Companies backed by private equity (PE) tend to transform faster and more often than public or family-owned firms do, and they consistently perform better than peers. McKinsey’s Marla Capozzi and Sacha Ghai researched nearly 300 CEOs across PE and private-capital companies to define their tactics and share their best practices with others. They and their coauthors published the findings in a recent Harvard Business Review article, and in this episode of The McKinsey Podcast, they speak with Editorial Director Roberta Fusaro about lessons from PE that any company can implement.
The McKinsey Podcast is cohosted by Lucia Rahilly and Roberta Fusaro.
The following transcript has been edited for clarity and length.
Playing the long game
Roberta Fusaro: What surprised you the most as you were doing this research and in your conversations with executives?
Marla Capozzi: We learned a few things. One is that nearly all the leaders we spoke with were focused on building sustainable, long-term companies—ones that would have a legacy, serve their communities, and create value today and for the next buyer and ongoing. I think we had a bit of a mindset that said, “They must be focused only on the holding period or a short-term mindset.” And that wasn’t the case. One CEO even told us, “Yes, I understand the role of cost cutting through labor, as well as having to deliver performance results, but I’m a part of my local community, and I will look for many other ways to cut costs before I do that.”
Also, when we started to summarize what was top of mind for them, they all selected four categories that emerged in this order: talent, strategy and operations, governance, and culture.
CEOs under pressure
Roberta Fusaro: Sacha, put this in some context. What’s happening in the market overall that makes this leadership topic so important?
Sacha Ghai: I think the first is just how big this community of CEOs is. It’s been written about in various publications, like The Wall Street Journal, which has used the phrase, “The world . . . is going private.”1 In the US, there are 17 private companies for every ten public companies. That speaks to how large this community is, why it’s important to study what its leaders do to make it great, and how leading a PE company is different from leading a publicly listed company.
The other important feature here is that there’s a tremendous number of challenges facing this community of private-company CEOs. Our latest research shows 60 to 70 percent of private-company CEOs are replaced by sponsors within the first few years of starting their job. The position is particularly difficult because they have to deliver outsize value creation in a very short period.
They are often working with limited resources because they’re running medium-size businesses. They have to deal with technological change, such as the rise of AI. They have to deal with trade and geopolitical issues. And that motivates the need to really explore the practices that make private-company CEOs successful.
Marla Capozzi: When we looked at these constraints, reflecting on what Sacha mentioned about the world going private, we really learned that these constraints drove a lot of creativity in terms of how these CEOs approached many of these challenges. And even though others may not have similar constraints right now, they’re likely to have them at some point.
Looking from the outside in
Roberta Fusaro: Let’s dive into the practices that you’ve identified. First, Marla, what’s full-potential diligence? And why might others want to adopt this practice?
Marla Capozzi: Full-potential diligence is taking an outsider or an investor’s view of your business. It looks at what you’re doing across various different levers that are important, such as strategic, commercial, operating, capital expenditure, and risk levers. It also looks at operational effectiveness and governance. So if I were an investor, not the CEO, how would I evaluate this business? How might I invest in it? Is it attractive? Why and why not?
We’re starting to see many of the PE sponsors going back and conducting further diligence processes for their business after the investment thesis, then coming back to the CEO and top team and saying, “We’re seeing this, we’re seeing that, in your business. You should address this.”
What we’re finding is the absolute best portfolio company CEOs are owning this process, doing it regularly, and then going to the board and saying, “Here’s what we’ve learned about both the what and the how of our business; our strategy is on track. Also, this is what we own and want to learn as a result of the outside–in view.”
How can revenue be unprofitable?
Roberta Fusaro: Sacha, another hallmark of the research is a focus on eliminating unprofitable revenue. Can you say more about this? Why is this so important?
Sacha Ghai: World-leading CEOs of private companies aren’t satisfied to grow just top-line revenue. They’re instead very focused on growing the bottom line, growing the fundamental profitability of the enterprise. And their resolute focus on that is distinctive.
World-leading CEOs of private companies aren’t satisfied to grow just top-line revenue.
