News & Insight
June 2006

Venture Capitalists Turn to Executive Assessment

Tim Morin

During the technology boom of the late 1990s, venture capital funds and other private equity investors could count on the bull market for public stock offerings to help them extract quick and large profits from even poorly managed portfolio companies. However, today’s tougher (or more “sane”) market conditions for IPOs and mergers have resulted in a decline, or at least a delay, in exit opportunities for these investors. For example, in 1998, venture- backed companies took an average of 3 years to go public. In 2005, it took 5 years to complete a listing. This means private equity investors are more dependent than ever on their portfolio company management teams to build for the long- term.

These investors are not just relying on these managers for longer stretches of time, but they are also counting on them to steer the company through more stages of growth and change. These investors can no longer rely on inexperienced or poorly suited executives to quickly pull off a sale or IPO. During the bubble, venture capitalists emphasized new technologies and Internet business models, while today, not also taking into account quality of leadership could be a recipe for disaster.

Making a bad hiring or investment decision around management, whether it’s for a start-up or a multi- billion dollar buyout, leads to millions of dollars in losses. When you take into account vested management options or stock, severance costs and executive search expenses, not to mention the loss of morale, momentum and growth opportunities for the company, poor decisions about company leadership can be deadly.

Of course, if asked, most private equity investors would say that the quality of the management team is a critical factor when evaluating an opportunity – and poor management is most often the reason cited when expected investment returns fail to materialize. Yet, ironically, many private equity investors spend less time analyzing management as part of formal due diligence than on other issues. Why? Probably because it’s time consuming and they believe reliable metrics are hard to come by. Also, while comfortable analyzing balance sheets and market shares, these bankers often find human capital issues rather “soft”. As a result, private equity professionals rely largely on routine background checks and gut instincts in assessing executives.

However, sophisticated investors are increasingly discovering fast, convenient and more rigorous options for assessing portfolio company leadership. Administered by a skilled organizational psychologist, a pre-investment evaluation using 360 interviews, a Strengths Assessment and other validated personality tests can be a powerful tool for investigating an executive’s:

  • Capability to successfully lead the company during transition to a new configuration (small private enterprise to larger public company, division of large organization to stand alone company, pre- to post-merger, etc.)
  • Cultural fit – both within the portfolio company and in partnering with the investor firm
  • Interpersonal adaptability and openness to consultation and advice
  • Sensitivities to ethics, laws, and regulations
  • Communication skills and style
  • Vision capability
  • Personality

In addition to being an invaluable component of a thorough due diligence process, this type of pre-investment assessment provides the equity firm with a clear understanding of the development needs of key personnel prior to investing or purchasing and allows the investor to build these needs into performance parameters from the start.

Tim Morin is Chief Financial and Marketing Officer for WJM Associates. Prior to joining WJM, Tim served as Vice President at Prudential Securities' investment bank, where he executed private equity transactions for media and technology companies.

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