 1970s the rubber tire industry was producing three types of tires. At the very low end were corded tires, cheap and subject to blowouts. These tires were hurtling toward obsolescence. Fiberglass belted tires held the middle ground. They were tough and roadworthy, and they represented the bulk of the market. At the top end were bias belted steel radials, even tougher and more roadworthy. These were clearly superior tires, but much more expensive to manufacture. The industry was in a nearly chronic overcapacity situation, and the plants that were dropping out were those that produced the old corded tires. In 1977, Goodyear upset the entire industry. In a bold move, Goodyear management decided to build a state-of-the-art steelbelted radial tire factory in Lawton, Oklahoma. The scale of the plant would aggravate the existing plague of overcapacity in the industry and depress the prices for steel-belted radial tires. However, from Goodyear’s point of view, the cost efficiencies built into the new plant would offset the projected decline in pricing. Goodyear would emerge with a larger market share, with competitors racing to catch up. Steel-belted radials would be cheaper and more universally available. This would quickly make them the standard of the industry. Goodyear reasoned that other competitors would not be able to justify building similar plants. Because Goodyear had the lead, other manufacturers could only expect to use the capacity of a new plant if they jettisoned old plants with similar production volume. Goodyear took the short-term EPS hit, but had such a strong “first strike advantage” that it won the battle with the other industry players, gaining an advantage that lasted for 20 years. A good strategy responds to changing market conditions and produces value. In the case of Goodyear, the strategy of early action was a speedy response to a new technology that provided a better product and addressed the probable future market conditions. With the superiority of steel-belted radials clearly proven, it was only a matter of time before consumers would demand them. The strategic question was how to find a way to provide the superior tires to

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a larger market that would demand lower pricing. Goodyear shifted both the supply curve and the demand curve for radial tires with a bold, speedy, and preemptive move. It remains the world’s largest tire maker, with factories working around the clock.20

DELAYING ACTION CAN COST BILLIONS In Chapter 2 we discuss the dramatic effects that followed from changes in marginal tax rates. One effect was that taxpayers alter the timing of income producing and recognizing activities. Recall that when people know that a tax decrease will come next year, they have a huge incentive to defer income from this year until next year. Of course, every individual in an economy does not control the timing of income, but many do. In a similar fashion, how much of the stock sales in the October 2008 stock market crash will eventually be attributed to wealthy stock market investors anticipating the election of a Democratic president who vowed to increase the capital gains tax and other taxes on the wealthy? Because speed and the ability to change can confer great advantage on companies, successful value builders keep an eye on the future and on changing customer needs. Monitoring trends for cues about what customers want provides smart companies with a definite advantage, if they act speedily. Many consulting companies watch legislative changes so that they can provide road maps for their clients to take advantage of opportunities and avoid risks that might arise. In some cases, the road maps help the companies decide how to avoid problems that the potential legislation might create. In 2007 the secret world of private equity was hit with the media spotlight. Huge profits of wealthy individuals and the tremendous growth of private equity funds sparked a movement to change the capital gains tax treatment of private equity carried interest. If proposed legislation was passed, the gains from purchase and sale of portfolio companies would have changed from capital gains to ordinary income. Large private equity funds sped into action. They quickly organized an association and lobbied against the change in the tax treatment that would have cost the industry billions. Speed and action go hand and hand with private equity.

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Only time will tell if private equity players can continue to tell a convincing story and avoid a capital gains tax increase. Like WalMart, their tremendous growth and wealth has drawn great attention. However, they perform a service for investors with speed that many public companies and family businesses have failed to achieve. Since a significant portion of private equity investment funds comes from retirement plans, legislators who are aware of that fact may be reluctant to upset these fast-moving agents of change.

DON’T RELY ON REGULATION TO SLOW THE SPEED OF CHANGE The airline industry in the United States has the reputation of having collectively lost money on operations for most of the past three decades, since the “deregulation” of the airlines in 1978.21 During this time over 100 airlines have declared bankruptcy; some, such as US Air and Continental, have entered the bankruptcy courts more than once. Some airlines that made money may have done so by buying and selling aircraft and routes. A quick poll of airline executives during many of those years would likely have resulted in a call for reregulation. Then came the disruptions of 9/11, SARS, and the Iraq war. On a global scale, profits were expected to return in 2007 to over $5 billion. However, this is only slightly more than a meager 1 percent of estimated global 2007 revenues of $470 billion. It is also “far below the seven to eight percent required to cover the cost of capital.”22 Speed is a survival requirement in some industries. Regulation protected the airline industry in the United States for decades. However, the largest U.S. airlines were ushered into the real world of global competition as the new deregulated climate took hold in the 1980s and global travel accelerated. Characteristic of deregulation and friction in the 1980s were numerous pilot strikes (Continental broke its contract with its pilots union in its first bankruptcy) and the air traffic controllers’ strike, which was broken by direct intervention of President Reagan. As the airlines were deregulated, and despite the pain, they made many of the necessary adjustments that the industry needed. Unfortunately, those changes were not made fast enough, nor were they dramatic enough to prevent a rash of bankruptcies.

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What has come to pass in the airline industry since that time is a realization that the airlines cannot rely on high volume alone. Airlines must be flexible and designed for low cost in both up-anddown markets and increasingly global markets. This is the type of adaptability and profitability that private equity investors demand in their portfolio companies. Consequently, there have not been many private equity investments in major airlines. Conditions in the industry continue to change at an accelerating pace with more fuel-efficient jets and increases in both global and domestic competition. Top value builder Southwest Airlines was a survivor and an exceptional value performer. 23 Despite the burdens of a union and industry overcapacity, it outperformed the S&P 500 average by a great degree. Industry overcapacity became critical as passenger traffic dropped off in the wake of the 9/11 attacks on the World Trade Center in 2001. With newer, smaller, and more fuel-efficient planes and no complex hub and spokes route structure, Southwest had a natural advantage in a world requiring maximum flexibility. Southwest said no to expensive reservation systems, in-flight meals, and routes that were uneconomical at the time. Other discount airlines, such as Jet Blue, unburdened with an aging workforce, followed Southwest’s lead. The surprise in the industry is not that the advantage so strongly shifted to Southwest, but that the advantage has persisted for so long. Southwest is not a global player. Although the European airline market was deregulated in the early 1990s, there still are several government-subsidized international competitors fighting for survival, such as Italy’s Alitalia Airline.24 U.S. airlines with highly profitable global routes were saved for a short time. However, the global airline industry consolidation will continue to accelerate, despite the subsidies that are given by various governments in the name of national pride. In the fall of 2001 and the wake of the 9/11 terrorist attacks, there was a veritable parade of airline industry executives in Washington pleading for federal bailout help. Airline executives from the major airlines offered arguments of war risk and disruption beyond their ability to predict. There was “no visibility of future earnings” for the airlines. In the short term their arguments gained some ground.

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Any capital-intensive industry with billions invested would find it difficult to drop the time-tested methods and the assets that supported them for decades. However, change is critical for the airlines, and change with enough speed is necessary for success. Once the political bailout decisions were made and individual airlines found the limits of governmental support that they could expect, it was time to move to the next step and adapt to the changes. Culturally, this was very difficult for the airline industry. By 2005, despite a round of large bankruptcies, many airlines still appeared to be in denial. Without solving the big structural problems in their industry, they found ways to cut unprofitable flights and fill the planes, rebuild traffic, and cut losses. Unfortunately, they have yet to find ways for the industry as a whole to make enough money to compensate the investors with a reasonable return on capital. Southwest continues to hold the high ground, with the simplest business model. The “majors,” despite some changes, continue to plow the same ground, with basically the same route structures, weaker customer service, and a dependence on high traffic volume. Even after bankruptcies that included United, Northwest, US Air, and Delta, the industry is still not making money on an economic basis. Industry consolidation is likely to continue. Publicly owned airlines are slow to act. United, after shedding pension liabilities and emerging from a three-year bankruptcy, is still looking to transform itself. It is evaluating decisions that include mergers and divesting profitable operating divisions such as its maintenance operations and reservation system to find a method of long-term survival. Despite earning below its cost of capital, United planned to invest $4 billion to upgrade information systems, aircraft, and customer service improvements. It will need large-scale partnerships to compete, or it will not remain as one of the 10 largest players, according to Glen Tilton, its CEO.25 Is it any wonder that, since the 1980s, most successful and smart private equity players have stayed away from major airlines in this troubled industry in favor of other troubled industries such as auto parts, steel, and coal? Deregulation has been working its magic. On the positive side, air travel is available to everyone in the United States at a lower real cost than under regulation.26 Even international prices have come down as international markets have been partially deregulated.

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Before the deregulation of the industry, the price of air travel, relative to other goods and services, was far higher. The examples above show that government regulation clearly slows decision making and economic progress. After generations of privilege, the airline industry culture was shocked when it was forced to adapt to a competitive environment. The people effect of those who were entrenched in a comfortable status quo was enormously difficult to overcome. Deregulation has increased the speed of change for airlines. Those that fail to change face failure. Is deregulation good or bad? You decide.

THE BIGGEST FAILURES ARE OFTEN FAILURES TO ACT Top value builders amass experience over a variety of businesses and corporate entities much more quickly than their counterparts in public companies. The level of change is far greater among private equity portfolio companies than among their peers. With a tight focus on value and superior knowledge of an industry or sector, private equity decision makers are more likely to make decisions quickly. Their decision speed is fast. Although information is never perfect, successful private equity players make decisions as soon as it is possible. They gather the facts needed to make a reasonable fact-based decision and speed to action. Most public companies march ahead much more slowly, building consensus, debating the risk, or calculating the impact on quarterly EPS. While waiting until they have the information they want, they sometimes miss the opportunity. It is not surprising that publicly held strategic buyers seem to follow the lead of private equity. Cultural differences perpetuate this gap in the speed of decision making. The major reason could be a public company board’s fear of the short-term earnings per share hit and a likely stock price drop as the penalty for making mistakes. Dramatic change often hurts short-term earnings. In public companies, every major decision affects earnings per share and can be second-guessed and picked over by a CFO focused on GAAP accounting, “do-gooder” outsiders, or a conservative board of directors. When stockholders are more convinced by the criticisms than by the original decisions, the impact on corporate executives and business value can

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be disastrous. Plans and decisions that might lead to greater corporate wealth in the future may be swept away by nervous boards in an effort to reestablish favor with disgruntled investors or protect and make quarterly earnings per share targets. The world of private equity is less enamored of conjecture, short-term EPS-speak, and quarterly earnings estimates. While the principals may make decisions that are criticized by their investors, a different dynamic is in place. Private equity players are in a position to explain the decisions in value-based language to generally more knowledgeable investors. In addition, it is less likely that the decisions that would bring about so much criticism from private equity investors would have been made in the first place. A strong focus on value and long-term horizon speeds decision making and communication. It is very easy for management of private equity portfolio companies to bounce the decisions off their private equity investors. Because they speak in terms of long-term value, they learn about any potential disagreements with the management teams of their portfolio companies early in the game. The strong bias toward action in the world of private equity produces fast decisions relative to public peers. Rather than stew on a decision, the mandate is to get enough information to make the decision, decide, and then take action. After all, management has been hired for its capability to make major corporate decisions and produce value over a given time period. Politics are reduced, and the targets are clearer than they are in public companies. Dennis Chookaszian, former chairman and CEO of CNA Insurance and a seasoned private equity investor and director of 5 public and 10 private companies, says, “The biggest failures in private equity are in the failure to act.”27 This is also a more sweeping criticism of public companies, where there may be an overwhelming concern with quarterly EPS performance and a bias to analyze decisions for too long before acting. Private equity portfolio companies are stripped down to the bare essentials where there is little room for error. Portfolio company performance is truly transparent to the private equity player. Because they are on a tight time schedule to build value, they act quickly to make changes that can transform a company from business as usual to a value machine that will meet or exceed the expectations of the investors. Management teams that cannot speedily

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produce the transformations needed to bring value rarely get a second chance.

WISDOM FROM A PRIVATE EQUITY PLAYER

Speed and efficiency of communication often beat using rule-based accounting measures. Private equity owners clearly communicate by setting cash flow and EBITDA business unit targets. This approach is much more effective than judging business performance by earnings per share. This small step is often enough to give private equity owners a significant edge in selling management on the need for change and improvement. Here are five lessons from a retired public company CEO and experienced private equity investor:28 1. Private equity players who get their market right usually can come out ahead. Private equity players are good at financial monitoring but rely on—and partner with—industry experts to get market insights. It is tough to grow in a shrinking market. 2. Public boards and committees are slow to act. Collegial decision making, a major characteristic of larger public boards, often produces gridlock. No company needs a board larger than nine directors. In small private equity-owned companies three or four directors may be adequate. 3. Intuition helps. If intuition tells you something is not right, successful private equity players and other top value builders take the time to speed ahead to dig deeper and understand the risks. 4. Success in private equity, as in all business, requires leadership. Leadership requires having a “strategic view of the future” and disciplined monitoring execution of the business strategy. 5. Basic EBITDA improvement goals provide focus and enhance speed. This short-term approach is particularly effective when aimed at improving an individual portfolio company.

SPEED CAN ALSO KILL YOU—AND QUARTERLY REPORTING OFTEN DOES! Public companies are burdened by the need for speed in meeting quarterly reporting requirements. Traders, not long-term investors, use the quarterly reports to buy and sell stocks in a way that can

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provoke daily movements of 20 percent and even 50 percent in value. This level of volatility seems to make stock prices almost meaningless. However, the constant call for performance reporting is taken by many CEOs and boards of directors as a mandate to focus all their energy on short-term performance, at the expense of strategic, long-term performance. Sometimes short-term considerations can be paramount. Several formerly strong financial institutions unraveled in the October 2008 market meltdown. Mark-to-market GAAP accounting requirements forced these institutions to take major write-offs, because there was no viable market for the assets that would be affected. The accounting write-offs triggered adverse responses in the credit markets, leading to a liquidity crisis. However, in more normal times, when liquidity can be better controlled, the focus must be shifted back to long-term value issues. The addiction to short-term stock prices and quarterly reports of earnings per share frequently causes management to make shortterm decisions that actually hurt long-term value.29 Those actions have been recorded in the press for a variety of companies. These value-destroying decisions range from minor to major but always send the wrong signals to the workforce. Typical short-term actions that hurt public company value in the name of making the quarterly EPS estimates include: Stuffing the trade. This involves selling products and services at a discount at the end of a quarter to boost quarterly revenues and EPS. This is an action that actually hurts future pricing and margins and trains customers to expect end-of-quarter incentives. It also boosts sales commissions for the quarter. • Deferring investments. This involves delaying potentially high-return projects that have start-up costs and are therefore likely to reduce quarterly EPS. • Deferring advertising. This is a move that can damage future sales and take months or years to repair. • Even more aggressive actions can border on fraud: • Booking sales before shipment or before customer acceptance of the sale. • Requesting shipment of inventories and pushing the vendor to delay the invoice. •

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Tinkering with “creative” reserves that can help to smooth earnings from quarter to quarter.

Private equity portfolio companies are monitored closely by the owners, who have a deep understanding of the trade-offs between the current quarter and long-term value. In fact, there are numerous examples of public companies going private to make the changes that would have hurt quarterly EPS but affect long-term value. There are those who argue that the short-term pressures are irrelevant and that the market participants must sell to other investors and therefore must be concerned about the long-term value of the companies they buy. In this view, the stock market is pricing the stock of public companies based on long-term considerations, regardless of the short-term pressures on management.30 However, there is a people effect involved, and it is aggravated by the market’s cycles of fear and greed. If the CEOs and the boards of directors of these companies believe that the market wants a shortterm focus and they deliver short-term performance at the expense of long-term value, then the companies will likely be worth less than they would be with a long-term focus. Even if the market sees through the flawed efforts of the management team, the actions of management will reduce value for everyone. When speed to report improved quarterly results is considered more important than quality or accuracy, speed may fail to help companies achieve their goals. Like the speedy but arrogant rabbit in the fable, a company may outwit itself by waiting too long before making substantial changes, hoping to catch up at the end, allowing the plodding and persistent tortoise to win the race. Without digging deeper to gain superior knowledge, speed can indeed kill.

SPEED CAN BE USEFUL, BUT DANGEROUS; PIPEs PIPEs, private investments in public equity, were once seen as vehicles limited to bailing out distressed companies, at a big discount off the going stock price. However, companies with potential for rapid growth also experience the same need for quick infusions of capital. PIPEs can allow public companies to bypass the time and

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administrative headaches associated with floating a public offering. This has made the PIPEs vehicle more acceptable and increased its use among public companies. While PIPEs bring benefits of both private and public capital to the users, they also bring risks. PIPEs can be arranged in weeks, compared with months required for public offerings. However, the hurried environment often impairs the ability of the company to know who is behind the investment and what impact they might have on decision making going forward. The company may also be faced with choosing between a deep discount on the stock (usually over 10 percent, but up to 70 percent off the market price)31 or giving immediate registration rights to the buyer, which could end up requiring the company to go through the same SEC processes that it hoped to delay by doing the PIPE in the first place. An additional reason for the companies involved in PIPEs to know the investor is that there have been many reported cases of investors shorting the stock, apparently as a way to increase the discount on the PIPE. This potentially illegal activity has caught the attention of the SEC. PIPEs offer the advantage of speed, but they are accompanied by additional risks.32 Private equity players with excess cash sometimes find a home and attractive investment returns in higher-risk distressed or rapidly growing public companies. However, PIPEs do not give private equity players the control they traditionally require and may be prohibited in the fund partnership agreements. “Once seen as the scourge of capital raising, PIPEs are not just for troubled companies anymore,” says Colin Blaydon, director of the Center for Private Equity and Entrepreneurship at Dartmouth College’s Tuck School of Business. “It’s been done enough times by strong, viable enterprises that it can be justified as a sensible alternative approach to financing.”33 Structured PIPEs include a variety of instruments that are convertible into equity. The riskiest structure for the company is the socalled toxic financing. Toxic financing structures are only for the desperate. They include provisions linked to the common stock price that increase the amount of stock the company will have to issue at the time of conversion. Institutional investors are wary of such structures. If they see such PIPEs put into place, such investors may sell off their positions in the company, thereby starting the

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proverbial “death spiral.” The stock price drops, guaranteeing that the company will have to further dilute stockholders with an ever increasing amount of stock necessary to cover the conversion on the PIPE, which in turn depresses the stock price.34 In response to the 2008 global economic crisis, it seems that Government Investments in Public Equity (GIPEs) are the newest investment vehicles being used to return confidence and order to the financial markets. GIPEs appeared on the scene when government officials were impatient and not willing to allow market forces to do the job. In many cases, both private equity and sovereign wealth funds were already responding with investments into distressed situations.

THE INTERNET PLACES INFORMATION AT EVERYONE’S DISPOSAL Providing information to the consumer via the Internet or continuous news feeds helps people make better decisions. It also can lead to panic.Weather radar available to anyone with an Internet connection helps determine to the minute when and where it will rain. Stock quotes and volumes of transactions are available at thousands of terminals where traders are constantly making buying and selling decisions based on bits of information. Think about Wilbur Ross, who invests in distressed companies. He has been very successful timing his bets on steel, coal, auto parts, and, most recently, bond insurers caught in the subprime crisis of 2007. He has invested the time to dig deeper and has developed the equivalent of “Doppler radar” for investments. He knows better than most when to buy and sell in these troubled industries because of his better understanding of their intrinsic values. “Trying to move fast with the need to have perfect product is one of the hardest parts of the job. It is challenging to run a company when Internet speed matters. It may take 10 years to design the perfect product, but by then the market opportunity may have disappeared,” says Joe Mansueto, founder, chairman, and CEO of Morningstar.35 Morningstar publishes intrinsic value and analyst reports on thousands of public companies, mutual funds, and a growing list of hedge funds. Despite an army of over 100 analysts,

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it is hard to keep up with changing financial markets and new asset classes. In the Internet age information travels faster than ever before; so does misinformation. Short sellers and the occasional rumors they spread via the Internet and cable news channels are believed by many to have contributed to the rapid loss of confidence and sharp drop in share prices of many noted public company stocks. A temporary ban on short sales instituted in September did not seem to slow the price drops after the short selling ban expired.36 Adding to the controversy, the moves by the SEC triggered criticism for undermining markets.37 Successful private equity players and other value builders use the Internet to their advantage. The larger ones have teams of analysts who can dig deeper and monitor industry trends and comments on the Internet. They gain expert knowledge on an industry at Internet speed. They have access to personal interviews and the diverse perspectives available on financial and market information. On the other side, public companies and regulators must respond to crises of confidence at Internet speed. Rumors circulate that can quickly destroy reputations and stock value. Traders trade on both information and misinformation, and public companies must respond to these rumors or see their stock prices plummet. According to Wharton professor Yoram (Jerry) Wind, “The Internet means that there is full transparency and you cannot hide. Anything can be distributed worldwide. Management has to respond fast and effectively”38 The global economy is interconnected by information. Public companies will be forced to provide more transparency with a high degree of speed in the Google age. Comparatively, private equity has the advantage of not being harassed by outside forces operating at Internet speed. Some public companies have found ways to deal with the outside forces without giving up on their efforts to operate at today’s necessary speed. Joe Mansueto, CEO of Morningstar, tries to run a public company without being distracted by market analysts and quarterly conference calls. Morningstar keeps public disclosures simple but not simplistic. They do not give guidance on earnings per share. They do not host analyst conference calls. They do, however, answer written questions posed by shareholders by posting answers

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on their Web site and through 8-K reports filed approximately monthly with the SEC. Morningstar’s eight-person board is large enough for healthy debate but small enough not to get bogged down in board communications. The company focuses on creating great products and building shareholder wealth while minimizing outside distractions. Because Morningstar’s directors believe the market is efficient, they are concerned only with providing timely and accurate information to their stockholders, not in managing the stockholders’ estimate of the company’s value. Larger companies are not constrained from adopting similar approaches, and they could all use the speed and flexibility that Mr. Mansueto has built into Morningstar.39

SUMMARY AND CONCLUSIONS: CREATE VALUE AND WEALTH WITH SPEED The Google age is here. Top value builders use speed to their advantage. Speed of decision making is accelerated through private equity firms’ hands-on board structure and their use of experts. We have shared stories that emphasize that fast trumps slow. Threatened by the effectiveness of Toyota’s approach to the “lean thinking” framework, other auto manufactures have been forced to become reluctant followers and adopters. Cycle times in all industries are shrinking to Internet time as best practices spread. The wake-up call is sounded daily in the press. Acting sooner can save thousands on an individual level, millions on a company level, and billions or even trillions on a national level. In this chapter we demonstrate that speed is of the essence in the interconnected global economy. When leaders try to slow others down rather than speed themselves up, they end up falling behind. Textiles, clothing, electronics, and auto industries in the United States are classic examples. Leaders who spend time filing complaints against competitors can only hope to temporarily insulate themselves from their own inefficiencies. In the 1980s with television production moving offshore, members of the consumer electronics industry put up a selfdefeating battle to use import restrictions to protect themselves from competition. Structural changes and globalization make markets work faster than ever before. Top value builders use change to their advantage. Speed in sensing and serving the unmet needs of

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customers can create tremendous value while the competition attempts to catch up. Accelerating the speed of change is critical to survival as industries globalize. Disruptions can be seen in advance. In Chapter 7 we see that top value builders embrace change more than the average public company. As we discuss in Chapter 8, the ability to see the emergence of inflection points in markets or in economic trends can be extremely valuable. By March 2008, it became apparent to some that the credit crunch of 2007 could lead to a global meltdown as regulators around the globe maintained a fixation on potential inflation rather than paying attention to the demand for money. The core advantage is in being able to act sooner, with speed and confidence based on the belief that the actions will pay off after the inflection point has occurred.

NOTES 1. Bryan Burrough and John Helyar, Barbarians at the Gate: The Fall of RJR Nabisco (New York: Harper & Row, 1990). 2. Andrew Ross Sorkin, “Is Private Equity Giving Hertz a Boost?” New York Times, September 23, 2007. Nytimes.com from: http://www .nytimes.com/2007/09/23/business/23hertz.html?_r=1&th=&oref= slogin&emc=th&pagewant. 3. Edith Hotchkiss, interviewed by William J. Hass on February 2, 2008. See also: Shourun Guo, Edith Hotchkiss, and Weihong Song, “Do Buyouts (Still) Create Value?” 2007 working paper, Boston College and University of Cincinnati, available at http://papers.ssrn.com/ sol3/papers.cfm?abstract_id=1009281. 4. Ibid, Sorkin. 5. Ibid. 6. Ibid. 7. Sorkin, correction dated November 11, 2007, appended to basic article, available at: http://www.nytimes.com/2007/09/23/ business/23hertz.html?n=Top/Reference/Times%20Topics/Subjects/ R/Renting%20and%20Leasing&pagewanted=all, accessed November 1, 2008. 8. Rick Popely, “Shrinking Chrysler Cuts 12,000,” Chicago Tribune, November 2, 2007, p. 1, section 1. 9. Ibid, page 24.

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10. John Rogers, “Private Equity: Tracking the Largest Sponsors,” Moody’s Investors Service, January 2008, http://int1.fp.sandpiper.net/ reuters/editorial/images/20080116/divrecaps.pdf, accessed on November 1, 2008. 11. Greg Burns, “Tribune Profile: Nobody’s Business but Her Own,” Chicago Tribune, October 14, 2007. http://www.chicagotribune.com/ business/chi-mxa1014magmainbarnesoct14,0,6946149. Print.story, accessed October 25, 2007. 12. “Sara Lee Corporation Presents Plans to Drive Top- and Bottom-Line Growth,” Sara Lee news release, September 11, 2007. 13. See Chew Jian Chieh, “Eight Workable Strategies for Creating Lean Government,” http://europe.isixsigma.com/library/content/c060322b .asp?action=print, accessed on January 15, 2008. 14. Employees or teams that are isolated from each other suffer from the silo effect. Their inability or unwillingness to work together produces subpar results. A stark example of the silo effect was the political barriers that separated federal and state government agencies and prevented them from working together during the Katrina crisis. More recently, silo differences between the Treasury, FDIC, SEC, and Fed slowed and confused their responses to the credit crunch in 2007. It took a prolonged crisis before these federal agencies better coordinated their efforts later in 2008. 15. François de Visscher, The Family Business Policies & Procedures Handbook: Practical, Step-by-Step Advice on Sustaining Your Company for Future Generations (Philadelphia: Family Business Publishing Co., 2006). 16. Ibid. 17. Dirk Jungé, “From Family Business Conflict to Family Connectedness,” Family Business Magazine, Autumn 2007. 18. Ibid. 19. See 2006 Berkshire Hathaway Annual Report. 20. See Tim Aeppel “Working an Odd Schedule Can Wreak Havoc at Home,” The Wall Street Journal.com, at http://www.careerjournal .com/myc/workfamily/20010803-aeppel.html, accessed on January 15, 2008. 21. Airline Deregulation Act (ADA) of 1978 22. Claire Spencer, “Consolidation in the Airline Industry,” Financier Worldwide Magazine, Special Report, Turnaround & Corporate Renewal, issue 56, August 2007, p. 33.

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23. In the 1990s, with Southwest Airlines on the move against the majors, Jim Wright as speaker of the House ushered through the House federal legislation that was pointedly designed to keep Southwest from competing with major airlines that dominated the Texas skies. 24. Claire Spencer, “Consolidation in the Airline Industry,” p. 34. 25. Julie Johnsson “United Chief Chases Change: Everything Is in Play as Glenn Tilton Tries to Stay Competitive,” Chicago Tribune, October 19, 2007, p. 3.1. 26. R. W. Poole Jr. and V. Butler, “1999 Airline Deregulation: The Unfinished Revolution,” Los Angeles: Reason Public Policy Institute policy study no. 255, p. 2. 27. Dennis Chookaszian, interviewed by William J. Hass and Shepherd G. Pryor IV, September 4, 2007. 28. Ibid. 29. It is hard to believe how strongly the current focus by analysts and traders on quarterly earnings per share and earnings per share estimates impacts decision making and distorts long-term value. One insightful but controversial proposal to reduce this preoccupation with “EPS-speak” is to prohibit the reporting of GAAP earnings per share and force analysts to compute it on their own. Sweeping changes are coming to the world of accounting, as international accounting standards and extensible business reporting language (XBRL) are introduced to the world of financial reporting. 30. Ralph V. Whitworth, principal, relational advisors, in panel comments at the National Association of Corporate Directors (NACD) national conference, October 2007. 31. Example of a PIPE: Asset management firm Legg Mason said it will receive $1.25 billion from private equity firm Kohlberg Kravis Roberts in exchange for 2.5 percent nonvoting convertible senior notes due in 2015. See details at http://pipes.dealflowmedia.com/ wires/top_wires.cfm, accessed on January 15, 2008. 32. Source: http://findarticles.com/p/articles/mi_m0DTI/is_9_32/ ai_n6188002/print, accessed January 16, 2008. 33. C. J. Prince, “Relief Valve? Done Right, a Private Investment in Public Equity, or PIPE, Could Bring Your Business Much Needed Cash,” Entrepreneur Magazine, September 2004. http://www .entrepreneur.com/magazine/entrepreneur/2004/september/ 72212.html, accessed on January 17, 2008.

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34. “Overview: Private Investment in Public Equity (‘PIPES’),” Friedland Capital white paper, July 25, 2005, source: www.friedlandworldwide .com. 35. Joe Mansueto, founder, chairman, and CEO, Morningstar, Inc., interviewed by William J. Hass and Shepherd G. Pryor IV, Februrary 15, 2008. 36. Lee Weisbecker, “Short Sellers Hurt Banks Such as Wachovia, Sun Trust, Regions,” Triangle Business Journal, Friday June 27, 2008, http://triangle.bizjournals.com/triangle/stories/2008/06/30/ story11.html, accessed November 1, 2008. 37. Andrew Horowitz, “The Ban on Short-Selling Hurt Investors,” MSN Money, October 10, 2008, http://blogs.moneycentral.msn.com/ topstocks/archive/2008/10/10/did-the-short-selling-ban-work .aspx, accessed on November 1, 2008. 38. Anonymous, “Can’t Run, Can’t Hide: New Rules of Engagement for Crisis Management,” Knowledge@Wharton, September 19, 2007, http://knowledge.wharton.upenn.edu/article.cfm?articleid=1807, accessed January 16, 2008. 39. Ibid., Mansueto.

CHAPTER 7

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“L

et’s go forward with the acquisition. We know how to do this! We have a formula for integrating new units into our system. I know it’s bigger than prior acquisitions. So what if we lose a few customers? We’ll have a great position in that market. Do it now! Anybody disagree? OKAY?” So ended another meeting of key managers of a big public company.

IN TODAY’S INTERCONNECTED WORLD, CORPORATE GREATNESS CAN BE SHORT-LIVED Based on its performance through the end of 1995, Wells Fargo & Company was celebrated as being a “great” company. However, a few years later in 2001, Wells Fargo was busy negotiating a disastrous merger. Circuit City received similar accolades and then watched as industry giant Best Buy roared past to dominate the consumer electronics markets. The pick of the litter in early 2007, though, was Walgreen Co., which, different from most of the other chosen companies, was able to continue outperforming the market in building stockholder value through pursuit of a consistent value discipline and customer-focused strategy for well over 30 years. Yet, by early 2008, its fortunes and value were being questioned by investors, as CVS acquired Caremark, and competition put into 223

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question its ability to grow. By October 2008 the stock prices of even great companies had declined significantly from their peaks, erasing years of value creation, as the credit crisis of 2007 moved from Wall Street into Main Street and became the 2008 Global Economic Crisis. In November 2008, Circuit City announced its intention to close 155 stores and renegotiate leases in an effort to stave off bankruptcy.1 Management teams are forever seeking a secret formula, a handful of key drivers, or some other simple mechanism that will help them “get it right.” If it worked before, it will work again. The problem is that getting things right is something like skeet shooting while standing in a canoe running down a river. Because of uncertain movement, there is no way to lock the sight onto the target with certainty. The data show that maintaining corporate greatness is probably more difficult than creating it in the first place, at least in terms of relative stock price performance.2 Sustainable great performance requires great discipline and leadership, according to noted author Jim Collins.3 However, great performance may also be made more difficult by the conditions under which public companies grow and operate and by the way industries change. Although continuous value-focused renewal is difficult, it is now a managerial necessity for all effective leaders. It requires both a short- and long-term disciplined view of value: Our hypothesis is that strategic inertia may cause sometimes great companies to continue with a strategy until it becomes a losing strategy. Rather than switching from one winning strategy to considering a better one as the competitive environment develops, some leaders lose value and customer-focused discipline. They fail to change. Many public companies have struggled with their choice of CEO and strategy, reluctant to change leadership or a strategy that has become stale even when peers are performing better. As a result they frequently wander from underperformance to crisis, occasionally changing CEOs as a Band-Aid, in an effort to recover. • A second hypothesis is that the touted high returns of successful private equity firms (typically more than double the returns of the companies in the S&P 500) result from buying smaller underperforming or average companies •

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and then making them great. This issue was researched in 2007 by financial academics Fama and French. Their research shows that small-cap value portfolios produced an annual return of 22.5 percent over the last 80 years, substantially above the 13.3 annual percentage return of a full market index fund.4 The private equity firms then sell out and redeploy the funds in similar situations, typically with a target time frame of three to five years. Wilbur Ross’s recent restructuring success in the U.S. steel industry is a perfect example of the power of timing, scale, and skill needed by leading private equity firms to produce high returns. Acquisition of several smaller firms is much easier than an acquisition of a large multibusiness company. As a company grows through internal growth or acquisitions, the importance of a value discipline and better value-focused metrics is critical. Top private equity players have learned that it’s easier to create value as a company grows from small cap to mid cap to large cap than to change a moderately successful large-cap company. Private equity firms frequently have both the goal and the opportunity to produce better returns. They add value by overcoming management strategic inertia and helping to make needed changes in leadership in order to improve operations and better serve the customer. Private ownership also brings the opportunity to be more decisive in the choice of both top management and strategy. Possibly because of these renewal capabilities and their goal to sell a company in its new renewed prime, top private equity firms generally seek target returns in the 25 to 30 percent range, while many public companies are happy with a far lower hurdle rate, typically the S&P 500 or a “preselected” peer group average.5 One important difference is the strong influence that private equity owners have on aligning top management with their highvalue/wealth creation goals through the performance incentives they provide. Another important difference is their ability to sell as value goals are realized. Even top-performing public companies have consistent problems with strategy and coping with change because of management inertia. The period 2006 and early 2007 brought greater opportunities

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for private equity players who were armed with significant capital and were able to acquire more and larger public companies. However, larger, more complex acquisitions may have more builtin inertia, and thus those formerly handsome returns may drop to more typical levels. After the significant stock price declines of October 2008, it again became an apparent buyer’s market for private equity as stock prices dropped well below intrinsic value in even the great companies. However, during this period, disruption in the credit markets made it increasingly difficult for all but the most liquid investors to participate in this potential opportunity. Only time will tell.

ONCE-GREAT COMPANIES REGRESS TO THE MEAN In preparing this chapter we looked at the performance of 11 companies highlighted in the best-selling business book Good to Great6 relative to the S&P 500 average and to certain “comparison” companies over the last decade. Figure 7.1 shows company performance based on 10-, 11-, and 12-year total returns going forward from 1995.7 The results were insightful for private equity comparisons and future research. Five great companies underperformed the S&P 500 or were acquired. • Five outperformed the S&P 500. • One performed at the S&P 500 average. •

The big winner was a comparison company, Best Buy, whose performance would put it at the top of the list, while by comparison, its close competitor Circuit City finished last. Ironically, Circuit City had been designated in 2001 as a “great” company. Our conclusion—based on three different end points—is that the strategies that bring great performance inevitably run out of steam. This does not contradict Collins’s findings. As competitive conditions change, effective leaders promote disciplined change and adapt strategies to new opportunities. Some companies and their leaders lose discipline and fail to use or improve the right

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metrics as their companies grow. Truly great companies are able to constantly renew themselves by refocusing and upgrading their strategies and their portfolios of products and services. Some companies look great for periods of 15 to 25 years because of environmental factors or performance of a new more competitive business model. Later, they typically fall into periods of arrogance and strategic inertia, unable or unwilling to change even an outdated or a doomed strategy. The top private equity firms, on the other hand, are able to earn returns above the S&P 500 by breaking management inertia and providing attractive incentives to promote renewal through acting sooner. They involve management in a value-building process with the end game of selling portfolio companies in a compressed time horizon, near their peak value. Collins’s Good to Great provides an insightful analysis based on hindsight. Its approach introduced selection bias into the choice of companies with great performance leading up to the end of 1995. The book examines several dimensions of corporate strategy and performance to identify factors of greatness.8 The subsequent performance of those “great companies” and a sampling of comparison companies show just how difficult it is to maintain great performance going forward. It also raises questions about the different leadership styles and discipline needed to promote dramatic change and value building, as well as those often found in private equity. To understand the performance of this group of companies, put yourself in the place of an investor. If you had put $1 into each of the 11 companies on Collins’s list at the end of 1986, the portfolio would have generated compound annual returns of 7.7 percentage points above the same investment in the S&P 500 through 1995. Jim Collins was right; this was truly impressive performance. Going forward, though, investing equal amounts into each of the companies at the end of 1995 and holding the position through 2006 and 2007 would have outperformed the S&P by only 4.1 and 3.0 percentage points, respectively. With all the benefit of hindsight (and selection bias), Collins was able to identify a portfolio that would continue to outperform the S&P, but by a considerably lower margin. Interestingly, if the two long-term big winners, Abbott Labs and Walgreens, are taken out of the sample,

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the comparison is more dramatic. The remaining companies would have provided 8.8 percent in excess compound returns over the S&P up to 1995, but that portfolio would have only barely scraped by the S&P by 0.9 percentage points through 2007, hardly

(a) A graphic comparison Figure 7.1 Comparing total returns relative to S&P 500 reveals few companies with lasting greatness *Acquired by Procter & Gamble in 2005. Source: ATIVO Research, LLC. Author analysis.

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Compound annual returns for 10, 11, and 12 periods from 1995 were used to create Figure 7.1a. “Good to Great” companies were identified by Jim Collins, based on performance in the 15+ years ending in 1995.1 Only half of that group has outperformed the S&P 500 since 1995.2 The chapter profiles three of the “great” companies. A brief description follows for those interested in how the other “great” companies fared relative to a selection of “comparison” companies after 1995. The original study period in Good to Great is shown in parentheses. Phillip Morris, now Altria Group (1972–1995), has navigated change well. M&A and litigation are factors in the trend of its stock price. Phillip Morris was more successful in fighting off lawsuits than investors had expected. It has been “a cash machine,” and it successfully diversified into food processing. Management has demonstrated its ability to run a diversified company for value. Nucor (1975–1995) has been a “great company” in a challenging and difficult steel industry. It executed a disruptive strategy, building on the new lower-cost minimill technology. Nucor initially benefited from the disruptive minimill technology, but more recently has ridden the wave of increasing commodity prices. In this environment, it has produced high returns in a commodity business by great execution. The U.S. steel industry has few good comparison companies. Problems among the major players in the industry required several rounds of bankruptcy and consolidation before dramatic change could be made. Along the way, though, comparison company USX was able to outperform many of the “great” companies. Abbott (1974–1995) has been a good or great company since early in its history. We do not see a significant leap from good to great. Recently, Abbott has had significant quality problems and, like many great companies in our research, experienced mixed performance, ranging from average to above average performance. Comparison company Johnson & Johnson has done consistently better than Abbott, but also experienced periods of earnings fluctuation. Gillette (1980–1995) was a highly profitable and innovative high-growth company for many years, meriting its selection as “great.” However, after over 11 quarters of missing its own and analyst estimates, the company brought in turnaround CEO Jim Kilts to solve the classic downward “circle of doom” that successful company inertia had produced. The best solution was sale to comparison company and truly great Procter & Gamble in 2005.3 Pitney Bowes (1974–1995) has performed at or near the S&P averages over the last 20 years. It has maintained reasonable returns as the digital age has threatened, but not displaced, its mail handling and postage meters. Comparison company IBM has produced significantly better returns by continuously renewing itself with CEO changes and shifting its focus from hardware to software to customer solutions. Kroger (1973–1995) performed below S&P 500 returns for the last decade. This demonstrates the fact that food retailing is a tough business. With new comparable retail concepts such as Trader Joe’s. Whole Foods, and Wal-Mart making inroads into the grocery segment, will Kroger remain a great company? Both Whole Foods and Wal-Mart have significantly outperformed Kroger over the last decade by a factor of 2 or 3 times. Fannie Mae (1984–1995) is our poster child for “creative accounting” among Collins’s “greats.” Its fall from grace may have begun as a 2004 annual report stated: “The massive accounting restatement goes back for several years,” making comparisons difficult. Fannie Mae is representative of companies that faltered due to accounting irregularities over the last decade. In 2008 the collapse of Fannie Mae reverberated through the global banking system, toppling others in its wake. Kimberly-Clark’s (1972–1995) stock accelerated in value when it skillfully executed a move away from commodity paper products to more consumer products. We think that to be considered a truly great company, Kimberly should have maintained performance above the S&P 500 index over time. Over the last decade. Kimberly-Clark’s stock has produced returns to its holders only about one half the levels produced by Procter & Gamble, a truly great complex consumer products competitor.

