Ten Tips for Hedging Leadership Risk

The private equity market has enjoyed tremendous growth during the past decade, driven primarily by the siren song of double-digit investment returns and the seduction of "dot-com" mania.

To their credit, the majority of leveraged buyout, venture capital, and mezzanine financing firms delivered superior returns to their investors throughout much of the 1990s.

But the heady days of the latter years of the previous millennium are gone. Today, private equity firms are facing profound challenges from all fronts, including reluctant investors still reeling from disappointing forays into high tech, increasingly conservative lenders, and recessional economic trends that are dampening prospects for growth at portfolio companies around the globe.

When "Soft" Becomes "Hard"

Shifts in the private equity marketplace are forcing many investment firms to hold onto their portfolio companies longer than they might prefer, and general partners are increasingly expected to assume more influential roles in the day-to-day management of these portfolio businesses.

Herein lies a major problem.

Although private equity firms are bastions of sophisticated financial and economic risk analysis—and their deal-making prowess is unparalleled—they typically fail to address the single issue that most impacts the success, or failure, of the businesses they control.

What is this nemesis of business success and higher returns? It is the failure of general partner representatives to effectively govern the companies they control.

In particular, it is a failure to effectively manage the executives that lead their portfolio businesses, especially the CEO and his or her senior team. Too many otherwise sophisticated investment professionals make the assumption that company executives always act in ways that encourage value creation. After all, aren't the majority of executive teams rewarded based on company performance?

Frequently, however, CEOs and their direct reports behave in ways that actually dampen growth and hinder profitability.

For all of their financial acumen, private equity professionals typically underestimate the impact that so-called "soft" issues (e.g., leadership, culture, governance, etc.) can have on the businesses they steward—and their CEOs are generally complicit in this failure.

What Is Leadership Risk?

In fairness to private equity firms, much as doctors make the worst patients, executives are notoriously difficult to manage.

The mindsets and behaviors of the men and women who lead portfolio businesses are constantly in flux (e.g., individual executives come and go, senior team dynamics shift over time, workplace behavior changes under personal stress, etc.).

And, since these mindsets and behaviors can directly impact portfolio value, these "soft" variables introduce a host of nonfinancial uncertainties into the risk assessments that guide most private equity decisions.

These uncertainties constitute a significant "leadership risk" that typically goes unmitigated (i.e., un-"hedged")—even by experienced general partners and their board-of directors counterparts.

Identifying and Hedging Leadership Risk: Practical Guidelines

The good news is that the various elements of leadership risk are readily identifiable.

The bad news, however, is that few investment teams make mitigating these risks a priority. Those charged with post-acquisition governance of portfolio companies should first diagnose the degree of leadership risk exposure at each portfolio business—and then move to hedge this risk, using an assortment of intervention strategies.

There are 10 readily identifiable elements of leadership risk—and listed below are 10 practical, realistic guidelines for managing these within a portfolio business.

This list is not comprehensive, but it addresses many of the factors that commonly contribute to portfolio company underperformance.

Tip #1: Avoid Conventional Wisdom Traps
Tip #2: Force Executives to Focus
Tip #3: Ensure Senior Team Alignment
Tip #4: Tame the "Controllasaurus"
Tip #5: Encourage Listening
Tip #6: Think Globally
Tip #7: Energize Product/Service Development
Tip #8: Instill Cultural Sensitivity
Tip #9: Understand and Address Executive Insecurity
Tip #10: Stop Wasting Valuable Time

Tip #1: Avoid Conventional Wisdom Traps

All CEOs and senior executives make judgments and decisions based, in large part, on their perceptions about the world around them. These perceptions are susceptible to both conscious and unconscious biases, based on the executive's experience, background, and personal world view.

Especially for executives who have long tenure within a particular company, industry, or functional area, the risk of falling into a "conventional wisdom" trap is great. This risk is especially insidious, since conventional wisdom is often based upon past realities ("it used to be true"), instead of current facts.

When decisions are reached and strategic direction is defined based upon conventional wisdom or faulty assumptions about the environment in which the company operates, the leaders have put the company and its many stakeholders at significant risk.

