People Alpha: Ident ifying Where the Workforce Fits into

PE's Return Equat ion

arren Buffett probably has fewer regrets than most investors. During Berkshire Hathaway?s Investor Day five years ago, he conceded one of his biggest faults is that he moves too slowly to make personnel changes. Anyone who follows private equity knows he?s not alone. What?s odd is that despite the challenges to get the ?people? component right ? and the costly disruptions when GPs don?t ? the prevailing approach when selecting leadership, pro- fessionalizing businesses, and then motivating the workforce remains an art rather than a science. In fact, human capital is one of the few areas left in which sponsors will rely solely on their guts even when the numbers continually prove their instincts to be wrong.

In a way, this stems from one of the biggest miscon- ceptions around Human Capital Management (HCM), which is that it?s merely a grandiose title adopted by human

resources professionals. It also stems from the fact that many GPs simply aren?t aware that a systematic and quantifiable process exists that can inform critical decisions around people. To clarify, whereas Human Resources covers a wider constellation of organ-

izational activities ? ranging from recruitment and onboarding to payroll and benefits administration ? Human Capital Management represents a far more specialized field within HR. It?s not unlike the role of a data scientist within the broader IT function. In recognizing the value of employees as a true asset, HCM professionals are tasked with optimizing the business value of the workforce through initiatives that can be measured and tied directly to company growth.

To be sure, few if any sponsors don?t recognize the role of people when it comes to returns. Carlyle Group?s David Rubenstein is on record saying the ?principal difference? between the firm?s successful investments and its failures is the CEO.

Human Capital Management is not HR; those who recognize the difference can leverage a toolkit for growth they never knew existed.

W

Henry Kravis, alternatively, has argued that it?s not about picking the right companies or the right management, but ?most importantly? ensuring the right incentives are in place. Yet, most GPs still conflate the HR and HCM functions. In the process, they overlook the material impact HCM strategies can have on workforce productivity, company performance, and ultimately fund-level returns. We refer to this as ?People Alpha.?

People As AssetsIt may be a generalization, but most deal partners bring little if any corporate experience into their roles. While this certainly isn?t true for everyone, for those who cut their teeth analyzing financial statements, it speaks to the confusion around human capital management. GAAP accounting standards don?t even classify employees as assets; instead guiding corporate accountants to incorporate staffing

costs along with other intangible assets into one, all-encompassing expense line on the balance sheet.

PE investors also have a blind spot when it comes to assessing the role of people at the front end of a deal. Many, for instance, will know the extent to which entry prices, capital structure, portfolio-company growth and multiple expansion will factor into their investment theses. GPs are also well aware of any tax implications. And throughout their ownership, investment committees will continually weigh the tradeoff between pursuing large-scale operational initiatives and extending their holding periods (to the detriment of IRR). As it relates to the impact of people, however, it?s not until an investment goes sideways that sponsors begin to consider where personnel decisions fit into the equation.

A recent survey from AlixPartners revealed that sponsors will replace CEOs at entry about 15% of the time. Over the life of the investment, though, the rate of CEO turnover jumps to 73%, highlighting the inadequacy of a reactive, backward-looking approach.

One of the biggest hurdles is that human capital

management does not lend itself to a recyclable playbook or one-size-fits-all archetype. Recruiting and retaining talent is hard enough under normal circumstances, but most PE investments also usher in a period of transformation, making management selection and alignment more challenging and consequential. Each circumstance can be vastly different, too, depending on the maturation of the company, the goals of the seller group, the investment thesis of the buyers, and other unique variables. But among GPs who have emphasized their approach to people as being foundational to value-creation, three common threads are generally evident: analytics, a keen awareness of context, and an appreciation for culture.

Measure what MattersLike every other business function today, data and analytics are revolutionizing how organizations can

measure and track KPIs related to employees and performance.

From an investor?s perspective, analytics not only provide a baseline to measure the state of a company?s human capital, but also provides a mechanism to continually optimize HCM strategies based on evolving ob- jectives and changes to the

market or economy.

The specific metrics that are most impactful differ from sector to sector. The ISO Standards for Human Capital, however, can provide a starting point to track organizational productivity, mobility and turnover, recruitment initiatives, diversity and inclusion, and other illustrative measures. Beyond just quantifying the role of people, metrics such as Human Capital ROI can also help to re-orient GPs to think of employees not as an expense, but as an investment with a payoff.

Marc Benioff?s recent book Trailblazer offers a great example of how analytics uncovered a gender pay disparity at Salesforce, the result of several acquisitions that had upset a balance the company thought it achieved. The data, beyond diagnosing the problem, provided a path to resolve it. Not to be overlooked, the positive impact of diversity and pay equality on company performance, itself, has also been well researched and documented, creating an investment case built around data and analytics.

People Alpha [pee-puh l al-fuh]Excess return available to GPs through recognizing employees as true business assets and applying a systematic approach to Human Capital Management -- ahead of investments (to evaluate people-related risks and opportunities) and during ownership (to optimize the value of the workforce, tied to distinct business outcomes, enhancing portfolio company performance and fund-level returns).

