case study
Brand New or Old News?
THE CORPORATE RESTRUCTURING TECHNIQUES
OF PRIVATE-EQUITY FIRMS
AND
THE CASE OF CROWN, CORK & SEAL
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mark andresen John Connelly became CEO of Crown, Cork & Seal in 1957, and subsequently rescued the firm from bankruptcy using strategies like those of today’s PE firms. |
The recent success of PE (private equity) firms has attracted a great deal of media attention. PE firms restructure corporations, implementing a hands-on management style that focuses directly on increasing firm value. Popular thinking has it that PE techniques are not possible in a public firm, due to the incentives imbedded in the ownership structure. However, the techniques used by PE firms are nothing new, and they certainly can function in a public firm. As long ago as the late 1950s, Crown, Cork & Seal implemented a radical restructuring along proto-PE lines.
A recent article by Robert C. Pozen (2007) describes the techniques PE firms use to increase firm value and demonstrates how these methods can be utilized in a publicly traded firm:
- Public firms retain too much cash. That cash should be distributed as dividends, as a higher payout will force management to perform at a level that will maintain the dividend. In theory, stock buyback plans could accomplish the same goal, but historically they have proven ineffective.
- Debt levels tend to be too conservative and should generally be raised to optimal levels that will reduce the cost of capital.
- Operating performance can be optimized by improving strategic long-term planning, plan execution, and cost-cutting measures.
- Executive compensation must relate directly to maximizing the value of the firm. The base pay for executives should be relatively low and equity compensation should be relatively high. Compensation should be concentrated so that the management directly responsible for improving performance receives the bulk of compensation (incentive compensation is more effective when more shares are in fewer hands). Large severance payments should be avoided.
- Boards must be leaner, and directors should be industry experts focused on increasing value.
Pozen is correct in his insistence that public firms can implement these changes and in his dismissal of many of the excuses that prevent such measures. This kind of reconfiguration is not only possible in publicly traded corporations, but occurred prior to the current PE fad.
Crown forged an alliance between management and board by committing both to maximizing firm value, which is certainly the goal of any restructuring performed by a PE firm. Furthermore, the strategy focused on long-term firm value.
The Crown, Cork & Seal Company was founded in 1892 to manufacture bottle caps and metal cans. In the early 1950s, its board was dominated by insiders. Crown management made a strategic mistake attempting to copy the high-volume/low-margin strategy of larger competitors. As the firm’s condition worsened, John Connelly began accumulating stock in the firm. In 1956, he became the board’s only outsider.
By 1957 the firm was in a liquidity crisis and Connelly became CEO. In that year’s annual report, Connelly summarized the firm’s circumstances in his letter to shareholders (1958):
Management was extremely discouraged. Sales were diminishing as reports were freely circulating among our customers that we were in difficulty. The complaints of stockholders were numerous and violent. Nearly $600,000, applicable to Common Stock, had been lost in the first quarter of 1957 with no prospects of reversing these losses. Six and one-half million dollars were owed to banks and it was thought that an additional seven million dollars would be needed to get us through the seasonal peak of our business.
Connelly subsequently rescued the firm from the brink of bankruptcy and remained CEO until 1989. During his reign, John Connelly instituted and executed strategies similar to those associated with today’s successful PE firms. His first order of business was to cut costs and make production more efficient (see Whalen 1962):
- All new purchase orders were cancelled.
- Seven million dollars of inventory was liquidated and all short-term debt was paid off without issuing new debt.
- Payroll was cut by $10 million and the divisional corporate structure was replaced with a lean vertical structure.
- Production facilities were consolidated from 53 multistory buildings to three single-story buildings.
- Management limousines were eliminated.
Drastic restructuring like Crown’s is the typical prescription for corporations taken private by PE firms. Inefficiencies are reduced to add value to the firm; however, long-term changes are also necessary. According to Pozen, management must take a hands-on approach and implement a strategic plan. Connelly’s actions were no different.
- Quality was emphasized in manufacturing and manufacturing variances were reduced.
- Sales forecasting was introduced to reduce overproduction and excess inventory.
- Connelly was very hands-on: he ate in the company cafeteria, consulted with line workers, and visited plants regularly.