That focus causes you to look at your business in different ways through different lenses. And one of the lenses that we’ve heard of time and time again is product or customer profitability, starting to slice and dice your business based on the individual products you sell or the customer segments that you sell to.
Here’s one quick example to bring this to life. A particular company that we were working with had 20 product categories, and it never looked at profitability at the product level. Once it did the fundamental analysis to allocate all the costs—like the front-office cost, back-office cost, sales cost, everything—to the individual products, it was very illuminating.
It discovered nine out of its 20 products were unprofitable. And by removing those nine unprofitable products, it was able to drive up free cash flow by more than 17 percent and add significant capacity that it could reallocate to its profitable products to grow them.
That’s an example of what we mean by “eliminating bad revenue.” Revenue went down a little bit, but profitability went up dramatically in the situation. And that’s a little bit of the logic that we’ve seen PE CEOs take to deliver outstanding performance.
Roberta Fusaro: How hard is that for public-company CEOs to replicate?
Sacha Ghai: It’s the same logic. You have to see how much time is being used, how much energy it takes, how many people are allocated to that particular job versus this. So you have to do a little bit of what I would call “plumbing and spade” work to get it set up. But whether you’re public or private, there’s no difference. It’s the same logic. It’s the same process.
Marla Capozzi: It really challenges the mindset we hear from many leaders that “all revenue is good revenue.” You first have to be willing to challenge that core belief, look at the numbers, and take action against that.
Streamlining talent
Roberta Fusaro: Sacha, you also highlight in this article the need to cleansheet the labor pool in order to work more efficiently, more effectively. But that’s not just about cost cutting, right? What does this best practice entail?
Sacha Ghai: What we found is when you talk to the leading PE-backed CEOs, they say, “What should be the cost of my finance function or my sales organization? I don’t care what the cost is right now. I want to build it from the bottom up.” And that’s where this word “clean-sheeting” comes from—taking a fresh look at what it should be.
So what do you do? Well, you do a few different things. One is you kill low-ROI work. You centralize groups. Rather than having a disparate set of call centers and a disparate set of service centers, you bring them together with better supervision, hence improved performance. Then if you reallocate work from lower to higher performers, you can improve productivity and save costs as well. And then you rebuild the organization.
Looking at all these levers, you ask, “OK, what should this organization look like to deliver the service or the capability for the best possible efficiency?” When you do this, you’re able to provide significantly better customer experience and employee experience because high performers want to work with other higher performers. And often, you can reward those people more for the performance they deliver. And all those things result in a healthier organization, not just a more efficient organization.
Roberta Fusaro: How often do PE company CEOs engage in clean-sheeting? Is it something that you do frequently? Is it something that you do just one time and let go? How should CEOs think about clean-sheeting?
Sacha Ghai: I think they tend to do it in a few specific instances.
The first instance is oftentimes when it’s part of the full-potential diligence. So they’re building what’s called a “VCP,” which is a value creation plan. And as part of that, they say, “If we cleansheet a few of these different functions, what could we potentially get in terms of effectiveness and efficiency?”
Another period is typically closer to the midpoint of the hold period. In PE, hold periods are typically about five to seven years.
Finally, toward the end of the hold period when they’re looking at a sale transaction, they may want to quantify what the upside potential is for the next buyer. Then they could harvest it and potentially gain some of that in the sale price.
Talent is an anchor
Roberta Fusaro: Marla, I’m going to switch gears a little bit. One might assume that PE portfolio companies would need to focus less on talent and culture, given the short time frames and so forth. But is that really the case?
Marla Capozzi: Interestingly, it’s not the case, and it’s a huge priority. The best CEOs really focus on having what we call “a fit-for-purpose leadership team.” There are two important questions: “Am I holding them accountable, and do I know that they have the expertise and the ability to deliver on what’s needed in the absolute short term?”
The best CEOs really focus on having what we call “a fit-for-purpose leadership team.”
The second question is a more interesting one: “If I start to look ahead, even for a three- or four-year period to the end of the holding period or for the next buyer, then is this still the right team that can deliver on those ambitions and that VCP?” Often, the answer is no, or it’s a mix, and then CEOs put discipline in place to execute against that.
