How Human Capital Matters Impact Private Equity Investment Decisions

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Co-authored by Joseph Bosch, the head of Human Capital Consulting at Optimum Associates and an advisory board member at Allegis Partners

Private equity firms carefully scrutinize many business factors before deciding whether to invest in a company—but rarely does that scrutiny include human capital. Yet, PE firms today commonly operate portfolio companies for years. So, we wonder, when will a company’s human capital challenges and opportunities—the people—become part of the “Go/No Go” decision?

PE investing has changed over the years. While earlier generations of PE investing tended to focus on financial levers or squeezing out costs and gaining operational efficiencies, in both cases, the hold period for a portfolio company tended to be relatively short. That meant that leadership and other human capital opportunities had less potential impact.

But around the year 2000, PE firms turned increasingly to business growth strategies. PE firms began hiring operating partners to help portfolio companies generate profitable growth, and hold periods extended to three to five years, or longer. The net effect: PE’s current growth and value creation strategies are highly dependent on exceptional leadership and talent at all levels of the portfolio company. Today, human capital has become almost a buzzword in private equity, as firms highlight their recognition of its impact.

Of course, private equity’s expanding emphasis on human capital is taking place during the most competitive and active PE market of the past two decades. During 2018, the U.S. private equity market closed a record 4,828 deals, worth a combined $713 billion. But in 2019, deal pace slowed. With record amounts of ready cash on hand, and assets continuing to flow into the PE space, firms face growing pressure to identify attractive investments.

One strategy from PE firms has been to invest in a full complement of operating partners with combined expertise that spans all functional areas, including human resources. These operating partners are able to economically bring best-practice expertise to portfolio company functional areas, while also providing support and mentorship to the company leadership team. This approach evidences private equity’s genuine commitment to the impact of exceptional talent.

And yet, when it comes to making the initial investment decision, human capital is often absent among the core decision factors. Will private equity soon include leadership, workforce, and culture matters as legitimate decision factors in the “Go/No Go” investment decision?

The Impact of Talent

Arguably, private equity has long been a leader in acknowledging the impact of human capital. Consider the regularity with which PE firms insert new leaders post acquisition. Securing superior leadership has always been non-negotiable for PE firms, as meeting the investment plan’s time-sensitive goals requires nothing less.

A handful of PE firms have built their investment premise on the idea that leadership and human capital are critical factors in the success calculus. But more commonly, PE firms conduct their human capital due diligence after the buy decision has been made, only then assessing the leadership and workforce risks to be faced in executing the business plan.

That overlooks the fact that workforce and culture problems can be intractable, and not always quickly solved. Prior to purchasing the company, investors should want to know what the workforce looks like today, and in the future. Are the skillsets readily available in the marketplace? Does the sector have high workforce turnover? Will the time and resources be available to address these issues?

Likewise, culture should not be ignored. One recurring reasons why mergers and acquisitions fail is culture. The angst that can come with a change in ownership can also lead to a retrenchment in the culture and a lack of performance. None of these issues should be underestimated.

And newly installed leaders need time to effect change—time that may not be factored into the investment plan. The potential represented by exceptional leadership is not the same as restructuring a division, taking out 20% of the headcount, and seeing that drop to the bottom line the next day. It takes longer for leadership impact to show up on a P&L.

What Best-In-Class Might Look Like

Just as PE firms comb through financial, operational, and marketplace issues as part of the initial investment decision, human capital matters are worthy of scrutiny prior to acquiring a company. A clear, repeatable process should be adopted to evaluate leadership capabilities and understand the marketplace labor dynamics, including labor scarcity, regulations, the impact of unions, and future labor force trends. Culture would also be part of this review. Ultimately, if any of those items prove too costly, or the tail is too long, the PE firm might pass on the acquisition.

Addressing human capital issues earlier in the investment cycle is not only about avoiding a downside. The upside may be better-than-expected returns for PE investors. Best-in-class will be reached when a quality evaluation of the company’s people capabilities becomes central to the “Go/No Go” investment decision.

The challenges involved in evaluating human capital issues will never be as straightforward and tidy as adding a column of figures, but human capital has a way of making an impact on business results, either positive or negative. PE investors understand this. It is best to go in with eyes wide open.

Originally published on Benzinga.com

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