When we talk about changing culture in an organization, it rarely starts with finance, but maybe it should. Why? Because finance has a significant impact — good or bad — on the culture of any organization. In an Executive Session at AFP 2021, Gary Bischoping, partner at Hellman & Friedman, and Greg Milano, founder and CEO of Fortuna Advisors discussed in great detail how to make it good.
Five traits of ownership cultures
In a traditional culture, you experience the following traits:
- Spend your budget or lose it.
- Hedge – smear resources around.
- Risk avoidance – even the good ones!
- Analysis paralysis/indecisiveness.
- Variances to plan and guidance.
In an ownership culture, it’s a little different:
- Spend money like it’s your own.
- Extreme prioritization.
- Willingness to fail.
- More doing and less talking.
- It’s about the long-term and the short-term.
In a traditional culture, you get a budget, and you spend it or lose it. There's this mindset that it really doesn't matter. I don't need to treat the money like it's my own; I just know that if I don't spend it all, they're going to give me a lower budget next year.
In an ownership culture, people spend money like it's their own, and that leads to more discipline. And it leads to more willingness to invest in good things. Very often when something good pops up during the year, an owner will say yes, that's great, let's go do it. But in a traditional company, many, many people will say that's not in my budget, let's see if we can get it in the budget for next year. It slows down progress. It slows down entrepreneurism and innovation.
“In a typical company, people smear resources around scores of activities without really emphasizing the ones that create the most value,” said Greg Milano, founder and CEO of Fortuna Advisors. “It would be like telling Warren Buffet he has to buy the same amount of every stock instead of concentrating his money in the ones he thinks are going to go up.”
Extreme prioritization is when people figure out where the value is being created, and then focus the resources on those activities, like an owner would. Whereas in a traditional company, the mindset is all about risk avoidance. But there are risks worth taking.
In an ownership culture, where there is more of a willingness to experiment and sometimes fail, that's where the breakthroughs and the innovation comes from. In a traditional company, we often see analysis paralysis — people are very indecisive. Management meets over and over again, and instead of making a decision, they come up with something else that some junior people need to study. In an ownership culture, there's a lot less talking and a lot more doing.
Also, in traditional companies, there's a variance to plan mindset rather than an emphasis on improvements. And it doesn't matter if you plan higher, or you plan low. If you beat the plan, you know, you get paid well in most companies, and there's this negotiation: I want a lot of profit; I want very little profit. I want to get my target as low as possible in an ownership culture. It's much more about the long term. We're willing to give up a little bit today to get something more in the future.
Fortuna Advisors has a measure that goes along with this called residual cash earnings. It's like EBITDA minus tax, less a charge for the gross assets invested in the business. If you're familiar with economic profiter EVA, it's similar, except they don't depreciate assets.
“The problem with EVA is when you buy a new asset, EVA crashes,” said Milano. “And then as that asset depreciates away, it gets better and better and better. So, what do people do? They stop buying assets and they sweat assets as long as they possibly can.”
The EVA led to a lot of under-investment in the business by having a similar measure without depreciation. Fortuna Advisors get a much better balance of investing in growth while having the discipline to produce margins and have capital productivity. This is a measure that can be used to make small decisions, big decisions, to evaluate acquisitions, develop business plans and, very importantly, measure performance and pay people. It's such a complete measure that they never ever measure it against the business plan. “We always measure it against last year — when it goes up, it's good; when it goes down, it's bad,” said Milano.
RCE drives TSR
When we look to the market, we see that the companies that are improving have above-median improvements in residual cash earnings (RCE); they have much stronger share price performance than companies with below-median improvements in RCE. And when you look at this by industry, you'll find this measure actually relates to total shareholder return (TSR) better than EVA or traditional economic profit in every single industry. And so, the act of doing it on a cash flow basis instead of on an accrual basis is really important to value recognition.
Residual cash earnings is always measured against the previous year. “The only thing you need to calibrate to a particular company is the slope of the payout curve,” said Milano. “How fast do the payouts rise when RCE improves, and how fast do they decline when RCE declines.”
If you have a volatile business, you'll want this payoff curve to be really flat so you're not hitting the cap on the floor every year. If you have a really stable business with a low volatility of EBIDA, then you’ll want a steeper payoff curve so the bonuses aren't always around one.
“This method eliminates probably 90% of the negotiation that goes on between competition, committees and management teams to set up comp plans,” said Milano. Once you've done this for a couple of years and everybody's comfortable with it, it just rolls forward every year, whatever it was last year, that's your target.
