Private equity firms have a strong history of driving organizational performance through financial engineering. However, gone are the days of buying, stripping and flipping “fat” companies to see huge returns. The competition has grown tougher and smarter. Infusions of capital, talent and strategy combined with cultural development that drives value are the new success tools.
Firms that effectively measure, manage and intervene on organizational culture have a competitive edge. An increasing number of private equity companies recognize that culture is one of the right metrics to pay attention to for value creation in their portfolio firms as well as in their own organizations.
The Impact of Culture
Organizational culture refers to how things are done in an organization: the norms, values and underlying assumptions and mindsets that manifest as observable everyday behaviors. High-performing organizations share certain cultural elements. They engage, develop and empower their people mission through these three elements:
- Involvement: Facilitate coordinated actions and promote consistency of behaviors.
- Consistency: Translate learning and the demands of the market to responsive and anticipatory actions.
- Adaptability: Provide a clear sense of purpose vision and goals.
These elements have been linked to companies’ short- and long-term performance, including financial performance, quality, customer satisfaction, employee satisfaction, innovation and safety. These relationships are often consistent across a variety of organizations and over time.
To better understand the specific role of culture in private equity-owned firm performance, Denison Consulting conducted a study using data from 38 portfolio companies and their lines-of-business — about 32,000 employees total (Editor’s note: The authors work at Denison Consulting). Data were gathered from 2011-2014 to examine the effect of organizational culture on financial performance, including EBITDA — earnings before interest, taxes, depreciation and amortization — and sales revenue.
To standardize these metrics across industries, average growth rates were calculated over a three-year period. To measure culture, this study used the Denison Organizational Culture Survey, or DOCS, a validated survey based on the culture model (Figure 1). High scores on the DOCS reflect greater levels of clarity and alignment on the cultural elements being measured, which lead to better performance.
Overall, the findings confirmed a positive link between organizational culture and financial performance among private equity-owned portfolio companies and their lines-of-business. There were strong positive effects of involvement, consistency, mission and adaptability on EBITDA growth and sales growth. Regression analysis showed the combination of the aforementioned four culture elements predicted 19 percent of the difference in sales growth and 4 percent of the difference in EBITDA growth across portfolio companies.
To help illustrate this relationship, researchers compared financial metrics from the top and bottom scoring cultures. Companies with the top scoring cultures had 8 percentage points greater EBITDA growth (10 percent vs. 2 percent) and 8 percentage points greater sales growth (5 percent vs. -3 percent) over a three-year period. These differences can amount to millions of dollars in EBITDA and sales for a large organization.
While many cultural elements contributed positively to financial performance of private equity-owned portfolio companies, the strongest and most consistent links were around employee involvement, or the bottom-up, active participation from employees. A focus on developing involvement empowers and engages a workforce and continually develops employee capabilities.
Organizations vary in the degree to which they involve employees in decision-making and invest in people to grow within the company. The best firms invest in their employees’ capabilities, empower them to act in accordance with those capabilities, and facilitate effective teamwork (See “When Learning Gets Loud” on p. 21).
Developing a culture around learning and involvement is important in virtually any organization, but it might look and feel unique in private equity or private equity-owned firms. In this particular environment, the investment needed to build associates’ capabilities is important because the industry is competitive and turnover is usually high at the junior associate level. Development can help to better retain top talent. For instance, private equity firms can adopt an apprenticeship approach to teach valuable on-the-job skills, provide various types of on-the-job training, and sponsor opportunities to purse an advanced degree in business and management.
Learning in Private Equity
Private equity firms can achieve significant learning and development success with a solid cultural foundation. For example, in the apprenticeship model, junior associates could shadow senior colleagues. They could also be paired with a partner who can act as a mentor.
The private equity firm also could emphasize on-the-job learning. Associates are required to travel intensely and “be on the ground” with portfolio companies. While the purpose of these hands-on apprenticeships is to understand the business challenges and provide the right level of support to the portfolio firms, it forces associates to learn quickly and expand their business knowledge.
They also can facilitate on-the-job learning by asking junior associates to give their perspectives on investments early and expanding their critical thinking abilities by exposing them to a heavy feedback and fast decision-making environment. According to the Denison study, private equity firms where young associates are involved in deal decisions and portfolio operations and have opportunities to learn and grow often have associates who are highly engaged at work and feel comfortable speaking up.
In this developmental scenario, junior associates could create a one-page summary about a potential target and share their ideas about the pros, cons and value creation opportunities with the team. They are not just encouraged to participate in investment committee meetings, weekly deal meetings and various others, but also expected to take the initiative and voice their opinions. In this business-learning environment, associates will have more opportunities to receive feedback on their work. Further, when they make mistakes, attempts to do early course corrections can be encouraged through open, straightforward communication.
In addition to on-the-job learning experiences, some private equity firms encourage and support participation in industry and professional conferences.
Recognizing the importance of managing leadership, talent and human capital, these firms also can invest in the learning and involvement of portfolio firms they acquire. Post-acquisition, they might start by increasing the organizational bench strength at the leadership and management levels — with talent from inside and outside the organization — by restructuring portfolio firms.
The compensation plans for management teams are often tied closely to organizational success factors, giving the team a strong personal interest in business success. During these change processes, portfolio firms often rely on the deal team members to provide support and resources so that transitions are smooth and successful. Putting the right people in the right position at the right time to grow the investment requires a tremendous level of knowledge and a strong skill set in leadership, human capital and management.
Private equity firms have different strategies to effectively transfer knowledge and best practices among their portfolio companies. The organizations that do this best are intentional about creating a community and infrastructure around their portfolio, emphasizing that knowledge-sharing across portfolio companies is a top tier strategy to directly transfer best practices. For example, private equity firms might have annual executive forums, events that bring together the C-level executives for each portfolio company for a day of learning and discussion.
Employee involvement, centered on building employee capabilities and empowering people to act in accordance with those capabilities, is a powerful element of culture that has strong relationships with financial growth in this context. For the CLO or culture enthusiast at the management table, a focus on organizational culture is an opportunity to add value in a new way .