Leadership is often acknowledged as the most important internal determinant of a business’ performance. This equally holds true for private equity, where the calibre of portfolio company management is widely accepted as the number one reason for deal success or failure.
The value of leadership
Whilst it is very difficult to directly quantify the impact on financial value, or indeed isolate the contribution made by leadership from broader operational improvements, 94% of private equity managers responding to a survey by Teneo considered portfolio leadership as “very important” and believed it contributed an average of 53% towards investment returns.
“Portfolio leadership quality can make the difference between 2x and 4x returns” – Operating Partner, Global PE firm
“75% of the deals that go wrong do so because we backed the wrong management team” – Managing Partner, UK Mid-Market Fund
The leadership gap
Despite this overwhelmingly positive sentiment towards the value of leadership, the evidence from Teneo’s research shows a significant gap between the importance that private equity firms attach to leadership and the time, resources and capital they dedicate to optimising it.
Why is there a gap?
There are several reasons why the effort and investment in optimising portfolio company leadership lag behind its perceived importance. To understand the current landscape, it is first worth recapping the background and evolution of the private equity industry, as these significantly influence the current ways of working.
Since its beginnings in the 1960s, private equity has evolved enormously. Evidence suggests that prior to the Global Financial Crisis of 2008, much of the industry’s performance (returns) was generated from multiple arbitrage or the use of financial leverage. Therefore, whilst the calibre of portfolio company leadership teams has always been an important part of the investment equation, it was not necessarily the primary ingredient to the successful execution of the investment case.
Today, value creation looks very different. Private equity firms now need to demonstrate value creation initiatives across a broader range of investment strategies.
In addition, the companies in which private equity invest are increasingly from technology and technology-enabled service sectors. The general movement towards investing in higher valuation multiple industries like these means that the capability of management to drive growth and deliver operational effectiveness has become a much more important part of the value creation equation.
However, whilst private equity value creation models have evolved, the approach to assessing and optimising leadership has remained largely unchanged. The reasons for this include conflicting priorities of the private equity manager, ambiguous return on investment measures and a reluctance to change what has worked in the past.
How we think about leadership at Pemba
At Pemba, we operate in the smaller end of the market. We invest in founder-owned and often founder-run businesses. We believe that whilst capital is an important part of successful businesses, the most crucial element is the talent and leadership driving them. This is particularly true for smaller founder-owned businesses.
Accordingly, we have a really strong focus on PEOPLE. The goal and vision for a company permeate through the organisation from the founder and senior management team. Their energy, enthusiasm and passion are critical to the success of the company. It is that culture, vision and passion that creates the employee drive in a successful business.
Investors not operators
At Pemba we are investors and not operators of the companies we partner with. We back the key people at the heart of the business we invest in. This means we rely on (and trust and empower) the founder and senior management team to run the day-to-day business and drive the organic growth initiatives.
Our role is to support and guide the business on the next phase of its growth journey, as well as bring opportunities that can accelerate the growth of the group. Given these clearly defined roles, ensuring there is strategic fit and cultural alignment between the leadership of the partner company and Pemba is critical.
People due diligence
At Pemba, we spend a lot of time getting to know the people we will be backing to drive the business improvement initiatives to achieve the growth we are targeting for the business over our investment period (usually 3-5 years). We try to understand what motivates these key individuals, what their strengths are, their potential blind spots, etc. This enables us to think about how best we build out the senior team around them ensuring there are complementary skillsets, so the value of the whole is greater than the sum of the parts.
We’ve even had opportunities we walked away from because we didn’t feel there was alignment with the key people in the leadership team we would be backing.
A partnership for us is a long term commitment. We work closely with the founder and management team for a long time, typically 3-5 years and often longer. As well as being successful, the growth journey should also be a pleasurable experience. We want to work with people that we enjoy spending time with.
If you would like to understand more about how we think about the importance of leadership at Pemba, then please InMail me and we can discuss further.