(b) Other “great” companies 1

James C. Collins, Good to Great, New York: HarperCollins Publishers Inc., 2001. ATIVO Research, LLC, with further analysis by the authors. (Note: Our analysis shows 10-, 11-, and 12-year performance from 1995, the year in which the companies were designated as “great.” This captures the full period from the end of Collins’s approximate study dates to the present. 3 William J. Hass and Shepherd G. Pryor IV, Building Value through Strategy, Risk Assessment, and Renewal, Chicago: CCH, 2006, pp. 241–245. Available at: http://onlinestore.cch.com/default .asp?ProductID=3643). 2

(c) Data references and sources Figure 7.1 (Continued)

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the stuff of greatness. Timing matters, and the 80/20 rule lives! These examples demonstrate that management’s strategic inertia and loss of a customer-centric value discipline can cause a meltdown from great to good and eventual regression of performance to the mean. Despite popular belief, and despite the very high returns realized by some top-performing private equity firms, the aggregate performance of private equity firms does not exceed the S&P 500 returns. A variety of researchers suggest that most private equity funds do not cover their high fees and that adding leverage to a portfolio of S&P companies can produce private equity-sized returns.9 Again, digging deeper into the risk and reward of a large sample of private equity firms often disproves common beliefs.10 However, the top-performing private equity firms substantially outperform the S&P 500. While it is clearly difficult to beat the S&P over time, the key is in breaking through the strategic inertia. Analysis of the data shows that only the most talented private equity managers, focused on building corporate value, can generate high returns year after year. There are also interesting cases among major corporations that operate more like private equity firms. Some of these surely are “top value builders”: For example, Berkshire Hathaway, Procter & Gamble, Johnson & Johnson, ITW, and GE treat their businesses more like private equity portfolios. They constantly empower great leaders, demand operational improvements, share learning, and refresh their business unit strategies, based on understanding the changing environment. These “great” portfolio companies have a better shot at producing long-lasting corporate performance, while many others may turn in only temporary great performance based on a new business model or new technology.11 Less well-known public companies like American Capital and Danaher are also modeled after the private equity model. They systematically improve operations and limit their leverage yet produce healthy returns. It is instructive to dig deeper into the stories behind the corporate strategies that might have contributed to great performance and that also might have contributed to strategic inertia. In the remainder of this chapter, we concentrate on examining the disciplined people, thinking, and actions of three pairs of companies:

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Wells Fargo and Bank of America, Circuit City and Best Buy, and Walgreens and CVS (now CVS/Caremark).

FORKS IN THE ROAD: WELLS FARGO—ONLY THE STRONG AND FLEXIBLE SURVIVE In 1986 Wells Fargo doubled its size by buying Crocker Bank from Midland Bank, Crocker’s British parent. The transaction was rife with corporate intrigue. Secrecy was of the utmost importance leading up to the announcement. Meetings held in the executive dining room at Wells’ Montgomery Street headquarters in San Francisco had to be done with the curtains drawn. Surrounding buildings gave too good a vantage point for prying eyes, and one too many telescopes had allowed analysts to guess events in the past. The move was brilliant for its time, and the integration of the two banks proceeded smoothly. The financial success boosted the company’s gusto for more acquisitions. Many smaller deals followed the “in-market” blueprint set forth in the Crocker transaction. Buy it; throw out everything but the customer accounts; and add to revenues, not to expenses. It all seemed to work, and management pursued the strategy with a relentless precision. Author Jim Collins focused on what the company hoped to be “best in the world at.” For Wells, that was “running a bank like a business, with a focus on the western United States.” Collins concluded that Wells leadership was getting it right and it was truly a good to great company. Carl Reichardt installed a high level of value discipline into the organization. By comparison, Bank of America had “failed [in its 1992 acquisition of Security Pacific], creating a multibillion dollar write-off.”12 Some industry watchers concluded that Bank of America’s historic inability to force disciplined organizational change on its acquisitions led to chaos. This gave Wells Fargo more reason to believe in rapid integration of acquisitions as a crucial strategic element. After the Crocker deal, Wells’ executives were constantly asked about Act 2. When would they pick up First Interstate Bank and really challenge Bank of America in the western United States? This question hung in the air for years. But the performance kept coming, allowing management to forestall analysts’ criticism. Finally, in late

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1995, Wells pulled the trigger and began hot pursuit of First Interstate. Would this be the icing on the cake? Leaders retire. In late 1994, Carl Reichardt, the retiring CEO, handed the reins of Wells Fargo to Paul Hazen. By the fall of 1995, Wells started to take aim at First Interstate. It launched the longawaited takeover attempt. After years of losses, First Interstate had finally reached some measure of stability. Unable to brush aside the overture from Wells, the company sought out white knights and surfaced First Bank System, run by Jack Grundhofer, a former Wells vice chairman. In its proxy to shareholders the company declared: “[Wells] has overestimated cost takeout and underestimated revenue losses.”13 The case was made that Wells would not be able to meet the cost reduction and timing goals and that the level of customer defections would be much higher than the aggressor had predicted. Leaders of First Interstate were fighting for their jobs. Many remembered reading that Wells had fired 1,650 top managers of Crocker Bank on day one of that merger, years before. Some of the unfortunate 1,650 had even found their way into the ranks of First Interstate. Fueled by the egos of the two CEOs, the battle continued, and then, late in the game, First Bank System exited because of a legal technicality regarding the timing of a stock buyback. First Bank System had not been prepared for an acquisition battle of that size and, in the heat of battle, stepped over the line with the SEC, an unrelenting referee. With First Bank System out of the picture, Wells was able to quickly negotiate final terms, terms that had been boosted by the wrangling between Wells and First Bank System. At Wells, the First Interstate integration was clearly not a replay of the Crocker experience. While management was prepared to execute with the same laserlike focus on cost cutting, things were different. Crocker had been a classic “in-market” acquisition. It was also delivered to Wells by its former owner, Midland Bank. This had given Wells the unique ability to fire many top managers on day one of the acquisition and to push its strong cost-focused culture quickly through the ranks of the newly acquired employees. By contrast, First Interstate had over 1,000 branches, scattered over 13 states, and organized into 17 subsidiary banks. In addition, the takeover terms required negotiation of senior management and board positions. Banking is a contest of timing and accuracy

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conducted in the midst of a tidal wave of transactions that cannot be stopped. Customers demand timely accuracy in the handling of their money. The Wells-First Interstate integration required crisp and correct choices, which had to be followed through on. Management poured its efforts into the mechanics of cost cutting and integrating computer systems. Choices were made by the Wells executive team, but at times they contradicted the advice from the line. An added hurdle stood in the way as two disparate cultures tried to learn how to communicate with each other. The complex array of First Interstate entities was dramatically different from the clear topdown hierarchy that had been built at Wells. The Interstate acquisition was beyond what Wells was great at—in-state acquisitions— and caused a loss of discipline. Customer friction accelerated. The Wells management team had never before met real resistance in its postacquisition integrations. This time, the combination of internal and external factors ended up in a snarl. Customers, new employees, and even old employees offered increasing resistance. Wells’ cost reduction approach to value building had gone too far: The IT world has since seen Wells as a poster child for botched systems integrations: “In its rush to cut costs, Wells Fargo closed too many First Interstate branches and ATMs, costing the bank $100 million as First Interstate customers pulled upwards of 20 percent of their deposits. At the time, CEO Paul Hazen called the merger ‘a sorry experience for far too many of our customers.’”14 • The problems of the bank stayed in the news. Other sources confirmed the problems: “In the merger-mad 1990s, banks expected to lose as many as 15 percent of their customers after a merger. As long as they succeeded in quickly slashing costs and making the deal pay off for shareholders, banks just did not worry about it. Wells Fargo, for instance, suffered a similar fate when it acquired First Interstate in 1996 and rushed the integration process in its haste to cut costs. The CEO ended up apologizing to shareholders for the bungled acquisition.”15 •

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The damage from the botched First Interstate deal in 1996 led Wells to arrange a merger with Norwest in 1998. Richard Kovacevich, CEO of Norwest, assumed the CEO title and brought in a new regime of customer service and a new era for Wells Fargo. The new Wells Fargo moved forward with Kovacevich at the helm as CEO; Hazen was elevated to the position of chairman, with limited management responsibilities. Hazen retired from that position in 2001.16 A Norwest watcher wrote in the Denver Business Journal: “Wells Fargo Chairman and CEO Paul Hazen admitted that the [First Interstate] merger attempted too much in too short a time frame and that he wouldn’t do a hostile takeover again. ‘We did the entire system and operations integration in four months and that was too fast,’ Hazen said . . . recouping the costs required rapid measures. But the hostile nature didn’t help in retaining top managers and talent from First Interstate. . . .” Looking forward, he predicted differently: “The latest merger [Norwest-Wells Fargo] is consensual and a pooling of interest among ‘equals’ with no premium rather than an outright purchase. It will be a slow one as well. The two banks plan to take as long as three years to integrate their systems. As in any marriage, slow and sweet may prove a more winning strategy than curt and commanding.”17 Apparently so, because in subsequent years, Wells returned to a position of strength despite a rocky road as the lost discipline toward customers and value was reestablished with a new leader. Winning Strategies Aren’t Forever Hubris can arise from a winning strategy and generate strategic inertia. In the 1980s Wells had perfected a technique of growth through in-market acquisitions, with quick and decisive integration of the new locations into the larger portfolio. First Interstate was different and approached its market differently. Wells’ CEO management team chose to ignore warnings about the differences and forced the deal into the proven “in-market acquisition” mold. The post acquisition integration was a clear disaster. When a strategy has faltered, and leaders have failed to renew their approach, it often takes radical surgery to correct the problems.

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Stalled by the First Interstate failure, Wells agreed to a cooperative combination with Norwest. The new bank went down a different path, with a new leadership and management team, focused on a renewal strategy based on better serving the customers that had been abandoned by Wells’ leadership team. The banking crisis of 2008 represents another turning point for the industry, providing opportunities for some and closing the book on others. Fortunes change. Many of the names of the past will disappear as the industry consolidates. Both Wells Fargo and Bank of America were among the early survivors and acquirers in the 2008 banking crisis. Notably, the corporate history of each of these institutions goes back over 100 years. Each is the product of multiple mergers. As crises and consolidations occur, the enduring names of banking will continue to adorn the entryways of the nations’ banks.

FORKS IN THE ROAD: CIRCUIT CITY LEFT IN THE DUST BY BEST BUY Circuit City outperformed the S&P 500 averages during Collins’s study period 1982–1995 as it led the move to big box consumer electronics and appliance retailing in a fragmented appliance and electronics market. Recall that 1980 to 1982 was a period of high interest rates and a great time to learn from all the failures that littered the consumer electronics marketplace as a result of the downturns of 1980 and 1981–1982. This was also the start of the Sony Walkman portable music era. Early success with Circuit City’s superstore model may have made Circuit City leaders overconfident that the model could be used for all big-ticket purchases. Circuit City launched personal computer sales in 1989 and entered the credit card business in 1990. In 1993 Circuit City opened its first auto superstore under the CarMax name, creating a true breakthrough in the used car retailing market. CarMax was a bold move into uncharted territory for a retailer of home appliances. After successful performance for three years, CarMax pressed beyond used cars and began moving into new car sales in 1996 with its first new car franchise. The company also announced plans to expand CarMax nationally, and it established a tracking stock for CarMax. In 2000, with about

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$10 billion in retail sales and $2 billion in CarMax sales, Circuit City admitted defeat in its core appliance business. Circuit City closed all appliance lines and converted the space to expand its offering of higher-margin packaged entertainment products (e.g., CDs, DVDs, video games, and digital cameras), a strategy it had earlier dismissed. The resulting product array more closely mimicked Best Buy. The changing environment of the 2000s has not been good to Circuit City. As further evidence of leadership and strategy failure, in 2005 private equity firm Highfields Capital Management sensed the need for additional change at Circuit City and offered $17 per share. The board rejected the offer, hoping to oversee the needed improvements itself.18 Leaders change. Circuit City leadership failed to act soon enough, and leadership was changed in 2006 with retiring Alan McCollough handing the reigns to Phil Schoonover, who had joined the company as executive vice president and chief marketing officer in 2004.19 Almost two years after the Highfields Capital 2005 offer, in April 2007, the company announced a significant restructuring and an 8 percent store staffing reduction. At that time the stock was trading at around the $18 level. Yet by year end 2007, its stock price had dropped to only $4.20 per share.20 On October 24, 2008, Circuit City announced that it had received notice from the New York Stock Exchange that the company had failed to meet one of the criteria for continued listing by the exchange. Circuit City’s stock price had fallen below $1.00 per share for a 30-day period.21 Phil Schoonover, CEO, was replaced.22 In the late 1990s, Best Buy seemed to come from nowhere, taking the lead in market share from Circuit City beginning around 1999. Best Buy was continuously learning how to beat the market leader, determining what to change, based on the feedback from employees and its growing portfolio of store locations. Circuit City eventually responded with a variety of management changes beginning in 2000 because it had not been able to successfully compete with Best Buy’s new and what seemed to be mysterious growth and profitability. Circuit City lost its leadership position in consumer retailing because of a loss of customer-focused discipline and because of

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inertia.23 After years of success with its superstore concept, management thought it had developed the best model for managing a high-ticket consumer sales (appliances) enterprise and entered the used car business with a radical new model. During the May 16, 2006, analyst meeting, CFO Mike Foss admitted that, unfortunately, CarMax and the credit card businesses had proven to be distractions. These distractions and a bit of arrogance allowed Best Buy to take the leadership position away from Circuit City. Best Buy was built on greater attention to entertainment packaged goods (DVDs, CDs, and gaming software) and changing customer tastes. Best Buy had concentrated on music and entertainment packaged goods in addition to big-ticket hardware, a combination that Circuit City leaders and other retailers of the time believed could not be done. Best Buy encountered some bumps on the road as well. Best Buy had some bad acquisition experiences, but it learned the lesson of the importance of understanding its customers. In an attempt to build its music sales in a smaller store format, Best Buy acquired the faltering Musicland chain to enter the smaller, mall store market, but acted with a value discipline and divested Musicland three years later as a bad learning experience.24 Best Buy stayed focused on changes in customer preferences. Circuit City was slow to respond and lost its leadership. In 2007 Circuit City’s management team had to admit that Circuit City’s real estate operation was broken and its top-down planning approach had failed to involve feedback from the frontline employees and customers. Over the last decade (1996–2006) Best Buy outperformed all Good to Great companies by a huge margin—over two to three times—by succeeding where Circuit City failed, namely, reading and reacting quickly to the change in retail customer preferences. Circuit City was unable to recover what it previously let slip through its fingers. Phil Schoonover, the CEO in 2006–2007, was the former Best Buy executive who led the customer-centric effort that helped keep Best Buy ahead of Circuit City. He was unable to turn the tables by transforming Circuit City to be more customer-centric, yet different from Best Buy. At the 2006 analyst meeting Schoonover indicated that he was happy with the smaller

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Circuit City footprint. He stated that he believed that the larger, 13,000-square-foot space dedicated to packaged entertainment goods by Best Buy is likely to be challenged by online media delivery.25 Circuit City also announced that it is rebranding its tech

retur n on invested capital (ROIC) Our return on invested capital calculation represents the rate of return generated by the capital deployed in our business. We use ROIC as an internal measure of how effectively we use the capital invested (borrowed or owned) in our operations. As a company, we define ROIC as follows: ROIC =

NOPAT (as adjusted) Adjusted average invested capital

Numerator = NOPAT (trailing four quarters, as adjusted)

Denominator = Adjusted average invested capital (trailing four quarters average)

Operating income + Net rent expense (1) – Depreciation portion of rent expense (1) = NOPBT (net operating profit before taxes, as adjusted) – Tax expense (2) = NOPAT (net operating profit after taxes, as adjusted)

Total equity + Long-term debt (3) + Capitalized operating leases – Excess cash = Adjusted average invested capital

retur n on invested capital ($ in millions)

FY 05

FY 06

FY 07

– Depreciation portion of rent expense (1)

$1,442 413 (214)

$1,644 464 (242)

$1,999 562 (292)

= NOPBT (as adjusted) – Tax expense (2)

$1,641 (579)

$1,866 (629)

$2,269 (801)

= NOPAT (as adjusted)

$1,062

$1,237

$1,468

Adjusted average invested capital Total equity + Long-term debt (3) + Capitalized operating leases, net of excess cash (4)

$3,874 579 849

$4,842 551 321

$5,662 605 776

= Adjusted average invested capital

$5,302

$5,714

$7,043

Net operating profit (as adjusted) Operating income + Net rent expense (1)

ROIC

20%

22%

Note: NOPAT (as adjusted) based on continuing operations data (1)

Based on fixed rent associated with leased properties

(2) Tax

expense calculated using effective tax rates for FY 2005 (35.3%), FY 2006 (33.7%) and FY 2007 (35.3%)

(3)

Long-term debt plus current portion of convertible debt, as applicable

(4)

Capitalized operating leases, net of cash and cash equivalents in excess of $300 million

Figure 7.2 ROIC is sometimes used as a proxy for total return Source: 2006 Best Buy Annual Report, reprinted with permission from Best Buy.

21%

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support services business as “Firedog” to better compete with Best Buy’s “Geek Squad.” At crucial times in its market, Best Buy continued to renew and evolved more effectively than did Circuit City and took Circuit City’s greatness with it. “It’s a merciless marketplace, and if you don’t evolve, others will evolve for you.” According to Michael Linton, Best Buy’s chief marketing officer,26 Best Buy is a fountain of value-building principles. It has embraced concepts of economic value while developing the necessary employee education and empowerment to better serve the most valuable customer segments. While many public companies have cut back on non-GAAP disclosures in their public reports, Best Buy has gone beyond standard disclosures and allowed shareholders and employees to dig deeper to better understand their value metrics. Best Buy has dedicated a full page to understanding return on invested capital (ROIC) in its annual reports for the last five years. The non-GAAP report outlines the key strategic initiatives taken to reach an established “stretch” 7 percent operating profit goal (as a percent of sales) by 2008. (See Figure 7.2 for a reprint of the clear communication of ROIC goals.) Circuit City’s slow-to-respond leadership was clearly several years behind Best Buy in executing a more customercentric strategy. As a result, Circuit City established a modest stretch goal of only a 5 percent operating income (as a percent of sales), which is significantly below market leader Best Buy.27

THINGS CHANGE FAST; PAY ATTENTION TO CUSTOMERS AND COMPETITORS While Circuit City abandoned its former core appliance business in 2000, Best Buy continued to maintain a sizable footprint devoted to home appliances. It will be interesting to see how Best Buy’s leadership responds to new competition from Home Depot and Lowe’s, both of which began offering major appliances a few years later. There are a number of lessons implied for the management of Circuit City and others in similar positions: •

The environment changes. Top value builders never lose focus on what matters to the customer. They change with

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the customer and avoid arrogance. They involve frontline people in their planning process. (In contrast to Circuit City, Best Buy’s top management did involve frontline input. Brad Anderson, Best Buy’s CEO, continues to believe in the value of listening to his employees and investing in store renewal. To make the stores more customer-centric, Best Buy embarked on a $500,000 per store makeover in 2007.28) They learn from experiments in their portfolio of businesses or stores. • Employees need continuous education in value. Top value builders educate the front line to understand how value is created and to empower them to deliver value. Focusing employees and investors on a non-GAAP value metric like ROIC rather than continuing with EPS-speak is a simple change that is not simplistic. • Disciplined thinking and action is lost without digging deeper. Top value builders understand the strategies of advancing competitors, pay attention, and react. They are not like oncegreat Circuit City, which waited long after being overtaken by Best Buy before beginning to make the necessary management and strategic changes in its retail business. The importance of a disciplined focus on customers, value, and continuous improvement and renewal is evidenced by Best Buy and other top value builders like YUM! Brands. YUM! is the 1997 fast food spinoff of another top value builder, PepsiCo. YUM! summarizes its goals in the form of five “dynasty drivers” that all employees can understand: Commitment to beat prior results. Intense focus on being customer-focused maniacs. Culture where every employee can make a difference. Differentiation from competitors based on what customers value. 5. Continuity of programs, people, and performance metrics. 1. 2. 3. 4.

Combining a focus on people (both customers and employees) and recognizing and rewarding employees for achieving performance goals based on what drives value enables companies like

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Best Buy and Yum! Brands to produce the highest returns and return on invested capital (ROIC) in their industry.29

FORKS IN THE ROAD: WALGREENS FACES HOT PURSUIT AND MANY CHOICES With 33 years of increasing revenue and profit, Walgreens was truly one of the greatest performing companies of the past half century. Wal-Mart is the only other company with a comparable record. Walgreens continues to turn in great performance and delivered an annual return of 17.0 percent over the last decade through 2006, double the 8.5 percent return of the S&P 500 and over a third higher than the returns of comparison company CVS. Many analysts agree that both Walgreens and CVS, buoyed by the baby boomer demand for pharmaceuticals, should be able to outperform the stock market averages through the end of the decade. The family-owned neighborhood drugstore that would home-deliver ice cream or quinine is gone forever. It has been replaced by bright standalone drugconvenience stores with drive-up windows and mail order pharmacies. Walgreens is a truly great company that has “home grown” its senior management team with effective succession planning and has refined and developed a high-return store format that works. As a result: “Walgreens plans to grow from about 5,500 stores currently to 7,000 stores by 2010. Convenience remains the key driver of business success. Besides better locations, the company has developed more freestanding stores with drive-through pharmacies and expanded business hours, keeping more than 1,500 stores open 24 hours a day. The company is also expanding into more managed-care services.”30 Walgreens’ expansion initiatives may be considered more like “experiments” than the bolder moves of Circuit City into automobile retailing and CVC into the Caremark acquisition. In 2007 CVS purchased Caremark, edging out Walgreens in the eyes of the public investors. CVS/Caremark turned the tables on Walgreens, boosting its 10-year shareholder returns slightly above those of Walgreens. Prior to the CVS/Caremark acquisition, Walgreens had produced higher returns for its shareholders. The race continues, despite the stock market meltdown in 2008.

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Over the last five years, Walgreens took advantage of its strong returns over its cost of capital and record low interest rates to expand its profitable free-standing drive-up convenience store network and business model. Despite its success with its brick-andmortar “convenience” drugstore format, it is experimenting with an expanded portfolio of service offerings with 38 home care facilities and three mail service operations to compete with other pharmacy benefit managers (PBMs). Walgreens, in contrast to many of the other Good to Great companies, has the advantage of participating in the high-growth pharmacy services market. But high returns and high growth attract competition. CVS became an aggressive competitor. Wal-Mart is intensifying price competition by expanding its focus on pharmacy services by offering $4 prescription services for over 300 generics. Mail order providers are offering delivery and replenishment services under long-term contracts with large companies and insurance providers. While Walgreens with 6,100 stores was the largest drugstore operator in terms of sales in 2007, it continues to face direct competition in key markets with its successful brick-and-mortar “convenience” drugstore model from comparison company CVS. Through aggressive acquisitions, CVS ended 2007 with 6,200 stores—the largest number of actual stores. CVS also completed its acquisition of Caremark for about $21 billion in March 2007.31 The acquisition made the newly named CVS/Caremark one of the largest pharmacy benefit managers as well as the largest drugstore operator, with total sales consequently surpassing Walgreens. The bidding war for Caremark that emerged and the acquisition of Caremark may determine the future of the industry. A Value Line analyst terms competition fierce and the merger a shock wave.32 While CVS/Caremark is now larger than Walgreens, the combined business model is not yet proven. Integration problems could develop as a result of complexity. As a result of the merger, the CVS/ Caremark board took a step backward when it changed the company’s long-term incentive program to focus on earnings per share in place of its prior focus on return on invested capital. Such a move, along with the amendment to the bylaws to require a threefourths board vote to oust the CEO, is a warning sign to corporate governance watchdogs and investors.33

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Regional competitors dominated many geographic markets in many industries for years. But the availability of capital for acquisitions and the hope of lower cost through economies of scale have intensified competition in regional strongholds. CVS has not allowed Walgreens to dominate Walgreens’ Chicago home market without a fight. In a recent walk through several suburban Chicago Walgreens and CVS stores, casual observation indicated a high degree of almost copycat similarity. In response to a query, a CVS clerk stated that some customers felt CVS had lower prices. Yet, we found many prices at Walgreens lower (along with an opposite opinion). Both competitors were using similar colored “WOW” signage and stickers as attention-getters in their printed and in-store marketing. Both operate high-margin in-store photo shops. Both companies are acquiring regional chains. Clearly, the competition is intensifying and the differences may blur for some segments of consumers. However, in this industry, small changes often make a big difference to specific customer segments. Customer-focused details such as store layout and lighting matter. Walgreens had plans to have 250 in-store clinics operating by August 2007, but Target, CVS/Caremark, Wal-Mart, and others are also experimenting with in-store clinics. Eventually, like other “greats,” the Walgreens retail business model may eventually hit the wall unless it continues to change with customer needs. The company has a large portfolio of store locations and other businesses and is carefully experimenting with a variety of alternative formats and appears open to change if a new format works. At the January 11, 2007, annual meeting Walgreens chairman David Bernauer commented: “Walgreens has faced similar challenges before . . . and prevailed. . . . I don’t believe either $4 generics or CVS/Caremark will have a long-term negative impact on our business, but both muddied the short-term performance of drugstore company stocks.”34 Because stock traders and longer-term investors both move stock prices on future expectations, the stock price has responded to the announcements of competitors. Walgreens’ leadership response that these changes are not likely to have long-term impact was appropriate as long as they remain open to change. For example, rather than reacting out of fear of competition, Walgreens’ leaders announced that Walgreens will continue experimenting to enhance the customer experience with

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ideas such as high-margin in-store coffee bars to entice customers to shop longer. Walgreens’ organic store growth model is expected to put it ahead of CVS/Caremark in store count in the years ahead. Yet the 2007 drop in stock price indicates that traders and investors have not been convinced. At the beginning of 2008 Morningstar calculated Walgreens’ “fair” (intrinsic) value at $56, far above its price of $35.06,35 near the time of its annual meeting on January 9, 2008. Walgreens Learned from Its Portfolio and Stayed Prepared to Change Walgreens stayed alert to change. Management kept changing the product and service portfolio to learn what works for the customer. The goal is to produce high returns, manage growth, and stay ahead of the competition. Walgreens has had six CEOs since its founding in 1901, all promoted from within. Walgreens grew from traditional neighborhood drugstore chain roots to an industry consolidator and value creation leader. Along the way it managed a portfolio of businesses that it entered and exited. Exiting the restaurant business, a natural outgrowth of the old-fashioned soda fountain, was one example. Experimenting with in-store clinics and other customer conveniences is another. The company also reviewed and renewed its strategies, based on what was learned. Over the years, Walgreens faced many choices and forks in the road, overcame inertia, and continuously renewed, while expanding nationally into new regional markets.36

SUMMARY AND CONCLUSIONS This chapter updates the pioneering work of Good to Great author Jim Collins and points to examples of discipline renewed and lost. Effective leaders avoid arrogance and management inertia. Unfortunately, leaders change. Truly great companies keep “getting it right” by continuous renewal of a portfolio of businesses, products, and services. They do this through disciplined trial and error and developing an understanding of the environment, combined with addressing customer, shareholder, and employee needs. Great companies learn by experimenting with ideas that matter to customers. They constantly refocus their strategies on value. They set

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higher goals. Disciplined action on those initiatives and goals builds value. Investors, employees, management, and other corporate watchers are all attracted to the proposition that certain companies have “figured it out.” The corporate watchers fall in love with those companies and place them on pedestals as paragons of corporate virtue. These companies populate media “best” lists and are offered up as mentors for all businesses to follow. Often, leadership begins to manage to this media image, forgetting the fundamentals that brought the praise in the first place. But the world is not static. Change occurs, and these stars eventually fall from grace, sometimes with stunning rapidity and sometimes in a slow-motion decline. After they fumble or fall, the questions arise: What happened? Why?37 Digging deeper into what drives long-term value helps us to understand why. We now have over a decade of follow-up data on Collins’s Good to Great companies. The turmoil during the period (1996–2007) was historic. Y2K, the dot-com/tech bubble, the attack on the World Trade Center, the wars in the Middle East, and the subprime credit crunch all affected corporate attitudes and performance. In our study of the performance data, we found that many of the Good to Great companies regressed toward the mean.38 What happened? Based on our research and the data, we believe that the initial spurt of “greatness” was a result of great strategies or new business models that worked very well for a limited period of time. The fall from greatness, though, was from lost discipline driven by a failure of leadership to listen, to continuously renew, to act sooner, and to keep the strategy fresh and great along the way. Like the popular buy and hold investment strategy, some of the companies seemed happy with average performance and overly reluctant to fix what wasn’t (clearly) broken. Unfortunately, and despite the warning signals from customers or competitors, good strategies eventually wear out before they clearly break. Average performance is one step from below average. In contrast, research suggests that the top-performing private equity firms have mastered the discipline of when and how to buy low, add value, and sell higher. Timing matters. Top performance shifts between different business sectors over time. They produce above-average returns because they break the

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inertia typical of many midsized public companies and have set aggressive goals over a three- to five-year improvement horizon and have a disciplined action plan to achieve returns above 25 percent. As we have seen with the Good to Great companies and our prior research, it is very difficult to outperform the market averages for long periods of time.39 Most public companies have a built-in inertia or gravity that produces mixed periods of under- and overperformance as they attempt to grow and survive. A clear private equity edge is a disciplined focus on value and the fulfillment of customers’ needs required to produce that value. While it may be years before the stock prices recover to the prices of December 2005-2007 used to compute 10- to 12-year average returns, it is unlikely the relative performance of these companies will change significantly. This exercise sheds greater light on the need for continuous renewal and change. A focus on both intrinsic value and a customer-centric discipline is critical to value building. Value cannot be produced unless employees who deal with customers are trained and centered on value. Leaders, management, and the board of directors should frequently ask searching questions about strategy and value. These questions are appropriate when considering a new strategy, as well as when asking the question: “Should we stay the course, or are we bound by inertia?”

NOTES 1. Circuit City press release, November 3, 2008. http://newsroom .circuitcity.com/releasedetail.cfm?ReleaseID=344747, accessed November 3, 2008. It filed for bankruptcy November 10. 2. This chapter is based on an adaptation and update of the lead article of William J. Hass, Shepherd G. Pryor, IV, and Dennis N. Aust, “Inertia or Change? Try Continuous Renewal!” Journal of Private Equity, Special Issue, vol 10, no. 2, spring 2007, pp. 1–10. 3. James C. Collins, Good to Great (New York: HarperCollins, 2001). 4. Eugene F. Fama and Kenneth R. French, “Migration,” CRSP working paper no. 614, February 2007. Available at Social Science Research Network: http://ssrn.com/abstract=926556. 5. Steve Kaplan and Antoinette Schoar, “Private Equity Performance: Returns, Risk and Capital Flows,” Journal of Finance. 2004.

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8. 9. 10.

11.

12.

13. 14.

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(Note: While data are limited, private equity firms on average and after expenses perform closer to the S&P 500 than most believe. We are all aware of the high returns claimed by the better firms but rarely hear the stories of those that underperform. Occasionally, portfolio companies of private equity funds do file bankruptcy.) Ibid. Collins. Source: Data provided by ATIVO Research LLC and analyzed by authors. Note: Our analysis includes a 10-, 11-, and 12-year look at performance to capture the full period from the end of Collins’s approximate study dates to the present. This analysis suggests how his conclusions would stand up over an extended period and the need for a disciplined focus on value. Check www.TopValueBuilders .com for periodic updates. Go to http://www.jimcollins.com for an insightful summary of lessons learned. See David Swenson, Unconventional Success (New York: Free Press, 2005). Steve Kaplan and Antoinette Schoar, “Private Equity Performance: Returns, Risk and Capital Flows,” Journal of Finance. 2004. (Note: Their research shows that private equity returns, as reported by some authors, are also affected by timing of investments and selection bias.) Note: Conglomerates and mutual funds do not on average create great performance, as most underperform the S&P 500 average. Greatness is the product of effective management that has high return goals and continuously evaluates change based on the ability to create value. Those goals are easier to attain through active participation in the strategic process, which mutual funds cannot do and which most conglomerates do poorly. Ibid. Collins, p. 254. We laud the Collins team for its suggestions regarding greatness and its efforts to identify elements of success. A much larger sample would be helpful to uncover the truly complex interplay between environmental changes, people, strategy, and processes. Collins’s findings related to the need for disciplined people, disciplined thinking, and disciplined action is a great start. Confronting the brutal facts of the continuous need for renewal and a value-centered and customer-focused discipline is something that even great companies may forget. First Interstate Corporation, Form Pre 14A, November 20, 1995. Eric Chabrow, “IT Plays Linchpin Role in High-Stakes M&As,” InformationWeek, June 26, 2006.

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15. Alice Dragoon, “Banks Fight Customer Flight,” CIO Magazine, April 1, 2004. 16. Sam Zuckerman, “Wells Fargo’s Chairman Exits,” San Francisco Chronicle, January 24, 2001, p. B-1. 17. Aldo Svaldi, “Wells Fargo Learned Hard Way about Deals,” The Denver Business Journal, June 12, 1998. 18. Circuit City company history, http://investor.circuitcity.com/history.cfm. 19. Laura Heller, “Turnaround Top Priority for New CEO of Circuit City,” DSN Retailing Today, July 10, 2006. http://www.findarticles .com/p/articles/mi_m0FNP/is_1_45/ai_n16002673. 20. Source of stock price:Yahoo.com/finance. 21. Form 8-K, Circuit City Stores, Inc., dated October 24, 2008, and filed with the Securities and Exchange Commission. 22. Form 8-K Circuit City Stores, Inc., dated September 22, 2008, and filed with the Securities and Exchange Commission. 23. See comments at Circuit City analyst meeting, May 2006, at http://circuitcity.onshowsite.com/webcast2006/checkID.asp. 24. Circuit City, 2004 annual report, p. 2. 25. Circuit City analyst meeting, May 2006. 26. Geoffrey Colvin, “The Colvin Interview, Talking Shop with Mike Linton,” Fortune, vol. 154, no. 4, August 12, 2006, p. 80. 27. Circuit City analyst meeting, May 2006. 28. Jeff Greenfield, “Interview with Brad Anderson, CEO of Best Buy,” CEO Exchange, December 3, 2007. 29. Adapted from David Novak, and John Boswell, The Education of an Accidental CEO (New York: Crown Publishing, 2007). 30. Morningstar.com, Walgreen analyst report, December 22, 2006. 31. CVS/Caremark Corporation, Form 8-K, March 22, 2007. The merger was completed as of March 22, 2007, at which time the company was renamed CVS/Caremark Corporation. 32. Andre Costanza, Value Line Investment Survey, December 29, 2007, pp. 770, 771, and 779. 33. Mitchell P. Corwin, “CVS Caremark,” Morningstar.com, February 1, 2008. 34. Sandra Jones, “Walgreens Plans to Expand Clinic Service,” Chicago Tribune, January 11, 2007, p. B1. 35. Morningstar.com, January 25, 2008. (Morningstar.com provided the quoted intrinsic value for Walgreens’ stock.)

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36. For additional insights into the thought processes at Walgreens, see John U. Bacon, America’s Corner Store: Walgreen’s Prescription for Success (Hoboken, NJ: John Wiley & Sons, 2004). 37. Enron was a classic example of management hubris mixed with opportunism and denial. Plunging headlong into new and uncharted markets, it failed to assign any importance to making prudent experiments, or learning along the way. A fatally flawed incentive system continually led the company into new ventures that had high current funding needs and risky prospects going forward. A detailed account is presented in Kurt Eichenbach, Conspiracy of Fools (New York: Random House, 2005). 38. This would not be surprising if the companies had been chosen at random. However, this was a rarefied group that had been blessed with outstanding performance during the previous decade or more. 39. William J. Hass and Shepherd G. Pryor, Building Value through Strategy, Risk Assessment, and Renewal (Chicago: CCH, 2006), p. 464.

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CHAPTER 8

Inflection Points Act on Insights from the Fundamental Drivers

“This looks like the one. The timing is right for an offer. Let’s go with a $35 per share bid. It is 15 percent above the current stock price, and our offer should be attractive to their board. We can lock in today’s low interest rates with few if any covenants. It will be a great addition to our portfolio and serve as a platform to explore other opportunities in this depressed industry. I love these covenant-lite deals. We can work out all our problems before ever having to talk to the bank about them. This is the golden age of private equity.” These comments could have been made in any private equity firm boardroom in 2006. However, the considerations that private equity players must make are much more complicated than finding cheap money and a favorable purchase price. Top value builders understand changing macroeconomic fundamentals and their impact on intrinsic value and stock prices in both up and down markets. In fall 2008, with fear sweeping the global stock markets, top public and private value builders with cash were again shopping for bargains. Many operating executives and private equity players are comfortable in stable environments: A leads to B leads to C. They can be extremely decisive and quick to determine the right course of action in such environments. However, in the interconnected global economy, the logic of macroeconomics is much more complicated. Offsetting impacts of price changes, interest rates, exchange rates, and time lags defy quick intuitive judgments. Perhaps because of the complexity and the different levels to which 251

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various commentators carry their analyses, there are divergent opinions on almost every macroeconomic issue that hits the news headlines. A quick trip through the business newsstand can find predictions of recession alongside predictions of boom. Only one can be right, and timing matters. Private equity took advantage of the covenant-lite opportunity and the excess liquidity in the financial system while the window was open. The climate began to change in the third quarter of 2007. Transactions that had been planned for months began to experience delays, as lending terms tightened. The window of opportunity for covenant-lite transactions slammed shut, and the availability of credit became a more frequent concern than was pricing. This chapter highlights how people interact with macroeconomic issues that the private equity players in the above story can use to their benefit. These issues include over- or undervaluation of the market, the false signals that can arise from an inverted yield curve, the impact of oil prices, drivers behind foreign exchange rates, and the impact of monetary policy. A better understanding of these issues can be accomplished by applying the economists’ basic tools—fundamental supply and demand curves. Today’s businesses operate in constantly changing environments. The macroeconomic environment seems to be far removed from the corporate office because companies feel they can only react to the environment and not control it in any way. Macro cycles also seem to be long and unpredictable. Business strategies that mesh with macro cycles have the best opportunity to succeed. When they collide with macro cycles, it is like pedaling uphill, and the outcome can be a disaster. In today’s world, it takes more than just working hard to build wealth. Successful private equity players use their understanding of macro cycles and interest-rate changes in particular to gain an edge over public companies. Less successful private equity players do not.

DIG DEEPER TO FIND INFLECTION POINTS—AN EXAMPLE FROM 1999 Digging deeper into the fundamentals can help unearth clues to the timing of upcoming inflection points. Success at understanding and finding inflection points is valuable in reducing risk and providing opportunities.

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United States Japan United Kingdom Canada Germany France Italy

253

1999 Unemployment Rate

Average Annual Real GDP Growth, 1995–1999

4.2% 4.6% 5.9% 7.5% 10.6% 11.1% 12.0%

3.8% 1.1% 3.1% 3.2% 2.0% 2.2% 1.7%

Figure 8.1 The United States outperformed most other economies in 1995

to 1999 Source: “Red Sky in the Morning, Investors Take Warning: The Preconditions for a Major Market Disruption Are at Hand,” Laffer Associates research paper, November 12, 1999.

In 1999, while investors were bidding up the prices of stocks as though the boom would never end, there were already negative signals hidden in the market statistics. At the time Arthur Laffer wrote: “The preconditions for a major market disruption are at hand.”1 By digging deeper, he found clear signals in the numbers. (See Appendix 1, Figure A1.4f.) Just like teenagers’ fashions, economics too goes through fads. The consequences of bad taste in teenage fashions, however, are a lot less severe than are the consequences of bad taste in economics. When economics goes off the track, people are hurt, and sometimes they are hurt badly. In 1999 a quick look across the globe illustrated how fortunate we were here in the United States, as shown in Figure 8.1.2 That was not always true. In the late 1960s and throughout the 1970s, U.S. economics and economic performance fell into a blue funk. Our country increased taxes on people who worked, at the same time increasing government payments to people who did not work. In the United States real job growth all but disappeared, and there were lots of people not working. From 1966 to 1982 the unemployment rate rose from 3.8 to 9.7 percent. After adjusting for inflation, the stock market (measured by the Dow Jones Industrial Average) fell by 66 percent. Who said this was “the Great Society”? Just look at the major unfavorable trends prior to 1983 in Figures A1.1 through A1.9 in Appendix 1. During the 16-year period of 1966 through 1982 period inflation averaged 6.8 percent per year, and the dollar was devalued.

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The prime interest rate peaked at 21.5 percent in December 1980, and the price of gold rose from $35 per ounce to around $900 per ounce. People were unhappy to say the least. Strikes and riots were an everyday occurrence in the United States of the 1970s. By 1983 economic fashions once again changed, and the United States embarked on a new set of policies, including the antiinflationary policies of the Fed under Chairman Paul Volcker.3 Under President Ronald Reagan the country cut tax rates, watched where tax dollars were spent, and actually used restraint on how fast the government printed money. A strong dollar was considered an essential component of a strong country. The changes were amazing. The new fad in U.S. supply-side economics was much healthier than the old Keynesian fad of the 1970s. As we learned in Chapter 2 and will learn in Appendix 1, from 1983 to 1999 the new economic fad in America—supply-side economics—brought unemployment down to 4.2 percent from a high of 9.7 percent in 1982. Annual inflation averaged 3.3 percent, and the stock market, after adjusting for inflation, rose by an incredible 495 percent. All these changes came about because of a change in economic fads that took hold in the early 1980s under President Reagan. Robert Mundell, one of the economists responsible for these wonderful changes, was awarded the Nobel Prize in Economics in 1999 for conceiving the ideas behind the new prosperity. He deserves that prize more than anyone we know, and we’re a lot better off as a result. Who says economists don’t matter? Of course they do. Unfortunately, successful economic trends do not last forever. In October 1999, Laffer Associates published a paper indicating that underlying conditions of the U.S. economy appeared to be on the verge of a significant change. And that change was not for the better.4

ASSET VALUES, PROFITS, AND INTEREST RATES FOOLED MANY EXPERTS IN 1999 From early spring 1999 through the start of the fourth quarter, according to Abby Joseph Cohen,5 the Goldman Sachs models for asset values indicated that the S&P 500 had been at approximate fair value. However, from the perspective of our old friend “capitalized

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economic profits” relative to the S&P 500, asset values were most definitely not at fair value (See Appendix 1 Figure A1.5b.)6 By October 1999 the market was calculated by Laffer’s model to be some 30 percent overvalued. The S&P 500 market values exceed capitalized economic profits by that amount based on corporate economic profits and the 10-year government bond yield. This degree of overvaluation put the market in roughly the same shape it was in during 1987 just before the “market correction” of that year. Yes, markets do get overvalued. Using the same data, between the fourth quarter of 1995 and October 1999, corporate profits had grown by 25 percent and interest rates had risen by 4 percent, which had resulted in a 21 percent rise in capitalized economic profits. Stock prices, on the other hand, had risen by an amazing 120 percent over the same period. This type of disassociation between stock prices and capitalized economic profits was unprecedented. Other adjustments can be made to the analysis, such as using after-tax operating earnings. Although the adjustments may reduce the dramatic difference between the levels of stock prices and capitalized economic profits, none of the adjustments reverses the finding that the market was significantly overvalued in late 1999.7 Laffer’s call of the impending inflection point was accurate and far more useful to investors than the three years earlier statements by Greenspan. Interestingly, in his 2007 book The Age of Turbulence, Mr. Greenspan claimed he still had no idea why the market crashed a few months after he took office in 1987. He attributed the crash to an unreasoning fear that took hold and said that “investors sought relief from pain by unloading their positions regardless of whether it made financial sense.”8 However, Laffer’s capitalized economic profit model clearly suggests that the market was significantly overvalued leading up to the 1987 market crash. (See Appendix 1, Figure A1.4f.)

