The aim of financial investors is to acquire established companies with strong cash flows, develop them further and sell them at a profit. For this purpose, financial investors need a qualified and highly motivated management.
Harmonisation of interests: Turn managers into entrepreneurs
The objective of management participation is to manage existing conflicts of interest between financial investors and managers by bringing together diverging interests through participation in value growth. To achieve this, managers must necessarily become entrepreneurs. This is achieved by the managers investing in the equity of the company (“skin in the game”). The guiding principle here is: “The investment should hurt the manager, but not ruin him”. After all, the adrenaline level of the managers should rise through the investment, but at the same time the manager must still be prepared to make risky decisions for the future, so the risk must not be too high. In fact, it is often the case that the managers’ investment has a higher risk profile than that of the investors. In return, managers can often expect a higher return on the capital invested if the company is successfully sold. In addition, management participations also compensate for the fact that, contrary to the managers’ regular long-term thinking and their own safety, they tend to pursue a rather short investment horizon. In addition, the management must be compensated for labour market disadvantages. These disadvantages are revealed when the greater risk appetite of a financial investor and the closer management leadership prompted by it are compared with the risk appetite of an owner-managed medium-sized company or a listed company with widely distributed equity capital and corresponding management freedom. Overcoming the aforementioned divergences of interest is necessary from the investor’s point of view in order to achieve the central goal of achieving the greatest possible increase in the value of the company. This requires an incentive structure as described above.
What changes does a financial investor bring for the management
The aim of financial investors is to increase the value of the company and to sell the company at substantial profits. The management of the company must ultimately generate this increase in value. This results in specific requirements and challenges for the management, but also opportunities for entrepreneurial activity. The focus on “Cash is King” should be emphasized. Due to the high level of debt financing and the associated repayment and interest charges, it is essential for a buy-out that the cash flow is stable and can be generated at least as presented to the banks in the business plan. Accordingly, the management must pay much more attention to cash and working capital issues than in a group environment or in family businesses. Investments are also examined much more closely for their contribution to value generation. In addition, the banks have considerable reporting requirements. But the willingness to exchange existing managers and management teams must not go unmentioned either. This is mainly due to the fact that the financial investor only has a short period of time left to generate the intended value enhancement. As soon as the impression is created that difficulties exist with one or more managers in this respect, consequences are quickly drawn. Particularly in the first few months, the financial investor, with the support of a large number of consultants, will attempt to corroborate the findings of the due diligence, critically review the corporate strategy and carry out an in-depth assessment of the individual members of the management team. Financial investors are looking for managers who, in addition to a clear strategic view, are able to manage primarily by means of financial ratios. This is already a result of the high level of external financing. Often in family businesses, but also in corporate groups, a controversial discussion about corporate goals and corporate strategies is avoided. However, these are precisely the demands that a financial investor places on his managers. While in other situations the operative management often only passes on a fraction of the available information to the controlling bodies, exactly this is not desired by financial investors. A maximum degree of transparency and communication is required. The advantage of financial investors is in particular that they have a clear goal orientation. While political considerations may well play a role in other ownership structures, financial investors focus exclusively on increasing the value of the company. All decisions are measured against this principle. In addition, the company is always a core asset of the financial investor. The private equity managers who carried out the transaction are personally interested to a high degree and are also incentivised to lead the company to success. Accordingly, the full attention and resources of the financial investor are devoted to the company and its management team. This is not always the case, particularly in the case of group companies that no longer belong to the core area of the company’s activities.
Overall, it can be said that the management team is being subjected to much more critical scrutiny and challenged, but on the other hand, there are considerable opportunities for the management due to the professionalisation of corporate monitoring and control and the financial investor’s focus on the company. Underpinned by a genuine participation in the equity capital, the manager becomes an entrepreneur whose scope for action in the private equity environment regularly increases.
Prof. Dr. Alexander Götz