CEO alpha: A new approach to generating private equity outperformance

| Article

Private equity (PE) sponsors and portfolio companies continue to view operational improvements as a crucial lever for realizing outsize returns.1 But there is another important enabler of PE value creation—what we call CEO alpha, or the value created from CEOs’ outperformance. If the PE portfolio company CEO, who calls the shots and makes the strategic decisions, lacks the right leadership capabilities, targeted operational improvements are less likely to be sustained or may never materialize.

McKinsey research shows that top-quintile CEOs have historically delivered total shareholder returns that are 9 percent above industry peers in each year of their tenure. In industries such as financial services and automotive, these high-performing CEOs have achieved excess total annual returns of 16 percent on average.2

Against this backdrop, it’s clear that CEO alpha is an idea whose time has come—or is maybe even overdue—in the rapidly evolving PE industry. Private equity sponsors generally agree. They increasingly cite leadership as an important source of EBITDA growth and value creation alongside the usual performance levers (the targeted operational improvements as well as technology innovation, financial leverage, and multiple expansion). Indeed, in a 2022 survey of general partners, 94 percent say they believe PE portfolio company leadership contributed an average of 53 percent toward investment returns.3

In our own conversations and work with PE CEOs and sponsors, all acknowledge the importance of CEO alpha and agree that they could, and should, do more to build PE portfolio company CEOs’ capabilities to realize outsize returns. Industry research suggests the same. For instance, among the general partners polled in the 2022 survey, 8 percent say they are committing money, 27 percent say they are deploying resources, and 36 percent say they are putting in the time to optimize PE portfolio company leadership.4

What’s more, playbooks for intentionally building leadership excellence in private equity have been scarce, which represents a huge missed opportunity: investing in human capital now can pay off over the longer term.

To achieve CEO alpha, PE portfolio company CEOs need distinct capabilities—those that go beyond typical leadership traits found among the best public company CEOs—and that account for PE-specific time horizons for investment and exit and speed to impact. In this article, we provide an overview of those capabilities and the ways to achieve them. Whether the CEO is new or an experienced leader, an expert practitioner of PE, or someone with a more diverse background, the essentials of CEO alpha can be customized and adapted to meet their unique context and opportunities.

Why CEO alpha matters in private equity

PE portfolio company CEOs face unique challenges in an already complex role. The level of autonomy in decision making, the degree of focus on EBITDA, and the way that boards govern are different in PE portfolio companies than in other companies. “There is less freedom within strategy setting,” the CEO of a PE-owned healthcare company told us. “Where to compete is also more tightly defined, because of the time-bound nature of investments.” Another PE executive, based in Canada, noted that EBITDA is a central theme in all conversations among the portfolio company CEO, the board, and the general partners.

Changes in the global economy and the broader business landscape have only made the job of these CEOs harder. Private equity is not immune to cyclical economic challenges such as the elevated risks of a US recession, high interest rates, and inflation. It also faces digitization, sustainability, the changing geopolitical order, and other disruptive trends that are likely to have profound and lasting consequences on the investing ecosystem. These headwinds, coupled with the volatility in financial markets, slowing IPO activity, and falling tech valuations, are weighing on PE deal flow, fundraising, and performance.

In addition, PE portfolio company CEOs tend to come from varied backgrounds. Some may have a science background or previously led public companies. Often, company founders grow a small business to a certain level, take in private capital, and suddenly find themselves leading a midsize company with very different organizational needs, which they may not have the necessary expertise, experience, and PE-specific core competencies to navigate.

Most leadership development programs are not tailored to the unique needs of this community of CEOs. In fact, in our experience working with PE CEOs, we have not encountered many such programs that have been widely adopted in the industry. The few programs that do exist are usually the result of an enterprising sponsor that is beginning to build a unique capability.

Achieving CEO alpha in private equity

At the heart of the concept of CEO alpha is the belief that leaders can systematically develop the capabilities required to achieve outperformance. Indeed, PE portfolio companies should design their capability building programs with the essentials of CEO alpha in mind (see sidebar, “The essentials of private equity CEO alpha.”)

A focus on three essentials of CEO alpha, in particular, could help PE portfolio company CEOs address some of their toughest challenges and realize even greater impact: talent management, PE performance management, and strategic planning.

1. Talent management: Building a fit-for-purpose team

Talent management is a top concern within private equity these days. This reflects, in part, the ever-changing competition for talent, but it also reflects the unique executive profiles that PE portfolio company CEOs are targeting, as well as the number of roles they must fill. For example, one PE portfolio company told us that 37 roles among thousands of employees in the organization drove 80 percent of its EBITDA, which prompted senior leaders to change time allocation, managerial focus, and apprenticeship priorities for employees.

