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CEO Co-Invest? An Analysis for Private Equity Leaders

HIGHLIGHTS

Some private equity funds offer co-investment opportunities to new portfolio company CEOs, other funds require it.

Aligned ownership, figuratively and literally, is key for private equity Boards and CEOs.

CEOs should use co-investment analysis as a proxy for whether or not they should join the company at all.

PRIVATE EQUITY ALIGNMENT

Private equity firms strive for alignment throughout their endeavors.

It’s a long held belief that portfolio company alignment can be achieved through management compensation packages that include an option/equity grant.  This strategy does create a certain level of alignment but at a relatively intellectual level.  Experience tells us that alignment is most powerful when it exists at both an intellectual, and at a deeply-rooted emotional level.

UNDERSTANDING THE PRIVATE EQUITY PERSPECTIVE

Private equity firms put their heart, soul and skin in the game by putting their own capital and the capital of their investors at risk on every deal.  The stakes don’t get much higher. The depth and intensity of a firm’s commitment is unflappable and all consuming.

THE CEO DISCONNECT – FOR THOSE WHO HESITATE TO CO-INVEST

CEOs accept a new position based upon a belief that an opportunity is worth changing the course of their career and often relocating (or spend significant time away from) their families.  So how can a CEO make such a significant professional and personal commitment and yet still hesitate to make the same financial commitment? 

A CEO who does not insist on co-investing may be suffering from a lack of true belief in the opportunity or in their own capabilities. Therefore, those not interested in co-investing may be unwise to accept the role under any circumstances.  Portfolio company CEO roles are difficult as it stands, that difficulty only increases if there is a question mark in about a CEO’s level of commitment and/or belief. CEOs anxious for alignment should insist on having the opportunity to co-invest to help forge a more meaningful partnership with their private equity Boards.  Investing also creates more wealth, taxed at capital gains, for the CEO.

CO-INVESTMENT AMOUNTS & TIMING

Co-investments should be a “personally meaningful” amount.  In general terms, a minimum of $100,000 is customary.  Target amounts between $250,000 and $500,000 are traditional.  Consider that a CEO is expected to deliver a 3X cash on cash return so co-investment can be an excellent wealth creation tool.  PE funds require that the CEO’s investment be made within 90 days of starting employment.

WHAT ABOUT PERSONAL LIQUIDITY CHALLENGES?

Many successful candidates are facing cash flow pressures such as college tuition and other expenses that impact liquidity.  In these and other cases, CEOs should investigate a self-directed IRA.  This tool will enable co-investment check to be written from a roll-over IRA without penalty.

ABOUT ROB HUXTABLE

Rob is a recognized expert on the topic of private equity CEO performance.  He is Founder & Principal of PrivateEquityCEO.com.  He is also Managing Partner of Integis which is the nation’s leading search firm focused exclusively on the private equity-backed, middle market.

Reach Rob here.

Recruiting a Portfolio Company CFO: A Field Guide for Private Equity CEOs

OVERVIEW

The best CEOs build the best teams.  And selecting the right CFO is arguably the most important decision a CEO can make when building her/his team.

CFO roles in private equity-backed, middle market portfolio companies involve greater rigor, urgency and expectations compared to finance leadership roles across other asset classes. Private equity firms and their portfolio company leaders face greater demands from investors, and multiples remain historically high. These realities place unprecedented value on a management team’s ability to execute at the highest possible level.


Millions of investment dollars are at stake and incremental multiple of invested capital (MOIC) will be gained or lost on a deal based upon the quality of the management team, including the CFO.



The Degree of Difficulty for PE-Backed CFOs is Compounded By:

  • Leveraged Balance Sheets
  • Private Equity Demands
  • M&A Integrations
  • Extreme Urgency
  • Finite Resources
  • Financially-Savvy Boards
  • ERP Implementations/Upgrades
  • Demands for Forecasting & Analysis

Historically, many CEOs have settled for CFOs who, in retrospect, were more-or-less strategic controllers or tactical CFOs. Today, leading private equity funds are actively raising their standards on CFO hiring. However, and in spite of the increased focus on CFO recruitment and assessment, CFO hiring mistakes consistently outpace mistakes made on other management team hires.

