The Journal of Private Equity: The Mistakes PE Firms Make When They Pick CEOs For Portfolio Companies
Originally published in the Journal of Private Equity, Spring 2017 edition
The growth of the global private equity industry over the last 10 years suggests investors remain bullish on private equity firms’ ability to assess acquisition targets; assets under management have increased 2½ times between 2006 and 2016 despite the Great Recession. Yet data indicates PE firms are not assessing the CEOs who run their portfolio firms with the same rigor. Research by Bain & Company found PE firms replaced nearly half the CEOs of the companies that they owned. What’s more, in 60% of those instances, the PE firm didn’t expect to replace the CEO when it bought the firm. And in the clear majority of those cases, the PE firm didn’t change the CEO until “after the all-important first year of ownership – after the honeymoon period had ended and the opportunity to build early forward momentum had passed.”
By too often keeping or hiring the wrong CEOs, PE firms are leaving growth opportunities on the table. Why does this happen? Over the past eight years, we evaluated 181 leaders of PE-backed companies. As part of these evaluations, we conducted structured interviews with over 2,000 executives who worked with, for or over them. We also added these evaluations to an extensive database to see trends in traits of the best leaders – the characteristics the top performers have in common. Our research and experience in helping PE executives evaluate and develop CEOs and members of their senior management teams indicate that PE firms frequently evaluate CEOs or CEO candidates on the wrong criteria.
Where should PE Firms focus when evaluating CEOs for their portfolio firms?
We have identified three skills that separate the best-regarded leaders from the rest:
The ability to think both strategically and “systemically” – quickly and expertly recognizing how a major change in strategy will affect the people, operations and culture of a firm.
Building alignment and commitment to that strategy. Without both alignment and commitment in place, a CEO must spend significant time making sure that, as filmmaker Francis Ford Coppola once put it, “Everyone is making the same movie,” and that the entire executive team is truly excited about it.
Developing the skills of select members of the executive team – investing time and resources into building specific skills crucial to accomplishing the strategy and leading the organization.
In this article, we explain in greater detail these traits and why they are critical to leading the growth or turnaround of a PE-owned company – typically in a shorter time than many public company CEOs get to reverse or accelerate the growth of their organizations. We also explain how common interview approaches and resumé checks fall short when evaluating CEOs, and how to transform subjective evaluations into more rigorous, effective, and objective assessments.
Shifting from Subjective to more Objective Evaluations
Before we talk about the three most effective traits of successful PE-backed CEOs, let’s take a moment to review common CEO evaluation processes and their potential pitfalls. Executive assessments can be viewed as a highly subjective exercise -- a beauty contest of sorts in which the wisest and wittiest win the job or get to keep it. Moreover, rarely are such assessments unanimous. The opinions of a dozen people interviewed about the current CEO or the candidates to replace him can vary significantly. And, of course, the opinion of that CEO about his or her strengths and weaknesses can (and often does) differ significantly from everyone else’s.
Many companies have decided over the last 30 years that they needed to shift such subjective exercises into more objective territory. Some have embraced 360-degree reviews to assess their people, and several studies have argued for their value. One study found that a person’s ratings by those familiar with him were far more accurate in predicting how well he performed on objective criteria than the person’s own assessment. In fact, the study found, the bigger the gap between an individual’s self-rating and his ratings by others, the poorer his performance. In our own extensive evaluations of CEOs, such “over-estimators” scored far lower on their 360-degree reviews than the “under-estimators.”
Thus, our first advice is to beware the CEO or CEO candidate who vastly overestimates his abilities. Those with such “blind spots” are far less likely to be viewed as being effective than CEOs who question their own capabilities – that is, someone with the perspective of a “learner,” not a “knower.” CEOs with the blind spot problem usually haven’t received or asked for enough feedback on how they lead. They are like the person who hasn’t looked in the mirror to notice ketchup on his beard, or hasn’t stood on a scale in a while.
Over the past 30 years, we’ve been asked by private equity-owned and other companies to assess executives (or candidates for executive positions) and help those whom they felt could be developed. With increasing frequency, PE companies have asked us to use our 360-degree assessment approaches to help them determine who to keep, who to hire, who to develop and how. As a greater percentage of the economy is represented by private equity-owned firms, and the competition for great leaders to run these firms becomes more intense, PE companies are growing more willing to revisit the methodologies they use to evaluate the heads of their portfolio companies.
