The Market's Best-Kept Secret

From 1998 to 2006, private equity emerged as an integral component of our global economy, making up an increasingly large portion of all deal volume. A handful of major PE firms, such as Blackstone Group (NYSE: BX  ) and Fortress Group (NYSE: FIG  ) , even reached out to public markets to raise capital after attracting hundreds of billions into their PE funds over the years. Despite restrictions that kept all but wealthy investors out of PE funds, many small investors argued to open the gates and let everyone in.

With the bear market, however, private equity has taken a big hit. The leverage that made their investing model possible has now burned many firms, leaving many analysts wondering whether private equity is a thing of the past.

In my view, private equity is far from dead -- and it has many lessons to teach investors in public companies.

Pssst ...
The success of private equity firms isn't a complete mystery. Four points in particular help reveal just how these funds have used a long-term value-creating approach to enhance returns:

  1. Unlike public companies, PE firms don't have to report short-term results, so managers can stay focused on the long haul.
  2. PE firms have definite exit strategies, motivating managers to act swiftly and invest in projects that will deliver the highest future value.
  3. Despite a reputation for lavish excesses, PE executives' salaries are actually tied to the businesses those executives manage, and they must invest much of their own capital in every deal.
  4. Boards of directors at PE-owned firms tend to be more active in helping managers run the business.

Three starting points
There's nothing about any of those four qualities that public companies couldn't follow if they wanted to. So how do you find stocks where management is applying these strategies?

First, seek firms with relatively high corporate governance quotients. For example, Walt Disney's (NYSE: DIS  ) board meets all of the key characteristics of corporate governance best practices, far exceeding all of its media rivals. Most notably, Disney maintains a fairly independent team of board members, with an independent chairman, and the board meets regularly without corporate managers in attendance. Furthermore, its audit, compensation, and governance and nominating committees are all composed solely of independent directors. Disney also requires that all directors own or buy at least $100,000 in company stock within three years of coming on the board.

Secondly, carefully scrutinize annual reports, particularly the Management & Analysis section, for signs of long-term vision. Berkshire Hathaway's (NYSE: BRK-A  ) (NYSE: BRK-B  ) Warren Buffett is notorious for sharing his long-term thoughts and opinions for the business, and stressing a timeline of holding stocks "forever." Management that spends too much time focusing on today's phenomenal bottom-line figure, rather than explaining how it will return cash to shareholders in the future, is a worrisome sign.

Third, understand how executive compensation is calculated. Apple's (Nasdaq: AAPL  ) Steve Jobs and Google's (Nasdaq: GOOG  ) Sergey Brin, Larry Page, and Eric Schmidt earn just $1 in salary every year. But they get relatively huge amounts of compensation from performance-based incentives. Thus, their overall wealth is directly associated with stock performance -- and that performance has been strong.

The bottom line
There are many valid arguments against the use of private equity, particularly in today's changing credit markets. But the fact remains that these firms have done well in extracting value from the companies they manage. By searching for public firms that operate in a similar fashion, you can help ensure that you'll get the best value for your investment dollars.

Related Foolishness:

Berkshire Hathaway and Disney are Motley Fool Inside Value recommendations. Berkshire Hathaway, Disney, and Apple are Stock Advisor selections. Google is a Rule Breakers recommendation. The Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days.

Fool contributor Kristin Graham owns shares of Apple. The Fool has a disclosure policy.


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