Alignment to Achieve Sustainable Profit Improvement

Achieving Sustainable Profit Improvement: It’s About Alignment Not Creating Motivation

When Carpedia Capital considers investment opportunities, we always frame the potential for returns against the magnitude of risk (recall our definition of risk as the likelihood actual realized returns are lower than those required over a reasonable time period and the potential for permanent loss of capital) we are taking to ensure this relationship is appropriately balanced.

In our opinion, the primary determinant of investment risk in private equity deals is how “good” the business is today and how likely it is to become exceptional during our holding period than it is likely to become the converse. Consequently, we spend the bulk of our time assessing businesses against these two criteria when deciding which companies to seriously pursue – focusing extensively on ensuring our management partners are aligned with us to build an exceptional business that experiences sustained profit improvement.

Alignment to Achieve Sustainable Profit Improvement: As owners of businesses, we employ professional managers as our representatives to oversee operations on a day-to-day basis, execute the implementation of strategies and to generate ever-improving returns on capital for shareholders. Given that we provide our management teams with a great degree of autonomy and responsibility, it is essential to us, as owners, that we know our managers are making decisions (both small and big, on the front line as well as in the executive suite) through the same shareholder value framework they would if the owners directly oversaw day-to-day operations.

Creating and sustaining this degree of partnership and alignment throughout the lifecycle of a private equity investment is a complex matter which evolves over time. It is, however, in our opinion, simplified and enhanced by having or implementing the following from an early stage:

  • Open-Minded, Humble But Driven Managers that are Self-Motivated: A management team which is open-minded to a collaborative partnership that empowers and significantly rewards their success, while being humble but driven to improve are essential conditions to successfully build an exceptional business. Provided that the management team meets these basic requirements, we are cognizant that the most effective form of motivation to build an exceptional business is self-motivation. As such, we choose to partner with management teams which have an ethos of doing only great work and which choose to work hard every day at building their business – as these are attributes which match closely with the Carpedia organization’s own philosophy. We find that these individuals make this choice by virtue of being passionate about what they do and having the drive to be excellent at what they do right down to the details – the halo of which tends to rub off on those around them and attract other like-minded, enthusiastic and hard-working people to their organization – thereby creating the positive momentum essential to growing a business and driving positive change;
  • A Cash Investment Alongside of Us: There is no substitute for management putting actual dollars at risk from their personal account to invest on the same terms as we do – it focuses the mind and makes the transaction “real” for everyone involved. Therefore, we require a personally meaningful cash investment by each key manager that is large enough to make it permanently top-of-mind but not so outsized relative to individual net worth that its potential impairment could have you regularly sweating at night; and,
  • Results Oriented, Transparent and Equitable Compensation: A comprehensive rewards system that is focused on results, is transparent in its award and calculation and which is equitable across a range of scenarios is essential to achieving sustainable profit improvement. This rewards system meaningfully shares in value creation over the long-term (through ownership and options) and in the short-term (through cash-based incentive plans and dividends on shares owned). The rewards system includes special emphasis on integrating the achievement of results targets determined by the Carpedia operational improvement project and the terms of the investment transaction. While our approach to compensation ensures our managers are well compensated and that they feel taken care of, which we do so in spades, it is important to note that the type of people with which we look to partner do not need to be, and are not, coerced through compensation to get engaged – they already are – and, in our opinion, if we are trying to “motivate” management to get engaged using money then we have already failed as owners; that said, management universally likes to know that their efforts, merit and the company’s success appropriately rewards them commensurately for their hard work and the value they have created.

We have found that this approach, when matched with regular communication by the board regarding the potential value of management’s shares, options and incentive plans as determined through a transparent and clear framework (which allows the participants to directly observe how value evolves up and down with performance and how key factors over which they have control impact value) actually achieves the owners objective of causing management to think and act like owners themselves and reinforces their hard work to grow the business and its equity value – irrespective of whether these transparently determined estimates precisely capture the exact market value of the equity of the total business. We have also found that the ‘value’ placed by management upon their shareholdings and the motivational benefit of option and cash-based incentive plans decreases dramatically (almost to the point of being negligible) in the absence of clear communication and transparent calculation methodology; therefore, for the management team to ascribe value to it, and for the shareholders to actually benefit from what they are paying for in cash compensation and through dilution, the board must ensure value is transparent and well-communicated to those participating in the rewards and compensation programs.

We have also observed that the payment of regular distributions to shareholders, which fluctuate directly with the observable performance of the business, has a tremendous impact upon the perceived value of shares owned by management shareholders – particularly when management can influence the factors driving performance; the impact of initiating distributions is often an inflection point in management’s perceptions of the value as are changes in the direction of distribution growth, both upwards and downwards. As such, as part of our compensation philosophy to achieve alignment with management, we seek to pay distributions to shareholders as soon as is practical within the context of banking agreements and when it is value-added relative to available capital investment opportunities.

Conclusion: Creating alignment with management is essential to increase value and minimize risk. We believe this is best accomplished by partnering with self-motivated managers that share our philosophy, having them invest alongside us on similar terms and then providing them with transparent, results-driven compensation which rewards them commensurately for their hard work and the value they create. The combination of these three strategies aligns management to think and act like the owners they have become and rewards management for sustainably increasing profits as part of building a great business.

What’s Next: How we create value in ways other than through operational improvement will be the subject of our next blog.

We welcome, enjoy and encourage feedback from our readers – on this or other investing topics. If you have a comment or would like to discuss further, please submit your perspective to capital@carpediacapital.com or contact us.