The free cash flow is the overriding accounting measurement. You have to live by it. You get to the real root of economics. It is with cash that you reimburse the debt and following on, it is debt that creates IRR for equity. Believe it or not, this is a concept most people have a problem grasping… Therefore, you need to have the best financial director on hand.
The third concept is to establish a trust relationship with your restless LBO investors. This has to click in almost immediately and a compact will be established between you and your investors in the understanding that everybody has got to profit from this.
It is impossible to succeed at LBOs if you do not build trust with your bosses, the LBO funds. “First impressions are always the best” and you don’t get a second chance at making a good first impression. The key here is that trust is a long-term proposition that builds slowly as people use your expertise, get good results, and do not feel disappointed or cheated. In other words, true trust develops from a manager's actual behavior towards his investors experienced over an extended set of encounters. Trust is difficult to build and easy to lose. A single violation of trust can destroy years of slowly accumulated credibility.
After the small talk, the first informal introductions, the usual civilities and superficial bonding you are led to the upstairs meeting room where the excitement is replaced by the reality of the hard core negotiations for your own pay package and for your lieutenants’. You’re fighting your corner. Next comes the first board meetings which will turn your world around! This is where you cut into the meat of the LBO drama and you realize that actual people have vast sums invested. This is your chance to step up to the plate and enter into a special relationship of trust, confidence, or responsibility with your investors. You are reminded that the engine that drives the markets is not money but integrity. It takes a roomful of committed, principled, and vigilant participants to make the LBO project successful.
You must demonstrate your ability to think on your feet, and show that you process information quickly, that you are on top of the strategy, that you know the company inside out, that you know where you want to take the company and that you share professional excellence and thought-leadership. You also must be open to any questions, be willing to disclose any information or discuss any issues. You must be very transparent when you are only dealing with these shareholders.
The people you have in front of you are of the highest caliber and deeply engaged. I have been remarkably impressed by the quality of my counterparts at the fund where they offered their insights, reflections, hopes and doubts. I came from a world where I witnessed many a grandstanding board meetings where a roomful of supine board directors could be taken in by the managers’ posturing, duplicity and double talk.
Here, the shareholders are highly professional. As you would expect from activist investors, they are highly knowledgeable, master the operational know-how, are well versed in dealmaking and possess a strong entrepreneurial spirit. The carried interest system subjects each LBO fund manager to put part of their salary in each of the deals.
The quality and focus of the board meetings is fundamental. The degree of excellence of the participants is enhanced by the fact that their own money is at stake. The debates are highly focused and intensely axed around some very pressing issues. In previous circumstances, I had known board meetings to go off on tangents that have absolutely no bearing on the main subject. Political and psychological digressions where participant end up in an irrelevant debate about the state of the world leave much to be desired. The focus here is the end of the month bottom line: How do you extract cash? What’s the cash flow? What’s the better strategy? Who can we hire to carry it out?
This is a whole new set of work rules. No philosophical digressions here, yet, it is all the more enriching. On a personal level, it was a life altering experience and I could never return to the less driven environment of the routine shareholder meetings.
Equally important to the foregoing is that you do not manage the company as though it is under LBO. LBO funds have been criticised for taking over companies with lacklustre growth but healthy balance sheets. The argument goes that they skimp on the overheads, spin off divisions, and re-launch the company on the stock market laden with debt and stripped of some of its business divisions. It becomes clear that setting an industrial strategy and production goals are key to the success of the LBO venture. Thankfully, I was lucky enough grasp this corollary risk of LBOs very quickly. I had to explain to my shareholders that if you do not create industrial value, you cannot create financial value. You absolutely need an industrial strategy and a financial policy that are adequate and allow strong business development and set more tangible goals for the staff.
If you go into the business throwing your weight around saying: “I’m the sole new owner of this company, and to fund my acquisition I’ve taken up debt equivalent to seven times EBITDA.” and with the first 100 dollars that comes in being funneled out again towards debt repayment, with nothing left for investments and to fund growth, you’ll find it hard to rally your troops!
It’s true that for someone unfamiliar with the business, there is a most peculiar side to LBOs. Companies take on the aspect of railroad switching terminals for cash. Say you have a debt that is 300 million, cash comes in through one end and goes out the other end. Usually, the banks have sucked it up. You barely see it coming and it’s already gone to the banks! You could just as well be at “Grand Central Station” and have missed the express to Wallawalla /get away! All this because you didn’t state your claim in due time!
You have to adopt a firm stance with the LBO fund managers. You have to set some rules and state that you won’t have 100% of EBITDA going towards debt reimbursements. You’ll try and keep 20 to 25% for investments. It’s your company. Nothing will change the fact that it needs be perceived as more than a cash cow to repay the bankers. It’s a going concern or it will not work!
So here are four rules that are in my opinion quite powerful and I think every manager operating under an LBO has to deal with these variables. In sum, a clear time frame, management as though it’s an ongoing business venture, absolute transparency, and the cash obsession!