For nearly eight years, we’ve been adding to and maintaining a database to help turn the often highly subjective exercise of evaluating a CEO or CEO candidates into an objective one. Since 2009, we’ve conducted comprehensive assessments of 491 executives, including 181 leaders of PE-backed companies (CEOs and other members of the leadership team). These assessments are based on two streams of research:
A 68-question online survey with 65 close-ended and three open-ended questions. For each of the 181 executives (including 25 CEOs), we have surveyed between eight and 15 others on their strengths and weaknesses (evaluated on a scale of 1-5). In all, this research is based on the opinions of more than 2,000 executives who report to these executives, or to whom they must answer (as well as on the executives’ own opinions). These “360-degree” performance evaluations provide insights into the behaviors, beliefs and practices of executives running PE-owned companies from the people around them – insights that are often missing in the executives themselves.
Oral interviews (in person and by phone) conducted simultaneously with the online survey. We conduct three to five complete interviews of people identified by an executive. The answers we get to our questions enable us to get a richer picture of strengths and areas for improvements.
The questions we ask about executives fall under two categories: how they do their work (for example, how they create strategy, how well they know the business they’re in, set goals, delegate, measure performance, and communicate, develop and support others, and model integrity), and their state of mind and presence at work (their impact on the performance of others).
The Three Traits of the Best-Regarded Leaders
In 2016, with this database of more than 2,000 evaluations and 68 data points in each evaluation, we identified the skills, or sets of skills, that distinguished PE executives with the best overall ratings, as judged by the individuals around them. (From each person’s overall score, we subtracted out their self-assessment.) From all that data, the best-regarded executives were rated to be far stronger in three skill sets. Let’s take a deeper look at each one.
1. Having Both Strategic and Systems Thinking Skills
The ability to set a company’s strategy is, of course, a given – particularly in the PE world, where many companies must be restructured or placed on accelerated growth paths to satisfy investor expectations. But strategic thinking – the ability to determine in which markets a company should play, with what offerings, and how to gain a competitive advantage in going to market with them – was not the only strategic characteristic that separated the best-regarded leaders from the rest. Leaders who were also “systems thinkers” separated themselves from the pack.
What do we mean by systems thinking? It refers to considering and understanding how a change in an organization’s strategy will affect the kind of people it needs, the operational changes the firm must make, and likely its culture. Systems thinking abilities are particularly important for CEOs of PE-owned companies that must enter new markets or launch whole new products – i.e., big changes in strategy.
It is not easy to recognize whether a CEO or CEO candidate has both strategic and systems thinking skills in abundance. It is much easier to spot people who aren’t strong in those skills; the CEO who is unaware of, or doesn’t care, how his actions affect those around him frequently lacks systems thinking skills.
Our interview with the founding CEO of a firm that was acquired by a PE company suggested to us quickly that he was short on systems thinking skills. After being told by the PE firm to spend time with us and be forthright, he provided fast and superficial answers to most of our questions, after arriving late to the meeting and not apologizing for it. Our initial hunch about the CEO turned out to be right: Six months after the PE firm closed the deal, it realized the CEO was wrong for the job. The firm’s sales growth had flattened. Key initiatives were stalled. Top team morale was low. The PE company tried for six months to get the CEO to change his style and behavior, as well as boost the firm’s performance, but it couldn’t. The PE company believes it sold the firm at a lower price than it would have gotten had it replaced the CEO with a far better one right after the deal closed.
2. Building Alignment and Commitment
The second trait that separates the best PE firm leaders from the pack is the ability to get their management team members aligned around the strategy – and deeply committed to executing it. This is not surprising, given the short window in which PE-backed companies must turn around flagging performance or accelerate slow growth. With an average hold period of 5-7 years, PE-owned companies need to clarify their strategies quickly in Year 1 of ownership. That is harder to do when a new CEO is brought in after Year 1.
The best CEOs in this skill area – the ones who can get their direct reports 100% bought into the strategy and excited to execute it – are different in several ways. First, they empower others to execute their piece of the strategy – and don’t try to execute it for them. CEOs who struggle to gain alignment and commitment to their strategy typically have an insatiable desire for personal recognition – to continually show they’re better at the tasks they delegate to their team. Instead of telling their direct reports exactly what to do in their areas, the best-regarded CEOs present clear (and aggressive) performance targets, and then leave it up to their team members to determine how to achieve them. Then those CEOs provide positive motivation for achieving and reaching those goals.
