For anyone interested in the practical challenges of operational value creation, the report released by Boston Consulting Group this week on the relationship between private equity owners and their portfolio company CEOs is well worth a read. GPs are always talking about 'backing management teams' – but this blandishment tends to obscure how complex the dynamic can be between a highly-engaged, heavily-incentivised owner and the people ultimately responsible for delivering on their investment thesis.
The first notable point is that of the 198 private equity-backed companies BCG studied (ranging in size from £200 million to £2 billion in revenue), the owner had installed a new CEO in 57 percent of them. In other words, they were more likely than not to get rid of the CEO in charge when they bought the business.
Firing CEOs is not something most GPs like to talk about, and you can see why: it can't help in negotiations with incumbent managers if they think they're going to get sacked the day after the deal is signed. (One notable exception is Terra Firma's Guy Hands, who admitted at an event in Paris this week that he got through four management teams in two years at residential housing business Annington Homes before settling on the right CEO.)
But it clearly happens a lot. And having interviewed 60 of the CEOs at these businesses, BCG thinks it has identified one of the reasons why: “mutual misunderstanding and skewed expectations”.
To put it simply: GPs and CEOs still seem to have very different expectations of what the other is bringing to the table. As BCG's Antoon Schneider puts it: “Tensions often arise because the CEO fails to grasp what PE firms prioritise when they select and evaluate a chief executive”. GPs want someone who's principally an operator, whereas CEOs see themselves principally as strategists; GPs want someone who'll take risks, whereas CEOs want to mitigate them; GPs see their main role as providing input on specific operational issues, whereas CEOs see them mainly as providers of capital. With such a clear mismatch, it's no wonder that the two sides often end up falling out.
Ultimately, there's only one (deceptively simple) way to avoid this potentially sticky issue: transparency. Both sides must be very clear up front about exactly what their expectations are. As Geoff Scott, CEO of Uster Technologies (a veteran of two buyouts), told us recently: “It’s really important that both sides sit down and have a really open discussion before the process begins, so expectations are really clear on both sides. You need to establish in advance what the working relationship will be”.
What's more, this level of transparency has to be maintained throughout the life of the investment. “The key thing is that [the GP has] to know you’re going to share everything that’s important,” says Andrew Norman, CEO of Vision Capital-backed JDR Cable Systems. “If they know that, the trust will be there; but if they think you’re trying to hide something, you’re just setting yourself up for issues in the future.”
And there's a big potential upside. According to the BCG study, 90 percent of the CEOs said that working under private equity ownership had been good for the company's performance, while a similar percentage said it had also improved their own personal performance. Presumably there's a degree of survivor bias going on here (the ones that are still around to be surveyed are ipso facto the ones that do well under private equity ownership). But it does suggest that when managers get it right, it leads to real alignment and engagement. And that's when value creation is most likely to happen.