Much more than public company CEOs, PE portfolio company CEOs must build their management teams to execute a specific investment thesis. They must find and hire leaders who are execution focused, decision oriented, financially astute and motivated, and able to make consequential decisions quickly. What’s more, PE portfolio company CEOs often have to build and rebuild their teams. For example, on average, they are responsible for filling between 30 and 40 percent of level-two positions (heads of divisions) and 50 to 65 percent of level-three positions (vice presidents).

As one PE executive said in an interview, “Outside of M&A, people decisions are most important, and getting them right is critical.” McKinsey research supports this point: CEOs who frequently reallocate talent are 2.2 times more likely to outperform their peers, and those that get talent right in the first year achieve 2.5 times the return on initial investment.5A playbook for newly minted private equity portfolio-company CEOs,” McKinsey, September 24, 2021.

How can PE portfolio company CEOs begin to build capabilities in talent management? Keeping the investment thesis and time horizons in mind, they’ll need to identify the roles that will create the most value for the portfolio company and then match talent to value (whether from inside or outside the company). As one PE leader advised, “Do it fast, and early in your tenure.”

PE portfolio company CEOs will also need to institute performance management processes that set “reverse hockey stick” targets (rapidly making decisions that drive the greatest financial benefits the soonest) and make it easier to monitor organizational performance and address unfavorable variances. For instance, a PE portfolio company may expect 60 to 80 percent of all run-rate benefits targeted over a three-year period to be captured within the first six to 12 months. The performance management process must allow for private-equity-style consequence management and provide upskilling opportunities for leaders.

2. Cascaded performance: Using financial and operational dashboards to run the business

PE portfolio company CEOs must be on top of every performance metric at a level of detail unfamiliar to many public company CEOs. Given the short time horizons for meeting value creation goals, they are expected to continually monitor performance, spot variances, and pivot quickly as needed. It’s important, then, for PE portfolio company CEOs to set up robust performance dashboards (and rules for using those dashboards) that take both people and purpose into account.

At a minimum, the dashboards should enable standard reporting, risk management, and identification of key opportunities. They should yield detailed and dynamic performance reports that take pricing, safety, quality, speed, satisfaction, efficiency, and integrated economics into account. The teams using these dashboards should be clear about their roles and operate within the scope of those roles. And CEOs should ensure that dashboards are used in all decision-making discussions across the organization.

This detailed, holistic approach can yield positive results: one PE portfolio company was looking at controlling high labor costs, but a closer look at the company’s integrated performance dashboards revealed that a lack of world-class safety was actually a big factor in the increased labor costs. With this information, the PE portfolio company CEO was able to successfully divert resources to address both safety and cost issues.

3. Strategic planning: Achieving far more in far less time

All CEOs must help to define their company’s vision and strategy, but the process is different for PE portfolio company CEOs. The PE sponsor typically performs rigorous due diligence on a portfolio company, often over a six- to 12-month time frame, and formulates a specific investment thesis. The PE portfolio company CEO is then hired to execute the sponsor’s thesis in a timely manner. That CEO must partner with the PE sponsor and the board on strategy, ensuring that any changes made will create value within the industry’s typical three- to five-year time horizon for value capture. To achieve CEO alpha in strategic planning, PE portfolio company CEOs must embed strategy into their day-to-day work—that is, in every discussion with sponsors, teams, and other key stakeholders, and in every review of performance outcomes and financial and operational results. Strategic actions in this context must be bold, actionable, and executed quickly. “Public companies build aspirational, long-term, often vague visions,” the CEO of a private debt firm told us. “But PE companies need to have clear, tangible short-term decisions. As a PE CEO, you are almost always given the strategy as part of the value creation plan and expected to refine and execute.”

With the essentials of CEO alpha in mind, sponsors can review their portfolios against their value creation plans to identify where the biggest opportunities and capability gaps are and create fit-for-purpose capability building programs for PE portfolio company CEOs.

The prevailing research and our work with hundreds of PE company sponsors suggest that an increasing number of PE firms are doing just this. They are prioritizing CEO development and leadership effectiveness as the means to generate outperformance. They are starting to put just as much emphasis on recruiting, onboarding, peer learning, succession planning, and performance management as they do on other key levers of value creation.

In short, they are beginning to target the essentials of CEO alpha. And the sponsors that get it right can build portfolio companies that attract and develop topflight CEOs and seed the industry with even more high-end talent for the future.

Explore a career with us