Shifting market conditions require executives to reallocate resources across opportunities at different stages in their life-cycle. This sounds straightforward in theory, but many firms struggle to achieve portfolio agility in practice. Portfolio agility requires a diversified collection of units, a disciplined process, group control of resources, a cadre of general managers who can work on various businesses, and leaders willing to make the hard calls. In addition, several common pathologies, such as delayed disinvestment, systematically derail portfolio agility within organizations.
An over-reliance on value-based management can also impede portfolio agility, to the extent it prevents experimentation outside a company’s core activities. In the downturn, many firms have tightened their investment criteria, to focus on projects with a positive net present value, an approach that emphasizes credible forecasts of cash flow. The most credible forecasts, however, come from low-risk projects in known domains–sticking to one’s knitting, in management-speak. An investment process that values credibility and low risk above all else penalizes projects with uncertain outcomes, even
This Friday, the London Business School Private Equity and Venture Capital Club hosts its annual Private Equity Conference. I will moderate the closing panel discussion called “Value Creation: Overtaking Leverage?” that will explore how buyout firms can create value not by piling on debt, but by improving the operating performance of their portfolio companies. This is a particularly topical issue right now, as debt has become more expensive, financing terms more onerous, and market conditions more challenging for portfolio firms.
In preparation for the panel, I have reviewed recent research–largely by financial economists–on private equity, operational improvement, and value creation. Recent papers provide some very helpful, and in some cases surprising, insights into how late-stage private equity firms add value. Below is a selective review of papers that bear on a set of questions related to how leveraged buyout firms create economic value through operational improvements. (For comprehensive reviews of private equity trends, see papers by Cumming et al. and Kaplan and Stromberg).
- Do leveraged buyout firms create economic value? Excluding fees, leveraged buyout firms
Companies, like people, must pass through a life cycle according to the conventional wisdom in management. Start-ups begin their life in a period of rapid-fire experimentation, pass into the organizational equivalent of adolescence as the company scales its business model, eventually mature into the dull reliability of middle age, and then lapse into unavoidable decline. Like Shakespeare’s seven ages of man, the stages of the corporate life cycle are clear and inevitable. Sometimes companies progress through this sequence as a cohort. Minicomputer makers arrayed along Boston’s Route 128 including Wang Laboratories, Digital Equipment Corporation, Data General Corporation, and Prime Computer rose and fell as a group. Other times a company passes through the lifecycle in isolation, as Polaroid or Laura Ashley did. Whether firms pass through it together or alone, life cycle according to this viewpoint, is destiny. For many people, maturity is a tough life stage, hence the midlife crisis. The thrill of youth has passed, while the
In turbulent markets, firms must disinvest from under-performing units to free resources necessary to exploit new opportunities. Most firms are better at getting into new things than getting out of established ones. In a recent survey, respondents cited their firm’s lack of a “well-defined processes to exit declining businesses and kill unsuccessful initiatives” as the second biggest obstacle to agility (out of a total of thirty possible factors). My last post summarized data suggesting that firms typically delay exit beyond the optimal point, and in the process deplete resources to invest in growth opportunities.
Why do firms struggle to kill failing initiatives? There are many sound reasons to delay exit, including uncertainty about the payoff to persistence, closing costs, and interdependencies among units that prevent a clean severing of ties. In many cases, however, executives fail to exit even as evidence mounts that the costs of persistence outweigh the benefits of staying the course. Instead they double down, and increase their investment rather than pulling back to revisit their ingoing assumptions, and make mid-course corrections or pull the plug.
Management scholars refer to this tendency as “escalating commitment to a failed course of action,” and have
In my last post, I argued that turbulent markets demand portfolio agility–an organization’s capacity to reallocate cash, people, and other resources from stagnant or declining businesses into promising opportunities, and do so in a timely manner. Effective portfolio agility consists of both investment and disinvestment. Unfortunately, most companies are better at getting into new businesses than they are at getting out of declining subsidiaries or ones that no longer fit as the corporate strategy evolves. Firms can rarely avoid disinvestment forever, but they often delay the inevitable for far too long. These delays consume scarce resources, and starve promising initiatives of the cash they need to succeed.
Research has shown that companies regularly divest businesses to re-balance their portfolio. In a study of 9,276 deals completed by 86 of the Fortune 100 firms in the 1990s, Belen Villalonga and Anita McGahan report that the median number of divestitures was 17 for firms they studied. Divestitures were almost as common as major acquisitions–the median for firms in their sample was 19 completed acquisitions over the same time
When I ask executives to list examples of agile companies, they often mention firms such as Tesco, Southwest Airline, or Wal-Mart, which excel at operational agility–the ability to seize opportunities within a focused business model. Operational agility is important, but it is not the only way that firms can exploit changes in their environment. Diversified companies including Johnson & Johnson, Goldman Sachs, Samsung Electronics, and the Tata Group exemplify portfolio agility, or the the capacity to quickly and effectively shift resources, including cash, talent, and managerial attention out of less-promising opportunities and into more attractive ones. Fluid reallocation of resources is necessary in turbulent markets, but many companies struggle to achieve portfolio agility. Below are five prerequisites for portfolio agility.
1) Diversified portfolio. The broader the range of business units, geographies, or products a firm encompasses, the greater scope it will have for portfolio agility. The conventional wisdom holds that the disadvantages of diversification–including loss of focus, subsidization of under-performing units, organizational complexity, and potential for empire building by top executives-outweigh the advantages. Conglomerates, as a result, trade at a “diversification discount.” My last post argued that the benefits of diversification–protection against unexpected threats and exposure to growth opportunities–are more valuable in turbulent markets. Firms can gain the benefits of diversification while minimizing the costs in several ways: Firms can, as General Electric does, give business units a great deal of autonomy to achieve their profit and loss objectives. Companies can also minimize complexity and maintain focus by diversifying around a set of core competencies, as Procter & Gamble does with multiple products that all draw on the company’s marketing expertise, or firms can stick to a core business but diversify across global markets.
2) Disciplined processes for revisiting investments. Portfolio agility requires a process to evaluate the existing portfolio of business units, regions, products, or customers on a regular basis to reallocate resources from less to more productive uses. In turbulent markets, the relative attractiveness of opportunities shift more rapidly than in stable contexts, necessitating more frequent reviews. A disciplined process is conducted by