June 19, 2020 – The past decade has been widely viewed as a golden era for private equity. As global markets recovered from the shock of the last financial crisis, private equity firms did not simply sit back and reap the rewards of improving market conditions, according to a report by Spencer Stuart. In fact, quite the opposite. The same could be at hand for the current pandemic crisis.
The report notes that as private equity firms have learned from past crises, they have placed greater emphasis on being more hands on with portfolio companies. More often, that means evaluating talent and finding new ways to unleash higher levels of leadership to boost results and enrich returns. Many firms now deploy a much wider range of capabilities to drive value, for example building operating partner teams and adding more specialized functional expertise.
Revolutionary Changes Afoot
According to PE talent chiefs, there is in fact a fundamental shift underway in private equity HR. According to Jason O’Briant, managing director of human resources at Blackstone, private equity firms are continually improving the process of talent management, moving beyond traditional views of human resources to something more transformative – with a heavy emphasis on talent management & development, culture and engagement. This dynamic transformation in focus, and how it will help to improve everything from talent acquisition and recruitment to engagement and retention strategies, is now at the forefront of the entire sector. Blackstone, KKR and others are in the vanguard of revolutionary changes afoot.
“A critical component of this approach has been to apply more rigorous assessment to the management team and especially the CEO,” the Spencer Stuart report said. Private equity firms have been early, enthusiastic adopters and expert users of cutting-edge assessment methodologies in recent years, said the search firm.
“Many firms have institutionalized the assessment of management teams during the first 100 days following a deal, giving them deep insights into their new investment. This allows them to plan and shape the right support structure around the management team and apply the full range of the investor’s new functional capabilities to position the team for success.”
“Not only have we seen increased use of assessments by PE firms over the past several years, their use is increasingly sophisticated,” said Scott Gregory, CEO of Hogan Assessments, a global provider of personality assessment and leadership development services. “Although a key focus remains on ensuring the right CEO is in place, there is a trend in using assessment to ensure the CEO and his or her team function well as a unit and increased interest in linking leader personality to financial metrics,” he said. “We’re also seeing assessment used earlier than in the past, even during the due diligence process, which enables deals to close with a clear plan in place for team support and succession.”
Picking the Right CEO in the First Year
A challenge unique to private equity investors is ascertaining whether a CEO and management team can work openly and collaboratively with their new owners, according to the Spencer Stuart report. “Can they adapt to that private equity firm’s particular approach and make full use of the support provided to them? Or will they maintain a distance to their owners and fail to maximize the value of the expertise available? If not, the incumbent CEO will underperform, regardless of their capabilities.”
In a separate study, Spencer Stuart looked at the timing of, and reasons for, CEO changes in private equity portfolio companies. The report concluded that a great deal of value was being lost due to underperformance, with private equity investors forced into a large number of unplanned CEO changes. More than half of these occurred in the later years of the deal, i.e. from the third year onwards.
“Some research suggests that having the wrong CEO in situ after the first year is a major reason why deals underperform and typically leads to longer hold times and lower returns,” Spencer Stuart said. “With all the new assessment capabilities and functional expertise at their disposal, private equity firms should be more successful than they have been at identifying the right CEO in the first year and supporting him or her to be a success.”
Spencer Stuart has also witnessed a clear shift in private equity firms’ ability to control the timing of CEO transitions, with only 35 percent of CEO changes unplanned at the time of the transaction. “It is equally encouraging that nearly half of all changes occurred within the first year, a growing trend since 2013,” the firm said. “This is a strong indicator of rigorous assessment having a clear effect on the speed and quality of decision-making.”
One noticeable trend during the past decade according to Spencer Stuart has been the lengthening of average hold periods to around five years. “Private equity firms are now commonly facing the conundrum of CEOs completing four years in their role without seeing a successful exit,” the firm said. “This has created a need for planned CEO successions in the later years of some deals (i.e. from the third year onwards).” Already, 12 percent of the CEO changes the search firm analyzed involved carefully planned succession processes from the third year onwards, despite this being a recent development. Spencer Stuart said it anticipates that as PE firms hold on to assets for longer periods, they will need to strengthen their succession planning later in the deal cycle and consider a more diverse pool of potential leaders.
Another trend that should give private equity investors pause for thought is that around 30 percent of all the CEOs hired were later replaced in unplanned changes; on this measure there has been no improvement since the search firm’s original study.
