What Public Companies Can Learn from Private

Scarcely a day goes by without news of a private equity fund snapping up another well-known stock market company. Fast forward a few years and you can expect the same company to re-list on the stock exchange, leaner, meaner, skimmed of surplus workers, plant and non-core businesses - and worth a lot more money!

Why are private equity funds able to carry out the surgery required to turn flabby companies around and make them more profitable, while directors of underperforming quoted companies appear to be ducking the hard decisions?

THE RISE OF PRIVATE EQUITY AND VENTURE CAPITAL FIRMS

The British Venture Capital Association estimates that more than 11,000 firms employing close to 20% of all private sector workers are now owned by private equity and venture capital funds. Around £100bn is invested in private equity companies. The sector has sales of £233bn and pays an estimated £29bn in taxes.

Restaurant chain Pizza Express has just returned to the stock market after an absence of two years. Venture capitalists TDR Capital and Capricorn Ventures bought the high street chain for £280m and re-floated it with a value of £430m after reducing their stake from 80% to 51.4%.

Food giant RHM, owner of brands from Hovis to Bisto gravy, was re-listed with a price tag of £1bn by European buyout group Doughty Hanson after several years undergoing corporate surgery behind closed doors.

EQUITY LURKS OUTSIDE THE GATES

The threat of a private equity firm arriving on the doorstep to carry out some overdue spring-cleaning hovers over a number of quoted companies whose performance has been patchy. Once in control, private equity funds work quietly, discretely and swiftly - and often brutally - making the necessary cuts and changes aimed at unlocking value and making the operation more attractive to future investors.

Let us be clear - they have certain advantages over a publicly listed company. While a public company with thousands of shareholders has to generate cash to pay dividends or deliver capital gains, a private fund is under no such pressure. Debt is often cheaper to service than equity, which means that private equity buyers are able to make acquisitions at prices which look attractive.

The era of low interest rates has spawned the growth of the private equity funds. Backed by pension funds, insurance companies and wealthy investors, they borrow funds cheaply on the grounds that their backers will be prepared to wait a few years before pocketing a large capital gain when the business is re-listed on the stock market.

But while the way they are financially structured gives them advantages over a publicly listed company with shareholders, a competent board of directors should still be able to take action to improve the efficiency and operation of its business rather than wait for a predatory equity fund to come along and do the job for them.

START WITH THE OVERHEADS

There are obvious overheads that can be reduced. So a diligent board should look closely at the size of its workforce and examine whether there is scope for slimming down without harming the efficient operation of the business.

All costs should come under scrutiny - rising energy bills have triggered a number of profit warnings by companies in recent weeks so this is now a key area for savings. The cost of fleet cars and even the running of the staff canteen should not be spared.

Disposal of unwanted fringe businesses can yield useful rewards. Often companies are too close to the action to realise that not all of their businesses fit together. Some would be better off sold to management - or new corporate owners.

Then there is the location of offices - perhaps there is scope for consolidation in some regions. And what about the head office itself? Does it really have to be in such a fashionable part of town? Remember how M&S clung onto its luxurious Baker Street head office, long after it should have sold it and moved to somewhere more appropriate.

And there are the company's other property assets. Some may be on sites which would be more valuable if released for redevelopment. These can be hard decisions. Sometimes there are emotional attachments to buildings - the factory may have been built by the present chairman's grandfather, for instance, so there will be a natural reluctance to sever links with the past.

Procurement costs are an area where some hard bargaining with suppliers can pay dividends. When RHM was re-floated it emerged that £20m had been shaved off its procurement costs in the previous three years.

BALANCE SHEET MEASURES

There are also other balance sheet issues. Perhaps the interest bill could be reduced by restructuring the debt over a longer period or with more understanding bankers. Or a factorer or invoice discounter could produce better credit controls than keeping this in-house. These are all measures that private capital funds would be carrying out if they were in the boardroom.

Advocates of private equity insist that its non-sentimental approach ensures managers perform consistently highly. And because managers have often sunk their own money into the venture, they are naturally incentivised to perform well, whereas directors of public companies are often unfairly criticised for pay and benefits levels.

Of course, directors' inflation-busting pay rises and regular fistfuls of stock options are hard to defend in an underperforming company, but such rewards are perfectly justifiable if directors have delivered strong returns for all shareholders.

So, while public companies can learn from the actions of private equity firms, the market should also take note. We must be less eager to pass judgement on directors' gains when they are deserved, and improve the way we reward the creation of shareholder value.