Value creation and value creators: Human capital challenges in private equity

Of all the investments which private equity firms make, human capital is uniquely important. During a recent discussion with operating partners from leading private equity firms, they talked about their approaches to managing the executives who help them add value and realize strategies.


 

Gaining buy-in

This process starts with getting buy-in to the value creation road map. Mike Monahan, National Managing Principal of People & Community for Grant Thornton said, “It’s really important that stakeholders understand and fully buy in and evangelize to the value creation road map. It isn’t just enough to document it.” Monahan recommended strategies such as changing the cadence of discussions about the road map with the members of the management team. These changes in form are sometimes as important the content to be discussed; they encourage fresh perspectives and acknowledge behavioral styles while also giving time to reflect and consider how best to support shared objectives.

Private Equity operating partners echoed the importance of acknowledging behavioral, cognitive, and cultural styles and have had success with this at the due diligence, debrief, and off-site team-building stages of the process. By accounting for these differences, PE firms should be able to more effectively communicate their intentions and generate enthusiasm for their plans. The remaining challenge is precisely connecting behavioral styles to the value creation road map.

It’s also important when getting buy-in to acknowledge the core objective of the private equity firm: to give investors back maximum returns on their investment. This means scaling companies rapidly, creating a more valuable organization and selling them. The executives who built the company into an attractive private equity investment know that they will likely be replaced. The skills which built the company to that stage are often not the skills which scale a company and prepare it for the next step in the journey.


 

Aligning incentives

So how do you align incentives so that the executives perform at the highest levels? Carlos Ferreira, Grant Thornton, National Managing Partner, Private Equity phrased the question even more specifically, “How do you transition while still keeping the founders’ intellectual property and knowledge?” Some answers are straightforward: Award the leadership team profit units in a pool which is shared with the private equity firm. This way, they both succeed together. It’s also important to simplify the short-term incentive plan so that it aligns with the investment thesis and value creation plan. The already powerful motivator of equity can be further enhanced when vesting is triggered by specific performance goals aligned with the value creation plan.

Key metrics typically go beyond EBITDA to a more balanced set of metrics which could include bookings, revenue, and growth. Because there is a natural offset between revenue growth percentage and EBITDA, a goal which combines the two often works well.

Of course, one key to managing the best executives is to not overmanage them. Participants believed in letting good teams do what they’re best at. At the same time, the founding executives should have regular communication with the private equity firm and access to resources who can help them navigate the new water they’ve entered.

The board is key here. One emerging best practice is to have board members who can confidently and successfully lead in an executive capacity but who are not necessarily looking to fill a role in day-to-day leadership. This provides a ready successor without having current leadership feel like they have someone hoping that they fail. Instead, they can show by example what next level leadership looks like and also be prepared to step into a role very quickly, if a need does in fact arise.


 

Defining nonfinancial metrics

Ferreira raised the challenges of carbon footprint and DE&I—values which fall outside of traditional accounting measures but well within current discussions of corporate responsibilities.

Participants have not yet defined success metrics for these, but they have taken serious steps toward acknowledging these values. This means discussions with their firms and even with other PE firms about defining what a baseline might be so they can determine what “good” looks like.

To facilitate that discussion, some firms are initiating affinity groups across their holdings. Such groups will help define issues, formulate metrics, gather data, identify leaders, and suggest best practices. At the same time, firms are collecting data through other means—which is challenging—and then harmonizing and iterating that data so it’s meaningful.

Firms which do business internationally face additional challenges. Inclusion looks different in different parts of the world. Monahan commented that, “The international challenges highlight the importance and complexity of these questions and what is called intersectionality. Exactly what diversity matters—and do the same things matter in the European Union as in North America or on the continent of Africa? What happens when affinity groups overlap?”