In August and September, Egon Zehnder’s Greater China team welcomed more than 20 experienced operating partners and buy-out investors from various private equity funds to gather for an insightful discussion in Shanghai and Hong Kong.
With a challenging fundraising market and subdued investment appetite, portfolio management, value creation and exits have become the core activities that private equity investors focus on as ways to differentiate and deliver value to their LPs. This trend is also reflected in the client engagements and dialogues Egon Zehnder has met with private equity investors as they seek advice on various leadership topics related to the Board and management team of portfolio companies. The power and opportunity from bringing industry practitioners closer together becomes apparent to us.
Read on for the discussion highlights:
Making Effective Board and Executive Hiring Decisions
Post-Covid, China has experienced much slower economic growth that many have hoped for, which demands private equity investors to think and influence portfolio companies with a different mindset. “It’s about minimizing value destruction, rather than achieving value creation,” as one participant described.
There is also mounting pressure to act decisively and fast. All operating partners have come across the dilemma of whether and when to make key executive management changes. Replacing a CEO, in particular, is a major challenge due to existing market knowledge and established internal and external relationships. Many of the participants agreed that timing is key. If someone does not appear to be the best fit for CEO, it is better to make the decision to replace them sooner rather than later. Ideally, a pipeline for CEO and other key positions can be developed before closing of deals. This way, potential CEO candidates can be involved in due diligence as industry advisors, making their transition into executive roles smoother.
When choosing the right candidates, our participants said that it is crucial to spend time on the role specifications at an early stage, while also ensuring mechanical and disciplined measurement of performance and alignment of interests with the key talents throughout the process.
The type of leader that portfolio companies demand has also evolved. “China has a lot of growth leaders, who know how to spend to achieve top line growth. We need CEOs who can also manage cost, and that cannot just be a CFO’s job.” Another participant mentioned the need to have more resilient leaders in China. “It takes a different mindset to weather through a downturn. No one knows how much things may get worse before they get better. It is critical to set the right tone from the top and motivate your team.”
Structuring the right board that can support and guide management can also be a powerful tool. Onboarding experienced independent directors or advisors with the specific skills needed in a downturn not only enriches the discussions in the boardroom, but allows them to act as coaches for the management team.
"China has a lot of growth leaders, who know how to spend to achieve top line growth. We need CEOs who can also manage cost, and that cannot just be a CFO’s job.”
Working with Business Founders
Founder-led portfolio companies make up a sizeable part of many private equity firm’s portfolios in Greater China. Some participants noted the shift of sentiment of some founders. “Market uncertainties have triggered some founders to think differently about how and where they can grow their business. Some founders’ desire to continue running their business is also dampened by policy uncertainties as well as the lack of family succession options,” stated one participant. While this, on one hand, opens up potential investment opportunities for private equity firms, it also adds to the challenge for operating partners when working with founders.
Our participants often work with founders under different scenarios, depending on the specific deal structure—single buyout, joint-control with other investors, and minority investment. While joint-control portfolios are more about stakeholder management and minority-stake portfolios are more about indirect influence, operating partners spend the most time with founders of single buyout portfolio companies.
Before entering a buyout deal as the sole investor, private equity funds begin working with the founder on deal structuring and due diligence. Our participants believed it’s important that founders are willing to cooperate on transition planning, which is not only about transferring ownership of the company, but also about handing over business relationships and influence power, both internally and externally (e.g., client and supplier relationships). As another participant put: “Whether it’s during due diligence or post deal management, talking to the middle management and employees can reveal a lot of real issues that the senior management team may not be willing to tell." Grasping of such issues will play an important role in transition planning.
Paying close attention to details while aligning with founders on the transition plan is a way for operating partners to avoid losing their voice in business operations or clashing with founders after closing of the deal, which would have a devastating impact on the exit agenda.
Said one participant: “Founder-led businesses are of higher risk to manage, but they come with the biggest buyout opportunity in the coming years in China. MNC or large corporate carve-outs are considered lower risk deals, but those are driven by the current wave of strategy restructuring of big corporates – there are limited opportunities and can be competitive.
"Whether it’s during due diligence or post deal management, talking to the middle management and employees can reveal a lot of real issues that the senior management team may not be willing to tell."
Facing Challenges in Exits
More than fifty percent of our participants are working on exits targeted for within the next two years. Given current market conditions, some of our participants are exploring innovative financial engineering methods to navigate the environment while they manage expectations regarding the delayed exit timeline.
Broadly speaking, it is a tough environment to exit, because of poor valuation and limited IPO venues for China based companies. Attendees exchanged learnings from select financial innovations—continuation funds or secondary transactions—which could play a key role if certain funds require to deliver earlier DPI.
The participants also discussed what type of management team they need in their portfolio companies before exit. “If the exit strategy is through a trade sale, it’s critical that we adapt the mindset of potential future buyers early and think “How can we make the management team more attractive at sales?” One participant highlighted the complexity and fine balance this requires. “You would like to have a strong management team at sale, but you also don’t want future buyers to worry that the business cannot be run without such a team.” Structuring the right incentive schemes for management team also becomes critical. “Ideally you would like to provide incentive to management that can be realized partially from exit, and also leave further upside should they stay for the new buyer. Having said that, the scheme cannot be too restrictive which limits future buyers ability to make management change depending on their value creation strategy.”
As we rounded up our discussion on exits, another participant noted that some LPs are actually quite understanding about the current environment and the challenge to exits, because they themselves may be managing some direct investments elsewhere. This certainly strikes a less pessimistic tone to our conversation.
“If the exit strategy is through a trade sale, it’s critical that we adapt the mindset of potential future buyers early and think “How can we make the management team more attractive at sales?”
“We Are in This Together as an Industry”
As we wrapped up our gathering, almost all participants were grateful for the exchange of ideas and the opportunity to network with each other. The discussions not only provided them with new insights on how to tackle their portfolio challenges but allowed them to appreciate that they are not alone. “When it comes to portfolio management and value creation, I don’t see each other as competitors. I would love to tab the brain of my peer group more in the future,” one participant concluded.