Conventional wisdom suggests that the first thing a PE firm will do when it buys your company is to load it up with debt. The second is to fire the CEO. True enough: one-third of companies will change their CEO or CFO in the first hundred days, and after 3 years, two-thirds will have done the same. Doing one or other of these in a publicly listed company will normally register a mid-single-digit percentage change to the stock price. No need to look too far for proof - Alstom's CFO departure caused a 5% drop on April 14th. So, it's high-impact stuff.

Things heat up fast and suddenly the level of board scrutiny is totally different. While PLC boards accompany the executive team and worry mainly about risk and compliance, PE boards actively lead the strategy with an intense focus on cash flow and multiples. With this comes a temptation to make further team changes to improve performance when things are not going well.

The Surprising Data on Management Turnover

But data suggest this might not always be the obvious itch to scratch. Agreed, companies with long-tenured executives have multiples that tend towards the industry average which is the opposite of break-out performance. Higher leadership turnover does deliver performances that are standard deviations from the norm. But based on return-on-assets over a 3-year period, it does so in both directions and in roughly equal quantities.

To complicate things further, a 2022 analysis by NYU Stern on transaction multiples from 28 sectors in the US showed that valuations improve between 0.9x and 2.3x additional EBITDA depending on top team stability. The more stable the key team, the higher the valuation.

In which case, does it pay to keep the band together? Some HR experts recommend an 18-month stability period before making changes. But this is a long time (especially for GPs), and it seems that something more subtle might be going on.

Modeling the Impact of Management Change

So what if we could model how swapping the management team would impact performance? What if a crisp combination of input variables, for example, characteristics of the industry and insights into the company, the management challenge and its leadership quality – could inform our approach?

In this case, there would be only three areas to cover. First, what determines the optimum amount of change? Second, what will influence the magnitude of the change? And third, how does this inform overall thinking about changing management teams? Drawing on research by Messersmith, Guthrie & Ji in 2014, Morg&Co has drawn up some guidelines.

Four factors determine the optimum amount of management change. First, munificence. If resources, cash, talent and commercial opportunities are plentiful then higher numbers of incoming leaders can piggyback on the tailwinds until they are fully onboarded. Second, disruption. If the company is in a fast-paced industry, then the incumbent team's knowledge and networks may quickly go stale, making more change desirable. Third, transformation. If the Company should grow and transform substantially within or across new industries, then new energy, knowledge, skills and networks could be necessary. And fourth, tenure. If there is already a stock of long experience on the team, then more changes can be absorbed before the institutional memory and social capital of the Company erodes too harmfully.

Conversely, if the company is in a fragmented industry where relationships and connections and personal contacts are more important than the individual brand, making too many changes could pull the company in different directions, causing it to stand still instead of growing. And if the Company itself is very complicated, possibly with highly involved product supply chains or is operating in multiple global jurisdictions, then options for rapid change to the team are significantly diminished. In these cases, the optimum number of changes reduces.

When Team Quality Matters Most

Beyond quantity, the potential magnitude of the change is modified by the degrees of freedom that the management will enjoy. If the Company is in a simple industry where strategic choices are limited, then the impact of the team's choices will be simple and small. Conversely, if the industry is in a fast-growth, immensely competitive and rapidly evolving sector where disruption and change are constant, then the quality of the team will be a major influence on long-run performance. The impact of quality management is always multiplicative.

In other words, a majority investor probably won't need to change many people from the top team of a national chain of car parks. The industry is stable, with stable cash flows and insulated from disruption, and although average tenure is likely to be quite long, the top team will likely be small with limited managerial discretion. Changing the CEO or CFO is unlikely to make much difference to overall performance (although changing both at the same time is seldom a safe move).

But if they planned to transform a large taxi company into a global logistics giant, then a stock of long-tenured executives would probably struggle to lead its radical growth. Managing new competition, aeroplane capital leases, expanding global operations and attracting a different employee base would likely be beyond the capabilities existing leadership team. It would be eminently sensible to approach the deal anticipating a high degree of change. And given the complexity and need for strategic managerial judgement and execution skills, being uncompromising on quality will further de-risk the impact on performance.

The Path to Performance

There are two takeaways: First, positive impact on multiples only happens before the maximum point of change is reached. The fewer changes that have to be made, the lower the probability of weak performance. And second, higher quality management will always increase the multiple, regardless of the sector. This leads to the conclusion that most often, keeping the team together as much as possible and helping them to do their best work under pressure at speed is the most powerful route to performance.

Based on this research, Morg&Co's has developed a collaborative approach to combining strategy and psychology to deliver high-performance execution from day one. Our team creates operational clarity of what needs to be done by the top team and then helps executives quickly align themselves to the leadership challenge. This de-risks the existing management team, helping to reduce the optimum point for change. With a demonstrable impact between 0.9x and 2.3x EBITDA, this is an approach that increasing numbers of firms are considering.

Copyright Morgandco Limited 2023. All rights reserved.

* Messersmith, Guthrie & Ji (2014) "Turnover at the Top: Executive Team Departures and Firm Performance". Organization Science, Vol. 25, No. 3, May–June, pp. 776–793