Marrying the right CEO to your investment

Katherine Steiner-Dicks interviews Mark Ligertwood, Director at European midmarket private equity firm, Dunedin Capital, to get to grips with one of the most critical and widely debated issues facing private equity investors...selecting the right CEO for your investment.

CEOs and finance directors have a one in four chance of being sacked or 'let go' after being invested in by private equity firms, according to a Grant Thornton report. However, it is common knowledge that management change is more likely to occur as a company goes through transformational change by becoming larger, merging with another business or expanding into new geographic markets, etc.

But why was this study done in the first place? David Ascott, head of Private Equity at the advisory firm, said that the research was set to help directors prepare for the "sometimes challenging realities of private equity investment."

But it will be the finance directors, more so than the CEOs, who will suffer from 'several risk factors' including the demands of leverage calling for a significant change in financial sophistication, external investors scrutinising their work more closely than that of other executive directors, their skills being seen as more of a 'commodity', says Ascott.

But having to replace a CEO who holds so much knowledge about a target company's sector and its customers is not an advantageous position to be in for a private equity investor. That is why keeping in the back of your mind a Top 10 Best CEO characteristics check-list is a valuable thing to have.

A University of Chicago study (see Page 6) did some meaty analysis alongside other academics and professional firms and came up with a list of descriptions of individual characteristics of high performing CEOs that would be ideally matched with VC and private equity backed investments.

We thought in addition to highlighting some of the study's winning attributes we would ask Mark Ligertwood, Director at mid-market private equity firm Dunedin Capital, to devise his own CEO Wish List, to compare notes. Peek at either list, the expectations are high; at quick glance they resemble (tongue in cheek), an 'ideal soul mate' checklist with the University study's number 2 characteristic, 'removes underperformers', right on the money for some of today's more discerning private equity managers.

Mark first offers some insight into what makes a CEO-investor relationship tick like clockwork.

Mark, if you are investing in a business that has been 'raised' by a CEO that knows that company and business sector inside and out, when would it be justified replacing that CEO?
It very much depends and has to be viewed on a case by case basis. From our experience, it can range widely from a CEO having health issues; people wanting to move on for personal reasons; or recognising themselves that they are not right for the role. There are situations when the incumbent Chief Executive to the business may not be the appropriate person for the company going forward. I would say, though, that is unusual for us. We spend a lot of time upfront making sure that the team we are backing is bigger than the business we are backing. We want to back a CEO who will be able to successfully run a bigger business in say five years' time. Many of our CEO's have indeed ran larger businesses previously.

Our core focus is on management buy-outs, which harness the knowledge and skills of the incumbent Chief Executive and his team. Sometimes, if the incumbent CEO is retiring or leaving, the situation calls for someone to step up to that role perhaps from a senior finance or chief operating officer role, in order to make sure that we have all the support around us to grow the business as planned.

I know that not every human is the same or how they approach their work is the same, but do any star qualities of the CEOs that have helped achieve excellent realisations come to mind?
One of the characteristics that comes to mind is energy. People who are highly successful in business and other walks of life seem to have two slightly larger battery packs inside them than the rest of us. They know how to use their energy constructively. The second characteristic that comes to mind is hunger. The fact that someone wants to work as a Chief Executive alongside a private equity house typically means they are not doing it just for our benefit, but also for their own financial benefit.

Private equity investments are typically structured to ensure that members of the senior team are equity investors themselves. This helps to align interests between the team and the private equity house, as they both work towards achieving a substantial capital gain over a three to five year period.

For most of the deals that you and other private equity investors complete, which is the common skill set that is missing or needs improvement?
If strong financial skills are not already in the business then these can be quickly added.. It is important for private equity backed businesses to have strong strategic financial skills to enable either forecasting accuracy or cash management to be optimal. This is not necessarily an issue for the CEO, but it is for the Finance Director.

Are there two types of CEOs?
You can find some CEOs who naturally fall into either the operational side of the business or the sales outward facing side of the business. Ideally, they cover all facets. It is important, for example, if you do have a sales outward facing Chief Executive that you have the right operational support next to him and vice versa. It is very much about building the team to cover all facets of the roles required.

