NRI Fellow John Chapman

Economists are hotly debating the extent to which the U.S. economy is headed toward recession, as the data are currently mixed. What is indisputable, however, is that the global economy has entered a period of considerable challenge. Slowed by housing and credit market problems, U.S. GDP growth in 2007 approximated 2.2%, declining for the third year in a row. Meanwhile, corporate profit growth has more than halved since peaking in early 2005, and by year end 2007 business net cash flow had declined 4.2% year-over-year. Coupled with deceleration in fixed investment, this implies slowing growth in operating profits. And in a flagging global economy, a falling dollar will yield higher input costs with little relief offered from pricing power. Economic "stimulus" notwithstanding, consensus forecasts for current year U.S. GDP growth hover at 1%.

Growth in Britain and the Eurozone is also expected to slow in 2008 toward 2%, from the 3% range of the last two years. Such an economy offers little margin for error in strategy or execution, and requires innovation from CEOs. As detailed below, a promising resource corporate leaders are turning to that deserves wider understanding comes from private equity, both indirectly via learned best practices and directly via transactions known as "PIPEs" (private investment in public equity). Let's examine how this is happening.

The involvement of--some CEOs would say pressure from--active investors in public equity markets is not new, and is in fact heightened during turbulent economic times. Carl Icahn, for example, who has amassed a fortune by buying stakes in undervalued companies and pressing for organizational or strategic change, is so concerned about the current environment that he has just announced a blog (http://icahnreport.com/) where he will exchange ideas about corporate governance and valuation improvements. Icahn continues to believe that most corporate boards are under-serving their shareholders, and this is most egregious in tough markets. Especially in times like the present, external assistance (or pressure from investors like Icahn) can invigorate under-performing corporate assets.

But not all forms of external influence need be unwelcome, as the case of private equity shows. Orit Gadiesh and Hugh MacArthur, consultants at Bain & Company, have written authoritatively on what public companies can learn from private equity in a new book (Lessons from Private Equity Any Company Can Use, Harvard Business School Press, 2008). In short, say the authors, the discipline of higher leverage, specific goals driven by compensation, and effective strategic planning for change over a 3-5-year horizon all force a corporate focus on results that drive firm value--which, in the private equity world, reduces to the paramount metric of free cash flow. Based on more effective governance mechanisms and corporate strategy, this culture of relentless focus on cash flow is an import from private equity, which has led to broad improvements in productivity and profits in corporate America over the last two decades.

More directly, in recent years private equity investments in public companies have arisen. PIPE transactions are unusual for buyout firms, which are best known for buying controlling stakes in companies, engineering changes in governance, strategy, or operations, and then selling the firms years later. In a PIPE deal, the private equity firm purchases a (strategic) minority stake in a publicly traded corporation. The investment vehicle usually involves convertible securities bought at a discount to the firm's market value per share, and the private equity firm gains board representation. For the public company, this offers an efficient alternative to raising capital in the public markets as well as considerable added-value resource support.

According to Sagient Research Systems, private placements and PIPEs approximated $50 billion in 2007. Recent PIPE deals include the acquisition of a $700 million stake in Aeolus Re by Warburg Pincus and Merrill Lynch Private Equity, and a $700 million stake in Sun Microsystems by KKR. Elevation Partners acquired a 40 percent stake in Forbes Media for $275 million, and 25 percent of Palm for $325 million. Two examples of these transactions, in business services and information technology, serve to illustrate the benefits of PIPEs.

In 2002, Friedman, Fleischer & Lowe (FFL), a $1 billion private equity firm based in San Francisco, invested in Korn/Ferry International, an executive search firm with 90 offices worldwide. Korn/Ferry had fallen victim to an industry downturn, as revenues had declined by 50 percent from their peak in 2000. Layoffs approached two-fifths of the firm's professionals worldwide, and the company faced significant debt repayments to a major lender whose desire to exit the investment was driven by the industry's seemingly poor prospects.

Based on extensive knowledge of upscale professional services industries, FFL saw things differently. Here was a durable brand and global franchise, caught in a cyclical downturn, whose clients and employees still believed in the firm. FFL made a significant investment in the form of convertible notes, eventually acquiring 12 percent of Korn/Ferry's common stock. This boosted the morale of the firm and its clients and offered highly positive signals concerning the firm's future. In turn, FFL acquired two board seats, and in the three years of the investment, provided significant assistance in terms of acquisitions, recruiting, capital allocation and management, and extensive industry, competitive, and financial modeling. With resources far greater than those available from the typical board member, FFL was critical to the tripling of Korn/Ferry's stock price during the period of its investment. Paul Reilly, Korn/Ferry's CEO, commented that "FFL was a strategic partner in the truest sense of the term. They challenged us, supported us, encouraged us, and provided tremendous aid during a difficult market environment."

In April 2005, Silver Lake Partners invested in NASDAQ Stock Market, Inc., as part of a multifaceted acquisition of Instinet Group, then a publicly traded corporation. One of Instinet's divisions, INET ECN, had a cutting-edge technology platform that NASDAQ wanted to acquire, and Silver Lake wished to facilitate. With INET ECN, Silver Lake believed NASDAQ would develop competitive superiority in software development--this would foster innovations in equities trading, and create future market opportunities. Silver Lake thus purchased $145 million in convertible notes from NASDAQ, and Silver Lake's co-founder and co-CEO, Glenn Hutchins, became a member of their Board. At the same time, Silver Lake purchased Instinet Group's institutional brokerage unit, since NASDAQ had no interest in this business.

Since Silver Lake's investment, the INET platform has improved performance for NASDAQ's trading clients, and NASDAQ has gained significant market share. Additionally, NASDAQ developed a new options market based on the new technology. Lastly, Silver Lake's insights fueled NASDAQ's acquisition strategy, leading to the announced acquisition of OMX in Sweden, and the Boston and Philadelphia Stock Exchanges. Silver Lake's equity stake more than tripled in value.

In sum, private equity has been the subject of much recent controversy, but as an empirical matter, researchers including Steve Kaplan of the University of Chicago and Josh Lerner at Harvard Business School have detailed the substantial increases in operating profits, free cash flow, and corporate value engendered by the sector. Indeed, Harvard Business School's Mike Jensen has termed private equity a "new and powerful model of general management applicable to many, if not most, firms and organizations." PIPEs are an extension of the superior governance, industry-specific knowledge, value-creating entrepreneurship, and strategic resources provided by private equity investors, and should be on every CEO's dashboard of options in a challenging economy.

John L. Chapman is an NRI fellow at AEI. Omeed Jafari is a former research associate at AEI.