Performance assessment is relatively new to private equity. Unlike large corporations, where managing performance is something of an industry in and of itself, the entrepreneurial roots and the small teams of most private equity firms have meant that performance could be managed for many years by the personal observations of the founder partners. However, with ever-larger amounts of capital being deployed, and greater competition to secure investments, there is little room for error.
Underperformance in an investment team ?the valuation model is incorrect, the due diligence is inadequate ?can cost investors millions. Therefore, ensuring the team is working to the highest possible standards is a necessity, and doing this through a consistent and transparent process is key.
Setting performance criteria
Private equity firms face an almost unique challenge in measuring the performance of the team: the results of work done this year will not be known fully for many years to come. An investment made today will remain in the portfolio for maybe five or six years before it is sold, and a lot can happen in the intervening period. This essentially renders most ?standard? financial institution performance measures redundant. While at a fund level it is important to track the performance of each investment on a regular basis, it can be misleading to look at the ongoing performance of the portfolio when assessing any individual member of the team.
This may seem counterintuitive: in most corporations, numerical targets and measures are key to ensuring that employees are contributing to the bottom line, and, given that private equity firms are ultimately measured by investors on their IRR, it would seem reasonable to assume that team performance would be measured in a similar way. However, such measures can encourage behavior that is counterproductive: measuring people on the number of deals they have done this year or the amount of capital they have invested makes highly motivated people more likely to take unacceptable risks, particularly not walking away from a deal when they should.
It is therefore essential that performance criteria are measures of long term success derived from empirical evidence of what makes a great investor. This means looking at the people in the firm who have, over the years, delivered consistently outstanding investment returns based on the firm’s investment strategy and identifying the activities and attributes of these proven top performers: what activities do top performers undertake and what skills, expertise and behaviors do they possess which enable them to perform these activities at the highest level? The key steps in setting criteria are to identify:
? Business activity: what activities are successful investment professionals undertaking?
? The role at each level: what do top performers achieve as they progress through the organization?
? The skills, expertise and behaviors that top performers possess at each level in the organization.
This article provides a generic approach to setting performance criteria. The actual criteria will vary from firm to firm depending on investment strategy and organization structure. However, the activities that will be assessed are likely to apply to most firms.
1) Business activity. Private equity typically operates on a fairly straightforward business model: deals are identified, investments made, the investment is managed and then it is sold, ideally at a large multiple of original investment. As a result, business activity has three main components:
? Deal generation: identifying potential investment opportunities
? Transaction execution: evaluating the investment opportunity and structuring the transaction
? Portfolio company management: installing a management team, providing strategic oversight, managing the capital structure and preparing the company for exit
2) Role at each level. There are four standard levels within a private equity firm:
? Partners, who usually have more than twelve years work experience, including at least six years in private equity
? Principals, who have eight-twelve years work experience, including two-six years in private equity
? Senior Associates, who usually join the firm with five or six years work experience in an investment bank, management consultancy or relevant industry, and often have an MBA
? Associates, who join the firm for a fixed term of twothree years, usually after a year or two in an analysts’ program at an investment bank or management consultancy
Most firms run an ?apprenticeship? model of career progression, where people learn how to be a successful investor by working with more experienced colleagues on a range of investments. This means that from a relatively early stage people are involved in all aspects of the investment process, and they gradually progress from learning to leading. It is fair to say, however, that the bulk of valuation and due diligence work is undertaken by the more junior levels, and deal generation and portfolio company management become a larger part of the role as people become more experienced.
In setting performance criteria, it is important to establish what a top-performing senior associate/partner would be doing in their role: what are the activities they engage in that lead to successful investments? Obviously, this varies to firm to firm, depending on its organization structure and team size. For example, where a firm sources most of its deals from intermediaries, the focus on deal generation will be much lower than in a firm that generates proprietary deals. Alternatively, if a firm outsources much of its due diligence to advisers, its team will not necessarily need a great depth of experience in evaluating businesses (although relying too much on advisors can be risky!). However, for a team involved in all aspects of the investment process, their performance could be assessed on the following basis:
The performance appraisal process
As with most businesses, people benefit from feedback about their performance at least on an annual basis. Usually, feedback on an ongoing and timely basis (such as at the close of a transaction) is most useful to the individual in their development. There is also, though, considerable benefit to both the individual and the firm in conducting a formal performance review process on a regular basis. Not only can high performers be acknowledged and advanced, underperformance can be identified and managed at an early stage. Apax reviews its team every six months. Whilst the human resources department manages the process and ensures it is completed properly, it is the partners of the business who lead the evaluation, setting the standards of performance, reviewing team members and providing fair and accurate feedback to them. As with all firms, this is not the most popular event of the year, but it is considered critical in ensuring that the team that is capable of delivering exceptional investment returns.
