Human capital proves key to value creation

In a fast-moving deal market where financial engineering is no longer a route to returns and funds have evolved into operational experts, managers are searching for other innovative ways to create value. Recognition of the role of human capital in powering growth is rising.

While GPs have consistently stressed the importance of a good relationship with the management team – and the chief executive in particular – to successfully execute the value creation plan, a growing number are beginning to take a more detailed look at what specific skills its implementation requires. And some GPs are starting to open the lens even wider to assess how all employees contribute to growth across the business.

“Private equity is being forced to address these topics to get the return,” says Andros Payne, CEO of Humatica, a specialist advisor on organisational performance at private equity-backed companies. “Lack of differentiation [between managers in a competitive market] is forcing funds to look at the more difficult fruit to pick.”

The change is recent. “Previously GPs diminished the contribution the management team or CEO made to value creation,” says AlixPartners managing director Ted Bililies. “They were engaged in financial engineering and didn’t think there was a substantial difference between CEOs. Over the past five to seven years they have become more savvy about the importance of CEO fit [with investment thesis objectives].”

However, CEO churn is high with a potentially detrimental impact on the implementation of the value-creation plan and the exit timeline. An enormous 73 percent of CEOs are likely to be replaced during an investment’s lifetime and most of those in the first two years, according to an AlixPartners survey of more than 100 GPs and portfolio company executives. The most common reason given for replacing a CEO is lack of fit with a business’s new strategic direction. Underperformance is another common cause. And almost 80 percent of investors surveyed reported pace of change as the most significant source of conflict with CEOs.

As GP are aware, effective leadership is critical to delivery of the value creation plan. The imperative to pick well is clear. Bililies says when selecting CEOs, GPs are inclined to rely on a candidate’s track record of success and prefer prior experience in a private equity-owned business, rather than selecting CEOs based on the specific skills needed to reach strategic goals.

“Managers tend to rely on gut instinct. Progressive investors use a rigorous process of assessment,” says Bililies, who advocates, in addition to measuring factors such as mental and emotional intelligence, that GPs consider comparing decision-making style and prior achievements against business priorities. “GPs must pay attention to optimal fit at the beginning of the investment or they are kicking the can down the road,” he says.

Replacing a CEO later in the investment cycle can be costly in terms of compensation, reputation, market positioning and time. “It almost always results in a longer hold period,” says Bililies.

GPs know this. Deciding to change leadership, searching for a replacement and bedding in a new person, constitutes a lengthy process that is high risk. “The delay is something investors are less open to given the competitiveness of the market. The tendency to swap someone out is decreasing,” says Payne.

To avoid future misalignments, managers “are getting much more assertive on getting transparency on talent and cultural issues upfront so they can initiate changes earlier driven by [the desire for] IRR maximisation,” says Payne.

This applies across the senior team. “Investors are more and more aware of what falls on a [finance director]’s shoulders and how a really good one can add value,” says Equity FD managing director Sarah Hunt, who specialises in placing senior finance professionals into high-growth businesses.

“Bringing in the right person to partner with the CEO broadens the skill set and lightens the load. It frees the chief exec to go out and grow the business. Investors get that 100 percent. Having that team is a requirement in any business,” she says.

Signalling the importance of a compatible CEO, Hunt adds that the decision to hire an FD, who is often swapped out as the role changes over the course of an investment, falls to the business, not the investor.

“If it’s not working it can be extremely difficult to fix and it can cause you unexpected underperformance”
Chris Watt

Some managers are going further still, looking at the entire workforce and a business’s organisational culture as a source of value creation. ECI Partners is one. The mid-market firm began to notice that its most strongly performing investments shared “a really positive culture within the business”, says ECI managing partner Chris Watt. “It’s a real phenomenon and it’s something that we’re increasingly looking to recognise and factor in.”

Watt attributes the dynamic growth at Dublin-based car hire aggregator CarTrawler, which ECI acquired in 2011 and sold three years later reaping a 6x return on its initial investment, to “the [employees’] excitement and collective enthusiasm to be part of a successful growth story. It’s powerful in attracting talent. But it’s also really important in driving performance.”

And if a positive culture is not already embedded, then the deal team has an opportunity to create it. When ECI acquired regulatory compliance business Citation in 2012 through a management buy-in, the GP “identified a need to move the culture on in a positive way”, says Watt. This involved the CEO galvanising the employee base through a new style of leadership, he says.

When time came to exit, ECI “promoted the strong culture of that business as an attribute”, which Watt maintains was a factor supporting the 5.4x multiple the firm generated when it sold Citation in early 2016. “If you are live to these issues you can move the needle and make a difference to the capital value that you create,” he says.

Conversely, a “dysfunctional culture” can derail even a well-positioned business in a growing market, says Watt. “If it’s not working it can be extremely difficult to fix and it can cause you unexpected underperformance.”

The quality of a business’s culture is “something you can really feel, but it is relatively intangible to describe to an investment committee”, says Watt.

How GPs establish an empirical link between human capital and value creation is “the holy grail question”, says Payne, noting it is difficult to separate organisational performance from other contributors to financial results.


However, in assessing an organisation’s ability to make and execute decisions that assist an organisation adapt and create value, a business can track specific behaviours, such as whether meetings start on time, or does a supervisor seek verbal confirmation of an action item, he says.

The difficulty expressing in numbers the impact of organisational factors on value creation could explain the slowness of the industry, relative to other corporate segments, to seize the opportunity. In Humatica’s report The Third Wave, only 30 percent of GPs surveyed undertake organisational due diligence, and only 16 percent had a structured approach. “Soft factors are seen as too problematic to evaluate,” says the report, which is based on a survey of more than 85 northern European private equity professionals.

However, Payne points out that this gap provides managers with a welcome opportunity. Pursuing organisational excellence “is one of the biggest arbitrages left in private equity”, he says.