STOCKS MOVE TO BEING UNDERVALUED—MID-2002 The stock market peaked in mid-1999 and then went into a protracted slide, with the S&P 500 dropping 47 percent from its high by December 2002. It is not uncommon for markets to overreact to

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bad news, but the overreaction can sometimes last for longer than might be expected. From July 2002 and continuing through 2007, the market remained undervalued despite the climb of stock prices back to levels comparable to those at the 1999 peak. (See Appendix 1, Figure A1.5c.) By mid-2007, capitalized economic profits had remained above stock prices for five continuous years. Throughout the period, the market basically was ignoring the positive signs of the growth in corporate profits and relatively low interest rates. This undervalued market was the perfect time for private equity to raise funds and purchase public companies at an effective discount.9 By early 2008, the fear created by the subprime credit crunch took its toll on stocks. Despite continued strong corporate earnings in many sectors, the sizable write-offs in housing and financial stocks shook the markets. Fears of impending recession were spread in the news headlines and presidential candidate debates. Financial service providers like Citicorp and Merrill Lynch received infusions of billions of dollars in cash from wealth funds to remain solvent.10 Slow response by the Fed, and a failure to reduce the Fed funds rate below the 90-day Treasury bill rate, put an added tax on banks at a critical time when bank liquidity was strained. This prompted banks to tighten further, rather than loosen the credit reins. Trading systems that encourage traders to sell when a stock drops below 8 percent of purchase price were saying “sell-sell-sell!” Fear and the people effect caused by growing uncertainty erased the months and years of stock price gains. The downward cycle of negative expectations was renewed. Stocks and distressed debt were now even more “on sale.” The class of private equity players—sometimes known as vulture investors—that focus on distressed debt were raising billions of dollars of new money to take advantage of the mountain of distressed stocks and bonds that they anticipated would become available when the economy slowed and stock prices tanked. Also by early 2008, Morningstar’s bottom-up analysis of the market’s intrinsic value further confirmed that the market had overreacted in its sell-off during 2007. On February 15, 2008, the Morningstar Web site indicated that the market was selling at a 12 percent discount to the Morningstar estimate of the market’s

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intrinsic value and had been undervalued for virtually the entire time since mid-July 2007.11 Indeed, traders and long-term investors have different perspectives on how markets work and on how they interpret differences between intrinsic value and stock prices.

DIGGING DEEPER INTO TRADE DEFICITS AND EXCHANGE RATES WILL HELP YOU ACT SOONER Many unprepared private equity players and other investors entered the 2000s with more than a dent in their financial status. Had they taken advantage of the analysis in the foregoing section with the right economic metrics, they could have been far better off. Many superficial metrics—such as price-earnings multiples—seem to work for a limited period and then fail. They fail because they are measuring effects and not underlying causes. Top value builders constantly dig deeper to know when change might reduce the effectiveness of the metrics that they use. Even the best investors can get caught offguard, but successful private equity players are better at timing when to “buy low” (when the market is undervalued) and when to “sell high” (when the market is overvalued).12 Some widely reported news events remind us of the difficulty of predicting turns in market trends. One of the world’s wealthiest men and most successful investors, Warren Buffett, lost close to $1 billion betting the wrong way against the U.S. dollar. His timing was a particular problem. The dollar declined throughout 2004 and then rebounded at the beginning of 2005, strengthening until 2006. Mr. Buffett suffered losses of $955 million in 2005. He finally cut his bet against the dollar in 2006, just before the dollar’s steepest decline in 18 months.13 In Mr. Buffett’s case, he has both the financial staying power to take large positions and the wisdom to limit the size of his positions. However, many corporate decision makers do not have either reasonable assumptions or a sound framework with which to evaluate currency inflections. They should travel with extreme care. In a 2005 paper, Laffer Associates set forth a framework for understanding the U.S. trade deficit and the increases and declines in the value of the dollar that have occurred over the past three to

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four decades.14 Three points made in that paper can be initially considered as if they were independent of each other, and then all three points can be merged into a consistent integrated framework of the United States in today’s interconnected global economy, based on price levels, interest rates, comparative advantage, and taxes. The first point asserts that the overall U.S. price level has been and is determined by actions of the Federal Reserve. Likewise, the euro price level is the consequence of the actions of the European Central Bank (ECB). With both euro and dollar price levels being set independently of the foreign exchange markets, the dollar/euro exchange rate then represents the price of U.S. goods and services relative to those in the Eurozone. A decline of the dollar means that U.S. companies become more competitive, that is, U.S. goods and services become cheaper and of course foreign goods more expensive to American buyers. This first point is by no means innocuous. There are consequences to Federal Reserve actions. In the late 1960s and throughout the entire 1970s, currency devaluations were inevitably associated with fully offsetting inflation. These were the bitter fruits of devaluation. Back then, if the U.S. dollar depreciated against the German mark by, say, 11.3 percent, U.S. prices would increase by 11.3 percent more than German prices. The relative prices of U.S. and European goods would be unaffected by changes in the exchange rate. Without the secure link to domestic products, there would be no limit as to how far the dollar could fall. The only limit would be how high dollar prices could rise. With the tight control over domestic prices of products, there are definite upper and lower limits to the value of the dollar. The second point outlines the Ricardian framework of comparative advantage.15 Under that framework, the United States produces some products more efficiently than the Eurozone and some less efficiently. Those we produce more efficiently we export, and those we produce less efficiently we import. The equilibrium real exchange rate balances exports with imports. Both parties benefit from free trade when they sell the goods and services that they produce most efficiently. Once we allow the real exchange rate to deviate from the equilibrium rate, we see that the weaker the dollar, the greater will be

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the U.S. trade surplus (i.e., the smaller the trade deficit) and vice versa. Also, the further away from equilibrium the real exchange rate moves, the more difficult it becomes to move that currency even further away.16 Just like stock price movements and intrinsic value, there are natural, albeit fuzzy, limits on how far a currency can move from its central value. In addition to depending on the level of the exchange rate, quantities of traded goods purchased and supplied also depend upon changes in the exchange rate. Decisions to buy depend not only upon price but also upon where prices are expected to be in the near future. The trade responses to a weak dollar will differ dramatically depending upon whether people believe the dollar will get weaker still or will reverse trend and get stronger. And, to reinforce the point, there are definite trends in the movement of exchange rates, allowing rational market participants to forecast future changes in the exchange rate. Third, investors and successful private equity players make their global allocation of capital based upon their perceptions of after-tax returns. When investors shift their investments to a more attractive country, that country will experience a trade deficit and a capital surplus, while the less attractive countries will have trade surpluses and capital deficits.17 The important point here is simply that relative investment attractiveness determines whether a country has a trade surplus or deficit. Contrary to popular belief, the trade deficits are not caused by the spending habits of consumers or by shadowy speculators. Trade deficits are caused by investment attractiveness. Looking ahead, the investment attractiveness of the United States has declined dramatically relative to other countries; this will affect the ability of the U.S. economy to maintain a trade deficit. The summary point integrates the prior three points. A country’s trade deficit is determined by its capital flows, which in turn are determined by its domestic economic policies relative to those abroad. Real exchange rates then adjust to provide the trade deficit (or surplus) as determined by capital flows. Last, with domestic prices set by domestic policies, the nominal exchange rate becomes one and the same as the real exchange rate. The conclusions then follow: It was a bad time to bet against the dollar in late 2007.18

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UNDERSTAND THE FUNDAMENTAL DRIVERS AND CAUSES OF INTERNATIONAL CAPITAL FLOWS The framework, as discussed above helps in understanding the interaction between exchange rates, price levels, demand for goods, and capital flows. It can also be used to predict the outcomes that will arise from changes in existing trends. Consider the fundamentals that were driving the value of the dollar in 2007. Here are some clues from the real world: By mid-2007 there were at least 16 countries with flat personal tax rates.19 The number is expected to hit two dozen within a few short years. The United States has gone from one of the lowest corporate income tax rates to one of the highest in the world without the United States making any changes. The supply-side tax revolution has occurred everywhere else in the world. This shift in tax policies has reduced the demand for U.S. dollar investments, consequently lowering the value of the dollar relative to other currencies.20 Any prospect that investors see for a future increase in U.S. tax rates has further reduced the demand for dollars. • Prospects for increases in capital inflows into the United States are limited to the relative attractiveness of investments in the United States, but these investments are attractive only to the extent that they produce after-tax cash flow that is competitive with investments in other countries where there are lower tax rates. As an example, private equity investments outside the United States now exceed those within the United States.21 At some value of the dollar, the relative attractiveness of after-tax returns on investments in either the United States or foreign countries will equalize, slowing the deterioration. A downward trend is not likely to continue forever. • The trade deficit decreased through 2007, somewhat in response to a decrease in the capital inflows. A remaining big piece of the puzzle was oil. When oil prices collapsed in the second half of 2008, the result was a big reduction in •

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the cost of oil imports, reducing the supply of dollars that flowed into the foreign exchange markets to purchase oil. This decreased pressure on the trade deficit. With no change in the relative taxing policies of the United States and other countries, the decrease in oil prices brought about a strong rebound of the dollar in currency markets. If U.S. tax policies were changed to be more competitive with those of other countries, the rebound would be even more dramatic. This framework makes it clear that it was unwise to bet against the dollar in late 2007.

RECENT TIMES: WHY TRENDS CAN BE MISLEADING In 2005, the United States was still doing well, but other global trading partners had gone to the edge of the economic precipice, realized their mistakes, and started to embrace limited supply-side economic policies. Astute private equity players and other alert investors are fully aware of the global opportunities that these changes may bring. With the turnaround in expected returns in other countries, investors now wish to invest a larger share of their assets outside the United States. A U.S. capital surplus of over 6 percent of U.S. GDP no longer seemed warranted. The excess demand function for capital had shifted. With this shift, as with any market shift, the initial impact is on price. Demand and supply curves, in the short run, are chronically inelastic. But in the long run—over several years—they are amazingly elastic. As a consequence, the period from the early part of 2002 to 2005 saw a dramatic drop in the foreign exchange value of the U.S. dollar with no noticeable effect on the trade accounts. But in markets, expectations matter. If people believe the dollar will be lower in the near future than it is today, they will defer buying dollars even if the dollar is dirt cheap. Periods of rapid currency change—like 2002 through 2004—are materially different from periods with stable currencies. The sharp fall in the dollar set up a pattern of expectations in the marketplace of further declines in the future. The trap in blindly following trends is that they may reverse suddenly and

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erase any gains that investors had made in relying on a continuation of the trends. In the case of currency trends, the changes have a self-correcting market mechanism. Once the dollar starts falling, quantities start changing and imports become more expensive and decrease, while exports become more appealing to foreigners and thus increase, causing the trade deficit to shrink. These quantities change the supply/demand pressures in the foreign exchange markets, reversing all the logic for future trend-based declines in the dollar. The dollar decline ended abruptly, with the value of the dollar bouncing off its local bottom on December 31, 2004, and then climbing throughout 2005. Investors who were digging deeper were skeptical of the trend. By developing an understanding of the economic fundamentals that drive currency prices, they could add more content to their analysis of the outlook for the dollar. The lesson is that markets work and are interrelated. Looking only at trade deficits or foreign exchange trends will not give the entire picture. Digging deeper to understand the fundamentals of how exchange rates interact with both goods markets and capital markets is not simple but is necessary to identify when trends will come to an end. We have talked about the impact that oil prices might have on the foreign exchange value of the dollar. What about the future direction of oil prices? Let’s dig deeper to know when to act sooner.

RETURN OF THE OIL PRICE DEBATE 1981–2007 Commodity prices move up and down. Private equity players rely on experts who understand commodity prices. Oil is a key commodity in the interconnected global economy with unique characteristics, including oil’s ability to be transported, stored, and produced in a variety of places at different prices. As decision makers look for indicators of inflection points in the markets, they need to use every method they can to enhance their position. The business media offer up their usual menu of conflicting predictions. News media speculations on oil prices abound. Will prices go up simply because they have gone up? Are conspirators or speculators driving up oil prices? What is the impact of oil prices on foreign exchange?

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Oil prices have taken center stage on several occasions since the first oil shock of 1973. Those who participated as consumers will never forget the angst at first provoked by lines at the gas pump, and ultimately by dramatic price increases. The first go-around prompted changes in the media vocabulary, with “recycling petrodollars,” and “oil-price spikes” becoming common topics. Much of the public, along with the media, clamored for more information to clear away the uncertainty of future oil price trends, while looking for the conspiracy. “Who’s to blame?” was asked more frequently than “What can we do?” As oil transformed from a cheap and plentiful commodity to one that everyone realized we critically depended on, oil price movements began to take on a new level of importance. Prices of major commodities rarely change smoothly. They move on shortterm expectations as well as longer-term fundamentals. They have a way of either soaring or plummeting, and as many have personally learned the hard way, price changes can make or break fortunes along the way. Predicting inflection points in oil prices is very valuable to both public and private equity investors and their underlying companies. Trends do reverse, but when?

INFLECTION POINTS ARE DIFFICULT TO PREDICT AND ACCEPT

When prices have been rising for long periods of time, the suggestion that prices might fall is not always accepted well by market participants. Predicting a turn may provoke those who hope that no turn is likely.22 But ignoring a good prediction can be disastrous in both the short and the long run. The story of Rowan Companies, the provider of oil well drilling services, is illustrative. Laffer Associates distributed a study to its clients in 1981 predicting that oil prices would drop. One of the firm’s clients passed a copy of the study to a key executive at Rowan Companies. Obviously, the outlook for Rowan’s business would diminish if the Laffer forecast came to pass. The Rowan executive did not take Laffer Associates’ report lightly; he rejected it out of hand. In a detailed response he told the (Continued)

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authors of the Laffer report that they were basically wrong about the outlook for the offshore drilling industry in both the near term (6 to 12 months) and the long-term (1 to 5 years). He said that the outlook for offshore drilling had never been more certain. He stated that he was sad for Laffer Associates and glad for Rowan shareholders even if the price of oil dropped below $24 per barrel. On February 16, 1983, when oil prices were in the $30 range, Laffer wrote: “The amount of conservation and increased oil production capacity that has occurred since 1978 indicates that the price of oil in today’s dollars is likely to fall to $19 a barrel or even lower.” After a period of booming production and prices, by 1986 the oil patch was in ruin. The price of oil had dropped to $10.43 a barrel, from a peak two years earlier above $38 per barrel, 23 validating the conclusions of the 1981 Laffer study. As for Rowan, its stock hit $20 in 1981, but had dropped to $9 by 1984, along with collapses in earnings per share, pretax margins, and returns on equity. Rowan’s long-term returns trailed the S&P 500 index for an even longer period. Many unprepared suppliers to the oil industry went bankrupt in the 1980s. By focusing on the short term, too many people fail to look into the future or to learn from the past. Digging deeper to understand the fundamentals is a key to value building.

What does it take to predict a drop in oil prices when the news is glutted with warnings about the perpetual shortage of oil, rising demand, dictatorships, and political upheaval in areas where the world’s oil is produced? Looking at oil prices from the point of view of an economist and taking a long-term view gets away from the short-term fears that fill the news media.24 The oil market is characterized in the short run by highly “price-inelastic” demand and supply. This means that perturbations in the market result in large price swings with only small changes in the quantities demanded and supplied. In the long run, however, both the demand for and the supply of oil are highly price-sensitive. High oil prices set into motion an array of substitution effects which both reduce demand and expand supply. However, it can take a long time—three or more years—for these substitution effects to manifest themselves. If the country is full of cars that are gas guzzlers that were built when oil was cheap, they will not be thrown away just because oil

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prices spike. Now it is true that in the short run people will drive less, but there are limits to how much less they can reasonably be expected to drive. Car manufacturers, however, will start to build more fuel-efficient vehicles, based on decades of experience in Europe and Japan. It may take a long time to replace all those gas guzzlers with fuel-efficient cars, but once the auto stock is more fuel-efficient, the demand for oil and its rate of growth will be a lot less. The same will be true for many oil-based products. On the supply side, when oil prices are low, drilling grinds to a halt, oil exploration all but stops, nuclear power is stifled, and other energy sources are shunned. However, once oil prices rise, all of these supply-side activities spring back to life. In addition, higher oil prices mean that existing wells will be run at higher capacity and some old wells will be uncapped and reenlisted. Again, there are limits to how much additional oil can be produced with existing wells. Many alternative sources of energy take a very long time to come online, but once online they effectively last forever, and the supply of oil is greatly augmented. It was not all that long ago that the naysayers argued that the supply of oil is limited. It is not. Because markets work, at the right price you can get all the oil you will ever want over the longer term. Consider the huge deposits of tar sands and oil shale in the United States and Canada that may be economical whenever crude oil prices are above $50 per barrel with current technology. New technology promises to lower the cost of these sources of supply in the long run.25 In Figure 8.2, real oil prices are shown from 1890 to 2008. Note the four more recent periods of high-priced oil: 1974, 1980, 1990, and early 2008. In each period high-priced oil was followed by an economic slowdown and a rapid price decline. Because the laws of economics hold as they have before, then sooner or later, real oil prices had to come down from their 2008 peak. As we have seen, oil prices did drop below $65 per barrel in November 2008—almost a 50 percent drop from their peak of over $150 per barrel. True Believers in Ever-Increasing Oil Prices Ignore Economics The news media highlight those who take strong positions. The oil price “debate” is always filled with many comments that are

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Figure 8.2 Real inflation-adjusted oil prices vary, but are bounded

by reality Source: 1900–1985 global financial data, 1986–2007 (in 2007 dollars). Energy Information Administration (www.eia.doe.gov).

meaningless when viewed close up. For example, in a television interview an economist stated that oil prices would never come down as long as China’s GDP continued to grow at 11.9 percent. While this type of statement is passed through uncritically by the media interviewers, the statement itself is contradictory. Comments such as these pay no attention to the supply side of the equation that determines oil prices. The hard fact is that China’s growth depends in some measure on energy, a certain portion of which is supplied by oil. At least some of that oil is being purchased in world markets, where prices are competitive. Thus, for any period, the supply of oil to China is equal to its demand for oil, at the price China is paying. What matters is not the growth of China’s demand for oil but the relationship between the demand and the supply. Today’s investors in China have a choice on where to spend each investment dollar; should they spend it on producing more manufactured goods or on finding more oil? With high oil prices, the incentives should be there for a great amount of investment in producing oil, in addition to all the demand-side incentives to conserve oil and find substitutes for oil. Too frequently, commentators ignore the realities of the supply function, concentrating only on the demand for oil. The economist could have just as sensibly said: “As long as the supply of goods

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and services in China is growing at 11.9 percent, oil prices will never increase.” The future path of oil prices will depend on the longer-term balance of supply and demand for oil. The demand for oil is driven by the demand for energy and the price of oil relative to other sources of energy. The supply of oil is driven by oil producers who are motivated by long-term profits. The false picture is of a world totally dependent on oil, with no long-term alternatives (such as coal, gas, nuclear power, solar and hydroelectric energy, biomass, wind, tides, etc.) and of a fixed supply controlled by OPEC. The real world is different. All oil is not controlled by OPEC, and OPEC knows it. There are numerous alternative sources of energy, and the high prices and free markets continue to coax new investment into methods of extracting oil from shale and tar sands, as well as methods to make nonoil sources of energy more costeffective. Innovations will present themselves as oil prices ratchet higher and the incentives for developing them become even greater. New supplies will develop.

THE HAMMER COMES DOWN ON LAFFER

In 1983 Dr. Armand Hammer was the chairman of Occidental Petroleum. Among all the captains of industry in the 1970s and 1980s, he stood tall, ruling his company with an iron fist. At a regular board meeting in 1983, Arthur Laffer was invited to present his views on the outlook for oil prices to Dr. Hammer and his board of directors. Up to that time Dr. Laffer had served as a regular economic advisor to the board. Two oil price crises in the 1970s had driven prices up to historic records. Some falloff had occurred, but most analysts predicted continued high price levels, and industry members were their true believers. Positive thinking was high in the oil patch and quite contagious. “. . . therefore, oil prices will go down, and they will go down a lot!” Laffer concluded. All eyes in the room went to Dr. Hammer, as did all ears, for he started to scream. According to Bob Richley, then EVP at Occidental, Hammer had arrived late and missed the introduction and reason for Laffer’s presentation. Instead of listening to (Continued)

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an independent macroeconomic perspective, Dr. Hammer was hearing someone contradict his beliefs about the future course of oil prices. “Who the hell is that? Get him out of here. . . . You’re fired!” 26 Mistakes at the top are always costly. As we know, oil prices dropped like a rock, to below $10 by 1986. Inflection points don’t advertise themselves well. They have to be coaxed out of the data. Those who have the capability to identify the fundamental drivers and the early indicators clearly risk incurring the wrath of those who expect the good time trends to continue. Those who miss the operating market fundamentals and drivers do not yet see the fork in the road and are therefore not ready for or open to the message. The wise listen: Bill Gates says: “Success is a lousy teacher. It seduces smart people into thinking they cannot lose!”27 And, in congressional testimony, Arthur Laffer recalls Milton Friedman saying: “One man and the truth is a majority.”

Yes, real oil prices will continue to fluctuate within a wide but reasonable band over time. Just watch the trend and be alert to differences between short-term spikes and long-term fundamentals. Geopolitical forces and efforts by OPEC to control oil prices will always increase the likelihood of pricing spikes.

DIG DEEPER AND THEN DON’T OVERREACT TO FALSE SIGNALS: WHY THE INVERTED YIELD CURVE OF JULY 2006 DID NOT MEAN RECESSION IN 2006–MID-2007 CEOs deal with a constant flow of information. Much of it can be chilling. Forecasts of recession, adverse reports on trade deficits, warnings about inflation, and a host of other worrisome issues can prompt concerns. Even comments that the economy is doing too well can cause a thoughtful CEO to pause before moving ahead with an expensive product launch. Fear can be paralyzing. However, factbased analysis of the changing macroeconomic environment can provide answers. Difficult questions must be tackled, but those who expend the effort can be rewarded. Top value builders pay attention to the very broadest context within which they operate. One question they must tackle is whether the presence of an

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inverted yield curve is a definitive predictor of a forthcoming recession.28 At any given time, you can always find someone who will say that the United States is headed for recession long before a recession occurs. The questions are when and how deep. Whether it is the “collapsing” dollar, “unsustainable” trade deficits, or skittish consumers, rest assured there will always be something for Chicken Little to crow about. But when it comes to harbingers of hard times, there is none more credible than an inverted yield curve—or at least some believe! In late 2006 and early 2007, the yield curve continued to be inverted. The yield curve had inverted before each of the previous six recessions. Since the late 1960s, every yield curve inversion has been followed quickly (within three to four months) by a recession. It thus seemed that the yield curve was very good at predicting recessions. Investors were more than worried. The yield curve had been inverted since July 2006, yet the S&P was reaching new highs! In this section we explain why the yield curve has been so prescient in the past, and why it did not signal a recession for early 2007. First let us preview where this discussion is going: 1. In the past cases of the yield curve’s successful “predictions” of future recession, the stock market was either flat or had dropped sharply just prior to the recession. During the first half of 2007, during which the yield curve remained inverted since the fourth quarter of 2006, the real S&P 500 index increased by some 11.3 percent. Throughout this period, the stock market was most definitely not forecasting a recession. 2. Past inversions were the result of credit crunches that drove up short-term yields. (Think of a credit crunch as an excess supply of short-term debt securities, that is, people and businesses desperate to borrow.) However, there was no evidence of a credit crunch in the market of January 2007. 3. Through mid-2007 TIPS (Treasury inflation-protected security) yields were not dropping, still pointing to continued prosperity. Leading up to the 2001 recession, by contrast, the TIPS yields were falling at a time when the

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yield curve inverted. Business activity was softening, and demand for long-term credit was falling. 4. In the late nineteenth and early twentieth centuries, inverted yield curves were typical. The upward-sloping yield curve has only been “normal” in the post-World War II era, when long-run inflation was expected and became the norm. In December 2006, Dr. Jim Smith, UNC Chapel Hill, said, “The U.S. Treasury yield curve has now been fully inverted from three months to ten years for over four months. . . . In the past 91 years this occurrence has always been followed by a recession. . . . [Y]ou should start your recession watch next May [2007] and stay alert until a recession is obvious or March 2008, whichever comes first. . . . Just remember that inverted Treasury yield curves that persist for three months or longer, as has been true of the current episode, have always been followed by recessions since the Federal Reserve System has existed. Many people want you to think that this time is different, but as my late mother always said, ‘I’m from Missouri and you’ll have to show me!’”29 Dr. Smith’s recession watch period was empirically too long. Past inversions signaled the onset of a recession within three to six months. So, for his prediction to be empirically valid, there should have been a recession by mid-2007, which never occurred. Remember, timing really matters. Imagine a weather forecaster who would forecast rain today, tomorrow, or maybe next week. So, “show” we will. In the following sections we explain why the yield curve has been so prescient and, more importantly, why the 2006 inversion was not an accurate signal for a recession through mid-2007. (In a separate and later situation, insufficient action by the Fed in late 2007 and a stock market crash put the economy at risk of a recession in 2008 or 2009.) Digging Deeper Uncovers the Real Facts about an Inverted Yield Curve The yield curve is represented by a graph of Treasury yields on the vertical axis versus their maturities on the horizontal axis. Figure 8.3 displays the inverted yield curve as it appeared in December 2006 and a normal yield curve as it looked in December

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By the beginning of 2007, the yield curve had been inverted for four months

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A “normal” yield curve (as of January 11, 2008)

Figure 8.3 Yield curves, normal and inverted Source: FRED® (Federal Reserve Economic Data mantained by Federal Reserve Bank of St. Louis).

2007.30 Normally the yield curve is upward sloping; that is, yields increase with maturity. The conventional explanation for everincreasing yields as maturities lengthen is the presumption of a risk premium for longer-term debt and the expectation of future inflation. Even if bond traders expected short-term rates to remain constant for the next 10 years, investors would require a higher yield on 10-year notes because of the danger of tying up cash for such a long period. Flexibility seems to be a valuable trait. From time to time however, as was the case in 2006, yields on short-term (three to six months) securities exceed yields on the long end (five years and over). Inverted yield curves where the threemonth T-bill yield exceeds the yield on the 10-year Treasury bond have proven to be uncannily reliable in forecasting recessions. Arturo Estrella, an authoritative Fed economist, summarizes, “The yield curve has predicted essentially every U.S. recession since 1950 with only one ‘false’ signal, which preceded the credit crunch and slowdown in production in 1967.”31 Since at least 1950, not only has every inverted yield curve been followed quickly by a recession, but there has never been a recession that was not preceded by a serious flattening or inversion of the yield curve. This type of one-toone correspondence in macroeconomics is vanishingly rare. (See Appendix 1, Figure A1.4d.)

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Evidence from the Stock Market in Early 2007 Signaled No Immediate Recession There is one other series that has been almost as accurate in predicting recessions as is the inverted yield curve—the stock market. Where the rub occurred in 2006 was that there was not the slightest inkling of a recession in stock prices, and yet there was a strong signal of recession in the yield curve. During the 2006–2007 inversion of the yield curve, the stock market performed well. From August 2006 to June 2007, the S&P 500 index increased by 15 percent.32 Stock market performance was clearly well above the long-term average real return of 8.1 percent since 1982. For the recessions of the early 1960s, 1967’s almostrecession, and the recessions of 1974, the early 1980s, and 2001 there were definite drops in the stock market. Even with the recession of 1991–1992 there was a mild drop in the stock market. Not one of the recessions or near recessions was associated with a stock market increase anywhere near the magnitude of the rise in 2006 and through mid-2007. Appendix 1, Figure A1.4e plots the inflation-adjusted S&P 500 index and recessions. As the chart illustrates, the market does not bid up stock prices just before a recession. The divergence between the yield curve’s forecast of a recession and the stock market’s forecast of continued growth in early 2007 was as great as ever seen. In early 2007, investors who took their cue from the healthy stock market had more favorable results than those who followed the implied advice of the yield curve.33 The Academic Link between Inverted Yield Curves and Recession Is Weak Attempts to establish causation between inverted yield curves and recessions are weak. Recessions always happen for a reason. It may be a tax hike, it may be a trade restriction, it may be poor monetary policy, or it may involve a new egalitarian incomes policy.34 And when recessions do happen, there is always an excess supply of short-term debt which causes short rates to rise. (Think of this as a large amount of commercial paper—short-term debt—in the marketplace. Corporations increase their commercial paper borrowings to cover short-term needs that arise when business volume slows. In addition, the existing commercial paper in the market must be

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rolled over, and with the usual corporate buyers needing to increase their own debt, the price of short-term debt will go up.) In essence the inverted yield curve and recession may have different causes, which are only indirectly related. In that case the yield curve is a symptom, not a cause. The academic argument is attempting to add a link that the data suggest may not be there. Yield Curves and Recessions: Correlation Is Not Causation So, what of the 2006–2007 inversion? Granted, no cause for a recession was apparent. It is unsettling that the yield curve—such a good indicator of prospective recessions in the past—was apparently calling for a downturn in early 2007. As we shall see, there are factors that make this inversion qualitatively different from previous ones. Whenever prices are used to forecast quantities—as is the case with the inverted yield curve and recessions—ambiguities arise. Prices can change as a consequence of either demand shifts or supply shifts. Higher apple prices can result from a crop failure or the discovery that apples have aphrodisiacal qualities. Either case yields higher apple prices, but with a crop failure there will be fewer apples while the discovery of aphrodisiacal qualities will eventually yield more apples—quite an important difference. The ensuing consequence of fewer or more apples will reverberate throughout the economy for quite some time. Unless you dig deeper to learn the cause for a change in apple prices, you cannot use the change in price as a forecast of a change in quantity. An inverted yield curve results from an incipient excess demand (higher prices and lower yields) for long bonds relative to short bonds. It is the emergence of the inverted yield curve that actually balances the changing demands for credit and debt with their supplies. The incipient excess demand for long bonds relative to short bonds can be precipitated by an increase in the supply of short bonds (corporations borrowing to cover short-term needs), thus pushing down their price and raising their yield, or by an increase in the demand for long bonds (investors buying bonds to lock in yields which they believe will decline in the future), thus bidding up their price and lowering their yield, or both of the above. While an increase in the supply of short bonds and an

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Figure 8.4 Use a napkin sketch to understand and communicate the fundamental shifts in both demand and supply Source: Accompanying text adapted from Arthur B. Laffer, with assistance from Robert P. Murphy and Jeffrey Thomson, “Money Matters,” Laffer Associates research paper, May 4, 2007.

increase in the demand for long bonds will have similar yield curve consequences, they most definitely will not have the same consequences on the future path of the economy—i.e., a recession. You can draw the supply and demand curve shifts on the back of a napkin for a better understanding of the shifts in the fundamental supply and demand curves (see Figure 8.4). Now fast forward to the 2006 economy. Recall from Chapter 1 that in 2006 the United States was wallowing in a market malaise of pessimistic expectations. Yet times were good. The Fed was increasing the discount rate to forestall inflation. The main media message was: “There must be a recession coming, because the yield curve is inverted.” However, to this point asset values were about as low as they had ever been relative to our old friend, capitalized economic profits. This shroud of dark thought impaired our collective ability to see clearly just how fantastic the U.S. economy really was and how

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bright our long-term future remains. In essence, the stock market continued to be undervalued, as witnessed by the continuing frenetic pace of private equity purchases of public companies throughout 2006. In 2006 the public markets far underestimated how bright our future could be. The 2006 inverted yield curve inversion did not stem from an excess supply of short-term debt because of a credit crunch; far from it. Through mid-2007, there was plenty of liquidity in the marketplace, and most businesses showed no signs of a credit crunch despite the growing subprime mortgage problems. The inverted yield curve for the first time in probably a century reflected an excess demand for long-term securities, perhaps in part because of the confidence in the Fed to control inflation and a strong Main Street economy. There could not have been a more bullish sign. Short rates rose because of a shift in preference on the demand side away from short-term assets toward long-term assets. Thus we had higher short rates and lower long rates as the shift progressed. The 2006 yield curve inversion does not deserve a further update. It was proven unfounded as a predictor of recession in the first half of 2007. The 2006 inverted yield curve did not cause or signal a near-term onset of recession in the typical three to six months. To understand the real threat of recession that appeared at the beginning of 2008, analysts should look for a different set of signals, such as the decline in stock prices, or a precipitating change in government policies, or a lack of response by the Fed. There will always be debates about the probabilities of recessions at any given time.35 Lessons learned: Bad policy decisions, be they on monetary policy, taxation, trade, or regulation, cause recessions. Bad policy decisions also cause yield curve inversions. But remember that yield curve inversions do not cause recessions. Time will show that 2008 was filled with bad policy decisions that eventually led the global economy into recession. A Century Ago Inverted Yield Curves Were Common Economists have offered theories to explain the 2006–2007 inverted yield curve and why it was benign. Better policies worldwide—most notably central bank discipline—have led to

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declines in both expected inflation rates and the volatility of real and nominal short-term yields, which contribute to a flattening yield curve. Indeed, a flat or inverted curve was nothing unusual in the late nineteenth and early twentieth centuries, when longterm stable prices were the rule, not the exception. Seen in this light, the 2006–2007 inverted yield curve was a sign of strength and stability and control over inflation, not, as many believed, impending recession. The TIPS Yield in Early 2007 Signaled No Immediate Recession Indeed there was clear evidence that the broad market of 2006–2007 did not expect recession. We rely on the TIPS yield, which is the best proxy available for the market’s expectation of future real growth. Figure 8.5 plots the 10-year TIPS yield against the spread in nominal yields on the 10-year and 3-month Treasuries. Unfortunately,

Figure 8.5 TIPS yield versus nominal spread: confidence for low inflation in the future Source: Laffer Associates, author analysis, based on Fed data.

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TIPS have been in existence only since 1997, so our data window will catch only the 2001 recession. As the yield spread headed south (and eventually became negative) in early 2000, the TIPS yield began its collapse as well, presumably because investors expected real yields to fall during the upcoming recession. Interestingly, in the period when the long bond yield collapsed, going from 6.75 percent in January of 2000 to 3.25 percent in June of 2003, the expected rate of inflation remained at or around 2 percent. In contrast, the steady decline in the spread beginning in early 2004 has been matched with a fairly stable, even increasing, TIPS yield. Thus, the market’s views on medium-term economic growth did not become more pessimistic over the last three years, whereas they began falling before and during the 2001 recession. The yield curve inversion in 2006 and early 2007 was driven by beneficial market forces, not government meddling. Through that time, the government had taken no steps to induce a recession, despite its publicized fears of inflation.36 Credit Crunch in the Third Quarter of 2007 Changed Nothing So, a reader might ask, what of the credit crunch that grabbed the headlines in the third quarter of 2007? Does that somehow overturn the commentary about the relationship between an inverted yield curve and a recession? The answer is no. Allow us to reemphasize the point that the same conditions that lead to a recession also lead to an inverted yield curve. However, there are other conditions that can lead to an inverted yield curve that are not indicators of recession. So, while there is a historical association, the cause and effect relationship is sometimes misunderstood. Both the inversion and the recession are effects. The inversion is not a cause of a recession. In the third quarter of 2007, there was news media talk of a recession on the horizon fueled by the development of a credit crunch spreading beyond the subprime mortgage market and the volatility and declines in stock prices. However, the Fed eventually took offsetting action by reducing rates and experimenting with a “term auction facility” (TAF) to provide liquidity in the face of an impending credit crunch. After an initial media frenzy, the markets

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temporarily shrugged off the credit crunch, which was somewhat abated by the Fed’s actions. The stock market bumped along through September 2008, only to collapse in October 2008. What caused the credit crunch? See the section below for more detail, but briefly, a sharp turnaround in the economy’s demand for money (liquidity) caught the Fed off guard, putting the Fed into a position of suddenly unintentionally starving the economy’s demand for money. The subprime mortgage market was just the weakest link in the chain. Subprime lenders ran out of money first, precipitating the apparent crisis. However, the economy was still growing, and the demand for credit was high. Soon, borrowers of all types found that terms and availability of credit were turning unfavorable. Credit Crunch—Where Is the Villain? Is the Fed a Villain? Whenever there is an apparent financial crisis, it seems that it sets off both a media frenzy and a congressional investigation. They seek evil-doers, usually within companies that are swept up in the crisis. The credit crunch of the third quarter of 2007 is no different. The airwaves were full of commentary about whether it was “loose lenders” or unscrupulous brokers luring innocent borrowers to the slaughter house, or whether it was the borrowers themselves who were at fault. The Fed certainly contributed to the problem, partly because of trying to serve dual goals. In choosing between its two goals of maintaining price stability and maximizing employment in a growing economy, the Fed picked price stability. The Fed’s fear of impending inflation led to a decision to hold the Fed funds rate at its peak level, while other money market rates fell away. This strained the banks and derailed the economy and in October 2008 produced a global economic crisis. Dual goals create problems. History again shows that it is impossible to serve two masters. Again, to dig deeper, it is necessary to recognize that there is both a demand for and a supply of money in the economy. This is a crucial relationship that most, including many economists, have trouble understanding. The demand for money is strongly influenced by interest rates and the transaction demand for cash, which moves with the level of national income (GDP).37 The supply of

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money is controlled by the Fed. The two must stay in balance for the economy to run smoothly. The transactions demand for cash arises from the need to fund purchases and required payments throughout the economy. When GDP rises, the transactions demand increases. Separately, there is a speculative demand for cash balances. This speculative demand rises whenever interest rates fall. One way to think of this type of demand is investors’ demands to hold cash until interest rates increase and bonds provide better returns. With a little detective work, we can track the progress of the credit crunch. In the first part of 2007, yields on 91-day T-bills hit their peak at 5.18 percent (with the inverted yield curve at its most inverted position). At the same time, real GDP growth hit a trough in the first quarter of 2007 with growth of only 0.7 percent. These two trends would have reduced the demand for money to just about the bottom. Then came the second quarter, and “bang!” GDP growth went through the ceiling at over 4 percent (pushing up the transactions demand for cash). Meanwhile, short-term interest rates leveled off and start dropping rapidly (further increasing the speculative demand for cash balances). This set off an inflection point in the demand for money. The demand for money went from collapsing in the first quarter of 2007 to expanding rapidly. This is an instant recipe for a serious credit crunch, demanding immediate attention by the Fed. And before the Fed could collect enough data, the first domino, the subprime mortgage market, toppled. Congress may well find villains, but they will not find causation beyond the rapid changes in monetary balance. The Fed has taken on the responsibility of balancing the supply and demand for money, but it only controls the supply of money. In order to avoid credit crunches and other monetary crises, the Fed must be prepared to respond quickly to changes in the economy’s demand for money, as Greenspan’s Fed did in anticipation of Y2K and after 9/11, and Bernanke’s Fed eventually did in October 2008. To cut through a lot of the economic jargon and confusion on the topic, Arthur Laffer simplified it for an investor group during a recent conference call by relating the following story:38 “Think of the Fed as a fisherman on a boat, fishing for marlin. Let’s call the fish the economy. In between the fish and fisherman is a critical link, the line. Think of the line as money. The fishing reel is

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the supply of line controlled by the fisherman. But the demand for that line, well, that’s up to the fish (the economy). The Fed controls the money supply through the monetary base, and the economy controls the demand for money through its reaction to interest rates and GDP growth. “At the beginning of 2003, the banks had been battered by the corporate scandals and the aftermath of the terrorist attacks in 2001. In their effort to avoid risk, they had bought Treasury bills, driving down the short-term interest rates. In the third quarter of 2003, in response to the Bush tax cuts, GDP soared 7.5 percent. The demand for money was extraordinarily high. The Fed had accommodated by increasing the monetary base. “But then a couple of new trends emerged. Short-term interest rates began to rise (decreasing demand for liquidity), and GDP growth slowed dramatically, (cutting transaction demand for cash). The system was awash with excess money. To keep up, the Fed had to mop up the excess supply by decreasing the monetary base. The marlin was now swimming toward the boat. It seems that the faster the Fed pulled down the supply, the faster the economy reduced its demand and delivered up more of its liquidity. This went on for over three years. This is where the U.S. economy was in the first quarter of 2007: yields on 91-day T-bills peaked at 5.18 percent (with the inverted yield curve at its most inverted position), and real GDP was growing at a rate of only 0.7 percent. “Unfortunately, the fisherman cannot see under the water and into the mind of the fish. The fisherman has to wait until the fish moves before he can react, just like the economy and its demand for money. Now came the second quarter of 2007. GDP growth rates went through the ceiling at over 4 percent (and the transaction demand for money jumped up). Interest rates leveled off and started dropping like a stone (further increasing money demand). That marlin flipped over and changed direction all of a sudden, and there was an inflection point in the demand for money. It went from collapsing to expanding rapidly, and there went the marlin, swimming away from the boat. The Fed had been reeling in the supply of line so fast that the change almost yanked the rod out of its hand, and what happened next? The credit crunch that began in mid 2007!”

