Private Equity Investment: Identifying Low-Risk Management Teams

Our guide for private equity investors to derisk investments by assessing the leadership teams in portfolio companies during risk-off periods.

By: Leadership Dynamics team


4 mins

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A business is ultimately a function of its senior leadership team. So, when buying a business, private equity investors are also buying a group of individuals, on whom they must depend to drive performance, achieve the targets of the value creation plan and deliver the expected return at the end of the investment period.

It stands to reason that one of the biggest risks in private equity investing is the leadership teams in their portfolio companies. While leaders are a business's greatest asset, they can easily become its biggest liability. So, in a risk-off market environment, where risk sentiment sees the economic outlook as poor, management due diligence (MDD) becomes one of the most important ways to derisk investments.

This article will detail how to mitigate risk when identifying investment opportunities in private equity, including how to employ people analytics as a risk management tool to assess and optimise the current leadership team.

For more on deal origination and due diligence, see our Deal Origination and Due Diligence in Private Equity Explained

The importance of leadership due diligence to value creation

Creating value in a company depends on using investment to affect various value creation levers, such as internationalisation, M&A, operational efficiency and digitisation. However, the most important enabler of these levers is high-performing leadership; only a solid management team can execute the strategies that align with the value creation plan.

Management due diligence (MDD) or, as we like to call it, leadership due diligence (LDD), is becoming more and more important as a requirement from investment committees, as PE firms recognise that the quality of the management team is a major differentiator. In fact, our research shows that 71% of investment directors cite the calibre of leadership as the primary reason for success in a PE growth journey.

The cost of poor leadership due diligence can be dramatic. We know that unplanned changes to CEOs add, on average, 18 months to an investment period. And it takes time for a new CEO to settle in, often bringing in their own ways of working, new initiatives and advisors. It takes time for the other leaders on the team to acclimatise to the new way of doing things. In effect the disruption can entail a huge cost to an investor as, for example, a 4 year timeline could be extended to nearly 6 years.

Since buyers will be looking at the performance and sustainability of the leadership team, it's important to have a committed leadership team in place at all times. If this isn't the case pre-deal, a succession plan needs to be developed and agreed upon by all parties to ensure leadership sustainability.

Management team red flags

When assessing a management team pre-deal, there are a few symptoms of a dysfunctional team to look out for, which without change may fester into poor performance.

1. Leadership attrition

The foundation of good performance is a leadership team that is committed to the journey, and remain for however long they are right for the company during that journey.

Leadership attrition represents a big risk to the performance of a company, as well as investor risk tolerance and to the sale of the company. If leaders are leaving, it's difficult to say whether the performance to-date will continue after the deal is made. Even if investors make it clear that they back the management team and want them to continue on the journey, there may be an inherent incompatibility in the team dynamic.

It's never possible to completely ensure people will stay as long as you would like them to, but it is possible to create the conditions that make it far more likely that a team will remain committed. And it has a lot to do with ensuring each individual is behaviourally compatible with the rest of the team. Assessing the team before a deal with behavioural analytics can help give investors a clear picture.

If leaders leave soon after the deal is made, it's unclear if the performance is going to continue, not to mention the disruption to the rest of the workforce.

2. Leadership concentration

This is where a certain level of competency or experience is concentrated in too few individuals, or even just one person, and so the rest of the team becomes dependent on them.

For example, if a CEO is supported by relatively junior leaders, the level of performance is largely due to the CEO. If they leave, the more risk there is that the performance will dip.

3. Groupthink

This is almost the reverse of leadership attrition. Groupthink leads to poor outcomes because there is a lack of opposing voices, which hinders creativity and encourages complacency.

One of the signs of groupthink is a leadership team with individuals that have stayed in place for many years, and while performance is steady, it's also stagnant. The longer a team has been together, the more likely it is to have an established way of doing things. It's unlikely that a team suffering from groupthink is going to be able to push the business beyond where it is today.

Fortunately, there is a method of surfacing groupthink so you can eliminate it – using behavioural analytics tools to look at the team's concentration of behaviours. If the top leaders have very similar behaviours, there is a lack of cognitive diversity which means they are less likely to challenge one another, which is especially prevalent in founder-led businesses.

How to derisk the leadership team pre-deal

Keeping the risk return trade off in mind, of all the aspects of an organisation's success, people are the hardest to predict. But employing data to analyse a team can help close the gap.

People analytics

Private equity investors often have to make decisions based on the quality of their relationships, but these relationships can introduce bias. Firms that use data-led people analytics tools allow themselves a dispassionate assessment of an existing or potential team, which removes any personal biases and relies solely on objectivity.

Assessing with relevant data. People analytics tools work best when they use data that is relevant. Most well-known psychometric tests rely on surveys from the general population, which is too broad to have any relevance when hiring leaders.

More than 4000 executives from high-growth businesses have taken our PACE test (PACE – Pragmatism, Agility, Curiosity and Execution), which has a relevant dataset to create archetypes that suit each C-suite role. Take the test and discover your behavioural profile. It will give you an idea of how detailed you can get with potential hires and current leaders in your portfolio companies, and your prospective investments.

ESG as risk assessment criteria

ESG as criteria for private equity investment has become more and more prevalent as investors understand that making a difference can also mean maximising returns.

For private equity buyers, it's the G in ESG that enables the E and the S. Good governance is manifested by a company’s leadership and is measured by its ability to maintain organisational effectiveness. If the company for sale has a formalised ESG strategy, it's more likely that there are solid structures underpinning its performance. Governance indicates the resilience of its leadership.

Plus, companies with good ESG are looked on more favourably by limited partners. Such as pension funds managing retirement pots for pre-retirees, whose personal values mean responsible investing is more in demand. In fact, American public pensions applied ESG factors to at least $3 trillion in assets in 2018. Since good ESG indicates better performance, it makes sense to use this criteria to assess organisations as less risky investments.

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