Why Private Equity Investors Should Focus on Leadership for Value Creation

Leadership is the most important value creation lever portfolio companies have at their disposal, more so than M&A, digitisation or internationalisation.

By: Leadership Dynamics team

17/08/2023

5 min

In the world of private equity investing, the quality of leadership within a company has a significant impact on value creation. While digitisation, M&A and internationalisation are seen as key value creation levers, leadership is essential to their success. As investors look for new opportunities and seek to maximise returns, it is crucial for them to consider the effectiveness of leadership at the helm of their target investments.

The link between leadership and private equity

Research shows that strong leadership is one of the key drivers of successful private equity investments. A 2022 Teneo survey of global PE firms and recruiters found that leadership contributed an average of 53% towards investment returns. Companies led by competent, growth-oriented leaders are more likely to experience increased revenues, operational efficiency and overall growth – all critical factors to maximise returns on private equity investments.

One of the reasons for the strong correlation between leadership and value creation in private equity is the need for transformational change within a relatively short period. When private equity firms invest in a company, they often have specific, ambitious goals to achieve significant improvements within a certain timeframe. A skilled leadership team is crucial in executing the necessary changes, making it a top priority for investors. One of the responses to the 2022 survey said that 75% of the deals that go wrong are due to backing the wrong management team.

Another reason why private equity investors focus on leadership is the relationship between management and employees. A skilled and collaborative leadership team is essential for maintaining a healthy corporate culture and fostering employee engagement. As investors consider the long-term prospects of their investments, they must ensure that the management team is capable of attracting and retaining top talent within the company.

The importance of leadership in value creation

In the world of private equity, value creation is the ultimate goal. To achieve this, private equity firms must look beyond traditional value creation levers and focus on effective leadership, particularly among CEOs and the leadership team.

Role of CEOs in effective leadership

CEOs play a crucial role in driving the value creation process within a private equity-backed company. They are responsible for setting the strategic direction, aligning the organisation’s culture and resources, and executing on key initiatives. Leadership from CEOs has become an increasingly important factor in EBITDA growth and private equity value creation, alongside operational improvements, technology innovation, financial leverage and multiple expansions.

In order to maximise value creation, CEOs must:

Have a clear vision and strategy for the business
Engage with their leadership team and employees to mobilise resources and drive initiatives
Be adaptable and flexible in response to changing market dynamics
Demonstrate strong decision-making skills based on data and insights

The importance of a CEO becomes most stark knowing that an unplanned CEO exit delays, on average, an investment timeline by 18 months. Succession planning is a must for all leaders, but most critically for founders and chief executives.

The importance of a robust leadership team

Beyond the CEO, the rest of the C-suite is also essential to maintain solid value creation. The leadership team serves as the backbone of the organisation, driving day-to-day operations and supporting the CEO in executing the strategic vision.

As part of value creation initiatives, private equity investors may make key changes to the leadership team to enhance performance and value. This could include:

Recruiting new talent to fill skills gaps or bring fresh perspectives
Implementing performance management systems to align incentives and encourage accountability
Fostering a collaborative culture that allows leaders to work together effectively

A strong leadership team not only supports the CEO in executing value creation strategies but also drives performance in their respective functions. A CEO is often characterised by their vision and ability to get others behind it, but they need their COOs, CFOs and other “operators” to take over the day-to-day and execute relentlessly.

By investing in leadership development and promoting a culture of continuous improvement, private equity firms will be well-positioned to drive successful and sustainable value creation outcomes.

Due diligence and leadership assessment

In the world of private equity investments, thorough due diligence is crucial for making well-informed decisions. One aspect often overlooked in due diligence is leadership assessment, which can be a determining factor in the potential success of a portfolio company. By focusing on understanding and evaluating the quality of leadership within a target company, private equity investors can better position themselves for value creation.

Read our full article on how to conduct leadership due diligence.

People analytics in leadership due diligence

People analytics tools, such as Leadership Dynamics, can play a vital role in the leadership assessment process, offering valuable insights into the skills, strengths and potential shortcomings of a company's senior management team. By applying data-driven methodologies and including them as part of their private equity portfolio management software stack, investors can gain a deeper understanding of the company's leadership capabilities and make informed decisions on whether to proceed with an investment.

By involving data-driven people analytics tools, private equity investors are able to:

Identify key leadership strengths and areas for improvement, allowing for targeted post-investment initiatives to enhance overall company performance.
Assess the potential impact of leadership changes on the company's culture, operations and financial performance.
Evaluate the depth of the leadership pipeline, ensuring that there are a sufficient number of promising internal candidates for succession planning.

In addition to these benefits, the use of people analytics during the due diligence phase can lead to more efficient and effective leadership assessments, ultimately contributing to the successful management of a private equity portfolio.

Behavioural analytics in leadership due diligence

A growing subcategory of people analytics are the tools that focus specifically on behavioural assessments. Psychometric personality tests have been popular for decades, but we have found that behaviours are a far better predictor of high performance than personality traits. While personality tells us what a person is like in general e.g. “I am an emotionally intelligent person”; behaviours tell us how a person is likely to act in a specific situation in a specific environment, e.g. “I use my social awareness to navigate difficult conversations at work.”

To learn more about how behavioural analytics can help you assess your leadership team and potential leaders, see our PACE Behavioural Analytics page.

Emphasis on ESG in value creation

Integrating Environmental, Social, and Governance (ESG) factors into the private equity investment strategy can lead to significant value creation for investors. As ESG becomes a strategic priority for private equity firms, it is crucial that proper attention is given to the leadership qualities required to drive ESG-focused initiatives and improvements.

Focusing on ESG in value creation allows investment managers to assess a company's performance beyond financial metrics and includes elements such as natural, social and human capital. This approach is becoming more important as the value of a business is increasingly being evaluated through a broader lens. To ensure a successful ESG integration, companies must have strong, capable leaders who can navigate the complexities of ESG factors and embed them within the organisation's strategic plans.

One of the key reasons for prioritising ESG in value creation is stakeholder pressure. Limited partners, regulators, customers and employees are increasingly demanding that companies address ESG issues in their operations. ESG-conscious leadership ensures that companies are well-positioned to respond to these demands and can capitalise on the opportunities that lie within sustainable initiatives.

Moreover, aligning an organisation's strategies and practices with ESG factors has shown to be beneficial for managing reputational risks, improving brand value, and securing long-term financial performance. This underlines the importance of leadership that is well-versed in ESG matters and able to implement effective change management processes within the company.

Read our full article on ESG investing, its benefits and challenges.

Identifying skilled leaders who can identify, drive and manage ESG-related initiatives is a critical component of value creation in the private equity space. They must have a solid understanding of ESG opportunities and challenges and be adept at translating them into tangible, value-driven outcomes.

The ability to uncover this situational experience is a must, something that just a CV and an interview are unlikely to do.