Dodging Bullets: Flagging Management Deal Breakers Early in the Ownership Process

By: Steven Gilbert

The unplanned replacement of a portfolio company CEO can have disastrous consequences. Most private equity firms have painfully experienced it at some point in the life of a fund. The full extent of poor senior executive leadership often takes time to fully surface and longer to rectify. Finding a full-time replacement CEO, onboarding, and rebuilding organizational alignment all inject risk and potential for delay in exiting.

The difficulty in getting true management access to understand the pulse of the organization, the standing of the CEO, and broader leadership capabilities—particularly in a competitive bid situation—puts even more pressure on deal partners to sharpen their sensitivities to flag potential issues. Having a cast-iron perspective on senior management pre-close is difficult to attain; having said that, certain warning signs should be monitored post-close (assuming deal completion) to ensure any transitions that need to occur are planned and executed quickly. These warning signs fall into three buckets: transparency, alignment, and speed.

Transparency

Having a clear line of sight into the business and a consistent sense of management transparency are imperatives underscored across all our clients. Yet getting information about the right issues at the right time over the ownership period continues to be a source of frustration. There are examples of CEOs and management teams who actively try to hide or are selective with the truth—but often other issues are at play. Particularly in small- to mid-market companies, systems and processes are imperfect, and accurate forecasting or the ability to get a proper handle on the business is difficult. Companies and CEOs who have not been previously PE-backed are not fully clued into what information their PE backers need or why they need it.

What to listen and look for:

  • Does the CEO understand the business at the level of granularity needed?
  • Does the CEO understand where systems are lacking and what information would be ideal to running a tighter, metrics-driven business? What steps have been taken to date?
  • How does the CEO respond to challenge and scrutiny? Does he/she demonstrate openness, the ability to admit mistakes, and a history of learning from them?
  • When and how has the CEO delivered bad news to a board? Did he/she delay? And if so, why?

Alignment

Transparency and alignment go hand in hand. CEOs are generally strong-willed, independent-minded people who like to be left alone to run their business. Many talk about managing the board rather than leveraging it and prefer to operate on a need-to-know basis. CEOs who are having their first experience working with the PE firm usually underestimate the degree of oversight and scrutiny. Getting aligned on the operating and governance models, ideally pre-deal, is critical. Beyond alignment on the requirements for partnership, there must be strong agreement on the growth plan both at the CEO-PE level and between the CEO and management team. We’ve witnessed gaps open quickly in both areas. Firms that excel in this area are transparent about how they operate in diligence. They tightly link the CEO’s scorecard to organizational priorities and then assess progress to goals in a formal way each month. Delays in decision making and action are monitored, and all parties align on the acceptability of gaps to plans and short-term contingencies. Recurring excuses and promises that fail to materialize are challenged, and rules of engagement are quickly set rather than being tolerated as part of the learning curve.

What to listen and look for:

  • Does the CEO understand what is different and unique about a PE operating environment? Can he/she verbalize that understanding in a coherent and detailed manner?
  • Is the CEO aware of how his/her leadership needs to adjust in response to the new environment? What examples can he/she provide that demonstrate personal adaptability and agility?
  • How responsive is the CEO to input and feedback? Does the CEO listen? Who does he/she use to sound out issues? How will the CEO leverage the board?  
  • Where and when has the CEO experienced gaps in alignment with stakeholders in the past? How did he/she manage the gaps? Why did they occur?
  • Does the management team have a consistent sense of growth plans? Who are the doubters? What is the resistance built on?

Speed

Given the yardstick of a five-year hold period, the need to move at pace is central to success. Assessing the CEO and management team’s true understanding of this cannot be underestimated. All PE firms know this, yet many are still caught off guard by the sluggishness they see in their portfolio companies. We often see a short period of toleration followed by mounting frustration as decisions are delayed or poorly executed. In diligence, it is critical to pressure-test if management truly possess a “barbarian eye on the business” and ability to move at the clip needed. The most common issue we see is slowness to act on underperformers, sometimes based on loyalty but often due to a lack of understanding of what strong talent looks like and willingness to pay for it.

What to listen and look for:

  • How are decisions made in the organization and who is involved? Where are the bottlenecks?
  • Which decisions come easily to the CEO and which ones are hard? Which issues cause the most deliberation and why?
  • Where might loyalty blind the CEO to talent realities? Does the CEO have a sense of what future talent requirements are and what good looks like in pivotal positions? Has he/she tolerated mediocrity to date?
  • How does the CEO currently inject speed? What clear examples can he/she provide? Is it fast enough?

Getting everything right in diligence is difficult, particularly in a competitive bid situation. However, having a clear set of questions that get at some of the common areas of failure can reduce the risk of frustration and future gaps in alignment. Similarly post-deal, monitoring concerns that were or become apparent and moving quickly to establish clear operating norms is critical. Gaps can open quickly and sometimes are left to widen based on a wait-and-see or hands-off approach with new CEOs. When the warning signs are there, even if they are rooted in intuition versus hard data, they should be tackled head-on to ensure damage is minimized.

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