Unplanned CEO turnover can harm financial results of portfolio companies

10 April 2018 Consultancy.uk 5 min. read
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Private equity companies that are considering a CEO change as part of their investment should think twice before they bluntly push for the change. Nearly half of private equity respondents in a new survey by AlixPartners said that an unplanned CEO appointment not only erodes financial performance, but also lengthens their investment hold times.

The private equity industry is booming, with more than $440 billion invested in buyouts last year, according to a recent analysis by Bain & Company. One of the measures which private equity managers commonly put in place in newly added portfolio companies is a new leadership team. While doing so is regarded by many as an effective way of re-aligning leadership competencies with the revamped strategy – often geared at growth or turnaround – a new study shows that displacing a CEO may, in fact, trigger harmful effects too.

In a survey of over 100 leaders in the private equity landscape (both from portfolio companies and private equity firms), AlixPartners found that when an unplanned exit of a CEO takes place, in only a quarter of the cases the financial performance of the company (measured by the Internal Rate of Return) improved. In 46% of the cases, it led to poorer performance, with 29% of the respondents highlighting no change in results. Moreover, 83% of respondents said that forcing a CEO to leave adds to the holding time of portfolio companies, which typically sits between five to seven years.

Impact of CEO turnover in private equity

Building on the above findings, researchers highlight that private equity players should weigh the CEO replacement decision with careful deliberation. One of the factors which should be considered is the timing of the change. Four in ten respondents (39%) said that it is most disruptive to replace a portfolio company CEO a year after the acquisition and a year before the exit. Interestingly, the vast majority of respondents (58%) acknowledged that replacements are in that period.

Another factor which is key for a successful leadership assessment is assessing the fit between the CEO’s capabilities and the new strategy defined for the business. The most used approach for assessing current or prospective CEOs is reference checking (87%), followed by meetings with private equity executives (81%) and interviews with external consultants (77%). More than half (53%) reported using personality assessments in their CEO evaluations, and 23% reported used cognitive ability tests.

When should private equity replace CEOs

The drawback of the approach is that investors tend to rely on sources that focus on CEOs’ past performance and current (subjectively assessed) characteristics. “These are relatively unhelpful for evaluating important dimensions of CEOs’ ability to deliver high performance in the future, which will rely on the potential to learn and change – that is cognitive and emotional flexibility – and cultural fit. As a result, investors may be getting only part of the picture of a CEO’s potential, one that doesn’t highlight how effectively he or she will be able to execute new business strategies defined by the private equity firm and lead the portfolio company in often unpredictable future environments,” stated Mark Veldon, a Managing Director at AlixPartners in the UK and one of the researchers of the report.

Getting insight into the full picture is, however, easier said than done. Respondents indicated that the most important drivers for high CEO performance, such as leadership skills and strategic thinking, are also the capabilities that are the most difficult to assess. To gain better insight into this, private equity firms should venture outside of the traditional third-party executive assessment approach and add alternative methods to the mix. These include structured interviews with leaders, aligned with the investment thesis, benchmarking candidates on both hard as well as soft factors, checking social media ratings on sites such as Glassdoor.com and conducting psychometric and behavioral assessment instruments whenever possible.

Misalignment of CEO capabilities

On top of ensuring that the best CEO is in place, private equity firms are also advised to do more once the chief executive is installed. Portfolio managers can set the stage for successful delivery on their investment theses by clarifying expectations about goals, performance metrics, and content; cadences and channels for interactions and meetings with members of each portfolio company’s leadership team. For CEO’s working in a portfolio company for the first time, investors can arrange meetings with peers at other companies in the investor’s portfolio who have more experience in the C-suite and in portfolio companies. “Through interactions with these more seasoned leaders, newcomers can gain vital insights into questions such as what role they’ll be expected to fulfill in the company over the investment life cycle and how they can best build a mutually beneficial relationship with their investors,” said Veldon.

Summarising the study’s main outcome, Veldon remarked “Clearly, the disruption triggered by ill-timed CEO replacements does little to help drive the return that private equity owners are looking for. Combine that disruption with the longer investment hold times that also come with unplanned CEO turnover, and it’s obvious that investors need a better approach. Improving CEOs assessment and CEO support can help.”

Related: Private equity companies quickly shed incumbent CEOs.