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Executives who hone their skills at the helm of private companies tend to be more driven, more bottom line-oriented and have much more flexibility than CEOs at publicly owned companies, who are constrained by their need to balance multiple objectives in a corporate ecosystem.
That was the consensus of four panelists who discussed the management challenges at private equity-backed firms during the recent Wharton General Management Conference. The panel was titled, “Managing Public vs. Private Companies in an Age of Buy-outs.”
Today, private equity is facing “an industry transition from competing on capital [and] financial engineering to competing on value creation and access to the best management talent,” said panelist Elena Botelho, a partner at ghSmart, an executive assessment and talent management consulting firm for investors, boards and CEOs. “This is driven by the need for these firms to get maximum improvements in their portfolio, especially now that the market is tough.”
Botelho noted that this affects the way CEOs are hired as well as how top executives perform in an era of increasingly common corporate buy-outs. The result is a blurring of the lines between public and private firms, with shifting expectations of senior management. Although the current credit freeze has limited the number of recent private equity deals, the situation has created a unique set of pressures for managers, since so much attention — from the media and the federal government — remains focused on financial performance. At publicly traded companies, the normal expectations of shareholders about quarterly earnings have been ratcheted up with the significant increase of federal regulatory involvement. But as private equity firms gain more investor interest as an alternative to the public markets, CEOs at private companies find themselves expected to reap quick gains in a rapidly changing environment.
Gone, however, are the days of private equity “strip-and-flip” buying and selling, a period that many see as having ended with the collapse of two Bear Stearns hedge funds in July 2007 — the beginning of the ongoing credit turmoil. A key question now is whether private CEOs, accustomed to taking greater short-term risks to maximize long-term returns, can thrive in a new, more transparent environment under unprecedented demands.
“Private equity firms get measured on IRR (internal rate of return), which is highly sensitive to the time they hold an investment, so every extra year means they have to drive more EBITDA [Earnings before Interest, Taxes, Depreciation and Amortization] improvements,” Botelho said. “Before, if they bought the company, took on leverage and flipped it in two years, especially in an environment where multiples [or] valuation was expanding, it was a lot easier to show attractive IRR. Now they need to attract the best managers to improve the business.”
More Science than Art
According to panelist Mark Brownlee, associate vice president at Infosys Technologies, CEOs in publicly traded firms necessarily practice business as more of an “art” compared to the top executives at privately held entities, where expectations and results are uncluttered by the corporate “ecosystem.” In public companies, this ecosystem comprises “their trading partners, shareholders, their public culture and brand, and … far too many people to answer to,” Brownlee said.
At the private companies he has worked with, however, executives “don’t care about an ecosystem,” Brownlee noted. “[They] are much more isolated and can make more independent decisions. Management teams can be more like business technologists — they understand the science of running a business. With a public company, you need to be the face of the company, dealing with analysts and [having] a constant interaction with the media. [Private] companies are great places to be because that’s where you can work with people practicing the science of business.”
Jonathan Hsu, CEO of New York-based 24/7 Real Media, a digital marketing firm, agreed. The comparison is “pretty stark,” Hsu said. “Running a mid-size company and [being] responsible for everything makes you tougher than someone entrenched in a large public company.”
Increased liability for public company executives and enforcement of the Sarbanes-Oxley Act, in addition to the comparisons shareholders have made with returns garnered by hedge funds — fair or not — have only exaggerated the distinction, Hsu added. “These trends have made public company executives more short-term focused [on] quarterly earnings targets, and in general, more risk-averse.”
“For us, the title of CEO doesn’t really exist,” said Jude Tuma, founder and managing partner at Geminus Capital Partners. “When hiring a CEO, I do not look to a public company, [where a candidate would have] a very defined role. At private enterprise, we’re looking for someone who can do a lot of different things.”
Hsu suggests that the time it takes to interact with a public company’s board and its shareholders — what he called “a glorified cocktail party that you have on the road, all the time” — detracts from a CEO’s performance. At private companies, “quite frankly if you do well with the bottom line they leave you alone.” Not so with public “corporate overlords,” he said.
Lambs and Cheetahs
Botelho stressed that the panel was discussing private equity-backed firms, not necessarily private companies in general, and that top CEOs at publicly traded firms can be just as nimble and focused on the bottom line as their private counterparts. “Jack Welch is probably one of the best examples,” she said.
To fine-tune the comparison, she referred to a study that ghSmart did in collaboration with economists and finance professors at the University of Chicago. It analyzed in detail assessments of more than 300 candidates for CEO jobs at firms funded by buy-out or venture capital investors. Candidates were rated on more than 30 specific abilities under three leadership categories. The “Hard” category included leaders who are efficient, aggressive, persistent and proactive. “Soft” was characterized as being flexible, a good listener, open to criticism and a team player. The third group was neither particularly hard nor soft, but seen as being persuasive, organized, analytical and calm. These are all positive traits, of course, but the “hard” and “soft” candidates were later re-defined as “cheetahs” and “lambs,” making it clear which group made for better performers in terms of the bottom line.
A surprising finding of the study was that buy-out investors are twice as likely to invest in lambs, probably owing to their interpersonal skills and the level of comfort they instill. The cheetahs made board members nervous with their aggressiveness and willingness to move forward without waiting for direction.
The “success” of the candidates who won the jobs at the firms ghSmart studied was determined in two ways, depending on if the CEO was still in the job or had left. If still with the firm at the time of the study, success was measured as meeting or exceeding targeted EBITDA. If he had exited, an attractive return on the investment was deemed successful.
The bottom line? According to the study’s metrics, lambs achieved success only 57% of the time. The cheetah outpaced even the most bullish expectations, with 100% of those in the study earning their money in a “successful” fashion, according to investors’ expectations.
“Where [the cheetahs] really spiked was what we call ‘PEP talk’ — persistence, efficiency and productivity,” Botelho said. “They drove hard, made the right decisions and went at it pretty relentlessly. The other group is [the one] we’d like to have dinner with. What made them special was consensus-building.”
Given the results, she said, “When looking at CEOs, you’re probably going to go for a cheetah.” Later, in an interview, Botelho said she would never suggest that the best public company CEOs are not talented, driven and bottom-line oriented. Though the panel focused on private equity-backed firms with assumed profitability, it was also true that “there are scores of private companies that are family- or founder-owned, or are partnerships that don’t have the performance pressure that comes from having public shareholders or active financial investors…. Some of those fall far behind public companies in quality of talent, business practices and results.”
Still, Brownlee’s point about corporate ecosystems rang true to her. “The point is that the set of issues a public company CEO has to deal with is broader than that of a private company,” Botelho said. “Therefore, their balancing act between different objectives is more complex.
She added that firms that take a long-term view — public and private — use down markets like the current one to grab talent they otherwise couldn’t afford or attract. “For example, in the last downtown of 2001, American Express hired a lot of people out of top strategy consulting firms when those firms were struggling with decline in demand. We see the same with our clients now — they are actively looking for strong performers that are ‘poachable.’ In private equity in particular, it’s typically difficult to attract senior talent from other firms because of carry (the executive’s financial interest in the portfolio companies when they sell the company). In times like this, some of the portfolio companies are starting to struggle, and therefore carry is not looking as valuable as it did 18 months ago. The challenge for these companies is to have strong assessment processes to differentiate truly strong performers from thousands of average players.”