This tendency for replacing the CEO more than once during the lifetime of a deal reflects PE firms’ greater willingness to course correct. Although the second CEO change now tends to happen earlier, multiple changes of CEO can nonetheless be disruptive. Acting decisively to remove underperforming CEOs is important, but some question why it is so frequently required.
So, what’s changed in 2020 in the current COVID-19 environment, and what can we expect as the year progresses? Executive search consultants who specialize in private equity recruiting have some thoughts.
“There are multiple transactions that have been cancelled or delayed due to the current economic environment,” said John Marshall, co-founder and CEO of JM Search, a senior-level talent provider serving private equity investors, portfolio companies and Fortune 1000s. “This has enabled CEOs to reevaluate their current situation from a timing and economic standpoint,” he said. “This uncertainty has encouraged them to be more open to new opportunities that have opened up in the industry.”
“Collective management team assessment and performance are more important than ever,” said Dan Hawkins, founder and CEO of Summit Leadership Partners. “Investors now realize it is not enough to assess and upgrade just individuals on the team. They must better understand the capacity of the team to solve complex business challenges, make rapid decisions, and effectively align the organization,” he said. “Accelerating team performance for portco management is more powerful than simply focusing on the CEO alone.”
Hardwired for Action
Heather Hammond, who co-leads the global banking and markets practice at Russell Reynolds Associates, said that the bar for portfolio company leadership is exceptionally high right now. “We build our assessments in several ways,” she said. “One is by virtue of our own expertise and the way we compare their experience to that of their peers in the market. We look for patterns, such as continued sustained success in roles that they have had. We look for their success being tested in different environments. So, for example, if you take someone who has come out of a big conglomerate, have they had experiences along the way of perhaps testing that in a more entrepreneurial venture either after that experience or before that experience that you can look at their experience in different environments?” Also, you obviously speak to references. And you do psychometric assessments as well to understand how they are wired and what their DNA is all about.”
Another consideration, especially with the specter of darker economic days on the horizon, is the question of just how well a leader handles tough times. “Obviously, we’re at the end of an economic cycle,” said Ms. Hammond. “Things can get more turbulent sooner rather than later depending on what’s going in the macroeconomic sense or the political sense or what have you, and how does complexity and uncertainty test the quality of a portfolio company’s leadership?” That’s when the great leaders emerge, she noted. “They have to adapt and demonstrate decisiveness and judgement on what they’re going to do.”
A New Talent Blueprint
“Our clients seemed to go immediately in one of two directions when COVID-19 hit: self-preservation or opportunism,” said Andrew Thompson, founder and managing partner of Notch Partners. “If their portfolio companies were heavily impacted, they went into cost reduction and cash management mode. Suddenly, the important skill sets were more defensive than growth oriented.”
Now that the dust has settled from the initial pandemic shock, said Mr. Thompson, “most PE investors are declaring emphatically that they are open for business.” And, he noted, they are seeking to partner with CEOs who understand how to tactically manage through a crisis while maintaining the clarity of vision to see opportunities where others are just ducking for cover. “Expertise in hard-hit industries, such as travel, and growth industries, such as last-mile logistics, are at a premium,” he said.
“As one PE partner said in the middle of a search for a $600 million company we were closing in March that we were in peacetime growth 30 days ago and now it’s wartime and hunker down,” said Keith Giarman, managing partner of the private equity practice at DHR International. “Specs for a lot of positions – CEO, COO, CFO and others – changed overnight depending on the upside growth and trajectory of the business,” due to the pandemic, he said. “If there is a way to reset appropriately, PE firms need to think carefully about the skill sets that will win the war right now.”
Certain market segments are flourishing with the explosion in things like e-commerce and the transportation and logistics associated with keeping up with demand, Mr. Giarman said. “Companies that were rapidly digitizing are moving even faster now, from market-facing sales and customer acquisition all the way through the order to cash and fulfillment and customer service process,” he added.
Of course, private equity talent leaders themselves know first-hand how important human capital can be to driving strong returns. For them, aligning talent, capabilities and culture to a clearly defined value creation agenda are the best way to deliver the superior returns that are expected in a highly competitive market. For some, like Jim Hirshorn, partner – private equity and head of the portfolio management group at Ares Management, and his private equity team, institutionalizing a systematic approach to maximize value creation from portfolio companies begins and ends with connecting and integrating strategy with talent. The unique leadership demands of private equity are creating a new set of blueprints for every private equity leader, their talent acquisition teams and their executive recruiters.