Does my PE firm really need a Chief Performance Officer?

The days of cheap money may be over, but debt covenants are still there, growing EBITDA is still the goal and cash flows still have to eat away debt. And since financial engineering won't do the job alone, then boards are justified in looking more closely at operational improvements as critical drivers of performance. So, it is unsurprising that in the last months much has been written about acquiring capabilities within the PE Firm that focus on operational growth to accelerate a company to its next transaction. Step up, the 'Chief Performance Officer', and their hybrid team of specialists from strategy consulting, industry leadership, science and technology, and psychology.

Viewed uncritically, the proposition is good. A Chief Performance Officer would seem to be a 'must-have' addition to any Firm, whose appointment will yield demonstrable benefits in time, operational efficiency, cash-flow and EBITDA. In other words, alpha. But before too many corporate leaders get excited about new opportunities in the world of Private Equity, Morg&Co suggests that a few factors should give them pause: To start, at what point does an overall portfolio reach the critical size so that there is enough work to justify a single full-time specialist appointment? Furthermore, what proportion of PE firms even achieve this scale and make this kind of appointment worthwhile? And then, even when fully deployed, is the promise of alpha-creating expertise in fact only a sheen for what amounts to little more than expert oversight needed to monitor and coordinate operational performance when the number of Companies starts to get too high?

The Numbers Don't Add Up for Most Firms

The numbers might suggest that a scattering of full time 'Heads of Strategy' in a fund's early-stage Companies might come out at the same annual cost. So, a $500k-per-year operating partner should aim to spend 80% of their working year out in the Portfolio and focus the rest within the PE Firm. This comes out at around 180 days in the field and given that a portfolio company would average 20 days' annual attention across a 6-year holding period, then a until a PE firm has 9 companies under management a motivated Chief Performance Officer might spend more time than anticipated hunting for valuable things to do.

This number also sets a minimum theoretical limit for funds-under-management before these roles should start to appear. In the mid-market, transactions range between $50m and $500m, with a very rough approximate average of $200m in total invested in any one Company. Using this as a proxy and not counting dry powder, with 9 portfolio Companies a firm would probably have $1.8bn under management before a sole operating partner is fully used, making the bottom-line AUM before contemplating a single addition to be somewhere around $2bn.

No matter how brilliant the appointed person is, they are unlikely to cover all specialisms in a meaningful way. To get real value, it is likely that at least three areas will need to be addressed in depth, for example, production & supply, cyber/AI & IT, or people & culture. To have three specialists full-time given the same logic needs 27 companies in the overall portfolio, or in other words, a pooled fund of approximately $6bn.

The Reality of Fund Sizes

But the median fund size is AUM $1bn, and the median number of portfolio companies is somewhere closer to 7. Anything above AUM$5bn nudges the territory of the small number of 'mega funds' which accounted for 44% of raised capital in North America and Europe from 2016-2019. Some of these giants really distort the average, so it's fair to suggest that most PE firms will fall somewhat short of the scale needed to warrant a productive discussion on these kinds of role.

It is unquestionable that the mega-funds are acting rationally when they establish performance teams. With their scale it is clearly an advantage to have a subject matter expert oversee and monitor the status of the whole portfolio, flagging issues to the board when needed and overseeing overall project progress. And there is some evidence that smaller funds generate break-out performance a little more frequently. So, a little extra overhead at the larger end will helpfully top-up the attention that each firm receives.

But at the other end of the scale, can an operating partner or performance team contribute deeply in a significant way? Even though they are individually capable of doing so, should CPOs and their teams be expected to accrete value beyond managing a supplier network and contributing broad expert oversight? Or from another angle, given that smaller funds are subject to the same economic environment and Limited Partner expectations, do they face any real critical disadvantages by not having one?

The Fundamentals Haven't Changed

Recent analysis by Morg&Co suggests that the fundamentals of value creation have not changed, and that if a company gets these basics right, then it doesn't matter whether they the trusted advisors they use are in-house or as part of a trusted network.

The two areas are timeless and predictable.

First, if there is a coherent, well-developed, shared value creation plan for a given portfolio Company (sometimes called a 'strategy') that explains to the Board how the Executive Team intends to grow and run the business, then the Board should be comfortable that the people in the team know exactly what they are supposed to be doing, why, and get on with it industriously.

Second, if the team has been picked and oriented specifically for the work that needs to be done, and if they are insightful enough about themselves and accountable each other, then they should be able to fully use their skills and experience to develop the organization's operations and culture and grow EBTIDA as planned. They are, after all, experts and leaders with agency, experience, networks and brainpower.

Simply knowing detailed and valid answers to these two questions enables a Board member to fully articulate exactly how the top team is working to deliver a plan that will confidently underwrite the investment thesis, while being able to actively manage the execution risks with the leadership team. Result? A fully empowered Board of Directors, an insightful and focused executive team, an organization on-track for fast growth, and not a CPO in sight. A worthy mention at this point is that in itself, this is not an easy task to do properly and requires the special kind of crossover of strategy and psychology that Morgand.co is known for.

Meanwhile, the open question of how Chief Performance Officers work with executive teams to bring superior abilities that can both accelerate organization progress and realise the promise of economies-of-scale across a portfolio, is obviously a topic for a future article. This is not an easy relationship to manage, and the very best will set an example for the rest. But for now, smaller firms can probably rest easy that they are not unduly disadvantaged by choosing not to carry the extra full-time overhead.