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The Fed needs to balance many factors to keep the economy growing while avoiding inflation. It too can make mistakes if it forgets that the demand for money can change quickly. Mistakes were made again in late 2007. Failure by the Fed to bring the Fed funds rate into balance with the 91-day Treasury bill in late 2007 effectively put a tax on banks and put the economy at risk of a 2008 recession. The indicators were clear: an additional 100 basis point reduction was needed in November or December 2007 to maintain the proper balance and restore confidence. As 2008 opened, Chairman Bernanke and the Fed seemed somewhat out of touch with the need for monetary balance. While he promised support, his wait-and-see attitude created even greater uncertainty for the financial markets as the people effect on traders multiplied. As Chairman Bernanke and the Fed talked about the need for fiscal stimulus, rather than an immediate adjustment in the Fed funds rate, confidence declined further. In conversations with a former Fed governor39 and Chairman Bernanke’s testimony before Congress on January 17, 2008, it was clear the Fed did not see a recession as the “most likely scenario” and that its long-term concern for controlling inflation was more important than maintaining economic growth. This attitude prevented more dramatic action in late 2007 or prior to the January 28, 2008, board of governors meeting.40 Did the slow response of the Fed help to cause the January 2008 stock market drop? On Tuesday morning, January 22, the Fed acted, because of a “deepening panic” in global financial markets about a possible recession in the United States with “. . . the biggest one-day reduction of interest rates on record [75 basis points].”41 After the Fed seemed to ignore domestic market signals for several weeks, the Fed was no longer able to brush off the growing severity of the problem, when the foreign markets collapsed. The lesson to the Fed is that our global interconnected economy means that liquidity problems and market problems are now global. Smooth functioning of the global financial system requires a proactive and decisive U.S. Federal Reserve. In response to the problems created by the Fed’s slow reaction, politicians in Washington began to look for solutions. Unfortunately, they decided to employ a fiscal cure for what started as a monetary disturbance. In their effort to set forth a

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program to reduce the likelihood of recession, compromises were made: “. . . the lemmings in Washington have employed a fiscal cure for . . . a monetary disturbance. A rebate is the wrong policy— deadly wrong—yet almost none of the congressmen or senators in this country understood this. Republicans and Democrats, and liberals and conservatives, have all jumped on the bandwagon of a rebate, despite the fact that it is going to have very serious negative consequences.”42 In short, a rebate distorts rather than stimulates. Some receive rebates, while others pay. The rebate is merely another form of transfer payment. It will fail to provide any incentives for the productive activity the economy needs in order to recover. Will better monetary and fiscal policy prevent a deep recession in 2008 or 2009? Or will we see more poor policy decisions? Only time will tell how regulators, politicians, and markets respond globally. Top value builders run scenarios to prepare for the best and worst of times. Those who have prepared by digging deeper will act sooner with conviction. Learn more about current solutions at www.TopValueBuilders.com.

SUMMARY AND CONCLUSIONS Timing matters. Calling inflection points is very difficult. Three or six months can mean the difference between a good decision and a bad decision that results in destroying value. Successful private equity players and other value builders learn from experience and use experts to read and act on the market inflections just a bit better than their peers. Even top value builders make mistakes, but they make fewer mistakes than others, and their timing is better than others. In general, top value builders exhibit extreme discipline in analyzing opportunities. Many will spend well over a million dollars on due diligence and then walk away from a proposed acquisition if they find that the required returns cannot be achieved. Because markets are now interconnected and global, old rules of thumb such as the inverted yield curve forecasting a recession need to be constantly reexamined under changing market fundamentals. Understanding the underlying changes in supply and demand curves can provide better insights. Better metrics, such as

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capitalized economic profits, are available. Successful investors understand: Correlation is not causation. • Inflection points give off subtle signals. • Watching the fundamental changes of supply and demand is crucial. •

The Fed’s handling of the 2007 subprime credit crunch indicates the need to act sooner by digging deeper to understand change in the demand for money. Bernanke’s Fed did not have a common understanding of economic data and in late 2007 appeared slow to act. Fed governors are talking to bankers for new insights on market supply and demand, but apparently in late 2007 they felt that the subprime credit crisis would not spread into a recession because of the strength of the nonfinancial economy. The Fed precipitated the global economic crisis of 2008 by maintaining restrictive monetary policy in the face of an increase in the demand for money. We have learned time and again the difficulty of serving two masters and dual goals. Correlation is not causation. Making decisions based on measurements of economic symptoms leaves the decision vulnerable to changes in the underlying causes. Digging deeper is the only solution. Understanding money market supply and demand fundamentals can help to identify upcoming inflection points. These pivotal moments have dramatic impacts. Successful private equity players have the scale to gain a better understanding of macroeconomic fundamentals. Failing to understand macroeconomic fundamentals can subject decision makers to apparent whims of the markets. Underlying trends are not whimsical when viewed through a lens sharpened by better knowledge of the fundamentals. Oil prices and oil substitutes, interest rates, foreign exchange rates, the demand for money, and the sometimes strange actions of the Fed are all areas where digging deeper is extremely valuable. Identifying inflection points is valuable but extremely difficult. Precision is not critical, but a framework that helps in calling the turning point in any market, just a little bit better, can make an investor rich beyond anyone’s dreams. Such frameworks are also very difficult to communicate to those not willing to listen until there is a crisis.

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However, understanding the changing market forces that will ultimately force an inflection point gives those who dig deeper the ability to plan for the change and act with conviction. Appropriate action at the right time can create wealth and reduce risk.

NOTES 1. The following three sections are adapted from Arthur Laffer, “Red Sky in the Morning, Investors Take Warning: The Preconditions for a Major Market Disruption Are at Hand,” Laffer Associates, San Diego, 1999. In the paper, Laffer called the market peak/downturn about three years after Fed chairman Alan Greenspan first warned of it and began to complain about “irrational exuberance” in December 1996. The Greenspan quote appears in another footnote. (See following notes.) 2. Between 2002 and 2007, 140 countries had an average five-year GDP growth of over 4 percent, and the Dow Jones Industrial worldwide index was stronger than the U.S. indexes. When the inflection point occurred, it had global impact. The Dow Jones Industrial Average (domestic) peaked on January 14, 2000, at 11,722 and did not reach that level again until October 3, 2006, when it closed at 11,797. 3. Paul Volcker, as Fed chairman beginning in 1979, changed the thrust of monetary policy. At his swearing-in ceremony he said: “We are face to face with economic difficulties really unique to our experience. We have lost that euphoria that we had 15 years ago, that we knew all the answers to managing the economy.” “Slaying the inflationary dragon,” the plague of the 1970s, was his mission. His major tool in that endeavor was to limit the money supply. Source: Alan Greenspan, The Age of Turbulence, Adventures in a New World (New York: The Penguin Press, 2007), pp. 84–85. 4. Arthur Laffer, “Red Sky in the Morning, Investors Take Warning: The Preconditions for a Major Market Disruption Are at Hand.” Also see Arthur B. Laffer, “Deadly Serious, Four Key Issues of the New Year,” research paper, Laffer Associates, January 7, 2000. See www.TopValueBuilders.com. 5. For the purposes of this section and the original paper (Red Sky) Arthur Laffer used comments from Goldman Sachs’ market economist Abby Joseph Cohen made on October 15, 1999, to highlight the difference in the views of Laffer and Cohen. 6. Source: http://www.federalreserve.gov/boarddocs/speeches/ 1996/19961205.htm, data through November 11, 1999.

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In December 1996, Fed chairman Greenspan had warned in a speech that the market could become overvalued with his “irrational exuberance” remarks. At that time the capitalized economic profit models still computed the market to be undervalued. However, over the ensuing three years, the Dow climbed 79.4 percent (a 21.5 percent compound annual growth rate). Remarks by Chairman Alan Greenspan at the Annual Dinner and Francis Boyer Lecture of the American Enterprise Institute for Public Policy Research, Washington, D.C., December 5, 1996, “. . . Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? And how do we factor that assessment into monetary policy? We as central bankers need not be concerned if a collapsing financial asset bubble does not threaten to impair the real economy, its production, jobs, and price stability. Indeed, the sharp stock market break of 1987 had few negative consequences for the economy. But we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. Thus, evaluating shifts in balance sheets generally, and in asset prices particularly, must be an integral part of the development of monetary policy. . . .” For example, using after-tax operating earnings indicates that capitalized after-tax S&P 500 operating earnings rose by 48 percent while interest rates rose by 4 percent, a 44 percent rise in capitalized values, while the S&P 500 itself rose 120 percent, still a huge difference. Alan Greenspan, The Age of Turbulence, Adventures in a New World (New York: Penguin Press, 2007), p. 465. Most of the funds used the by private equity buyers were provided by institutional investors, including public and private pension funds seeking the higher returns that established top private equity funds had been producing. Aaron Kirchfeld, “Sovereign Funds Beat Buffett with Stakes in Citigroup, Merrill,” Bloomberg.com, January 22, 2008. http://www.bloomberg.com/apps/news?pid=20601109&sid= aLlJPxrLw2MA&refer=news accessed February 21, 2008. Interview with Joe Mansueto, founder, chairman, and CEO of Morningstar, Inc., February 15, 2008. See also http://www.morningstar .com/cover/pfvgraph.html.

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12. Portions of this section are adapted from Arthur B. Laffer, “Whither the Dollar,” research paper, Laffer Associates, July 6, 2005, available at www.TopValueBuilders.com. 13. George Stein and Josh P. Hamilton, “Buffett Timing Off in Dollar Strategy: Currency Contracts Made Millions but Could Have Made More,” International Herald Tribune, Marketplace by Bloomberg, August 7, 2006. 14. Arthur B. Laffer, “Whither the Dollar,” Laffer Associates, 2005. 15. David Ricardo, On the Principles of Political Economy and Taxation, 1817. It introduced the theory of comparative advantage, which concludes that free trade benefits all trading nations. 16. For example, a weak dollar lowers effective export prices for the foreign buyers, while increasing import prices for domestic buyers. This promotes an increase in exports and a decrease in imports, which then strengthens the dollar. The greater the disparity between the equilibrium price and the real exchange rate, the greater the incentives are for buyers of exports to increase their purchases and buyers of imports to decrease their purchases. 17. A simplified reconciliation of the aggregate economic activity of the country for a given period shows that the trade balance (exports minus imports) will net against the capital balance (capital inflows minus capital outflows) to a total of zero. When there is a trade deficit, the positive capital balance will provide the foreign exchange to pay for it. Any discrepancy in this reconciliation will represent a change in the net foreign exchange reserves held by the country. There are economic incentives that cause these reserve discrepancies to remain minimal. 18. The logic of Arthur B. Laffer, “Whither the Dollar,” Laffer Associates, July 6, 2005, regarding the strength of the dollar still held through 2007. That is, at the end of 2007, the dollar should be expected to rebound, rather than to sink any further. 19. Daniel J. Mitchell, “The Global Flat Tax Revolution,” research paper, Laffer Associates, June 19, 2007. See also “Tax Rates Around the World,” Wikipedia, available at: http://en.wikipedia.org/wiki/ Tax_rates_around_the_world. 20. This can be expressed as a shift in the demand for dollars in the foreign exchange market. Investors consider the value of their investments in terms of after-tax cash flow. As the relative returns shift in favor of foreign investments, investors need fewer dollars from the foreign exchange markets to purchase U.S. investments, thereby decreasing the demand for U.S. currency.

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21. “Globalization of Alternative Investments, Working Papers Volume 1, The Global Economic Impact of Private Equity Report 2008,” Anuradha Gurune, ed., and Josh Lerner, the World Economic Forum, Davos, Switzerland, 2008, p. 16. 22. Thomas E. Nugent, “Whatever Happened to Rowan Companies?” National Review Online, May 17, 2005, http://www.nationalreview .com/nrof_nugent/nugent200505170856.asp. 23. Arthur B. Laffer, “Oil Is on a Slippery Slope,” Laffer Associates, December 8, 2006. 24. This section is adapted with permission from Arthur B. Laffer, “Oil and Gold—An Economist’s Perspective,” Jordan Opportunity Fund. See http://www.jordanopportunity.com/news/pdf/laffer.pdf. 25. Bank of Canada economist at the Turnaround Management Association, annual meeting, Orlando, FL, October 2007. See also “Non-Conventional Liquid Fuels,” Energy Information Administration, Official Energy Statistics from the U.S. Government, http://www.eia.doe.gov/oiaf/aeo/otheranalysis/ aeo_2006analysis papers/nlf.html, accessed February 22, 2008. Also see, ”Crude Oil: Uncertainty about Future Oil Supply Makes It Important to Develop a Strategy for Addressing a Peak and Decline in Oil Production,” United States Government Accountability Office, GAO-07-283, February 2007. 26. Interview with Robert Richley, president, Douglas Wilson Companies, February 22, 2008. 27. Bill Gates, The Road Ahead (New York: Penguin Books, 1995). 28. Adapted from Arthur B. Laffer, “Why the Inverted Yield Curve Doesn’t Mean Recession,” Laffer Associates, January 2007, available at www.TopValueBuiders.com. 29. Arthur B. Laffer, “Why the Inverted Yield Curve Doesn’t Mean Recession,” research paper, Laffer Associates, 2007. 30. To see how the yield curve has changed over time, see http://stockcharts.com/charts/YieldCurve.html. 31. Arturo Estrella, “The Yield Curve as a Leading Indicator: Frequently Asked Questions,” Federal Reserve Bank of New York, 2005, p. 2. Available at http://www.ny.frb.org/research/capital_markets/ ycfaq.html. 32. S&P 500 adjusted close (closing price adjusted for dividends and splits) on August 31, 2006: 1,303.82, on June 29, 2007: 1,503.35. Source Yahoo.com: http://finance.yahoo.com/q/hp?s=%5EGSPC, accessed January 6, 2007.

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33. Corporate profits remained strong throughout 2007. Problems did not come until the fourth quarter, when the financial services sector was affected by the subprime crisis. The crisis for homebuilders, which had started in mid-2006, deepened with the subprime mortgage crisis. 34. Examples include fiscal policy (the G. H. W. Bush tax hikes), incomes policy (the “Great Society” in the 1960s–1970s), trade policy (the Smoot-Hawley Tariff of 1930), and monetary policy (the Fed’s actions in 2007). Contrast these policy mishaps with the following: the Reagan tax rate cuts, diminished prominence of the National Labor Relations Board, NAFTA, and the Volcker commodity price rule. 35. In 2007 Intrade.com tracked the odds of a recession in 2008, based on inputs from independent online traders. During 2007, the odds of a recession occurring in 2008 ranged from 30 to 60 percent, falling to their low point of approximately 30 percent in October 2007. In January 2008, the odds increased to above 50 percent. See Scott Stoddard, “Economy Teetering Near a Recession; Stocks Sell Off Hard,” Investor’s Business Daily, January 8, 2008. 36. After a year of leaving the Fed funds rate at 1 percent, in response to the 9/11 crisis the Fed raised the Fed funds rate starting in July 2004, and did so continually through July 2006, reaching a peak of 5.25 percent. After that point, the Fed funds rate was held steady until August 2007, despite the decline in the T-bill rates that began in March 2007. Through the end of the year, the Fed funds rate was allowed to decline, but more slowly than the decline in T-bill rates, prompting critics of the Fed to point out that the relatively high Fed funds rate was serving as a tax on bank lending, further exacerbating the credit crunch. 37. For example, a decline in the growth of GDP decreases the demand for money needed to effect transactions; increasing interest rates increase the demand for money balances, as investors of the balances convert them into less liquid, interest-bearing accounts. 38. Arthur Laffer “The Glass Is Half Full (at Least),” conference call summary, Laffer Associates, December 7, 2007. 39. Conversation with Michael Moscow, retired Fed governor, following his presentation of January 11, 2008, before the Turnaround Management Association, Chicago. 40. Only time will tell if the global actions taken up to the presidential election in November 2008 will abate the global recession. Naturally, policies adopted by the new president and administration will have a significant effect. While the decline of the U.S. economic miracle was

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forecast by many since the 1970s, under the supply-side principles of Reaganonmics, the U.S. economy has succeeded in outpacing more controlled economies like Japan and Russia. In 2008, in spite of the stock market crash, the economy was far better off than during the Jimmy Carter days of the stagflation 1970s. Could the 2008 crash have been prevented? Yes, but crashes do occur even in growing economies. History books may eventually show that the shock of the terrorist attacks of 9/11, the increase in spending for homeland security, and the Iraq war caused a significant turning point for the U.S. in the global economy. There have been many unintended consequences. As in the past, good policies can produce a rebound of the U.S. economy. Bad economic policies can return us to the malaise of the 1970s. For more detail on the choices and possible mistakes to be made see: Arthur B. Laffer, Stephen Moore, and Peter J. Tanous, The End of Prosperity: How Higher Taxes Will Doom the Economy—If We Let It Happen (New York: Threshold Editions, 2008). 41. Edmund L. Andrews, “Fed’s Action Stems Sell-Off in World Markets,” The New York Times, January 23, 2008, http://www.nytimes .com/2008/01/23/business/23fed.html, accessed January 23, 2008. 42. Arthur Laffer, “Mistakes from the Top,” conference call summary, Laffer Associates, February 13, 2008.

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CHAPTER 9

Experimentation and Innovation Action Accelerates Learning

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ongratulations! Your business plan was creative and innovative. Too bad your public employer thought it was a waste of time. We believe this product could launch a whole new wave of industry consolidation. Your employer will wish it had funded your plan. “This is Fred. He is our expert in your emerging technology and was vice president of technology at one of your old competitors. He is now one of our entrepreneurs-in-residence. If you accept funding from us, we would strongly suggest you hire him on a part-time basis as your vice president of R&D and welcome him as a member of your board of directors. “Now let’s discuss more about your plans. We don’t usually sign nondisclosure agreements at this stage of our review process, but we do have some questions concerning your published articles in the trade journals and the related experiments. “Before we begin, we expect full disclosure on your part about any reservations you might have about our involvement. Do you welcome our advice as well as our capital?”

TOP VALUE BUILDERS USE A PORTFOLIO APPROACH TO EXPERIMENT AND LEARN Successful private equity firms look before they leap. They use experienced executives with skin in the game to find new technologies, management talent, and undervalued assets. They have 291

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experienced technology executives and due diligence teams to dig deep into start-up ideas, potential patents, intellectual property, and company operations. They experiment with different technologies, business models, and transaction types, but they always focus on value creation. Their own incentives are based on value, so they are very selective and focused. They act sooner when they invest and sell, and they build on superior knowledge and the experience of the people involved. They have experience in judging people. They make significant bets on people and ideas, but unlike their public peers, they do attach strings.

HAVING A PORTFOLIO OF EXPERIMENTS OR BUSINESSES MAKES CHANGE EASIER Experimenting modestly is clearly better than betting the farm. Value-building experiments are a critical tool of successful private equity players and other value builders. Failing on small projects can be cheap tuition for a thoughtful company. “Failing cheap” can build valuable experience that allows for quick action in the future. “Failing expensive” is a failure on opening night. Rapid prototyping is an example of a way to accelerate product innovation in small steps. It is not surprising that private equity firms have an advantage in experimenting and controlling risk. As discussed in Chapter 3, the risk to avoid is the “fractal risk,” that is, avoiding risk that could destroy the company and even the fund. At the same time, it is important to take the business risks that can make the company rich. This requires trying things that may end up as home runs. The private equity model of a portfolio of independent companies is a productive breeding ground for home runs. If one portfolio company strikes out and fails—and some will—the private equity fund investor looks to the other companies in the portfolio to make up the difference. While any given portfolio company in such a group may have a very high risk strategy, the important protective mechanism for the overall group in the fund is to ensure that the risks that the individual companies take are different. Even if each of these risks is very high, if the risks are independent and far from likely to all go bad together, the overall group stands to win over time as a result of the one or two portfolio companies that hit the proverbial home run.

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VENTURE CAPITAL IS THE PRIVATE EQUITY VEHICLE FOR EXPERIMENTATION Private equity makes capital markets more efficient from cradle to grave. Venture capital is the private equity “asset class” cradle for innovation and experimentation. Venture capital is a special and long-established version of private equity that invests in early-stage businesses. These early-stage companies clearly have high risk. They do not have a proven product or business model. Many have no revenue and require periodic infusions of financial capital and human capital. We all know the stories of billionaires and tremendous wealth created in California’s Silicon Valley. Silicon Valley, more specifically the Sand Hill Road area near San Francisco Bay, is one of the centers of venture capital in the United States that grew tremendously in the 1980s and 1990s. Technology and the life sciences receive the majority of venture capital funding. Unlike private equity funds that invest in special distressed situations that are one step from the grave, where jobs are often lost, venture capital helps once-small start-ups like Boston Scientific, Amgen, and Genentech grow. Private equity investments in these companies not only help save millions of lives but also help them grow to employ thousands of professionals.1 Over the last 20 years venture capital returns in the United States averaged 16 percent, well above the 13 percent earned on buyouts and the 8 percent on the S&P 500 average.2 Venture capital had a great year in 2007.3 86 companies had initial public offerings totaling $10.3 billion, a 51 percent increase over 2006. • 305 venture backed merger and acquisitions (M&A) transactions totaling $25 billion were closed, the highest value since 2000. •

It may be no surprise that venture capital, like other forms of private equity, has boom and bust cycles affected by interest rates, occasional changes in tax legislation, and the stock market. Changing government regulation gave venture capital firms a boost in 1974 when regulators, under the Employment Retirement Income Security Act of 1974 (ERISA), gave the green light for pension plans to invest in this then new and unproven asset class. Tax

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reform and the stock market boom in the 1980s resulted in over 100 initial public offerings in 1983. The venture partners cashed in their investments at the new lower tax rates and started a variety of new and very successful funds that continue today. Examples include Kleiner Perkins, Sequoia Capital, and InterWest. The stock market crash of 1987 took its toll on the venture capital industry, but the dot-com boom of the 1990s created tremendous wealth and value until the market meltdown of 2000 and 2001. Venture capital activity dropped to about half its peak 2000 level in 2003 to 2005. Later, other private equity firms began to pick up the slack, and by 2006 were in full stride, with a frothy market. Successful venture capitalists had enough wealth to fund new technologies and benefit from the strong market rebound of the initial public offerings (IPOs) in 2005 and 2006. IPOs in this last wave of venture capital investments included Google, Salesforce.com, and others. Strategic buyers like eBay, in its purchase of Skype, also helped put huge returns into venture capital investor pockets. Individual private investors such as Apple’s Steve Jobs and Oracle’s Larry Ellison funded other start-ups. Similar to other private equity classes, the typical venture capital fund has a 10-year investment life and great incentives. General partners typically receive an annual 2 percent management fee based on funds invested and 20 percent of the net gains—or carried interest—that are eventually distributed to its limited partners or investors as capital gains. As a result of the 10-year fund life and the high-performance incentives, venture capitalists are extremely selective in the business plans they fund. While VC funds differ widely, the National Venture Capital Association (NVCA) suggests that of every 100 business plans received by a fund sponsor, “ . . . usually only 10 or so get a serious look, and only one ends up being funded.”4 This occurs only after extensive due diligence and efforts to match skills and management personality. Again different from public boards, it is not unusual for venture capital partners to sit on the boards of early-stage and start-up companies and have weekly or even daily interaction with the management teams of their portfolio companies. Not all venture capital investments pay off for the investors. The NVCA reports that of the select few venture capital-funded companies, “ . . . only one in six ever goes public and one in three is acquired.”5 Many industry

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watchers believe that the odds of success are lower than one in four. Yet one big IPO success in a fund can make up for the weak or average returns of many other “experiments” and produce the 40 percent returns targeted by the best VCs. Huge risk and returns are possible in venture capital because VCs typically invest in unproven but potentially disruptive technologies and business models. Such technologies and business models are often rejected by large public companies as misfit ideas. This is often because cautious and entrenched management teams believe that these new ideas might eventually cannibalize existing products and profits, and so they are usually reluctant to make the investments. As a result, many such management teams allow venture capital firms to fund such investments. Such risky investments affect earnings per share and management bonuses. The public companies protect their short-term profits, and the venture capitalists receive the lion’s share of the value when they bring such companies public or sell them to public company strategic buyers.

VENTURE FUNDS FILL A VOID, BUT SIZE IS A FACTOR Start-up ventures are funded daily by personal debt and credit cards. Friends and family usually can support a venture of up to $250,000. After that angel investors fill a gap to $1 million and up. The amount of funds flowing into venture capital ebbs and flows with the economy. With a recent increase in funds flowing into venture capital, larger venture capital funds generally only begin to take an interest in investments at over $10 million because of the high cost of due diligence. Some observe a human resources gap that accompanies the funding gap. As these businesses grow, they need new skills: a new accountant or controller, a new marketing plan, a new operations manager. Talent becomes as important as capital.6 Up to a point, a small company can secure bank loans based on the personal credit and assets of the owners. As a company grows, its needs for financing will typically exceed the personal credit of the owners, and it must rely on the strength of the business to provide the ability to repay a loan. The problem is that many of these high-growth or high-risk businesses are costly to analyze, and

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traditional banks cannot afford to conduct the due diligence to determine if a growing but unproven business can repay a loan. Few bankers look to the future to get repaid; they look for current assets, historic accounting statements, and liquidation value. In start-ups and new companies these are lacking, and traditional lenders are limited. Projections and estimates of intrinsic value are not things that traditional bankers typically consider. Until a business model is proven and profitable or the company has hard assets, equity capital is difficult to find. Once a business model is proven, additional external capital is typically not needed. Private equity firms or wealthy investors fill the void. They pore over hundreds of business plans and projections, looking for those potential home runs. They not only provide risk capital, but they often provide human capital and the contacts needed to fill the gaps as the business grows.

IF YOU HAVE MORE KNOWLEDGE THAN OTHERS, CONCENTRATE YOUR BETS Larry Ellison is one of the most successful corporate value builders from Silicon Valley and a knowledgeable private equity player. Ellison built Oracle, a multibillion-dollar software company, from an idea. Oracle is one of the few companies that have been extremely successful in growing and acquiring software companies. Ellison understands data storage, and he knows the software and the hardware needed to make data storage function properly. Using his private equity fund, Tako Ventures, Ellison invested a good deal of his own money to fund Pillar Data Systems. Pillar competes in the data storage business against established giants such as EMC and IBM. Pillar is a relatively small player whose technology may disrupt the established data storage industry. It uses over 2.5 million lines of software code to enable inexpensive serial advanced technology attachments (SATA), hard drives, which are found in most personal computers, to operate as effectively in speed and at a fraction of the cost of the fastest competition. An added benefit of the Pillar system is the ease and time savings it brings to system administrators. Using Pillar’s system, companies can reduce IT headcount7 at larger data centers.

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After four years in development, with a team of experts from a variety of its biggest competitors, Pillar is taking on the big guys. Valuing Ellison’s bet and the need for continued investment to support marketing and a million-dollar monthly cash burn rate requires running a variety of scenarios. At such a level of investment, this is important, even if you are a billionaire. When you have superior knowledge and insight into an industry, the wisest approach may be to concentrate your bets. Only time will tell if Pillar will be disruptive and make a dent in the highly competitive data storage business. You can bet that if it is, Pillar will be worth many multiples of Ellison’s investment. Estimates of Pillar’s intrinsic value could be in the billions. Yet since value depends on future cash flows, no precise estimate of value can be made. Only a future transaction between knowledgeable buyers and sellers will set a price for Pillar. High-growth companies such as Pillar are difficult to value because current performance is not a good indicator of value or risk. Larry Ellison’s wealth allows him to take big risks on a company like Pillar without betting the farm. Despite the difficulty of valuing innovations, they are crucial to top value builders, both private and public. Larger companies must avoid resting on their past successes and strive to produce a steady stream of innovative products and services. “Lacking this can lead us into what has been called ‘commodity hell.’ Continuing with tired products usually prevents us from earning the margins we need from our customers, and performing at an exceptional level” 8

PUBLIC COMPANIES ARE DISADVANTAGED IN RESEARCH AND DEVELOPMENT Private equity and venture capital have many clear advantages over their public peers. Only a few public companies like 3M have managed to overcome these structural disadvantages and remain innovative for decades: Size and bureaucratic culture usually kill the entrepreneurial spirit. • The “not invented here” syndrome closes many public companies to new ideas. •

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Accounting treatment and quarterly focus on earnings per share cause public companies to treat R&D as an expense, not the investment in the future that it surely represents. • Current risk management approaches encourage large companies to outsource innovation. • Acquisitions are difficult; over 50 percent of corporate acquisitions do not provide value. • Smaller and more agile are the province of private equity, including venture capital. •

Because of the pressure on quarterly earnings, many public companies isolate their experiments and innovation through smaller independent companies or start their own venture capital funds. Public corporations are among the largest sources of strategic buyers for venture capital-funded enterprises. However, when the venture is sold to a public parent, the entrepreneur often takes a huge payday and departs rather than staying with the public company.

EXPERIMENTS HELPED WELLS FARGO COMPETE IN A CONSOLIDATING INDUSTRY Few would think of a major bank as a laboratory for exploration of high-risk strategies. However, take a strong CEO, a single-minded focus on increasing stockholder value, and an ever-changing market for financial services, and you have the right recipe. CEO Carl Reichardt sharpened his business tools while running a real estate advisory and lending subsidiary of Wells Fargo Bank’s holding company. When running this small company in a dynamic market, he placed a premium on having an organization that could move quickly and flexibly in virtually any direction. He then went from running a unit with a few dozen employees to running a bank with thousands of employees. He never let go of the vision of having flexibility and the ability to change quickly to adapt to external conditions. “Everything is for sale,” he would say, determined that the balance sheet would not become hostage to any of the bank’s product lines or businesses.

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Many of the employees lived in fear. What would happen to their jobs if the CEO was not committed to remaining in their business? Two answers arose, one from anxiety and one from optimism. The anxious chose to think that the CEO’s lack of “commitment” to their business or product line would put their business into a death spiral from which it could never recover. The optimistic, on the other hand, concluded that the CEO was giving each business unit the opportunity to take the right risks and prove its value to the overall business. This attitudinal format gave Wells Fargo a great opportunity to experiment with various businesses. Financial markets are notably cyclical. Products and services flourish and play their role on the world’s stage. Some of them become a permanent part of the landscape, and others fade away. The strongest players in the banking markets are the institutions that are able to recover capital from the operations that are being dropped and to redirect it into growing markets and products. A notable example was the cycle of corporate banking. In the early 1980s margins were declining as the public markets were beginning to displace the banks as the lenders of choice. It appeared that the business of corporate banking was on an inevitable decline. Given the quick decision process at the top, anxiety began to fill the hallways about the fate of corporate banking. Would it be cannibalized to support other options that the bank had for the future? While the coin was still in the air, a change occurred in the market for domestic bank loans. The growth of investment banking boutiques focusing on leveraged buyouts of public companies rejuvenated loan demand, providing real profit opportunities for banks that were prepared to play. Wells Fargo could play in this arena under the right management. With characteristic speed, Reichardt got behind the effort, made changes in the management of the corporate banking effort, and challenged the group to build a portfolio of leveraged buyouts. More active than most banks its size, Wells pushed into the corporate banking markets and became a serious player. Profitability of the group was high and represented a mainstay of overall bank profits in the late 1980s during the first private equity and LBO boom.

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At the end of the 1980s, the clouds began to build up in the bank market. Stockholders and analysts turned negative on banks that carried large portfolios of “highly leveraged transactions.” Committed always to the future, the CEO looked at the big picture and decided that the time had come to promote other aspects of the bank to its analysts and to minimize the thrust of corporate banking in the future. In many companies this would be more than a tough decision. For several years the group had been producing over 25 percent of the bank’s total net income. Rather than dwell on the past and wish for a continuation of a strong corporate banking market that all could see was entering a period of severe decline, management’s decision was to downsize the activity. The experiment had been an enormously profitable success, but its time was over. Public companies are known for their ability to grow by adding new products and business units. However, only a limited few find ways to make a clean break with products and business units when their capital can be used better elsewhere. This skill is far more concentrated in the world of private equity. The Wells Fargo experience shows that even in an industry known for its inflexibility, the right management can employ the techniques of top value builders. By contrast, it took a subprime crisis and a new CEO for Citibank to begin a review of its broad portfolio of business units.

PEOPLE DON’T KNOW WHAT THEY WILL BUY UNTIL THEY SEE IT While snow skiing in the early 1970s, Bill recognized the value of quality stereo music in the outdoors. As an engineer and entrepreneur, he loved to tinker with the stereo equipment of the time. After some experimentation with headphones and car cassette players of the time, he applied for a patent on a below-the-ear stereo that overcame the isolation and safety problems of headphones. This was years before Sony introduced the Walkman in 1980 and decades before the iPod. Experts at Magnavox and North American Phillips liked the stereo sound it produced and the patented technology but turned the concept and the idea down. Like many young aggressive entrepreneurs, Bill persisted and got the product into production by

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partnering with a direct mail promoter. Bill traveled to Hong Kong over the July 4 holiday in 1979 to finalize the design. The product was featured in November 1979 mail order catalogs and millions of pages of print advertising in airline and other magazines. Shipments began in time for Christmas. It was a hit at the January 1980 Consumer Electronics Show—the same show at which Sony introduced the Walkman. About 200,000 units were sold in the first 18 months. It was an immediate and profitable but short-term success. Bill learned firsthand that macroeconomics matter, because in 1980–1981, the economy hit a double dip recession, as 20 percent interest rates shut off the “open to buy” at major retailers. For well over 25 years global manufacturing has been accessible to everyone. Only in the last decade have people really discovered the benefits of global trade and outsourcing. Yet the disadvantages and safety issues of headphones which are apparent today remain unsettled. Ultimately, limited distribution and demonstration in combination with cheap copies of the Sony Walkman destroyed the market for this innovative but unbranded product. Over 30 years after Bill’s personal discovery of the value of portable stereo outdoors, millions of everyday people are seen wearing stereo headphones everywhere yet the safety problem remains unsolved. Later in the late 1980s, as a consulting partner with public accounting giant Ernst & Young, Bill was an early user of $1,000 Motorola brick-sized cell phones and $900 home faxes. He used technology to better serve his clients and boost his personal 24/7 productivity. He saw the benefits and personal productivity enhancements long before his fellow partners. Fellow partners would comment in the mid-to-late 1980s: “I would not want one of those ‘cell phones’ because they would disturb my quiet time.” Well, the value of the productivity enhancement and convenience apparently far outweighs the negative value of the intrusion, as cell phones and laptops (which quickly replaced fax machines) are now in widespread use. Personal productivity of professionals has skyrocketed. Deregulation of the airwaves made the cell phone boom possible, and scale made huge reductions in price and size possible. Few would have thought of these technology-based productivity gains 20 years ago. Despite inflation, these products now sell for less than one-tenth of the price at which they entered the market.

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Twenty years ago, who would have believed that millions of people would be carrying cell phones with built-in cameras all over the world? Who would believe that anyone could access billions of pages of print through the Internet or on a cell phone? Who would believe that senior executives would be typing with both thumbs and text messaging their kids and coworkers during meetings and that the number of text messages would exceed the number of phone calls? Technology and innovation have changed many things in our everyday lives and will continue to do so. Top value builders see the unexpected future needs of people better than others do. They develop products and services that meet the wildest and most unexpected needs of people. The potential for huge wealth, venture capital, and low capital gains tax rates provide incentives for entrepreneurial people to innovate and experiment. There is a clear lesson to be learned from personal experience. Change takes time. Innovators experiment with wild unproven ideas. Working prototypes and experiments are needed to get market insights and feedback. Weak consumer signals are often the sign of huge untapped markets. Cost is always a factor. Most people do not always know what they want until they see it and use it. As a result, it is very difficult to project new product sales volumes and business values accurately. There is a wide range of possible outcomes. Innovators need incentives—such as low tax rates—to take the risk and invest in their ideas.

EXPERIMENT, BUT DON’T BET THE FARM Many of us can remember a 2000 Super Bowl commercial with a creative hand puppet of a dog: “Pets.com because pets don’t drive.” Pets.com was backed by Amazon.com and, despite an $82.5 million IPO in February 2000, it failed in only nine months, proving that creative advertising and money alone cannot launch a successful company.9 The late 1990s was the era of the superstar dot-coms and a boom in venture capital. Come up with an idea and a business plan, float a prospectus, and then ride on the tidal wave of investment that would come your way. Oh, yes, make money, sooner or later. But the important thing was to get the initial investment. Contrary to earlier eras, going public was not the last event in the

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arduous process of building a company. It was the opening act. Get the money first, and then prove the concept. This was an exciting time, particularly for those who were being backed to undertake these high-risk experiments. Unbridled optimism was the order of the day. Analysts were rationalizing that brick-and-mortar retailers would become a thing of the past. With the ability to order everything online, shopping would drop out of the culture, and the world’s distribution patterns would change— and it would happen quickly. Pets.com was a seemingly great idea, a national “virtual” pet store without physical stores could save money, but only if people would respond with huge dollar demand. A big splash with a Macy’s parade balloon and million-dollar Super Bowl commercial was the solution! The logic seemed to be to jump over the barriers to entry in the pet supplies market by achieving high sales volume right out of the box. If the members of the public just saw the wisdom of ordering pet food and supplies over the Internet, they could not help but become customers. Unfortunately, pets not only do not drive, but they do not buy high-margin jewelry either. So the average order size and shipping cost never made sense. The things people do not like to buy at stores and have to lug home are the bulky, heavy, low-margin products. The toys and accessories and high-margin items that make the pet food stores profitable are much more subject to impulse purchase, where immediate gratification for either the pet or the owner can be highly important. The war continued between physical retailers and virtual (Internet) retailers for a few years until it became clear that the real strategic advantage was held by the retailers who had physical distribution, some customer loyalty, and the Internet. If brick-andmortar retailers created an Internet presence of their business, it could be successful. Virtual companies like Pets.com ended up working against themselves, in effect, cherry-picking the unprofitable segments of the business. Many dot-coms like Pets.com filed for bankruptcy or were acquired by one of their brick-and-mortar competitors. As experiments go, betting the vast majority of the cash hoard on a single strategy like the success of one Super Bowl ad has

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enough to criticize. If it does not work, the company fails. With the same money, and perhaps with far less, one of the existing pet food chains could have created a more modest experiment with the same capability as Pets.com, and it could have been a success. This wisdom would have been lost on the originators of “Pets,” since they were after a quick kill and takeover of the industry. This may have seemed possible in the eyes of those who were true believers in, not only the new technology, but also the way customers would react. Looking back, it is difficult to believe how so many investors and corporate decision makers put themselves in a position where they had to have a marketing “near miracle” occur in order for the company to survive. The people effect on markets is the final arbiter of economic activities and can be a harsh task master. Finally, people change only when they can see the clear benefit in doing so. Change takes time and requires the investment of patient capital and skills typical of successful private equity and venture capital players. Hindsight is often 20-20. It may seem unfair, but digging deeper just a little before the Pets.com fiasco could have saved millions, even if the only finding was the wisdom of scaling down the size of the experiment. Many venture capital investments go bust. Hundreds of millions of dollars were pumped into dot-com dreams by wealthy individuals and venture capital funds during the dotcom bubble, and thousands of new high-tech jobs were created. Many venture capital funds were “under water” when the dot-com bust ushered in the recession of 2001–2002. The wise ones had portfolios that survived to participate in the great bull market that followed the bust. Despite the bust, many venture capital firms survived. Over $5.1 billion and $10.3 billion flowed into IPOs of venture capital-sponsored companies in 2006 and 2007, respectively, up from under $ 2.1 billion in 2002.10 Fed Experiments in 2007 Bet the Farm In early 2006, Ben Bernanke stepped into his job as Fed chairman at a time of an impending real estate bubble caused by five years of Alan Greenspan’s low interest rates and the aggressive lending policies promoted by bankers and Congress and magnified by high-commission mortgage brokers. In addition, the curtailment of capital gains taxes on housing, the ability of homebuyers to prepay

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loans without penalties, and changes in housing codes all pushed up prices and created an engine of home production that could not be shut down quickly.11 These were times the likes of which had rarely been seen before in the U.S. economy. Bernanke’s econometric models based on “arithmetic” ignored or understated the people effect of a credit crisis in an isolated sector—subprime. The models failed to take into account the growing impact of the interconnected global economy.12 This was combined with mixed signals on the economy, Dr. Bernanke’s lack of experience in communicating with the public, and his experimenting with a more consensus-building style of working with the Fed’s Open Market Committee (the FOMC). As a result of a mentality of “it’s not a crisis yet,” Bernanke’s Fed bet the success of the unproven “temporary auction facility (TAF)” experiment against the possibility of triggering a global recession. Turnaround experience suggests that during a crisis, committees hinder decision making and excellent decision-making and communication skills are critical. That is exactly what happened in late 2007, exacerbating the crisis. In an effort to offset the damage, the Fed eventually dropped the Fed funds rate target to 3 percent at its January 30, 2008, meeting. Unfortunately, it was too little, too late. The period when reduced rates could have helped to avert a recession had passed. The TAF was a new and unproven experiment to coax banks to borrow from the Fed and inject money into the banking system without the stigma of borrowing at the discount window. Many economists looked favorably at the “academic” but unprecedented experiment, but many thought it was experimenting with a growing global credit crunch “in the dark” and “cautioned that the Fed’s experiment at finding another way to inject cash into the banking system had not been tested.”13 Clearly this was a time for decisive leadership and not a time to experiment with unproven ideas. Only time will tell if the January 30, 2008, cut to 3 percent following the Fed’s previously slow response to the 2007 credit crunch mitigates the global recession. As this book went to press in late 2008, it was clear that the TAF experiment was not enough and the rate reductions were too little, too late. Even more dramatic programs were later put into place in an effort to stabilize the global economy as the Fed funds rate was dropped to near zero.

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BUSINESSES IN TRANSFORMATION BENEFIT FROM PRIVATE EQUITY EXPERIMENTATION Venture capital is the class of private equity designed for nursing new, emerging, previously unknown companies and concepts. Private equity also provides a haven for mature companies in need of transformation. Transformations are hard for the public markets to understand. Private equity takes companies private so that what the public markets might perceive as risky transformations can be made without regard to the impact on earnings per share during the quarterly earnings call. Transformations, designed to increase longterm sustainable value, typically depress short-term earnings per share, which could depress stock prices for years. Some examples of recent private equity player transformations include: KKR and its affiliates took First Data private in a mid-2007 transaction valued at $34 per share or about $29 billion. According to various reports, First Data had to make a significant investment to consolidate data centers for the future, so it went private. If done as a public company, the consolidation would have hurt short-term earnings and possibly the stock price, although management believed it would increase long-term intrinsic value.14 • TXU, a Texas utility, was taken private by a consortium of private equity funds including Texas Pacific, KKR, and Goldman Sachs in a $45 billion cash and debt transaction, making it the largest buyout of that time. The group paid about $69.25 per share, a 15.4 percent premium over the market price of February 23, 2007, the last business day before the agreement was struck. TXU management felt that the public market did not like management’s growth plans and thus discounted the stock price, making private equity an attractive alternative. As part of the buyout, the number of planned new coal-fired power plants was reduced from eleven to eight. No doubt this made the takeover more attractive to environmentalists. In addition, the new equity owners might be pleased to see the less profitable plants dropped from the plans.15 •

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Chrysler was in need of a dramatic makeover. Cerberus took on the tremendous task, as noted in prior chapters. The dramatic changes needed clearly would have depressed the earnings of its previous owner Daimler-Benz. Amid the global economic downturn, is a merger with General Motors or Nissan dramatic enough of a change after the admitted failure of the Daimler-Benz merger? Only time will tell.

