Prevailing auction processes, with tightly controlled access and slick coaching of management, make it very hard to accurately assess CEOs. One LBO partner candidly told us his firm has a 25 percent success rate in its CEO evaluations. Yet, private equity firms rank selecting the right management team as one of the top drivers of their investment success. A structured process, using several key practices and centered on the CEO Profile, a hiring system that our firm developed, can deliver more accurate assessments and ultimately improved investment returns.
Before outlining the CEO ProfileTM process, let’s explore the environment. Successful private equity firms boast impressive qualities related to evaluating people. The partners usually have extensive board experience, deep experience hiring and governing executive teams, loads of business acumen, and the finest educations available. To have some modicum of success in the buyout world, they must have unusually good abilities to read and relate to executives. They compound these advantages by hiring top analytical staff, operating partners, and outside advisors. Enjoying these advantages, buyout firms would seem to be near infallible.
What can go wrong? We see a few patterns, each of which introduces a margin of error into personnel decisions, often leading to “false positives,” or inaccurate views of a CEO’s fit.
• What private equity firms lack, usually, is time. Winning an auction requires making judgments on thin data sets, at a time when many issues are demanding the deal team’s attention. It is easy to let human capital analysis take a back seat to financing, strategy, or other areas.
• The focus on hard numbers, coupled with a highly choreographed pitch, can negatively affect the views we form of people.
• Historical success in executive evaluations has a way of teaching people to rely on their instincts, believing they are smart enough to make the right decisions. Private equity pros have some of the best gut judgment abilities in the business world, yet they sometimes fail to support this with a rigorous analytical process.
• Deal teams can devolve into groupthink, especially when they discuss “softer” issues like human capital. Too often, without a structured approach to forming and synthesizing views, the lead partner on the deal will state an opinion that too quickly becomes the accepted wisdom of the team.
• People often overweight a CEO’s past performance. The future always brings new requirements and challenges. Investors often fail to consider how well a CEO’s motivations fit with the company’s future requirements.
• Firms limit the assessment process to structured tests for senior executives, including self assessments and interviews by third party professionals. As noted below, these tests are useful, but occur later in the deal process and are often the only tools used.
Know What You Want
The CEO ProfileTM process is a structured approach designed to use leading human capital practices at each stage of the deal process. This lengthens and deepens the traditional evaluation process. It is also a knowledge management system to pull together disparate points of view; collate and organize data; and build a consensus point of view.
The process starts in conjunction with developing the investment thesis. Before meeting the CEO (and before being influenced by personal interactions), firms can draft a profile of the CEO traits and competencies that will be needed to fulfill the thesis. This becomes the foundation for the evaluation, with the team adjusting the assumptions as the deal progresses. The CEO ProfileTM also serves as the template to accumulate and synthesize data about the CEO.
Ultimately, the CEO Profile must lead to resolving key questions: Is this the right person to steward the company through its next phase? What level of motivation and drive can we expect from this person in the next three to five years? What strengths will the CEO be leveraging, and can we make sure she has the resources to do this? What weaknesses do we need to monitor or mitigate? What factors should inform our succession planning? What is the right board composition to govern, guide, and (sometimes) mentor the CEO? What tendencies and warning signals should the board be on the watch for? How resilient will this person be in times of great surprise or havoc? How confident are we that management would prefer us to win versus other bidders? Should we kill the deal, or do our insights into the CEO encourage us to bid aggressively?
Despite the auction process constraints, there are lots of information sources available for investors who make CEO evaluations a priority during the diligence period. Prior to a management presentation, most buyout firms will begin developing industry contacts and assembling their advisory team. Beyond strategic and operational expertise, these people can be sources for back-channel reference checks. What is the CEO’s reputation in the industry? What do his former investors, customers, competitors, and employees think of him? How has her performance been through various market conditions? A proactive investor can begin developing useful views of issues, strengths, and weaknesses before even meeting the executive.
The management presentation is often the primary chance to meet a CEO and gain crucial first-hand insights. Firms that have built a preliminary CEO Profile, and then use that to drive their evaluation of the executive, have an advantage over those relying entirely on unstructured observations and instinctive judgment.
