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Pivotal people

In assessing the quality of a potential portfolio company's management, you must frequently see through top management to find a core of ‘pivotal jobs.’ By Chip Hughes

One of the few things that private equity professionals seem to agree on is that it is the people that make the most difference in the success of a portfolio company. If you have the right people in place, setbacks will be overcome, new markets will be addressed creatively, customers will be happy, banks will be managed properly, and general prosperity will reign. Get the wrong people and every problem threatens the success of the investment or even the very existence of the company.

As a result, private equity professionals spend a great deal of time assessing the people aspect of a prospective investment, and even more monitoring the performance of the people in a company they own. The management team is the subject of endless discussions both before and after an investment is made.

However, this attention focuses largely on the CEO and his or her direct reports. The emphasis is on who's going to lead the company, and on the main lieutenants. It is a truism that the company CEO is the single most important driver of value. However, there are other people issues as well, and sometimes they can have a decisive effect on the performance of the portfolio company. Specifically, there are the people who occupy what consultants McKinsey & Company call ?pivotal jobs. A pivotal job is more than just one job. It is one job description that is filled by an entire layer of personnel within the company, generally quite close to the front line. These are the people who truly drive operational performance, and either do or do not deliver what is needed for competitive differentiation.

Letme give an example: At Blue Capital, we were involved with a 30-shop chain of autobody repair shops (one of several such chains backed by private equity players in the late 1990s). Every month, it was the same story:10 of the shops would deliver performance that made our investment projections look conservative, 10 of the shops would hang in there, and 10 of the shops would lose all the money the best ten made. This was compounded by the nature of the auto-body repair business all the indicators move together. If costs are under control, then working capital is, also, and customer satisfaction is high (so we get more cars). Conversely, an out-of-control shop performs poorly across the board.

We looked at every possible explanation for the performance variation. Some locations were better than others, some shops had better reputations with insurers' claims agents, some had better technicians, some had worse weather – more wrecks! In the end, though, whatever the other issues, when we put a star unit manager in we got great results, when we put a weak player into even a strong shop, results turned bad. In other words, the unit manager was the pivotal job.

Now the initial challenge was clear — how could we go from 10 star performers, 10 decent performers and 10 weak performers to, say,12 stars,15 decent, and only 3 weak (let's not ask for miracles). More subtly, since we were looking to grow the number of shops, how could we build an ever-increasing roster of solid-to-great performers?

This was a different kind of people challenge. Instead of looking to fill one slot, the CEO, or a few slots, the CEO and his senior team, we were looking to find a way to reliably attract, develop and retain an entire level of our management structure.

This was a different kind of people challenge. Instead of looking to fill one slot, the CEO, or a few slots, the CEO and his senior team, we were looking to find a way to reliably attract, develop and retain an entire level of our management structure.

If pivotal jobs are so critical, what are the implications for the private equity shop, both before and after making an investment?

As with any challenge, awareness is the first step. It behooves the private equity firm to address the issue explicitly in due diligence. In many cases, detailed analysis of performance data, across the organization, over time, and relative to competitors, can help identify the pivotal job. Once it is identified, a series of logical questions follow. How well staffed is the pivotal job category? What has been the company's record in developing personnel for the pivotal job? Will the cadre within the pivotal job grow ?naturally, or is intervention required?

To illustrate, let's go back to the auto-body shop example, and do some simple arithmetic. First, we have the one-time problem alluded to above, namely going from 10 strong, 10 decent, and 10 weak performers to something more like 12,15, and 3. Thatwill take the chain from breakeven to attractive economics, but it means moving 9 unit managers up a category, on a base of 20 that aren't already in the ?strong category. Quite a challenge, but not the whole story, because the situation isn't static-we need to take both retention and growth into account. Suppose history shows us we should expect a 15 percent to 20 percent voluntary turnover rate, and that the business plan calls for 15 percent to 20 percent annual growth in the number of units. Now, in addition to the one-time improvement, we need another nine or ten capable unit managers a year, in an organization that has only developed 20 solid-to-strong performers in its whole history. That may or may not be achievable, but this simple (albeit not initially obvious) arithmetic makes one thing crystal clear-there must be a compelling new program to develop this cadre of people.

