Two interesting pieces of research have gone round our offices in the last month. One was from the Centre for Management Buyout Research (CMBOR). It reported that some 44 per cent of private equity exits end up in receivership – a figure that has been consistently high for a number of years and is not just down to the current weakness in the IPO market and a shortage of trade buyers. The other report was from the CASS Business School, with help from RSM Robson Rhodes, and looked at how private equity firms source and use due diligence. Among other things, it found that they judge management to be the key factor when making their investment decisions, above financial and commercial considerations – yet only 20 per cent conduct any structured management due diligence.
Neither finding is that surprising. Whenever we speak to investors about why exits fail, three reasons come up repeatedly: weak management, over-optimistic plans, and pricing – and of these, weak management is the most common. The answer seems simple enough. Conduct more rigorous management due diligence, and better management and exits will logically follow. That is true to a point, but there is more to it than that.
Certainly there is a good case for a more structured approach to management due diligence. Current practice tends to simply involve checking out CVs, consulting headhunters and peer groups, and maybe some rudimentary psychometric testing. Most firms do not even go this far, relying instead on gut feeling and whether ‘they have made money before’. Such basic screening only tells you what people have done and most of the time simply confirms prior knowledge. This is a start when considering a management team, but you really need a predictive assessment of the team’s capacity to deliver in the context of the proposed business – and there lies the problem.
Context is all
Private equity firms frequently tell us that most commissioned due diligence lacks any real sector insight and has no firm opinions. This is not surprising, since there tends to be a fragmented approach to due diligence – some financial here, a bit of commercial there and management occasionally elsewhere. This can happen even when firms use a so-called integrated provider, since the different due diligence teams rarely meet to share findings, relying instead on a single co-ordinator to staple the report together. When disparate reports are prepared without a sense of the overall business context, how can anyone give a firm opinion?
There is also the missing context of time. Due diligence tends to look back and discover that the figures look decent for the last three years, the market has grown, and management’s record is good. It rarely provides for predictive planning, taking into account such things as: where the market is going; can the team cope with the changing business environment; how do these different elements affect the exit strategy; who are the likely buyers in two to five years time; and can the management team position the business to appeal to them? A management team might be right for a £30m company but wrong for a £300m company – or vice versa, since some corporate high flyers have difficulty fitting into the SME culture. No amount of good financial due diligence will compensate for poor management or a badly executed business strategy.
The sum of the parts
Private equity firms can and should do more to assess the capabilities, competencies and values of all of the management team, and how these might change over time. This is not simply with a view to selecting or rejecting them. We all have strengths and weaknesses, but what a shrewd investor needs to know is whether the team has the right strengths and whether its members can compensate for each other’s weaknesses. Scenario interviews are one way of taking teams through real examples of developing businesses. They can offer so much more than a simple psychometric test – such snapshots of a candidate are static, but business is dynamic. Scenario interviews identify how people behave under pressure, how they work with others, and how they think and respond as different and increasingly complex issues arise.
However, it would be wrong to confine this predictive approach to management due diligence. Context is all and rarely does a venture fail for a single reason: even if the main one is weak management, there are normally other contributing factors. This alone should point the way to better management of exits. Surely, a fundamental question that due diligence should try to answer is “how will this management, with this product and financial backing, in this market work together – what is the corporate potential?”
Even when things have started to go wrong it is not too late to recover the situation. The standard response of sacking the management team is in most cases an expensive waste of talent and learning. It is also a tacit admission that the original selection procedure, if there was any, was wrong. A more sensible approach is to reappraise the team and the business to see what has changed. Circumstances do change, and firms should be prepared to adapt. This can lead to smarter solutions, such as improving management support, particularly in the form of non-executives. However, as with initial due diligence, such portfolio reviews can only work in context.
Private equity firms tell us that they want ‘best of breed’ due diligence, but an uncoordinated approach seems inappropriate to our dynamic and complex business environment. When you have identified a deal, the least you should expect from your advisers is a clear, concise opinion of where the business is going. Such opinions demand an holistic approach reflecting an understanding of how all aspects of the business will work together, backed up by both specialist sector knowledge and strategic insight into the investment’s corporate potential. Even if private equity firms reject the idea of a holistic approach to due diligence, they should at least invest as much in management due diligence as they do in financial or commercial due diligence – if they want to improve the chances of a successful exit.