Be careful using "other people's money" to make acquisitions

From The Mistake Bank.

[This story is from Ray Anderson, Founder and Chairman of Interface, Inc., a manufacturer of carpeting and fabrics.]

When we began [Interface], I made the initial investment personally. And then friends came in, then a much larger partner joined in, and we eventually financed the company. And, by the way, the day we had our finance all in hand is the day we count as the birthday of Interface. Up to then, everything is conception and gestation, beginning with the gleam in my eye, perhaps the idea; but it’s only when you have your money in hand that you can truly call yourself a company. And that’s the birthday.

Interface, after getting through that treacherous startup, in the teeth of the worst recession since 1929, really hit a home run year after year, 70 percent compound growth. And then ten years later we went public, and for the first time had access to other people’s money. Investors who bought shares in the stock, our expanded capital base of Interface, enabled us to begin to make acquisitions, and we made acquisitions in Canada, in Northern Ireland, and eventually in the United Kingdom and in Holland. And then in 1998, when the company was fifteen years old, we were a global company. Then we made other acquisitions, made subsequent stock offerings to the public, and had people subscribe to the stock and further expand the capital base, which enabled us to do more. We leveraged other people’s money time and again over the years, so much so that it got to be a little too easy to access it.

And then we made a concentrated series of acquisitions to create a downstream distribution system. We made twenty-nine acquisitions, over a very short period of time, of contract dealers, the people who install and maintain their products. We wanted a captive, owned distribution system, and we invested $150 million of other people’s money, basically by selling stock and doing bond offerings. And it was too easy.

If we’d been spending our own money, we would have thought very hard about those acquisitions. In the long run, they turned out to be a mistake, and six, seven years later we began to dismantle this distribution system and liquidate it, selling the businesses back to the owners or back to the employees. And we might not ever have undertaken that unfortunate series of investments if we’d been investing our own money. We would have questioned it.

Reprinted by permission of Harvard Business Press. Excerpted from Lessons Learned: Straight Talk from the World’s Top Business Leaders--Starting a Business. Copyright (c) 2008 Fifty Lessons Limited; All Rights Reserved.

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acquisitions, narrative, capital, financing, startup, entrepreneurism, reading list, Mistake Bank

We may be running out of fossil fuels, but there's an inexhaustible supply of "strategic secrets" out there

I love the Harvard Business Review. But as the years pass I've grown less interested in the articles that offer me a secret sauce to easily grow my business, outwit my competitors or take advantage of new opportunities.

They begin to sound like the infomercial guy back in the 1980's showing me how to make millions by buying houses with cash advances on credit cards and selling the houses quickly for profit.

My question to him was: if your secret is really that great, why are you wasting time on TV telling me about it?

The latest effort is "The Strategic Secret of Private Equity" in the September HBR (free link). Apparently private equity companies have discovered a better way to run a company--buy it in order to fix it up and sell it. (It sounds suspiciously like the credit-card cash advance guy.)

Are many private equity companies doing well? Yes. Have they exploited inefficiencies in the market? Yes. Will these inefficiencies be around long enough to help anyone who reads "The Strategic Secret of Private Equity"?

No.

Markets are complex/chaotic systems (read this post from Gary Klein's guest blog on Cognitive Edge for insight on the financial markets as resistant to quantification). Past performance is no indicator of what will happen in the future, especially the near future. Factors that enabled the private equity boom, including initial reactions to Sarbanes-Oxley regulations, cheap and abundant bank financing, and, most recently, the pack mentality at work, will not and cannot persist. Complex systems adapt.

It's more likely we'll be reading something like "The Benefits of Lower Leverage" in HBR next year than people still extolling "The Strategic Secret of Private Equity." And the newer article will have as much long-term value. But that's the magazine business. There's always a readership for strategic secrets.

And if you think the supposed long-term advantages of private equity haven't been explored before, check out "The Eclipse of the Public Corporation" (link - $$) from HBR, published in 1989.

strategy private equity finance investment capital structure complexity Harvard Business Review

Private equity companies great business strategists? Baloney!

I've been wondering when the private-equitization fad will dissipate, and maybe the current credit squeeze is our answer. Private equity firms treat companies as commodities--buying low, processing and purifying a bit, as if they're iron ore, and reselling, recapitalizing, recombining into something that has enough value to compensate their investors and cover their fees.

In the July/August Harvard Business Review, Walter Kiechel lauds the private equiticians for bringing sound strategic thinking to their acquisitions ("Private Equity's Long View" - free link). I agree on one point--with respect to scrutinizing the capital structure of the company and deploying a pretty limited toolset--leveraging up--they are certainly more creative and strategic than those they acquire from.

And, writes Kiechel,

They identify a strategy that favors the line of business in which the acquisition dominates its competitors, and then they often sell off its other businesses (it was the strategy movement that got companies thinking about their assets as a portfolio of businesses, with some stars and some dogs to be divested).

Yet all the examples Kiechel cites to prove private equity's strategic mastery are all quantitative in nature--use of debt, focus on cash flow, reducing costs and shedding of underperforming assets.

Strategic thinking also involves questions like, "How can we increase our added value with customers? What is the world likely to look like in 10 years and how can we participate in those changes? What new products do we need? What technology investments will be required? How can we keep our best people?"

Quite frankly, it's not stuff that can be captured on a spreadsheet. And, despite their "long view," PE investors have little to offer on those questions. Frankly, most plan to be long gone before those questions are answered. And that's not strategic mastery, it's myopia.

As value in business increasingly shifts from dumb assets (like oil wells, factories, mines, etc.) to smart assets (creative people), the side effects of private equity strategy--personnel displacement, loss of company culture and insight, lack of employee loyalty, poor morale--will prove fatal. Businesses will look more like professional partnerships of today, rather than plain old corporations.

In fact, they'll start to look a lot more like private equity companies, wherein upheaval results in partners and associates leaving and starting their own firms.

What will PE buy then?

(Disclosure: I worked for several years for a private-equity-owned company.)

strategy private equity portfolio management capital structure Harvard Business Review