Succession Planning in Private Equity Explained

This article on succession planning is part of our series on change management.

Succession planning as generally taught in business schools does not always apply in the highly pressurised and time-sensitive environment of private equity-led investments. While the theory is helpful for understanding how things should happen to listed companies, the reality of succession planning in private equity (PE) is a different story. When taking a company from, for example, £100m to £500m in three years, the high calibre of leadership able to deliver that journey needs to be in place at all times.

So, we have written this explainer to help you understand the fundamentals, benefits and importance of succession planning in this unique PE environment.

If you are an investment director in a private equity firm, a founding team looking for investment, or a human resources director within a PE-led company, this article is for you.

If you already know what good succession planning means for your company or investment, but are looking for a practical understanding, read our next article on how to build an effective succession plan. 

Contents:

• What is succession planning?

• Why succession planning is important

• Benefits of succession planning for private equity

• Data-led succession planning

• Getting the right data

What is succession planning?

Succession planning (also known as succession management) is a process of identifying individuals to succeed in key positions in leadership, either by bringing in external talent or developing existing internal candidates well in advance of a leadership vacancy.  In PE, the meaning of succession planning is slightly different. It can be a proactive process to make sure the right team is in place before a primary investment, or in advance of an exit so that the next buyers can be confident in the continued performance and the long-term sustainability of the team and the business.

Since investment journey timelines are finite, the purpose of succession planning is not just to prepare for disaster scenarios, such as health issues or unplanned exits. It’s a less tactical, more forward-planning mindset that is part of good governance and ensures the sustainability of the leadership team while adhering to ESG (environment, social and governance) responsibilities.

Good succession management is about having the right team in place at the beginning of the journey, and if the company continues to scale as expected, it’s about making sure the right individuals are in the right senior leadership roles at key points along the roadmap of the value creation plan.

The question is not “is this leader right for the business today?” The question is, “as this company scales, will this leader remain right for the business?”

Similar to how central bankers use forward guidance, a succession plan advises on what future conditions will mean maintaining the status quo and what conditions will mean making changes.

Why succession planning is important (and the cost of ignoring it)

Today, as competition has intensified, private equity can no longer simply buy-to-sell; it has had to become more sophisticated in the way it creates value from its investments. Typically, the focus for creating this value is on internationalisation, M&A, improved operational efficiencies and digitisation. But you can only unlock those value creation levers with the right management team in place, and that’s where succession planning comes in.

Doing succession planning badly (or not at all) comes with a cost, especially in PE where the journey from investment to exit is fixed, meaning any delays to suitable replacements can dramatically impact returns. 

On average, an unplanned CEO change will typically add 18 months to an investment timeline, which is why moments of leadership change need to align with growth plans. It’s necessary, but too much too quickly can be damaging and unsettling.

Even when a leadership role change is needed, it’s difficult to start the conversation at all. Founding teams at primaries are often old friends, and that emotional connection can override rational decision-making. The can gets kicked down the road, and performance lags behind expectations while precious months go by. 

Here’s an example: If you take into account that it typically takes three months to make a search for the right replacement, three months to serve out a notice period, plus the time it takes to acclimatise to a new role, 6+ months are lost. When difficult conversations are avoided for months on top of that, it can easily take up to a year. If the timeline until exit is 3 years, that’s a third of the journey time spent with the wrong team makeup.

Whether planned or unplanned, the cost in time, performance and returns are significant. We have found that on average for every one month into the investment cycle a change occurs, and another week is added to the timeline for a PE fund to realise its desired return on investment.

The benefits of succession planning for private equity

The advantages of succession planning boil down to keeping the investment journey stable; it maintains the levels of high performance necessary for creating value in line with goals. Here are the underpinning succession planning benefits that help PE and leadership teams get there.

Prepares for the unexpected

Unexpected leadership turnover can be costly. 83% of PE firms say that unplanned CEO turnover lengthens their investment hold times, while 46% say that it has eroded their internal rate of return. Plugging those gaps before they occur, can be the difference between reaching a successful exit and not.

Prepares for rapid change

As companies evolve and expand, the need for new skills and experience can change drastically in just a six or 12-month period. A healthy leadership pipeline can meet those requirements quickly and without impacting performance.

Highlights existing skills

Identifying employees with high potential and including them in the plan can motivate them to be ready to step into senior roles, giving them time to acquire the skills and experience to perform well. This is especially relevant to prepare for changes in the motivation and desires of leaders who have already benefited from previous buyouts. A plan also communicates to other employees that the business is willing to invest in them. 

The benefits of data-led succession planning

Succession planning by itself is not enough. It has to be done right. Using data to analyse a team and its needs ensures an investment journey stays on track. Here’s why:

Cuts through emotion and ego

Conversations around replacing roles can be uncomfortable for both management teams and PE investors. It’s a sensitive subject for founders who are friends, but it’s also for PE teams who believe in the business. 

If you have an objective analysis, it creates the opportunity for people to rationally assess themselves, and come to the realisation that what makes them more comfortable may not be good for the company.

Helps leaders think like shareholders

A data-led succession plan is a way of holding up a mirror to a leadership team, to help them disconnect from their own role and see the company as an entity with its own risks and opportunities laid out. This lets individuals think like a shareholder rather than like salaried employees, so they can invest in the success of the business more than in the success of their own performance. Ultimately they start to make or accept decisions in the interest of the company.

The image below is an example of a functional balance chart showing the ideal balance of where each leader sits with their skills and competencies.

Prepares for change in motivations

By the time a company reaches secondary and tertiary investments, it may well have been three or five years since leaders came into their role. Their motivations and desires are very likely to have changed, especially if they have already received a payout from previous PE exits, and they are ready to slow down or move on.

By having a view on who else has the ability to step up into those roles, and manoeuvring them into positions where they can have hands-on experience of current leaders for several months, it gives the company’s next buyers confidence that the skills and experience are in place to keep their investment on track.

Derisks owner-founder behaviour

However brilliant and charismatic the founder of a primary investment is, there will typically be flaws that need a counterfoil. The only way they can be the best they can be is with the right people surrounding them, to dampen the negative behaviour, and amplify the positive. 

For example, we’ve seen emotionally intelligent leaders who are not specialists in their roles but who are trusted confidants able to manage technically brilliant but erratic founders. They insulate their negative behaviours from the rest of the team, but because it’s not obvious what their value is, those trusted confidants are often replaced due to poor succession planning. The result is often that the erratic founder eventually causes divisions with abrasive behaviours and key people start leaving.

Without the objective insights derived from data-led analysis, the value of the counterfoils is often overlooked. But with objective facts, you can maintain the right balance and diversity of behaviours and competencies in leadership teams.

How to find the right data

The more relevant the data, the better. At Leadership Dynamics we look at behaviours, leadership balance and experience. Our behavioural evaluation model, PACE, is a psychometric assessment tool that measures the behaviours of leadership teams and maps them to those that correlate with success, using our leadership balance and value creation quadrant analysis tools. These last two tools have been created by analysing only those leaders in the upper quartile of more than 7,500 successful exits from the past ten years, whereas most tools take their data from the general population.

PACE stands for its four overarching behavioural scores: Pragmatism, Agility, Curiosity and Execution. Try it out for yourself.