Process innovations also require experimentation. Lean thinking concepts made popular by Toyota and others have been around for well over 20 years. Everyone would agree that elimination of waste is a good idea. Yet waste still exists in many businesses and governmental activities. Apparently, despite our free-market economy, there is not enough incentive to change until there is a crisis. Public markets reward the most efficient producers like Toyota. Private equity clearly helps those like Chrysler in need of major transformations and change. Innovative improvements in supply chains take time. Boeing, the multibillion-dollar aircraft maker, made a variety of innovative but risky improvements in its supply chain, including relying on certain vendors as sole source for the 777 Dreamliner. When supply chain deliveries slowed in 2007 and 777 deliveries had to be moved back a quarter more than once, Boeing’s stock price was hit. CEOs don’t like to explain changes in projections to analysts, so they tend to be risk-averse when major changes are involved. Is it any wonder that certain CEOs look to private equity when major transformations are likely to affect short-term earnings per share? Private equity has the inventiveness to take the short-term risk in view of long-term value enhancements. Value-building strategy requires changing to meet customer needs and technological changes faster than ever before. Private equity is better suited to juggling the risks and overcoming the bumps in the road. These include both technological changes as well as product changes. Any CEO or board member will agree that it is difficult to introduce a new product that will cannibalize sales of existing products and hurt short-term quarterly earnings per share. On the other hand, venture capital and other private equity players that see the long-term value of change are there to take the risk.

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Experience gained in the LBO experiments of the 1980s created a new cadre of private equity players with experience in transforming companies. When conditions ripen and distressed companies are on sale, these private equity players typically have raised capital and are ready to pounce. Based on their experience, they look for attractive deals with big discounts like those that reappeared in later 2008. Successful private equity players are not afraid of companies that need dramatic changes to unlock value.

CORPORATE PORTFOLIOS SOMETIMES BECOME UNMANAGEABLE AS MARKETS CHANGE Motorola is in transition. In January 2008, activist investor Carl Icahn was chasing Motorola for a board seat with the intention of helping to unlock value. Although Icahn did win his bid for a board seat, he did settle a pending lawsuit in May 2007, as two executives recommended by Icahn, Keith A. Meister and William Hambrect, were elected as directors. After a four-year stint attempting to revive Motorola, Ed Zander stepped down as chairman and CEO in early 2008. Motorola has been spinning off divisions to find and focus on a core business for several years. In July 2004 Motorola spun off its $4.9 billion (sales) semiconductor division as Freescale Semiconductors. After nurturing that business for over 50 years, Motorola sold Freescale at a low point in the market for semiconductors. At the IPO Freescale’s market cap was only $6 billion, of which $4 billion went to Motorola. Only two years later private equity players took Freescale private for $16 billion. The deal paid shareholders $40 per share, better than a 25 percent premium to market price just days before the offer.16 Motorola experimented and grew the semiconductor division but could not concentrate on it enough to make it a sustainable economic contributor. The semiconductor business is technologically difficult, capital intensive, and cyclical. Motorola viewed it as a captive supplier and made the same errors as the auto industry made with the captive parts and finance companies. They viewed them as a source of product instead of as standalone profitable businesses. As outsourcing semiconductors became a lower-cost alternative to captive manufacturing, Motorola was saddled with

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a low-margin, capital-intensive business. As a public company, Motorola had no real incentive to spin off the semiconductor division, despite years of cyclical losses, as other divisions were doing very well and masked the semiconductor division’s problems. However, when competition took away the profitability of other divisions, Motorola had a new CEO with Carl Icahn beating on the door, and no choice. Freestyle had a brief history as a public company. Bidding between private equity companies drove up the buyout price. Private equity is showing it the way. Freescale still has a rocky road ahead since a sizable portion of Freescale’s sales are tied to the success of Motorola products. 17 Only time will tell if Freescale’s private equity owners, which include Blackstone, The Carlyle Group, and Texas Pacific Group are able to turn the 2006 experiment with a large traditionally cyclical business into a highreturn investment.18 As this book goes to press, it is likely that the initial private equity investment was significantly under water, as Motorola and Blackstone’s own stock have dropped significantly because of a growing fear of a prolonged recession. As a private equity portfolio company, Freescale will be out of the spotlight for now. However, as Blackstone has public shareholders who can vote with their feet, Blackstone’s public investors will be watching the performance of the major investments that Blackstone makes. Motorola enjoyed a huge success following the commercial launch of the cell phone in 1983. In the late 1980s and early 1990s Motorola developed Iridium, a multibillion-dollar international satellite phone venture. The innovative concept of a cell phone that could be used anywhere on earth sounded great, but because of high fixed costs and delays, the economics did not work. Iridium eventually went active in late 1998, but filed for bankruptcy in 1999, and litigation continued for over eight years. Fortunately, Motorola had organized the Iridium venture as a separate company, which it spun off in 1993, and took on international partners to finance the effort. Iridium was a great experiment that failed to become a successful business model. You have to give Motorola’s management credit for trying. The satellite system is still operating after the bankruptcy, as a private firm. Motorola’s Iridium experiment significantly damaged Motorola’s reputation and stock price,

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which has never again reached its peak of approximately $80 per share. Lawsuits and competition in the cell phone market took their toll. Lawsuits continued to look for deep pockets, and new product introductions were not as successful as others. Motorola’s attempt to isolate the risk of the new venture was successful, but only to a degree. Did the bold Iridium experiment distract Motorola’s management? Although management structured Iridium as a separate legal entity and obtained outside investors to mitigate the risk, that risk may have been too great for a public company to overcome. Research by strategy guru Richard Rumelt suggests that highly diversified companies do not earn returns as high as those of moderately diversified companies.19 As a result, private equity firms are motivated to find ways to unlock the value of highly diversified public multibusiness companies. They often see the parts worth more than the price pubic shareholders place on the whole company. While breakups are not a great innovation, private equity experiments in breaking up large companies like Tyco still continue.

WELL-MANAGED EXPERIMENTS PAY OFF In early 1988, Bell and Howell was a Fortune 500 company, recently taken private by the Robert L. Bass Group. The price had been bid up to about $800 million, supported by only 10 percent equity. In 1990 Bill White joined the company as chairman and CEO after many years of public company experience. By this time the equity had all but disappeared, and dramatic changes were needed to rebuild value. The efforts paid off, as the private equity investment was worth $1 billion by the mid-1990s. The private equity transformation and success was a result of the ability of management and its private equity owners to work together in ways that are nearly impossible in public companies. What worked was a series of experiments, some of which failed. For example, one business unit sold software to auto dealers. By changing the way it priced and marketed the product, the new management team was able to triple sales in one year. However, efforts to export the technique to other markets did not work out. Another business faced a do-or-die situation that required a $50 million

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capital equipment investment. It succeeded, but such a risk had to be managed extremely carefully. The underlying secret was in the way management and the private equity owners worked together on innovation and change: •

•

•

•

•

Management and the owners had the same goal: “Make the business more valuable.” This means constantly tracking the value of the business units of the company. Investment decisions were made quickly, with all the investors really involved in the conversation; this is impossible in a public company, given larger boards and committee processes. The funding of experiments could be continued or halted at each milestone. Failed experiments died quickly. In contrast, managers in many public companies seek full funding of projects up front and often delay or avoid revisiting individual project status with the board. They never “bet the farm.” They experimented carefully, measuring value along the way. Top value builders often encourage use of a disciplined systematic process such as Stage-Gate to control investments.20 “Being right” meant differentiating between good projects and bad at each step along the way. There was no fear of being wrong for having started a “bad” experiment. This factor alone costs public companies billions, as their decision makers rarely want to admit error.21

Top value builders never lose sight of their top priority— value. They understand and monitor the value of the individual business units of portfolio companies. Ultimately, judgments about value drive their strategies and actions. Billionaire hedge fund entrepreneur Eddie Lampert, chairman of Sears Holdings and owner of about 49.6 percent of its stock,22 faces some difficult questions about the value of his investment. In January 2008 after another top management change, analysts from Credit Suisse took an outside look at the value of the company and concluded that the stock, at $99 per share, was overvalued. Just as a private equity player would look at the parts, the outside independent analysts toted up ranges of intrinsic value in billions for seven parts of the

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business, netted out the debt owed, and arrived at a range of stock value as follows: • • • • • • • • • •

Retail stores. . . . . . . . . . . . . . . . . . . . . . . . . . .$4.0 to $6.0 Home services. . . . . . . . . . . . . . . . . . . . . . . . .$1.0 to $1.5 Sears Canada. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$2.14 Lands End. . . . . . . . . . . . . . . . . . . . . . . . . . . .$1.0 to $2.0 Other segments. . . . . . . . . . . . . . . . . . . . . . . .$1.2 to $2.1 Total estimated value. . . . . . . . . . . . . . . .$9.34 to $13.74 Less net debt. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$2.78 Implied market cap. . . . . . . . . . . . . . . . .$6.56 to $10.96 Divided by number of shares. . . . . . . . . . .0.139 billion Equals implied share price. . . . . . . . . . . . . . .$47 to $79

The share price had been propped up by a series of repurchases, but the cash and the income of Sears Holdings had both declined significantly in 2007. At the time of the analysis, the company needed more cash. In such a case, there is no convenient solution. Some say that value will only come from breaking up the business, but the estimated values of the pieces do not look favorable.23 The future for Sears Holdings will be interesting, but possibly painful for its largest owner. Major doses of innovation and experimentation are called for. No doubt Mr. Lampert has a plan, but he has not communicated his plan to the market very well. If Sears were private, the transformation would not receive such public scrutiny. From February 1, 2008, to September 30, 2008, Sears’ stock price traded in a wide range of $72 to $114 per share, and by November 1, after the October 2008 crash, it traded between $55 and $58 per share, confirming that the range of the prior Credit Suisse analysis may have been optimistic. Experiments and transformations are difficult for public markets to understand.24

PRIVATE EQUITY PLAYERS ARE FOCUSED AND GOOD AT SAYING NO Anyone in the workforce for more than a decade can confirm that the pace of change continues to accelerate. Many lament the high speed of change caused by e-mail, cell phones, and Blackberries. However, top value builders have generally accepted that learning

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to adapt to changing conditions provides the greatest business advantage. Companies confronted with the need to adapt to rapidly changing competitive environments are faced with a constant stream of strategic choices. Many of the choices will be lost by quick actions of competitors. New product launches, technological developments, regulatory changes, and contracts with dominant players in the industry all can take away options or make them fleeting at best. Bill White, former CEO of Bell & Howell, notes that one successful method private equity players use to stay focused on strategic alternatives is to say no. By this he means that companies are often faced with “either-or” alternatives. Companies that are sidetracked by such decisions lose out to those that move quickly in a focused direction. The important difference is that top value builders learn to say no more quickly, and they move on with the chosen alternative. This is not snap judgment, but reasoned judgment usually based on a three- to five-year value building plan. Having long-term value as a goal keeps management focused. A specific goal of long-term value helps refine the alternatives, enabling decisions to be made and applied within a tight time frame. Top value builders know what they are betting on and keep that focus.

SUMMARY AND CONCLUSIONS Experiments help decision makers learn to build wealth and reduce risk. Experimentation and innovation are critical to value building. Successful private equity players and other top value builders have a clear edge. They use a value-based portfolio approach to learn and experiment. Action experiments and innovation accelerate the learning process through experience and feedback. Because the economy and corporations are influenced by changing markets, the best digging may be obtained by taking an experimental step in the direction that may enhance returns and reduce risk. Top value builders never bet the farm. They stage their investments and say no to low-return projects. Successful private equity players have an edge over their public peers because they have the experience, knowledge, and freedom to experiment without the bureaucratic controls and quarterly

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earnings per share disclosures that are typical of larger public corporations. They promote and fund the experiments, innovations, and transitions with a better chance of focus and success. Without action, there is no learning. Without learning, wealth creation is nothing more than luck. Top value builders increase their luck by placing narrow bets in areas they have experience with. Luck and timing play a part. Luck is nice only while it is good. Let’s not forget that many wrong decisions are defensively attributed to bad luck. Venture capital is the version of private equity that specializes in early-stage experimental products and services as well as innovative business models. Successful private equity players experiment and encourage their portfolio companies to experiment. However, portfolio company management must accept coaching as part of the process and stay within the bounds of a mutually accepted plan designed to create value. Venture capital comes with a commitment to use human capital and advice from experienced and knowledgeable private equity players and their designated experts. Personal experience matters. Venture capital players who experiment gain ground-level experience in new industries and business models that the average businessperson would fail to understand. They experiment by putting capital at risk and coaching the management teams of the investee companies. They fund products that might cannibalize existing products. Thus, venture capital players gain new insights and understand how actions drive value in these new experimental and innovative areas. Without experimentation and learning from experience, companies eventually die. Successful private equity players and other value builders do experiment. They experiment and encourage innovation with people and capital. They are careful to watch their investments closely and provide coaching along the way. They invest a relatively small amount of initial capital in portfolio companies and monitor progress to avoid a complete loss. They rarely put the entire fund at risk. They continue to invest when projected returns are acceptable, and they maximize the value of learning per dollar invested. LBO experiments of the 1980s created a crop of executives who had experience in dealing with major business transformations. Many of them were able to form their own private equity funds as

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it became a more popular asset class in the early 2000s. They understand and monitor the value of all the parts of their portfolio. Value-building experiments are a critical tool of successful top value builders. Failing on small projects can be cheap tuition for a thoughtful company. “Failing cheap” can build valuable experience that allows for quick action in the future. “Failing expensive” is unacceptable. Rapid prototyping and controlling investment at each stage are examples of ways to accelerate product innovation in small steps and control investment. It is not surprising that private equity players have the discipline to say no. They find the right balance between experimenting and limiting risk.

NOTES 1. Michaela Platzer, “Patient Capital, How Venture Capital Investment Drives Revolutionary Medical Innovation,” National Venture Capital Association white paper, 2006. 2. National Venture Capital Association 2008 Predictions Survey, National Venture Capital Association PowerPoint presentation available at: http://www.nvca.org/. 3. “Venture Backed IPOs Exits Strengthen in 2007,” National Venture Capital Association white paper, 2007. See NCVA.org. 4. “Venture Impact: The Economic Importance of Venture Capital Backed Companies to the U.S. Economy,” 4th ed., National Venture Capital Association white paper, 2007, p. 10. 5. Ibid. 6. Doug Tatum, No Man’s Land: What to Do When Your Company Is Too Big to Be Small but Too Small to Be Big (New York: Penguin Group, 2007). 7. Tom Foremski, “Pillar Data Systems: Larry Ellison’s $150m Data Storage Company Emerges from Stealth Mode,” SiliconValleyWatcher, http://www.siliconvalleywatcher.com/mt/archives/2005/06/ pillar_larry_el.php. 8. “Avoiding Commodity Hell: How John Deere Is Driving Growth through Innovation,” Remarks by Robert W. Lane, chairman and chief executive officer, Deere & Company, Industrial Research Institute Annual Meeting, Rancho Mirage, California, May 7, 2007, available at http://www.deere.com/en_US/compinfo/speeches/2007/ 070507_lane.html accessed February 6, 2008. 9. See Kent German, “Top 10 Dot-Com Flops,” at http://www.cnet.com/ 4520-11136_1-6278387-1.html, accessed January 20, 2008. “The most

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12. 13. 14.

15.

16.

17.

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astounding thing about the dot-com boom was the obscene amount of money spent. Zealous venture capitalists fell over themselves to invest millions in start-ups; dot-coms blew millions on spectacular marketing campaigns; new college graduates became instant millionaires and rushed out to spend it; and companies with unproven business models executed massive IPOs with sky-high stock prices. We all know what eventually happened. Most of these start-ups died dramatic deaths.” “Venture Backed IPOs Exits Strengthen in 2007,” National Venture Capital Association, 2007, available at NCVA.org. Arthur B. Laffer, “Housing and the Wealth Effect,” Laffer Associates research paper, November 2, 2007. This paper analyzes the “wealth effect.” Many claims are made that declining housing prices inexorably lead to a drop in output and could push the economy into a recession. The analysis in the paper digs deeper to show that the link between housing wealth and output is ambiguous, with the outcome depending on whether the wealth effect is accompanied by a shift in demand or supply. The complete detail of the analysis is beyond the scope of this book. Once housing prices began to fall in 2006, they were not going to recover quickly because of the planning cycle on home building and the huge number of housing units in progress. The credit crunch came after housing prices had begun to fall and multiplied the impact. Roger Lowenstein, “The Education of Ben Bernanke,” The New York Times, January 20, 2008. “Federal Reserve Works with Other Central Banks to Deal with Credit Crunch,” Associated Press, December 12, 2007. NACD presentation and conversations with consultants. See http:// www.altassets.net/cgi_local/MasterPFP.cgi?doc=http://www .altassets.com/news/arc/2007/nz10758.php, accessed January 20, 2008. See http://www.businessweek.com/print/bwdaily/dnflash/ content/jun2007/db20070604_925609.htm, accessed on January 20, 2008. Adam Lashinsky, “Serious Business at Motorola,” Fortune CNNMoney.com, November 30, 2007. http://gowest.blogs.fortune .cnn.com/category/motorola/, accessed January 20, 2008. Michael Brush, “Shady Practices Shape Too Many IPOs,” Money Central, MSN, http://moneycentral.msn.com/content/P107021.asp, accessed on January 20, 2008.

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18. Adam Lashinsky, “What’s Ailing Blackstone?” Go West (blog), July 20, 2007, at http://gowest.blogs.fortune.cnn.com/category/ blackstone/, visited on 1-20-08. 19. Dan P. Lovallo and Lenny T. Mendonca, “The Strategy’s Strategist: An interview with Richard Rumelt,” The McKinsey Quarterly, McKinsey and Company, November 2007. www.mckinseyquarterly.com/article_print.aspx?L2-21&L3-37& ar2039, accessed on January 17, 2008. 20. See details of Stage-Gate at www.stage-gate.com. 21. Interview with Bill White, former CEO of Bell & Howell, January 29, 2008. William J. White is currently a professor at the McCormick School of Engineering and Applied Science at Northwestern University. Prior to joining Northwestern, White served as chairman and CEO of Bell & Howell and as a senior executive at Mead Corp. and other public companies. He has been a member of the board of directors of seven publicly traded companies. 22. Sears Holdings Form DEF-14A, dated March 26, 2008, filed with the SEC. 23. Monee Fields-White, “Lampert’s Last Stand: Shrinking Cash Stash Forces Sears Boss’s Hand on Asset Sales,” Crain’s Chicago Business, January 28, 2008, vol. 31, no. 4, pp. 1 and 8. 24. Data source, Morningstar.com, accessed October 30, 2008.

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CHAPTER 10

Summary and Conclusions Insight and Action Give Private Equity the Edge

“O

ur offer is fair. Your shareholders will receive a 15 percent premium over the recent market price. We did our homework. We don’t make offers without digging deep into the intrinsic value, risks, and potential value of businesses. We have the right people and incentives to make a difference in your company.” The senior private equity partner summarized his presentation to the public company board and continued: “You are currently limited by the public markets’ preoccupation with quarterly EPS. In running a private company, management will be able to make the changes that your public board has been reluctant to make and control the risks in ways that it has been unwilling to do. As you know, these changes will depress quarterly earnings for a year or two and could have a negative impact on your stock price if you remained public. “We have the capital and are prepared to act quickly. We have built a reputation of integrity and value creation in our six funds over the last 15 years. We have a place for you on our team. If you buy into our value-building focus, you will have an opportunity to become wealthy. Interest rates are low, so we need to act now. We would like your answer in two weeks.” Successful private equity players have a clear edge, but others can learn from their example. Highly motivated and focused people are a clear—if not the leading—component of the private equity 319

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edge. Communicating the goal of building value focuses everyone on increasing wealth by increasing the size of the pie. It is difficult to motivate people to divide a stagnating or shrinking pie. There are many examples of public companies that have found the value edge. Any organization—public, private, nonprofit, or political— can improve value and wealth by finding ways to dig deeper and act sooner as it develops better knowledge of the alternatives. Successful private equity firms do not buy companies without digging deeper and acting smarter than other investors. They have the edge of knowledge and speed in any negotiation. Yes, top value builders make mistakes. However, on average, they make fewer mistakes than others, and they learn from them. Larger private equity players spend millions of dollars on due diligence to dig deeper before they act. The funds they manage typically specialize in a single asset class, such as distressed companies, midsized companies, technology, or new ventures. They have access to industry and other experts. For example, venture capital players do not fall for the first inventor with a new idea. They have personal knowledge, and they dig through hundreds of business plans. When they find the right combination of ideas and people, they invest and build portfolio companies, based on plans designed to create long-term value. They retain the option of continuing to fund the plan or stopping funding based on the ability of the portfolio company to meet or exceed performance benchmarks. Value-building action requires integrity, preparation, and meaningful goals. Effective value builders set value creation (Chapter 1) as a primary goal and provide value-based incentives (Chapter 4) to experienced leaders to make it happen. They select top management players who are skilled in bringing about change. They understand the difference between stock prices and intrinsic value, and they focus on after-tax cash flows (Chapter 2). Imagine a sports team without a goal. Top value builders have the integrity to state their goals of building value and wealth clearly. They use experience and preparation. They engage small oversight boards of directors who have a deep understanding of both the changing mix of industry-specific competitive conditions and their own capabilities. This enables portfolio companies to take advantage of opportunities and produce value more consistently than their public peers. Public companies tend to serve too many

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masters, including analysts, activists, and more regulators than their private peers. As a result, their goals are often distorted by short-term EPS-speak and rarely motivate the rank and file. At the top of the house, effective value builders set specific value-oriented goals and engage people with incentives and skin in the game. These goals and incentives take into account the views of the most relevant outsiders, including customers, owners, creditors, citizens, voters, and employees. Listening and learning from experience are important value-building skills refined by top value builders, be they public or private. Building long-term shareholder value is not possible without careful attention to what the customer needs and wants (Chapter 7). Information and action working together are critical components of better decision making. Top value builders take action to get the information they need for decisions. They dig deeper to value alternative strategies. They quantify risk (Chapter 3), run scenarios (Chapter 5), understand market fundamentals (Chapter 8), and experiment (Chapter 9). Imagine a sports team that does not practice and develop alternative plays. Successful private equity players run scenarios to evaluate options and alternatives. Industry players who gain the slightest better insight from experience, experimentation, and analysis enhance their ability to act. This bias toward action gives them a clear edge. Data are not information. Effective value builders use their experience and better frameworks to recognize new risks and patterns emerging from the data (Chapter 3). They build on their experience and analysis to identify and use inflection points (Chapter 8) to build wealth. They innovate and experiment (Chapter 9) to build new competitive advantages that create value. People can be overwhelmed by data and undigested information. Top value builders use better frameworks to understand their markets (Chapter 8). They understand the numbers and the people effects. They use simple value-based incentives (Chapter 4) to focus everyone on factors that affect value, ignoring the noise. Data, action, and experiments accelerate learning processes. Effective value builders are in the market looking for new deals. Speed is important to learning and creating value (Chapter 6). A few months or even a few days can mean the difference between success and failure.

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Speedy change combined with a better fact base gives top value builders an edge. Successful value builders use feedback from their experience and actions to enhance their successes. They engage small effective boards in decision making. Having the knowledge and guts to change quickly requires experience, analysis, insight, an understanding of the risks, and an understanding of what builds intrinsic value. Timing matters. Anticipating inflection points helps successful private equity players build wealth and reduce risk (Chapter 8). The key to continued corporate and national success is engaging more people in continuous renewal (Chapter 7). The interconnected global economy is here. Top value builders avoid corporate inertia by making better decisions and applying speed to the right actions to meet the dynamic needs of the interconnected global marketplace. They are not perfect forecasters, but they seem to recognize and respond to changes in the global market just a little bit better than many of their slower-moving public peers. It is not that most public company executives fail to understand the need for change; they just lack the passion for the degree of valueenhancing change embraced by top private equity players. Figure 10.1 compares how three different organization classes differ in their approaches to building value and wealth. All Private Equity and Top Public Value Builders

Public Companies Not Highly Focused on Building Value

Governmental, Nonprofit, and Other

Value-Building Analytics ➢ Goals

Clearly focused on value and cash flow

Confused by multiple agendas (short-term results, green issues, etc.)

Mixed: different ideologies causing conflict on goals

➢ Identifying value

Intrinsic-value measures and hard transactions. Heavy focus on customer value

Weaker accountingbased measures, e.g., quarterly earnings per share. Concern about “balancing” value for all stakeholders

No real metric other than GDP

➢ Cash flow orientation

Very strong focus on after-tax cash flow

Weak to moderate

Weak and highly focused on annual budgets

Figure 10.1 Different classes of value builders act differently

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➢ EBITDA focus

Pressure on management to meet EBITDA targets

Use of GAAP measures, earnings per share growth, and price/earnings ratios

None or mixed metrics

➢ Cost of capital awareness

High awareness throughout the organization

Mixed awareness throughout the organization

Not well understood or shared

➢ Source of capital

Institutional and individual capital, privately placed, with incentives to invest wisely

Public markets, with fiduciary responsibility to stockholders and creditors

Taxation, with other forms not well understood Borrowing

➢ Leverage

High

Limited

Great concern over national debt levels

➢ Risk taking

Aggressive, with use of scenarios and risk control

Muted

Little to none

Right People and Incentives ➢ People resources to dig deeper

High investment in due diligence, funded by high management fees

Limited resources available to outside directors, except in crisis

Deep pockets in government, without focus

➢ Outside experts

High use

Occasional, only when desperate

High use

➢ Governance

Direct, by owners who have high personal stake in outcomes

Indirect, through representatives of owners, where director risk is litigation, not loss of personal value

Indirect, through elections and promises to electors

➢ Incentives

Strong value-oriented incentives

Erratic accountingor stock-oriented incentives

No incentives for keeping promises

Speed of Change ➢ Quick action

Bias toward action

Prove first, act later mentality

Change impeded by politics

➢ Acquire/divest balance

Balanced approach, value-oriented decisions

Bias toward acquisition; divestiture seen as failure

N/A

➢ Reorganization for value

No hesitation

Only when desperate

Political, defensive, and crisis only

Figure 10.1 (Continued)

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organizations can clearly learn from the private equity model. Some will gain the edge that private equity has found. Every organization is a combination of various elements at different times.

CAN YOUR ORGANIZATION BE A TOP VALUE BUILDER? In the preceding pages, we have shared a variety of stories based on our more than 100 years of collective experience, summarized leading-edge research from a variety of sources, and shared interviews and comments with top value builders from private equity, public companies, and government. Building shareholder value is a fundamental basis of corporate business. Yet it has become the target of many who see only the negatives. We trust our readers will not be confused by people who reject value building by linking it to the darker side of terms such as outsourcing and headcount reductions and asserting that it requires cutting back on quality. Building intrinsic value is much more positive than that. Without a robust corporate community committed to building value, the wealth of our nation would fade. We live in an interconnected global economy. Competing in that economy requires constant value-creating change. All management teams must take this fact into account when seeking to build value in their companies. Top value builders are committed to the future and are leading the way. Top value builders create value and wealth by digging deeper so that they can understand, communicate, and act sooner to get the people effect right on three levels: 1. How you position yourself to accommodate macroeconomic and industry changes; 2. How you empower and align people inside your organization to produce value; and 3. How your people engage customers and suppliers in the value chain In addition, we have shown that understanding macroeconomics is far more important in building corporate value and enhancing investment performance than most people think. For

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example, better metrics tied to fundamental economic principles do make a difference. Timing of investments and knowledge of market cycles matter. Industries and asset classes go in and out of favor. In this economic context, the activities of private equity firms add a diversity of opinion on value and a willingness to convert the opinions to action. Their presence boosts the efficiency of capital markets, providing needed financing and operating alternatives to the public markets. Any organization can be improved by applying the personal experiences gained from digging deeper and acting sooner. Thoughtful action, mixed with an understanding of economics, risk, and how people respond to incentives, builds wealth. Adding to personal experience are personal integrity and intuition. If it doesn’t feel right, dig deeper. Intuition—if based on experience— usually provides good signals for successful value builders. Integrity is a necessary condition for long-term value creation. A culture with a passion for value building with integrity, blended with the right combination of experimentation and effective incentives, accustomed to thinking through risk with scenarios, and committed to continuous renewal will lead to a more agile and productive organization. The result is an organization with a greater chance of building value and wealth. All the best to those who adopt the challenge of value-building change. Join us at www.TopValueBuilders.com for more examples and ideas.

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APPENDIX 1

The Health and Wealth of Our Nation in 2007 (With an Occasional Peek Ahead)

T

op value builders learn from their personal successes and failures. They chart a course that takes advantage of market and macroeconomic changes. They understand trends and inflection points in the markets that they serve. Over the last 25 years, the incentives provided by lower marginal tax rates and free-market capitalism have resulted in both U.S. and global economic growth and prosperity. Some call this “the greatest story never told.” Certainly our glass is more than half full. Our prosperity runs over and helps spread the power of democracy and free markets throughout the interconnected world around us!1

NATIONAL HEALTH AND WEALTH DRIVERS ARE BROAD BASED From reading the newspapers, one might believe that our economy and our world are doomed. As you examine the following data, we encourage you to make notes on the mosaic of charts in this appendix. Consider the charts and their trends, the result of changing the controls of the economic cockpit. Identify the macroeconomic factors that have affected the long-term value of your business and industry. Links to a variety of sources are provided at www.TopValueBuilders.com for those who wish to dig deeper. 327

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The Health and Wealth of Our Nation in 2007

Despite the many bumps on the road to economic prosperity, we as a nation have accumulated an abundance of human, intellectual, physical, and financial capital never before seen in the history of our world. If we make the right decisions, we should continue to prosper in the years ahead. Yet mistakes can be made if we do not learn from the data. This appendix provides a graphic overview of our country’s economic progress over the past half century. Wealth and wellbeing are defined differently by every individual, so we begin with a broad variety of issues that are more appropriately designated as social, political, and international. Any member of the baby-boom generation can attest that America has changed a lot over the last 50 years. The point we want to make is that in our lifetime, we have never seen an economy that comes even close to the current U.S. economy. While the United States is not perfect, our system is the closest thing to it that this planet has ever created, despite the periodic booms and busts. We share our wealth. The United States has been a clear leader in creating a global interconnected economy that benefits millions of people beyond our borders. We can learn from the key economic policy changes—both good and bad—that have occurred during the last half century and their consequences. On the soft side, there have been huge advances. Take a look at Figure A1.1 and some examples. Life expectancy is up more than eight years since 1950 (Figure A1.1a). Pollution is way down (Figure A1.1b). Even racial harmony has taken a turn for the better, with the disparity in median incomes declining significantly (Figure A1.1c). The Misery Index is down dramatically from its peak in 1980 (Figure A1.1d) as a result of decreases in both of its components: unemployment (Figure A1.1e) and inflation (Figure A1.1f). While the United States is not perfect, the vast majority of our people have more opportunity and a higher living standard than any other people on earth. We are still a “go-to” economy, but we have more global competition than ever before. The world is a dangerous place. In the United States alone, over 40,000 people die and over 3 million people are injured on the highways each year, and over 16,000 people are murdered.2 Globally, however, despite the dangers, huge positive changes have come to pass. When we were young, people built bomb shelters,

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and we all feared a Soviet nuclear attack that could wipe out life on earth. We won the Cold War without the long-feared nuclear holocaust. As bad as terrorists and the remains of the evil empire are today, they still are no match for the Soviet Union. We’ve never been safer as a nation, but we live in a world of risk and uncertainty. Fortunately, our national wealth enables us to serve—in part—as protectors of the more defenseless nations. We helped former enemies Japan and Germany become economic miracles. We provide economic and military aid to countless others in the name of spreading democracy and free-market capitalism throughout the world. Despite the major conflicts and wars that have scarred the decades along the way, we ended the draft. We have a volunteer army that is ready to defend our nation and the defenseless. Currently U.S. defense spending is averaging less than 5 percent of annual GDP, down from 16 percent in the 1950s and 12 percent in the 1960s.3 Surely this is hard to believe in the context of today’s headlines and TV commentators. Even little things, like smoking and driving under the influence, have been on a long downhill slide. Crime and teenage pregnancies are receding, but obesity is up. Homicides in New York City reached a 40-year low of 488 in 2007. Yes, it is true, things could be a lot better, but they rarely have been. Let’s get back to economics with some trends and hard data. While we are spreading the word about the economic miracle of free markets around the globe, we must remember that a freemarket economy forces creative destruction. The process produces both winners and losers. Top value builders understand the trends that can make a difference. Top value builders may make mistakes, but overall they are more often winners than losers in the interconnected global economy.

THE FOUR GRAND PARTITIONS OF MACROECONOMICS AFFECT ALL BUSINESSES Few businesses grow and create value in unfavorable economic and political environments. The world of political economics comprises four all-inclusive grand partitions: fiscal policy, monetary policy, trade policy, and incomes policies. When all four categories are

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favorable, we see dramatic increases in business value as well as the creation of personal and national wealth. When one of the four categories is poorly managed, values decline and wealth is destroyed. Fiscal policy encompasses government spending and taxation. • Monetary policy focuses on Federal Reserve policies related to the money supply, prices, and interest rates. • Trade policy affects imports and exports through tariffs, quotas, and other impediments to the free flow of goods and services across national boundaries. • Incomes policies are the regulations, restrictions, and requirements that affect income distribution, such as minimum wage laws, wage and price controls, and transfer payments (Social Security). •

There is some overlap and ambiguity when it comes to which policy goes in which category, but the broad boundaries are understandable. Policies in these areas are crucial to the wealth, health, and welfare of our nation. We have learned a great deal from the ups and downs of the last century. If the policymakers get all these areas mostly right, the national wealth grows. If one goes wrong, bad things can happen to the economy and the national wealth, as the peaks and valleys of Figures A1.2 through A1.9 demonstrate.

FISCAL POLICY HAS A NEW SUPPLY-SIDE FRAMEWORK EMBRACED BY VALUE BUILDERS The first great kingdom of macroeconomic policy is fiscal policy.4 Federal and state government spending and taxing set the stage for national growth or decline. In this area, the conceptual framework of how fiscal policy works has been turned upside down since the early to mid-twentieth century. A graphic history of the mountains and valleys of tax rate increases and decreases is shown in Figure A1.2. We certainly have experimented with different approaches to federal income taxation! Some of the key results of tax rate changes are shown in Figure A1.3 and the figures that follow.

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A revolution has occurred in economics. The economics of John Maynard Keynes, preoccupied with stimulating demand and relying on heavily progressive taxes, came to dominate public policy from the 1930s through the presidency of Jimmy Carter (1977–1981). Beginning with Ronald Reagan’s presidency (1981– 1989), Keynesian economics was turned on its head, and a total change in policy was the order of the day.5 Despite the great resistance to policy change discussed in Chapter 2, the United States moved toward supply-side economics, the economics based on incentives. Despite decades of success based on supply-side economic policies, debates continue today as devotees of Keynesian policies seek to reestablish their former dominance. Both Keynesians and supply-siders agree that tax cuts can stimulate the economy, but with different logic. Keynesians couldn’t care less how taxes are cut, because for them the stimulation results from increased spending and demand. Supply-side economists seek cuts in marginal tax rates, thereby increasing the incentives to produce more. (With the right tax cuts, a dollar given back to a high-earning taxpayer is more likely to become a dollar of investment, increasing growth, production, jobs, and national wealth.) The supply-side prescription is for government to reduce spending and cut marginal tax rates to increase output, stabilize exchange rates, and tie money growth to a price rule. As we will see in Appendix 2, the debate over the choice between taxing the “rich” and taxing the “working poor” continues. What is clear is that the proportion of households paying federal income tax has declined significantly as our economy has grown. In business, we have the same contrast at the margin. Acrossthe-board price cuts may reduce revenues from existing customers but attract new customers. Volume rebates and quantity discounts are much better, as they both attract new customers and encourage existing customers to purchase more. Simple arithmetic is not enough. Productivity Drives Value and Wealth Figure Al.3 helps illustrate just how healthy and competitive the U.S. economy truly is. In terms of our share of the planet’s production, we are still doing fine. Our economy is getting bigger (and

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better) relative to our OECD peers (Figure A1.3a). Although we seem to be losing ground to some of our lower tax rate competitor nations, the U.S. economy is the only developed economy that is also a long-term growth economy. Even when it comes to the rudimentary premises of free-market pro-growth democratic capitalism, it doesn’t get any better than the United States. Figure A1.3b displays aggregate U.S. corporate profits—correctly calculated corporate economic profits—as a share of GDP. Despite many ups and downs, since 1983, they’ve never been higher. Private equity has helped the nation become more productive. Increased productivity is a result of changing processes in order to produce more efficiently. High marginal tax rates kill the drive to increase productivity and the incentive to change. It’s just not worth the effort. When the cuts in marginal and capital gains tax rates were introduced, there were great incentives to do so, and enormous changes occurred. Despite the job dislocation and the failure of less efficient businesses that have occurred along the way, there have been more people employed in the United States than in any previous time in our history. At the margin, people are working at rates unlike anything we saw in past decades (Figure A1.3c) and business productivity is up (Figure A1.3d). A small percentage change at the margin makes a huge difference in national income and wealth. If the political environment remains favorable (always a big “if”), fiscal policy can continue to allow our nation’s economic engine to run as it has, virtually unimpeded, since 1981. It doesn’t get any better. Unfortunately, the winds of change began blowing in 2008 as politicians reacted to the global economic crisis. Given the many adverse fiscal policies being employed and under further consideration, the trends on many of the charts are certain to change.

MONETARY POLICY ATTEMPTS TO KEEP INFLATION UNDER CONTROL As we explored in Chapter 8, the story of monetary policy is the story of wisdom lost, then reacquired. The prime purpose of monetary policy is to promote growth while stabilizing prices, thereby eliminating inflation. Just how monetary policy achieves this price

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stability is open to debate, but suffice it to say that inflation is basically too much money chasing too few goods. Inflation is everywhere and at all times a monetary and goods phenomenon. Stable prices require a continuous balance—repeat, a continuous balance—between the quantity of goods and the quantity of money. Figure A1.4a displays consumer price inflation, Figure A1.4c tracks the Dow Jones Commodity Index and the Fed funds rate, and Figure A1.4b shows the trend in the 10-year Treasury yield, which reflects inflation expectations. Just as a business needs access to capital, a stable monetary policy helps provide the liquidity an economy needs if it is to grow without causing either inflation or derailing growth. Control of inflation helps to stabilize interest rates, and interest rates set the price of capital. Just look at the positive trends since Volcker started using a “commoditybased” price rule around 1980. After World War II, the United States was one of a number of countries whose currency was based on a gold exchange standard under the Bretton Woods agreement of 1944, which also included the formation of the International Monetary Fund. The U.S. Treasury supported the price of gold at a fixed $35 per troy ounce, which kept the quantity of money in balance with the quantity of goods. The process was simple, automatic, and elegant. Bretton Woods’s two biggest shortcomings were, first, its assumption of each and every country’s “good intentions” to keep domestic inflation in check and, second, its assumption that gold was the right indicator of the general price level. Neither of these assumptions turned out to be as enduring as the creators of Bretton Woods had anticipated. As in corporate life, assumptions can be dangerous. Foreign governments routinely engaged in mischievous shenanigans with the international monetary system. By the late 1960s/early 1970s, the system had become irreparably damaged, and monetary policy devolved into a collection of unhinged paper currencies. From 1970 to 1980, we experienced the awesome destructive power of an international monetary system gone awry—a veritable monetary tsunami. Inflation became a global problem. Responsive monetary policy matters. Around 1980, Volcker returned to a price rule by tying monetary policy to commodity

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prices, bringing inflation under control (see Figure A1.4a).6 Stable money and Reagan’s lower tax rates produced more than 30 years of growth in the United States with only two recessions. Imbalances between the supply and demand functions for short-term and longterm credit show up in the yield curve. An inverted yield curve has been a near-term leading indicator of impending recession. Digging deeper reveals that an inverted yield curve is a result, not a cause, of recession. The yield curve spread (Figure A1.4d) is one way to track yield curve inversion. Experience shows that the trend in stock prices (Figure A1.4e) is a better predictor of recession than the yield curve. An even better indicator is capitalized economic profits (Figure A1.4f).

THE STOCK MARKET RESPONDS TO FAVORABLE ECONOMIC POLICIES Perhaps the purest expression of the effectiveness of the policies discussed up to this point is the performance of the stock market since 1983. Three factors play the greatest roles in equity performance: corporate profitability, tax rates (corporate and personal), and interest rates (the market’s discounting mechanism). Those factors are direct results of fiscal policy and monetary policy. Figure A1.5a plots the inflation-adjusted S&P 500 Index. The S&P 500 is the benchmark used for most equity investments and the one that is most often used by private equity investors to determine performance bonuses. The inflation-adjusted equity returns paint quite a picture of wealth and value creation. Note that in February of 1966, not too long after the Kennedy tax cuts, the Dow Jones Industrial Average peaked at 995. In August 1982, the Dow hit a low of 777. Now just think about that. The nominal value of the Dow went from 995 in 1966 to 777 in August 1982. Thus, over a period of a little more than 16 years, the Dow fell 22 percent in nominal terms, or at an average annual loss of 1.5 percent each and every year. Keeping in mind the high inflation of the period, and adjusting those nominal returns for inflation, you end up with a real loss of 74 percent in value and wealth from February 1966 to August 1982, or a compound annual loss of 7.9 percent per year In 1983, President Reagan’s tax cut finally took place. Once the bulk of the phased-in tax cuts was in place, the economy soared,

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and so did asset values. From the low point in August of 1982 (777) to the beginning of 2008 (13,262), the Dow Jones Industrial Average rose 1,607 percent, a compound annual growth rate of 11.85 percent, as a result of putting pro-growth, supply-side policies into action. That is a clear indication that marginal tax rates have an impact on value and wealth. Better models provide better signals. Over the years, Laffer Associates has refined better ways to capture the intrinsic value created by the economy. These overcome some of the problems of focusing only on S&P 500 GAAP earnings. Figure A1.5c displays Laffer Associates’ capitalized economic profits (CEP), described in Chapter 1, with buy and sell signals. Figures A1.5d and A1.5e show that the model is more accurate that either the Fed model or Tobin’s Q model.