To manage this risk, private equity professionals need to ensure that the executive team is identifying and challenging all assumptions—and replacing them with facts about market potential, customer behaviors, distribution channel dynamics, competitor reactions, internal
processes, etc.

While this sounds simple and straightforward, it is often difficult to get executives to recognize and acknowledge the assumptions underlying their action plans—or the faulty conventional wisdom that they have accumulated over years of service.

Private investment teams must begin by asking their portfolio executives about the origin of their assumptions—and posing the hard question "What do we know to be true—and what do we simply believe/hope to be true?"

Portfolio managers should develop the habit of asking executives "Why?" and "How do you know?" three consecutive times. This practice usually exposes leaps of faith, faulty logic, and other "traps" associated with conventional wisdom.

Tip #2: Force Executives to Focus

How many "key initiatives" can a CEO and his or her team successfully drive at any given time? The answer is "No more than five"—and probably, in truth, only two or three.

The old adage "If everything is important, then nothing is important" is especially apropos to the behavior of most senior teams. CEOs frequently suggest major new change initiatives as a means of "taking action" when, in reality, they are fostering confusion, resentment, and "initiative fatigue" among employees—all of which are counterproductive. The best leaders know that choosing what not to do is at least as important as deciding what to do.

How can private equity professionals encourage focus within their portfolio businesses?

Focus should come from a clear and realistic strategic plan. The strategic plan should not be a huge book assembled by the company's best and brightest, with the help of highly paid outside consultants—but instead should be an accurate portrayal of where the company wants and needs to be in the next two to four years. All key initiatives should logically flow from this strategic direction, and be both necessary and sufficient to accomplish the plan.

The most powerful hedging technique to offset the almost cancerous impact of "initiative overload" is to force CEOs to ruthlessly prioritize all current and planned activities. Investment teams should insist that: (a) all strategic and ongoing tactical decisions be based upon current realities (see Tip #1) and (b) if updated information suggests that resources currently being applied to a particular product, process, or initiative would be better refocused on higher-potential opportunities and activities, then these resources must be redirected—immediately.

Tip #3: Ensure Senior Team Alignment

A crewing (i.e., rowing) illustration is helpful to put the issue of leadership alignment in perspective.

Assuming that the few things that the CEO has chosen to focus on are the right things (see Tip #2), then he or she has established the course to be run by the crew. But, to get to the destination ahead of the competition, everyone on the crew must put his or her energy into propelling the boat in the same direction.

It is unacceptable for one or two crew members to try and steer the boat in an unapproved direction—or at an unapproved pace. It is equally unacceptable for a crew member to simply sit and watch the others "put their backs into it." If one crew member is unwilling, or unable, to help propel the boat forward, he or she must leave the crew.

And so it is with effective company leadership. Once the direction is established, no divisiveness or distraction should be tolerated.

But, in fact, lack of alignment is one of the most common ailments afflicting companies both large and small. A key reason for this stems from the paths taken by most CEOs and their teams to reach their current positions.

Despite years of advice from leadership development gurus extolling the benefits of cross-training, most companies continue to promote individuals within functional silos (e.g., sales, marketing, operations, finance, etc.).

The predictable result is that those individuals who are tapped to lead these functional hierarchies (and, by virtue of their positions, sit on the company's senior team) have historically been rewarded for being successful managers of their functional areas.

When these individuals are suddenly called upon to think and act crossfunctionally—which is absolutely critical to being able to prioritize all prospective strategies, tactics, and action plans from the perspective of the total enterprise (see Tip #2)—they find it very difficult not to overemphasize the importance of their own functional specialties.

The most important strategy for hedging this particular element of leadership risk revolves around frequent measurement of the degree of misalignment among company leaders, and between the senior team and the rest of the organization.

Only after diagnosing the severity of leadership misalignment can appropriate solutions be considered. Potential responses on the part of investment firms range from facilitated workshops designed to resolve identified differences to restructuring the entire senior team—with the goal of avoiding continued leadership dysfunction.

