June 24, 2020
The strength of leadership in Private Equity portfolio companies is critical to successful value creation and is an essential lever to unlock potential and deliver a value creation strategy in a business. At Drax, we have found that there is a real “heat map” of value creation within key relationships across the Board, such as between the CEO and Chair, or the CEO and CFO and of course that pivotal relationship between the CFO and the Private Equity house itself.
With borrowed capital, the financial performance of a business must perform with limited time to demonstrate results; and with the CFO facing pressure from investors to report and justify data, under what may be unprecedented scrutiny, it does not come as a surprise that of the 252 UK exits in 2018/19, 69% of those businesses underwent a change with the CFO during the investment period.
Typically, of highest priority for Private Equity Investment Directors during the CFO hiring process, is the identification of a CFO with prior experience of successfully exiting another PE backed business; in fact, tracking exits and leadership team complementarity by using powerful data analytics such as drxDATA, is relatively easy – the challenge comes in testing those individuals’ appetite to run the cycle again and their continued propensity to be successful.
Figure 1. Average CXO change since 2017
In my experience, the CFOs who have repeatedly performed well over multiple investment cycles are now increasingly reluctant to take on new executive roles (often a testament to lucrative management incentive programmes) and consequently, there is a growing rarity for available proven Private Equity CFOs with both the desire and propensity to be successful again and again. So, this raises the question:
Where are the next generation of Private Equity CFOs going to come from?
We can look at a number of different sources, the most obvious being the ‘step up’ candidates who have recently supported a CFO through a Private Equity exit as the ‘number two’ in finance. Other channels include Group CFOs from listed businesses or Divisional Finance Directors from similar corporate environments. However, every one of these options presents a potential risk to the Investment Director.
CFOs from outside Private Equity may not understand the emphasis put on cash flow in a leveraged environment, where weekly or daily reports on cash are the normal. Corporate CFOs may never have operated in a business without state-of-the-art systems and processes or a large finance team to fall back on. Divisional Finance Directors likely have relied on shared services from the Group, and even the ‘number two’ options from exited Private Equity portfolio businesses will not have had full P&L ownership.
How can we help the Investment Director mitigate, or remove that risk?
Ultimately, replacing an underperforming CFO is time consuming and expensive. Therefore, in a demanding environment like Private Equity there needs to be appropriate leadership due diligence to maximise confidence in future performance and enhance value creation. This is where data analytics can help – “the Moneyball of leadership”.
The drxDATA Leadership Success Propensity Model (LSPM) benchmarks the candidates’ behavioural traits against the UK marketplace in order to predict their ability to deliver sustained value creation.
Figure 2. Different CFO profiles
Translating the differing profiles into an ROI for a Leadership Team means that it is possible to indicate not just the experiences and complementarity of an individual, but the likely impact on the value creation plan. In fact, our research shows that the best Leadership Teams deliver 20% more growth annually, which compounds to deliver significant value throughout the hold period. The CFO archetype can be applied to any CFO inside or outside of Private Equity.
What are the benefits to expanding the search beyond Private Equity CFOs?
‘Step up’ candidates are driven to go the extra mile in order to prove themselves in their first ‘number one’ role, and similarly CFOs from outside Private Equity are typically more motivated by equity participation and personal wealth creation than the PE CFO who has just received their earn-out from their last exit.
Looking beyond Private Equity also widens the candidate pool with relevant sector experience, bringing knowledge of appropriate KPIs, the competitive landscape or experience with specific regulatory bodies. Divisional CFOs from corporate organisations can bring knowledge of ‘best-in-class’ systems and processes, with experience at a more comparable scale to a mid-market Private Equity portfolio company.
Figure 3. First time #1 CFO in PE candidates
At Drax, our data driven approach to evaluating candidates has enabled us to support our clients by providing them with increased optionality for key Board hires and access to top talent pools that they were previously unable to tap into. This applies across the entire Leadership Team, but particularly of note are our clients’ successes in hiring exceptional first-time Private Equity CFO talent onto their Boards.