The leadership challenge

GPs need to focus more on upgrading a portfolio company’s management team, argue Justin Allen and Dave Ulrich.

Newly acquired private equity portfolio companies inevitably require transformation. In the past, much of this transformation has focused on financial re-engineering to restructure debt and ensure fiscal discipline, followed by a strategic reorientation to focus on where to compete and how to win.

More recently, operational excellence has been achieved through integration of new technology and process re-engineering to streamline operations. Meanwhile, our research and experience shows that the most successful private equity firms in the last two to three years are increasingly focusing on upgrading leadership and culture as one of the highest priorities in successful portfolio firm transformation.

To upgrade and align a portfolio company’s leadership and culture, most private equity firms require additional organisational expertise. As we have gathered data from over 60,000 individual leaders in thousands of companies around the world over the last five years, our key question has been: “What leadership and culture variables have the most impact on overall business performance?”

The graphic above highlights the two domains of leadership and culture and the critical factors within them that would enable firms to make a timely and sustainable transformation. We call this the Leadership Capital Index, or LCI.

Our research shows that most transformations either fail or occur much slower than desired, not because of a lack of financial, strategic or operational expertise, but due to the inability to make change happen in a timely and sustainable way. In successful transformations, financial discipline is not an event but a pattern; strategic clarity is not a direction but a commitment; operational excellence is not a tool but a mindset.

Making these shifts requires increased attention to organisational governance around two domains: individual leadership (competence) and organisational capability (culture).

In order to audit and then transform the companies in their portfolios, private equity firms are establishing a new role that we call a leadership capital partner. We have described this new position in our recent Harvard Business Review piece entitled ‘PE firms are creating a new role: leadership capital partner’.

LCPs play an essential part in portfolio company transformation to prepare them for premium divesture valuation. The time it takes to execute value-generating transformation is most often a function of the firm’s ability to transform talent, leadership and capabilities. High-performing LCPs play three roles in creating organisational renewal of a portfolio company. The first two roles are focused on the two domains of the LCI (leadership and culture); the third focuses on closing the gap from current state to desired future.

In summarising our leadership research, we found that leadership has a 10 to 15 percent impact on financial performance and a 25 to 30 percent impact on market valuation. Because leadership has a profound financial and strategic impact, the best LCPs conduct annual LCI audits in portfolio companies. Some of these audits actually begin during due diligence to determine the quality of leadership in the potential acquisition. In auditing leadership, LCPs need to:
• Have a broad view of leadership rather than focusing on just an individual leader: individual leaders matter, but collective leadership depth matters more.
• Deploy a comprehensive view of the elements of effective leadership, which requires accessing the science of leadership beyond personal experience (eg, utilising the LCI framework).
• Assess through many mechanisms (surveys, interviews, observations, social media) the extent to which portfolio companies possess leadership capital.
• Invest in leadership improvements, which may include acquiring new leaders with skills required for the future, developing leaders through training and/or assignments, or using leadership advisors who can coach current leaders to develop new skills.
Successful organisational renewal requires the right leaders and leadership for the future.

Individual leaders matter, but culture and leadership teams matter more. We found that the quality of organisation has four times the impact on business performance than the skills of the individual leaders. LCPs are increasingly tasked to conduct organisation or cultural audits that ensure that the right teams and culture are in place for the acquired firm. Replacing individual leaders without addressing the team and the overall culture generally does not successfully result in creating a more effective firm.
An organisation audit starts with defining the right culture for the organisation and then adjusting the talent to support that culture. We have defined the right culture as the desired identity of the portfolio company in the mind of key customers.
As a portfolio firm shifts its external brand in response to its key customers, its internal strategic focus also changes. This strategic focus shapes an organisation’s managerial systems in order to drive the desired culture, including structure (roles and governance), accountability (performance review and rewards), talent (flow of people into, through, and out of the organisation), information (communicate ideas with impact), and work policies. When these organisation systems are aligned to a new strategy and culture, the organisation becomes a source of sustained competitiveness.

A company turnaround focuses on costs and can often be done through financial re-engineering and cost-cutting measures. A transformation requires more fundamental changes in the organisation culture, management processes and leadership. LCPs can help architect a transformation by answering why transformation is required, what the transformation looks like, how to make the transformation happen and who to involve in it.

Dave Ulrich is the author of The Leadership Capital Index: Realizing the Market Value of Leadership, published by EDS Publications, and the Rensis Likert Professor, Ross School of Business, University of Michigan. Justin Allen is co-founder of Ulrich Allen Leadership Capital, an investment diligence advisor.