The Most Important Part of Diligence Nobody’s Talking About
Management team effectiveness remains the single most important factor determining the success of a private equity investment.
First published in PE Hub Copyright PEI Media
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The most important part of diligence that nobody is talking about | PE Hub
4/1/24, 12:20 PM
The era of cheap capital is over. Now, more than ever, returns are becoming increasingly reliant on operational execution and value creation, driven by management teams and talent in portfolio companies. This puts a much higher emphasis on hiring a deeper, broader pool of talent and having the right organizational architecture in place to enable high-performance execution from the jump – and right now firms that are able to demonstrate operational value creation are being held in much higher esteem by allocators.
Due diligence of prospective investments has always included market mapping, assessing product-market
fit, and stress testing the financial business plan – all important drivers of investment success. However,
management team effectiveness remains the single most important factor determining the success of a
private equity investment, and team effectiveness comes down to more than just their hard skills. In
fact, hard skills will become increasingly commoditized and devalued as AI enables faster process-oriented decision
making. Soft skills, which have historically been thought of as difficult to measure, will come into greater focus as the “x-factor” essential to high performing portfolio company management teams.
Picking an all-star team
Imagine you’re picking your starting five for an all-star basketball team. You could pick individual proven superstars, or you could pick talented players with highly complementary skills and expertise. Nearly every time, even when you’re the Chicago Bulls of the 1990s, the team with complementary skills beats the team of individual superstars. This same phenomenon plays out when looking at management teams and investment performance outcomes for portfolio companies. Recruiting managers based on the specific skills required for their respective roles and ensuring that the individual skill sets are highly complementary is hands down the best pick every time. Further, high
performing players and teams always have coaches who fuel their critical thinking, learning, development and adaptation to optimize operational execution and value creation.
When individual managers are unfit for purpose, it puts an albatross around the neck of the sponsor, as PE firms bear a high cost in the form of longer holding periods and lower returns. Identifying the problem with an individual
manager, letting them go, recruiting a replacement, and giving the new executive time to hit their stride is an 18-to-24 month endeavor, pushing out the holding period and negatively impacting IRRs. Management teams can execute on their business plans to maximize returns only when they flexibly navigate the complexities of changing macro and industry conditions. When individual managers do not have the skills required for their roles and cannot work in a complementarity fashion with their teams, sponsors lose their most important lever for driving strong operational performance at portfolio companies.
The new model
How can PE firms consistently pick the right management teams? The old model for talent included hiring proven, industry-experienced operators predicated on past success being a predictor of future performance. Improving operational execution has always been a key part of the value creation playbook, but now the most advanced GPs are turning to a new model that involves using the most contemporary talent assessment tools at their disposal, to ensure the right team is in place from the start.
These tools involve two key elements.
First, post exclusivity and pre-closing, GPs are identifying fit-for-purpose managers and operators using data-driven assessment tools such as Hogan, Leadership Circle, MBTI and DiSC, among
others.
Second, post-closing, GPs use performance coaching as a team assessment and development tool to improve clarity, alignment and
communication within operating teams. Management team performance coaching focuses on helping each manager develop clarity on their own roles relative to those of their peers and the CEO, understand how to align with their teammates as the company grows and scales, and communicate better to make operationally stronger collaborative decisions.
A structured management team assessment process uses a curated universe of assessment tools. The assessments, interpreted by executive coaches that are experts in those particular assessments, paint a granular image of each team member and the team as a whole. First, using objective assessment data and in person interviews, benchmarked against the scores necessary for their role, sponsors are able to form a complete image of each team member to better understand personality and professional skills. Second, a comparative analysis across the team enables PE firms to understand strengths and weaknesses of the team to identify how the organizational architecture must evolve, and
which individuals will fit (or might need to evolve their skills) to successfully execute on the business plan.
The investment private equity GPs make in human capital assessment represents a small amount relative to its outsized importance in de risking investments and maximizing the probability of meeting or exceeding the business plan and return expectations. Talent assessment and coaching are powerful levers integral to enabling PE firms to enhance operational execution and value creation to drive returns within shorter time frames. LPs and asset allocators increasingly understand what best-in-class PE firms have already made a part of their playbook: a focus on management team assessment and performance acceleration coaching to de-risk PE returns.
First published in PE Hub Copyright PEI Media
Read original PE Hub piece
Not for publication, email or dissemination
The most important part of diligence that nobody is talking about | PE Hub
4/1/24, 12:20 PM