The bottom line is that talented private equity-backed, portfolio company CFOs are in rare supply and can be difficult to assess. The price paid for an average or poor CFO hire can be steep.

Poor CFOs Can Mean:

  • Frustrated CEOs and Funds
  • Poor Visibility into Company Performance
  • Earnings Restatements
  • Audit Adjustments
  • Poor Forecasting/Visibility
  • Covenant Violations
  • Ineffective Integrations
  • Underutilized ERP Systems

WHITE PAPER: THE 7 DEFINING CHARACTERISTICS OF AN ELITE, PE-BACKED CFO


 Contact Us
For a complimentary copy of the
complete CFO Recruitment white paper
which includes:

  • The 7 characteristics to evaluate during your CFO search and selection process
  • The intangible traits that best predict portfolio company CFO success
  • Most frequent derailers of private equity CFOs
  • Compensation analysis including salary, bonus & options/equity
  • Vetting guidelines


ABOUT ROB HUXTABLE

Rob is the Founder & Principal of PrivateEquityCEO.com.  He is also Managing Partner of Integis which is the nation’s leading search firm focused exclusively on the private equity-backed, middle market.  He leads the firm’s CEO search practice.

Top 7 Risks for First-Time Private Equity-Backed CEOs

OVERVIEW

Serving as the CEO of a private equity-backed company can be a rewarding challenge with significant wealth creation potential.  However, many executives underestimate the degree of difficulty of these uniquely demanding roles. As a result, first-time private equity-backed CEOs can be particularly vulnerable to derailment.

Private equity Boards:

  • Have minimal patience for learning curves;
  • Offer little in the way of onboarding and;
  • Demand results quickly.

Although there ample challenges to address, there are seven common risk factors faced by CEOs leading their first private equity-backed company.

SPEED

Private equity simply moves faster than other asset classes.  Period.  In spite of believing they move fast, many first-time private equity CEOs are at risk of being caught flat-footed by the break-neck urgency of private equity.  Speed of execution is paramount and arguably the most important thing any CEO can contribute to value creation.  Maintaining a private equity pace for many years is easier said than done.

TEAM

Private equity CEOs must quickly assess their inherited management team’s horsepower and act decisively to replace, upgrade, coach or create key positions.  In the corporate world, leaders are used to relatively more methodical management of human capital and often benefit from the support of a sophisticated human resources group.  CEOs would be wise to make a call on each key management team position within their first 90 days.  If a key role requires action, now is the time.

HANDS ON

Many corporate leaders view themselves as hands-on only to find out the hard way that their private equity sponsors have a more intense interpretation of this concept. Private equity-CEOs must be quasi-micromanagers who work alongside their teams with sleeves rolled up and with proverbial dirt under the fingernails.  CEOs must also have a clear command of the business details…a necessity that will be tested during each monthly operating review and quarterly Board meeting.

RIGOROUS GOVERNANCE

Private equity drives rigor and process into everything it touches, including portfolio company governance.  Leaders can anticipate lively calls with the Board chairman each week; intensive, on-site monthly operating reviews; and rigorous, quarterly Board meetings.  Along the way, CEOs will encounter a variety of other demands from their sponsors that add to the pressure to perform.

MANTLE OF CEO RESPONSIBILITY

Private equity-backed CEOs play a huge role in value creation.  They do so without the benefit of a traditional boss or team of peers.  Portfolio company CEOs are on an island of accountability and pressure.  Even the most rigorous corporate cultures don’t fully prepare a Division President for the transition into the realm of private equity.

FINANCIAL SOPHISTICATION

True P&L experience is a viable training ground for a private equity CEO.  However, these P&L roles benefit from treasury as a shared service.  As a result, these leaders often understand how to drive a P&L but can struggle when it comes to the competing dynamics of the balance sheet.  First time CEOs also lack experience partnering with a full credit CFO and managing through the many and varied cash flow issues seen in an LBO.

“PETER PRINCIPAL”

As many know, the Peter Principal states that all leaders will be eventually promoted to the point of incompetency.  Many strong corporate leaders simply can’t successfully make the transition into a private equity-backed CEO setting.  The degree of difficulty of these assignments is among the most challenging in business. One imperative for any candidate considering the transition in to private equity:  be intellectually honest with yourself about the challenge ahead.  Many candidates can get caught up in competing for a private equity CEO role and can miss the important step of diligencing their own capabilities against the gravity of the portfolio company challenge

SUMMARY

In my experience, first-time private equity CEOs can be just as effective as their more experienced counterparts.  However, they face unique challenges that should be openly explored during the search process.