Given that the results of someone’s investments will not be known for years, measuring performance is about establishing empirical benchmarks: how well does this person perform benchmarked against 1) historical top performers, 2) their peers, and 3) their performance last year?
Probably the only useful absolute standard relates to numerical accuracy: is the person accurate in their calculations and valuation modeling? This is an essential skill; errors in valuation models can lead to costly investment mistakes, so everyone needs to be ?above the bar? numerically to remain on the team.
Other absolute measures are unlikely to be meaningful. For example:
? How many contacts have they made? It does not really matter, it depends on the quality of contacts ?will they bring in deals or not?
? How many new deals have they presented to the Approval Committee? It does not really matter, it depends on the quality of deals, and that will not be known for a long time
? What is the unrealized market value of their investment? It only matters insofar as it focuses attention on how the investment needs to be managed, but it might not reflect what is eventually realized.
Thereafter, measuring performance is dependent on gathering factual and anecdotal feedback on the quality of a person’s work and ability. Clearly, the risk with this type of feedback is subjectivity: what one person considers exceptional, another can think is quite ordinary. To provide a fair assessment, it is best to gather feedback from as many sources as possible:
? The individual self-assessment: how do they assess their own abilities? What do they consider to be their strengths and weaknesses relative to their colleagues?
? More senior colleagues: how do they assess the individual relative to 1) historical top performers, 2) their peers, and 3) their performance last year?
? Peers and more junior colleagues: this is so-called ?360 degree feedback? ?how do juniors rank the person in respect of their technical, coaching, management and leadership skills? For more senior members of the team, it can, in some circumstances, be useful to gather feedback from external advisers and portfolio company managers and boards, for example, when someone is being considered for partnership.
As we are in the 21st century, a simple online system can be used to collect and store assessments. However, the real value comes from partners sitting down with each person individually to discuss their performance: where they are doing well and where there are areas for development. Each individual should get clear feedback on their perceived strengths and weaknesses, and what they need to work on in coming months to develop their skills. In addition, senior executives get a clear picture of the overall capability of the team to deliver the investment strategy, and from there they need to make (often tough) decisions about the composition of the team ?who stays and who should move on.
Dealing with high and low performance
The performance standards in most private equity firms are high. They have small teams investing billions of dollars or euros, where the consequence of high performance can be multiple returns to investors, and the consequences of underperformance can include significant loss of capital and, in situations of consistent underperformance, the failure of the firm to raise another fund.
Given this, it goes without saying that high performers need to be nurtured, promoted, remunerated fairly and provided with carried interest which reflects their contribution to the fund.
They are pivotal to the success of the firm and its funds in the future, and should be motivated and incentivized to continue. Dealing with underperformers is actually just as pivotal to the success of the firm in the long term. As noted above, there is only one role as an investment professional. Unlike an investment bank or an industrial company, there is not another department to move to where one’s strengths can be utilized. In a small team working sometimes under intense pressure, there is no capacity to work around someone’s weaknesses. Where underperformance is a result of lack of experience, then this can be addressed quite easily by a person working under the supervision of someone who can coach them, or receiving some formal training. However, if this does not work, then there is a tough decision to be made about the person’s future.
Because the results of one’s investments are not known for many years, it is a challenge for any firm to decide when someone should move on: are they clearly not going to be a good investor, or will they improve with another year’s practice? This is further complicated by the fact that very few underperformers leave of their own accord: there is little lateral movement between firms, so people tend to ignore ?the writing on the wall.?
Most firms hire at the associate or senior associate level and grow their own teams; lateral hires at more senior levels only occur when specific business needs arise, e.g., setting up an office in a new country or entering a new investment space. It can be a challenge for a leaver to find another role in the industry.
To be fair to the individual concerned, the decision about their departure should be made as soon as possible. Once there is sufficient concern about their abilities that they are finding it hard to be staffed on deals, it is probably time for them to move on. The earlier it is in their career, the more opportunity they will have to establish a new career elsewhere, in venture capital, hedge funds, investment banks or industry.
Neither the leaver nor the remaining team (or the investors) will benefit from senior management taking too long over decisions about team composition.
From Apax’s perspective, actively monitoring and managing performance enables a regular alignment of the team with the investment strategy. Through the performance assessment process the team can be developed to become great investors, and ensure that sufficient resources are going into developing them. This in effect, ensures that the best possible team is working to the highest possible standard and thereby delivering exceptional returns to investors.
* Catherine Brown joined Apax Partners as director of human resources in 2004. A more extensive version of this article is available in Human Capital in Private Equity, recently published by Private Equity International Books.