Why Private Equity Needs to Invest More in Talent Development

CURT NICKISCH: Welcome to the HBR IdeaCast from Harvard Business Review. I’m Curt Nickisch.

It used to be that if you were a leader at a company getting acquired by a private equity firm… you had good reason to be scared. That’s because PE firms would often cut jobs or bring in their own leadership teams at the companies they bought.

As a business, private equity firms raise money to buy up struggling or promising businesses. The idea is to restructure them or change their business model and then sell them several years later at a profit. But rising inflation and surging rates have been hitting the private equity industry hard. After years of robust growth at low interest rates, these firms now have to create more value just to break even. Plus, there’s a lot more competition now.

Our guest on the show today says private equity firms can turn things around by investing in the talent at the companies they manage. In short, it used to be all about the financials. Now, it’s about the people.

Ted Bililies is a partner and managing director of AlixPartners. He wrote the HBR article “Private Equity Needs a New Talent Strategy.” Ted, thanks for being here!

TED BILILIES: Thank you so much for having me. It’s a real pleasure.

CURT NICKISCH: How bad is it? Like how big of a shock is this interest rate climate for the private equity industry?

TED BILILIES: Well, rising interest rates are pretty much of a shock. I mean, it makes it more expensive for investors to buy companies, and for private equity investors, it’s all about their returns. So if the cost of capital is going to be higher, it means that the hurdle rates on the other end are going to be more challenging. Unfortunately, it’s not just interest rates that are providing sort of headwinds, there’s also more capital chasing fewer deals. That’s a challenge, and then what private equity is actually buying is challenging. So suffice it to say, there are some pretty significant headwinds challenging the sector right now.

CURT NICKISCH: Why are there fewer deals with more capital chasing fewer deals?

TED BILILIES: The universe of kind of 100 million to $400 million companies has actually gone down. Private equity is now a $12 trillion industry, so the number of competitors have gone up. As you know, historically, private equity has bought companies, put a bunch of debt on them, generally looked to sell them in three, maybe four years. That whole business model is, if not kind of coming apart, it’s just really, really challenged so that holding periods are now increasing a great deal. There are fewer of those deals to find.

What private equity is actually buying has changed. I mean, increasingly, private equity isn’t buying just one company. They’re doing what are known as platform deals, where they’ll buy a large company, and they’ll add smaller ones or roll-ups, where they’ll buy six, seven, eight HVAC companies or dental offices, and then meld them together. Those kinds of deals are becoming much more common because those standalone, buy one company deal is becoming harder to get.

CURT NICKISCH: So that puts a lot of pressure on the industry to professionalize across the board in a way that it maybe hasn’t had to before. There are lots of things that they do and they can maybe improve upon. You’re arguing that one of the best ways that they can make more money, serve their investors better, manage this new climate, is by improving the talent at the companies that they manage.

TED BILILIES: Basically, yes. The essence of private equity is accelerated value creation, so the question becomes, “How can you create the most value quickly?,” given everything that we talked about, the surplus of capital, the rising interest rates, these roll-ups and platform deals, the longer hold periods. “What lever hasn’t been pulled or pulled enough to create accelerated value creation, basically to help grow the asset?” And I maintain that it’s the people variable. It’s the people, it’s the talent, it’s the strategic management of the talent that historically has been very neglected, kind of shockingly neglected, but now is becoming more into view.

And why is that important? Well, if we just take one of those aspects, like doing more platform deals, bringing companies together more, in integrating teams, you need to create a coherent culture. If you’re putting six companies together, you can’t have six different cultures, and so you can use the term, professionalized management, but whatever term you use to accelerate value creation in this collection now of assets, you’ve got to be able to integrate those companies, you need to have a coherent culture across those companies, and you have to invest in people because you’re going to be holding that asset now, not three years, not four years, but potentially six years or seven years. So you’ve got a longer holding period. That means you’ve got to look at the bench strength of your leadership.

And here’s a real key fact, which is the war for talent is still going on. I think the United States unemployment rate is a whopping 3.9% up from 3.6% a year ago. It’s still at historical lows. So how do you attract and retain talent at your private equity-backed company that you’re holding onto now for a longer period of time? Right?

That’s a very, very challenging question. And the way to do that is to be able to understand the talent that you want to attract and understand what’s important to them. So 50% of talent in the United States right now is comprised of Gen Z and younger millennials. We know that the values of the company matter to them, and their alignment with the values of the company. So that’s a huge factor in this war for talent. You’ve got a company that you’re holding twice as long as you’re used to holding, you’re trying to create value there, you understand that it’s nestled in the people, but how do you get those people, and how do you retain those people? And the answer to that is leadership.

CURT NICKISCH: You called it neglected before, but how has private equity management of portfolio companies treated leadership? And I’ll just say that probably the stereotype was that PE firms came in, replaced everybody, brought in people that they wanted, kept people on who would do what they wanted, and cut a lot of costs, cut jobs, and then create value that way. That’s the stereotype maybe for the industry.

People in the industry probably say that they look at the management team as partners. They’re there to work together to create value, and when they even decide which companies to buy, they look at who’s running it, they have conversations, and they’re trying to figure out how to create value together in a partnership. How is it done, really, do you think, and then what opportunity is there then to change this talent strategy, or to do things differently?