Tip #4: Tame the "Controllasaurus"

A number of studies have proven emphatically that today's typical style of leadership—centered on one person at the top of a hierarchical pyramid—is increasingly counterproductive. Too often, the CEO is reluctant to share power with others, or to invite the collaboration and teamwork so essential to capitalizing on the company's diverse strengths—and moving the entire business rapidly forward.

This type of all-powerful CEO—or the "Controllasaurus"—is, with good reason, becoming an endangered species. But he or she still represents a significant challenge for private equity professionals looking to maximize growth.

How can an investment team manage this sensitive issue within a portfolio business? Pushing the "Controllasaurus" to be more collaborative and team-oriented is the preferred strategy, but getting him or her to accept the benefits of working with, versus simply directing, other members of the senior team can be a challenge.

Team simulations that demonstrate the power of synergy are often helpful. Synergy, by definition, means that the results of the team are "better" than the results possible from any one member of the team separately, including the CEO. Once recognized, the individual and team behaviors that led to synergy can be institutionalized in order to foster similar results in real-world situations. Such "mountaintop" experiences can significantly improve both senior team and company effectiveness.

Tip #5: Encourage Listening

Who is best suited to first see the need for directional changes, for new products and services, for quality improvements, etc. within portfolio businesses? Is it the CEO and his or her direct reports? Not likely.

Important change should almost always be driven from within the rank and file of the business—by experienced shop managers, brash young recruits, seasoned marketing and sales personnel, etc.—those who are closest to the action. Unfortunately, the typical CEO is so overconfident in his or her ability to lead that he or she rarely takes time to listen to those at lower levels of the organization.

Private equity professionals can help to foster listening by ensuring that communication mechanisms are put in place that encourage the surfacing and filtering of insight from all levels of the business—not just from those in its top tier.

While it may be true that the CEO and his or her executive team are best equipped to evaluate and prioritize the major changes that will transform the business (see Tip #2), they are rarely best positioned to see the need for these changes in the first place. Fostering a culture of open and frank communication is a great way to leverage all of the company's brain power, experience, and insight.

Tip #6: Think Globally

Private equity professionals should ask themselves "How much time do our portfolio executives spend abroad? Do they travel internationally for both business and pleasure?"

Globalization is directly or indirectly affecting every industry and every company in every nation—and portfolio company leaders must be increasingly sensitive to the impact of globalization on their markets, competitors, supply chains, capital, and human resources. To avoid a US-centric or outdated world view (see Tip #1), they must cultivate a truly global mindset.

The key for investment professionals is to ensure that a global perspective is a prerequisite for CEOs and senior team members. Various assessments are available to provide quantifiable feedback regarding global awareness, which can be very useful in identifying US-centric biases.

Such biases create significant added risk, given the speed at which global competition can now remake almost any industry. It is especially critical to eliminate these biases so that portfolio companies can capitalize on all available growth opportunities.

Tip #7: Energize Product/Service Development

The speed of business in every industry is increasing dramatically—thanks to increasingly stringent consumer and channel expectations.

In order for portfolio businesses to meet this challenge, new product/service development efforts must not be relegated to marketing and engineering staff alone (see Tip #5)—or be a one-time effort. Instead, product and service innovation should be an ongoing, organization-wide effort driven by the CEO and his or her entire senior staff (see Tip #3). In addition, product and service ideas should be quickly screened for their potential—and, if the analysis is favorable, driven rapidly to market to capture the opportunity.

How can investment teams encourage this type of energized process? In many industries, new products are going from concept to commodity in under 24 months—developed and nurtured by crossfunctional teams of employees.

Private equity professionals should ensure that their portfolio businesses are benchmarking and emulating these leaders—and hold CEOs accountable for driving innovation and aggressive development of new products or services.

Tip #8: Instill Cultural Sensitivity

This element of leadership risk does not refer to an appreciation of the arts, or respect for other races, religions, societies, etc.—although these may be admirable goals.

Instead, at issue here is the typical CEO's general lack of awareness of, and appreciation for, the organizational culture of the business that he or she is trying to lead. How many new CEOs come storming onto the scene believing that their skills, education, experience, track record, charisma, and intellect—and these traits alone—will be enough to lead their new companies to financial success and corporate glory?

