For any company, having a CEO who makes effective, strategic decisions can help teams go far. CEOs who excel at this have what McKinsey senior partner Sacha Ghai calls “CEO alpha.” In this episode of Deal Volume, McKinsey’s podcast on private markets, McKinsey partner and host Brian Vickery talks to Ghai about how private-market companies can foster the CEO alpha in their own leaders. They discuss trends shaping the industry, the importance of CEO upskilling, how to shape next-generation leaders, and, most important, how private equity firms can benefit from investing fully in their portfolio company leadership. An edited version of their conversation follows.
What is CEO alpha?
Brian Vickery: In my years as an analyst and a consultant, I’ve spent a lot of time looking at investment managers and portfolios trying to tease out alpha from beta, but I’ve never come across the concept of a “CEO alpha.” Can you explain this term?
Sacha Ghai: CEO alpha is a term that we at McKinsey came up with. Alpha is a pseudonym for outperformance or extra performance, and when applied to the finance sector, alpha refers to the ability to perform better than the market. CEO alpha, then, refers to when a company outperforms because its CEO is also outperforming. CEOs make substantial decisions around strategy, resource allocation, M&A, and hiring and firing top talent, so making those decisions in the best way possible will have an outsize impact on the performance of the company.
CEO alpha does empirically exist in the public realm. One of my favorite pieces of research that calculates CEO alpha is CEO Excellence: The Six Mindsets That Distinguish the Best Leaders from the Rest by Carolyn Dewar, Scott Keller, and Vik Malhotra.1 They looked at the top-performing CEOs globally based on a variety of factors and calculated the outperformance of those companies relative to each company’s industry peers. They found that this type of analysis in the public company realm had a value of up to $5 trillion. So, we think it exists.
Brian Vickery: Why do we need those distinct analyses? What’s different about the private sector?
Sacha Ghai: You could look at it simplistically and say, “A CEO is a CEO is a CEO.” The decisions they make are similar. When you dig a little deeper, you realize the differences between the public and private realms.
When we did our interviews and research in the private realm, a few differences stuck out to us. Number one is performance edge. The amount of focus on performance, particularly short- and medium-term performance, is higher in private realms, which makes sense considering the governance structure and the way private equity, for example, operates. That has a material impact on how CEOs make decisions and rightly allocate resources.
The boards of directors in public and private companies are also different. For some private companies, the board is running the company and the CEO is executing its decisions, which is very different than a public company’s environment. Another difference is operations. The compensation packages are different in public and private environments, which impacts talent attraction and retention.
These differences determine the types of capabilities required to succeed; the public and private sectors have different rubrics because they’re different types of positions, which also determines the type of capability-building programs and experiences that CEOs need to be successful.
Brian Vickery: I’ve sat in on first board meeting conversations with private equity CEOs where they discuss the results from diligence and five-year plans. They’ve planned ahead, which is different than how a public company might view the world.
CEO upskilling and development
Brian Vickery: It sounds like we’re not talking about CEOs as fundamentally different people who can create the alpha; we’re actually talking about upskilling and training CEOs so they have the capability over time to create alpha. In your experience, how have CEOs been spending their own time improving their skills?
Sacha Ghai: When we had conversations with private equity CEOs, they expressed a real hunger for insight and capability building, but they wanted it to be delivered in a way that takes them out of the classroom and into the management boardroom or team room. We also discovered how much they needed training. Many CEOs’ backgrounds are not in leadership, and if you ask them how well prepared they feel for this job, many of them will self-disclose that they do not feel prepared, and it’s trial by fire. It’s learning by doing. One data point that struck us was 75 percent of private company CEOs in the United States are replaced within the private equity holding period, which suggests that if you’re not performing, you’re going to be replaced quickly. When you combine those two forces, it creates a willingness and an openness to build capabilities.
In terms of how they want to learn, CEOs expressed a want to be given up-front insight and a framework of how to think about a particular topic that they don’t know very well, and then get help applying it to their operating environments. For example, for talent management or talent-to-value, a CEO may want to learn about how to build a high-performing team and about the critical roles that are needed in their company. If they get help identifying and recruiting the necessary people, and then get help applying them within the company over the course of two or three weeks, they could end up in a better position than they were in before. That field and forum model needs to be customized to the private equity environment.
Brian Vickery: What are the critical components to CEO alpha? If you’re a CEO in a portfolio company, what skills should you be learning?
