Maximising returns in challenging times: how leadership assessment can help PE unlock hidden value

As the economic environment becomes increasingly more challenging, there is an onus on PE to focus on, not just financial engineering and operational efficiency, but also previously neglected factors within their portfolio companies.

Firms that invest in their human capital, including the assessment and development of portfolio company talent, generate above average returns(1). After all, in a recent study, PE general partners, attributed 53% of returns to portfolio company leadership(2). With management teams facing the difficult task of balancing the day-to-day demands of running a business with the need for transformational value gain through M&A or accelerated organic growth, the most forward-thinking investment theses include a focus on the leadership capabilities needed to execute the chosen strategy.

Different approaches, organic growth vs. extensive M&A for example, require distinct leadership characteristics and assessment can distinguish between those who will help or hinder execution of the value creation plan. No two businesses, value creation plans, or C-suite leaders are the same, meaning that getting the right talent in the right seats has never mattered more. In this climate, leadership assessments offer a valuable tool to support data-led decisions in management due diligence, selection, development and succession planning.

A tougher economic environment requires owners to focus on talent to drive value

In today’s higher interest rate environment, the tried-and-tested playbook of financial engineering (and some operational improvement) can no longer be relied on to generate superior returns. In the first nine months of last year, buyout firms generated just $584bn from exits, around $100bn less than in the same period in 2022 and almost 66% less than the same period in 2021(3). Strong exits are not as easy to come by as they once were, meaning PE firms and management teams must work even harder to optimise businesses for exit.?

A recent Bain report indicates that PE firms globally are sitting on 28,000 unsold companies worth more than $3tn(4). At the same time, these firms have amassed huge war-chests that they need to invest, with dry powder hitting a record $2.49trn(5). Well-run businesses with strong management teams will still attract interest but, as most investors know, these aren’t always easy to find. So, with attractive targets in short supply, investors are re-examining how they can increase their chances of generating good returns on new and existing investments.

The quality of management, incumbent or new, is more often than not the differentiator in generating returns and more firms are looking to use human capital as a lever for growth. Many are developing a talent ‘playbook’ for their portfolio with one mid-cap portfolio talent partner remarking that they are seeing “far greater emphasis and focus on management teams across the deal lifecycle”. The increase in talent operating partners within PE value creation teams, the growing emphasis on the CPO/CHRO role within portfolio companies and the rising prevalence of function-specific, peer-to-peer learning events across entire portfolios are further evidence of this evolution.

Investors understand that undisciplined, uninformed hiring and development wastes time and money and they are taking steps to mitigate this. As many senior executives have only known a growth market and have limited experience of leading through times of economic stress (resulting in a shallow candidate pool that ticks the ‘relevant experience’ box), the best firms are looking to identify managers with the potential to lead successfully through tough economic times despite having never done it before. Creating value in this challenging environment demands a different skillset within the management team. Whilst focus, pace and execution remain paramount, leaders need to be entrepreneurial and flexible, but also able to adapt their communications to suit different stakeholders, ensuring they take everyone with them.

Leading a company through a challenging financial period, navigating a digital transformation or integrating numerous acquisitions requires specific competencies, traits and drivers. Structured leadership assessments done well can show how an individual will react under increased levels of pressure, providing further data points to predict likely performance in a given scenario relevant to the portfolio company in question.

Challenging deals like secondary buyouts, carve-outs and roll-ups are forcing senior leadership to develop a different skillset

The competencies needed to sell a business to PE are not the same ones required to deliver a new value creation plan in more complex situations. Evidence shows that the smartest firms make the necessary changes to the senior leadership team within the first year(6).

2023 was the second-biggest year for secondary buyouts on record(7). In these situations, most, if not all, of the low-hanging fruit (in terms of value gain) have been delivered by the previous PE owner, so the management team needs to be both creative and aggressive with their new value creation plan. The team that can formulate and execute that plan may be the incumbents, but often changes or additions are needed.

The success of roll-ups and carve-outs is highly dependent on the quality of senior leadership. 2022 was a record year for carve-outs with 3,808 deals completed(8), with the number of bolt-ons rising by 44%(9). Merging several companies together (integration) or separating a business from its parent company/division (independence) requires certain management skill sets (both in terms of personality and ability) but, in dynamic situations like these, the best teams and their leaders are flexible, resilient and creative, skills that are difficult to assess through CV reviews, unstructured interviews or referencing alone.

Longer hold times are increasing the need to invest in succession planning

As the economy becomes less predictable and early exit opportunities are harder to come by, PE firms are holding onto portfolio companies for longer, increasing the impact senior leadership teams have on investment returns. Last year, the average hold period for European funds (5.89 years)(10) and North American funds (7.1 years)(11) far exceeded historic norms of around 4 years.

