Under Institutional Ownership for the First Time

Complete alignment between sponsor and management is an immediate priority, often addressed pre-close.

Expectations and a proposed road map can be circulated and committed to at the outset to set up a productive alignment.

Although strategies differed quite a bit, Roundtable participants agreed that alignment and coordination between management and sponsor is critical to a successful investment. Some firms commit to transparency at the earliest possible moment and share the IC memo with management with the goal of starting the alignment process pre-close. Additionally the sponsor may structure the deal so that management is asked to fund alongside the sponsor, either through an earn-out (a common approach) or by having management write actual checks into the deal (a much more psychological approach to alignment). This particular buy-in strategy combines a high-degree of visibility with an outlay of capital to pull management alongside the sponsor. Roundtable participants were quick to note that management should never be asked to personally overextend themselves financially, as that could lead to risky and irrational strategic behavior.

Other members of the Roundtable, while agreeing that transparency was crucial to alignment, were wary of too much disclosure pre-close, fearing that management could always opt-out of a deal and decide to go it alone with the plans specifically developed and shared by the pending sponsor.

Two common strategies came out of the conversation:

• Installing a strong and reliable outside Board member is crucial. Beyond typical mentorship and advisory work, a strong outside Board member should have the ability to act as an intermediary when a misalignment between the sponsor and management occurs.
• There was strong agreement among participants that the sponsor needs to be highly transparent about the exit plan for the company. Communicating this objective clearly means that sponsor and management share a common goal throughout the holding period.

Identify possible gaps between sponsor and management, and focus on how to bridge them.

Entrepreneurs may have a very particular way of looking at their business, but ultimately their perspective needs to align with the sponsor’s. This may be a challenge, especially as sponsors employ more of a data-driven strategic decision-making process, in environments where the entrepreneurs have traditionally managed by “feel”.

Speaking from experience, a number of professionals at the Roundtable pointed out that it was particularly helpful to show management teams how the sponsor specifically breaks down and tracks metrics around other portfolio holdings. In fact, this can be useful as part of a larger conversation about expectations that the sponsor has for the target management team. A number of participants reiterated the need for a management team that synthesizes data and reaches their own conclusions before sending to the sponsor, rather than just providing detailed but overwrought data dumps.

“A 400 page data dump is far less valuable than a concise 10-page pack focused on the actionable info and metrics. However, management teams often take this information overload approach to simply appease the sponsor.”

Of course, as pointed out by one Director from a multibillion growth equity fund:

“It’s important to keep a keen eye on management’s motivations. If management seems particularly resistant to providing more data around the business it could be a sign of a technical gap, or more problematic, management trying to hide something.”

Of course, if it as simple as a personnel or technical gap, the sponsor should try to respond quickly and provide the necessary support to management. Applying pressure to a new management team is part of the process; however, too much pressure can sour a new relationship and create problematic misalignment.

Beyond clear and direct alignment of expectations, deals can also be structured in a way that optimizes the relationship, underpinned with a proper focus on incentives.

Although the numbers vary, many of the private equity professionals in attendance at our Roundtable agreed that it was crucial that management keep some skin in the game. At least one participant said that they sign all management teams to five year vesting arrangements with no acceleration upon a change of control, a significant value proposition for a potential buyer that can ultimately drive a higher multiple but misaligns management with the sponsor. Others cautioned against any misalignment of incentives on exit, as it may signal less than total commitment by management to the sale process.

The specifics of each arrangement rely on an understanding of management’s motivations, economic climate, and the sponsor’s proposed exit strategy. Finding a number that makes management feel the same pressure as the sponsor, while keeping them out of hot-water seemed to be the approximate goal, though there were diverse investment strategies represented at the Roundtable.

When alignment isn’t possible between the CEO/founding management team and the sponsor it is important to quickly, smoothly, and competently rebuild the management team.

While not a pleasant consideration, a fact of life in any private equity deal is that the management team at acquisition may not be the team that is best suited to grow the company through the next life cycle and through exit.

“There’s a real difference between a founding leadership team and a ‘management team’ and this needs to be addressed early and often.”

One point that came through clearly was that, if a management change is appropriate, it needs to be executed quickly.

“No one has ever said ‘I wish I had waited longer to make an executive management change’ after seeing the benefits of upgrading a management team.”

One participant stated that management change really needed to be on the Board’s agenda within six months, if results were not as expected or progress wasn’t being made on any misalignment. Beyond the specifics, a number of the private equity professionals at the Roundtable made it clear that there needs to always be a management backup plan in place and ready. In fact, arguing that it’s an exception that an entrepreneur continues to operate the business. One speaker made it clear that a backup plan is a priority pre-acquisition.