Sacha Ghai: The list of skills needs to be customized to CEOs’ backgrounds and to what they’re solving for in the investment thesis. Some companies will be growth oriented, some will be M&A oriented, and some will be focused on operational improvements. Each prescribes a certain set of capabilities. So, it’s about assessing what needs to be done for the company and what the CEO’s perceived vulnerability or skill gaps are and bringing those two together. There are ten essentials that we have found to be relevant across different archetypes of private equity assets.
There’s talent-to-value to drive the investment thesis; strategic planning in a three-to-five-year time horizon; mastering the human dynamic of leading a portfolio company, which is working with a board effectively or with a private equity operating partner; and private equity performance management and dashboards, which is managing data seamlessly to manage more effectively; and profit dissection and resource reallocation. Companies that reallocate resources more dynamically across their portfolio have a total return to shareholders two to three times more compared to companies that don’t.
There is also inorganic growth, M&A, advanced financial decision making, value creation with frontier technologies, and exit prep. It’s important for CEOs to think about their business in the context of changing technology, macroeconomics, inflation, and the higher interest rate environment. Many CEOs feel vulnerable because of these factors and would value insight and a framework for how to think about them.
Top-of-mind macro forces for private equity CEOs
Brian Vickery: In the context of everything that’s happened over the past 12 months and the impact it has had on our general partner [GP] clients, what themes have CEOs been considering? What are they worried about more today than they may have been in the past?
Sacha Ghai: One theme is the cost of debt and the impact it has had on balance sheets. For CEOs, that impact shows a need to improve operating models to service that debt. Another theme is depressed multiples. If multiples are atypical, they can increase the hold period for many of these companies, which affects the internal rate of return. Inflation is another big issue, because many of these institutions are talent driven.
Another big theme is AI and how ChatGPT will affect call-center agents and business-process-outsourcing [BPO] businesses. Also, more private equity companies are thinking about geopolitical risk and how markets will be affected by it. Last, 60 percent of private equity and institutional investor sponsors require their portfolio companies to have a sound ESG [environmental, social, and governance] strategy. CEOs need to think about ESG and how to view it as both an offensive and defensive strategy for their businesses.
Building next-generation CEOs
Brian Vickery: You mentioned that 75 percent of CEOs don’t last the tenure of the investment hold period. While the research focuses on making CEOs better, does it say anything about how GPs ought to think about the CEOs that they select or which types of CEOs are able to grow?
Sacha Ghai: One of the themes that’s come up in our interviews has been a huge need around succession planning and finding good CEOs for portfolio companies. We have been exploring the idea of creating capability-building programs for up-and-coming executives who aspire to become a portfolio company CEO over time. That is an area that people want to explore but don’t have a lot of options, so the demand is there. If you ask private equity CEOs where they got their learning, many will say it was all from ad hoc mentoring situations, and I think we can bring more structure and focus to building next-generation CEOs.
How limited partners benefit from the CEO alpha
Brian Vickery: Are there any lessons in this for limited partners [LPs]? How can LPs use the CEO alpha concept and relate it to their portfolios?
Sacha Ghai: There’s no difference in what an LP and a GP could take away from this. If LPs buy into the thesis that finding and growing exceptional leaders will lead to alpha, then they can systematically ask questions of their partners and investment managers about how to grow talent in their portfolio companies. In fundraising pitches to LPs, GPs often talk about their own talent. But the real question I’d put out there is, how can you build an ecosystem and be a destination for talent with the world’s best capability-building programs?
Private equity firms and institutional investors who are investing with private equity firms should be asking questions about how they grow talent and develop capabilities. For example: What is your strategy to have great leaders, especially in our increasingly volatile, complex world? Having people with a diverse set of skills, competencies, knowledge, and different backgrounds is going to be even more important in the decade ahead of us.
Brian Vickery: That is another way for GPs to think about operating value creation, too, because creating value in operations is generally functionally approached. They can do functional improvements with procurement and pricing, as well as the strategy that goes with those. But they also can do the upskilling and change the talent pool beyond hiring new people. It’s unique for a GP to have the ability to upskill even the most senior leaders of their team.
Sacha Ghai: At the end of the day, one of the biggest fundamental drivers of value creation for portfolio companies is a high-performing team. And having a CEO who is a fabulous talent developer and recruiter, who can pitch a terrific story and who surrounds him- or herself with outstanding talent, makes all the difference in the world. That’s another reason why investing in that CEO is important. Companies can directly influence who’s in that job and how they equip that person to be most effective in their job. Then they can leverage that capability to have tremendous impact up and down the organization of the portfolio company.