TRADE POLICY AND THE IMPLICATIONS OF TRADE DEFICITS ARE NOT WELL UNDERSTOOD Trade policies today are unquestionably freer than they have been in decades, as shown in Figure A1.6. Back in the sixteenth, seventeenth, eighteenth, and even nineteenth centuries, tariffs provided the lion’s share of government revenues, and customs were a major government activity. Governments’ focus on trade peaked in 1930 when the United States imposed a huge set of tariffs on imported goods, collectively known as the Smoot-Hawley tariff. The pattern of stock market collapse as this tariff legislation wended its way through the U.S. House and Senate demonstrates beyond reasonable doubt the prescience of markets. What followed this massive government intervention against free trade were unintended consequences. Intervention and disruption of free trade produced the biggest stock market crash in history, a period of unimaginable economic contraction, wealth destruction, and ubiquitous misery called the Great Depression. The World War II era, which immediately followed the Great Depression, was also a period of highly restrictive trade policies, as enemy combatants were literally embargoed; i.e., all trade with them was stopped. Following World War II, there were many policies aimed at rebuilding the world’s economies, including

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massive foreign aid and freer trade, but trade was still far from free. It still astounds us that governments back then actually thought that capital controls would work and would improve economic health. President Reagan was exceptionally pro-free trade, successfully backing several major rounds of tariff reductions, but from time to time he did submit to the constant political pressure to impose one-time protectionist measures. President Reagan proposed NAFTA but was unsuccessful in winning Congress over to his view. President George H. W. Bush (41) continued President Reagan’s push to get NAFTA through Congress but was equally unsuccessful. The surprise was President Clinton. President Clinton went against his own party, defied the unions, and became the champion of NAFTA. He was able to bring enough Democrats on board to actually get NAFTA passed by Congress—no small feat. Following on the heels of President Clinton, President George W. Bush (43) redoubled America’s efforts to make global trade more free. He not only backed the Doha Round of tariff reductions but actually sponsored DR-CAFTA (the Dominican Republic–Central America Free Trade Agreement) and got it passed by the skin of its teeth. None of the prior presidents in the postwar era were completely consistent when it came to free trade,7 and President Bush, too, had some notable setbacks in the form of the Agricultural Bill, a Canadian lumber tariff, and steel tariffs. Thankfully, President Bush’s efforts and the efforts of most presidents in recent decades have, on balance, been toward free trade. The decline in the average level of tariffs on all U.S. imports going back to 1929 is shown in Figure A1.6a. Thanks to ever-declining duties and restrictions, trade in the United States has never been freer. The results of this move toward free trade have been impressive. Perhaps the best reflection of the benefits from freer trade is a simple plot of total U.S. trade (U.S. exports plus U.S. imports) as a share of U.S. GDP (Figure A1.6b). Just look at the large and growing share of the U.S. economy that trade represents today. It is absolutely spectacular. Over just the past 11 years, U.S. total trade with China as a share of U.S. GDP has risen from 0.8 percent to 2.8 percent! (Note how an apparently small number can have such a great impact.)

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INCOMES POLICIES ARE A REAL BURDEN BUT HAVE ABATED IN RECENT YEARS Incomes policies run the gamut from regulations, restrictions, and requirements to wage and price controls, national health-care plans, and other such initiatives. Today, incomes policies may not be at their all-time lowest levels, but they are very, very close to those lows. For perspective, one only has to look back to the economic restrictions under President Eisenhower and President Johnson or remember President Nixon’s and President Ford’s wage and price controls or President Carter’s gasoline rationing. It was all pretty shocking. President Reagan decontrolled oil and waged a war against excessive regulation. One of the most memorable events of our lifetime was when President Reagan fired the air traffic controllers. The television image of President Reagan dropping the Federal Register of Government Regulations said it all. With President George H. W. Bush (41), incomes policies made a small comeback, but President Clinton and President George W. Bush (43) fought a good fight. One of the best barometers of the progress that we’ve made is illustrated in a comparison of union membership (both private and public) as a share of the labor force (Figure A1.7a). Union membership—except in the public sector, where it has remained fairly level around 30 percent —is down significantly. The minimum wage is another seductive yet harmful concept with unintended consequences. Comparing the federal minimum wage as a percentage of total average hourly wages reveals that the relative minimum wage is at its lowest point since at least the late 1970s (Figure A1.7b). Relative benchmarks such as these really matter. Real progress has been made against government intervention in the labor market. Sarbanes-Oxley (SOX) regulation has imposed significant costs, but it has increased the transparency of American firms dramatically. With the right approach and attitude, companies can experience significant gains in effectiveness through the exercise of the Sarbanes-Oxley Section 404 controls. However, SOX did not prevent the abuses in the credit, finance, and investment banking sectors of the last few years. Regulation rarely can be considered a fix-all. As long as there are people to game the system, there will be

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abuses and fraud. When the cost of business fraud is measured in the billions, a significant deterrent may be cost-justified.8 While there is no single measure that fully captures the concept of incomes policies, Figures A1.7c, d, e, and f track trends in pages of regulations, work stoppages, regulatory employment, and regulatory spending. All have positive trends and demonstrate moves in the right direction.

OUR NATION’S WEALTH IS STRONG, UNLESS WE RUIN IT Despite this age of unprecedented economic performance, you would think the world was coming to an end if you relied on televised news stories, opinion polls, and politicians’ speeches. It is true that oil prices, housing prices (despite regional price declines in 2007), and commodity prices were at all-time highs, but they have come down as a result of market forces. Everything was rosy through 2006. However, now that the United States, Europe, Japan, China, and India are in cyclical decline and mortgage interest rates are higher, all of these prices are lower, and the world is a lot sadder. Global happiness and wealth have declined. When the world booms, resources become stretched, and relative price changes—not government regulators—tell markets what to produce and what to conserve. Please refer back to Figure A1.4c to see that it was during periods of economic expansion that commodity prices were high, and it was during contractions that commodity prices were low. The markets work if we let them! And yes, the latest empirical research suggests that every now and then, markets might need a tweak back to reality—a tweak, not a tsunami, of regulation is usually required. Wait too long and the problems grow quickly. When relative prices change because of artificial interdiction of markets, then there is a real problem. In 1974 with the Arab oil embargo, in 1981 after the Iran hostage crisis, and in 1991 with Desert Storm and the Iraqi oil embargoes, we had high oil prices—not because of natural market forces but because of state intervention. The oil market of 2008 was not your grandmother’s oil market. Oil prices and commodity prices were high because they should have been in a free-market economy that is growing and asking for more.

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Household debt has risen sharply in the past few years. This is what you would expect when mortgage rates and other household borrowing rates fall and real incomes rise. In addition, the debt service load relative to disposable income has also increased, evidence that the confidence of both households and lenders has increased. (See Figure A1.8a.) Does this level of debt put households at risk? It did. Our credit economy allows everyone to live better. Our property laws allow everyone to earn the right to credit. Compare the growth of our economy to that of economies that do not have property rights and available credit. We can borrow because of our nation’s respect for well-defined property rights. Take away credit as the credit crunch has done and wealth and value decline. The homeownership rate has been rising and is near an alltime high (Figure A1.8b). Mortgages as a percentage of household debt are also at all-time highs, and homeowners’ debt as a percentage of assets is also at an all-time high (Figure A1.8c and d) because of confidence in the future and more liberal lending policies. The subprime crisis of 2007 and an oversupply of homes will take time to resolve, but if the other segments of the economy remain strong, the housing market will eventually recover.

ABOUT THE DEFICIT—GET REAL! USE THE RIGHT METRIC! Any businessperson knows that too much is bad. However, debt is not bad if the proceeds are put to good uses that build future value. Successful companies increase their level of debt as they grow but ensure that the interest can be covered by future cash flow. Top value builders use debt to grow profitable businesses. It’s no different with the federal deficit. The real question is whether the debt was used reasonably. Earlier in this appendix, we discussed our international trade deficit, or, as it more accurately should be called, our international capital surplus. The reason we have such a huge trade deficit is because others want to hold their wealth in our country. Would you really rather have people not wanting to invest in America? We don’t think so. To reiterate, the only way foreigners can acquire U.S. assets net is to generate a dollar net cash flow by buying less of our

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goods and selling more goods to us. The U.S. trade deficit and the U.S. capital surplus are one and the same. Trying to get rid of the trade deficit is an unworkable idea. It makes no more sense than trying to get rid of illegal and legal immigrants or trying to stop outsourcing. High-quality workers who are willing to work at low cost are simply good for America, and so are high-quality, low-cost products from abroad. Despite the conventional wisdom, outsourcing, immigration, and imports are the lifeblood of a prosperous America as well as being good for the global economy. We are spreading wealth around the world and doing it with trade, not handouts. We are raising the standard of living of millions throughout the world, and we all benefit. A final point to touch on is the old saw of budget deficits. Most corporate executives agree that companies need capital to finance growth. The U.S. economy is no different. Look at the U.S. budget deficit and the resulting national debt, both as a share of GDP, and you can quickly see that through 2007 they were far from their highs in both recent and historical terms. In 2007, the federal budget deficit was $306 billion, or 2.2 percent of annualized GDP in 3Q2007. (See Figure A1.9a.) In the wake of the September 11, 2001, attacks on the World Trade Center and the Pentagon and the recession of 2001–2002, the deficit rose dramatically as a percent of GDP, reaching 4.6 percent of GDP in 3Q2003 (the highest level since 1Q1993). From then through 2007, the deficit has generally declined as a percent of GDP. However, the deficit will be growing from the 2007 level as a result of the various government “bailout” programs intended to restore confidence and growth. As you can see, the level in 2007 was well below other periods over the last 30 years. Yet far too many politicians of both parties do not understand this concept. They warn of impending danger, report “record” budget deficits in nominal (not real) dollars, and fail to comment on the deficit’s true relation to GDP. They appeal to fear in the voting public, increase risk, and reduce potential wealth.9 The gross federal debt held by the public reached $4.8 trillion, or 36.6 percent of GDP in 2007 (Figure A1.9b). Now let us run a worst-case scenario. Assume that over the coming 10 years our economy experiences the same rate of nominal GDP growth that it did over the past 10 years, an average annual rate of 5.3 percent. So why the doom and gloom?

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But even the metric of debt as a share of GDP overstates the problem. It is not the amount of debt that matters (or the deficit, by the way), but the cost of that debt relative to income and why the deficit was incurred. Just as some corporations have unfunded liabilities that do not show up on their balance sheet, the U.S. government has unfunded liabilities for future payments, such as social security and Medicare. These represent a hidden part of the deficit. Looking at the historical series of U.S. gross debt held by the public and assuming that the debt at each moment in time costs the government the 10-year T-note yield at that time gives a sort of steady-state budget cost of that debt. When this cost is plotted as a percentage of GDP (or even government spending), you can quickly see that despite defense spending on two wars, it was declining rapidly until recently (Figure A1.9c). Does this look as if we had a serious government debt problem in 2007? No. It is amazing how some people can distort the facts. When you dig deeper into the fundamentals and relative measures, you get a very different picture. But now let us end this best-of-all-possible-worlds story with a sobering note: what government macroeconomic policies give, bad policies and bad decisions can take away. Deficits sometimes do matter in a big way, depending on why the deficit is incurred. Incurring a deficit to defend against a military attack or to maintain the nation’s infrastructure may be productive reasons that well justify the undertaking. However, incurring a deficit to fund transfer payments saddles the economy with debt with no offsetting boost in future output and no wealth creation. This is the problem that the government has been recently creating in its pursuit of various stimulus programs that are nothing more than transfer payments. A corporate corollary is spending money decorating the corporate jet or other projects that produce no future cash flows. The reason the United States has been prosperous for the 25 years through 2007 is simply our pro-growth economic policies, including restrained government spending, low rate flat(ter) taxes, sound money, limited regulations, free trade, and open borders. Reverse these policies, and we will quickly experience the dark side of supply-side macroeconomics. Over the last 100 years, there were several periods during which we could have lost our entire

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democratic system to communism. Strong national defense and the right supply-side economic incentives allowed our free enterprise system to prevail. While free markets work better than anything else on this earth, they certainly are not perfect. In general, there will always be more winners than losers in a free-market capitalist economy. The last half century of economic history proves that it is possible to make bad decisions, based on faulty or weak frameworks and data. Many have followed the wrong path to ruin. Top value builders dig deeper to understand the fundamental drivers of their businesses and the economy to make better decisions.

(a) Life expectancy chart (life expectancy at birth) Source: Center for Disease Control.

(b) Violation of air quality standards (percent of days in violation of federal standards, Los Angeles, South Coast Air Basin) Source: South Coast Air Quality Management District.

(c) Ratio of black to white median incomes (annual) Source: U.S. Census Bureau.

(d) Misery Index: inflation plus unemployment (U.S. inflation is year over year, monthly) Source: FRED®.

(e) Unemployment Source: Federal Reserve: FRED®.

(f) Inflation Source: Federal Reserve: FRED®.

FIGURE A1.1 Nonfinancial indicators suggest that we are making

progress Comments: Life in the United States has improved tremendously on many fronts. Life expectancy (a) continues to increase (see www.cdc.gov). Air and water pollution (b) in major cities is down. Interracial income disparities (c) have steadily declined. The Misery Index (d), which combines unemployment and inflation rates, has dropped significantly from its peak in the early 1980s. A low unemployment rate (e) is a key economic driver. While there have been cyclical upticks in unemployment, it has declined broadly since the early 1980s. Providing incentives for putting people to work is critical to economic growth and political stabilitly. Inflation (f) also peaked in the early 1980s. Diligence by the Fed has contained inflation since that period.

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(a) Personal income tax: top marginal rates

(b) Corporate income tax: top marginal rates

(c) Capital gains tax: top marginal rates on long-term gains

(d) Estate tax: top marginal rates at death Source: IRS.

FIGURE A1.2 Lower federal tax rates provide incentives Comments: Significant cuts in marginal tax rates create high incentives in the economy. The recent era of prosperity was triggered by the Reagan tax cuts, which went completely into effect in 1983. Top personal tax rates (a) were dropped by the Reagan, Clinton, and G. W. Bush administrations. Corporate tax rates (b) were cut during the Reagan administration, boosting corporate profits ever since. Cuts in taxes on capital gains (c) have improved the investment climate and built stronger corporations. Cuts in marginal tax rates on estates (d) have benefited family businesses and farms.

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(a) U.S. GDP as a percentage of total OECD GDP (annual through 2007, total OECD GDP of the member countries) Source: OECD.

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(b) Corporate economic profits as a percentage of GDP [quarterly through third quarter 2007; national income and product account (NIPA) after-tax corporate profits adjusted for capital consumption and inventory] Source: Bureau of Economic Analysis.

(c) Civilian employment/population ratio (people age 16 years and older, monthly through 2007) Source: Bureau of Labor Statistics.

(d) Business productivity: change in output per hour of all persons (three-year moving average of year-to-year change, quarterly through third quarter 2007) Source: Bureau of Labor Statistics.

FIGURE A1.3 Reagan tax cuts improved our competitiveness as a nation Comments: Supply-side incentives ushered in an era of prosperity, putting people back to work and improving the competitiveness of the United States. This took place despite the competitive threats from Europe and Japan and the military threat from the Soviet Union. The payoff has been enormous. Since 1983, the United States’ share of GDP in the OECD (a) has grown dramatically. Corporate profits (b) soared, providing growing employment opportunities (c). At the same time, the productivity of the employment force grew (d), reinforcing the GDP and corporate profitability. Warning: Failure to maintain the economic incentives that make the United States competitive can lead to a lower share of global growth.

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(a) U.S. consumer price inflation (CPI year over year, monthly through November 2007) Source: Bureau of Labor Statistics.

The Health and Wealth of Our Nation in 2007

(b) Ten-year Treasury note yield (monthly through May 5, 2006) Source: Federal Reserve.

(c) The Fed price rule: Dow Jones Spot Commodity Index vs. the Fed funds rate (monthly through May 2006) Source: Federal Reserve Economic Database, Wall Street Journal.

FIGURE A1.4 Monetary price rule brought inflation under control Comments: The years of Volcker’s commodity price rule have demonstrated that such a rule can be better than a gold standard, if it is employed with discipline. The challenge is maintaining the discipline in the face of political pressures. Thanks to Fed Chairman Paul Volcker and his successor, Alan Greenspan, inflation and interest rates were finally tamed. The plan broke the back of inflation (a), and we saw a 180-degree turnaround in interest rates in the early 1980s. Take a look at the 10-year government Treasury note yield (b). A decade after the gold standard was jettisoned, leading to a period of stagflation and economic turmoil, the price rule based on spot commodity prices (c) helped to return monetary policy to sanity until 2003, when commodity prices again took off.

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(d) Yield curve spreads have preceded recessions (ten-year minus three-month Treasury yields, secondary market monthly averages) Source: St. Louis Fed.

(e) Inflation-adjusted S&P 500 Index typically drops before recessions (S&P 500 Index, semilogarithmic scale, through December 2006; January 1966 ⫽ 100.0) Source: Standard & Poor’s.

(f ) S&P 500 relative to capitalized economic profits—percent overvalued (ⴙ) or undervalued (ⴚ) Source: S&P, BLS, and NIPA

FIGURE A1.4 (Continued)

Unresponsive monetary policy has caused recessions Comments: Inverted yield curves themselves do not cause recessions. Rules of thumb like the inverted yield curve leading to recession can be wrong. The charts in this figure indicate that the inverted yield curve is a leading indicator of a recession by a short (three- to six-month) period only when the S&P index also drops. In 2006 there was an inverted yield curve but no recession, as the S&P index continued to climb. Likewise, capitalized economic profits also provide a better signal of market overvaluation than rules of thumb like the S&P’s price/earnings ratio. The causes of recession, disruption in one of the four kingdoms of macroeconomics, also cause inverted yield curves.

(a) Inflation–adjusted S&P 500 index demonstrates the Reagan prosperity (semilogarithmic scale, January 1966 ⫽ 100, monthly through January 2008) Source: Standard & Poor’s, BLS.

(b) Stock market overvaluation in 1999. Capitalized economic profits versus stock prices of S&P 500 provides greater insight (through January 2008, semilogarithmic scale, 1Q1993 ⫽ 100) Source: S&P, BLS, NIPA.

FIGURE A1.5 Stock market responds to favorable economic environment Comments: The underlying economics of business in the US was changed in the early 1980s by Reaganomics, as lower marginal tax rates and stable monetary policy produced a major turnaround in the economy. The dramatic turn in the stock market (a) is evidence of the change in the investment climate produced by Reaganomics. Similar to a business turnaround, Reaganomics resulted from a change in leadership and changes in the metrics used to monitor performance. Down the road the markets were periodically over or undervalued. In 1999, markets had become particularly overvalued, ready for a crash. The coming downturn could be seen by comparing capitalized economic profits and the S&P 500 index (b).

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(c) Capitalized economic profits (CEP) signaled the market was undervalued since 2002 Source: Laffer Associates and S&P. Laffer CEP Equity Call

Tobin’s Q Equity Call

% Change in S&P 500

Correct Signal

4Q1960–1Q1962

Buy

Sell

22.2%

Laffer CEP

4Q1962–4Q1968

Buy

Sell

82.3%

Laffer CEP

2Q1970–3Q1970

Sell

Buy

⫺4.3%

Laffer CEP

3Q1971–3Q1973

Buy

Sell

13.3%

Laffer CEP

2Q1980–1Q1982

Sell

Buy

9.5%

Tobin’s Q

1Q1987–2Q1987

Sell

Buy

16.3%

Tobin’s Q

2Q1990–3Q1990

Sell

Buy

7.7%

Tobin’s Q

1Q1991–4Q1997

Buy

Sell

285.0%

Laffer CEP

3Q1998–4Q1998

Buy

Sell

14.2%

Laffer CEP

1Q2001–3Q2007

Buy

Sell

40.8%

Laffer CEP

Period (Quarterly)

(d) CEP signals beat Tobin’s Q 7 of 10 times (differing signals: capitalized economic profits versus Tobin’s Q) Source: Laffer Associates, “Equity Valuation: Whom Do You Trust?” August 21, 2002. Laffer CEP Equity Call

Fed Model Equity Call

% Change in S&P 500

Correct Signal

10/94–1/95

Buy

4/96–3/98

Buy

Sell

1.7%

Laffer CEP

Sell

70.7%

10/98–2/99

Laffer CEP

Buy

Sell

21.8%

Laffer CEP

3/01–4/01

Buy

Sell

0.8%

Laffer CEP

3/01–4/01

Sell

Buy

–8.2%

Laffer CEP

9/01–10/01

Buy

Sell

0.7%

Laffer CEP

Period (Monthly)

(e) CEP signals beat the Fed model six of six times (differing signals: capitalized economic profits versus Tobin’s Q) Source: Laffer Associates, “Equity Valuation: Whom Do You Trust?” August 21, 2002.

FIGURE A1.5 (Continued)

Capitalized economic profits is a better metric Comments: The comparison of Capitalized Economic Profits (CEP) with the S&P 500 index gives clear signals of over- and undervaluation in the market. Top value builders use better metrics. Adding the right cost of capital into the decision framework improves decision making across the board and allocates resources more effectively. Using the Capitalized Economic Profit framework was more accurate than the Fed rule (d) or Tobin’s Q (e), two commonly used measures for market over- and under valuation. 349

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(a) Average U.S. tariffs as a percentage of all imports (annual through 2006) Source: U.S. International Trade Commission.

The Health and Wealth of Our Nation in 2007

(b) Total U.S. merchandise trade as a percentage of U.S. GDP (annual imports plus exports of goods through 2006) Source: Census Bureau, Bureau of Economic Analysis.

(c) Trade deficit (ⴙ) or surplus (ⴚ) as a percentage of GDP vs. real GDP growth (quarterly, GDP through first quarter 2006, trade through fourth quarter 2005) Source: Laffer Associates.

FIGURE A1.6 Free trade helps promote national wealth Comments: After the lessons of the disastrous Smoot-Hawley tariffs in 1930, tariffs have been on a general long-term decline (a), much to the benefit of the economy. Once a resurgence of protectionism was defeated in the 1970s, trade took off, further enhancing the GDP (b). The trade deficit that worries so many commentators is the flip side of incoming investment from foreign sources. Typically, the United States runs a trade deficit because we are growing faster than other nations. The financing for the deficit comes from inbound investments. Foreign investors find the risk/return characteristics of U.S. investments favorable, and thus are willing to support this high level of capital flow into the United States.

(a) Union membership as a percentage of the labor force (annual through 2005) Source: Bureau of Labor Statistics.

(b) Ratio of the federal minimum wage to the average wage (average hourly earnings of total private nonfarm workers, annual through 2005) Source: Bureau of Labor Statistics.

(c) Annual pages published in the Federal Register (pages maintained by the Mercatus Center at George Mason University)

(d) Number of major work stoppages involving more than 1,000 workers

(e) Staff of economic regulatory activities as a percentage of the total labor force (annual through 2005)

(f ) Spending on economic regulatory activities as a percentage of GDP (annual through 2005).

Source: U.S. Department of Labor.

FIGURE A1.7 Declining government intervention has helped growth Comments: Government intervention often inhibits business growth and profitability, retarding the growth of national wealth. Fortunately, many of these inhibitors have been on the decline. For their own benefit, special interest groups continue to press Congress to revert to the more destructive forms of intervention. The decline of union membership (a) has given greater operating flexibility to U.S. corporations. Less union membership means fewer disruptions, such as work stoppage (d). Reduction in the impact of the minimum wage (b) has reduced unemployment among urban teenagers and unskilled immigrants. On the negative side the page count of the federal resister (c) shows that Congress continues to press more into the affairs of business. hurting productivity. Decreasing government regulatory staff (e) might imply that regulation is abating. However, when we look at the share of GDP that is absorbed by regulation and compliance, we can see that the direct costs of regulation have been passed to the business community. Thus, the economy can still be threatened by overregulation. Parts e and f include a broad base of activities, in particular, industries using economic controls such as price ceilings or floors, quantity restrictions, and service parameters. See the Mercatus Center and Weidenbaum Center’s annual Regulators’ Budget Report.

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(a) Household debt service as a percentage of disposable personal income (quarterly through third quarter 2007)

The Health and Wealth of Our Nation in 2007

(b) U.S. homeownership rate (quarterly through third quarter 2007) Source: Census Bureau.

Source: Federal Reserve.

(c) Mortgage debt as a percentage of household debt (quarterly through third quarter 2007) Source: Federal Reserve.

(d) Household debt as a percentage of household assets (quarterly through third quarter 2007). Source: Federal Reserve.

FIGURE A1.8 Home ownership and household wealth have grown:

household wealth statistics (quarterly through fourth quarter 2005) Comments: Debt fuels growth. When people have incentives to own property and the means to acquire it, they work hard to keep it. Consumer access to higher debt loads (a) has enabled higher levels of investment by consumers (b). Consumers have gravitated to investing in real estate, as the tax benefits of borrowing against real estate are favorable. In addition, as they build up equity, the same tax benefits provide incentive for consumers to concentrate their borrowings in the form of mortgages (c). This strategy has led to higher debt relative to total assets (d). In the midst of a “subprime crisis,” many imprudent borrowers, enabled by creative forms of mortgage financing, defaulted, leading to a pause in the mortgage market. However, the underlying uptrends will resume once problems with subprime loan practices have been cleared up.

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(a) Federal government budget deficit as a percentage of GDP (quarterly through fourth quarter 2005, NIPA basis) Source: Bureau of Economic Analysis.

(b) Gross federal debt held by the public as a percentage of GDP (annual through 2006, NIPA basis) Source: Bureau of Economic Analysis.

(c) Budget cost of the federal debt as a percentage of GDP (annual through 2005, in billions of dollars, NIPA basis) Source: Bureau of Economic Analysis, Federal Reserve.

FIGURE A1.9 Reasonable deficits can promote sustainable growth Comments: Politicians often talk about absolutes, misleading voters. Top value builders know when a relative metric is needed. Debt is best compared with ability to pay interest. When measuring the budget deficit against the GDP (a), it is interesting to note that the impact of the deficit has declined, despite all the political and media clamor over the deficit. Projecting forward, assuming the annual deficit continues to run at around $376 billion and the economy continues to grow at a nominal rate of 5.3 percent, the amount of federal debt held by the public (b) will continue to be below 40 percent of GDP, below comparable levels in the 1990s, and below the levels of several other developed nations (e.g., the U.K. and Germany). The cost of carrying the debt is below 2 percent of GDP (c), less than half the relative burden that the economy was bearing in the 1980s and 1990s.

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NOTES 1. This appendix is adapted with permission from Arthur B. Laffer and Jeffrey Thomson, “The Condition of Our Nation,” Laffer Associates, 2005. Go to www.ValueBuildersEdge.com for the original white paper. 2. See Statistical Abstract of the United States at http://www.census .gov/prod/2001pubs/statab/sec21.pdf for thousands of environmental statistics that may affect your business. See the FBI Web site, http://www.fbi.gov/ucr /cius_02/html/web/ offreported/02-nmurder03.html for murder statistics. 3. Source: Bureau of Economic Advisors. 4. In the corporate world, discounted cash flow methodology has overtaken accounting metrics just as supply-side gained popularity. 5. For a discussion of this transition from Keynesian thought and the roots of the supply-side movement, see Bruce Bartlett, “Supply-Side Economics: ‘Voodoo Economics’ or Lasting Contribution?” Laffer Associates, November 11, 2003. 6. Following Volcker, this policy has been meticulously adhered to by Alan Greenspan, and most economists expected that it would be adhered to by Ben Bernanke. The Fed has arrived at a monetary system that, while it does have flaws, is better than any system ever before designed by man. 7. President Johnson had a checkered record. He also made the heretofore voluntary capital flow restriction programs mandatory, expanded the “Buy America” program, and prohibited U.S. citizens from engaging in private transactions in gold. President Nixon was pretty much an across-the-board protectionist. President Ford’s trade policies weren’t all that memorable. President Carter, however, was protectionist, especially when it came to energy. 8. The Institute of Certified Fraud Examiners, in its annual report, estimates the cost of fraud at almost 6 percent of sales, a number greater than the after-tax profits of many businesses. See www.CFE.org. 9. It was the Fed’s fear of inflation and growing debt in 2007 that contributed to the credit crunch. The credit crunch in turn seized global markets, resulting in a loss of confidence that has tipped off a global recession. As this book went to press, we have recently seen the most dramatic change in the monetary base in living memory. After choking off the growth engine in 2007 and hurling the economy into a credit crunch, the monetary authorities delayed any

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correction for months. Suddenly awakening to the deepening crisis, they flooded the system with liquidity. Between mid-September 2008 and mid-November 2008, the monetary base increased by 45 percent. By contrast, the run-up in the two months before the Y2K money spike was a little shy of 8 percent. Clearly a delayed fix requires far more effort than an earlier one. We still await the markets’ ultimate reaction. One thing is for sure: at some point, the markets will respond and then the Fed will have to bring the monetary base back into line. They will truly have to walk a fine line to bring the monetary base back into alignment with market demand in their hope to bring things back to normal.

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APPENDIX 2

Digging Deeper into Tax Rate Cuts and Tax Revenue

Cutting taxes and limiting your expenses allow people to raise their standard of living. Afterwards, you will no longer need to worry about famine and shortage.

—Yu Juo (467 BCE)1

Top value builders understand how their customer segments contribute to revenues and value.2 Companies manage revenue very carefully, dropping prices to compete and provide value to their customers and stockholders. • Value-building governments are reducing taxes so that their economies can remain competitive, grow, and promote wealth creation for their citizens. •

Appendix 2 is the beginning of a deep dive into taxes and the Laffer Curve. The data from credible sources speak volumes. Tax rate reductions of the past stimulated the economy and resulted in increasing tax revenues over time. As marginal tax rates have been lowered, the top slice of earners has paid an increasing share of total tax revenues because the economy has grown. The economic pie has grown over the last 25 years, despite ups and

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downs. This long-term trend could change if tax rates are increased.

THE ORIGIN OF THE LAFFER CURVE DATES BACK TO THE FOURTEENTH CENTURY Arthur Laffer frequently exclaims, “The Laffer Curve, by the way, was not invented by me; it has its origins centuries back in time.” For example, the Muslim philosopher Ibn Khaldun wrote in his fourteenth-century work The Muqaddimah: It should be known that at the beginning of the dynasty, taxation yields a large revenue from small assessments. At the end of the dynasty, taxation yields a small revenue from large assessments.

This fourteenth-century phrase was quoted by Ronald Reagan occasionally during the late 1970s and 1980s. Laffer points to a more recent version of “incredible clarity” written by none other than the traditional economist John Maynard Keynes:3 The argument [should not] seem strange that taxation may be so high as to defeat its [purpose], and that . . . [at times] a reduction of taxation will run a better chance than an increase [in tax rates] of balancing the budget.

This is a pretty simple concept if you consider that tax rates are the price of government services. Like a company trying to increase revenues, value-building governments set their prices to optimize tax revenue. However, even monopolists realize that, beyond some point, increasing prices can reduce revenues. President Kennedy also had it right. In 1962, President Kennedy gave the graduation address at Yale University. He talked about myths. He said that deficits are the consequence, not the cause, of bad economics, and that any administration that focuses on balancing the budget will find itself grossly short. That is an important lesson learned, but too often forgotten, over the last several decades. Kennedy further reiterated his beliefs in his Tax Message to Congress on January 24, 1963: In short, this tax [rate reduction] program will increase our wealth far more than it increases our public debt. . . . [T]o borrow prudently in order to invest in a tax revision that will greatly increase our earning power can be a source of strength.

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359

TWO MAJOR EFFECTS SHAPE THE RELATIONSHIP BETWEEN TAX RATES AND TAX REVENUES The basic idea behind the relationship between tax rates and tax revenues is that changes in tax rates have two effects on revenues: the arithmetic effect, or the “numbers effect,” and the economic effect, or the “people effect” (sometimes referred to as the “feedback effect”). The numbers effect is simply arithmetic. If tax rates are lowered, tax revenues per dollar of tax base will be lowered by the amount of the decrease in the rate. And the reverse is true for an increase in tax rates. The arithmetic is simple, but it is not representative of what actually happens when tax rates are changed. The people effect, however, recognizes the positive incentive impact that lower tax rates have on work, output, and employment, and thereby the tax base, by providing incentives to increase these activities. Raising tax rates has the opposite people effect, as it economically penalizes people who participate in the taxed activities. The numbers effect always works in the opposite direction from the people effect. Therefore, when the people effect and the numbers effect of tax rate changes are combined, the consequences of the change in tax rates on total tax revenues are no longer obvious through simple arithmetic alone. Figure A2.1 is an illustration of the concept of the Laffer Curve. Note that there are only two specific levels of taxation that correspond to a specific level of revenues: 0 percent and 100 percent. At a tax rate of 0 percent, the government would collect no tax revenues, no matter how large the tax base. Likewise, at a tax rate of 100 percent, the government would also collect no tax revenues from free citizens because no one would be willing to work for an aftertax wage of zero—there would be no tax base. It should be easy for anyone to visualize the two extremes. Between these two extremes, there are two corresponding tax rates that will collect the same amount of revenue: a high tax rate on a smaller tax base (Point A) and a low tax rate on a larger tax base (Point B). There is more. Moving from total tax revenues to the challenge of balancing budgets, there is an expenditure effect in addition to the two effects that tax rate changes have on revenues. Because tax rate cuts create an incentive to increase output, employment, and production, they also help balance the budget by reducing

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Figure A2.1 The Laffer Curve—tax rate versus tax revenue—changed the way many leaders think about tax rates and tax revenues

government expenditures to the underemployed and unemployed. There is clearly a carryover to local taxing bodies as well. The true impact of a tax rate cut is beyond the simple arithmetic and may last many years.

THE HISTORY OF CUTS IN U.S. MARGINAL TAX RATES YIELDS VALUABLE LESSONS Not all tax rate cuts are the same. Historical marginal tax rate cuts have increased the national wealth. Without a detailed review of major periods of U.S. tax rate cuts, three critical lessons learned should be emphasized: 1. The size of tax rate cuts matters. People are concerned with after-tax results. Tax rates are the crucial issue. Under a progressive tax structure, an equal across-the-board percentage reduction in tax rates should have its greatest impact in the highest tax bracket and its least impact in the lowest tax bracket. 2. The timing of tax rate cuts matters. People can change when they work, when they invest, and when they spend. Just as

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361

people will not shop at a store a week before its welladvertised discount sale, they will defer income and realize that income only when tax rates have fallen to their fullest extent. Tax rate cuts influence behavior but do not create incentives until they actually take effect. 3. The location of tax rate cuts matters. People can also choose where they earn their after-tax income, where they invest their money, and where they spend their money. As a result, regional and country differences in various tax rates also matter. Capital Gains Taxes Provide a Prime Example Capital gains have been a popular target for taxing authorities for decades. Holders of capital assets have control over when they realize gains, which are then taxed. Some holders defer the gains until they die, after which the gains are locked in and go untaxed. For the rest, there is evidence that capital gains realizations really do respond to tax rates. For example, before an increase in capital gains tax rates, realizations rise quickly, and then afterwards they drop. The opposite occurs for tax cuts. Thus, the tax revenue realizations unambiguously increase with deceasing tax rates and decrease with increasing tax rates. As a result, the government collects more when the rates drop. (See Figure A2.2.) Because capital gains are affected by inflation, they, like our federal tax brackets, should be indexed for inflation to avoid eroding incentives for economic growth. Low capital gains taxes help increase after-tax returns and stimulate economic growth. Thus, lower or even zero capital gains rates are clearly good for the longrun health of the economy. It is highly likely that they create a “winwin” for all economic classes, with the total economic benefits offsetting any decrease in current tax receipts. An approach such as indexing the tax brackets bridges the difference between short-term and long-term thinking and leads to sustainable growth. Seldom in economics does real life so conveniently conform to economic theory. The Laffer Curve helps to explain this capital gains example. Lower tax rates clearly provide the incentives to change people’s economic behavior and stimulate economic growth and wealth creation, which can, in turn, create more, not

Appendix 2

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Figure A2.2 Capital gains tax rates affect revenues (top capital gains tax rate and inflation-adjusted revenue, 1960–2006, federal, in billions of 2006 dollars) Source: Treasury Office of Tax Analysis; authors’ calculations, adapted from Arthur B. Laffer and Stephen Moore, “The Onslaught from the Left, Part III: The Capital Gains Tax,” Laffer Associates research paper, February 5, 2008.

less, tax revenues. Economic theory may not be as precise as budget arithmetic, but because it tracks how people respond to incentives, it does have more impact and more empirical validity for those who dig deeper into the data.

THE WAR OF “POLITICAL” WORDS ON TAXES CONTINUES . . . Investor’s Business Daily shed some light on the politically hot topic of the “middle-class” tax squeeze, based on data from the Congressional Budget Office (CBO). The data clearly show that “the effective tax rate for middle class Americans has fallen since the late 1970s. While that has happened the median after tax household income (adjusted for inflation) jumped by more than a quarter.” The article continues to cite CBO data: •

“Under the Bush tax cuts, the top 1% paid 39.4% of the federal income taxes in 2005, up from 37.4% in 2000 and

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30.3% in 1995, when the Clinton administration was in charge and pushed a tax hike through a Democratic Congress.” • “As for the bottom 50%, they paid 3.1% of the federal income taxes in 2005, down from 3.9% in 2000 and 4.6% in 1995.” • “The Bush Tax Cuts have been good for every taxpayer in the country, not just the rich.”4 While a more comprehensive analysis of federal tax rates and federal tax receipts is beyond the scope of this text, we provide additional sources for those interested in learning more at www.TopValueBuilders.com. The federal tax revenues are only part of the prosperity that the Reagan, Clinton, and Bush tax cuts have provided over the last 25 years. Local communities collect more tax revenue from sales and property taxes from working households. Most charitable organizations have grown from record contributions. Technology, offshoring, and cost reduction have placed color TVs, cell phones, home computers, and the Internet within the reach of all economic classes in the United States. Yes, we could all be better off with more, but despite the economy’s ups and downs, the vast majority of U.S. households are much more prosperous than their parents. This trend is clear in the 25 years up through 2007. The future trend will depend on how the crises of 2008 are resolved.

NOTES 1. Yu Juo (also known as Yu-Tsu-yu) was born in the kingdom of Lu, 12 years after Confucius (467 BCE). Lord Ai of Lu once asked him, “What should be done if there is famine and not enough money in the government?” Yu Juo replied, “Why don’t you impose 10 percent taxation?” Lord Ai said, “[The current] 20 percent taxation is hardly enough, how can I change it to 10 percent?” Yu Juo explained, “Cutting taxes and limiting your expenses allow people to raise their standard of living. Afterwards, you will no longer need to worry about famine and shortage.” Source: Taipei Confucius Temple, http://www.ct.taipei.gov.tw/EN/01-history/hst2.html.

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2. This appendix was adapted from Arthur B. Laffer, “Laffer Curve Past, Present, and Future,” Laffer Associates research paper, January 6, 2004. We thank Bruce Bartlett, whose paper “The Impact of Federal Tax Cuts on Growth” provided inspiration. For a deeper dive on taxes, see Arthur B. Laffer, Stephen Moore, and Peter J. Tanous, The End of Prosperity, Threshhold Editions, a Division of Simon & Schuster, Inc. (New York; 2008). 3. The Collected Writings of John Maynard Keynes (London: Macmillan Cambridge University Press, 1972). 4. Anonymous, “About That Middle-Class Squeeze . . . ,” Investor’s Business Daily (editorial), March 5, 2008, p. A12.

