3 Qualities Private Equity Firms Seek When Picking Portfolio CEOs

March 19, 2020 – Private equity firms conduct rigorous due diligence in assessing acquisition targets. Those with the best track records place high trust in their ability to size up a prospect’s financials, operations and market position. But many mid-sized PE firms are less successful in choosing the CEOs who run their portfolio companies. One study of PE firms, in fact, found a little less than half had to change the CEOs who ran their portfolio companies.

How does this happen? According to a revealing report by FMG Leading, a business and human capital advisory firm, “Investors can overlook three leadership skills that are crucial to rapid, profitable growth: thinking strategically and systemically; building alignment and commitment to the firm’s strategy; and developing essential team members.”

Private equity firms with solid track records of turning around or accelerating already-growing businesses in a short period of time have a well-developed knack for choosing businesses with great growth or turnaround potential. “In short, they buy right,” said the report, “The Missing Ingredients: Three Things PE Investors Should Look for in a CEO.”

“Buying right” has become more important in recent years for PE firms, yet also more difficult, said the study’s authors, Matt Brubaker, FMG Leading’s chief executive officer, and principal MaryCay Durrant.

In addition to facing increasing competition on deals, many PE firms struggle to determine whether they have the right CEO for the job.

“Whether or not a company is owned by a PE firm, its chief executive has a massive impact on performance,” said Dr. Brubaker. “As CEO consultant Ram Charan said in a classic Harvard Business Review article that ‘CEOs’ performance determines the fates of corporations.’ The choice of CEO is even more critical in PE-owned firms. Investors have far more to lose if they choose unwisely, since their average hold time is five to six years, and because generating a strong return on a portfolio company exit requires stellar financial performance.”

And a delay in replacing an underperforming or ill-equipped CEO can be costly.

Throughout his 25-year career, Dr. Matt Brubaker has studied and coached executive leaders in a variety of capacities, advising and consulting in numerous practice areas including senior and high potential leadership development, conflict resolution, and large-scale organizational assessment and change. An expert in sustainable transformation, his client work focuses on enterprise-wide change initiatives, C-level development, and building high-performing, strategically-aligned executive teams.

Larger private equity firms are more likely to be prepared to evaluate CEOs and CEO candidates. “They have developed the infrastructure to employ seasoned HR experts, resources and processes to incisively size up their portfolio firm CEOs,” said Ms. Durrant. “However, midsized PE firms typically lack the resources and don’t have the time to develop proprietary tools in the human capital arena.”

The authors said they were not surprised that many midmarket PE firms struggle to assess the CEOs of their portfolio companies. “Good investors trust their instincts, and often those instincts are sound,” said Dr. Brubaker. “But relying only on those instincts alone can be faulty, as the statistics on CEO turnover at PE-backed companies demonstrate.”

Even investors who are attuned to human capital issues sometimes have little time to probe below the surface of a CEO’s personality and gauge its impact on an organization. “This is especially true when they are under the gun to decide whether to acquire a company or how to scale it rapidly,” said Ms. Durrant. “They feel more pressure to focus on strategic, operational, financial and marketplace issues rather than leadership matters.”

The unique demands that PE firms place on their portfolio companies, said the authors, require CEOs who excel on three fronts:

1. Combining Strategic and Systems Thinking

PE firms need CEOs who can help them plot a new, faster-growth course for the companies they buy. “Strategic skills are a given,” said Dr. Brubaker. “But CEOs must also be able to get beneath the bold strokes of a new growth strategy. They must be able to identify and orchestrate the process and people changes needed to pull it off – i.e., the larger system dynamics.”

The first component of a strategic and systemic thinker is the ability to balance strategy and tactics – the big and small picture. This is often missing in founder CEO who have successfully built and sold their firms to PE companies. The skills to scale that firm for rapid growth – a firm that will become far more complex to manage – are very different. “Those skills are about understanding how to make the key working parts of the organization function together like a well-oiled machine,” said Ms. Durrant.

“CEOs of PE-owned companies must also know how a change in strategy (for example, a new target market or new product) will affect manufacturing, marketing, selling, servicing and other processes,” said Ms. Durrant. “This is often referred to as ‘systems thinking’ – knowing how different parts of an organization relate to one another. CEOs who are excellent systems thinkers are particularly important in PE firms that buy and integrate other companies into their portfolios. Systems thinking is also a vital trait for CEOs in PE firms that push their portfolio companies to enter new products or ramp up product innovation.”

