Über die Autorin bzw. den Autor

Arthur B. Laffer, Ph.D., servedas one of President RonaldReagan’s chief economic advisersin the 1970s and 1980s.His supply-side theories helpedtrigger the global tax-cuttingmovement of the 1980s. Laffer is on The WallStreet Journal’s Gallery of the Greatest PeopleWho Influenced Our Daily Business and wasreferred to as one of the “century’s greatestminds” in Time magazine. Inventor of the“Laffer Curve,” he serves on various publicand private boards and is the recipient oftwo Graham & Dodd awards and the AdamSmith award.
William J. Hass, CTP, is CEOof the strategy and turnaroundfirm TeamWork Technologies.He previously served as chairmanof the Turnaround ManagementAssociation and was apartner of accounting giant Ernst & Young.He is a certified turnaround professional.
Shepherd G. Pryor IV is a consultant,corporate director, andeducator on the subject of corporatevalue. He has served onthe boards of four corporationsand was formerly corporatebanking leader at Wells Fargo Bank.

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THE PRIVATE EQUITY EDGE

The McGraw-Hill Companies, Inc.

Contents

Chapter One

In today's interconnected and global economy, much of what goes on behind the closed doors of a boardroom is too sensitive to be shared with the public. Here is a classic example of what might happen on any public board.

The boardroom was filled with an uneasy quiet. Then one director spoke: "Our CEO needs to go. We can't continue without taking action. We can't ignore the employees, the shareholders, and the share price any longer. His pay package for the first five years of over $100 million without any increase in our stock price has made our board a target of activist groups. Is there any way we can get him to accept a pay cut and better tie his compensation to the stock price?"

A second director chimes in: "We all thought he was the right guy, but he continues to pursue a strategy that analysts say will kill the company. A third director comments: "My partners in our private equity fund would have my head for that kind of payday, given the stock decline and market share loss relative to the other major competitors in our industry."

Several public company CEOs became the poster children for what was considered wrong with many big public corporations: excessive CEO pay for poor stock performance. Many were not surprised to see CEOs of public companies resigning to join private equity firms in order to run large portfolio companies.

The time was ripe for mistakes to be made. Public companies had to compete with private equity firms when seeking CEO talent. In an effort to simplify the process of hiring and overseeing their CEOs, some public company boards chose simplistic solutions that ultimately failed, sometimes catastrophically. Private equity firms, overseeing CEOs in their portfolio companies, could take a different tack. Rather than lure CEOs with high salaries with the soft landing of generous severance packages, the private companies required that CEOs share in the risk. CEOs would have to actively invest in their companies and accept modest salaries. However, if they were successful, their incentives could change their lives.

WHAT DO PUBLIC COMPANY BOARDS MISS?

In public companies, when things do not go right, they spur headlines. For example, in January 2007, Bob Nardelli resigned as CEO of Home Depot. As he departed, he was heavily criticized in the media. A few months later he was named CEO of Chrysler by its private equity fund owner. We expect that Mr. Nardelli's experience will be vastly different in his new situation.

The Nardelli story is not unique. Many companies have suffered misfires, especially when a bold strategy has been employed to change corporate culture and performance. At the end of the day, Home Depot failed to meet shareholder expectations for continued growth in real cash flow returns and size. As a result, investors lost faith in Home Depot's ability to create future cash flows. Home Depot's stock price languished relative to its rival, Lowes. Nardelli did not find a way to communicate the value of his strategy to the market and stock analysts in terms they could translate into expectations about future cash flow. His focus on accounting metrics—sales growth and earnings per share—and his tendency to dismiss the importance of stock price and shareholder wealth, as well as his handsome "nothing at risk" compensation package (except for his stock ownership), made him a very independent, some have said "arrogant," CEO.

Nardelli had significant experience in acquisitions from his years at General Electric. As a strategic business unit (SBU) head, however, he did not gain experience dealing directly with stockholders. It was clear that he acquired building supply businesses to boost Home Depot's sales growth and earnings, but at what price? Nardelli spent over $7 billion on the acquisition of builder supply businesses when home building was booming, thereby changing the focus of the company. The acquisition of the lower-margin supply businesses dropped Home Depot's overall margins and real return on assets. Although generally accepted accounting principles (GAAP) earnings increased, the price-earnings multiple dropped. Apparently, these accounting metrics were not those which the market considered important to share price. Under Nardelli, Home Depot lost market share and growth opportunities to Lowes in the higher-margin core retail business. Consumers complained that stores were messy and that customer service had declined. Lowes had taken the lead in quality and service. Home Depot seemed to have lost its focus and hurt its intrinsic value.

The day Mr. Nardelli's resignation was reported in the press, the business press reflected doubt about the future of Home Depot's cash flow and growth. "Nardelli has also drawn heat for his huge pay packages and for the way he handled last year's annual meeting. Under his guidance, Home Depot has lost market share to rival Lowes Cos. while its stock has fallen 7.9 percent."

In brief, Home Depot's board was correct to finally ask Bob Nardelli to take a pay cut. His apparent superior pay negotiation skills and stated belief that "Share price is one measure of corporate performance I [Nardelli] could not control" are examples of selective oversight. Being selective on only the facts that are CEO-friendly is typical of the interchange between CEOs and the boards of many companies with underperforming stock prices.

A mission-critical part of the CEO's job is to convince the board, shareholders, employees, and suppliers that the current strategies will result in building long-term shareholder "intrinsic" value. Communicating thoroughly is often neglected by "autocratic CEOs." Nardelli had great discipline and a vision for Home Depot, but without a clear understanding of what would build Home Depot's intrinsic value (i.e., using the wrong metrics), he was doomed to failure. He did not communicate the intrinsic value or the potential cash flow of his strategy.

Despite the doubling of sales and earnings at Home Depot over the previous five years, Nardelli failed to communicate to his board and shareholders how his planned acquisition strategies would make Home Depot a more valuable long-term investment. Nardelli's apparent hubris in dealing with people and communicating with Wall Street was a weakness, possibly uncovered in GE's succession planning process.

Enter a value builder. In June 2007 Nardelli's successor, Frank Blake, took steps to recognize the importance of returning cash to shareholders. After a much needed strategic review, Home Depot announced on June 19, 2007, that it would sell the builder supply business for $10.3 billion to a private equity group and use the sale proceeds and other funds to repurchase 30 percent of Home Depot's outstanding stock for $22.5 billion. However, things changed. By August 2007, housing slowed further and debt markets were suffering from a reassessment of risk. The $10.3 billion deal was in danger of collapse. To get the deal done, Home Depot dropped the price to $8.5 billion, a 17.5 percent decline from the price agreed upon less than three months before. Home Depot also had to guarantee $1 billion of the debt and retain 12.5 percent of the equity...