 

CEOs vs. Private Equity Boards (Part III – Operational and Detail orientation)

In a recent post, we dug into the differing priorities of Boards and CEOs cited in the Boston Consulting Group’s “Private Equity and the CEO, Partners in the Quest for Value”.  Following is a more focused analysis of two of that report’s findings on the competing priorities of Boards and CEOs.  Among other questions, BCG asked investors and CEOs about the following:

  • Operational vs. Strategic focus: more private equity investors responded that CEOs should primarily take on an operational focus while more CEOs responded that strategic focus was the priority;
  • Big picture vs. Detail orientation: more private equity wanted CEOs to balance details with the big picture while more CEOs stated they should primarily have a big picture orientation.

Lost in Translation

During the recruitment phase, CEOs and Boards typically agree on the importance of being operationally oriented and minding the details.  However, much is lost in translation due to a lack of mutual understanding.

The CEO Perspective

In my experience, many CEOs (especially first-time private equity-backed CEOs) don’t fully understand the extent to which private equity Boards need them to be operationally focused and detail oriented…essentially, hands on.  Many CEOs believe they understand the needs of private equity only to find that they are out of alignment once in the seat.

Understandably, many CEOs are excited about the opportunity to leverage their strategic skills.  Many successful CEOs have also developed a habit of delegating and then trusting their teams to execute.  Unfortunately, the above two perspectives will usually result in a poor relationship between the CEO and the private equity Board.

The Reality of Most Private Equity-Backed CEO Roles

Private equity investors buy a company with a clear investment thesis in mind.  They then refine that thesis with a strategic planning process that, in many cases, can take place prior to the arrival of a CEO (depending on the timing of the search within the hold period).  As a result, CEOs need to understand, buy-in and confirm the extent to which they can  (or cannot) refine the Board’s strategy.  While maintaining a strategic perspective, CEOs need to be deeply rooted in operational initiatives (execution) while remaining completely aware of the details of their portfolio companies.

Private equity CEO assignments are serious and require truly outstanding, detail-oriented execution.  In my experience, private equity wants execution-oriented operators with a strategic value add.  They typically do NOT want strategists with an execution value-add.

This means that CEOs must:

  • Possess a deeply-rooted President/COO mentality that stays fixated on execution;
  • Be quasi-micro managers.  Private equity CEOs must trust AND verify while living in the detail weeds.

The Intellectual Honesty Question

The best private equity CEOs love the asset class for the challenge, the opportunity to grow, the accountability tied to creating value for investors and the chance to create wealth for themselves.  However, they also understand these CEO roles are not sexy, strategic, high-flying assignments.

Instead, the best leaders realize these mandates are exceedingly difficult, require heavy-lifting and continuous focus on execution while maintaining a command of the details.  A private equity Board meeting is no place for an overly strategic, hands-off leader who lacks detailed insight into her/his portfolio company.  CEOs and Boards must help one another candidly and accurately assess the fit on these issues during the interview process or face a high risk of derailment.

CEOs vs. Private Equity Boards (Part II – Risk Taking vs. Risk Mitigation)

Overview

In a recent post, we dug into the differing priorities of Boards and CEOs cited in the Boston Consulting Group’s “Private Equity and the CEO, Partners in the Quest for Value”.  Following is a more focused analysis of that report’s findings on risk.  When BCG asked investors and CEOs about risk, more private equity investors responded that CEOs should primarily focus on risk-taking while more CEOs responded that risk mitigation was the priority.

The Private Equity Risk Perspective

CEOs must understand that financial sponsors are risk-takers by definition.  Consider that many Investment Partners are entrepreneurs who started their own firms.  Moreover, most private equity funds employ less than 50 personnel so, in spite of their portfolio size, they are risk-tolerant, small companies in their own right.

Further, private equity firms are in the business of taking risk on behalf of their LPs. Private equity is a top performing asset class, in part, because its risk appetite.  Additionally, private equity firms only own their portfolio companies for a finite period putting a premium on moving the ball down the field quickly…moving fast means incurring risk.

