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Human Capital In PE:
The Diagnosis is the Treatment

By Shannon Gabriel, Managing Director at TBM Consulting Group

Key Takeaways:

The ability to solve the “people question” is fast becoming the lynchpin upon which value creation either takes hold or fails to gain traction.
• A hyper-competitive labor market demands a new framework to assess human capital and where it fits into an investment thesis.
• The C-Suite remains core, but acute challenges facing entry-level and middle management roles are equally impactful to investment timelines and IRRs.


As part of a recent panel discussion at Tecum Capital’s CEO Summit, TBM Consulting Group’s Shannon Gabriel outlined a new framework for sponsors to identify the talent risks that can undermine growth initiatives, investment timelines and, ultimately, returns.

At a fireside chat in February, Ford Motor Company CEO James Farley emphasized the importance of talent no fewer than 16 times in discussing the auto giant’s long-term ambitions and its more immediate efforts to build out its electric vehicle (EV) operations. The challenge, Farley noted, isn’t necessarily in doubling down on past recruitment strategies. To appeal to “new talent,” Ford has to rethink altogether how the company approaches human capital.

“[It requires] different compensation systems, more focused objectives, and [new strategies to] integrate A-class talent into the company,” Farley described. An added wrinkle he alluded to is that management has to sustain Ford’s legacy operations, while building out the areas expected to drive growth in the future. It’s the innovator’s dilemma with a talent twist.

It doesn’t attract the same level of scrutiny or attention, but the human capital challenge confronting private equity’s middle and lower middle market is no less acute. Ford, of course, represents a bellwether in the labor market. Not only are small and medium-sized businesses competing against the auto giant to attract a limited pool of capable employees, but the world’s largest employers have far more resources to pour into recruiting, compensation and upskilling. Business leaders in the middle market simply have to be more agile and more creative to stay ahead of the curve.

For sponsors who see themselves as enablers of growth, the ability to solve the “people question” is not only more complicated than before the pandemic, it’s fast becoming the lynchpin upon which value creation either takes hold or fails to gain any traction. If there’s one constant, it’s the pressure on portfolio company leadership to scale businesses significantly over a three- to four-year timeframe. If sponsors are waiting around for human capital issues to bubble up to the surface, they will be too late. It means talent shortcomings have already begun to impact productivity and performance, push off investment timelines, or even degrade corporate culture.

Tecum Capital, like other GPs, has seen talent issues emerge more frequently and more acutely since the pandemic. The Pittsburgh-based firm dedicates significant resources to help portfolio company leadership address these challenges. One of the firm’s most effective strategies is to facilitate a dialogue between CEOs that allows leaders to share best practices, identify the subtle red flags that might signal issues down the road, and raise their hands for help navigating 2022’s unfamiliar talent landscape.
At a recent CEO Summit hosted by Tecum, I had the chance to share the floor with several partners at the firm. In the discussion, we outlined a new framework through which GPs and their portfolio company leaders can better assess human capital to understand the extent to which labor will either facilitate or stand in the way of growth assumptions that underpin an investment thesis.

Setting Up a Change-Readiness Framework
From the perspective of middle and lower-middle market companies, many organizations will underestimate the scrutiny and accountability that comes with institutional capital. This is particularly the case for companies and employees going through their first change-of-control transaction.

Due diligence should be able to identify and outline strengths and weaknesses of an organization’s talent, and identify the biggest red flags. In the initial diagnostic phase that informs value-creation, a more comprehensive change-readiness assessment, post-close, can holistically determine what’s needed from a personnel perspective to scale the business, drive profitable growth and map out how portfolio companies can fill the gaps.

While there are certainly other factors to explore, the critical areas that can often make or break the
most ambitious growth initiatives include leadership capabilities and risks; organizational health and talent management; technical capabilities; and culture—not necessarily in that order.


