Why Private Equity Succession Planning Is Good Governance

If good governance is a manifestation of good leadership, then selecting that leadership is the most important decision stakeholders can make. 

The private equity context demands that, in order to exit successfully, a buyer needs reasonable proof that their purchase is going to continue to provide a sustainable return long after the acquisition. If a business is ultimately a function of the senior leadership team, then what they are actually buying is a group of talented individuals on whom they can depend to deliver that return. 

But why is governance so important to the success of a portfolio company, and how does a succession plan ensure the right leaders are in place to maintain it? 

This article digs into the relationship between succession planning and governance in private equity, and why they are both important to the success of a value creation strategy.

Contents:

• What is corporate governance?

• What does good governance look like?

• Why governance is important for private equity investments

• Why succession planning is important

• What are the two types of private equity succession planning?

What is corporate governance?

Governance is the responsible distribution of rights and responsibilities for decision-makers across a business, including the senior leadership team, the investors and board members. The mechanisms that hold each of those stakeholders to account. Frequently, the "E" and the "S" in ESG (environment, social and governance) get the most attention because they are simple to understand. But it's the "G" that enables the first two.

Governance and succession planning are closely intertwined, mutually impactful concepts. Good succession planning ensures good governance; and vice versa. 

A balanced and effective leadership team can ensure that the basic structures of governance are in place, and that the responsibilities to maintain them are distributed across all stakeholders.

What does good governance look like?

The aim of governance is to maintain the health and sustainability of a business, as well as its transparency. Some of the signs of good governance are easily recognisable. They can be literal, like up-to-date certifications in regulated industries where businesses must comply with standards and government guidelines. But some signs rely on the actions and perceptions of senior stakeholders.

Good governance is manifested by a company’s leadership and is measured by its ability to maintain organisational effectiveness. It is critical to get the selection of a leadership team right so they can competently deliver on the corporate strategy, realise the vision, and manage its resources effectively while maintaining quality standards.

In short, it’s about who gets hired and how they get hired.

To use an example of when governance is undermined, WeWork started to lose its shine because of the people in senior positions and the lack of oversight from the board. When the founder and CEO Adam Neumann took a more personal view to hiring, his stakeholders allowed him to add family members as leaders – including his wife, her brother-in-law and her cousin. The conflicts of interest permeated through the company culture, which ultimately turned sour.

Examples of good governance at portfolio companies:

• Transparent reporting practices

• A clear strategic direction

• Clear principles

• High levels of employee engagement

• Low attrition at senior level

• A data led approach to leadership and senior appointments

• And of course, solid financial performance

Why governance is important for private equity investments

There is a chain of accountability stretching from the portfolio company’s leadership team, to their private equity investment directors and general partners, who have a fiduciary responsibility to their limited partners, who are often themselves accountable to their own clients.

For example, some limited partners are pension funds in charge of workers’ retirement pots. They have a responsibility to those workers, so they want to know that the portfolio companies their money is going into is run using good governance practices.

Governance is the set of structures that keeps a business well-managed and healthy so that those investments are kept safe. 

In terms of the private equity funds, or general partners, their aim is to build value and sell their portfolio company after a period of, usually, 3-5 years. But a sale is predicated on the sustainability of that value or else it becomes unappealing to buyers, who themselves want to see a continued return. They have a responsibility to make sure the performance is sustainable, and that means making sure the leadership is sustainable.

And that's where succession planning comes in.

Why effective succession planning is important

Doing succession planning badly comes with a cost, especially in private equity where the journey from investment to exit is defined, meaning any delays to suitable replacements can dramatically impact returns. 

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, six or more months can go by with an underperforming team. And if stakeholders spend time avoiding difficult conversations, it can easily take up to a year.

Whether leadership change is planned or unplanned, the cost in time, performance and returns can be significant if the succession plan is executed poorly. On average, for every one month into the investment cycle a change occurs, another week is added to the timeline for a private equity fund to realise their desired return on investment. 

A well managed succession plan ensures that delays are minimised. Read more about the benefits of succession planning in our succession planning in private equity explainer.

What are the two types of succession planning?

There are two main forms of succession planning in private equity-backed portfolio companies.

1. Founder succession

Growing a company from 0 to 200 people is not the same as growing from 200 to 500 people. Founder succession is about evolving a power structure from a single charismatic leader managing it all, to a professionalised system with a competent leadership team.

Entrepreneurial founders can sometimes find wrestling with the demands of a professionalised and corporatised businesses a challenge. They are used to dominating the decisions over the entire structure, but it grows unwieldy, and they need to be able to evolve leadership into a syndicated structure in which there are strong functional leaders across different parts of the business. They can lead and drive success in their departments with the founder/CEO orchestrating at one step removed, rather than managing it all.

The ease and effectiveness of founder succession often depends on the personality of the founder themselves. Change can be emotional, which is why investment directors and chairs look to data to make their case. 

2. Proactive succession planning

While much of succession planning tends to envision who can take over a role if a leader quits or is incapacitated, this is a kind of leadership succession planning that integrates fully with the value creation plan. 

This in-depth planning requires regular analysis of the current team and a forecast of the demands of every leadership role. Identifying which skills, experience and behaviours will be required to do the job at each stage of the value creation plan, and then manoeuvring potential leaders into position so they are ready to take the reins.

Businesses like portfolio companies that must adhere to a strict timeline need to be sure about the right time to make those changes and about the right people for the job. Assessing teams with data-backed people analytics tools helps smooth the journey and build business cases for implementing leadership changes. 

How to manage succession planning well

Leaders at portfolio companies and investors at private equity funds have an interest in upholding good governance by managing their succession planning effectively.

(We recommend reading our step-by-step guide on succession planning.)

The success in succession lies in how well you can assess your leadership team and identify potential leaders for future roles. This means going beyond the "gut feel" about someone's personality and delving into each individual's skills, experience and behaviours using data.

Behaviours tell us what a person is likely to do in a given situation, no matter their experience. So while personality traits show us "who they are", behaviours tell us "how they act".

Our PACE behavioural assessment is based on our learnings about which people with certain behavioural profiles work well together. Take the test yourself for free to see a detailed analysis of your behaviours, and which other behaviours they complement.