After languishing in the aftermath of the global credit crisis, private equity activity is once again on the rise. As of October, buyout firms had made $173 billion worth of deals this year, a level representing a bump of about 95 percent over last year, according to Thomson Reuters. And, with debt cheap and private equity firms flush with cash, deal-making momentum should continue to build—as will the need for seasoned leaders able to steer portfolio companies to growth.
But while the corporate world teems with would-be portfolio company CEOs, finding one who can engage employees, make operational improvements and ultimately deliver value is no easy feat, agreed private equity CEOs gathered for a Chief Executive roundtable discussion held in partnership with Fifth Street Finance and Rutan & Tucker, LLP. At a struggling company, the right CEO can make all the difference, asserts Len Tannenbaum, CEO of Fifth Street, who points to one of his portfolio companies, California- based Traffic Control and Safety, as an example. Near collapse when Fifth Street brought in a new CEO six months ago, the company is now stabilizing under his watch. “That crisis is evidence of the difference the right management team can make,” says Tannenbaum.
At the same time, even the most diligent of private equity companies can go through a lengthy vetting process to identify a financially savvy leader with a fantastic track record, a seemingly perfect skill set and relevant industry background, only to have him crash and burn. Just ask Michael Bruno, managing partner of Stonebridge Partners. “We’ve had some CEOs with the greatest resumes you’ve ever seen who failed miserably,” he reports.
Why the disconnect? In brief, the challenges and opportunities inherent in running a portfolio company, and the high cost of failure, make identifying and attracting an appropriate leader particularly tricky. Sometimes the issue is all too clear—at least in hindsight. For example, a leader who thrived in a large public company environment often struggles to replicate that success in a more entrepreneurial company with limited resources and less structure.
In other cases, success in one industry doesn’t translate to another, notes Andrew Brickman, a partner at Baird Capital Partners, who recounts a failed attempt to install a chemicals business CEO at a distribution company. “You think, ‘Oh, he’s a great athlete and he can win anywhere,’ ” he says. “That hasn’t worked for us.”
Worse yet, a wrong call on a CEO can quickly devastate an organization. “There’s a multiplier effect when you pick someone and go in the wrong direction,” warns Richard Latto, managing director of Longroad Asset Management. “Because that person hires three people, those three each hire three more, who each hire three more and so on until you’ve hired 81 bad people within 18 months.”
So what does work? How can private equity firms suss out the business leader able to step seamlessly into a portfolio company, implement operational improvements and lead it to growth? Stonebridge Partners’ secret sauce in CEO selection is to engage leaders with a specific set of experiences. “Typically they’ve worked in a private business as well as with a larger company and have already done a few private equity deals,” says Bruno, noting that the high level of debt that portfolio companies tend to carry requires more vigilant cash-flow management. “CEOs who haven’t had much debt don’t know how to oversee a private equity transaction.”
The Deep Dive
Many private equity firms find the issue critical enough to warrant a rigorous assessment process. At Spire Capital, a psychologist is brought in to conduct two-day, 16-hour evaluation sessions with prospective CEOs. “We get a deep psychological profile as well as feedback on a list of 20 areas that we identify for them as sensitive issues,” says Richard Patterson, co-founder of the firm. “We’ve found they’re 80 percent accurate in identifying problems.”
Calvert Street Capital Partners uses a similar process to vet not only CEOs, but every professional in the firm. “It reveals any red flags in a person’s personality, but it also helps identify potential issues, such as a flaw in a person’s ability to communicate, that we need to know about one another in order to be good partners,” explains Joshua Hall, a senior partner at the firm. Beyond helping a private equity firm choose a CEO, the process can highlight areas where that individual might need support.
Because Baird Capital places a premium on the ability of a prospective CEO to cultivate leaders, its evaluation process involves an in-depth look at members of a CEO’s former management team. “We dive into their backgrounds,” says Brickman. “We look at whether the people who worked for him went on to succeed because then chances are he can regenerate that team again.”
For Serent Capital, the importance of strong portfolio company leadership led the firm to designate one partner who focuses solely on recruiting, retaining and cultivating CEOs. Because most of the company’s acquisitions entail a CEO transition, the partner attends any serious meeting held with the leaders of prospective acquisitions and performs a full diagnostic on its management team. “We buy companies in the $20 million-to-$40 million revenue range, so who’s in that slot matters a lot,” says Ryan Kerrigan, the firm’s managing director. He emphasizes that the partner in question is both a former CEO and an executive-search-firm veteran. “We built that into the design of our firm. It’s that critical.”
Of course, what a private equity firm looks for in a CEO has to be tailored to the situation. “We believe there are two types of CEOs—peacetime and wartime generals,” says Latto, who says his firm generally buys “horribly run” companies and changes out the management team. “For example, it might be a poorly run, highly leveraged family business where you need to remove not only the CEO, but his two brothers, three kids and countless holding company relationships they had.”
Longroad Asset Management generally sheds the top layer of management, brings in a CEO and seeks to promote some of the competent people in the layer below to balance out the new leader’s skills set. “If your CEO is a tremendous salesperson, you want a strong operator and a very good finance person,” explains Latto, who seeks a team capable of covering the three key management areas: sales, operations and finance. “If he’s good financially, you need sales and operations.”
With troubled firms, often a special ist is in order. For example, a turnaround of the home decor company Design Within Reach demanded a CEO who could rally employees around dramatic change, recounts William Sweedler, cofounder and partner of Tengram Capital Partners. “We recognized that it was going to be the ultimate turnaround, so we had to find the CEO who could not only change the culture, but come in and take the surviving employees and motivate them and lead them in a new direction. Our search focused specifically on that.”
“Not every CEO is right for every role,” agrees Sam Levine, managing director and co-head of Eos Partners. “There are a lot of middle-market companies who don’t have great back office functional controls; they need a CEO who can help them professionalize to gain scalability and get to the next level. You have to look for what the situation calls for.”
At the end of the day, the portfolio company CEO and his or her working relationship with the private equity firm will play a large role in determining the portfolio company’s ultimate success or failure. “You really need to do your homework,” says Greg Grosch, founder of White Cap Industries. “It’s a puzzle and all the pieces need to be there. Missing any one can be disastrous.”