APPENDIX 3

Digging Deeper into Corporate Value Audits

THE DEMAND FOR INSIGHTS ON VALUE AND CASH FLOW DRIVES THE USE OF DISCOUNTED CASH FLOW MODELS The popularity of value audits began in the 1980s with the rise of the leveraged buyout (LBO) and the first wave of private equity players such as KKR and Blackstone. Analysis was conducted and deals were negotiated with the aid of a new wave of modeling software, computerized databases of stock prices, and low-cost computing power. As early as the 1960s, mainframes were capable of dealing with huge amounts of data and testing various models, but the personal computer interface made it possible for any academic, investment house, or corporate finance department to access and manipulate large databases. As a result, a variety of personalcomputer-based, user-friendly valuation models became available. Some were backed by financial theory and years of empirical testing; others just allowed users to create simple or complex discounted cash flow spreadsheets and valuation models of their own design. Value-based planning and thinking took off. Chicago was an early center of value-based planning and valuation models as a result of the academic work of Miller and Modigliani, the Center for Research in Security Prices at the University of Chicago, and the investment research that burgeoned around the university. For years, Callard, Madden & Associates (CMA) had been providing mainframe-based cash flow 365

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valuation services. It also produced newspaper-sized stock price chartbooks on public companies for investment houses such as Stein Roe. The combination of financial theory and commodities futures markets helped Chicago develop into the center of financial futures markets. On the East Coast, research at General Electric and Harvard in the 1960s and 1970s had popularized the link between strategy and performance. The research was based on a business unit database created through the PIMS (Profit Impact of Market Strategy) Program. A young researcher at Harvard, Michael Porter, formed many of his ideas on the “Five Forces” and his first book, Competitive Strategy,1 after or as a result of his work on the PIMS database. Boston became a global center for strategy consulting. The combination of strategy and valuation methodology made possible a new level of value-based thinking and consulting services. Theories and books poured out from the universities and consulting firms. These include2: • • • • • •

Strategic Planning Institute (strategy audits and The PIMS Principles) BCG (Boston Consulting Group’s Growth Share Matrix) L.E.K.3 (Alcar4 and Kellogg GSM professor Al Rappaport’s book Creating Shareholder Value5) McKinsey (Copeland’s book Valuation6) Stern Stewart (Financier, The Quest for Value7) BCG (HOLT-CFROI8)

Many of these theories and models were first used during the M&A and leveraged buyout booms of the 1980s, bringing a new level of analytical thinking and cash flow analysis to deal making. In Chicago, diversified corporations such as FMC, Esmark, Dart & Kraft, Northwest Industries, and Beatrice began to use computerbased valuation models. These companies made significant changes in their large portfolios of business units with the explicit goal of “increasing shareholder value.” Gurus in value building rose to the top as the bull market for stocks took off in 1983, when the Reagan tax rate cuts came into effect. Stories about value builders like investor Warren Buffett became widely known. Buffett conducts his own value audit every

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year as he prepares his annual letter to the shareholders of Berkshire Hathaway. He keeps it simple by referring to his goal of increasing the intrinsic business value on a per share basis every year. Although he does not publish his estimate of intrinsic value, he tries to provide investors with the financial data and market facts that he uses to calculate it. Accounting “book value” is no longer his preferred intrinsic value benchmark. Fortunately, data providers like Morningstar provide an “independent” fair or intrinsic value and value range in their analyst reports for thousands of companies. For example, on January 4, 2008, Berkshire Hathaway B Shares (BRK.B) traded on the NYSE at $4,516. This was about 10 percent below Morningstar’s estimate of BRK.B’s intrinsic value of $5,000 per share (see Figure A3.4).9 However, after the October 2008 stock market crash, BRK.B shares were trading in a wide range of $3,000 to $4,100 for weeks, well below intrinsic value. Morningstar is a public company itself. In its 2007 annual report, it shares its use of intrinsic value as a goal and discusses its non-GAAP free cash flow metrics:

HOW WE EVALUATE OUR BUSINESS When our analysts evaluate a stock, they focus on assessing a company’s estimated intrinsic value—the value of the company’s future cash flows, discounted to their worth in today’s dollars. Our approach to evaluating our own business works the same way. Our goal is to increase the intrinsic value of our business over time, which we believe is the best way to create value for our shareholders. We do not make public financial forecasts for our business because they are, by their nature, subjective and could have an effect on our company’s stock price. . . . We provide three specific measures that can help investors generate their own assessment of how our intrinsic value has changed over time: • Revenue; • Operating income (loss); and • Free cash flow, which we define as cash provided by operating

activities less capital expenditures [a non-GAAP measure]

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We monitor developments in the economic and financial information industry on an ongoing basis and use these insights to help inform our company strategy, product development plans, and marketing initiatives.10

After decades of enhancements, the valuation models keep getting richer. Empirical testing allows desktop researchers to dig deeper than ever before. So what is the real value of a company and its stock? There are many ways to look at stock value. In this appendix, we discuss some of the more popular and newer approaches, as well as how they have contributed to the thinking about the relationship between stock price and intrinsic value. Intrinsic value comes with many different names, but regardless of what you call it (warranted value, fair value, or discounted EVA), they all try to get at the same thing: the discounted value of expected future cash flows. There is little argument about the fundamental principle of finance that the value of an asset is the discounted present value of its future cash flows. Miller and Modigliani published this foundation for finance in the mid-1960s.11 The questions for analysts are how to produce an “outsider’s” forecast of future cash flows and what discount rate to use so as to predict stock price movements. The question for corporate manager “insiders” is how to develop and execute the strategies that will produce the best cash flows with acceptable levels of risk. Both need navigational tools to help them along the way. Some of these tools are complex, yet others can be surprisingly simple. Bruce Henderson at the Boston Consulting Group has simplified all this to say that the most important performance measure is cash returned to investors: “Reported profit is only a signal. . . . Cash is all that counts.”12 Another simple approach, the dividend discount model, or the Gordon growth model, computes the value of a stock by assuming that the dividend paid on the stock has a constant growth rate in perpetuity.13 Personal computers have made these simplistic models nothing more than academic exercises. Various practitioners and academics have proposed a variety of alternative means of computing corporate value, all founded on the discounted cash flow (DCF) concept. The capital asset pricing model (CAPM) is a foundation that is taught in most business schools and that seems to be the current and most widely accepted

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“academic” technique for business valuation. CAPM valuation requires a forecast of cash flows, which is much easier for an internal team to produce and much more difficult for an outside investor or analyst. The CAPM model also suggests a formula for calculating a cost of capital rate, which is related to the risk of the project or company being evaluated based on its volatility relative to the market and the risk-free rate of a U.S. Treasury bond. More sophisticated multifactor models such as arbitrage pricing theory (APT)14 were also developed and marketed commercially. No model is perfect or without controversy. The traditional academic CAPM cash flow model15 is used to estimate the value of projects, business units, and entire companies. In its raw form, it can appear intimidating. However, in practice, the analyst typically uses accounting information to compute a forecast of cash flows for the next five years, assumes a terminal (or salvage) value, applies the discount rate, and computes the valuation. For additional information on CAPM and APT, the reader is referred to standard business finance textbooks such as Financial Management by Brigham and Ernhardt.16 Practitioners “operationalize” the academic model with a variety of spreadsheet models. A typical CAPM valuation in spreadsheet form is shown in Figure A3.1a. Note that the same spreadsheet can be used to explore the sensitivities of EBITDA to operational assumptions and value ranges based on EBITDA multiples. Salvage value or terminal value is usually a significant component (over 65 percent) of the overall value computed with this model. The range of possible values for both terminal value and the total enterprise value is very wide. Because total value depends on a variety of sensitive assumptions related to both cash flow and terminal value, it often brings the practicality of DCF models into question. Ranges of values are often generated by varying the assumptions and developing an understanding of how the estimate of value reacts to various key assumptions. This type of sensitivity analysis helps managers understand the key value drivers and ranges of value. An important benefit of the value audit process comes from the insights into the business and the discipline that can be developed while generating a meaningful five-year cash forecast, the terminal value, and the supporting assumptions. Cash flow forecasts

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should not be simplistic. They should be based on a complete understanding of the business model and its environment. Figure A3.1b shows the many drivers of value and moving parts. The graphic framework indicates the importance of understanding the environment, the competition, and how strategic actions relative to the competition influence and drive operating and financial value drivers. These, in turn, produce the ending net cash flows. The cash flows are used to fuel growth through capital expenditures and increases in required working capital. Remaining cash flows over the future represent the company’s ability to pay holders of debt and equity and in turn determine the most likely range for the current value of the company. A large number of research studies have shown that profitability and value are strongly influenced by relative quality in the eyes of the customer, relative costs, and relative productivity.17 Yes, the customer is still king in the value chain. Customers and operations drive cash flow. The key word that many people forget is the word relative. Cash flows are not created in a vacuum and in many industries are strongly influenced by competition and by the broader economic environment. Relative quality is typically defined as a function of quality and reputation, that is, the quality of a company’s products and services and its reputation relative to its competitors and its served markets. This highlights the importance of competitive position and competitor response in strategy development and value creation. General Electric chairman Jack Welch told his senior managers that at GE, each strategic business unit (SBU) must be number one or number two in its industry or the business unit would not be part of General Electric. He was emphasizing the importance of relative competitive position to the value and profitability of the business unit. However, this simple empirically based rule is often incorrectly taken to mean that sales growth is more important than profitability. This is just another example of how easy it is for simple slogans and simplistic rules of thumb to confuse and mislead people. A value audit attempts to clarify the factors that drive after-tax cash flow and corporate value, so that managers can think and act productively as conditions change. Refinement and improvement of multiyear cash flow forecasts usually requires the use of multiple metrics at the strategic,

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tactical, and operational levels. Enlightened management teams are clearly changing the metrics in many industries. At an accelerated pace, corporations are moving away from more traditional metrics such as sales per employee (aimed at operating efficiency) to more value-based metrics such as economic profit, SVA (shareholder value added), and the lifetime value of a customer or product line. Value-based metrics bring the cost of capital into view for all employees. Companies will use different internal metrics depending on their sophistication and the industry in which they compete. A comparison of traditional and value-based metrics is shown in Figure A3.2a.

THE OUTSIDER’S PERSPECTIVE: INVESTORS AND ANALYSTS USE DIFFERENT CASH FLOW METHODS Many investors and stock analysts will build a discounted cash flow valuation model similar to the one used by a company’s internal financial analysts in their evaluation of its strategic plans. However, given the outsider’s limited access to inside information and new corporate disclosure rules, this is a more difficult process. The outcome of the analysis is dependent on multiple assumptions. As a result, a variety of “outside analyst” approaches have been developed to estimate future cash flows and the intrinsic value of a company’s stock. The ability to do this with any degree of accuracy is worth millions or even billions in the hands of the right investors. Wise investors continually search for methods of checking the reasonableness of a stock price, as they typically are not insiders. Despite the SEC’s fair disclosure rules, different investors have access to different levels of information derived from the same public data. For example, a private equity fund investor may have an experienced industry executive on its team. That person may have broader “insider knowledge” from working for a target company, a supplier, a customer, or a close competitor. Clearly, insiders have an information advantage, as they are more completely familiar with management’s plans and its ability to execute them in the face of competition and other obstacles. However, insiders often lack the more realistic perspective of the competitive and general market

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environment that an outside investor may have. As a result, both insiders and outside investors have searched for better methods of computing the intrinsic value of a business and then comparing that to the current stock price. A number of these cash flow valuation models have received broad attention and support from both the investment community and the corporate performance improvement world. Many are proprietary, and the names have been trademarked to protect the developers’ intellectual property. Each claims to have the best solution, yet they are all founded on the basic principles of discounted cash flow and residual income. Callard, Madden & Associates (CMA) and HOLT were among the first researchers to provide independent automated discounted cash flow models commercially, digging deeper for outside investors. They were among the first to dig deeper into market statistics and the linkage between stock prices and accounting information.18 The CMA and HOLT models were based on a concept called cash flow return on investment, or CFROI for short. CFROI is now a registered trademark of CSFB HOLT. These analytic models forecast future cash flow returns based on careful and insightful economic analysis and adjustment of historical GAAP accounting results. They then use the forecasted returns to produce an “intrinsic” or “warranted” value based on an estimate of future returns and cash flow. Their unique contribution to the art of valuation is the corporate life-cycle approach to predicting future real rates of return. The life-cycle approach suggests that the cash returns generated by any business unit will “fade” to the average real cost of capital over time. The concept is based on empirical studies and the observation that competition forces the returns of all companies to eventually regress to the mean. In other words, trends of both outstanding performance and terrible performance are short-lived. High-performing companies usually return to more normal levels as competition forces their returns down. Likewise, if a company isn’t earning its cost of capital, it is usually forced to either improve its performance or go out of business (see Figure A3.2b). The CMA and HOLT models use a real cost of capital that adjusts for inflation, helping to isolate company performance from changes in interest rates.

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Stern Stewart & Co. approached the evaluation problem from the point of view of economic value added (EVA) or the residual income model. EVA is a registered trademark of Stern Stewart. Based on a variety of spreadsheet models originally developed by bankers to help companies better understand mergers, Stern Stewart uses the discounted future EVA to estimate current intrinsic stock values. The model typically uses a CAPM-based cost of capital to develop the charge needed to reduce accounting profit to an “economic profit.” Stern Stewart’s unique contributions to the value audit concept were passionate efforts to explain the distortions of typical accounting statements and efforts to encourage management to use economic measures such as EVA in communications to shareholders, in executive compensation programs, and in internal capital allocation. Creating a positive EVA requires a company to earn an economic profit, a return that covers the cost of the capital invested. It is easy to explain in concept and has had wide success in getting employees at all levels to think beyond simple EPS and in terms of value creation. See Figure A3.3a for an example of corporate disclosures in the annual report of an EVA convert, Manitowoc Corporation. Stern Stewart computes EVA by first adjusting GAAP accounting statements to remove accounting distortions and determine economic income after tax. A charge for the use of capital (total operating capital multiplied by the weighted average cost of capital) is then deducted.19 The EVA is then the value added to the business, and it should equal the increase in the total enterprise value of the company. Because EVA can be computed at the SBU level, it can provide tools that enable management to align activities at the SBU level with corporate value. Private equity companies use measures such as cash flow, EVA, and SVA without the distractions of changes in daily stock prices. The downside of using EVA is the complexity of its implementation and acceptance within the corporate culture. Top value builders such as John Deere disclose SVA by operating division in their annual reports (see Figure A3.3b). Other providers of intrinsic value estimates continue to refine and enhance these two basic economic cash flow approaches in their proprietary models, looking to improve ease of use and links

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to market prices. By using real rates of return and a real discount rate, CharterMast intrinsic value analysts provide insightful multiyear performance comparisons with an index like the S&P 500.20 Comparing the cash returns on investment over several business cycles to the cost of capital provides insights into corporate value building. Relative wealth charts help managers and investors understand how a variety of operating changes drive relative value.21 LifeCycle Returns’ (LCRT) models prepare a forecast of future economic rates of return and cash flow based on past results but apply a “reasonable range of value” to stock price value based on a deeper empirical analysis of the data. The proponents of the model argue that its ranges and accuracy in tracking stock prices over time are the highest and most generally applicable of any available model. An added twist appears in the LifeCycle Returns’ models that helps keep values consistent with the total market value of all stocks. LifeCycle Returns’ models make use of a single market discount rate, assigning a universal cost of capital to all companies and calibrating valuation models by forcing the model parameters to value 50 percent of the stocks as overvalued and 50 percent of the stocks as undervalued. The valuations are then based on projected risk-adjusted cash flow streams developed from the current real rate of return, fading to the mean. The fade rate is based on empirical testing.22 In addition to automating and visually presenting rational value ranges, LCRT is pioneering the use of standardized value audit metrics in support of executive compensation decisions. LCRT proposes providing visual comparisons of corporate value in relation to intrinsic value and/or total return over time relative to other public peers in the form of an “S” chart and a geology chart.23 These proprietary models are not generally available to individual investors, although Ativo analysis is available to Fidelity clients through Fidelity.com. Morningstar, a leading provider of mutual fund performance insights and data, provides DCF-based individual stock valuations to the individual investor market. These valuations are based on strategic concepts such as the

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“competitive moat” and compute a “fair value” on over 2,000 stocks. Morningstar’s unique contribution is the broad distribution of its fair value estimates compared to stock prices paired with an independent analyst narrative (see Figure A3.4). Value Line Investment Survey is the oldest and one of the most widely available sources of investment information that uses cash flow analysis to anticipate movements in stock prices. Based on its proprietary software, Value Line computes a variety of metrics, including a projected range of stock price values over the next three to five years. Although the range is wide, reflecting uncertainty about the future, the appreciation potential and ranges are different for different companies. Value Line is a comprehensive service offering insights on individual companies, industry segments, and the economic outlook for the economy overall. The 1,700 public companies profiled are grouped into 90 industry groups, which are profiled on a rolling quarterly basis (see Figure A3.5).

WHICH DCF METHOD IS BEST? The consultants who compete to provide DCF and residual income–related corporate value models continue to argue about which method is “best.”24 Apart from this discussion, they all agree on the fundamentals of DCF and the need for a business to earn a return above its cost of capital. It is the implementation of the fundamentals that spawns the differences. Corporate decision makers sometimes grind to a halt when faced with a choice of which model to use, unsure of how to choose. Even worse, some managers choose simplistic rules of thumb rather than more insightful and empirically based methods. Each of the major proponents has designed empirical tests to show that its own method is best. More than likely, one of the methodologies works better in one situation and another methodology works better in another situation. So, it is ultimately up to the user to figure out which method to use based on his particular needs and situation. Fortunately, using any of the major methods is better than not using a DCF or residual income approach at all. Thus, it is

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rather difficult for a company to go completely wrong in the process. A frequent error that companies make is choosing a methodology that is too sophisticated for the company or one that requires a level of detail that creates an unsustainably complex model. For companies that lack the internal financial analytical resources, it is far better to start with a simpler version from among the DCF alternatives. Most companies do better if they use outside consulting resources to help them choose and implement appropriate models. At a minimum, managers need to understand their cash flows and cost of capital. Top value builders use cost of capital thinking in everyday decision making. This means that both cash flow and cost of capital must be understood throughout the organization, from top to bottom. Once the choice has been made, corporate executives must decide how to communicate the information that they develop by using these techniques. As in the previous examples of Manitowoc Corporation and Deere (Figure A3.3), some companies proudly display the analysis of their performance in terms that they believe are consistent with the way stockholders actually value the company. The same information is shared internally by top value builders, giving employees a greater understanding of the sometimes mystifying decisions that come down from corporate headquarters. As mentioned in Chapter 1, value proponent Bart Madden recommends that corporate boards commission a periodic shareholder value review (SVR), which would be provided to the stockholders. The SVR would include a description of the valuation model and a historical time series of the key drivers of the valuation model. In addition, value charts would be provided, with narrative comments regarding the creation or destruction of value that has occurred in each of the company’s major business units, similar to the SBU disclosures in the John Deere annual report. Recognizing that the companies that need such a review process the most may not undertake it voluntarily, Madden suggests that large investors demand it. Alternatively, he hints that the SEC could require companies to produce an SVR, perhaps in exchange for lightening up on some of the Sarbanes-Oxley reporting requirements.25

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MAXIMIZING LONG-TERM VALUE ALLOCATES CAPITAL EFFECTIVELY The controversy about the real objectives of business continues. Maximizing “value” seems single-minded and may seem to ignore the other stakeholders in the business, such as employees, customers, and the community. It does not! Top value builders always think long-term value. However, the authors agree with Michael Jensen’s comment, “A firm cannot maximize long term value if it ignores the interests of its stakeholders.”26 Long-term value maximization is thus an objective that is compatible with an enlightened view of stakeholder theory. However, without a strong focus on long-term value, it is difficult for managers to choose among the needs of conflicting stakeholders. The value audit approach identified in this section provides a periodic and holistic way to measure value and identify methods and strategies to increase it for the longterm benefit of all stakeholders. Without a value audit process in place, management may tend to hold more cash than necessary and invest in projects that fail to earn a return greater than their cost of capital. This agency problem is usually overcome in successful private equity portfolio companies, which use high leverage to force management to disgorge excess free cash flow and pay down debt.27 Without a value audit that identifies the value contributors and the value destroyers present in every business (note how the value waterfall in Chapter 1, Figures 1.2 and 1.3, accomplishes this), sales growth will continue to be the overriding goal. Sales growth is ingrained in the corporate culture of most companies, as it is a powerful and simplistic corporate imperative, and clearly benefits the management group in most companies. Research shows that the compensation of top executive teams has been closely aligned with business size and growth. Let’s face it, big company CEOs are generally paid more than CEOs of smaller companies. Nevertheless, the analytical work that has been done on corporate valuation shows us that annual sales growth and EPS growth, by themselves, are not correlated well with increasing shareholder returns. It is time to get beyond the simplistic and communicate in terms of cash flow and cost of capital and to embrace the concept of an annual value audit.

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(a) Practitioners use discounted cash flow spreadsheet models

(b) Value audits identify key actions that create value

Figure A3.1 Valuation models are driven by understanding business environment, actions, and results Comments: Financial projections and valuation estimates (a) come from a detailed understanding of the business model and the environment (b). This analysis, in turn, serves as the basis for improving corporate strategy. Value audits identify strategic actions to create value. Management will make better strategic decisions if it understands the links between the environment, strategic actions, value drivers, accounting results, and corporate value. Source: Board Resources, copyright © 2007.

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Strategic: Corporate board and SBU leaders

Tactical: Functional managers and supervisors

Operational: Front-line employees

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Traditional Metrics

Better Value-Based Metrics

• Delivering consistent results • EPS growth, ROA, ROS, ROIC • Revenue, margin. productivity

• • • • • •

Top quartile total shareholder return Delivering consistent “expected” results Delivering value relative to the S&P 500 Growing intrinsic equity value (IEV) Future cash flow generation capability Relative product value

• • • • •

Sales per employee Cost per function Variance reporting Sales and volume per product Relative to budget or prior year

• • • • • •

Value of product line Value of customer segment Elimination of waste Benchmarking best practices Relative quality Relative cost

• • • •

Sales per account rep Sales per account to goal New account goals Inventory turns, fill rates

• Contribution margin or value per customer account • Lifetime value of a customer • Exceeding customer expectations • Economic value per employee

(a) The use of value-building metrics is growing. It takes more than one metric to build long-term value Source: Adapted from J. Nicholas DeBonis, Eric W. Balinski, and Philip Allen, Value-Based Marketing for Bottom-Line Success: 5 Steps to Creating Customer Value (New York: McGraw-Hill, 2002), pp. 121–122.

(b) The corporate life cycle of returns and regression to the mean Source: Adapted from Bartley J. Madden, “For Better Corporate Governance, the Shareholder Review,” Journal of Applied Corporate Finance vol. 19, no. 1 (Winter 2007), p. 103.

Figure A3.2 Metrics vary with corporate life cycle Comments: Having the right metrics (a) for value building and a framework for evaluating long-term performance (b) helps in developing realistic projections. Using traditional metrics, such as earnings per share growth and sales growth, may not lead to value creation. An understanding that competition drives all high-return businesses toward average performance forces management to think more about continuous renewal and change.

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(a) EVA disclosure by Manitowoc shows management’s concern for value (Manitowoc’s calculation of EVA in millions of dollars is shown with the dotted line and measured on the left axis. It is compared to Manitowoc’s market value (MV) in millions of dollars as shown with the solid line and measured on the right axis.) Source: Manitowoc, 2006 Annual Report, p. 17. Reprinted with permission.

(b) SVA disclosure by John Deere is a major part of shareholder communication Source: Adapted from Deere & Co., 2006 Annual Report.

Figure A3.3 Top value builders disclose value metrics Comments: Manitowoc discloses EVA (a), and Deere & Company discloses its SVA by key divisions (b). Both companies demonstrate in their public disclosures their dedication to building shareholder value. These “best practice” companies consistently disclose their performance relative to these long-term measures. It can take a long time to convince shareholders that a measure other than earnings per share is appropriate for corporate performance. However, companies that take the time to create a rational value-based dialogue with stockholders will benefit management, employees, and owners. Underperforming companies rarely disclose value-based metrics such as these.

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Figure A3.4 Morningstar’s “fair value” information is available to

individuals Comments: The charts above for Berkshire Hathaway (BRK.B) and Walgreens (WAG) show the relation between Morningstar’s computed “Fair Value” or intrinsic value (narrow steplike line) to actual share price (bold jagged line) for the years 2004 to 2008. Each company also has a “Morningstar Rating” that changes over time. The Morningstar “STAR” ratings indicate periods of under- and overvaluation. Five stars suggest a time to buy (when the stock is undervalued). A one-star rating suggests a time to sell (when the stock is overvalued). See Morningstar.com for other examples. © Morningstar, reprinted with permission.

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Figure A3.5 Value Line provides estimates of a range of future values which may represent a “fair value” range. © Value Line, reprinted with permission.

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NOTES 1. Michael Porter, Competitive Strategy: Techniques for Analyzing Industries and Competitors (New York: Free Press, 1985). 2. Links to many of these Web sites are available at www.TopValueBuilders.com. 3. L.E.K. Consulting Group offers value-based consulting services. Al Rappaport has been L.E.K.’s strategic advisor concerning the application of shareholder value to business strategy since L.E.K.’s merger with the Alcar Group’s consulting and education practices in 1993. Source: http://www.lek.com/includes/getPublication .cfm?pk_id=DCCC1700-1422-216A-5BEC21457DFAC416&listType =Publication. Accessed September 2, 2007. 4. Alcar is a corporate valuation method, software, and consulting practice created by Alf Rappaport and Carl M. Noble, Jr. 5. Al Rappaport, Creating Shareholder Value: The New Standard for Business Performance (New York: Free Press, 1986). 6. Tom Copeland, Tim Koller, and Jack Murrin (McKinsey & Company, Inc.), Valuation: Measuring and Managing the Value of Companies, 2nd ed. (John Wiley & Sons, New York, 1994). 7. G. Bennett Stewart III, The Quest for Value (New York: HarperCollins, 1991). 8. BCG acquired HOLT, named for its principals, and its “cash flow return on investment” (CFROI) methodology in the mid-1980s. Later the portfolio management component of HOLT was spun out of BCG in the early 1990s and acquired by Credit Suisse First Boston around 2000. 9. See www.Morningstar.com. Data provided with permission. 10. Morningstar, Inc., 2006 Annual Report, pp. 32–33. 11. Merton H. Miller and Franco Modigliani, “Dividend Policy, Growth, and the Valuation of Shares,” Journal of Business vol. 34, no. 4 (October 1961), pp. 411–433. 12. Carl W. Stern and Michael Deimler, eds, The Boston Consulting Group on Strategy (Hoboken, NJ: John Wiley & Sons, Inc., 2006), p. 38. The book is a great resource reinforcing BCG ideas on speed, experience curves, portfolio management and debt, and valuation. 13. The model discounts all future dividends from the stock to present value. When the growth rate of dividends is slower than the equity cost of capital, the model resolves to a simple formula. The stock value is the projected dollar dividend divided by the difference

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15.

16.

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between the cost of capital and the growth rate. While the model has computational convenience, its accuracy is limited to situations in which the assumptions are realistic. Dividends may not show continuous growth, some stocks pay no dividends at all, and we may argue over the cost of capital. In many situations, the Gordon growth model is more of an academic exercise than a practical valuation tool. Stephen Ross of Yale University invented the APT model in 1976. See Edwin Burmeister, Richard Roll, and Stephen A. Ross, “Using Macroeconomic Factors to Control Portfolio Risk,” rev. March 9, 2003, in “A Practitioner’s Guide to Arbitrage Pricing Theory,” which was a contribution to Practitioner’s Guide to Factor Models for the Research Foundation of the Institute of Chartered Financial Analysts, 1994, available at http://www.birr.com/Using_Macroeconomic_ Factors.pdf, accessed by S. G. Pryor, January 25, 2008. Al Rappaport describes the APT in Creating Shareholder Value: The New Standard for Business Performance (New York: Free Press, 1986), p. 246: “APT is a potential challenger to the CAPM model. APT maintains the basic CAPM assumption that investors will be rewarded only for [accepting] systematic risk, i.e., market risk that cannot be diversified away. Unlike CAPM which measures risk solely by the sensitivity of a security’s return to movements in a broad market index, APT identifies sources of systematic risk as unanticipated changes in key economic factors such as inflation, industrial production, yield curves, and spreads between high- and low-grade bonds.” Finance textbooks typically define the capital asset pricing model using math symbols. However, the essence of the model is straightforward: the value of any asset (including a company) is the discounted present value of the stream of cash that flows from the asset, using a relevant cost of capital as the discount rate. The analysis includes a final cash flow amount from either the actual or the hypothetical sale of the assets. Most executives generally understand the concept but leave the details to the financial staff. Valuation software and spreadsheet models make the formula operational for any level of expertise. Eugene F. Brigham and Michael C. Ernhardt, Financial Management: Theory and Practice, 11th ed. (Mason, Ohio: South-Western Thomson Learning, 2005). Robert D. Buzzell and Bradley T. Gale, The PIMS (Profit Impact of Market Strategy) Principles: Linking Strategy to Performance (New York: Free Press, 1987).

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18. CMA is now licensed to Ativo Research, and HOLT is now owned by Credit Suisse First Boston. 19. Note that EVA does not automatically convert to an increase in stock price, because part of the EVA might find its way into dividends or interest payments. 20. CharterMast, an affiliate of Ativo Research (formerly CMA), produces an intrinsic equity valuation (IEV) based on adjustments to standard financial statements. Ativo valuation insights are provided to individual investors through a variety of sources, including Fidelity. CharterMast uses a proprietary three-factor model that claims greater ease of use than either CFROI and EVA without reducing predictive ability. CharterMast IEV analysts prepare a forecast of future returns based on past results and then discount an estimate of cash flows based on the projected future returns. Their unique contribution is ease of use and high correlation to stock price. 21. See www.TopValueBuilders.com for a variety of corporate examples and links to timely articles and books like William J. Hass and Shepherd G. Pryor IV, Building Value through Strategy, Risk Assessment, and Renewal (Chicago: CCH, 2006). 22. Note: The LCRT models produce an intrinsic value measure that is based on advanced automated DCF methodology, empirically tested across a universe of 7,000 publicly held stocks. Significantly, the models avoid a major weakness in most DCF models, the choice of a terminal value, which accounts for over 65 percent of the intrinsic value in typical DCF models. The use of “fade to” methodology removes the reliance on unrealistic and often overly optimistic assumptions of perpetuity growth rates, adding a higher degree of realism and accuracy. LifeCycle Return’s projected cash flows are adjusted for business risk and are therefore different from the cash flows used in other models. Other models put the business risk into the discount rate. In general, the LCRT projected cash flows will be lower and the discount rate will be lower than the same values in other DCF models. However, the discounted values could be the same. For example, a CAPM-based DCF model might produce the same intrinsic value for two companies, A and B, although the cash flows are higher for Company A. This could occur if Company A is in a riskier and more volatile business. That company would be assigned a higher cost of capital, on the theory that investors would have to be paid higher returns to accept the higher risk associated with Company A’s cash flows. In the life-cycle model, however, the cash flows of both companies would be discounted at the same rate. The

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25.

26.

27.

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life-cycle model would require an adjustment in the cash flows of Company A. The adjustments would generally be made in the rates of “fade,” that is, the rate at which the higher returns of Company A would return to the levels of its competitive peers. Go to www.Topvaluebuilders.com for more insights on alternative models. While all the models discussed are based on discounted cash flow principles, the results of some track actual stock prices better than others. Each vendor has a method of demonstrating how its metric outperforms basic accounting ratios and other proprietary measures. For example, based on stock prices and computed intrinsic values, Ativo/CharterMast can demonstrate graphically that the intrinsic value metric is better than either EVA or basic accounting ratios like EPS and price-to-book ratios. Bartley J. Madden, “For Better Corporate Governance, the Shareholder Review,” Journal of Applied Corporate Finance, vol. 19, no. 1 (Winter 2007), p. 102. Michael C. Jensen, “Value Maximization, Stakeholder Theory, and the Corporate Objective Function,” Journal of Applied Corporate Finance, 14, no. 3 (2001), pp. 8–21. (The JACF is published by Blackwell Publishing on behalf of Morgan Stanley.) The Jensen paper was originally published in an earlier version as an essay, a collection of which constituted the book Breaking the Code of Change, edited by Michael Beer and Nitin Nohria (Boston: Harvard Business School Press, 2000). “Two hundred years of work in economics and finance implies that in the absence of externalities and monopoly (and when all goods are priced), social welfare is maximized when each firm in an economy maximizes its total market value. Total value is not just the value of the equity but also includes the market values of all other financial claims including debt, preferred stock, and warrants.” Michael C. Jensen, “The Agency Costs of Free Cash Flow: Corporate Finance and Takeovers,” American Economic Review, vol. 76, no. 2 (May 1986).

APPENDIX 4

Digging Deeper on Top Value Builders

Private equity, while gaining more attention, is still a secret world. Common reporting standards are not widely used and published for the public. However, in some cases, limited partnerships and pension funds publish or share data, allowing some comparisons to be made. Individual fund performance data are also available from proprietary sources such as Thompson Financial, Preqin, and Standard & Poor’s. Figure A4.1 shows how diverse the strategies of top private equity firms are. In Figure A4.2, we rank the returns of the public top value builders mentioned in the preceding chapters. The 10year total shareholder returns (TSRs) of these public companies are compared with the 10-year S&P 500 benchmark and a selection of highly regarded “management classic” benchmark companies. While most private equity funds traditionally have promised returns of 20 percent or more to their limited partners, not all private equity funds have delivered the promised performance. Fund performance varies widely by fund type and year started. Aggregate performance data for private equity funds gathered by Preqin,1 as reported in the annual reports of 108 public pension funds with combined assets under management of $3.9 trillion, suggest that top private equity funds such as those profiled have delivered great performance: •

The 10-year private equity median returns reported by pension funds after fees were approximately 17 to 18 percent. This was approximately double, or nine percentage points per annum higher, than the returns on 387

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the total public pension plan portfolios. Private equity median returns exceeded total portfolio performance in one-, three-, five-, and ten-year horizons by a margin of 4 to 9 percent per annum. • Private equity investments displayed lower risk than other investments by outperforming other pension plan investments in 82 percent of the cases. Figure A4.2 compares the 10-year TSR of a selection of the world’s top value builders with the 20 to 30 percent returns promised by the top private equity funds. Relative performance matters. Since very few public companies in the S&P 500 actually have exceeded a 20 percent 10-year TSR, it is understandable why institutional investors have been increasing their asset allocation to top private equity funds. Only about 40 companies, or less than 10 percent of the 2007 S&P 500, produced a return of 20 percent or more for the 10 years from December 1997 to December 2007.2 • Some highly diversified public companies, like American Capital Strategies and ITW, operate like private equity funds and outperform the companies touted by management gurus, such as GE, Starbucks, and Southwest Airlines. • Shareholders of controversial “excess oil profits” companies like ExxonMobil did not outperform other value builders such as Apple, Best Buy, Nokia, U.S. Steel, Nucor, and Starbucks. It is obvious that any form of “excess profits taxes” on oil companies would be misdirected, despite political debates. •

Study the tables in this appendix and see why we believe that the free market system is the best mechanism for allocating capital.

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Top Private Equity Profiles Ranked by 10-Year Funds Raised (Billions of Dollars) Goldman Sachs Private Equity Group, New York ($66.4 billion). Key player: Lloyd Blankein (CEO). Recent deals: Alltel, Kinder Morgan, Biomet. Major funds: buyouts ($36 billion), real estate ($11 billion), mezzanine ($5 billion), funds of funds ($16 billion). Web site: http://www2.goldmansachs.com/services/investing/private-equity/index.html. Blackstone Group, New York ($58.4 billion). Key players: Peter Peterson, Steve Schwarzman. Recent deals: Freescale, Sam Zell’s Equity Office Trust. Major funds: buyouts ($34 billion), real estate ($22 billion), venture ($ 2billion). Web site: http://www.blackstone.com/. See Introduction and Chapter 9. The Carlyle Group, Washington, D.C. ($52.5 billion). Key players: Louis Gerstner Jr., Arthur Levitt. Founders: David M. Rubenstein, Daniel D’Aniello, and William E. Conway. Recent deals: Dunkin’ Brands, Hertz. Dutch media concern VNU, which owns A.C. Nielsen. Major funds: buyouts ($29 billion), distressed debt ($5 billion), real estate ($7 billion), venture ($4 billion). Web site: http://www.carlyle.com/. See Chapters 4 and 6. Credit Suisse Cust. Fund Invmt. Group, New York ($32.4 billion). Key players: acquired investment bank DLJ in 2000. Recent deals: United Site Services. Major funds: buyouts ($12 billion), funds of funds ($9 billion), mezzanine ($3 billion). Web site: http://www.credit-suisse.com/ib/en/alternative_investments/index.html. Kohlberg Kravis Roberts, New York ($31.7 billion). Key players: Henry Kravis, George Roberts. Recent deals: First Data, Sun Microsystems. Major funds: buyouts ($32 billion). Web site: http://www.kkr.com/. See Chapter 9. TPG, Fort Worth ($31.1 billion). Key player: David Bonderman. Recent deals: Alltel, Freescale, Biomet. Major funds: buyouts ($30 billion), funds of funds ($1 billion). Web site: www.texaspacificgroup.com/. See Chapter 9. Warburg Pincus, New York ($31 billion). Key players: roots in Germany. Recent deals: Aramark’s MBO. Web site: www.warburgpincus.com/. Apax Partners, London ($30.9 billion). Key player: Alan Patricof. Recent deals: TDC, the Danish tech and telecom; sold its interest in Intellisat. Major funds: buyouts ($17 billion), funds of funds ($14 billion). Web site: http://www.apax.com/. Bain Capital Partners, Boston ($30.8 billion). Key player: Mitt Romney. Recent deals: NXP Semiconductors, HCA hospitals. Major funds: buyouts ($26 billion), funds of funds ($5 billion). Web site: http://www.baincapital.com/. Permira, London ($29 billion). Key players: European. Recent deals: Freescale, Intelsat; sold Bridgepoint. Major funds: buyouts ($29 billion). Web site: www.permira.com. See Chapter 9. HarbourVest Partners, Boston ($26.1 billion). Key players: owned by management. Recent deals: invests in other funds. Major funds: other funds ($23 billion). Web site: http://www.harbourvest.com/. Apollo Management, New York ($24.8 billion). Key player: Leon Black. Recent deals: Harrah’s. Realogy Corp. Major funds: buyouts ($17 billion), real estate ($6 billion). Web site: http://www.apolloic.com/public/home.asp. CVC Capital Partners, Luxembourg ($25 billion). Key player: Javier Jaime. Recent deals: DCA Group, an Australian nursing home company. Major funds: buyouts ($25 billion). Web site: http://www.cvc.com/.

Figure A4.1 Top private equity firms are quite diverse Source: 2008 Preqin Global Private Equity Review (London: Private Equity Intelligence Ltd., 2008), pp. 64–67. Statistics reprinted with permission.

Appendix 4

390

Company Name *a “Good-to-Great” Company APPLE INC AMAZON.COM INC BEST BUY CO INC Nokia MANITOWOC CO ORACLE CORP YAHOO INC NUCOR CORP DANAHER CORP YUM BRANDS INC AMERICAN CAPITAL STRATEGIES UNITED STATES STEEL CORP DEERE & CO STARBUCKS CORP EXXON MOBIL CORP ALTRIA GROUP INC WHOLE FOODS MARKET INC TARGET CORP Berkshire Hathaway BAXTER INTERNATIONAL INC MCDONALD’S CORP NORDSTROM INC FORTUNE BRANDS INC WAL-MART STORES INC KOHL’S CORP MICROSOFT CORP EMERSON ELECTRIC CO PEPSICO INC CVS CAREMARK CORP* JOHNSON & JOHNSON WALGREEN CO* PROCTER & GAMBLE CO ABBOTT LABORATORIES* INTL BUSINESS MACHINES CORP Toyota Motor Corp. ILLINOIS TOOL WORKS WELLS FARGO & CO* BANK OF AMERICA CORP GENERAL ELECTRIC CO KIMBERLY-CLARK CORP* SOUTHWEST AIRLINES INTEL CORP KROGER CO* MACY’S INC TYCO INTERNATIONAL LTD PITNEY BOWES INC* COCA-COLA CO DISNEY (WALT) CO MOTOROLA INC PENNEY (J C) CO GENERAL MOTORS CORP FANNIE MAE* FORD MOTOR CO GOODYEAR TIRE & RUBBER CO CIRCUIT CITY STORES INC*

Annualized TSR 12/97 to 12/07** Chapter 47.3% 34.4% 28.9% 25.4% 25.2% 19.7% 19.1% 19.0% 18.9% 18.2% 16.3% 16.2% 14.8% 14.8% 14.2% 13.8% 13.2% 12.1% 11.8% 11.1% 10.9% 10.2% 9.9% 9.9% 9.8% 9.7% 9.7% 9.4% 9.4% 9.2% 9.1% 8.0% 8.0% 8.0% 7.2% 7.1% 6.9% 6.9% 6.4% 6.0% 5.0% 5.0% 3.9% 3.7% 1.7% 1.6% 1.3% 1.0% 0.6% 0.2% ⫺1.4% ⫺1.9% ⴚ2.7% ⫺6.7% ⫺7.1% ⴚ10.0%

9 6 7 9 ap. 3 9 6 7 7 7 7 7 4 9 ap. 4 7 4, 7 5, 7 3, 8 7 7 5 5 5 5 ap4 7 9 7 7 5, 7 7 7 7 6 7 7 di7 7 7 6, 9 7 7 5 5 7 ap. 4 4 3, 9 5 3, 6 7 6 6 7

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Comments by the Authors

Innovation Turnaround—Renewal Innovation—Dot.com Survivor Value Builder—Compare to Circuit City Top Value Builder—Compare to Motorola Top Value Builder—Uses Value Metrics Software Consolidator—Late telecom Innovator—Internet age Good to Great—Process Innovator Diversified—Private Equity Model/Lean Customer Centric—Pepsico Spinoff Diversified—Private Equity Like Model Comparison Co. to—Good to Great Nucor Top Value Builder—Uses Value Metrics Service Innovator—Benchmark OIL Wealth Benchmark Comparison Co. to—Good to Great Kroger Comparison Co.—New Concept Innovator Retail Renewal—Product Differentiator World Famous Investor—Warren Buffet Comparison Co. to—Good to Great Abbott Fast Food Benchmark High Svc—Customer Centric Benchmark Diversified—Portfolio Changer Top Retail Benchmark Top Retail—Game Changer Top Tech Benchmark Diversified—Portfolio Manager Top Brand Benchmark—Portfolio Changer Top Acquiring Retail Drugstore Co. Top Corp. Culture Benchmark—Portfolio Mgr. Benchmark—Good to Great Top Brand & Consumer Product Benchmark Good to Great Company Top Tech Turnaround—Benchmark Lean Thinking Leader—Auto Benchmark Diversified—Portfolio Manager Bank—Benchmark—Good to Great Comparison Co. to—Wells Fargo Top Value Builder—Benchmark Good to Great—to AVERAGE Top Airline Game Changer—Benchmark S&P 500 AVERAGE BENCHMARK Top Tech—Benchmark “Paranoid Leader” Good to Great—Intense Competition Retail Benchmark—In Transition Fraud Benchmark Good to Great—Technology Change Best Brand—Benchmark—Buffet Favorite Top Entertainment—Benchmark Tech Benchmark Retail Turnaround? Top Auto Benchmark—In Transition Good to Great—Accounting Discipline Top Auto “Quality Job #1”—Benchmark Auto—Tire Change Leader—Benchmark Good to Great—Intense Competition

Market Rank Cap 12/07 S&P ($billions) 2 6 9 n/a 15 42 50 51 53 62 90 92 100 101 111 118 125 144 n/a 157 161 175 177 179 183 184 185 194 196 202 203 222 223 224 n/a 244 252 253 268 277 295

173 38 22 149 6 116 31 17 28 19 6 14 41 15 512 159 6 42 219 37 70 9 11 190 14 333 45 122 59 191 38 228 87 149 192 29 102 183 375 29 9

317 325 345 348 350 355 359 364 384 386 397 421 424 431

156 18 11 20 8 142 61 37 10 14 39 14 6 1

**TSR Data Provided by ATIVO Research, LLC

Figure A4.2 Top value-building public companies outperform the management

classics

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NOTES 1. Source: 2008 Preqin Global Private Equity Review (London: Private Equity Intelligence Ltd., 2008), p. 119. Statistics reprinted with permission. 2. Source: TSR data provided by Ativo Research, LLC. Author analysis.