TED BILILIES: I think the scenario that you described, Curt, are kind of like two extremes. So coming in, firing a bunch of people, loading on debt, I mean, of course, that happened. It happens a lot less now for lots of reasons, including that many companies that are bought by private equity firms are bought from other private equity firms. In other words, a lot of these companies have made the rounds. They’ve already had their costs taken out of them. They’ve already been kind of skinnied down, if you will.

So investors, private equity investors have to get a lot more creative, and they do have to move more towards the other side of what you described, which is partnering more with the management teams. So as they partner more with management teams, as the nature of employees change, they become younger, they become more demanding, and the holding period increases.

What we’re finding private equity investors needing to do a whole lot more is to say, “Let us explain to you what the employee value proposition is for working for our company. Let us help you, the CEO and management team articulate that message to the workers you have and the workers you want so that you can attract and retain the talent that you need.” That’s through career pathing, that’s through mentoring. “How will you or I, as a worker in this company that’s now private equity-backed, how will we attain our own goals and achieve our own potential?”

Now, the previous view was, well, you’re going to get so many stock options. You’re going to be able to realize so much financial wealth. We go right back to who we’re trying to hire. Is money important to younger workers? Of course it is, but what we’re finding is that there are things besides that, that are important. So private equity has had to become more sensitive, more aware, more nuanced to how it helps private companies grow through this lever of talent.

CURT NICKISCH: It’s interesting because what private equity does, whether it’s five years or seven years for an average holding period, it’s longer than quarterly earnings, right? They don’t have to worry about the public markets and the stresses of that, but it’s still relatively short-t erm to establish value in a company, see through their thesis of how they feel like they can invest and create value, and then hopefully sell it or take it public or whatever. Developing people, and attracting talent, and creating a strategy for that feels a lot longer term. It feels like a slower strategy. I don’t know if that’s right. How do you square those two?

TED BILILIES: It’s not a slower strategy, it’s definitely a newer strategy. So seven years is a long time, and there’s something called succession planning. Succession planning is not just for the C-suite, it’s not just for the CEO. Succession planning is for any value creating role in the organization, and as we move into this digitized phase, we’re finding organizations have value creating rules at all levels of the organization. It isn’t just the CEO and his or her direct reports anymore.

So the first thing a good private equity investor understands in the due diligence process is, “Where is value created in this organization?” Here’s a hint, it’s not always at the top of the organization. Question number two, “Who’s in that role?,” and question number three, it’s very unlikely that that man or woman is going to be in that role for seven years. We need to really think about not just buttressing and supporting him or her, but there are a whole bunch of people and a whole bunch of roles.

So now, you get into leadership development and succession planning over the longer term. I would say we’re really talking now about culture. How do you identify, understand, and build and strengthen the culture over time, because ultimately it’s going to be culture that helps retain your talent?

CURT NICKISCH: So what does it look like for a private equity firm to change the talent strategy at a company? How can they help?

TED BILILIES: Well, there are a number of things that both the private equity investor can do, and then the Port Co itself can do.

CURT NICKISCH: Port Co being-

TED BILILIES: The portfolio company. Yeah, the portfolio company. So from the PE side, and investors will always say that they want to partner with their management teams. The reality is, Curt, there’s a lot of room for improvement in this partnership.

Number one is the private equity firm can hire or appoint a human capital partner on their side who it’s going to work with the CEO, the CFO, the CHRO and the portfolio company, to instill the recruitment and development systems necessary that that company is going to need to attract and retain talent.

So the first thing is, side by side with the deal partner is a human capital partner at the private equity firm. And in that deal thesis, in that investment thesis, as in the due diligence phase, why would we invest in this company? We are going to identify the leadership and management capabilities that they have and that they’re going to need to be able to deliver value, and the human capital partner on the PE side is going to help guide that discussion.

CURT NICKISCH: Are there firms that do this already?

TED BILILIES: I estimate about half of the really big firms, so now, we’re talking Blackstone, Carlyle, TPG, Apollo. Roughly half of the really big firms that are approaching or exceeding a trillion dollars under management already have this position. Now, the vast majority of private equity firms are what’s called middle market, smaller, and some significant portion of those are starting to acquire this person. In the early days of acquiring this human capital partner, he or she oftentimes were assigned, and to some extent still are, with running searches. That’s not what we’re talking about.

I think what the goal is here is to help the Port Co, the company that the private equity firm’s owning, is to really build systemic, integrated human factor capability in their company, not just filling that hole and filling that hole. “Oh, we need a new head of marketing and company B, and we need a new head of consumer products and company C.” That’s some kind of progress, but creating an integrated system is really the goal.

CURT NICKISCH: Are these folks hard to come by? Like what makes a strong leader there?

