Human Capital Best Practices: Real World Challenges when Creating Value in Private Equity Funded Companies

White Papers | November, 2012

By Keith Giarman

Dear Private Equity Professional,

As global leader of DHR’s Private Equity Practice, it is my honor to present our summary report gleaned from our 2012 conference titled “Human Capital Best Practices: Real World Challenges when Creating Value from Private Equity Funded Companies.” As the fifth largest and fastest growing retained executive search firm in the United States, DHR has made a strategic commitment to the private equity industry. As a result, we have successfully completed hundreds of C-level search assignments – CEO, COO, CFO and many other roles – working with our private equity clients. These assignments have been executed working with small and mid-market, as well as larger private equity funds around the country and around the world. The assignments cut across all industry segments, including technology, industrial, consumer, retail, healthcare, aerospace, and many others. We pride ourselves in our partnering mentality working with our private equity clients. We are hands-on and quality oriented.

We hope you enjoy the conference report and look forward to being of service to you and your firm in 2013 and beyond.

Best,

R. Keith Giarman

Global Leader, Private Equity Practice

 

Introduction

DHR International’s conference, “Human Capital Best Practices: Real World Challenges when Creating Value in Private Equity Funded Companies,” explored the role human capital and organizational issues play in facilitating value creation and investment success of private equity sponsored companies. The goal of the conference was to provide a forum for approximately 50 investment and operating partners to explore value creation challenges and corresponding human capital issues encountered by their portfolio companies. Keith Giarman, Global Leader of DHR’s Private Equity Practice, oversaw the event with support from key members of the firm’s PE practice who served as moderators of the panels. Like the conference itself, panels consisted of investment and operating partners of various PE firms, as well as successful operating executives with significant experience working with PE firms.

The conference consisted of a keynote presentation, three panels that addressed specific issues, and a lunch workshop. The daylong agenda included the following:

Agenda

Keynote: Transformation in a Middle Market Portfolio
Gary Pinkus, Director, McKinsey & Company

Based on recent research from two McKinsey colleagues (Scott Keller and Colin Price), Mr. Pinkus discussed the importance of understanding and measuring organizational health to ensure effective and sustainable changes that result from formal transformation projects (which fail 30% of the time). Measurement of organizational health is just as important as clearly defined objectives, effective project management, and clear communications from upper management in ensuring sustainable results for the entity. Mr. Pinkus offered McKinsey’s 5-point framework – Aspire, Assess, Architect, Act, and Advance – to structure a successful project and defined the firm’s organizational index as a measurement vehicle to properly monitor and facilitate success.

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Panel One: Value Creation: Theory & Reality


Moderator

Craig Randall, Managing Director, DHR International, Chicago (Headquarters)

Panelists
Sean Cunningham, Managing Director, GTCR
Bill Drehkoff, Partner, Linden LLC
Mark Morris, Partner, Blue Point Capital Partners

Synopsis
This panel addressed leadership and organizational issues that may have contributed to a portfolio company’s inability to realize the financial objectives defined in the PE firm’s value creation plan for the entity. The panelists discussed specific deals where the investment thesis was not realized and discussed the characteristics of CEOs and management teams necessary to achieve investment success.

Panel Two: The View from the Executive Lens


Moderator

Martin Pocs, Managing Director & Vice Chairman, DHR International, Denver

Panelists
Peter Weber, Chief Executive Officer, Carpathia Hosting
Chris Hunter, Chief Executive Officer, Special Devices
Jim Eberle, Chief Executive Officer, Critigen

Synopsis
In this panel, seasoned CEOs from PE funded companies described their experience in evaluating firms and partners before deciding to join a PE funded company. They also described their experience working with the PE firm and its partners, specifically both the positive and more challenging aspects inherent in such situations.

Panel Three: The Ideal Operating Partner: Fact or Fiction?

Moderator
John Baker, Managing Director & Global Leader Life Sciences Technology DHR International, Boston

Panelists
Tom Nolan, Operating Director, Berkshire Partners
Fred Lunger, Operating Partner, Linden LLC
Chris Behrens, Operating Partner, Baird Capital
Hal Strong, Operating Partner, Genstar Capital

Synopsis
This panel addressed different types of portfolio support functions, which vary depending on a firm’s structure, and the best way to support their portfolio companies. The panelists also discussed challenges faced by operating partners as they made the transition into their role and the type of issues faced when working with portfolio companies.

Lunch Workshop: Predicting Investment Success: A Clarifying Model

 

Dr. Kevin Somerville, Ph.D., Chief Executive Officer, Somerville Partners

Dr. Amanda Foster, Ph.D., Senior Consultant, Somerville Partners

Dr. Somerville and Dr. Foster put forth a 5-point model where investment success correlates with strong leadership and culture as much as favorable markets and strategies. The degree to which portfolio companies approximate the high performance model is directly and strongly correlated with financial returns. The model consists of five elements, which can be assessed at any time during the life of the investment. The five elements are:

  • Leadership – A widespread belief in the CEO and that the company is well-led, coupled with a clear understanding of the strategy and how individuals fulfill their specific missions, was the most powerful predictor of financial success.
  • Focus – The concept of “focus” is frequently discussed as a determinant for success, but research suggests there are really only three types of focus applicable to any business: (1) operational excellence; (2) innovation driven; and (3) the premiere provider of tailored solutions.
  • Common Culture - Just like focus, the concept of “common culture” is often a victim of ambiguity. Simply put, culture defines the way “we behave and treat each other and our customers in our struggle to succeed.” 
  • Systems and Structure – A company’s focus dictates the nature of its “systems and structure.” For example, Wal-Mart is an operationally excellent company that runs on metrics. They “worship the altar of efficiency,” where everything is clear, specific, exact, and measured. In an innovation-driven company, there is a higher tolerance for ambiguity and risk-taking. The company is “creative” as it strives to conceptualize, build, and deliver something the world may have never seen before.
  • Constituent Relationships – This element refers to the real value the company offers its customers, which varies in terms of focus as defined above. “While the approach may vary in terms of a company’s focus,” according to Dr. Somerville, “when it comes to the leadership attributes of the CEO, he always needs to affiliate with customers. I connect with them. I am highly empathic with them. I am humble because the customer constantly educates me about their needs so I can continuously improve in myself, my employees, and my company’s service to them.”