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BIBLIOGRAPHY OF SELECTED READINGS

BOOKS AND ARTICLES Bacon, John U.: America’s Corner Store: Walgreens’ Prescription for Success. Hoboken, N.J.: John Wiley & Sons, 2004. Bartlett, Bruce: “Supply-Side Economics: ‘Voodoo Economics’ or Lasting Contribution?” Laffer Associates, November 11, 2003. Bartlett, Bruce: Reaganomics: Supply-Side Economics in Action, 2nd ed. New York: Morrow/Quill, 1981. Brinkley, Douglas, ed.: The Reagan Diaries. New York: HarperCollins, 2007. Buffett, Warren: “An Owner’s Manual,” originally produced in June 1996, as updated on www.berkshirehathaway.com, accessed January 5, 2008. Burmeister, Edwin, Richard Roll, and Stephen A. Ross: “Using Macroeconomic Factors to Control Portfolio Risk,” rev. March 9, 2003, in “A Practitioner’s Guide to Arbitrage Pricing Theory,” which was a contribution to Practitioner’s Guide to Factor Models for the Research Foundation of the Institute of Chartered Financial Analysts, 1994. Available at: http://www .birr.com/Using_Macroeconomic_Factors.pdf, accessed by S. G. Pryor, January 25, 2008. Burrough, Bryan, and John Helyar: Barbarians at the Gate: The Fall of RJR Nabisco. New York: Harper & Row, 1990. Buzzell, Robert D., and Bradley T. Gale: The PIMS (Profit Impact of Market Strategy) Principles: Linking Strategy to Performance. New York: Free Press, 1987. Collins, James C.: Good to Great. New York: HarperCollins, 2001. Copeland, Tom, and Vladimir Antikarov: Real Options: A Practitioner’s Guide. Texere, NY: Monitor Group, 2001. Copeland, Tom, Tim Koller, and Jack Murrin: Valuation: Measuring and Managing the Value of Companies. New York: John Wiley & Sons, 1995, 1996. D’Souza, Dinesh: Ronald Reagan: How an Ordinary Man Became an Extraordinary Leader. New York: Free Press, 1997. Dash, Eric: “Executive Pay: A Special Report, More Pieces. Still a Puzzle.” New York Times, April 8, 2007. Available at: http://www.nytimes.com/2007/04/08/ business/yourmoney/08pay.html. Fama, Eugene F., and Kenneth R. French: “Migration.” CRSP Working Paper No. 614, February 2007. Available at Social Science Research Network: http:// ssrn.com/abstract=926556. Feynman, Richard P.: Classic Feynman, Ralph Leighton, ed. New York: W.W. Norton & Company, 2006. 393

394

Bibliography of Selected Readings

Gabaix, Xavier, and Augustin Landier: “Why Has CEO Pay Increased So Much?” MIT Department of Economics Working Paper No. 06-13, May 8, 2006. Available at Social Science Research Network: http://ssrn.com/abstract= 901826. Greenspan, Alan: The Age of Turbulence: Adventures in a New World. New York: Penguin Press, 2007. Greider, Bill: “The Education of David Stockman.” Atlantic Monthly, December 1981. Hamel, Gary: The Future of Management. Boston: Harvard Business School Publishing, 2007. Harvey, Campbell R.: “Identifying Real Options.” Cambridge, Mass.: National Bureau of Economic Research, latest revision December 30, 1999. Hass, William J., and Shepherd G. Pryor IV: Building Value through Strategy, Risk Assessment and Renewal. Chicago: CCH, 2006. Jensen, Michael C.: “The Agency Costs of Free Cash Flow: Corporate Finance and Takeovers.” American Economic Review vol. 76, no. 2, May 1986. Jensen, Michael C.: “Value Maximization, Stakeholder Theory, and the Corporate Objective Function.” October 2001. Unfolding Stakeholder Thinking: Theory Responsibility and Engagement, J. Andriof et al., eds. Sheffield, OK: Greenleaf Publishing, 2002. Kaplan, Steve: “Why CEOs Aren’t Overpaid.” Chicago GSB Magazine, Summer/ Fall 2007. Kaplan, Steve, and Antoinette Schoar: “Private Equity Performance: Returns, Risk and Capital Flows.” Journal of Finance, 2004. Lowenstein, Roger: When Genius Failed: The Rise and Fall of Long Term Capital Management. New York: Random House, 2000. Madden, Bartley J.: “For Better Corporate Governance, the Shareholder Review.” Journal of Applied Corporate Finance, vol. 19, no. 1, Winter 2007. Madden, Bartley J.: Cash Flow Return on Investment, CFROI. Oxford: Butterworth, Heinemann, 1999. Mandelbrot, Benot, and Richard L. Hudson: The (Mis)Behavior of Markets: A Fractal View of Risk, Ruin, and Reward. New York: Basic Books, 2004. Mauboussin, Michael J.: More than You Know: Finding Financial Wisdom in Unconventional Places. New York: Columbia University Press, 2006. Modigliani, Franco, and Merton H. Miller: “Dividend Policy, Growth and the Valuation of Shares.” Journal of Business, October 1961. Novak, David, and John Boswell: The Education of an Accidental CEO. New York: Crown Publishing, 2007. National Venture Capital Association: “Venture Impact: The Economic Importance of Venture Capital Backed Companies to the U.S. Economy,” 4th ed. National Venture Capital Association white paper, 2007. National Venture Capital Association: “National Venture Capital Association 2008 Predictions Survey,” National Venture Capital Association PowerPoint presentation. Available at: http://www.nvca.org/. Platzer, Michaela: “Patient Capital, How Venture Capital Investment Drives Revolutionary Medical Innovation.” National Venture Capital Association white paper, 2006.

Bibliography of Selected Readings

395

Poole, R.W., Jr., and V. Butler: “Airline Deregulation: The Unfinished Revolution.” Los Angeles: Reason Public Policy Institute Policy Study No. 255, 1999. Porter, Michael: Competitive Strategy: Techniques for Analyzing Industries and Competitors. New York: Free Press, 1985. Posen, Robert C.: “If Private Equity Sized Up Your Business.” Harvard Business Review, November 2007. Preqin: 2008 Preqin Global Private Equity Review. London: Private Equity Intelligence Ltd., 2008. “Private Equity: Tracking the Largest Sponsors,” Moody’s Investors Service, January 2008. Available at: http://www.moodys.com/moodys/cust/ research/MDCdocs/11/2007000000468164.pdf?doc_id=2007000000468164& frameOfRef=corporate. Pryor, Shepherd G. IV, William J. Hass, and Dennis N. Aust: “Driving Long-Term Value: What Are the Next Steps?” Directors Monthly, vol. 30, no. 12, December 2006. Pryor, Shepherd G. IV, William J. Hass, and Dennis N. Aust: “Inertia or Change? Try Continuous Renewal!” The Journal of Private Equity, vol. 10, no. 2, Spring 2007. Rappaport, Alfred: Creating Shareholder Value: A Guide for Managers and Investors, rev. ed. New York: Free Press, 1998. Reagan, Ronald: An American Life: Ronald Reagan, the Autobiography. New York: Simon & Schuster, 1990. Ricardo, David: On the Principles of Political Economy and Taxation. N.p., 1817. Say, Jean-Baptiste: A Treatise on Political Economy, 6th American ed. Philadelphia: Grigg & Elliott, 1834. Skinner, Kiron K., Annelise Anderson, and Martin Anderson, eds.: Reagan: A Life in Letters. Introduction and commentary by Kiron K. Skinner, Annelise Anderson, and Martin Anderson. New York: Free Press, 2003. Snowden, David F., and Mary E. Boone: “A Leader’s Framework for Decision Making: Wise Executives Tailor Their Approach to Fit the Complexity of the Circumstances They Face.” Harvard Business Review, November 2007. Sorkin, Andrew Ross: “Is Private Equity Giving Hertz a Boost?” The New York Times, September 23, 2007. Available at: http://www.nytimes.com/2007/ 09/23/business/23hertz.html?_r=1&th=&oref=slogin&emc=th&pagewant. Stewart, G. Bennett III: The Quest for Value: A Guide for Senior Managers. New York: HarperCollins, 1991. Stockman, David: The Triumph of Politics: Why the Reagan Revolution Failed. New York: Harper & Row, 1986. Swenson, David: Unconventional Success. New York: Free Press, 2005. Taleb, Nassim Nicholas: The Black Swan. New York: Random House, 2007. Thomas, Rawley, and Laure Edwards: “How Holt Methods Work: For Good Decisions, Determine Business Value More Accurately.” Corporate Cashflow, September 1993. Tufte, Edward: The Visual Display of Quantitative Information. Cheshire, CT: Graphics Press, 2001. Ubelhart, Mark C.: “Encouraging Equity Excitement and the Creation of Value: Case Studies of Shareholder-Value Incentives.” American Compensation Association Journal, Autumn 1994.

396

Bibliography of Selected Readings

Wanniski, Jude: The Way the World Works: How Economies Fail—and Succeed. New York: Basic Books, 1978.

WEB SITES AND PUBLICATIONS WITHOUT NAMED AUTHOR Basel Committee on Banking Supervision, “International Convergence of Capital Measurement and Capital Standards, a Revised Framework,” Comprehensive Version. Available at: http://www.bis.org/publ/bcbs128.pdf. http://www.federalreserve.gov/boarddocs/speeches/1996/19961205.htm. http://www.sec.gov/Archives/edgar/data/47217/000104746907000347/ 0001047469-07-000347.txt. “Putting Pay for Performance to the Test.” The New York Times, April 8, 2007. Available at: http://www.nytimes.com/2007/04/06/business/ businessspecial/ 20070408_EXECPAY_GRAPHIC.html?_r=1&oref=slogin. Statistical Abstract of the United States. Available at: http://www.census.gov/prod/ 2001pubs/statab/sec21.pdf. www.Morningstar.com. www.preqin.com. www.TopValueBuilders.com.

ACKNOWLEDGMENTS

This book is a combined effort of three authors working toward a common goal: To bring new insights to the world based on asking, “What do the facts say?” To us, it is a familiar process, going back more than 30 years, when we variously met at the University of Chicago, where facts ruled. Years later, we have seen the world of value from several perspectives. Before and after a project of this extent, any part-time author would be wise to recognize the impact that writing a book has at home. Our families were all patient to a fault during our stint as coauthors. So, in particular, we thank our wives: Traci Laffer, Debby Hass, and Diane Pryor. Permissions are part of all modern publications. Fortunately, we had theirs. Along the way to producing this book, there have been many helping hands. Our research efforts were greatly assisted by the people at Laffer Associates and the many coauthors of various papers and monographs of Arthur Laffer over the years. These included Steve Moore of the Wall Street Journal, Wayne Winegarden of Arduin, Laffer & Moore Econometrics on stock repurchases, and many others. We especially thank Ford Scudder at Laffer Associates, who has been a fantastic supporter and who helped to keep us moving forward. Others at Laffer Associates include Jeff Thomson and Mark Wise, who were invaluable in providing us with graphics and data, and Tom Landstreet, Daniel Stephenson, Butch Butler, and Justin Laffer, who provided comments on our various drafts. We also thank our many friends in private equity who helped verify and clarify our research on some of the techniques that we discuss in the book. Thanks go out to Dennis Chookaszian, private equity player and also former chairman of CNA Insurance, and Bill White, a professor in the McCormick School of Engineering and Applied Science at Northwestern University, a private equity 397

398

Acknowledgments

player and former CEO and chairman of the board of Bell & Howell Company. Both were generous with their time in interviews and sharing their views on management. Operating world input was also provided by Bill Pesch, CEO of McBride, Inc., a portfolio company of Linx Partners, a private equity fund, Duncan Bourne of Wynnchurch Capital, Sean Falmer, vice president, Commodity Pricing and Supply, RBS Sempra Commodities, and many others. We also wish to thank the many top value builders from the public company world interviewed for this book, including Bob Lane, CEO of Deere & Company, and Joe Mansueto of Morningstar. We also greatly appreciate the encouragement from Jim Schrager and Bob Kaplan at the University of Chicago Booth School of Business, who are academic practitioners in private equity. On corporate value and value metrics, our mentors in modern approaches to corporate valuation and the stock market include Dennis Aust of CharterMast LLC; Ricardo Bekin and Ram Gopal at Ativo Research; Bob Hendricks of CSFB HOLT; Rawley Thomas, CEO of LifeCycle Returns; Mark Ubelhart of Hewitt Associates; Robert Agnew of Discover Card and formerly with FMC Corporation; Paul Muller of IBM; Don Delves, CEO of the Delves Group; and Glen Dahlhart, retired Ernst & Young partner. Books are never finished without the help of the publisher. We were fortunate to work with Jeanne Glasser, who as our editor provided crucial input that formed the final vision of the book, and Pattie Amoroso, editing supervisor, who led the production team and guided us through the production process to the finish line.

INDEX

Note: pages with “n” indicate note.

A Abbott Labs, 227–229, 390 Accredited investors, 120n38 Activist groups, xviii, 3 After-tax cash flow: evaluating incentives by, xiv impact internationally, 70, 72–73 impact on states, 68–71, 77n29 importance of, xxxi valuing corporations using, 11, 260, 286n20 Airline industry, 94–95, 119n22, 207–210 Altria Group, 229 Amaranth, 83, 86 American Capital, 230, 390 Amfac, 123–124 Antikarov, Vladimir, 181 AOL, 14–15 APT (arbitrage pricing theory), 369, 384 Articles, bibliography, 393–396 Automotive industry: “lean thinking,” 200–201, 307 perfect storm, 94–95, 195–196 turnarounds, 103–104 vertical integration, 119n22

B Baker, Jim, 57–58 Bank of America, 230, 390 Banking industry, 110, 114, 231–235 BankOne, 31 Bankruptcies, 175, 185, 207, 209

Barlett, Bruce, 50–51 Barney’s New York, 177 Barns, Brenda, 199 Basel Accords, 110 Beatrice Foods, 37, 366 Bell and Howell, 310–311 Berkshire Hathaway, 230 Bernanke, Ben, xii, 279, 281, 283, 304–305 Best Buy, 147–148, 226, 236–237, 239–241, 390 “Bet the farm,” 175, 302–305, 311 Bibliography, 393–396 Blackstone, xi, 12, 309, 389 Blake, Frank, 6 Boards of directors: private equity firms: characteristics of, 37, 320 judgments about corporate value, 155n30 stock repurchases, 162–168 public companies: characteristics of, 37 conflicts over compensation within, 138–139 examples of mistakes by, 3–4 risk identification, 80–81 Boeing, 307 Bonds, 105, 369, 373 Bonus systems: based on immediate feedback and incentives, 145–146 franchise systems vs., 142 team performance, 143–144 Breen, Ed, 161 Bryan, John, 199 Bubbles, xiii–xiv, 42n27, 90, 245, 304 399

400

Budget, federal: growth with reasonable, 353 myth of balanced, 49, 64–66 overstatement of problem of deficits, 340–341 Buffett, Warren: dollar decline, 257 on intrinsic value, 11–12 intrinsic value purchases by, 168 types of investments made by, 91–92 value audits, 366–367 Bush, George H.W., 57 Buyouts, 37, 137–138, 195–197 (See also LBOs [leveraged buyouts])

C Campeau, Robert, 175 Capital, cost of, 35–37, 323, 371–379 CAPM (capital asset pricing model), 368–369, 373, 384n15, 385n22 CarMax, 235–236 Carter, Jimmy, 48, 52 Case, Steve, 15 Cash, uses of, 162–168 Cash flow: communication, 5–6 EBIDTA as surrogate for, 28 growth, 172–173 incentives, xiv intrinsic value, 89, 93 long-term, 27–28 metrics, 164, 169 outsourcing, 18 predicting, 8, 13 at SBU level, 10 value building, 184–185, 322 valuing corporation using, 369–371 (See also DCF [discounted cash flow] valuation) CDW Corporation (formerly Computer Discount Warehouse), 127–128 CEOs, 4–6, 12–13 (See also Executive compensation)

Index

CEP (Capitalized Economic Profits): accuracy of, 20, 254–256 comparison with S&P 500 index, 349 construction of, 19 impact of formulation of, 18–19 model, 7 Cerberus Capital Management, 95, 103–104, 196–197, 307 CFROI (cash flow return on investment), 120n27, 132–133, 372 China, 266–267 Chipotle, 171 Chookaszian, Dennis, 105, 211 Chrysler Group, 4, 103–104, 196–197, 307 Circuit City, xxvii, xxxiii, xxxiv, 223–224, 226, 235–240, 390 CMA (Callard, Madden & Associates) model, 372 Collins, Jim, 224, 226–227, 229, 231, 235, 244–245 Communication: analysis of data, 109–110 of goals, 63–64 improving with napkin sketch, 79–80, 100, 106–109 of incentive plans, 152 of inflection points, 267–268 quarterly reports and stock volatility, 212–213 risk assessment, 98–101 speed and efficiency, 212 to stockholders using GAAP, 40n9 Comparative advantage framework, 258 Competition: bold measures, 205–206 customer focus, 236–241 executive involvement, 197–199 failure to act element, 210–212 impact of, xxvii integrating, 231–235 “lean thinking,” 200–201, 307 political aspects, 206–210 regression to mean of, 226–231

Index

speed, 194–197, 216 timing, 204 Conglomerates, 29–30, 247n11 Control premiums, 181 Conway, William E., Jr., 141–142 Copeland, Tom, 13, 181 Corporate value, 371–376 factors affecting, xxviv, xxx, xxxiii meaning of, xvii–xxviii stock prices and intrinsic, 20–26 COSO framework, 97–98 Cost of capital, 35–37, 323, 371–379 Covenant lite transactions, 17, 21, 251–252 Credit crunch: Federal Reserve, 278–283, 288n36, 354n9 impact of, 219, 245 inverted yield curve, 269, 271, 275, 277–278 stock prices, 256 wealth decline, 339 Credit derivatives, 113–115 Crisis, learning from, 7–10 Crocker Bank, 230 Customer focus: changing needs, 206 Deere & Company, 137 loss of, 233, 236–237 public institutions, 147–148 renewal with changes, 241–244 Toyota, 200–201 value building, 307 Whole Foods, 144 CVS/Caremark, 201–203, 390

401

advanced forms, 90 derivations of, xxv–xxvi different perspectives of, 371–372 GAAP vs., 11 importance of, 38 methodologies, 375–376, 378, 385n22 stock price levels vs. changes, 89–90 using real options instead, 180–184 valuing corporation using, 11, 26–27, 368 Debt, 7, 339 Decision making, 98–101, 179, 204, 210–212, 221n29 (See also Risk; Speed) Deere & Company, 390 bonus structure of, 144–146 cost of capital, 35 Lane and culture of, 136–137 risk assessment at, 99 Deficits: measuring, 339–342 reasonable, 353 trade, 257–262, 269, 286n17, 335–336, 339–340, 350 Deregulation, 207, 209–210 Derivatives, 113–115 Disciplined thinking, xiii, 240 Discount rate, choosing, xxvi Disney, 130, 134–135, 147 Distressed companies and industries (See specific companies) Dole, Bob, 53, 58 Dunkin’ Donuts, xv Dutch auctions, 187n10

E D Daimler Benz, 196–197 Danaher, 230, 390 Darman, Richard, 58, 60 Dart & Kraft, 366 Dayton Hudson Department Stores, 169 DCF (discounted cash flow) valuation:

Early-stage companies, 293–294 EBITDA (earnings before interest, taxes, depreciation, and amortization): CAPM and, 369 incentives, 129, 141, 154n13 multiples and valuation, 22, 28, 44n33, 45n39

Index

402

EBITDA (Continued) risk and, 79, 106–109 role in LBOs, 28 as surrogate for cash flow, 28 usefulness, 45n39 as yardstick, 191, 196, 212, 323, 369 Eckerd drugstores, 176 Economic effect, 359 Economic value, xxv Education, economic, 144–145 Edwardson, John, 23, 127–128 Efficient markets, xi, 218 Eichelbaum, Stan, 176–177 Eisner, Michael, 134–135 Ellison, Larry, 294–295 Employee recognition programs, 147–148 Enron, 249n37 EPS (earnings per share): action and speed, 194, 196, 205, 210–214 overemphasis on, xxvi action and speed, 194, 196, 205, 210–214 GAAP earnings vs., 5 incentives, 132, 135–136, 140, 152 quarterly reports, 136, 221n29 risk, 102, 105 valuation, 10, 20, 22, 25, 30, 38 ERISA (Employment Retirement Income Security Act, 1974), 293 ERTA (Economic Recovery Tax Act, 1981), 52–53, 55–56 Esmark, 366 ESOPs (employee stock ownership plans), 142, 144 Estimates, 101–102 EVA (economic value added), 130n27, 133, 373, 380, 385n19 Exchange rates, 257–259, 262 Executive compensation: disclosure rules, 125–127, 130, 132–133 government intervention, 125–126 incentives, 128–129

intrinsic value linked to, 139–140, 151 justification of, 129–135 private equity firms vs. public companies, 123–124, 127–128, 135–136, 138–140 severance, 134–135 team performance bonuses, 143–144 Exit strategies, 160–161 Expectations, market, xi, 30, 68, 167, 256, 261–263

F Fair value (intrinsic value), 11–13, 254–255, 375, 381 Fallacious reasoning, types of, xxxvi–n9 Family-owned firms, 201–204 Fannie Mae, xxxiv, 229, 390 Fat tail, 85–86, 100, 116 Federal Reserve (“The Fed”): credit crunch, 278–283, 288n36 currency devaluations by, 258 dual goals of, xxxiv monetary policy and indicators, 330, 343–353 response time, 279 TAF experiment, 305 trade deficits and exchange rates, xii, 258, 270–271, 281 Y2K predictions, 92–93 Federated Department Stores, xv, 172, 175–177, 188n20–22, 390 Feedback effect (See People effect) Financial Accounting Standard (FAS) 123R, 125, 132–133 Financial derivatives, 113–115 First Data, 306 First Interstate, 232–235 Fiscal policy, overview of, 330–332 Fixed income securities, 105 Flat tax, xvi, 70–73 FMC, 366 Ford Motor Company, 195–196, 390 Fractal behavior, 86–93

Index

Fractal events, 8–9, 40n7 Fractal risk, 292 Framework(s): based on fundamentals, xiv intrinsic value, 11–12 new supply-side, 330–332 for understanding risk, 83, 96–98 for understanding trade deficit, 257–261 (See also specific approaches to value) Franchise systems, 142 Freescale Semiconductors, 308–309 Frequency distribution, 40n7, 87, 91, 118n16 Friedman, Milton, 51–52 Frissora, Mark, 196

G GAAP (generally accepted accounting principles): cash flow in, xviii communicating to stockholders using, 40n9 described, 39n2 earnings vs. EPS, 5 estimates, 101 failure of, 11 stock prices, 12 top value builders, 35–36 use of price-earnings ratios, 30–31 Gaussian frequency distribution, 87–92, 102–103, 118n16 GDP (gross domestic product), xxv, 266, 278–279, 288n37, 336 GE (General Electric), 101, 174, 198, 230 General partners, role of, xxviv–xx Gillette, xli, 229 GIPEs (Government Investments in Public Equity), 216 Glassner, Frank, 129–130 Goals: clearly focused, xi–xv, 63–64, 135–136 common are critical, xiii, xxxiv, 278 distortion of, 320–321

403

EBITDA, 191, 212 focus on long-term value, 313 sales growth as, 377 shareholder value maximization as, 13 of value builders, 320–321 Goodyear, 205–206, 390 Government agencies, 201, 322–323 Grasso, Richard, 125 Greenspan, Alan, xii, 93, 111, 279, 285n6, 354n6 Growth and value, 23–24

H Halliburton Corporation, 126 Hamel, Gary, 143–144 Hammer, Armand, 267–268 Hanbrect, William, 308 Hass, Bill, 147–148 Hass, Veronica, 147–148 Hayakawa, S. I., xxx Hazen, Paul, 232–234 Heckmann, Dick, 7–10 Hedge funds: perfect storms, 84–86, 88 performance, 111–113 private equity vs., 118n15 risk level, 83–84 Hertz, xv, 195–196 Hewlett Packard, 124 HOLT model, 372 Home Depot: Blake and, 6–7 Nardelli and, 4–6, 9, 134–135 stock price, 12, 390 use of price-earnings ratios, 31 Hong Kong, 72 Hotchkiss, Edith, 194–195

I IBM, 229, 390 Icahn, Carl, 308–309 Iceland, 72

Index

404

Ideology, 56, 149 IEV (intrinsic equity valuation), 385n20 In-market acquisitions, 231–232, 234 Incentives: employee, 142–148 evaluating, xiv franchise operations, 142 importance of, xiv, xxxi–xxxii justifying, 131–132, 134 overview of, 150–151 public disclosure, 125–127, 130 stock options, 133–134 tax rates, 148–149, 344–345, 359–361 value-based, force change, xi in venture capital firms, 294 (See also Bonus systems; Executive compensation) Income policies, xi, 330, 337–338 Inflation: indexing tax rates for, 56 Keynesian policies, 59 monetary policy, 346 overview of twentieth century, 333–334 Inflection points: communicating, 267–268 identifying, 257, 283–284 importance of, xxxiv predicting, 263–264, 269–271 refusal to see, 267–268 as self-correcting market mechanisms, 261–262 timing, 279, 281–282 Information: data, 109–110 flow, 24–25 importance of, 321 Internet, 216–218 to stockholders using GAAP, 40n9 testing reliability of, 27 International capital flow drivers, 260–261, 286n20 Internet, 109–110, 216–218, 302–304, 396

Intrinsic value: calculating, xxvi, 11–12, 367–374 cash-generating capacity, xviii CEO communicating, 5–6 cost of capital and creating, 36–37 defined, xxv, 11 executive compensation, 139–140, 151 stock prices, 20–26, 168 stock repurchases vs. dividends, 190n39 theory vs. practice, 11–12 value audits, 33–34, 367–374, 385n22 waterfall, 31–35 (See also Incentives; Value) Inverted yield curves, 269–278, 334 Iridium, 309–310 ITW (Illinois Tool Works), 198, 230, 390

J JC Penney’s, 176–177, 390 Johnson, Ross, 194 Johnson & Johnson, 229–230, 390

K Kaplan, Steven, xx, 129 Kelly, Don, 37 Kemp, Jack, 50, 52 Kemp-Roth Act, 55–56 Keynesian economic policies, 48–49, 51, 56, 59–60, 331 Kimberly Clark, 229 Kinder, Richard, 137–138 Kinder-Morgan, 137–138 KKR (Kohlberg Kravis Roberts), 194, 306 Kmart, 169, 174 Kohl’s, 170, 390 Kovacevich, Richard, 234 Kraszny, Mike, 127–128 Kravis, Henry, 194 Kroger, 229, 390

Index

L Laffer, Arthur, 8, 47–48, 51–55, 57–58, 253, 267–268, 279 (See also CEP [Capitalized Economic Profits]) Laffer Curve: capital gains, 361–362 internationally, 70, 72–73 origin, 358 public awareness of, 66–67 state level, 70 Lampert, Edward, 174, 311–312 Lane, Bob, 35, 136–137, 144–146 LBOs (leveraged buyouts), xi, 28, 45n39, 81, 299–300, 308, 314, 366–368 LCRT (LifeCycle Returns) model, 374, 379, 385n22 Lead steers, 23 Lean thinking, 200–201, 307 Leverage, xxii, 9, 17, 85–86, 114, 185, 377 Limited partners, xxviv Liquidity, excess supply problems, 93 Long Term Capital Management (LTCM), 84–86, 88 Long-term profits, 20–21, 23, 136 Lottery model, 150 Lowenstein, Roger, 85 Lowes Cos., 5

M Macro cycles, 253, 324–325 Macroeconomic partitions, 329–332 Macy’s, Inc. (See Federated Department Stores) Madden, Bart, 13, 33–34 Madison Dearborn Partners, 127–128 Magnavox, 300 Management (See CEOs; Executive compensation) Management inertia, 224–226 Mandelbrot, Benoit, 87–88, 102 Mansueto, Joe, 216–217

405

Markets: allocate resources, xiii bubbles, xiii–xiv fractal behavior of, 87–88 nature of, 24–25, 87 Marshall Field’s department stores, 170 MasTec, 8 Mauboussin, Michael, 115 McDonald’s, 171, 390 McGuire, William, 131 McMillan, Steve, 199 Meister, Keith A., 308 Mergers, unsuccessful, 14–15 Meriwether, John, 84–85 Merrill Lynch, 135 Merton, Robert C., 84 Mervyn’s department stores, xv, 170 Messier, Jean Marie, 7, 9–10 Metrics: accounting, 4–5 arithmetic, 305 capitalized economic profits, 349 deficits, 339–342 to evaluate business, 367–371, 374–375, 379–380 importance of, xiv performance, 112, 132, 140 risk, 111–112 traditional, 371, 379 value-based, 132, 371, 379–380 Miller, Merton, 128 Misery Index, 343 Monetary base management, xii Monetary policy, xxviv, 330, 332–334, 346–347 Motorola, 101, 308–310, 390 Mundell, Robert, 51–52, 254 Mutual funds, 247n11

N NAFTA (North American Free Trade Agreement), 336 Nardelli, Bob, 4–7, 9, 12, 134–135 Neiman Marcus, 177

406

New York Stock Exchange, 125 NIPA (national income and products accounts), 19 Nonprofit organizations, 322–323 Nordstrom, 147–148, 390 North American Phillips, 300 Northwest Industries, 366 Norwest, 234–235 Nucor, 229 Numbers effect, xxiii, xxiv, xxvii–xxvii, 58, 67, 359 NVCA (National Venture Capital Association), 294

O Occidental Petroleum, 267–268 Oil prices, 260–268, 337–338, 388 Olsen, Frank A., 196 O’Neal, Stan, 135 Operating return on assets (OROA), 145–146 Oracle, 294–295 Outliers, 86, 88, 103 Outsourcing, impact of, 18 Ovitz, Michael, 130, 134–135

P Partners, types of, xxviv PE (price-earnings ratios): flaw as performance measure, 19, 45n38 impact of misuse of, 29–31 stock valuation, 22 People effect (feedback effect): cash, 93, 162–163 importance of, xxviii incentives, 124 leadership, 48, 55–56, 67–69 overview of, xxiii–xxiv risk, 85, 93, 102, 115 speed of action, 210, 214, 256, 281, 304–305 tax rates, 48, 55, 68–69, 359 value, 26, 163, 324

Index

Perfect storms: airline and automotive industries, 94–95 financial models and, 87 frequency of, 85 Performance (See specific topics) Performance metrics, 112, 132, 140 Pets.com, 302–304 Phillip Morris, 229 Pillar Data System, 294–295 PIPEs (private investments in public equity), 214–216 Pitney-Bowes, 229 Planning horizon, 192–193 Portfolio approach, 291–292, 308–310, 314 Portfolio companies (See specific companies and topics) Price-elasticity, 264–265 Price rule, 60, 63, 331, 333–334, 346 Private equity firms: acquisitions by, 224–225 boards of directors: characteristics of, 37, 320 judgments about corporate value, 155n30 stock repurchases, 162–168 executive compensation metrics, 132 headquarters’ venues, 126, 389 investments made by, 91–92 public companies becoming, 138–139, 306–308, 310–311 public companies vs., 95–96, 123–124, 127–128, 151–152 renewal options of, 171 risk, 82, 94, 115 size and flexibility of, 117n3 value building, 141–142, 322–323 Private equity funds: diversity of, xx–xxi, 388–389 executive compensation metrics, 140 focuses of, 185n1, 389 global impact of, xxii–xxiii hedge funds vs., 118n15 information flow, 24–26 overview of, xxviv–xx, 387–389

Index

returns, xxviii specialization by, 320 Private equity market growth, 16–20 Privatization, 201 Probabilistic approaches, 99–100 Proctor & Gamble, xxxiii, 229–230 Public companies: acquisitive, 198–199 boards of directors: characteristics of, 37 conflicts over compensation within, 138–139 examples of mistakes by, 3–4 risk identification, 80–81 as cash hoarders, 162–168 costs and benefits over private, 125–126 crisis mentality, 160–161 executive compensation, 123–124, 127–135 goal distortion, 320–321 going private, 138–139, 306–308, 310–311 growth estimates, 16 growth vs. value in, 141, 390 information flow, 24–26 private equity firms vs., 95–96, 123–124, 127–128, 151–152 renewal options of, 171 research and development in, 297–298 resistance to change, 196–197 risk identification, 80–81 size and flexibility of, 117n3 spinoffs, 308–310 using private equity model, 230 value building, 171, 174, 322–323

Q Questrom, Allen, 175–177

R Random walk model, 88 Rappaport, Al, 13, 366 Reagan, Ronald:

407

as communicator, 64 Laffer and, 47–48, 52–53 tax policies, 254, 344–345 appeal to public, 61 background of, 48–52 debate over, 56–60 timing and phase in, 52–56, 62 trade policies, 336 Real options technique, xxxii, 180–184 Rebates, 282 Regression to the mean, 226–231, 379 Regulation: of hedge funds, 111–112 impact of declining, 351 protectionary, 221n23 unintended consequences, xii–xiv, 124–126, 335, 337 (See also SOX [Sarbanes-Oxley]) Reichardt, Carl, 230, 232, 298–300 Renewal: with changing customer needs, 241–244 scenarios, 73, 168–178, 185 speed, 239–241 strategies, 224, 227, 234–235, 244–246 Research and development, 297–298 Retail industry: Internet, 302–304 success of renewal scenarios, 174–178, 185 volatility and need for changing scenarios, 168–174 Returns: of “great companies,” 227–230 of private equity funds, xx, 387–388 Risk: in banking industry, 110, 114 control practices, 91 defined, xxvi–xxvii Gaussian normal use and, 87–92 identification of, 80–82 communication and, 98–101 COSO framework for, 97–98 matrix for, 96–97 Long Term Capital Management and, 84–86, 88 management, 83–84

408

Risk (Continued) overview of, 115–117 prioritizing, 97 views of, xxxi RJR Nabisco, 194 ROIC (return on invested capital), 238 Ross, Wilbur, 95–96, 216, 225 Roth, Bill, 50, 52 Rowan Companies, 263–264 Rubber tire industry, 205–206 Rumelt, Richard, 310 Russia, 72

S Salvage value, 369 Sam’s Clubs, 170–171 Sara Lee, 199 Sarbanes-Oxley (See SOX [SarbanesOxley]) Say’s Law, 50–51 SBUs (strategic business units), 10, 33–35, 370, 373 Scalability concept, 88 Scenarios: for acquisitions, 179–184 contingency plans, 160, 178–179 retail industry: success of renewal, 174–178 volatility and need for changing, 168–174 for stock repurchases, 178 using, xxxii value of, 184–185, 321 Scholes, Myron, 84 Schoonover, Phil, 236–238 Schultz, George, xxviii, 57 Sears, 174, 311–312 SEC (Securities and Exchange Commission): incentives, 125–127, 130 risk, 81, 97 speed of action, 215, 217 value, 11, 25, 34–35, 40n9 Sequential investment strategies, 180–184

Index

Short-term profits vs. long-term, 20–21, 23 Silo effect, 220n14 Six Sigma, 101 Smith, Jim, 270 Snow, John, 104 Sony, 300–301 Southwest Airlines, 208–209, 390 SOX (Sarbanes-Oxley): benefits to management of, 42n24 cost of, 16, 152 risk assessment, 80, 97–98 transparency, 337 S&P 500 comparisons: with CEP, 349 with “great companies,” 227–230 with private equity, xx, 230, 387–390 with value builders, xxv, 387–390 Speed: of action, 205–206 of changes after buyouts, 195–199 of communication, 212 of decision making, 204, 210–211 deregulation, 207, 209–210 family-owned firms, 201–204 importance of, xxxiii, 193–194, 200, 218–219, 279, 281, 321–322 of information, 216–218 renewal, 239–241 Spitzer, Elliot, 13 Start-up ventures, 293–294 Stern, Joel, 23, 373 Stewart, Bennett, 13, 373 Stock dividends, 164–166, 184–185, 186n5, 186n8, 190n39 Stock options, 132–134, 154n19 Stock prices: capitalized economic profits, 254–256 GAAP, 12 intrinsic value, 11–12, 20–26, 168 levels vs. changes in, 89–90 outliers, 103 overview of post-World War II, 334–335

Index

quarterly reports and volatility of, 212–213 recession forecaster, 65, 272–273 stock repurchases, 166–168 theories of changes, 87 Stock repurchases, 162–168, 177, 184–185, 186n5, 190n39 Stockman, David, 54–62 Sun Capital Partners, xi, 104 Supply-side economics, 50–51, 53, 56–60, 68, 254, 331 SVA (shareholder value added), 145–146 SVRs (shareholder value reviews), 376 Swift & Company/Esmark, 37, 366

T TAF (temporary auction facility), 305 Takeovers, 166, 179–180 Taleb, Nassim, 102–103 Target Corporation, xv, 169–172, 390 Tax rates: economic impact, 253–254 on corporate value, xxviv, xxx–xxxi, 17–18 at margin, 55–56, 66, 74, 332, 360–361 on states, 68–71, 77n29, 148–149 on stock market, 334–335 equity costs and leverage, 187n12 flat tax, xvi, 70–73 as incentives, xi, xvi, 344–345 inflation indexing, 56 as international capital flow drivers, 259–261 for middle class, 362–363 migration of businesses, 148–149 people effect and rate reductions, 48 Reagan cuts: appeal to public for, 61 background of, 48–52, 334 timing and phase-in, 52–56, 62 revenues and, 67, 358–360

409

stock repurchases vs. dividends, 165–166 timing, 54–55, 360–361 Terminal value, 369, 378 Time Warner, 14–15 Timing: importance of, xiv, 322 inflection points, 279, 281–282 of tax rate cuts, 54–55, 360–361 TIPS (treasury inflation-protected security) yields, 269–270, 276–277 Tobin’s Q ratio, 20, 43n28, 349 Toxic financing, 215–216 Toyota, 200–201, 307, 390 TQ (talent quotient), 146 Trade deficits, 257–262, 269, 286n17, 335–336, 339–340, 350 Trade policy, 330, 335–336, 354n7 Trader Joe’s, 229 Traders compared to value builders, xxv Traditional metrics, 371, 379 Transformations, 306–308 TSR (total shareholder return), 133, 388, 390 Turnarounds, 48, 64, 103–104, 161, 171, 174–178, 261, 305 TXU Corporation, 12, 306 Tyco, 161

U Ubelhart, Mark, 133–134, 136 United States Filter, 7–9 UnitedHealth Group, 131 USX, 229, 390

V Valuation models, 372–375 Value: of currency, 257–259 defined, xxv, xxix–xxx, 13 determining, 10–11, 14–15, 26–27, 102–103

Index

410

Value (Continued) employees’ education, 144–145 growth, 23–24 high EBIDTA goals as benchmark for, 191 of innovations, 295 long-term, 313, 377 private equity focus vs. public companies, 141–142 ranges, 13–14, 26–29, 156, 367, 374 relating macroeconomic variables to, 160 stock repurchases, 177–178 (See also Intrinsic value) Value audits, 33–34, 365–374, 377–378, 385n22 Value-based metrics, 132, 371, 379–380 (See also specific metrics, such as EVA) Value builders: actions specific to type, 322–323 adaptability, 312–313 attracting, xxxii, 135–136, 146–148 characteristics of, xv, xvi–xvii, xxiv–xxv, xxvii, xxviii, 38–39, 90, 239–240, 244–245, 320 compensation of, 135–136, 151 experimentation, 306–311, 313–314 family-owned firms, 203 focus of, xviii–xix, 307 GAAP, 35–36 goals of, 320–321 macroeconomic environment, 268–269 motivation of buyers, xiv in public companies, 171, 174 returns of compared to S&P 500, xxv, 206, 390 Southwest Airlines example, 208–209, 390 speed, 197–198, 204–206, 210, 218–219 stock repurchases by, 162–168

strategy of simplifying, 161 timing, 182 top, defined, xi–xxii use of scenarios by, 160–161, 178–179, 184–185 Value drivers, 34, 160, 369–370 Value ranges, 13–14, 26–29, 156, 367, 369, 374 Value waterfall analysis, 31–35 Variance analysis, 32–33, 99 Venture capital, xxxiv–xxxv, 293–296, 302–304, 306–308, 314 Vivendi, 7, 9–10 Volcker, Paul, 59–60, 254, 284n3, 333

W Wal-Mart, 163, 170–171, 173–174, 229 Walgreen, Cork, 161 Walgreens, xxxiii, 161, 171, 174, 223–224, 227–228, 241–244, 390 Wanniski, Jude, 51–52, 66–67 Wealth, defined, xxx–xxxi “Wealth effect,” 316n11 Web sites and Internet, 109–110, 216–218, 302–304, 396 Welch, Jack, 370 Wells Fargo, 223, 231–235, 298–300, 390 White, Bill, 310, 313 Whole Foods, 143–144, 147–148, 229, 390 Wickes Furniture Company, 104

Y Yield curves, 269–278, 334 Y2K predictions, 92–93 YUM! Brands, 240–241, 390

Z Zander, Ed, 308 Zuckerman, Gregory, 85

ABOUT THE COAUTHORS

The three coauthors bring together a unique perspective that no one author can provide. They have seen the world from the viewpoints of a political economist, a corporate director, a banker, a professional money manager, an entrepreneur, and a consultant. Collectively, they have broad experience ranging from the White House to working with both very profitable and distressed public and private companies. They share a passion for fact-based decision making, which complements their experiences at the University of Chicago Booth School of Business. Arthur B. Laffer, Ph.D. Dr. Laffer is a widely recognized supplyside economist and entertaining speaker. Like the other famous thinkers and doers credited by Time magazine, Dr. Laffer translated his love for the dull science into powerful ideas that challenged conventional wisdom and changed people’s lives for the better. He was noted in Time’s 1999 cover story “The Century’s Greatest Minds” for inventing the Laffer Curve, which was deemed “one of a few of the advances that powered this extraordinary century.” As President Ronald Reagan’s chief economic advisor during the start of this country’s greatest period of economic expansion, Dr. Laffer and his supply-side work helped trigger a worldwide tax-cutting movement in the 1980s that continues today. He has received two Graham & Dodd awards and an Adam Smith

award and has been honored in the Wall Street Journal’s Gallery of the Greatest People Who Influenced Our Daily Business. Dr. Laffer’s political and economic insights continue to have impact. He is chairman of Laffer Associates, a supply-side economics research and consulting firm, and Laffer Investments, an institutional investment management firm. William J. Hass, CTP Bill Hass is a world-class consultant and a former partner of accounting giant Ernst & Young. He is CEO of TeamWork Technologies, a strategy and turnaround firm located in Northbrook, Illinois. Bill is a lead consultant and facilitator for companies embarking on the “Value Journey” and a community leader for the Center for Financial Leadership, serving over 30,000 CPAs in over eight states. Shepherd G. Pryor IV Shep Pryor is a consultant who has conducted projects on four continents. He is an expert witness, corporate director, and educator as well as a former corporate banking leader at Wells Fargo Bank. Shep has served on the boards of four corporations—two public and two private. Hass and Pryor provide counsel for directors and management from the beginning of strategy formulation and strategy retreats through monitoring the outcomes of execution for both healthy and underperforming organizations. They are coauthors of Building Value through Strategy, Risk Assessment and Renewal (Chicago: CCH, 2006). To learn more about their corporate and speaking services, go to: www.topvaluebuilders.com.