“When you present that to a comp committee, they often say, well, wait a minute. What do you mean our target is last year? Don't we have some sort of an improvement? And then we explain, well, it already has the improvement baked in,” said Milano.
For RCE to be the same as last year, you need to improve EBIDA enough to cover an adequate return on whatever investment you make this year. If you invest more, your EBIDA target automatically rises. If you invest less, it doesn't rise as much. So it does have an improvement goal built into it, but the improvement goal is driven by how much you invest. That's where the ownership culture stems from.
Many companies have lofty forecasts for every investment they're going to make. But if you approach it from an ownership culture, you explain to them that if the RCE doesn’t go up, you’re going to make less money. All of a sudden, they’re looking back at their forecast and trying to decide whether or not they believe their own forecast, because now they’re in the shoes of the investor. Not only are they going to destroy value for the investor, if they make a bad investment, it's going to hurt them personally. If RCE goes down, they get less money. “And that's how we get people to start treating the capital like it's their own money,” said Milano. “The behavioral impact is significant.”
To get people to understand this requires a bit of change management. It involves a lot of training and communication. You can’t just change an incentive plan and all of a sudden everyone’s behavior changes — behaviors they’ve learned over 20 or 30 years. It requires a good training and education program to make it happen.
Case study: Varian Medical Systems
Varian makes radiation therapy devices used in the treatment of cancer, along with the software and services that go along with it. When Bischoping initially got there, the industry was only growing 2-3%, but in the five years prior to that, the industry was growing at 8-9%.
“What was striking to me was the lack of reinvestment,” said Bischoping. R&D as a percentage of revenue was going down, and there were a lot of share buybacks that were happening. The overall rate of returns in the business were very high: 30% return on invested capital.
“So, when the CEO called me and said, I'd love to talk to you about joining the company, my basic premise was simple, which is to say, that's fantastic, however, we need to reinvest in this business to get it to be innovative and drive growth over time,” said Bischoping. “And they said, that's great, let's do this, and I called Greg. I told him we've got a major ownership problem, we’ve got an incentive problem, and we’ve got a measurement problem.”
The company wanted to get their new technology out to patients to help cure cancer. That was the impetus, the cultural drive. This was Bischoping’s first CFO position with a public company. “I had committed to myself that, based on all the experiences I’d had, when I get in the chair, I was going to make sure we got the right measurement system in place.”
They decided to take R&D and treat it like an economic investment instead of an accounting expense. The CEO of product development and the board supported the plan, and it unlocked an amazing amount of innovation in the company. They started to see good ideas, and they also saw team members come forward with I shouldn't be spending money on this, right? It simplified the measure and got people to focus on one metric: when it went up, it was good; when it went down, it was bad.
There was some training and education. “We had to do work on how to treat some of the nuances of the actual measure,” said Bischoping. “But I’m happy to say that after that they uncovered a gem that had been buried in the company.” It was an artificial intelligence software program Varian had been working on to accelerate treatment time and spend less time overall with patients on the bed. It had been underinvested in on a quarter over quarter basis to meet a quarterly earnings per share target. By bringing it forward, they accelerated the amount of R&D and brought what was a five-year roadmap down to about two years. Varian’s stock price took off, and performance went from 2-3% to organic growth of 8-9%.
“This willingness to fail is really important,” said Milano. “For most companies, as long as the spending's in the budget, it doesn't matter. You don't get whacked. In this system, because you're always measuring last year, if you stop spending on something bad, the RCE goes up and you make more money. So the impetus to weed out the bad things and reallocate those resources to things that are more productive goes up significantly.”
It should also be noted that the finance organization played a major role. Working with Fortuna Advisors to define the metric, they were involved in all of the communication and training of operators. They also worked through that extreme prioritization of what they were going to do and not do. And, every member of the executive leadership team that reported to the CEO had a finance business partner who was trained on all the details and could work through what the RCU would be.
Case study: Transocean
About 15 years ago, from the end of 2002 to the end of 2007, the total shareholder return for Transocean, the offshore drilling contractors, was five times the market. Oil was doing well, but they were also investing in a lot of offshore, high-spec drilling rigs. In fact, they had the biggest fleet of high-spec drilling rigs in the world.
Three of the five years in that period management got an annual bonus of zero, one year they got 60% of target, and in only one year, did they get above target at 1.3 times. And the reason it happened was because it took them three years to build a rig, and they wouldn't start building a rig until they had a five-year contract from one of the big oil companies.
So going into a year, they knew what rigs were supposed to come on the line, what the contracted revenue was, and all the costs to launch it — all the benefits got baked into the budget. The only downside risk came if there was a delay, or a cost overrun or penalties from the oil company because they were late.