Having the right team is one of the most important drivers of performance, and we see in all our research that the right teams outperform significantly along the way.
What’s interesting is that many organizations might embark on a culture change that could take three, five years. It takes a lot of work and a lot of time to truly drive change, but PE CEOs have to ruthlessly prioritize what will make a difference within the context of the holding period.
Collaborating with the board
Roberta Fusaro: Governance and ownership are among the most significant differences between private and public companies. What do the best PE CEOs do here that would be relevant to others, and why?
Marla Capozzi: The best CEOs in this case really take stakeholder management as driving toward making being on the board a value-creating role, as opposed to one for compliance, box checking, et cetera. They establish real trust one on one, starting with the chair and with each member.
They’re very transparent, obviously. Nobody likes surprises. We hear that all the time. But they’re out in front of most things with the board. They’re having far more interactions with the board than four a year. In some cases, I’ve heard from CEOs, “I’m meeting monthly or weekly with the chair; I’m meeting weekly with the board.”
It’s a much more dynamic, collaborative partnership as opposed to thinking about it as board versus management, which is what we talk about a lot on the public side. And in that case, there are areas of ownership versus operational power that CEOs and boards have to sort out. There are decision rights. For example, when is the board offering direction versus advice? A lot of this tends to be the human dynamics of collaboration and stakeholder management, and so they end up being really good at that.
Carving out time to think
Roberta Fusaro: Sacha, what does “treat your time as capital” mean for a CEO and a senior leader?
Sacha Ghai: One of the things we’ve discovered when we talk to leading CEOs is they are highly, highly intentional and structured about what they do and where they get involved and where they don’t get involved. We ran a little experiment with a sponsor—a PE sponsor that had more than 100 companies.
We surveyed the CEOs of more than 100 companies and asked them, “How should you be spending your time in an ideal world?” And these CEOs said, “In an ideal world, I should be spending probably 10 percent of my time on my own thinking about the business and about 15 percent of my time in internal meetings.”
And then we said, “What’s your day to day like?” And they said, “Well, to be honest, I think I’m spending double in internal meetings. I’m probably spending 30 percent of my time in internal meetings, and I’m probably only spending 5 percent of my time thinking on my own.”
We got access to their calendars, and we crunched the numbers. And we found that the amount of time they were spending on their own thinking was zero, which meant they had precious little time for customers, thinking about strategy, thinking about culture, and all the other things that we talked about. So that’s why we use the phrase “treat your time as capital.” Capital is scarce. Capital is precious.
Roberta Fusaro: Marla, at the end of the day, what did the research reveal as the core attributes of the best PE CEOs?
Marla Capozzi: I’m going to answer this question a little bit differently, more about leadership and less about practices. What we heard from the CEOs we spoke to when we asked, “What do you believe made you successful and helped you achieve your role as a CEO?” were some pretty surprising things, I think.
One of my favorite quotes was, “It’s the most intense learning experience you will ever have.” You need to prepare to learn, more so than anything else, for yourself. And it’s not about getting there. Once you’re there, it’s just the start of this experience.
They named things like continuous learning, humility, stakeholder management, and the ability to really reflect on and be self-aware of what they’re doing.
Roberta Fusaro: Sacha, any reflections on core capabilities of the best PE CEOs?
Sacha Ghai: One that is fundamental, at least for me, is ambition. I don’t think we can discount the importance of waking up every day and striving to reach full potential, not just full potential of the business, but also full potential of yourself as a leader. “How good, effective, and inspiring can I be to the people around me?”
Just that mindset of wanting to stretch yourself in order to empower and create something special in your business and in your team is worth a lot of currency. That’s what’s going to allow you to learn from your mistakes, pick yourself up when you fall, find good people.
Because guess what? Ambitious people want to work with ambitious people, and building that positive, virtuous cycle results in really high-performing teams. It sounds obvious, but it’s quite deterministic in terms of the rest of the outcomes that you want to see when you build a high-performing business.
