Poor People Assessments Can Cut Into Deal Value Creation Buyers who bone up on their management assessment skills may be able to achieve higher returns from their acquisitions

These days, most buyers put rigorous effort into due diligence, poking at everything from the integrity of the target’s financial statements to the quality of the management team to potential environmental problems. Buyers can crunch numbers, kick tires, and probe for ticking time bombs until the cows come home, but if they fail to accurately evaluate management, they may be sorely disappointed with their investment decisions. Terms can be set in place to offset many potential risks, but what recourse do buyers have for taking on a bum management team? Sizing up people is particularly important for financial buyers, especially if they’re counting on the existing management team to drive value creation in the deal. They must decide which skills they need the target management team to possess, so that they can hit their investment goals, then price the deal accordingly. “Generally speaking, you don’t want to change management. I’ve heard stats being thrown around that that when you replace a sitting CEO, in an untroubled business, with an outsider, you have a fifty-fifty chance of it working out,” says Chris Oberbeck, a Partner at Saratoga Partners. Financial buyers may be expert numbers crunchers but how good are their people assessment skills? Perhaps not as good as they would like. “Financial buyers are not trained how to assess people, and they rely too much on their gut feeling,” says Geoffrey Smart, Chairman and CEO of ghSMART & Co. Inc., a management assessment and coaching firm in the private equity industry. “Financial buyers spend a lot of time doing due diligence and yet they don’t apply that same level of rigor to assessing management.” Nick Young, a Consultant who provides executive search services at Spencer Stuart, agrees, but adds, “Private equity firms are really in a difficult spot. They’re trying to assess management and sell themselves, over other potential buyers, at the same time. When they’re in a sell mode, it’s hard to be objective and evaluate the management team.” Smart notes that common regrets of buyers who ended up with less-than-ideal management teams include that they hurried to close the deal before another bidder arrived on the scene, or they became enamored with one particular aspect of the deal, such as impressive growth projections or an exciting technology, and ignored or failed to investigate other important deal aspects. Pitfalls in assessing management teams often occur in the approaches buyers take to sizing up people, Smart notes. Many financial buyers use what Smart calls the “prosecutor approach” in assessing people in which the investors grill the management team. “The name of that game is let’s see if we can stump management.’ The problem is that how quickly management answers questions on its feet is a fairly blunt instrument in judging how well they manage their business,” he says. Most commonly used by buyers is the “art critic approach,” which relies on quickly sizing up people and relying on gut instincts. “These buyers hit the mark about five out of every 10 times – if they’re lucky,” asserts Smart. Buyers who use the “sponge approach” spend a lot of time with management in a variety of settings – dining, playing golf, etc. – “soaking up” information then “synthesizing it in their gut,” but they often do not spend the time wisely, according to Smart. Eternal pessimists who think it’s impossible to assess human capital accurately often follow the “terminator approach”; they buy companies and fire weak managers rather than spend time assessing them up front. The assessment approach that produces the highest consistent returns for financial buyers, says Smart, is the “airline captain approach.” Like a pilot with his pre-flight checklist, a buyout firm will write up a checklist of must-have management qualities for a particular acquisition – leadership ability, industry knowledge, strategic thinking and vision, integrity, etc. – and measure management against it. Copyright 2004 Thomson Media Inc. All Rights Reserved. http://www.thomsonmedia.com http://www.majournal.com