For lower to middle market private equity funds, a key value creation lever can be the successful, collaborative transition of a founding CEO. A key part of the investment thesis in these instances is bringing in a new CEO to build upon prior success and lead the next stage of the company’s lifecycle.
During the courtship phase, financial sponsors and founders tend to agree on more rather than less. They often align on a similar worldview, a shared belief in the business prospects, and an investment thesis on how to maximize value. This investment thesis often includes a transition plan that allows for a new CEO to lead the company in the next phase and by default serve as a responsible custodian of the founder’s reinvestment equity.
It’s a great model for many entrepreneurs — get some cash out, move into a board role, let the PE firm and new CEO take on the punishing assignment of executing the next operating plan. After all, the investor’s track record demonstrates their ability to create value, trigger wealth-creating events, and this can all happen for a founder as an active board member versus an always-on CEO. As they say, “Would you rather be the king or would you rather be rich?”
Despite the shared understanding between sponsor and transitioning CEO about the validity of the plan, doubts will rise and fall in the entrepreneur’s mind. “Will we actually find someone who cares about the company and our employees the way I do?” “What happens if we hire a CEO who says all the right things but can sleep soundly at night when we have an unsatisfied client?” “Am I going to miss riding the roller coaster?”
During the process of searching for a new CEO, one of the most under-appreciated success factors is the collaboration between the executive search partner and the transitioning founder.
“Our ability to achieve our desired MOIC [multiple on invested capital] depends entirely on the CEO replacement search being a successful project,” says a partner at one lower middle market private equity firm. “The whole process is complex and it’s something we’re good at. But it also depends on a search partner who can calibrate quickly and empathize deeply with an owner/operator.”
We talked to several lower middle market private equity firms about best practices for working on founder/CEO replacement searches. These were the takeaways from our discussions:
- Find the right executive search professional. The search executive should have real world experience to establish trust and reinforce further with the founder that a replacement is in the best interest of their reinvested equity and the overall success of the company. Having an external executive search partner who can share his/her positive experiences on these exact questions can strengthen the buy-in process before, during, and after the search process.
- Prioritize in-person cultural intake.Make sure the search executive flies out to the locale of the founder/CEO, wherever that may be. It’s an important step in building the trust needed for success. And from a project management perspective, it’s hugely additive to understanding the culture of the company.
- Get the guard down. Surround the CEO candidates with operating advisors and search professionals that can develop peer-quality relationships with them through shard experience. This will help with the vetting process.
- Emphasize quality of relationship between PE and founder/CEO. Any solid CEO candidate will assign value to this factor. The search professional and operating advisors should sell on this point. If the acquisition happens to be a proprietary deal, that should be highlighted as it validates existing trust factor and quality of relationship between investor and management.
- Find hands-on operators. Focus on candidates that know how to work with leverage but also be hands-on at same time. All PE-backed companies in the lower middle and middle market need this hands-on factor, and this is particularly true when it comes to establishing a good relationship between the founder and incoming CEO. For example, when discussing a tough employee attrition or process compliance challenge, can the candidate demonstrate that they knew what was going on a root cause and solution level?
- Don’t forget the basics. While you’re looking for an outside CEO who will mesh well with the founding CEO, at the end of the day the most critical relationship is between the new CEO and the private equity investors. The basics still apply: ability to work under pressure, reflexively comfortable with change, high sense of urgency, low ego, adrenaline for hyper growth.