Lessons from Private Equity

Whether or not your firm has a private equity practice, you're surely familiar with its just this side of astonishing rise over the past half decade or so.  And if you're like me you've asked yourself, "Who are those guys?"  What makes them so successful at adding value to the companies they acquire?

Thanks to the usual suspects at McKinsey, we now have some preliminary indications.  Yes, it's true that they can generate outsize returns, and yes, it's also true that they do it by behaving in ways public companies don't.  But the devil fascination is in the details, and I'd like to discuss their practices.  As you read this, think "merger."  Specifically, think how you'd manage a firm or large practice group you might acquire.

Last time I checked, your firm wasn't publicly listed.  So might it not be time to take a page, as it were, from private equity?

First, let's define "outperformance."  Since McKinsey was interested in what differentiators lie behind superior performance, their sample set was"skewed toward the better deals by the better firms."   More broadly, they found that three-quarters of all private equity firms "perform no better than the stock market over time [but that] the top 25% outperform...by a considerable margin--and persistently."

So let's cut to the chase.

They examined 60 deals completed by 12 "top-half" private equity firms, and examined the returns on those deals compared to a comparable investment in publicly traded equities.  Here were the key differentiators:

• Before the deal, winning private equity firms conducted "deep research" into the target.
• After acquisition, they exert powerful ownership control over management, which just starts with high levels of performance-related compensation to align managers' interests with that of owners.
• Compared to poorer performing private equity firms, and in stark contrast to public companies with diffuse shareholder ownership, imperial CEOs, and nonexecutive directors who have no research staff, no budget for outside consultants, and access only to the information management cares to provide, activist private equity firms devoted at least half their time to the company, usually at its headquarters, for the first three months after the deal.  Less active investors spent only 15% of their time doing the same.
• Active investors had "teams of analysts;" less active ones worked alone.
• Active investors formulated their own hypotheses about what needed to happen to release, or discover, value in the target firm (educated guesses they had formed during the pre-acquisition due diligence process), while less active (shall we say "passive"?) investors tended to review and comment upon proposals made by incumbent management.
• Active investors got to know individuals in senior management early on, and made needed replacements quickly and expeditiously; passive investors ultimately made some replacements as well, but "usually much later."
• Finally, active managers looked at operational indicators to measure performance (which more closely track plans for actual changes in the way the business runs), while more passive managers stuck with traditional financial measures, which may not be tailored to the firm and may not have quick response times—may, in other words, be lagging not leading indicators.

If you're starting to see a theme here, McKinsey does as well (emphasis supplied): 

"In our view, this active assertion of ownership is the crucial difference between the best private equity firms' concept of good governance and the one put into practice by public companies and less successful private equity firms."

A few more observations are particularly noteworthy.

First, contrary to popular belief, private equity's most potent weapon is not financial re-engineering or mere price arbitrage, it's what McKinsey dubs "governance arbitrage," extracting value from firms whose owners and managers are misaligned.  Fascinatingly, McKinsey sees this as such an enormous opportunity "that private equity is likely to maintain, and perhaps to expand, its presence as a parallel system to established public markets. It would revert to marginal status only if the governance of public companies improved dramatically."

Elsewhere in the article, McKinsey discusses the how the interplay between private equity and public ownership may play out over the coming decade or longer, and while many of their observations are intrinsically interesting, their lessons for brilliance in executing law firm M&A are less obvious.

But I can't resist sharing a few:

• They sharply rebuke the conventional wisdom that public company governance has "greatly improved...notably since the cleanups that followed recent high-profile corporate scandals."  Rather, what they say has  happened is that nonexecutive directors of public companies are utterly absorbed and preoccupied by ensuring they don't run afoul of "the growing number of codes and regulations," to the exclusion of strategic reflection on how to create value.
• The incentive structure compels risk-aversion:  Nonexecutive directors stand to lose big if compliance short-circuits, but have little upside for outstanding performance.
• Boards are still kept in the dark.  Only 10% of directors McKinsey polled felt they had a "complete understanding" of the firm's strategy and long-term objectives, whereas more than half described their information about that as "limited" or "none."

Where does this leave us if we're not contemplating a merger or significant lateral group acquisition?  Essentially all of this applies with one-to-one congruence to managing the firm's everyday activities, not to mention its aspirations for the coming decade.  Here is one last piece of learning.

Create an intense, externally focused strategic review

The best private equity firms do this with their acquisition targets; why not do it for yourself?  Look to benchmark your firm against your competitive set as a start; but if you stop with benchmarking, you consign yourself to middle-of-the-pack mediocrity, by hypothesis.

After benchmarking, to see if you're a significant laggard, look to leaders within and outside our industry, to learn from how the best of the best do it.  ("It" can be anything from KM to client relations to word processing and PowerPoint presentation production.)

The last two McKinsey recommendations, having to do with creating "tough but realistic" targets, and linking them to compensation, and with critically evaluating senior managers and pursuing an ongoing search for talent, are behaviors that I presume you're already pursuing, or else have pursued to the point of effective cultural diminishing returns.

So what are we left with?

We can happily take a lesson from private equity:  We're closer to their model already than our public-company clients, and we have the internal brains; critical and analytic firepower; and power at communicating a vision, to follow the game-plan.

Best of all, we have the resources to pay people who share and pursue the vision for their efforts.  Why shouldn't your firm be a model for "the better deals pursued by the better firms?"

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Update: Charlie Green of Trusted Advisor Associates writes:

Bruce, this is one of the better explanations--along with McKinsey’s original stuff--of what's happening vis a vis private equity and governance.  Interesting to apply it to law firms!
I look forward to hearing others' reactions.  Many thanks.

Grant Aldrich of Professional Services Marketing writes:
Hi Bruce, How do you think this aggressive restructuring and active assertion of ownership would differ in its implementation, from a law firm with a partner management structure as opposed to a firm with a formal executive management team? Grant

My thought, Grant, is that it should not fundamentally differ: But the reality is that the partner-management structure is likely to be less effective than a formal executive management (and full-time management) team. So long as one is a partner with an active practice, clients will always come first (as indeed they must under professional ethics).

Yet another reason, I would aver, to have real executives at the helm.