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
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.
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:
- Unlike public companies, PE firms don't have to report short-term results, so managers can stay focused on the long haul.
- PE firms have definite exit strategies, motivating managers to act swiftly and invest in projects that will deliver the highest future value.
- 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.
- 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
Secondly, carefully scrutinize annual reports, particularly the Management & Analysis section, for signs of long-term vision. Berkshire Hathaway's
Third, understand how executive compensation is calculated. Apple's
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.
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.