Finally, private equity firms realize that they must drive meaningful change in their portfolio companies if those businesses are to grow even faster and/or turn around even more quickly.  Driving change is hard, and, represents risk.

The CEO Perspective

Unless they have been true entrepreneurs, most private equity CEOs have advanced in their careers, in part, by properly managing risks for themselves and their businesses.  If not properly balanced, this otherwise responsible perspective may be at odds with the private equity’s ambition.

When running a private equity-backed company, many CEOs are conflicted by what they perceive to be competing forces — driving a winning equity outcome and protecting their positions/careers.  Ironically, a conservative leadership approach usually leads to a derailment.

The Psychology of Risk for Many CEOs

As human beings, many CEOs fear failure and therefore can sometimes postpone important initiatives.  They also operate under the scrutiny of high-horsepower Boards and do not wish to fall out of favor with their private equity sponsors. Some CEOs can lack the confidence and self-assuredness required to accept failures as part of a winning formula.

The Winning Approach for CEOs

In my experience, one trait required of all great private equity CEOs is an intense bias for action.   The best CEOs are always moving forward and taking high-velocity, focused action at all times.  With these ideal leaders, risk is mitigated one of two ways: a.) they fail fast on incremental steps and recover quickly; and/or b.) they rely upon the wisdom of their Boards to help make strategically decisions that can benefit from the wisdom of the team.  Private equity Boards appreciate this action-oriented, risk-tolerant approach from CEOs and will be more forgiving when setbacks do occur.

CEOs vs. Private Equity Boards – Where to Focus (Part I)

Overview

In the piece “Private Equity and the CEO, Partners in the Quest for Value”, a Boston Consulting Group survey revealed instructive disconnects between PE investors and CEOs in terms of CEO success factors.

Areas of CEO and Board Alignment

The survey revealed general alignment between CEOs and PE investors on the following:

  • CEOs should balance their focus on the long and short-term.
  • CEOs should balance consensus building with direction setting.
  • CEOs should be driven by a balance of process and ideas.

Areas of CEO and Board Disconnect

However, the survey revealed three significant disconnects that can threaten deal performance.  My own experience in working with private equity Boards and CEOs supports BCG’s research here:

1. STRATEGIC PERSPECTIVE vs. OPERATIONAL PERSPECTIVE

  • The most common response from CEOs is that they should be primarily strategic in their perspective
  • In contrast, the most common response from PE investors was that CEOs should primarily take an operational perspective

2. BIG PICTURE vs. DETAIL ORIENTATION

  • The most common response from CEOs was to focus primarily on the big picture while placing a lower priority on the details.
  • In contrast, the most frequent response from PE investors was that CEOs should take a balanced approach that emphasizes details as much as the big picture.

3. RISK TAKING vs. RISK MITIGATION

  • The most common CEO response was to prioritize a balanced approach between risk taking and risk mitigation
  • In contrast, the most common PE investor response was the prioritize risk taking

In my experience, Boards and CEOs often fail to be intellectually honest about their differing perspectives during the interview and CEO selection process.  The philosophical fit between a Board and CEO will either contribute to alignment or to friction.  The latter can be dangerous for LPs, GPs and CEOs.


In upcoming posts we will address the psychology and behavioral traits that can contribute to CEO derailment in the aforementioned three buckets.

Takeaways for Boards and CEOs

For Sponsors

  • Come to terms with your own governance model and how/where past CEOs have suffered from disconnects that have led to poor performance.
  • Realize that many CEO candidates have an uninformed view of private equity’s needs.
  • Recognize that meaning is often lost in translation during the interview process….for example, most CEOs think they are hands-on but may not come close to PE’s definition of getting in to the details.
  • Take a careful approach during CEO recruitment to conduct behavioral interviews that reveal a CEO candidate’s preferred orientation.
  • Search for CEOs that are a philosophical extension of your fund.
  • Avoid the cognitive bias in interviews that will lead you to see what you want vs. what is true.