- Crown’s long-term strategy focused on manufacturing products with relatively high margins (specialty products such as aerosol cans) and entering markets that allowed relatively high margins (generally overseas). This was counter to the high-volume/low-margin, conglomerate strategies of competitors.
- The customer became the focus. Production facilities moved to areas in which customers could receive better service in a “just-in-time” fashion.
Connelly also changed the board structure and the management compensation package.
An important element of Connelly’s strategy was to expand internationally, where competition was not as fierce and profit margins were higher. Many of the board members were from foreign firms Crown had purchased. By increasing international representation on the board, Connelly enhanced both board expertise and information flow from operations abroad.
Board members focused on increasing their own wealth and that of other shareholders. All the new board members who replaced those from the pre-1957 regime had stock ownership in Crown. In the Connelly era, common stock ownership by board members averaged 34% of Crown equity.
Management compensation was based primarily on stock ownership rather than salary. Management ownership of stock was large and in the hands of the critical decision makers. When Connelly began rebuilding Crown in 1958, he was paid $34,166 a year, and his salary never rose above $250,000. However, Connelly benefited handsomely from his ownership in Crown. During his tenure, Crown’s climbing stock price increased Connelly’s personal wealth and that of his foundation by an average of $12.3 million annually. The compensation for other top officers was also primarily incentive based.
The lesson here does not lie in the success of Connelly’s initiatives but in the coherence of his vision. Crown forged an alliance between his management and board by committing both to maximizing firm value, which is certainly the goal of any restructuring performed by a PE firm. Furthermore, the strategy focused on long-term firm value. During Connelly’s tenure, the stock return for Crown averaged 18.7% annually, versus 13.4% for the average NYSE/AMSE firm. However, Connelly’s strategies were distinct from those of a PE firm in important respects.
The starkest difference revolves around dividends and capital structure. According to Pozen, larger dividends will force management to perform more efficiently. The specific emphasis on large dividends may not be a standard PE firm strategy, but the accountability of management with regard to performance is a definite PE goal during the privatization process. A large dividend is one means of accomplishing this goal.
In direct contrast to the PE approach, Connelly suspended common dividends indefinitely and followed a policy of frequent stock buybacks. Crown repurchased common stock in 29 of the 33 Connelly years and retired its preferred stock altogether in 1971.
The second disparity relates to Connelly’s minimal use of debt. Connelly moved swiftly to reduce annual interest and dividend costs by targeting the elimination of debt and preferred stock. Going forward, acquisitions were funded internally. In 1960, long-term debt financed 22.1% of Crown’s assets, but by 1989, this figure had been reduced to 5.7%.
Whether Connelly’s policies gave management a freer hand to focus on longer-term strategies or whether they insulated management from beneficial market scrutiny is an open question. Perhaps the policies were optimal at the time, but if a PE firm were to take Crown, Cork & Seal private today, the firm would immediately increase Crown’s debt structure. (Interestingly, the first noticeable differences in the managing of the firm after Connelly’s retirement were increased debt levels and the disbursement of a dividend.)
However, this is not a debate on the optimality of a no-dividend/low-debt policy, but a demonstration of the ability of various PE strategies to increase firm value. Consequently, PE methods should be examined in the context of an overall strategy rather than in isolation.
Management’s ultimate objective is to increase firm value. In the absence of this objective or its successful realization, management is dismissed, the firm experiences distress, and/or the firm becomes a prime target for purchase by a suitor that will focus on firm value. To imply that only one particular business structure can maximize firm value is misleading.
The strategies of PE firms are not vastly different from strategies that can be pursued by the management of a publicly traded firm (even from the 1950s). The curious question is: assuming firms can internally focus on firm value without going private, where are the new opportunities for private equity? Or, from a different viewpoint: how did public firms lose their focus on increasing firm value, and how did that loss of focus play into the fantastic returns recently posted by PE firms?
REFERENCES
Connelly, John. 1958. Letter to Shareholders. 1957 Annual Report. Crown, Cork & Seal Company: 3.
Pozen, R. C. 2007. “If Private Equity Sized Up Your Business.” Harvard Business Review, November.
Whalen, R. J. 1962. “The Unoriginal Ideas That Rebuilt Crown Cork.” Fortune, October.
Tom Arnold, C. Mitchell Conover, and Carol Lancaster are associate professors of finance at the Robins School of Business at the University of Richmond.