Each member of the buy-side team should enter a management presentation with a human capital agenda. This would typically include a set of questions for each member of the seller’s management, designed to produce specific data points deemed important to the evaluation. The buyers would also use the CEO ProfileTM process to prepare a short list of “tells” to look for, i.e., indicators that may support or contradict the team’s hypotheses about the person’s critical traits. In one example, a firm had learned through its backchannel reference checks that the CEO had a history of having wonderful plans, but always seemed to fall short. They suspected that he had good strategic vision, yet was weak on holding his managers accountable. Being prepared to evaluate this, multiple members of the deal team were able to note specific observations in the management presentation confirming this view.
It is also important for the deal team to arm themselves with a structured template to record pertinent observations. These have the most value when the team members note their views individually, before discussing them as a group. This brings some structure to the analysis, and has the advantage of resisting the human tendencies to anchor their views around either the first opinion voiced or around the most senior person’s view. Research into small group decision-making indicates that, even when all individuals are very talented, they can make large errors. There are tendencies to move to consensus too quickly, be influenced by interpersonal relationships within the group, and compromise standards due to “deal fever.”
The group de-brief following the management presentation is a critical step. Here, the deal team compares observations and impressions, synthesizing the information into a revised and much more informed CEO ProfileTM. As time-constrained as most deals are, a thorough de-briefing should include at least two hours of focus specifically on executive evaluations.
When the process allows for a dinner or other informal social setting, it affords buyers and sellers unique opportunities. Yet, even the most leisurely of meals and cocktail sessions are still relatively short time periods to cover the host of topics important to both parties. A well-prepared deal team has an advantage as it can use its time wisely. The social settings, with the ability to observe interactions with others and non-verbal “tells,” are excellent sources of information on a CEO’s attitudes, values, beliefs, and motivations.
Moreover, remember that in many auctions the seller’s management can have decisive sway on selecting the winning bidder. Auction winners are often determined not merely by which buyer will maximize shareholder value, but the seller’s management team personal comfort level and preference for a particular bidder. A buyer can have an edge over competing firms by forming the right emotional bond with the seller’s management. While you can’t manufacture personal chemistry simply by following a process, advance development of the CEO ProfileTM helps the buyer understand (albeit preliminarily) a CEO’s makeup and affords the deal team a slightly better chance of forming valuable personal bonds.
At this point in the investment process, the CEO ProfileTM approach yields important information that can help a firm gain a slight edge in competitive auctions, prepare for post-close success, and avoid potentially bad deals. Note that these benefits all come before the most commonly used evaluation methods, executive tests.
These tests are the most commonly used tools for executive assessment tests. Once a buyer has an exclusive letter of intent, the access to management affords the time for executives to complete individual interactive assessments. These usually take two forms. The first are self-assessments completed by executives. These are tests designed by trained clinicians and marketed by testing firms that also provide benchmark data. These can be excellent sources of information on a person’s motivations, attitudes, values, beliefs, and skills. They also provide insights into a CEO’s abilities and style of interacting with others.
The power of these tests increases significantly when part of a larger assessment performed by a trained psychologist. This includes interviews with the CEO and her direct reports, coupled with analysis of the self-assessment tests and other data from the CEO ProfileTM.
In preparing for post-close success, the deal team can use the CEO ProfileTM process to determine specific organization decisions. The equity sponsor will use this information to select outside board members, and develop guidance on how to interact most effectively with the CEO. Frequently, the evaluation process will help boards determine that the company will need a new CEO at some point before exit, creating the need for succession planning. In addition, it is common for this process to result in other changes in senior management, such as creating a COO position to fill a CEO’s skill gaps, or upgrading a senior functional leader.
Like any process, repetition allows the firm to develop its own lingo and approach, making CEO evaluations a core part of the firm’s unique culture. Moreover, they can use continuous improvement methods to systematically get better with each deal. In a competitive deal environment, if you’re not getting better, you’re probably falling behind. The CEO ProfileTM is one systematic way to approach every CEO evaluation.
Steven Julius is the founder and CEO of The Human Resource Consulting Group (HRCG). He advises corporations and professional sports teams, providing executive assessments, strategic planning, corporate reorganization, culture transformation, CEO coaching, succession planning, and executive development services. Jeff Temple is a partner and co-founder of The ProAction Group. He directs the firm’s strategy and business development activities and is responsible for managing select private equity and corporate client relationships.