New leaders fail a lot and, when they do, there are significant direct and hidden costs to a business. In the world of companies backed by private equity firms, the stakes are even higher – would you believe the costs are up to 20x the executive’s total compensation? Believe it. We know that 40% of executives fail; the impact of failed leaders in private equity backed companies will erode a firm’s returns. The stakes of failed leadership are much higher than one would expect due to the indirect and opportunity costs for PE-backed companies – the margin for error on new leaders in these companies is close to zero.
Let’s break down the whole cost associated with leaders that don’t get traction to put a finer point on this low margin for error. Our costs will be presented in a three-part framework that isolates direct costs, indirect costs, and opportunity costs. Collectively, the costs are huge.
Direct Costs
Direct costs are easiest to measure and well known. Considering the costs of recruitment, signing bonuses, relocation costs, salary, and severance expenses, the direct costs associated with failed leaders are material. All in, these costs are easily 2-3x total compensation.
Indirect Costs
Indirect costs are not as often attributed to costs of failure but they are broad and impactful. Here are a few to consider:
- Replacing CEOs is often accompanied by other leadership changes that slow momentum. CEOs bring new people to the business, some of which are closely linked to the CEO. Usually, business underperformance will be tied to one or more functional areas that are held accountable for the weakness – leading to changes of the guard in that department. At the end of the day, these further changes at the senior executive level create a pause in furthering strategic priorities – not to mention those priorities often change under new leadership. Slowing or changing strategic priorities cause revenue and expense misses in the short term.
- What is difficult to measure but perhaps most impactful is the damage to your client base and brand reputation. Changing senior leaders can create uncertainty with clients. Lost clients, clients you did not win, and a tarnished image for the brand can have lasting effects.
- Not often discussed but painful are the hits to employee morale when leaders are changed. Employees are savvy enough to know that leadership changes are prompted when businesses are not doing as well as expected – and that underperforming businesses can sometimes reduce headcount and other costs to compensate. Many employees bought into the vision of their CEO or leadership team and changes in that team can lead to disillusionment, confusion, and morale issues. As you know, lower morale leads to lower productivity and turnover – both of which slow business momentum – and it may be fair to say that a 10% impact in productivity contributes to, at least, a 10% hit to the bottom line.
All in, financial results may not be directly attributable to this under-performance but they are easy to measure. Do the math and you see the impact. For a business whose valuation may come at an 8x multiple of earnings, degradation of the bottom line comes with an amplified effect. A mid-market business with $10m of EBITDA and a valuation that is an 8x multiple loses $8m in value if the bottom line declines by only 10%. As a multiple of executive compensation, this constitutes 5-15x in lost value.
Opportunity Costs
An opportunity cost is the loss of potential gain when you choose the wrong path or miss an opportunity. This is where the impacts of PE-backed CEO failure get fuzzy….and quite large. A PE firm’s investment thesis always comes with a time to exit. They lose about two years with a failed CEO: the year they spend with a faltering CEO and the year it takes to find and onboard their replacement.
Let’s illustrate some of the impact:
- PE ownership time horizons average six years and leader mistakes narrow the window to build financial momentum, especially if there is a 2-year impact with any change. Strong financial returns on a business asset depend upon top and bottom line growth that likely starts slowly but builds momentum by year 5 – a few years of underperformance dramatically impact that momentum in the fifth year.
- Strategic priorities stall … and change. The second wave of leaders bring new strategic priorities and those priorities may require investment and time that further delay the building of top and bottom line momentum. On top of that, strategic opportunities to acquire other business assets can be derailed when the leaders of those deals are no longer involved…negatively impacting the creation of value for the business.
- Underperforming businesses with burdensome debt are often faced with debt covenant issues that occupy lots of executive management time and distract from growing the business. Worse yet, tripping debt covenants leads to dilution and other expenses that further weaken the value of the business.
Our fuzzy math would suggest that our business with $10m of EBITDA, an 8x multiple, and the potential for annual 10% bottom line growth takes a big hit with a failed leader. If this business doesn’t grow for the first three years, a valuation potential after five years of $128m turns into a $96m exit – a loss of $32m of enterprise value. As a multiple of executive compensation, this constitutes 20-60x in lost value.
At this point, can we admit that 20x might be conservative?
Avoid Failed Leaders in Private Equity
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John Hall
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