Now that the corporate honeymoon is over how do the new private equity owners and management move forward?
Most of the literature around private equity groups (PEGs) addresses the preparation of a company for sale and the sale process itself. There is little content to be found that addresses the period of ownership by a private equity group. CEOs/Owners often focus on the price and terms of the transaction but neglect to research the new partner/boss/equity group they will be working with for the next few years.
Private equity groups are so happy to have landed a transaction in today's hyper-competitive market that they often overlook and fail to address very visible warning signs of misalignment between CEOs/Owners and management. Technology and the way transactions are worked nowadays only compounds the situation. As a result, some partnerships fall apart, leaving both parties frustrated and disillusioned. Even worse, the company's value may be destroyed in the process.
"A successful post-transaction partnership between private equity owners and management requires up-front planning, a clear understanding of the differences in goals between the private equity group and management, and performing due diligence to address any such differences throughout the process from start to finish."
--- GREG PHILLIPS, ATTORNEY
A successful post-transaction partnership between private equity owners and management requires up-front planning, a clear understanding of the differences in goals between the private equity group and management, and performing due diligence to address any such differences throughout the process from start to finish. Only then can all sides avoid a potential nightmare after the honeymoon period.
Due diligence should be addressed before marriage and is something we'll address in an upcoming article. Today we'll focus on what to do now that the private equity group and management team are married. Avoid these five common mistakes and follow these five best practices for a successful business marriage.
So how can startups go about obtaining quality legal advice on a startup’s lean budget?
5 Common Mistakes Made Between New Equity Business Owners and Management
Lawyers are expensive. Retaining a lawyer from a traditional law firm can quickly blow the modest budgets of most startups and small businesses. Hiring a lawyer full-time is even less feasible. Lawyers are also necessary. Many companies end up paying attorneys the enormous fees they demand. However, for startups looking to reduce their legal exposure and to potentially increase their value on a reasonable budget, there are options.
A private equity group, when acquiring a company, will almost always require that a strong management team stay in place (or be put in place) before it is willing to invest in the business. While private equity groups may have substantial operating experience, often they are not operators --- they are investors. If the investors do not have a strong desire to stay actively involved in the daily management of the business, they should make their agenda clear from the onset to ensure that they and the management are aligned, or the new partnership will falter right out of the box.
Key due diligence items for new equity owners:
- Share your expertise on how you can help management. Private equity buyers usually know the players, competitors, products, technology, suppliers, business systems, processes, and other movers that drive the industries in which the fund specializes. Be transparent with the management team you put in place and help them see the big picture and be part of the solution. Too often management incorrectly sees private equity firms as money-grabbing corporate raiders that buy businesses, leverage them to the hilt, fire employees, break up different operating units and sell off crown jewel assets --- only for a profit. The new private equity group should invest in the relationship by helping management see clear goals and expectations and what's in it for them.
Key due diligence items for the management team:
- Align the "management culture" with the private equity group's style and expectations. As part of this effort, the management team should seek to speak with past and present management teams of the private equity group's portfolio companies. to understand the private equity group's style and expectations so that management can implement change processes to meet such expectations. This will allow for a smoother transition during the "honeymoon" period after the private equity investment has been made.
Peter Drucker said, "Management is doing things right, leadership is doing the right things." With this in mind and given the high stakes involved in any acquisition, it is better to understand how to build successful relationships when companies are somewhat between clear business success and doomed business failure. Within this "middle ground" is where private equity funds must:
- Ensure everyone is working towards the same goal --- post-acquisition.
- Detect early warning signs of marginal business performance and take appropriate actions.
- Develop a balance between support and challenge.
According to A. T. Kearney, "Clear upfront rules of engagement, defined accountabilities, and efficient ways of working are essential to running a business." Most private equity funds take pride in creating value through effective governance. Yet more than 60 percent of CEOs say they do not have clear rules of engagement established at the beginning. For underperforming firms, this number rises to 80 percent. It's difficult to say whether the perceived lack of clarity is the cause for underperformance or whether the rules of engagement deteriorate once expectations begin to slide. Regardless, work should be done up front to determine how things will be run if things are going well and what measures will be taken if performance begins to slide. Clear expectations and honesty can avert a lot of negativity and confusion.
Key due diligence items for new equity owners:
- Avoid having too many people involved in decisions. Sixty percent of CEOs prefer to deal with one person from the private equity operations team, with the rest limiting the number to two or three people. Yet, in reality, only 20 percent of CEOs deal with one person, and 12 percent say they interact with five or more people from the operations team. They also don’t appreciate when members of the private equity operations team have a full-time presence in the business.
- Interact more often with the CEO and management teams to ensure transparency of performance, clarity of decision making, and ultimately higher exit returns.
- Private equity operations teams play a crucial role in the relationship between CEOs and the private equity firm. They are often able to get closer to management than the private equity deal team because they speak a similar business language. They can also provide hands-on support in developing value creation plans.
A balance of push and pull, or challenge and support are very difficult to achieve overnight. Many of the relationships on both sides are rooted firmly in personality clashes, cultures, and working styles. This is especially true when experienced, authoritative professionals sit on both sides of the table. The lesson here --- leave your ego at the door.
Key due diligence item for new private equity owners and management teams:
- Listen to each other and be patient. The strongest negative reactions from CEOs occur when they feel disenfranchised and powerless. CEOs can often provide positive feedback when a private equity operations team adopts an interactive style based on asking questions, influencing, and bringing a challenge. One CEO put it this way, "Success comes when private equity operations teams influence management thinking without management even realizing it.” There are very smart people on both sides; a balance of authority and humility is essential to avoid a battle of egos that can destroy any relationship.
According to A. T. Kearney, most successful private equity operations teams challenge management in a respectful way to help ensure management gets full credit for the successes. These teams help CEOs succeed by highlighting business issues and facilitating discussions at the board level rather than taking on the challenge themselves. CEOs particularly value support in four areas (See Figure 2):
- Experience. Private equity operations teams with multi-industry expertise act as “sounding boards” or sparring partners, bringing an external challenge to management thinking.
- Networking. Private equity operations teams offer broader connections and a network of experts and consultants that can be rapidly deployed to support management.
- Coaching the management team. Private equity operations teams have the necessary experience to provide coaching and support in new and challenging business environments, as long as they don’t take control and micromanage.
- Coaching the CEO. Private equity operations teams help CEOs who are new to private equity transactions to change their focus from profit and loss to balance sheets and cash management. This is particularly beneficial for CEOs who are not familiar with the specific requirements regarding governance, capital structure, and relationships with banks and investors. This helps strengthen the relationship from day one.
Key due diligence item for new equity owners:
- Work behind the scenes to help the CEO become the hero.
- Learn where the CEO requires support
One CEO says the mantra of interaction between private equity firms and management should be "no surprises --- either good or bad." The signs of a broken relationship are pretty clear: lack of trust, lack of transparency, and hiding bad news.
It often starts with a request from the private equity operations team for more details to justify an area of underperformance. To a CEO, such requests can seem like an interrogation which only results in deterioration of trust and hiding problems rather than sharing them. This is the opposite of what you want to happen.
Key due diligence item for new equity owners and management team:
- Refer back to #2, followed by #4. Trust is hard to grow but easy to lose. Take the time to get to know each other, and respect each other's contributions.
"Management is doing things right, leadership is doing the right things."
--- PETER DRUCKER