Why rigorous human capital analyses are crucial for pandemic era valuations
The recession induced by Covid-19 has the potential to create enormous opportunities for myriad private equity investors. After years of sky-high acquisition prices, many GPs anticipate the market tilting in their favor and are ready to deploy considerable dry powder.
Like all bargain hunters, such investors need to be extremely thoughtful and deliberate to distinguish between phenomenal deals and investments they’ll inevitably regret. To successfully identify the former – high-value companies with attractive prices – they’ll need to go beyond financial and operational due diligence and evaluate the human capital or people-driven elements that impact a valuation. What’s more, they’ll need to approach such evaluations with the same consistency and rigor they apply to other valuation components.
While GPs have long relied on models and metrics to guide their thinking on investments, they’ve too often sized up companies’ human dynamics using little more than gut instinct. This approach has always been perilous, exposing GPs to the risk that they’ll inadvertently invest in a company with outsized human capital complexities. In today’s climate, such risks multiply. The pervasiveness of our current economic crisis has the potential to mask serious, underlying human capital challenges. Solving such entrenched problems can require a level of intensive operational support that would need to be modeled into an investment thesis and timeline.
Investors can significantly mitigate these risks by evaluating a company’s human capital systems using a much finer grain filter. Specifically, a rigorous analysis of four specific elements can determine the quality of its human capital and its impact on the company’s ability to drive value creation.
The four elements that should be part of a rigorous pre-close human capital analysis include:
Inclusive of but more comprehensive than a customary CEO assessment, leader quality analyses shed light on the quality of the management team as well as their level of engagement in and commitment to the business. They compare the investment thesis with the capabilities of the key leaders who will be accountable for delivering growth, realistically assessing their aptitude for success. While sometimes viewed with discomfort, the intention of such analyses is not to be intrusive but rather provide exceptional clarity regarding what kind of growth can be expected given the current leadership team’s skills and constraints.
Beyond evaluating key executives, leader quality analyses should also look carefully at those in “fulcrum roles” – people outside senior leadership circles who have an outsized impact on the organization’s value creation process. These might be site managers in a distributed operating environment or other critical talent pools required for scale. While the quality of those in fulcrum roles is important, it’s also necessary to examine the wider talent pool available if the company is committed to scale. (For example – if an organization has 20 exemplary individuals in fulcrum roles but will need 50 more in a specific city in order to meet growth targets, is its strategy feasible?)
Leader quality analyses should also evaluate how closely an organization’s management team, especially its top two layers, reflect the demographics of its employee and customer base. The structural injustices laid bare by the pandemic have made this an urgent priority for businesses. In our experience, organizations are always better poised for success, scaling faster and delivering more profitability, when their leadership has shared experiences with key stakeholder groups.
An in-depth analysis of a company’s strategic alignment requires consideration of two separate components: the clarity of its growth strategy and the alignment of key leaders with that strategy.
In examining the first component, clarity of growth strategy, analyses should put forth such probing questions as: Does a company’s strategy go beyond growth for growth’s sake? Has it determined how, where and why the company is growing? Has it determined what avenues toward growth might not be worth pursuing? Answers to these questions shed light on the extent to which leaders have interrogated their strategy – a vital exercise for companies looking to meet growth targets.
Analyses of the second component, alignment of key leaders with the organization’s strategy, go beyond determining mere agreement between executives. They determine whether and how coordinated mechanisms within the organization are in place to accelerate growth in the right direction. Such mechanisms might include clarity of mission, purpose and core values; clear identification of markets with the most compelling right to win; clear identification of areas of sustainable competitive advantage; and aligned incentives around compensation.
While strategically unclear firms can be valuable investments, GPs looking to acquire them must do so with the upfront understanding of such gaps and the knowledge that it will take time and effort to create clarity.
While often relegated to the realm of intangible “soft stuff,” culture exemplifies vital dimensions of human interaction and, crucially, whether they’re properly designed to support and accelerate a company’s growth strategy. Thus, culture can and should be properly analyzed using clear metrics and measurement of such elements as institutional messages, narratives and the design of the organization to facilitate relationships in and among key players.
Without such analyses, GPs might discover late that their acquisition maintains an operating culture in direct conflict with its visions, goals and strategies. Whether this has resulted from a dichotomy between what leadership does versus says, or an unsustainable culture of overwork and near burnout, such scenarios often require a “cultural turnaround,” which are best built into initial investment theses.
Investors should be ready to understand the degree to which diversity and inclusion will influence (or hinder) the value creation process in acquisition targets. While this has become a focal point in recent months, research has consistently shown that organizations with strong, equitable cultures perform better over the long haul. Organizations that have done the work of building these values are more likely to capture a higher return on their human capital assets; attract and retain top talent; and avoid preventable variable costs associated with lower productivity, turnover and misaligned performance.
Analyzing execution means examining how an organizational structure adheres to process. It seeks insight on matters such as: Where are there bottlenecks in the organization? How far can the current level of performance be scaled before breaking? Does the structure of the company match its growth aspirations or cement an old reality? Does the organization only thrive because of the heroics of several difficult-to-replace people or is there a consistent adherence to efficient processes that can be learned and taught to others?
In particular, GPs need to understand the extent to which a company’s process and structure match its strategy, culture and leadership.
While pre-close human capital analyses reveal important company-specific strengths and weaknesses, their purpose is not to disqualify targets from acquisition. Instead, they are designed to ensure investors understand companies’ human capital realities upfront so they can model them into valuations and investment theses. This work is particularly vital in today’s uncertain economic climate, which requires that GPs embark on investments “eyes wide open” to best ensure they have every tool, partner and intervention needed to truly accelerate value creation.
-- Will Busch III, managing director, FMG Leading, contributed to this article.