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The importance of leadership due diligence

May 25th, 2021

The importance of leadership due diligence

[audio mp3="http://www.draxexecutive.com/wp-content/uploads/2021/05/Real-Deals-Podcast-Matt-Finnie.mp3"][/audio]

During a recent Real Deals podcast, Mathew Finnie, Drax’s CTO, spoke with the magazine’s editor Talya Misiri about why leadership due diligence matters and how it should be conducted by private equity buyers and their advisers. Here is an abridged version of that conversation.

Talya Misiri: Why is due diligence important for dealmakers?

Matthew Finnie: When dealmakers invest in an organisation it is ultimately down to the leadership team to steer that investment and deliver a return. This is especially acute in the private equity world of defined outcomes. So, understanding the effectiveness of leaders within that context is a really important part of achieving your value creation plan.

TM: A recent report mentioned that less than 1% of fees across deals are being allocated to leadership diligence. Why do you think this is?

MF: The reason so few fees go into the diligence process is that it’s a hard thing to measure. It’s one thing telling an incumbent leadership team that their strategy isn’t very good. It's an entirely different thing to hear, as a c-suite executive, that we’d like to buy you but you’re not in the right role or that we’re not sure you’re right for this part of the journey. So, the challenge for the buyer is to understand as much as they can about the business. Hence all the financial, legal and commercial due diligence. Leadership is harder.  Firstly, it’s not an exact science and, secondly, you want to keep the management team on side such that, if it does come down to a competitive bidding situation, you're not going to get rejected. You also want to make sure that you are in a position to make any necessary changes as soon as the transaction goes through.

TM: Would you say that private equity firms have shied away from this in the past?

MF: I think the lack of leadership diligence applies to management teams within companies generally. You are as good as your track record. Private equity has closed a lot of deals recently and leadership diligence hasn't been a huge factor. In my view this is largely because there isn’t a really good way of dealing with it in the initial phase. It does depend on the type of business. The closer you get to a venture-type model in terms of the business being nascent in its strategy, the more reliant you are on the team. Whereas if you've got a mature business in a large sector that is well defined and you’re using a value creation plan to leverage a balance sheet, then maybe the impact of the management team, while important, is probably less acute.

TM: Yes, it does seem quite dependent on the type of business and the size of business, and perhaps how mature it is as well. I'm interested in understanding what is leading this type of diligence? What is driving the agenda?

MF: Over the last decade, the private equity world has evolved in sophistication when it comes to modelling businesses, understanding markets, and even modelling markets to a lesser or greater extent. Bain & Co recently surveyed some fund leaders and they asked what the most important factor in a deal’s success was. They said the management team. The survey also asked what the biggest cause of failure in an exit was. In second place was the management team. So, this is the variable that’s most material right now. Twenty years ago, there were a lot of inefficiencies in businesses which today have been fixed or remedied but you are still reliant on the management team to execute your value creation plan and contend with changes in the market as and when they come.

TM: What features and characteristics make a successful management team and does this apply generally or is it sector-specific?

MF: There are some hygiene factors that can give a sense of comfort and one of these is what we refer to as functional balance. Put simply, we could argue that the revenue and operational functions are the tactical elements. Then you've got a change function and that's nominally what the CTO should be doing – using technology to reduce your engagement in the market, for example. And you want a CFO who is going to tell you the truth; you don't want an enthusiastic creative in that position. You want someone who, when everyone else is really excited, will bring you back down to earth. It’s about setting yourself up with the right level of functional diversity and behavioural complementarity so that within a framework of unpredictable internal and external factors, you've still got the flexibility to execute.

TM: Clearly, certain deal processes can move very quickly and decisions have to be made. How can deal makers gain more than just a snapshot of a management team and their dynamic?

MF: There’s that famous comment on advertising that ‘50% of my advertising works really well; I just don't know which 50%.’ In terms of the market’s current offering around leadership diligence and evaluation, a 50% success rate might be a fair metric. However, over a matter of minutes our methods and platforms can be deployed at an arm's length remote view and deliver an ‘out-of-the-box’ 60% result. This is because we’re combining different facets. It’s not just an analysis of an individual’s skills where there could be 6000 variables which is fantastic but if the error on that is 10% to 30% then 6000 is irrelevant. What we are doing is delivering four different facets across four or five different perspectives, and therefore you get a quick comparative and objective view. It allows the investor to codify what needs to be changed within the management team.

TM: Really interesting. To finish, have you got any advice for private equity dealmakers who perhaps haven't yet considered leadership diligence?

MF: I think the simple thing is to try it and see if it works. The proof of the pudding is in the eating. We’ve based our psychometric model on the behaviours of leaders in private equity over the last ten years. We know there are a lot of data analytics and machine learning-type models out there but at Drax we’ve taken the market’s intuitive understanding and successfully overlaid it. PACE is our entry-level psychometric model tool and if investors want to dig deeper, we have a broader suite of leadership evaluation tools that do just that.

 

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