Know the ContextEven with data, human capital management is rarely if ever black-and-white. Context matters, especially when trying to determine how an executive?s track record may or may not translate on a different deal. It?s often the case in the middle market that existing CEOs are seeking a funding partner through a sale, versus a straight liquidity event (leaving buyers little choice at the outset). In other cases, the GPs themselves will tap into their own networks of executives, often prioritizing past experience with PE. But past per- formance, investors know, is not indicative of future results. This is especially true when it comes to people.

Even when sponsors tap a proven operator, they may discover that personal motivations have changed since their last assignment or maybe their skillset has become obsolete in an era of digital transformation. HCM strategies often begin with business objectives first and, only when the goals have been articulated does attention turn to the candidate. This bias toward the future extends to other roles too. In tapping a CFO, the specific growth strategy should inform whether the ideal candidate arrives with an FP&A or a Controller background. The same lens should be applied when looking for a Chief Marketing Officer ? experience at

P&G is terrific, but not necessarily if the CMO is expected to orchestrate a direct-to-consumer campaign.

In the absence of black-and-white answers, HCM strategies can help investors live in the gray. An entrepreneur, for example, may be a visionary in spotting a market opportunity, but ill-equipped to orchestrate a rollup. If the sponsor is worried a management change would put key client relationships at risk, then more nuanced solutions such as a structured succession plan can facilitate a smooth handoff, one that facilitates knowledge transfer and inspires a collaborative transition.

Feed the CultureWhile data and predictive assessment tools bring an ever-sophisticated approach to human capital management, soft skills remain critical. Acquisitions, especially involving new management, can have a knock-on effect felt throughout the organization. In the wake of any ownership change, particularly involving financial buyers, employees? antennas will be up for any signs the culture might be changing.

Are new positions being filled by internal candidates or new recruits? How long does it take to fill key positions? Is the workload increasing, while resources

disappear? Did the new owners do away with free pizza every Friday? Any one of these factors can have an impact, but if the workforce loses a sense of purpose, key functions will suffer. Employee benefits, to state the obvious, represent a key artifact of a company?s culture. There may be near-term cost savings available through changing insurance carriers. Some refer to this as the ?low hanging fruit.? But if employees are discouraged, investors will pay in the form of disengagement, lost productivity, and turnover.

The challenge, again, is that no two circumstances are ever alike, especially when considering key roles that reside outside of the C-Suite. We worked with one company whose most important employees were a small team of electromechanical technicians. It was a hyper-specialized role that would have been incredibly

difficult to replace given the distinctive skillset and location of the company. Only through a systematic and thorough HCM analysis were we able to recognize the critical importance of this team and outline several scenarios to quantify the opportunity costs should key personnel leave. Armed with this data, the company put in place retention bonuses, variable pay tied to specific goals, and other incentives to ensure the team members were aligned and motivated.

It?s this kind of thorough and systematic exercise ? applying financial modeling principles to investments in people ? that can inform everything from growth strategies and geographic expansion to training and continued education initiatives that pay for themselves.

Realizing People AlphaIf there?s one truth in human capital management, or life in general, it?s that people are unpredictable. Psychologists would explain that this is actually an evolutionary trait that has served us well, both for survival and in exploring new and better alternatives. It?s also a characteristic of successful CEOs, who instinctually ?zig? when others ?zag.? But this unpredict- ability is also what makes human capital management so challenging for those without experience. At the same time, it creates a material alpha opportunity for sponsors who can deliver a distinct edge in this area.

Bain & Co., in its latest Global PE report, highlighted that for the first time ever the public markets had outperformed U.S. private equity over a ten-year period

ending last June. The uninterrupted growth of the economy, fueled by ongoing monetary and fiscal stimulus over the past decade, made it difficult for any active manager to beat the market. But asset owners? focus on alpha is even more acute in private equity given the longer lockup periods, higher fees, and additional resources to make and manage fund commitments.

Not to downplay the skills of sponsors, but over the last decade, it?s been relatively easy to match historic returns, but increasingly difficult to produce repeatable outperform- ance given how crowded and competitive the PE ecosystem has become. Investors, in 2020, are going to again be

tested by an uncertain landscape, market volatility, and an economy that is all but certain to enter into a recession thanks to the dislocation caused by the coronavirus pandemic. The right leader, overseeing the right team, with the right incentives in place should be able to navigate this new terrain. And GPs, more than anytime over the past decade, will be calling on their CEOs to help them discern both the hidden risks as well as the latent opportunities. Yet it?s against this backdrop that those who recognize the asset value of their people ? and put initiatives in place to optimize and nurture these assets ? can realize the ?people alpha? that has been so elusive for so long.

Laura Kellers Queen, EdD, is the Founder and CEO of 29Bison, a consulting firm offering due diligence, value optimization and post-transaction services to help business owners and investors mitigate risks and discern value-enhancing opportunities related to human capital. She oversees the firm's advisory services, organization design, talent assessment, and coaching activities.

Among GPs who have emphasized their approach to people as being foundational to value-creation, three common threads are generally evident: analytics, keen awareness of context, and an appreciation for culture.