The third aspect of an excellent strategic and systems thinker is a gift for identifying the underlying causes of problems and then troubleshooting in a way that engages all stakeholders in the solution.

2. Building Strategic Alignment and Commitment

Every company, PE-backed or not, needs the top team and the managers below them to be aligned on the firm’s strategy and be clear on how to execute it. CEOs of PE-backed companies face even more urgency to ensure their management ranks are aligned on the strategy. The systems, processes and cultures of PE-owned companies must be clarified and scaled much faster for rapid growth in a five to seven-year timeframe.

“To accomplish that, the CEO must be able to communicate clearly, make sound decisions collaboratively, and be a solid business planner,” said Dr. Brubaker. “When a CEO is strong in these areas, he enables others to climb the mountain with him – to do the work and be committed to excellence.”

“The best CEOs know they have far more impact when they equip and empower others to execute successfully,” said Dr. Brubaker. “Their thinking differs from the CEOs who believe they contribute most by focusing on the excellence and capacity of their own execution skills. This type of CEO often feels the need to continually demonstrate their competence. With an insatiable desire for personal recognition, they unconsciously discourage others from participation.”

In contrast, the best CEOs of PE-owned firms create the conditions that enable their teams to execute with excellence. “What’s more, they realize that setting operational and financial targets for their direct reports alone doesn’t drive productive behavior,” said Ms. Durrant. “Team members, afraid of missing their targets, can quickly shift from collaboration to competition. Excellent CEOs supplement clear, aggressive targets with continual positive motivation.”

The best CEOs also build organizations where the highest source of authority is not the leader, but rather their firm’s ambitious yet achievable growth plan. “They typically operate with great humility,” said Dr. Brubaker. “They aren’t trying to prove they’re the smartest and most competent person in the room. Rather, they have adapted their leadership style to bring out the strengths of each team member.”

What is needed is a CEO who excels at creating an environment of cooperating with colleagues, not setting them up to compete against each other.

3. Developing Others on the Team

PE-owned companies too often overlook talent development. Because of the short timeframe in which they hold their portfolio companies, investors may view time dedicated to executive development as a luxury. In addition, the investment required to truly develop talent can be hard to validate using short-term ROI metrics. PE firms frequently view hiring as the answer to talent shortages. Why take months or years to make an executive more effective when you can simply hire new talent?

“The best-run PE-owned firms we’ve worked with emphasize both talent development and recruitment,” said Dr. Brubaker. “When they develop talent, they do it wholeheartedly and strategically. They focus on skills they believe are crucial to their competitive advantage and not widely available in the marketplace. In other words, they are huge proponents of talent development – but are usually quite selective of which individuals and which skills they develop.”

In identifying the critical skills that must be improved, these CEOs may even temporarily overlook the development of entire layers of management. By doing so, they can focus investments on executives and managers that will have the greatest business impact.

“PE firm CEOs who think this way realize that a winning strategy is not enough to grow a firm, and that not any team can execute that strategy,” said Ms. Durrant. “They are realistic about the ability of their own team to make it happen, and know which skills need to be developed for the strategy to be executed well.”

Some PE companies might consider such executive development superfluous. These investors often view this in a larger context: a PE-owned company has no time to coddle — only to “get stuff done.” In other words, urgency outranks empathy.

“We believe this is a false and harmful dichotomy,” said Ms. Durrant. “The best leaders, at PE-owned firms and others, create the conditions that generate deep engagement from their followers. The management team lives and breathes the company’s mission and strategy – so much so that they put much of their discretionary time toward making the company better. A CEO who leads with urgency and provides no empathy will produce followers who are afraid to get it wrong and thus become cautious.”

MaryCay Durrant brings a wealth of executive experience, having held senior leadership positions with both Thomson Reuters and Westlaw prior to joining FMG Leading. She also serves as an executive coach, weaving a unique blend of pragmatic business savvy with neuroscience in a way that ignites executives and their teams. Her approach envisions an inspiring future and unlocks the passion and potential within the organization through a blend of customized tools, workshops, retreats, and coaching.

“Urgency and empathy aren’t mutually exclusive,” said Dr. Brubaker. “In fact, urgency delivered with empathy will greatly increase the odds that the critical work gets done on time and in alignment with expectations. PE firms need CEOs who know how to use empathy to generate a highly positive sense of urgency, thereby generating greater momentum toward their strategic and financial goals.”

“The best leaders, at PE-owned firms and others, create the conditions that generate deep engagement from their followers,” said the study.