Strategic talent management, including plans to retain and support talent as well as formal succession planning, becomes more critical as hold times increase. As the team at the start of a PE firm’s holding period is unlikely to be the same team at exit, early succession planning is being talked about in a way that it wasn’t five years ago. To mitigate the risk of unexpected senior departures impacting timing/returns, PE firms are also investing in the development of potential portfolio company leaders in a way they have not done before. Savvy PE firms recognise that investment in development reduces churn in key value-creating roles further down the portfolio company (including those not tied into a management incentive plan). The best leaders leverage the fact that a mere c.3% of the workforce shape the perceptions of c.90% of their colleagues, with assessments for development being used to retain that c.3% in the recognition that their support is pivotal to the success of a business undergoing significant change(12).

The ‘contract’ between employer and employee has changed in the last decade; successful managers understand this and use it to their advantage

Ensuring management teams can create and sell an employee value proposition to attract the right talent is as important as their ability to identify underperformers and make tough calls.? Finding leaders with EQ, who can spot potential, develop talent, give feedback and address underperformance, as well as role-model company mission and values, is critical to success in any people business. What the workforce expects from their business and its leaders has evolved over the last 10 years, especially post-pandemic, and the skills and traits required for success are impossible to ascertain from some of the less structured, less scientific hiring processes relied on in the past.

As the Global Head of Portfolio Talent at a US PE firm stressed, “Assessment for development very soon after acquisition can be the difference between a successful and an unsuccessful deal”. The really shrewd funds are also beginning to recognise the value in identifying those with high potential (at whatever their current level of seniority) who can be redeployed for roles in other companies within the portfolio, or in future acquisitions.

The wrong talent risks delaying exit, wasting time and money

The right leadership at the right time often correlates with investment outperformance, but the opposite is also true. Making the wrong hire delays exit and leads to lower returns for the PE owner. Laidlaw Associates’ analysis of c.80 C-level hires over 12 portfolio companies in one fund we have worked with shows that using leadership assessment increases the chances of hiring success from 50% to 70-75%, a figure that should translate through to improved investment returns whilst reducing distraction for the PE owner.

As noted, evidence suggests that successful deals substitute weak leaders for stronger ones within a year of the acquisition. New CEOs recruited within the first year of ownership generate an average return (3.09x MM) higher than those recruited two years after initial investment (2.15xMM)(13).

As a partner at a growth capital fund says, PE is “very wary of late C-level replacements that could derail overall returns”. As soon as possible, the investment team must consider the effectiveness of their management team, their individual strengths and weaknesses, but also how they work together and communicate with each other, with shareholders and across the business. Not having the right talent in the right ‘seats’ costs time and money, the two factors paramount to delivering successful PE returns.

A shortage of ‘PE tried-and-tested’ leaders means looking at alternative candidates

Progressive PE firms are increasingly using assessment to understand whether ‘step-up’/alternative candidates have the potential and growth mindset to run a portfolio company. It is hard to predict how an individual will fare as part of a management team and harder still to know how those from a PLC background, for example, will perform in a leaner, faster-paced environment(14). With only 29% of CEOs remaining in place at the end of a PE firm’s ownership(15), the failure rate for first-time CEOs is even higher, meaning that the more data collected to predict the likelihood of success, the better.?

Decades of research show that the combination of psychometric tests and structured interviews result in better hiring decisions than reviews of education, CVs, references and unstructured interviews. Structured assessments also limit the impact of a potential 150 types of cognitive bias, meaning ‘heads aren’t turned’ by charismatic leaders exhibiting style over substance(16).

If a buyout’s value creation plan is already in place, an assessment can be tailored to predict whether a candidate will be successful for the specific requirements of the challenge ahead. If the plan has not yet been determined, then focus can be turned to the generic capabilities known to be needed to lead successful buyouts, such as urgency, comfort with change, willingness to get ones’ hands ‘dirty’, ability to make decisions with incomplete information, and to communicate with clarity. Similarly, candidates with the aptitude and intuition to identify the value creation levers in a business, to shape strategy and deliver on its execution can also be determined. Furthermore, a thorough leadership assessment process reduces risk by feeding into referencing at the final stage of a hiring process, guiding investors to dig into very specific areas they may have otherwise overlooked.

Whatever the knowns or unknowns about the road ahead, assessments can be designed to select the most appropriate hire(s), many of whom may not come from the most obvious sources.

So where can leadership assessment add value?