Does spreading the wealth opportunity make the CEO a more likeable CEO to his troops?
It can do, but it really depends on the people skills of the Chief Executive. There are situations whereby if you can share the equity with key individuals in the second management tier and beyond, it brings a shared sense of purpose and shared understanding of what we are trying to achieve and why it works. I think it really works for the wider team when they can visualise the capital gain; otherwise it is a paper offering that is less meaningful.

As for us, we spend a lot of time developing the relationships with the teams we back. By the nature of these deals and the investment timescales involved, however, we struggle to make closer relationships below the board level initially, but we achieve this during our period of investment.

That brings up another facet of the role we haven't yet covered, which is people management. What are some of the people management skills that are challenged with a fast growing business?
People running private equity backed businesses with under 200 employees have often had to develop the 'art' of managing people; handling challenges especially in fast growth companies. For example, when a company has to recruit heavily or open additional factory space on the back of contract or client wins. These kinds of challenges can bring a certain type of stress on the business. In these situations it becomes even more important to ensure that the CEO has the right team in place to manage both the stresses of growth whilst maintaining the wider strategic vision.

Are there any character flaws in a CEO that you see as red flags as a company starts to grow?
Someone who is overly confident or who has an inability to consider the opinions of others can be a risk in any business, especially if coinciding with the high growth phase of the business. If I can highlight this in a more positive light we enjoy working with a Chief Executive who is open minded to advice and support outside the business. A CEO who doesn't believe they have all the answers at their fingertips, consults with colleagues, advisers and customers is more likely to make the best decisions for the business. They are open to experts in their field coming in to support them or they consider alternative ways of doing things for the benefit of the business.

But can't bringing in outsiders make a CEO nervous, especially if they think their strategy or sector knowledge is going to be questioned?
Yes, it can. And another characteristic of strength is a mutual trust in a private equity relationship. Having a CEO trusting in us when we are making certain recommendations. Trust between the Chief Executive, Non-Executive Chairman and the private equity house is also an important facet in all of this.

Do you believe that private equity investors, such as you and your colleagues, have an intrinsic intuition to retain successful CEOs for a private equity backed business, over say your typical M&A deal professional?
You'd like to think so, but as in human nature just when you think you have got it right you can still get a surprise. We do have the benefit of objectivity and a degree of detachment from the businesses we back since running the business on a day-to-day level. We're one step removed and a good CEO will welcome that objectivity.

Another key role is bringing in the right Non-Executive Chairman, in conjunction with the CEO. It is a difficult role, that requires experience and gravitas, but also a degree of mentoring that may be needed from time to time.

Is there something that could be improved to make sure a relationship with a CEO starts off on the right foot?
It is never ideal to start any relationship with hard negotiations, but you are likely to be on the same side of the table through most of the private equity deal process. Funnily enough, the extreme pressures that the investment process brings on the business and the CEO can bring out extreme personality traits and help us understand what makes the team tick.

There will be a mixture of conflicts and pressure through any investment process, but ultimately we measure ourselves by our integrity and delivering on the promises we've made to instil a level of mutual trust for the relationship.

Looking back on your career, is there a CEO that you have in your mind that you wish you could magically replicate for future investments? What was their star quality that made everyone's job easier?
It may be a private equity cliché, but I'd have to say the 'no surprises' philosophy. I worked with one CEO for several years that would call me up about every ten days to get his concerns off his chest. Looking back, he felt that he was in fact troubling me with all these concerns and phone calls, but in fact he was doing the exact opposite, since I was less stressed knowing he was the one worrying about these things. I also knew he had the capabilities to deal with them.

Well, he certainly didn't have any trust issues, did he? Some may even say that he was naïve to open up that much.
While some may see this openness as naïve, the amount of trust that this Chief Executive had in me was flattering and ensured my openness and trust in him.

I am sure he did not share every small concern but he knew which significant issues could impact on our wider vision for the business in order to create value. There were never any surprises since he highlighted issues to me weeks before they ever had an impact on the business.

Not all relationships with CEO's go this way, but in the case of this particular CEO, we still keep in touch today and we chat every few months to chew over ideas even though we are no longer investors in the business.