These important traits of CEOs at PE-owned companies can be difficult to recognize. To ensure CEO quality before or after an acquisition, said FMG Leading, PE firms that pursue seven lines of inquiry can shed considerable light on whether the candidate has what it takes:

• Exploring key accomplishments in their careers.

A number of questions will expose how well CEOs think strategically and systemically, the importance they attach to gaining alignment and commitment to a strategy, and their history of developing people. Asking a CEO about his three to five greatest career accomplishments can be very revealing. How much of the success do they ascribe to a good strategy vs. thinking through the “systems” aspects of that strategy and putting the pieces in place? How much did they talk (if at all) about how they convinced key stakeholders to agree to the strategy, and how they gained that commitment? How much of their success do they attribute to their personal contributions vs. influence they provided that enabled others to exceed their own capacity? When a CEO speaks of his accomplishments through a purely personal lens minimizing the achievements of others and teamwork, it is a big red flag.

• Discerning their ability to manage high complexity.

Some CEO jobs at PE-owned firms are more complex than others. For example, the CEO job is less complex when the investor or portfolio manager is driving the strategy and the CEO is essentially the COO. Even when the CEO is asked to devise the strategy, his job may be less complex if the business model is simple – e.g., one core product and one market segment. But the CEOs who have functioned more as COOs or have run less complex businesses may not be ready for jobs with more strategic and complex responsibilities. They may not be able to set the strategy, integrate acquisitions, deal with multiple product lines, and handle other elements. Hearing how they’d deal with such complexities can reveal whether they’d be overwhelmed by them.

• Looking at how they would solve tangible hypothetical problems.

This is about posing a thorny potential problem that they may be asked to handle. The key is to make it tangible enough that it sparks their best thinking. Observing the degree to which they inquire more about the problem vs. respond quickly with a solution will illuminate their capacity for systems thinking. Do they follow with a line of inquiry rather than answers (a good sign)? Or do they respond with a formulaic answer (a bad sign)?

• Listen below the “storyline” when they talk about the people who worked for them.

The aim is to understand how much loyalty they’ve generated over the years in talented executives who could follow them. Who would they say are the most talented people they’ve met in their careers? Would those people join them in a new company, and if not, why? The CEO who has a hard time pointing to the most talented people he’s worked with may believe his career success was mostly about him … a red flag. The CEO who acknowledges others but doesn’t think they would work for him again may also prove troublesome.

• Asking how they manage multiple stakeholders.

CEOs of PE-owned firms must have a proven ability to manage multiple stakeholders. It can be very revealing to hear how the CEO managed multiple owners in the past without compromising the strategy or causing disharmony. Ask the CEO or CEO candidate to tell a story about how she navigated the often-choppy waters of employees, leaders, investors and owners – especially how she influenced those stakeholders aligned on the strategy. Every CEO of a PE-backed company must deal skillfully with multiple stakeholders – sometimes multiple owners and investors. It is important to know about the last time the CEO or CEO candidate had to respond to the demands of several owners who she thought might compromise company growth. How did the CEO resolve the conflict? Did the CEO have the credibility and clarity to reframe the assumptions and defend it with the board? Is the CEO able to differentiate when “going along to get along” will negatively or positively affect a sound strategy? You should also be looking to see if the CEO or CEO candidate has the resolve and maturity to do the right thing and absorb the heat from the board, without turning the heat on their team.

• Understanding their current goals for the company.

If the CEO is in place at a firm you’ve just acquired, you can discern much about her leadership skills from the way she describes her goals. Is she exclusively focused on achieving her equity payout, or does she balance this with a focus on developing key leaders so they can dramatically improve the firm’s performance? A great leader is one who believes they must be the servant who makes things happen for others on their team – not the center of attention and adulation. This isn’t to say that a dose of narcissism is bad in a CEO.

• Understanding their self-awareness.

Everyone operates with a mental model of how the world works. But PE firms need CEOs who have self-awareness, emotional intelligence and the discipline to reframe their perspectives when the situation warrants. They not only understand their own mental model, but also are able to alter it when new facts come into play. To determine whether a CEO continually refines his or her mental model, ask about their past failures. CEOs who offer a simple explanation of blame, external forces or inexperience are not likely to revise their mental model. In contrast, if they admit to failure and acknowledge their role, and can articulate their personal growth path from the lesson, they are likely to be able to evolve their mental models.

Contributed by Scott A. Scanlon, Editor-in-Chief; Dale M. Zupsansky, Managing Editor; and Stephen Sawicki, Managing Editor  – Hunt Scanlon Media