Is a greater focus on talent needed in the private equity industry?

As professional management takes hold in private markets, there’s renewed interest in talent issues.

Private equity saw a strong year in 2017. But as private markets rise, some are asking whether more attention needs to be paid to talent issues. In this video, McKinsey senior partner Aly Jeddy teases out important themes around talent management in the industry, including thinking about talent at the portfolio-company level, planning for leadership succession, and linking talent to value.

Video

Interview transcript

One of the things that has been ignored, relatively speaking, in the discussion about private markets investing, is that it is ultimately a talent business. We focus a lot on transactions, and we focus a lot on capital. We don’t talk about talent. And frankly, the clients of the industry, the institutional investors, by and large, have also, because they have been so focused on minimal attrition, made it seem like talent, once present, should just be maintained and not changed.

What we are starting to see is a much greater focus on the nature and quality of talent that firms have brought in. Over the years, we’ve done an extensive amount of research. And that has shown that the broader the mix of talent in the firm—so not just investment bankers and consultants but also executives, et cetera—the broader the talent base you have in the firm, the better the quality of the decision making. That’s both in due diligence and in the portfolio-company component of it.

The other thing that is quite important is thinking about talent at the portfolio-company level, not just at the CEO or CFO level but also on boards. The historical model for talent has been to take your best deal professionals, when they do a good deal, and tell them, “Now you’re sitting on a board.”

The reality is board membership and being an effective board member is a very difficult thing, because you don’t have line of control. You don’t have line of visibility. And you control and influence through persuasion, which is historically what someone who’s wielded a large economic carrot and stick has done.

So it’s a very tough spot to put people in, and to say, “I’m going to change your job description dramatically. The stakes are going to be very high. Perform.” The industry has not systematically invested in helping people with those transitions.

By the way, the other transition that is coming down the pike, which we’ve also never really focused on yet, because luckily all founders of investment firms are both infallible and immortal, is how you transition from deal doing to firm management.

The advent of professional management in our industry is a new phenomenon, an untested phenomenon in most firms, and still just beginning. So talent will become an enormously important question as you think about succession at the head of the firms and as you think about deal professionals progressing in their careers to board membership and beyond.

In the portfolio, we have systematically analyzed good transactions and bad transactions across a range of scenarios to say, “What is the single biggest driver of performance?” Of course, it is the management team.

In the vast majority of cases that we’ve analyzed, when a company is not doing well, the problem is the management team, and it is widely known that it is the management team. The issue is the owning firm does not have an alternative. And they always assume that the risk of changing the management is greater than the risk of keeping an incompetent manager in place.

And number two, the risk of an empty seat is far greater than a filled seat, even if with an incompetent person. Which brings me to my final point, which is why should there be the risk of an empty seat? The reason there is an empty seat is because firms have systematically underinvested in building stables of talent that can be quickly deployed into the portfolio companies.

Only now are we starting to see firms actively build rosters of executives, either from portfolio companies that they’ve had in the past, or frankly even from competitors of companies they own that could be brought in.

In the end, the $2 trillion to $3 trillion in private equity are really controlled by a couple of hundred people. That’s not that many. When we think about the scale of what we’re talking about, we also have to understand that the amount of intensive care that can go into the selection, the curation, and the development is not that vast from a scale-and-numbers point of view.

By the same token, precisely for that reason, given the capital at stake and the value at stake, it needs to be very intense per person. And we have seen nothing like that kind of investment made in talent, which the value associated with that talent and riding on its shoulders would justify.

That’s on the GP [general partner] side. I think there’s a corollary to all of that on the LP [limited partner] side. Increasingly, as LPs start to go direct, and as LPs start to build processes to try to rival GP-level processes, they are going to enter the same talent competition. Except, in many cases, there will be severe constraints on what they can pay people, how they can reward and incent people, et cetera.

It’s going to create a very difficult and different transition on the LP side compared with the GP side. But we’re much earlier in that journey. There will certainly be some lessons to be learned, but not all will be applicable on the other side of the fence.

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