Why Culture is Key to Success and Failure in Private Equity Deals

March 9, 2022 – The importance of culture and its impact on private equity strategy and returns has been growing over the past few years. As PE investment returns have lagged behind those of the stock market in the U.S., firms are feeling pressure to improve and deliver stronger results. “This fact combined with some high-profile private company debacles, in large part due to cultural toxicity and leadership miscues, underscores the urgent need for PE sponsors and portfolio companies to prioritize a focus on culture,” said Rob Andrews of Allen Austin in a report on the subject.

The survey found that PE firms and portfolio companies rated human capital, a key component of culture, as the top factor in predicting the success or failure of a PE investment. In addition, survey respondents in both groups – private equity investors as well as operating CEOs – chose “senior leadership team alignment” and “talent management” as leading factors in value creation. Once a PE firm invests in a business, performance expectations intensify, as the sponsors usually seek to improve the management and operations of the company. “To meet those expectations, the portfolio company management team and the rest of the workforce may have to modify how they do things on several fronts, such as establishing new organizational structures, collaborating in unfamiliar ways, and delivering results with greater speed,” said Mr. Andrews. “PE firm and portfolio company survey respondents agreed that it’s critical to consider the culture when building a company strategy.”

Evaluating Culture
However: Alix Partners’ research found that only 13 percent of PE respondents conduct a formal evaluation of culture.

    • Nearly 50 percent of portfolio company respondents reported that their culture is not fully aligned with their business strategy, and that they need help developing and nurturing the right kind of culture for their individual business environment.
    • Although 71 percent of PE investors and 81 percent of portfolio company executives emphasized that company culture is critical to the successful implementation of strategy, on a weighted average, nearly 30 percent of portfolio company respondents noted that neither they nor their investors formally evaluate their company’s culture, despite its importance for driving positive IRR.
    • 57 percent of PE investors (an increase from last year’s 49 percent) indicated average-or below ability to assess culture, which signals a significant need for improvement in order to deliver strong investment returns.

Critical Role of the CEO
“The right corporate culture at a portfolio company is essential for generating the results expected by the company’s PE sponsor,” Mr. Andrews said. “And a portfolio company’s culture depends to a great degree on who’s at the helm. After all, the term ‘culture carrier’ exists for a reason. Both cohorts in our study rated a world-class management team as the No. 1 predictor of a strong exit for a portfolio company. What’s more, a ‘disruptive or derailing personality’ was cited as the No. 1 factor to avoid when onboarding a new CEO post-deal.”

Alix Partners found that 75 percent of PE respondents who reported having experience with a portfolio company failure said it was a result of a CEO being an ineffective fit for the company culture. Sixty-eight percent of PE respondents reported hiring a CEO to purposely change a company culture, and 82 percent of those reported a high success rate as a result.

Interestingly, the majority of survey participants also said they believe that a portfolio company’s culture can be transformed by promoting from within vs. hiring an outside CEO. Either approach has pros and cons. For instance, outside CEOs bring proven track records based on the experience they’ve gained at other companies, but they lack deep knowledge of the portfolio company and its culture; for leaders promoted from within, the opposite is true.

“This year’s survey findings make it clear that leadership and culture are critically intertwined, and that adept management of corporate culture plays a central role in private equity investment success,” said Ted Bililies, global leader of the organization and transformative leadership practice at AlixPartners. “We identified several imperatives that portfolio companies and their PE sponsors must meet to maximize IRR. These include the ability of portfolio companies to quickly and effectively execute the strategy which in turn hinges on identifying leaders who possess a unique blend of skills. Recognizing that a strong culture with the right CEO and talent are vital to growth in their portfolio companies, investors would do well to invest time educating themselves and taking specific actions at the outset of an investment.”

“We’ve all seen the headlines announcing household-name companies that paid a high price for allowing a toxic culture to take root and sabotage the company’s future,” said Dr. Bililies. “PE firms and portfolio company management must take swift action to avoid these pitfalls or risk losing shareholder value, disrupting growth, and damaging reputation and brand. PE investors have been picking up on this development because they see how a portfolio company’s strategy toward a liquidity event hinges upon its culture. Strategy without culture equals nothing.”

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