Different Horses For Different Courses

At a recent private-equity conference, I managed to make a point that seemed to resonate with both my fellow panelists and the audience.

Here was the setup: We were discussing the fact that as of September 30 of this year, there were 5,862 “IPO-sized” portfolio companies in the United States—up from 2,219 in 2004 (see chart)—a rise that was a natural outcome of the 2005-2007 investing boom. At the recent historical rate of around 400 exits per year, that’s a 15-year supply of “unexited exits,” I noted.

While none of us believes, I continued, that it will take 15 years to work through that pipeline, it seems fair to draw the conclusion that holding periods for private equity firms are going to be longer than practically anyone originally anticipated. Then I made the point: Given this new dynamic, portfolio companies may need very different kinds of management teams today than when private equity firms bought those companies.

Put another way: Different horses for different courses.

Why might different types of management teams be needed in portfolio companies today? The short answer: private equity-owned companies, just like all companies, go through life-stages—especially when they’re held for a long time. “Situational leadership” calls for different types of leadership teams. A few examples of different types of management teams:

1) Founder-led teams. These first-generation-of-a-company managements exhibit the values and even the personality of the founder or founding team, and they often use lessons and anecdotes from the company’s early days as a way of binding everyone to the company’s mission and strategy. Private equity owners occasionally leave the founders and their teams in place after acquisition, in part because the feeling you get when walking around a company where the founder’s shadow still looms large can be quite contagious and attractive.

Sometimes, though, the founder or original team runs out of ideas or isn’t ready for a significant challenge to the business. My firm, AlixPartners, once worked at a medical-device company where the founder—a brilliant inventor—decided to try his hand at financial engineering… with disastrous results. The next management team had two challenges—turning around the business and gently pulling the employees away from their emotional ties to the founder.

2) Deal-driven teams. These managements are really good when a company is in a growth-by–acquisition stage. They are well-networked in their industries, creative in seeing synergies in new companies, relentless at chasing and closing transactions, and very good at integrating newly acquired companies. For “platform” companies with aggressive acquisition programs, these are the teams to have.

Until they aren’t. My firm worked a few years ago with another medical company, one that specialized in medical practices, that was buying up new companies using a “proven” formula:quick valuations, easy closes and a very fast method of bringing the new company in under its new brand. But when financing markets seized up, the acquisition game was over. As was the deal-oriented management team.

3) Growth teams. Like deal-driven teams, these managements are all about the top line. They understand all the different growth paths—product, service, geography, channel—and are driven to grow revenues above all else. Any concerns about earnings or working capital are dismissed, in the belief big investments are mandatory for the big growth they have been asked to deliver.

But, sometimes the music stops—and despite this type of team’s best efforts, further significant growth isn’t available. And the operating issues that have been swept aside come flying back at gale speed—issues that this type of team isn’t usually capable of addressing or, sometimes, even understanding. Often, a growth team is the first to hit the exits—some even find it boring to try to fix the business model to deliver profitability at slower growth levels. Just as often, the working-capital situation they leave behind is completely out of whack and difficult to fix—the company is still behaving as if the growth stage is coming back at any moment.

4) Operational teams. These managements are really good at fine-tuning a business model, which is needed at certain times. “All about” performance metrics, they can show you how they are performing against competitors in everything from asset utilization to cost structure to supply-chain efficiency to even information-technology effectiveness.

But private equity firms need significant growth, in both revenues and earnings, in order to make their investments pay off. And operational-only teams often have trouble delivering that growth; in fact, they often resist or reject growth investments because of the short-term impact on their performance metrics.

My firm worked in a consumer-goods company that had scores of production-based and cost-based performance metrics, but didn’t have a coherent growth strategy. Great operators, they assumed that simply delivering cost improvements would somehow be rewarded by the market, leading to growth. When the growth didn’t come, they were stumped.

5) Turnaround teams. These managements are a special breed of operational teams. Brought in when a company has gotten into serious difficulty, turnaround teams are good at analyzing situations and quickly developing and implementing short-term fixes. Cutting costs dramatically, managing for maximum cash, calming creditors and stakeholders, and fixing broken balance sheets are all core skills.

Once the turnaround is completed, though, this type of leadership is rarely the right one to put the company on a course of stable growth Further, this type of team has often ruffled feathers with the company’s employees (as well as with suppliers and creditors), and it’s usually easier to put in a new team than to try to repair the collateral damage done in effecting the successful turnaround.

My firm often takes on interim-management roles in turnarounds, often as the CEO or “chief restructuring officer” managing the company through the restructuring process. And in every case, we know when it is time to go when the company (or its owner) is ready to bring in the “permanent” management team that will return the company to a growth trajectory.

What does this mean for PE companies? Historically, there have been just two times for private equity firms to ask themselves if they have the right management team at a portfolio company at purchase and when performance heads south. Today, however, because of longer holding periods, a new, third “evaluation opportunity” has emerged.

At purchase, private equity firms almost always do a lot of due diligence on the quality of management. (However, in our experience, they almost never ask if the existing management team is appropriate to the objectives as stated in the investment thesis—whether they’re really “the right horse for this particular course.”)

Likewise, managements of course get plenty of evaluation if a portfolio company fails to perform—albeit not always for the better. Given that the usual private equity model is to participate in portfolio companies through board seats, not as active management, if the company starts to underperform the first reaction is often simply to change out one or more management members—not really to change the overall management team’s type. My company is frequently involved when private equity firms are pondering such management changes. Often, however, the conversation centers on past decisions the management team made rather than on whether it is the right type of team to lead the turnaround—and, perhaps, the subsequent operational phase.

The new, third opportunity to evaluate portfolio-company managements isn’t necessarily a negative situation such as the above. Again, it’s about life-stage—not necessarily life-and-death for the company. For instance, AlixPartners has encountered many private equity sponsors recently that would like to exit an investment, maybe even a great investment, but just can’t find a good exit in the current environment, where IPOs are generally unavailable and where other buyers are still extremely cautious. One solution: re-evaluate the existing portfolio-company management team to make sure there’s good alignment between the sponsor’s (evolved) objectives today and the team’s skills.

Here are some sample situations where a fresh look might make sense:

• The portfolio company has been a successful acquisition platform run by a deal-driven team, but getting the company ready for a sale would be better served by an operational team that can improve EBITDA performance, thus making the company even more attractive to potential suitors.

• The company has a growth team that has generated great top-line improvement, but an operational team— this time one that stabilizes the business model to drive profitability ahead of a sale—may be more appropriate.

• A turnaround team has pulled the company out of a ditch, but it’s time to put a growth team in to get the company back on a trajectory that will lead to a successful exit.

Of course, changing a CEO or a management team isn’t a decision that private equity sponsors should take lightly or execute frequently. Keeping that in mind, there are also other options that may provide most of the benefit without as much disruption. For example:

• Augmenting the management team with a new member in a key role—maybe one that didn’t exist before, such as COO or chief strategy officer.

• Increasing in board involvement or “seconding” someone from the sponsor into the company for a brief period of time.

• Temporarily inserting consultants who bring needed skills for a short time.

Whether the portfolio company management team is replaced or augmented, private equity sponsors should always be asking the question that bettors ask at the racetrack: What’s the best horse for today’s course?

Jay Marshall is a Managing Director at AlixPartners LLP, the global business-advisory firm (www.alixpartners.com).