The Rise of Human Capital in Private Equity
Private Equity (PE) investment continues to increase due to the low cost of capital, more favorable business conditions, and a surging middle market economy. New PE firms are abundant and are growing at a torrid pace, with over $3 trillion in funds raised during the past five years1. Over the past decade, most PE investors have shifted their focus from cost reduction and financial engineering to place greater emphasis on growth. New products, consolidating adjacent markets or competitors, technology shifts, and organization capabilities now drive growth strategies in portfolio companies. Therefore, firm valuation is being redefined like never before. While EBITDA will always reign king as the financial barometer for success quarter to quarter, determining future growth value is less clear. By some estimates, up to 50% of a firm’s value cannot be explained by its financials, which necessitates the use of different measures like strategic clarity, ability to meet customers’ needs, and leadership capital2. Today, value is increasingly defined by factors that have historically been considered intangibles.
Portfolio company leadership, talent development and organizational culture play an increasing role as growth enablers or constraints in the new world of PE investment. Too often, leadership issues, talent gaps, bottlenecked decision-making, and ineffective management teams obstruct growth and investment returns. Forbes estimates that half the time portfolio firms fail to achieve the returns their investors expect, it’s due to the wrong leadership running the companies3. While it is difficult to rigorously assess talent and leadership capabilities before an investment is made, PE detects and suffers the pain post transaction when the growth strategy is stalled. According to a 2017 report from Human Capital Moneyball, PE has been negatively impacted by human capital mistakes and estimate billions of dollars in value have been lost in past several years4.
Given that the average hold period for an investment is 5 years, it is critical to address human capital needs and opportunities as soon as possible. Speed in understanding leadership and talent priorities has become increasingly important. As further evidence supporting this trend, nearly all of our PE firm clients have either hired heads of talent / human capital in the last 2 years or plan to in the next 12 months.
It is challenging to formally assess talent and organization capabilities during due diligence. Luckily there are several critical activities that will accelerate how and where human capital can drive portfolio firm growth and ultimately returns.
5 Ways to Accelerate Growth through Human Capital
Set expectations early with the founder and/or management team. Establish early that PE will be involved in assessing and developing leaders in addition to building a top organization for the future. Often PE firms bring a level of sophistication and expertise regarding human capital that the owner and management team have never experienced. PE Directors usually know what great organizations look like. During negotiations, begin discussing the human capital required to grow the company.
Co-develop a human capital strategy within the first 6 months of the investment. Most PE firms expect and set an aligned, strategic business plan for the investment period within the first several months; normally by the first board meeting. A similar expectation for leadership, talent, and organization design should also be set. This “people strategy” should assess the current leadership and organization capabilities that exist to execute against the agreed strategy or investment thesis. The resulting initiatives and actions should be implemented in year one and two. We suggest the people plan be in place by the second board meeting.
Assess the leadership and organization. It is critical to preserve successful culture and capabilities in portfolio firms. It is equally as important to understand how and where specific leaders in the organization must change to scale successfully with the company. Using the five-year investment growth thesis as context, PE investors can comprehensively assess the CEO, management team, key leaders, structure, decision-making, and the overall organization’s strengths and gaps. Clear management actions and development priorities will accelerate the organization’s readiness.
Make specific and high ROI talent investments. Most portfolio firms and PE investors do not have the patience or capacity for long-tailed leadership development programs. Renowned books and Ivy League seminars provide interesting content but fail to provide change that has an immediate business impact. Investments such as executive coaching, 360° feedback, recruitment of a proven subject matter expert, leader forums, or intense focus on developing a high-performing management team yield great dividends in the near term. Most PE firms realize that you cannot just fire and hire your way to success.
Appoint a credible PE human capital executive. Renowned leadership strategist, David Ulrich, estimates that half of all PE firms have their own Leadership Capital Partner role5. In our experience, PE firms with more than $10B in assets make the move to hire someone responsible for leadership talent at their portfolio companies. It is critical for these firms to engage leadership experts, organization strategists, performance coaches, and influential decision-makers on human capital matters. The leaders in these important roles cannot be treated as glorified recruiters or compensation managers. Give them the reigns to assess key talent, develop high performing organizations, partner on investment decisions and establish standard team and organization best practices across all portfolio companies.
In Conclusion
Iconic companies such as Unilever, Honeywell, Google, and Procter & Gamble demonstrate that human capital will make or break a compelling strategy. Leadership and talent gaps and challenges are no longer reserved for the big companies. The labor market is shrinking, proven leaders are retiring in droves, and high potential talent is more selective than ever. As PE continues to shift towards growth, we expect to continue to see greater human capital challenges and increased focus on addressing leadership and organization needs. This can be accomplished with effective planning, rigor, and discipline to ensure a return for all investors.
Summit Leadership Partners advises Boards, Investors, CEOs, and senior leaders on strategically scaling business through talent and organization assessment, executive team performance and coaching, leadership development, and organization effectiveness. Our consulting team has held top leadership roles in successful companies across the globe. We are seasoned experts in strategy, assessment, leadership development, coaching, strategic talent management, and organization development. Connect with us to learn more about how we can help your business.
This post contributed by Dan Hawkins.
References
1 Bain & Company. (2018). Global Private Equity Report 2018.
2 Ulrich, D., & Allen, J. (2016). Private Equity’s New Phase. Harvard Business Review.
3 Brubaker, M. (2017). Private Equity Leadership Lessons: How CEOs Limit Company Performance. Forbes.
4 Private Equity International. (2017). Human Capital Moneyball: Linking Talent to Private Equity Deal Outcomes.
5 Ulrich, D., & Allen, J. (2017). PE Firms Are Creating a New Role: Leadership Capital Partner. Harvard Business Review.