It isn’t at all easy for investors to recognize whether a CEO or candidate for the job can get his team firmly behind a strategy. One PE firm we worked with found itself tiptoeing around the CEO and Founder of company it had recently acquired. The CEO had grown the firm rapidly prior to the acquisition, and it was highly regarded for high-quality service. Everyone we talked to feared him to some degree, and a few downright resented him. He constantly issued new and often conflicting directives. No one knew what might come next, and how it might nullify the previous demand.
In our interviews with the CEO, he disparaged his teams and exulted his leadership skills. Their assessment of him, in an anonymous 360-degree survey, was brutal. Most said they were afraid to work there, and some were ready to leave. The PE firm decided to install a new CEO above the founding CEO in a new corporate entity, while shifting the founding CEO to a role in which the company could tap his deep technical expertise. The new CEO kept three of the previous executive team members (after assessing their leadership skills), and then gained fast buy-in to his growth strategy. He did this by talking to each team member about their hopes and fears about a rapid-growth strategy. (One of their fears was that rapid growth would erode the quality of the firm’s services.) And he devised a strategy that would maintain high-quality services and increase revenue rapidly. Within 18 months, the firm’s revenue and profit more than doubled. The firm was acquired for several times what the PE firm paid for it shortly thereafter.
3. The Ability to Selectively Develop
The third common characteristic of the best-regarded leaders of PE-owned companies relates to talent development. These leaders were rated highly by others in their ability to determine the key jobs in the company that needed top-shelf skills, whether the people currently in those jobs had great skills, and (if not) how to improve their skills quickly.
In many PE companies that we know, training and development is considered a luxury – an investment with a suspect ROI, or at least, an ROI that couldn’t be achieved before it sold a portfolio company. We’ve found many PE firms think it’s better to replace a struggling executive than to develop that executive.
However, the best-regarded leaders of portfolio companies we know in the PE industry don’t regard executive development as a frivolous or difficult-to-justify expense. Instead, they identify the skills they see as crucial to executing their strategy – skills often in short-supply (such as social media strategy, digital strategy, “omni-channel” management, marketing segmentation and campaign strategy based on big data and analytics) – and they enlist outside experts to bring the selected insiders up to speed in those skills.
Andrew Hayek did this with great success as CEO of Surgical Care Affiliates. The Illinois-based provider of surgical facilities was initially sold to HealthSouth in 1997, then sold again 10 years later to a PE group led by TPG after HealthSouth suffered legal and financial turmoil. After acquiring the company in 2007, TPG hired Hayek to turn SCA around. Hayek crafted a new strategy and built a new culture. And he also identified the skills on the top team and other management levels that would be crucial to achieving his strategy. But rather than pushing training on those executives, he instituted a “pull” strategy: raising the bar of their performance year after year. Those who knew they needed development to achieve the new standards sought it out. Those who didn’t or had no interest in further developing their skills left the company.
The impact began to show after the first year, when SCA increased its profits by 11%. Between 2008 and 2015, SCA’s revenue jumped 88% to $1.3 billion, and profits more than doubled to $170 million. TPG and its other investors more than got back their investment after bringing SCA public in 2013. (Early in 2017, SCA agreed to be purchased by OptumCare for about $2.3 billion. OptumCare is a unit of UnitedHealth Group.)
Getting the Right CEOs on Board
So how many CEOs of PE-backed companies have all three skills? Our evaluations of the 25 CEOs, as well as the hundreds of evaluations of them from their direct reports and bosses, showed only about one in four were strong in all three skill areas of strategic and systemic thinking, the ability to gain alignment and commitment to a strategy, and selective executive development. Nearly half didn’t have even one of the skills. While perhaps shocking, the low percentage of CEOs who are strong in all three competencies underscores the opportunity for PE firms in finding portfolio company leaders who excel in the three traits.
Rapidly growing markets and strong executive teams can certainly help a PE-owned company overcome a flawed CEO. But when those conditions don’t exist, a mediocre CEO running a PE-owned company usually spells mediocre results. As management guru Ram Charan put it, “CEOs’ performance determines the fates of corporations.”
CEOs and candidates for the job can and should be evaluated primarily for these three skills, among others. Increasingly, PE firms will need to assess their top portfolio executives much more rigorously – as rigorously as they currently evaluate the market, product, operational and financial viability of companies they’re considering buying.