[This post originally appeared in Mainsheet Operating Partners blog, found here.]
A majority of the CEOs tasked with transforming PE portfolio companies into lucrative exits are instead being replaced within the first two years of the investment, thereby putting both the reality of those plans and their timetables in real jeopardy. Meaning that solving CEO turnover in PE companies is critical to industry success.
That is the consensus of a recent PE industry survey, which also suggests that much of this executive churn could be avoided through a more intelligent approach to due diligence, planning and managing the relationship between the CEO and ownership.
To those of us with significant PE-CEO experience, what’s most surprising about the survey isn’t its results but rather that anyone should be surprised by them at all. Replacing a portfolio company CEO may be a necessary evil but the IRR implications for PE funds are significant.
The Risks of CEO Churn
Today’s high asset prices are placing increased pressures on PE investments, requiring focused, steadfast approaches to value creation that quite naturally depend on an effective CEO and leadership team. Which is why the survey’s results – including the revelation that “an astonishing 73% of CEOs are likely to be replaced during the investment life cycle” – is such bad news for the PE industry.
The risks associated with CEO churn include:
- Time – One of the most precious of PE commodities, recruiting the right CEO can take six months or longer.
- Cost – Impact on EBITDA is very real, with agency and recruiting costs often exceeding $100k.
- Plan Execution – The plan underpinning the investment thesis could be slowed or altogether derailed during the search for a replacement CEO.
- Business Performance – Additional impact on EBITDA as productivity slows or stalls under a lame duck CEO.
- Risk – If you got the CEO wrong once, what’s to stop you from making the same mistake again?
In short, the loss of a CEO represents a major risk to the plan and investor returns.
How Operating Partners Reduce CEO Churn
Experience has taught us that an Operating Partner (OP) can be instrumental, not just to CEO longevity, but to plan success and investor returns.
In the survey 78% of PE owners cited pace of change as a major problem in their CEO relationships. It’s not a big leap to assume that the rate of CEO turnover is directly related to this conflict.
Pace of change (or assumptions about it) is critical as it underpins the whole investment case. Equally important, however, is the ownership of and commitment to that timeline. In our experience, bridging the gap between the investment thesis and the execution plan is something that needs to be tackled early and consistently across the life of the project.
As an example, not so very long ago we were involved as OP in a complex carve out of an Italian based aerospace flight control systems business. A major part of our role during diligence and immediately after was working with the executive team on the execution plan and resolving a number of problems, including:
The internal performance improvement plan was found to have too many elements. We pared back and focus only on the most critical elements.
The carve out plan faced substantial contractual and cost risks. We simplified the tasking and re-negotiated from a point of strength and knowledge.
The key here as OP was to ensure that the CEO, his leadership team, and the PE owners were fully engaged with and committed to a single plan and that that plan was as simple and focused as it could be.
The result: The CEO remained in place for the hold period and the fund exited with 10x investment.
2. Reality Check
In general terms, a PE fund should be able to rely on its OP to mitigate many of the risks associated with the longevity of a portfolio CEO, especially with regard to the pace of change and the investment model.
Pre-close, OPs should be able to apply their experience to the model presented by management and input a seasoned view on the reality of the pace of change.
Perhaps more important, post-close, there is a small window of opportunity in which the CEO and the OP can come to terms with the reality and the detail of the execution plan and present a refresh if it is needed.
In our opinion, an OP’s most important role is during the hold period when plan focus is key. The right OP will work with the CEO and leadership team to ensure the execution of the plan underpinning the investment model; and hold their feet to the fire to ensure critical plan projects are completed at pace in order to deliver investment returns.
Obviously, being able to deliver the plan is central to the CEO and OP roles. But so too is the ability to recognize risk before it occurs, and to present a cogent recovery plans should the plan start to slip and create problems between the CEO and PE owners.
Which is why an OP should always be a seasoned executive who has the social intelligence skills to gain the trust of the portfolio CEO. The Operating Partner should be spending enough time working on the portfolio company to have deep insights that can be shared with the CEO, based on an informed opinion.
Some degree of CEO churn will always be with us. But a good OP can reduce that by flagging an impending issue with the CEO in good time and put in place corrective actions to avoid the exit where possible. If/when turnover does occur, the OP should possess sufficient insights into the company, its management dynamics, and culture to offer clarity on the key requirements of a new CEO.