TED BILILIES: That’s a great question. So you’re saying, “How difficult is it to find and train those people?” It’s pretty difficult, because what you want is someone who not only has the requisite skills around recruiting and identifying an organization development. So there are a fair number of people. They come out of HR, they come out of search, they come out of the behavioral sciences, but then, you need someone who’s also able to hold their own with the deal team, so the internal aspect of that role, where they have to, at some point, they’re probably going to get elbowed out of the way a little bit just because of the way private equity is kind of structured, so they have to be pretty strong to say, “Look, you hired me to do a job here.” tThere’s some who have been very successful in that role, and that comes from knitting together really solid relationships with the deal team.

CURT NICKISCH: Can you tell me about any success stories? What’s a case where you’ve seen the value of this approach?

TED BILILIES: I’ve seen a number of places where it’s been successful, and there’s a well-known private equity firm that really embraced the human capital partner, understood his value right away. And then every deal partner wanted him involved in whatever deal they were looking at. Again, there are other factors we can point to, right? There’s high turnover with CEO. CEO turnover is up, CEO longevity is down. When a CEO leaves a company a year or two years into a hold period, that is incredibly upsetting and very, very difficult for the private equity firm to deal with. So again, if the human capital partner can avoid something like that happening, he or she is worth their weight in gold.

CURT NICKISCH: What are some other examples of the value of a human capital partner and this focus on talent at portfolio companies that can really pay off?

TED BILILIES: Well, let’s go back to one of the original points I made, which is that the standalone 100 million to $400 million companies are not exactly falling from the sky. Private equity firms are looking for platform deals and roll-up deals. Well, particularly with roll-ups, also with carve-outs, you’re dealing with buying an asset that either doesn’t have an HR function, doesn’t have a people function, or it has a kind of skeletal people function. Particularly, if you’re in this roll-up phase and you’re buying up smaller practices, there’s a head of HR who handles pay and benefits, doesn’t handle leadership development, doesn’t handle succession planning, doesn’t handle organization development, none of those things.

And these functions are absolutely essential now. What many of our best private equity firms do is that once or twice a year, they will bring into a central location the companies they own, the CEOs and the CHROs together, and we’ll facilitate a conversation about best practices. So it’s really about elevating the HR function in the companies that are owned by private equity. This would’ve been unheard of 10 years ago. It would’ve been unheard of five years ago.

CURT NICKISCH: Just because it wasn’t worth their time.

TED BILILIES: There really wasn’t the need. If I can flip a company in three years, I can use financial engineering to get all the return I need out of that. I don’t really need to stop and think about people, to be perfectly honest. If I can hire as many people as I need, and the cost of capital is cheap, it’s just not on my radar screen, but now it is.

CURT NICKISCH: Are there lessons here that private equity firms are learning, really, about developing leadership in tighter economic times, that you think other companies can learn from and other managers can learn from?

TED BILILIES: Well, let me tell you about a situation that we see all too often, and it’s a real difference between how leadership is understood and defined from the private equity view versus from the CEO operator view. We do research every year, and we’re almost at our 10-year mark of doing an annual private equity leadership survey, and we have two tracks in that survey, private equity investors and operators, CEOs, CFOs, CHROs.

And it’s just always fascinating to me. It’s this thing I call the myth of the magical leader. Private equity investors tend to think either consciously or unconsciously, that if they find the right person, that magical man or woman who is just an A player leader, that he or she is just going to change everything and make everything right.

By and large, CEOs don’t have that view. CEOs understand that leadership is a team sport and you succeed – frst of all, if you’re not succeeding and making other people successful at the same time, then nobody’s going to succeed. It’s a team sport, and you’re going to do that more often than not by having your ego in check and making other people successful.

Now, those two definitions of leadership are pretty much diametrically opposed, and I’d like to think that we’ve kept many private equity firms from making a terrible result by picking the most extroverted, or the most charismatic, or the most narcissistic leader, and basically have said, “Stop. Stop.” They interview, great, but you’re looking to accelerate the creation of value in this company now over multiple years. Let’s really understand how that’s going to play out.

CURT NICKISCH: Private equity plays a big role in the economy. What would you want leaders in this space to know? Like what’s a big misconception?

TED BILILIES: I think many private equity investors believe that the supply of workers is kind of endless, or that if you pay people enough money, you can pretty much get whomever you need, if you give them enough equity options or stock options in the company, and that just clearly isn’t true. We’ve got demographic issues, but as I said earlier, Curt, we’ve got a workforce across the world that is asking very different questions and has very different demands of its leadership than perhaps you and I did when we were coming up through the ranks.

And so generally, private equity investors realize that the times have changed. They need to think a little bit more complexly, a little more subtly rather, and they understand that, “Yeah, things like employee engagement, the values of the organization, the culture of the organization really matters.” and it’s never been more true than it is today with the war for talent.

CURT NICKISCH: Ted, thanks for coming on the show.

TED BILILIES: Thank you so much, Curt. It’s been a real pleasure.

CURT NICKISCH: That’s Ted Bililies, partner and managing director of AlixPartners, and he’s the author of the HBR article, Private Equity Needs a New Talent Strategy.

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Thanks to our team, Senior Producer Mary Dooe, Associate Producer Hannah Bates, Audio Product Manager Ian Fox, and Senior Production Specialist Eckhardt, and thanks for listening to the HBR IdeaCast. We’ll be back with a new episode on Tuesday. I’m Curt Nickisch.