For CEOs

  • Understand that each private equity firm has a unique view of where CEOs should focus.
  • Accept that you may be a great fit with one fund and a derailment statistic with another fund.
  • Moreover, understand that often each deal partner represents a sub-culture within a private equity firm.
  • Take time to explore a particular fund’s (and deal partner’s) needs and preferred areas of CEO focus.
  • Exercise intellectual honesty to critically self-assess your fit with a particular sponsor backed role…far, far better to walk away than suffer derailment 1 or 2 years in to the role.
  • Consider that, in my opinion, the single biggest predictor of your success will be the alignment (or lack thereof) you enjoy with your private equity Board.

About Rob Huxtable

Rob serves as the Managing Partner of Integis, a retained executive search firm with offices in New York, Cleveland and San Francisco that is exclusively focused on the private equity-backed, middle market.  The firm’s mission is to drive multiples of invested capital (MOIC) for private equity firms by recruiting high-impact portfolio company C-Suite leaders.  The firm has played a key part in helping many of its private equity clients achieve top-quartile and top-decile results.  Under Rob’s leadership, Integis has been recognized as one of America’s fastest growing privately held companies by the Inc. 5000 for 2015 and 2016.

CEO Performance Insights from Pete Carroll and Dr. Michael Gervais

OVERVIEW

I highly recommend investing 45 minutes in Dr. Michael Gervais’ interview with Pete Carroll. on the topic of performance-cultures.   Michael Gervais is a high performance psychologist who works in the trenches of high-stakes environments, where there is no luxury for mistakes, hesitation, or failure to respond.  His client roster includes an MVP from every major sport, internationally acclaimed artists and musicians and Fortune 25 CEO’s.  Pete Carroll is the Head Coach and EVP of the NFL’s Seattle Seahawks.

Gervais is also a great Twitter follow for those interested in performance psychology and leadership.  You can also subscribe to his podcast here.

MY SUMMARY BULLETS

  • Carroll’s leadership is grounded in one philosophy: he competes to master the art and science of helping people achieve their very best.  He sees that his “job is to help people be the best they can be.”  He develops this mentality within everyone in his organization.
  • Carroll’s laser focus is on process and performance – NOT on winning.  Winning is the goal of course, but the FOCUS is competing in every moment to help everyone be their very best.
  • Outcomes are merely information/feedback to guide you on your journey toward mastery.
  • Presuming solid talent, teams are VERY difficult to beat when they perform at their best.
  • Carroll puts 100% of his focus in each moment, he lives in that moment and nowhere else while paying attention only to what he can control.
  • Leaders need to be great at focusing…and that requires practice – on focusing!
  • To help others be their best, leaders must understand their teams infinitely well.  Carroll advocates that leaders must “learn the learner.”  Leaders must understand what their teams need, whether they know it or not, to be their best.
  • Carroll’s approach is built on a premise of LOVING what he does and, more importantly, loving who he helps.

MY TAKEAWAYS FOR PRIVATE EQUITY CEOs

  • CEOs should NOT consider this approach if they don’t share Carroll’s sincere and deeply-rooted love for teams and the organization.
  • Building a performance culture (rather than outcome culture) can be a powerful model for a portfolio company if well executed.
  • I submit that private equity firms would generally support this approach despite traditionally being laser focused on outcomes.  My rationale is that they are just as interested in process, execution and continuous improvement. And, any approach that grows EBITDA and revenue will of course be well-received.
  • A performance culture has many powerful benefits than can drive value creation for private equity firms, including but certainly not limited to:
    • Continuous commitment to getting better throughout the organization.
    • Greater resiliency to setbacks because teams move on to what’s next rather than dwelling on the past.
    • Teams are less susceptible to taking their collective foot off the gas after a big win…again, it’s 100% focus on moving into the next thing – and to getting better.
    • Leadership habits are cultivated at all levels of the organization.  This outcome builds a more powerful bench and acts as an organizational development mechanism that includes a stronger succession-planning culture.
    • A-Players will want to work for CEOs who adopt this cultural approach making it easier to build world-class teams.
    • Well-executed performance cultures can deliver sustainable, market out-performance.

As with any culture, CEOs must be ALL IN.  Every CEO I interview talks about culture but, unfortunately, not all CEOs share Carroll’s level of commitment, passion and enthusiasm in this area.  CEOs need to ensure that their hearts are in the culture game, not just their minds.