Originally published in Forbes.com
Despite today’s global economic jitters, the private equity industry continues to attract hundreds of billions of dollars in investments. That may calm some investors. But to get the returns they expect, investors need to ask another question: Can PE firms consistently attract great CEOs to run their portfolio companies?
Industry research on PE portfolio company CEO turnover and our years of experience suggest the answer is “no” – if conventional approaches to evaluating executive leadership prevail. In this article, we’ll examine the three traits that separate the top private equity leaders from the rest of the pack.
Despite a tumultuous U.S. political landscape, Brexit, and other economic uncertainties that are giving investors pause, the global private equity industry is showing surprising strength. In January 2017, PE industry tracker Preqin issued its most recent indicators. In 2016, PE raised an of aggregate $347 billion across 830 funds. While the number of funds closed in 2016 was 12% fewer than in 2015, the resulting average fund size was $471 million, an all-time high. PE fundraising broke another record in 2016, with 76% of PE funds closed either meeting or exceeding their target size.
However, despite the bullish investor appetite that continues into 2017, some PE firms struggle to achieve the returns their investors expect. The reason: Nearly half the time they choose the wrong leaders to run their portfolio companies. That’s what consulting firm Bain & Co., which conducts extensive research on the PE industry, has found. In the portfolio companies it looked at, Bain found that nearly half their PE owners changed the CEOs who ran those portfolio companies. In 60% of those incidents, the PE firm hadn’t planned to remove the CEO in the beginning. What’s more, the great majority of those CEOs were not replaced until after the first year the PE firm owned the company – that is, after “the opportunity to build early forward momentum had passed,” as Bain wrote.
Such a delay can erode a PE company’s return on a portfolio company, the Bain study concluded. “A delay in replacing an underperforming or ill-equipped CEO can significantly undermine even the best formulated value-creation plan.”
We agree, based on our experience and research over the last 30 years in helping PE firms evaluate portfolio company CEOs, as well as on assessing candidates for the position. So how can PE firms increase the chances they hire the right CEOs to run the companies they typically own for five to seven years?
PE firm Founders Equity Inc. is an example of a firm that got it right. Soon after buying an independent service provider for radiation therapy equipment, they hired a new CEO, Richard J. Hall, to lead the company (a current client of ours). Over the last four years, Hall and his leadership team doubled the company's value and boosted revenue 65%. Last July, Founders Equity sold the company to Jordan Industries.
The choice of Hall to lead the organization was a success. But as Bain’s research shows, success in selecting CEOs to run PE-owned companies is not as common as one might think.
Why Is This Happening?
From doing comprehensive assessments since 2009 on 181 corporate-level executives in PE-owned companies, we have found that unsuccessful CEOs of PE-owned firms all lacked the following three leadership traits:
1. The ability to think both strategically and systemically.
The latter quality refers to someone who deeply understands the process, people and technological impacts of changes in strategy, and the interplay among those elements. For example, until four years ago, Hall's organization didn’t have a dedicated sales team; its operations people also sold the firm’s offerings. While Hall decided he had to separate the two jobs, he also predicted the operations staff would greatly resist it. To smooth the transition, he had new sales people work closely together with the operations professionals over the first six months of the transition. “That enabled them to understand the role each played and to complement each other – not compete with each other,” Hall explains.
2. Building executive leadership team alignment and commitment to the strategy.
When Hall became CEO, he quickly realized that the management team wasn’t on the same page. They met only once a year, had irregular conference calls, and suffered from inconsistent communications. Hall instituted a 90-minute conference call every Friday morning for the top team, as well as regular Friday calls between regional and sales directors.
3. Developing executive leaders who need new skills or knowledge to execute a key part of the strategy.
In other words, these PE firms didn’t operate under a “sink or swim” mentality. One of the first things Hall did when he became CEO was put the top management team through intensive leadership development training. Says Hall: “The culture was very much engineering-driven. Concepts like management by objectives and performance metrics were totally foreign to them. We needed to professionalize the organization.”
To scale a business for rapid growth within the 5-6 year window, a PE firm typically holds a company before selling it, demands a CEO with strong organizational and leadership skills who can recruit and develop talent, build a high-performing management team, and create a workplace culture that advances the business’s strategy, all while maintaining good relations with the company’s new owners. These are leadership skills that, unfortunately, some PE firms minimize in favor of strong strategy and decision-making skills, and often lead to turnover at the top.