Gone are the days when above-market investment returns can be achieved through financial engineering alone. Clearly the financial expertise of a private equity partner can fuel the next-stage growth of a company, but today’s investors are keenly aware that operational expertise is also critical to the growth and profitability of platform companies.
If your investment horizon is three to five years, you have six months (and certainly no longer than a year) to get top leadership right at your platform companies or they will under-perform compared to investment expectations.
Key to delivering above-market returns, and one operational area where a private equity firm can excel and make a critical impact in the performance of their platform companies, is in the area of talent management.
Leadership under Private Equity Ownership is Different
For those of us who have spent time in the world of private equity, we know that effective leadership in this space is very different from other types of ownership and leadership platforms.
The acquisition of a company by a private equity firm is a seismic change for its leaders and employees. Yet a private equity firm places its “bet” based in large part on the strength of a leadership team that has succeeded in the past.
Research shows that effective leadership is situational and there is no single leadership profile that is most effective. A great leader in one company and under one ownership/market/financial situation can fail miserably in another, and it can happen quickly. Leadership skills that successfully propelled a company in the early stages of growth may no longer be effective when that same company matures with greater scope, scale and complexity. Correspondingly, a leader who has been effective in a turnaround may not be effective when the turnaround is complete and the focus shifts to growth.
The Wrong Leadership Destroys Enterprise Value
I think we all know, and have seen, that great leadership can significantly and expeditiously enhance stakeholder value. We also know how quickly bad leadership can destroy value in an organization. However, if great leadership is situational and hard to profile, the same can be said of wrong leadership until it becomes a serious problem and has drained resources and profitability from the platform company.
An example of this difficult situation occurred when a client called us expressing concern that one of their portfolio companies, a medical device company with $75 million in revenue, was not performing in line with their expectations. They suspected that legacy leadership in the organization was impacting performance results. An audit revealed that not only was the CEO producing poor results, but he was also engaging in behavior that exposed the company to liability, placing the entire sales trajectory at risk. The solution consisted of exiting the leader and finding his replacement within the existing ranks of the company, someone who was respected by his peers and the 150 employees in the firm. With the right leadership in place, the company started to see an immediate improvement in financial results.
Without the appropriate fiduciary oversight in place it can be difficult for private equity firms to spot when leaders are the wrong match for their platform companies. In a worst case scenario, private equity firms are surprised to learn that a CEO has carefully managed the Board by controlling both the information flow and their insights into what is really happening in the organization. This can result from the process of leadership oversight being ill-defined or non-existent. What is needed is a proactive leadership wellness program.
Six Principles to Ensure an Effective Leadership Wellness Program
As one of the Managing Partners at Kensington International, I can share a simple yet effective model we have developed for organizational leadership wellness programs.
This model proposes that private equity firms develop standards in the “core areas” of leadership talent management that are similar in principle to the standards that most firms establish for financial analysis and reporting. The key difference is that there are no GAAP standards, bank covenants or IRS and investor reporting requirements to follow. Each private equity firm should develop its own.
1. Make Talent Management a Top Priority
For bigger private equity firms operating in the large-cap company space, this likely means hiring a Chief Human Resources Officer, perhaps with a small staff to do recruiting, consulting, etc. For those mid-size firms operating in the mid-cap to small-cap company space, this likely involves partnering with outside resource(s) to assist in the development and execution of talent management initiatives on a consistent but “as needed” and variable cost basis.
2. Perform Pre-Acquisition Leadership Due Diligence
As part of the due diligence process and in the final stages of talent vetting and acquisition, it is a best practice to invest in leadership assessments. Although it's possible that such work can uncover leadership dysfunction that will “kill” the deal, that outcome is an exception. Skillful leadership assessments can be a critical strategic tool, sending a positive message to the leaders of the company about to be acquired. As the potential buyer, these assessments can reveal to the private equity firm to a wider range of managers that are not as trained, experienced and polished in the “roadshow” sale process. The outcome of pre-acquisition due diligence is a baseline understanding of leadership strengths, bench strengths and areas of possible concern or need of development in the organization you are about to acquire.
3. Immediately Clarify Private Equity/CEO Relationship
Using a consistent and formal process, invest in bringing clarity to the relationship between the CEO/President of the organization and the private equity firm. If this is not done, the CEO/President will continue to operate as he/she always has and all parties will waste time and energy trying to figure out how to work together effectively. Although private equity firms have different visions for what this “governance” needs to look like, we recommend a formal “Board of Directors” approach. In such an approach, the Board’s role needs to be made clear in terms of both performance monitoring and strategic oversight. Board meetings should occur regularly and should operate with a formal agenda. If this is a new experience for the CEO, he/she should be coached on how to work collaboratively with the Board.
4. Conduct an Early Leadership Effectiveness Audit
At the three to six month mark, the “honeymoon” is over and there is a greater awareness on all sides as to how well the leadership/private equity ownership team is doing. It is also the critical “tipping point” where great leadership will propel the organization toward top-tier private equity investment returns and less effective or bad leadership will correspondingly underperform. A well designed and consistently applied leadership assessment and development process will make good teams great, and if there are issues that are too big for development, changes can be made (top executive team additions or subtractions) at a critical time in the investment life cycle.
5. Own the Executive Recruiting Process
As the private equity owner, don’t abdicate responsibility for finding the “right-fit” new executive. When key leadership additions are required, think about the recruitment process strategically and not as a transaction. Without a vision of what’s needed, one may just get a retread of the very executive that was moved out. The executive employment markets are so transparent that it's easy to find executive level candidates who have industry, function or product/market experience. What is more important, and not as easy to find, is a leader who will bring the right new leadership behaviors into the organization. Organizational and cultural transformations start at the top and, if left solely to the discretion of the platform company they will be more likely to hire in their own image. As a result of this, we encourage our private equity clients to build a short-list of search firms who know how to assess the current culture of a company, and what changes are believed to be necessary in order to find the best new executive(s). Let the platform company executive make the final selection, but insist on a “best practices” process and firm.
6. Effectively Manage Executive Transitions
Don’t underestimate the importance of effective executive transition management, especially when it involves a previous owner. Even if they feel they are ready to move to a new life stage, some career/life transition support would be a good investment. It sends a positive signal to all stakeholders, including owners of future company acquisitions.
A prime example of this situation occurred when a $150 million energy company brought in our firm to coach an executive who was taking over the reins from the former owner. Through careful planning, an effective transition plan was put in place that recognized the contributions of the exiting leader, reassured the 1,000 employees in the workplace and successfully positioned the new leader to navigate his new role effectively. Supported by targeted reorganization and role alignment, within a mere three months, the company’s financial results were strong and the prospects for the future are bright.
Leadership Makes the Difference
Look at any business success story from start-up to turn-around and you’ll see that the prime factor in realizing ROI is leadership. Effective leaders inspire employees, make bold decisions and propel good companies to greatness. Conversely, average or poor leadership places downward pressure on results. When looking to optimize return on investment, one can’t start too early to make this assessment. Ideally it should occur during due diligence. If the process is not happening then, it should start now or else leave money on the table.