In other words, the private equity firm considering an investment should understand where they are in staffing the pivotal job, and what the likelihood is that the necessary level can be achieved and maintained. If growth is a key part of the investment thesis, as it usually is, the questions must extend not only to the existing organization, but also to cover the growth that is expected, or needed.

Once the firm owns the portfolio company, there is similarly a set of logical steps. First, and most obvious, is to pay ongoing close attention to the issue. As we all know, the company CEO pays attention to what his sponsor and his board pays attention to, and a company pays attention to what the CEO is talking about. Accordingly, ensuring that addressing the pivotal jobs challenge is high on the CEO's agenda is the first step toward solving it.

Second, it is important for investment professionals to have ?body contact with those holding the pivotal jobs. Senior management will naturally be inclined to portray itself as being on top of the challenge, whether they are or not. The private equity firm must have enough first-hand contact with those performing the pivotal jobs to assess for itself what is really taking place.

Third, the private equity sponsor and the company management team should jointly develop a program for building the pivotal job cadre. Elements of the plan can include the following:

Recruiting. Obviously, hiring strong performers from other companies is the fastest way to address the issue. However, remember that one of the reasons that spivotal jobs are so ?pivotal in the first place is that this skill set is what creates competitive advantage in the industry. Accordingly, it is a tautology that this skill set is in scarce supply-otherwise, it would provide no competitive advantage. This leads competitors to both protect their performers and raid yours, so external recruiting may break even at best, unless the recruiting program can be linked to, for example, creative compensation schemes.

Training and development.Analysis of the career paths of successful pivotal jobholders may indicate the most likely sources of strong performers from elsewhere in the company or the industry. It may also indicate what career experiences and/or relationships were most important in developing the scarce skill set. If so, the question becomes whether that set of conditions can be deliberately created and managed, rather than just being left to chance. For example, deliberately rotating prospective unit managers through various aspects of body-shop operations, and through a stint as assistant to the unit manager, might accelerate the development of well-rounded unit managers.

Building systems and infrastructure. Many middle-market companies, in particular, haven't done the hard work of ?institutionalizing their processes. In other words, they haven't systematically assessed the information needs of their pivotal jobholders (or other managers), provided decision support tools such as standardized policies and procedures, or captured and transferred best practices. As a result, pivotal jobholders are left to ?reinvent the wheel in terms of how they approach their responsibilities, and how they build their management processes. This is clearly a greater challenge than that of merely following well-established processes with good information, and so it requires a higher and broader, and thus scarcer, skill set. One of the great insights of such great operating companies such as McDonalds, however, is that ordinary people, with the right systems and infrastructure support, can be extremely successful. In other words, maybe the best way to break the pivotal jobs bottleneck is to sidestep it by, in essence, making the job more structured and, thus, easier.

Pipeline maintenance. The ?pipeline of candidates to be hired or grown into the pivotal job should be reviewed regularly, just as the customer pipeline is reviewed, and just as the progress of other critical initiatives is monitored.

Exit reviews. Whenever star performers are lost, careful attention should be paid to the reasons for the loss, and for any patterns which are emerging with respect to the company's ability to retain these critical personnel.

Long-term view. Finally, the private equity firm needs to strike a balance between achieving current economic goals, and building the pivotal job cadre. Since pivotal jobholders can be the limiting factor in achieving profitable growth, the development of this cadre of personnel should be viewed as any investment in growth would be, with the consequent willingness (up to a point, of course) to incur extra costs.

People are the core of any successful enterprise. Increasingly, for private equity sponsors, that means more than just the CEO and CFO. Successful sponsors will find a way to drive performance improvements not only at the top, but in every job where operational value is created most directly.

Chip Hughes is a co-founder and managing director of Blue Capital Management LLC, a private equity firm with offices in New Jersey and Los Angeles. He is also a management consultant advising private equity firms and their portfolio companies. Prior to co-founding Blue Capital, Hughes was a Principal (partner) in McKinsey & Company's New Jersey office, where he was a member of the firm's Health Care Practice and its Strategy Center.