The key reason for private equity's success

The massive profits that some private equity firms make on their investments evoke admiration and envy. The mainstream reason (which has been true for a large portion of private equity funds) is due to the firms' aggressive use of debt, concentration on cash flow and margins, freedom from public company regulations, and hefty incentives for operating managers.

But I believe the key reason for private equity's success is the forced strategy of buying to sell.

Why do I say forced? Mainly because it is my experience that  public companies, which, in pursuit of synergies, usually buy to keep. This attitude or frame of reference brings very different pressures to bear on management.

The chief advantage of buying to sell is simple but often overlooked. Private equity's sweet spot is acquisitions that have been undermanaged or undervalued, where there's a onetime opportunity to increase a business's value. Once that gain has been realized, private equity firms sell for a maximum return. A corporate acquirer, in contrast, will dilute its return by hanging on to the business after the growth in value tapers off. Public companies that compete in this space can offer investors better returns than private equity firms do. (After all, a public company wouldn't deduct the 30% that funds take out of gross profits.) Kinross is doing this by getting into diamonds, not just gold. Their more inexperienced investors attracted by the gold price hike, get nervous and want a concentrated stock. More experienced and professional investors appreciate the subtle nuance of the management team.

Corporations have two options: (1) to copy private equity's model, as investment companies Wendel and Eurazeo have done with dramatic success, or (2) to take a flexible approach, holding businesses for as long as they can add value as owners. The latter would give companies an advantage over funds, which must liquidate within a preset time--potentially leaving money on the table. Both options present public companies with challenges, including capital gains taxes and a dearth of investment management skills. But the greatest barrier may be public companies' aversion to exiting a healthy business and their inability to see it the way private equity firms do - as the sale and cashing in of a successful transformation, not a strategic error.

Jacoline Loewen, author of Money Magnet, Attract investors to your business