“While this is an extreme example, it’s also a very common thing,” said Milano.
It was a good thing Transocean was as aggressive as they were in continuing to build those rigs when the incentive plan basically said stop doing that. If you stop building new rigs, you'll have more certainty about what your budget is for the year, and you'll get paid.
Unfortunately, they also had long-term incentives, which they made a lot of money on during the period, but the annual incentives, especially for the lower people in the organization, was a much bigger part of their pay than stock. And they were getting whacked every year. “This is a big problem — being able to let go and measure against the previous year and say, if you do achieve success, we are going to pay you,” said Milano.
Willingness to perform acquisitions
How willing are these companies to still engage in acquisitions under the comp plan? Let’s take a look back at an example from Varian.
After Varian launched the AI product and reallocated R&D resources, it was very clear that there were other opportunities for them to inorganically grow the company. There was a physics problem they were trying to solve regarding radiation treatment using a magnet and a laser that allows you to see and have real-time continuous visibility to where the radiation is going in someone's body.
One of their competitors solved the problem and came out with a product that offered real-time visualization while radiation was being delivered. However, there was some debate over whether it was going to be simply a niche in the market for the academics to use because, with this device, it took 40 to 50 minutes to deliver treatment, whereas a traditional radiation therapy treatment takes seven to eight minutes. And they were getting varying degrees of effectiveness and efficacy because the visibility changed during the course of treatment. And, sometimes patients have comorbidity, which means they have a hard time breathing, so keeping them on a bed for 40 minutes is not a good idea.
The company’s stock price was trading at about 15 times revenue, and they were a high-flyer in the med-tech space. So, the question was whether or not Varian should buy them. And if so, what would you have to believe to make it a yes?
It was decided that when you broke it all down, was the price they would have to pay to get to a premium at which their board would approve it, was that product going to be more or less than 10% of the market? Varian put in their initial bid, and the company came back and said thanks, but no thanks.
Eventually Varian got to the point where they had to make a final offer. The chairman of the board and the CEO went into Bischoping’s office and asked for his thoughts.
Bischoping went to his whiteboard and worked through the residual cash earnings impact at below 10% of the market and at 10 to 20% of the market, and for the price that they would've had to pay, their revenue would have gone up. It would have been accretive growth rate, and their gross margins would've gone up. So they would have been accretive on an earnings per share basis within three years and earned above their cost capital in year four or five.
However, Bischoping advised against it. He told them that there was no case he could come up with, even at something like 20% of the market, where they could cover the amount they would be investing in this company. From a residual cash earnings perspective, they would have a continuous decline. So, they walked. “That was a pretty big moment,” said Bischoping.
Now, in the background, Varian had invested in this artificial intelligence device that was near real time and resulted in a patient being on the bed for seven minutes, not 40, with overall better outcomes that they could back with quantitative data. “We took an organic approach to solving that problem,” said Bischoping. “Not exactly as sexy as the real-time approach, but more patient-centric. And low and behold, if you look back today, that other product is still less than 10% of the market. So it turned out to be a pretty good idea to walk away from that one.”
At the same time, there was a near adjacent market called interventional oncology that used the same visualization techniques that Varian used in that artificial intelligence device, but they delivered the therapy by going in through different veins and different places in the body, with different immunotherapies you could deploy, rather than radiation.
Varian bought five companies over the four years that Bischoping was there and ended up being the number two or three player in interventional oncology. The company is still investing in that space today and is doing very well.
In more general terms, what Fortuna Advisors finds in its clients is more willingness to invest, whether it's organic or acquisitive, but more discipline about what they invest in. Within some industries, they find that the size of the acquisition matters a lot to success. “These big blockbuster deals don't always lead to the best share price performance for the buyer; they lead to really good share price performance for the seller,” said Milano.
It's often the smaller deals where people are doing them regularly that they're getting good at them. They know how to integrate them and how to exploit whatever it is that the new acquisition brings, whether it's a distribution channel or a technology or product.
But the discipline we find around not just finding good companies, but finding good companies at the price you can afford. And, more importantly, the discipline to walk away when things don't look good anymore. The mindset of, well, it's a great company, and I would love to have it, but not at that price. That's how we would all behave with our own money.
“It’s just like if you wanted to buy a house or a car, it might be a beautiful house or a beautiful car, but there's some price at which it's a good deal and some price at which you'd walk away,” said Milano. “And it's just trying to instill that discipline in a more concrete way than we see in most companies.”
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