 

Overall Summary & Findings

The panels, presentations, and subsequent discussions that emanated working with the audience yielded a plethora of useful insights.  These insights are categorized by “theme” and captured below.

 Characteristics of Successful CEOs

The key to strong financial performance really does start at the top. Dr. Somerville described the effectiveness of the CEO in terms of the “followership” and “belief” evident throughout the organization. “There is absolutely nothing more important in terms of the financial well-being of a business than the widespread belief that we, as an organization, are effectively led, but what does that mean? It means there is a clear strategy that articulates a way to win in the market. As an executive or employee, I understand and support that strategy. Importantly, I am clear about what I need to do to advance that strategy and I trust my CEO.”

  1. CEOs can come from various backgrounds, but will have a proven track record of directly attributable value creation in a prior company as a C-level executive regardless of whether the company was private, public, or PE funded.
  2. The best predictor of success when evaluating a CEO is proven value creation in a prior PE funded company where value creation mapped to the firm’s original or modified investment thesis.
  3. The demand for great CEOs, especially ones with proof points of success in PE funded companies, far exceeds supply. Thus, it is critical to search widely to ensure a sizable pool of strong executives.
  4. When searching for executives from other arenas (e.g. public companies, etc.), it can be helpful to source in entities that have a track record of producing proven general management and leadership skills based on the entity’s focus on developing leadership talent. 
  5. Executives should be fully assessed to ensure they can “think like an owner” of the business. Such qualities would include, at a minimum, a capacity to:
  • Think strategically and, in parallel, tactically with a hands-on approach as required
  • Thrive in a company with a leveraged balance sheet where intelligent spending is critical
  • Manage and effectively communicate financial health, notably cash flow and EBITDA
  • Build and manage according to Key Performance Indicators (KPIs)
  • Align with, respect, harness, and effectively manage sophisticated investors
  • Enjoy or adjust to accelerated velocity and fact-based decision-making
  • Operate in an open, transparent, trusting, and predictable manner
  • Prioritize time in the field working with employees and customers
  • Embrace change and continuous improvement as a daily condition 
  • Build and top-grade the executive team (and key players throughout the organization)

It is difficult to perfectly assess for these qualities. When attempting to do so, it is just as important to employ informal venues (dinner, drinks, etc.) as well as more formal interview techniques, testing and scorecards, and simulation exercises where the executive is exposed to peers and the board in a “case” addressing real-world issues facing the business. In addition, the use of operating partners when assessing CEOs is critical to establish fit from a functional as well as leadership and interpersonal perspective tied to the inflection point and challenges facing the business.

Working with PE Firms

CEOs evaluate PE firms and their partners as much as PE firms evaluate CEOs. When considering an opportunity to work with a PE firm, CEOs should have a well-defined thesis regarding what they are looking for in terms of industry, entity size, and other parameters. They must also make sure these parameters map to the expertise of the PE firm.

CEOs should do due diligence to understand the cultural norms of the PE firm and be mindful regarding the style of the lead director and how the firm shares wealth with executive teams.

There are pros and cons working with PE firms. The more positive aspects of working with PE investors include:

  1. Decision-making is accelerated and more effective. Panelists noted the energy, urgency, and increased velocity of the business.
  2. Decision-making is more efficient based on alignment amongst the parties. Everyone is clear that they are part of an “investment” scenario where the goal is return on investment.
  3. Accountability is a priority and that mentality at the top typically pervades the organization. Accountability drives fact-based decision-making. Rigor of process is emphasized.
  4. Investors have experience that leads to effective brainstorming on key initiatives. PE resources can be effectively harnessed to make better business decisions.

 

The more challenging aspects of working with PE investors include:

  1. Alignment is not perfect. PE firms can apply shorter-term thinking that might not make sense if the CEO were running an entity with a longer horizon for results to occur.
  2. The PE firm is very focused on ROI, but the CEO also has to deal with other stakeholders. PE firms do not always prioritize these other constituencies as much as they should (or the CEO needs to). 
  3. More focused on financial performance, the PE firm’s definition of success is metric-oriented when more balanced and qualitative measurements, like organizational health, are also important.
  4. The CEO needs to “manage up” when PE staff members are deployed to set boundaries, establish clear timelines tied to objectives and make sure everyone wins.


Reflecting on their own experience, panel members suggested the following for CEOs to achieve their goals and work effectively within PE funded companies.

  • Be maniacal about the mission and the plan.
  • Improve your game where it makes sense, but do not try to change and conform.
  • Stay confident, listen, and understand what the mission is at all times. Be nimble.
  • Be prepared for a very performance driven experience where you think like an owner. It will likely be more intense than one experienced in the past.
  • Use all the resources available via the PE firm to realize business and financial results.
  • If you see misalignment coming, do not wait. Be open and honest with your PE partner and reset expectations quickly.
  • Trust is a two-way street. CEOs must practice as much transparency, candor, and openness as the PE firm.
  • It is contingent on the CEO to do their own due diligence across multiple vectors before deciding they can succeed driving value in a specific company with certain investors.