C-suite turnover is epidemic in lower middle market private equity (LMM) portfolio companies, a reality that, not surprisingly, can seriously damage or even derail the value creation process.
The challenge – and its solution – is tied to the unique nature of these ventures and their corresponding need for CEOs and CFOs with the skillset and background to identify and manage the outliers – portfolio investments that stand out because of their particularly strong – or poor – performance.
In short, LMM portfolio companies need outlier CFOs – highly experienced financial managers with a keen understanding of what builds portfolio value, and what hurts it.
A recent survey of 100 PE firm partners and portfolio company CEOs conducted by a partnership of Vardis and AlixPartners revealed that CEO turnover occurs during the hold period in 73% of PE deals. Based on my 13 years of working with LMM PE portfolio companies, I would say the 73% figure is too conservative – and this applies to CFO churn as well.
Among other reasons, I believe the turnover rate in the LMM is higher than for PE deals in general due to “unplanned” CEO exits wherein the CEO (often times the pre-deal majority owner) underestimated the changes wrought by now “having a boss” and find the new arrangement untenable.
Disagreements over strategy, goals, speed of change, etc. can often drive a change at the top, and likely more so with single Owner/Founder sellers typically found in LMM deals. Obviously the turnover of CEOs can be very costly both in terms of dollars as well as time, and often derails planned exit timing.
Underestimating CFO Churn
I also believe the turnover rate for LMM CFOs is higher than 73% given CEO turnover will often cause CFO turnover (among other reasons I will cover in future postings) – CEOs often like to build their own teams, with the CFO arguably being the #1 most critical hire.
When the CEO leaves, the CFO often follows. In my experience, the high level of CFO turnover in the LMM can often be driven by the difficulty in finding a CFO who can flex as the company grows from lower middle market (revenues less than $100 million) to middle market and onwards.
A LMM portfolio company CFO typically wears many hats (often responsible for not only the CFO role, but also IT, HR, Procurement, etc.) so a broad skill and knowledge base is critical in the early days, as is the willingness and capability to manage these other functions simultaneously.
Early on much of the LMM CFO’s time is spent on the nitty gritty of setting up and running a professional accounting function with typically lean resources as the “day job.” As the company grows the CFO’s ability to help manage organic growth via scalable systems, controls, and analysis as well as integrating add-ons often across multiples sites and the ability for the CFO to provide strategic input becomes more important.
In my experience, the high level of CFO turnover in the LMM can often be driven by the difficulty in finding a CFO who can flex as the company grows from lower middle market (revenues less than $100 million) to middle market and onwards.
Finally, as the business grows towards the upper limit of the LMM, the focus of the CFO becomes much more strategic. The IT, HR, Supply Chain, etc. functions that the CFO had been responsible for often times have been staffed with functional specialists by this point, and the CFO role is now more focused on the core accounting/finance role and fully developing a “business partner to the CEO” role. Finding one CFO that can manage this transition is difficult.
The High Cost of CFO Churn
In my nine years as Group CFO for the Riverside Micro-Cap Fund, I led the effort to hire CFOs for over 30 portfolio companies, sometimes having to replace CFOs we hired more than once for the same company (costly mistakes). This inability to “grow with the business as it grows” was perhaps the #1 driver for CFO turnover in the Micro-Cap Fund.
Dr. David Brophy, professor at the Ross School at the University of Michigan during my MBA program used to apply the “different horses for different courses” axiom to a number of aspects with regards to the private equity industry – and it applies very nicely to the CFO function. An excellent CFO during the growth to $100 million revenue stage (broadly the dividing line between lower middle market and middle market), may not have the skill set to manage once the company grows beyond $100 million.
Further, changes in market conditions, internal operational problems, etc. can often challenge CFOs (not to mention entire management teams) who were not hired initially for a turnaround or workout situation, but now find themselves having to deal with cash crunches, covenant and lender issues, severe cost reduction initiatives, falling morale, etc. CFOs accustomed to a stable, measured growth business will often find themselves unable to contribute effectively when business conditions head South (or very rapid growth stresses the team and systems), and the role is more turnaround oriented.
How Outliers Helps
Outliers was developed to address these issues. Our “Acquisition through Exit Services” (ATES) offering is intended as an overlay to the existing finance staff (which could be as minimal as a bookkeeper or office manager or an outside accountant, etc.) for a new acquisition. We provide PE experienced CFO expertise to augment the existing accounting staff during the LMM portfolio company hold period.
Once the deal is consummated, the Outlier CFO Partner will drive the establishment of internal controls, reporting disciplines, metric scorecards, contribute significantly to the 100 day plan, establish cash forecasting, and handle net working capital true-ups, earn-out metrics, etc. – this is what we call “Foundation Building”. The level of effort required during the Foundation Building stage is significant and results in a lean, well-functioning accounting/finance function within the portfolio company, augmented with the Outlier CFO Partner.
The portfolio company management team and PE deal team will have a common set of metrics, timely and compelling financial information and analysis, strong internal controls, etc. – i.e. a solid foundation from which to grow. The Outlier CFO Partner continues to be involved with the business as the business goes into the “Growth and Challenges” stage which typically comprises the bulk of a portfolio company hold period. This stage is characterized by scaling the business for organic growth, helping deliver and integrate add-ons, address and resolve business challenges (e.g. cash crunches, very rapid growth, operational issues, etc.).
It should be noted significant changes to the business such as the acquisition of a large add-on can force a re-visit of the foundation built earlier for revision and enhancement. Finally, the Outlier CFO Partner helps prepare for the eventual exit of the business. We believe preparations for exit should begin on day one after the initial acquisition, but take on added focus and intensity roughly two years ahead of the projected exit date.
The Outlier CFO Partner will assist in preparing for exit including the build out of the data room, additional analyses, preparation of road show materials, etc. It should be noted, Outliers can provide flex resources above and beyond the CFO Partner who originally teamed with the portfolio company – when needed, Outliers can provide additional CFO Partners to help with add-ons, special projects, exit prep, etc.
I believe Outliers can help reduce or eliminate CFO turnover by providing PE and industry experienced resources, matched to the correct stage in the portfolio company hold period. We can provide the correct horse for the various courses encountered as the portfolio company grows!