The reality is that most new CEOs, as well as many entrenched ones, routinely underestimate the impact that a particular company's existing corporate culture can have on the business' ability to respond to needed improvements. And they greatly overestimate their personal ability to change that culture quickly.

The good news for private investment professionals is that corporate cultures can readily be assessed in terms of their strengths and weaknesses and, if strategically necessary, changed quickly (i.e., within 12 to 18 months).

The bad news is such a change cannot be achieved by executive force. Keeping culture and behavioral norms in sync with evolving company strategies requires data—not blind mandates.

It is therefore prudent for private equity managers to periodically examine the current "cultural climates" in their portfolio companies, even when financial performance is satisfactory. A baseline cultural assessment can provide an early warning system for numerous organizational ills, including failing leadership. Such analyses can also highlight the degree of alignment (see Tip #3) among important company constituents (e.g., customers, employees, management, the CEO, etc.).

Tip #9: Understand and Address Executive Insecurity

Any consultant experienced in advising the most senior executives will, if they are honest, affirm the following truth: The more senior an executive, and the more self-confident and in command he or she appears, the more insecure that executive probably is in his or her leadership role. It is imperative for private equity professionals to understand and act on this basic truth in their dealings with portfolio company executives.

This is not a medical or psychological diagnosis; it is simply a phenomenon that is observed time and time again by practitioners of the consulting trade. And the ramifications for private equity professionals can be far-reaching.

Addressing executive insecurity—and creating true self-confidence—is obviously a delicate issue, and it generally requires outside intervention. A host of executive assessment and coaching services are available, any one of which could provide insight into the degree to which insecurity and related dysfunctions are, or could be, affecting portfolio value.

Getting executives to embrace or, at least, to tolerate such "meddling," however, may be a challenge. But it's a challenge that holds tremendous return on investment if private equity managers can rise to it.

Tip #10: Stop Wasting Valuable Time

Another—perhaps more widely recognized—business truth is that few senior executives manage their time effectively.

While this topic has been addressed with humor in such forums as the popular "Dilbert" management comic strip, the implications of this wasted time are very serious for those seeking to maximize productivity and profitability.

One excellent example of time wasting is excessive internal meetings. A significant percentage of all internal business meetings are unnecessary. Whether driven by a need to control others (see Tip #4), a lack of trust in those to whom work is delegated (see Tip #3), or personal insecurities (see Tip #9), an excessive amount of executive time is spent in staff meetings that accomplish little—usually covering topics that have already been addressed, or which could be more effectively addressed by individuals or smaller teams.

How can investment professionals encourage better time utilization among the executives who manage their portfolio businesses? Simply encouraging a more judicious use of staff meeting time would go a long way in addressing this issue.

Every recurring meeting should be examined in light of the following questions: Is face-to-face communication necessary or desirable? Are agendas set in advance? Are only necessary participants invited? Are decision-making roles and processes clear? Are follow-up actions documented—and is accountability reinforced?

Failure to manage executive time with an eye toward value creation—and the mitigation of the above elements of leadership risk—can significantly hamper growth and profitability. Time should be treated as the most precious of resources.

In Conclusion

At its most fundamental level, business success comes from managing cash flows, margins, turnover, sales growth, and return on assets. Every CEO and his or her senior team should be able to clearly articulate the value propositions, strategies, and associated action plans necessary to achieve success against these metrics. And every private equity professional should hold their portfolio companies' executives strictly accountable for delivering these necessary and quantifiable results.

But the ability of the CEO and his or her team to effectively execute their company's plans in an uncertain and hostile business environment is a function of their leadership skill and acumen. Although more difficult than gauging performance against financial standards, investment managers must also assess their executives' leadership capabilities and results—and understand the degree of risk created by any lack of fundamental management skill, or by any individual or team dysfunction.

As demonstrated above, leadership certainly has its risks. Understanding these risks—and acting to mitigate them—can significantly improve the performance of individual portfolio companies and, as a result, help private equity firms to meet their investors' demands for superior returns.