By measuring the capabilities of leaders after a new acquisition or even pre-acquisition, a view can be established of:

1.?????????? How well their competencies and traits align with the delivery of the investment thesis. Data points can inform difficult decisions allowing PE firms and management to decide whether to invest in an individual or move them on.

2.?????????? Individual and team development needs, which can then be supported through one-to-one executive coaching or team development if appropriate.

3.?????????? Collective team weaknesses and skill set/competency gaps that need to be considered and mitigated through further hiring when development/coaching is not enough.

4.?????????? How well the management team understands the goals, whether they are committed to these and, ultimately, whether they can go the distance.

5.?????????? Whether the drivers and values of those leaders match the culture the investor needs for the investment to be a success.

But leadership assessment is being used to go further than this, with a trend towards:

1.?????????? Giving the chair and/or investor director the data and insights to get the best out of specific managers, both as individuals and as a team, and therefore the business.

2.?????????? De-risking ‘alternative’ hires, reducing the typical unknowns when recruiting from outside the sector and assessing potential in ‘step-up’ candidates.

3.?????????? Enabling management teams and PE owners to think more clearly (and in a data-led way) about what the business needs for successful succession planning.

4. ????????? Identifying high-potential employees further down the organisation, retaining and developing them so that they are ready to step up when required.

5.?????????? Deciding whether the management team in place is the right one to take the business to exit towards the tail end of the deal cycle.

Conclusion

The heightened focus on leadership assessment in private equity-backed portfolio companies reflects a strategic response to the complexities of generating strong investment returns in today's economic environment. As the business landscape continues to evolve, leadership assessment has become an integral component of the private equity playbook, ensuring portfolio companies are well-positioned to thrive in the face of uncertainty.

A rigorous multi-measure assessment process provides a broader view, deeper insights, and strengthens any decision-making process. Done in the first few months of ownership, directly against the requirements of the value creation plan, it can ensure the right talent is in the right place at the right time to drive success within that first year, a strong predictor of overall investment success.?

Likewise, assessment for development and succession planning can play a key role in maximising investment returns. Identifying those individuals further down the organisation who have an outsized impact on value-creation and then investing in their development and retention can only have a positive impact when it comes to exit.

Contact us to learn more about how assessments could act as a talent multiplier for your firm.

Caroline Rowland is a Chartered Psychologist and MD of Laidlaw Associates, a consultancy specialising in leadership assessment for investor-backed businesses.

Our assessments support data-led decisions in management due diligence, selection, development and succession planning.

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Sources

1 David Waller, Courtney della Cava, Kristin Schroeder and Rolf-Magnus Weddigen, ‘A Left-Brained Approach to Portfolio Company Talent Decisions’, Bain, 2021.

2 Josh Lewsey, Sue O'Brien OBE, Peter Callas and Jarek Golebiowski, ‘Leadership Alpha in Private Equity’, Teneo. 2022.

3 Samantha McClary, ‘Private equity firms face worst year for exiting investments in a decade’, Financial Times citing PitchBook data, 2023.

4 Bain & Company, ‘Global Private Equity Report 2024’, 2024.

5 Dylan Thomas and Annie Sabater, ‘Private equity dry powder swells to record high amid sluggish dealmaking’, S&P Global Market Intelligence citing Preqin data, 2023.

6 LCap, ‘Quantifying the impact of leadership in UK private equity backed businesses’, 2023.

7 Lazard, ‘2023 Secondary Market Report’, 2024.

8 Lindsey Canning and Guy Potel, ‘Carve-outs: A valuable tool for European firms’, White & Case, 2023.

9 Julian Longhurst, ‘Market Tracker: Q4 2023’, Real Deals, 2024.

10 Muhammad Hammad Asif and Annie Sabater, ‘European private equity holding periods extend as exit activity slumps’, S&P Global Market Intelligence citing Preqin data, 2023.

11 Karl Angelo Vidal and Annie Sabater, ‘Private equity buyout funds show longest holding periods in 2 decades’, S&P Global Market Intelligence citing Preqin Pro data, 2023.

12 Jeppe Vilstrup Hansgaard, ‘The 3% that make your change viral’, Innovisor, 2023.

13 Paul A. Gompers, Steven N. Kaplan and Vladimir Mukharlyamov, ‘The Market For CEOs: Evidence From Private Equity’, NBER.

14 Geoff Colvin, ‘How private equity’s hiring spree is upending the C-suite at public companies’, Fortune, 2023.

15 Paul A. Gompers, Steven N. Kaplan and Vladimir Mukharlyamov, ‘The Market for CEOs: Evidence from Private Equity’, NBER, 2023.

16 AESC, ‘Assessments for Executive Selection: Considerations for Search Firms’, 2021.