“Every portfolio company is different, and we anticipate there will be unexpected challenges unique to each one. But it’s similar to a pilot who sets a course and arrives at
a destination; they won’t get there without being able to navigate around unexpected storms or other distractions.”

Matt Harnett
Partner, Tecum Capital


Leadership Capabilities & Risks
More than any other factor, private equity sponsors appreciate the role of leadership in the success or failure of their investments and the extent to which they’re able to drive corporate growth. An effective litmus test to determine if the C-Suite is up to the task is the extent to which they’ve been able to scale their own teams. If they can’t communicate effectively, empower and delegate to trusted deputies, or if their function endures recurring turnover, leaders will be hard-pressed to scale an entire organization or motivate an entire employee base.

It’s not always so cut and dried in terms of what constitutes a true risk and what doesn’t. For instance, Tecum’s David Bonvenuto, noted that it’s not uncommon for a company to outgrow the skillset of their leadership during a sponsor’s holding period.


“Our goal is to drive growth. If a company goes from $3 million of EBITDA to $10 million, it’s inevitable that the day-to-day responsibilities of executives will change.”
David Bonvenuto
Director, Tecum Capital


But through diagnosing where current executives may be deficient, sponsors can anticipate the challenges that will come with growth and address them before they become an issue. It’s not always about making a change at the top. Just as often, it’s about complementing leaders with other executives who can bring in new skillsets. “In one case, we brought in an executive with experience integrating add-ons,” Bonvenuto added.

Organization & Talent Management
Navigating the challenges at the top of the org chart has become routine for most sponsors, particularly
in the middle and lower middle market, where “professionalizing” and building out the C-suite is often core to an investment thesis. A newer challenge, though no less material today, are the obstacles that stand in the way of building out the broader organization – from entry-level staff to middle management.

In an era of full employment, it’s not uncommon that a company’s ability to grow will be limited to its ability to recruit and retain front-line employees.

Bonvenuto, for instance, cited that where the HR function sits on the org chart can represent a “tell” for prospective buyers signaling structural impediments. “When the HR function reports to the CFO, it generally means the company views talent as a cost center versus an area of strength.”

Sophistication around talent management, however, doesn’t necessarily require complicated solutions. More than anything, the most stable organizations are effective in outlining a career for their people.Communication is also critical. If the C-suite isn’t sharing the company vision and highest-order goals to lower levels across the enterprise, they won’t be able to drive engagement. Education and development programs to upskill employees will drive both productivity and loyalty, while helping companies compete for talent in an era of rising wages.

Special care should also be taken to attend to the needs of middle management. On an org chart, this may be one of the easier areas for investors to overlook, but it is also one of the most important areas to assess in small- to medium-sized businesses. Outlining a path for growth is just as critical, but investors should also analyze the workstreams of high achievers to pin down any pain points that will come with further growth. It’s important, too, to ensure middle managers know their past efforts have been recognized and appreciated.

Technological Capabilities
In this era of transformation, the technical capabilities of both senior leaders and the workforce at large
are becoming more important every day. In fact, the availability of talent with technical backgrounds
is increasingly shaping other decisions across the business and in boardrooms.

For instance, when Intel announced plans to construct two new chip factories in Ohio, the company cited
the state’s experience in advanced manufacturing and R&D. Intel also pledged a $100 million investment to bolster research programs in the region and “build a pipeline of talent.”

In the middle market, where employers may not have the brand awareness or the resources of the world’s largest companies, it can be even more difficult to attract specific skillsets. Tecum’s Sean Edmonson noted that the firm has gone so far as to relocate portfolio companies to access higher-quality talent in other markets.

From an investment perspective, digital transformation represents one of the highest-profile initiatives underpinning value creation strategies. Sponsors, thus, are remiss to place their trust in executives taking on these types of projects for the very first time.


“When we scrutinize technical capabilities, we’re looking at the ‘repeatability’ factor. Every executive selling a company is going to share a grand vision; we need to see a track record that gives us confidence they’ve done it before.”
Sean Edmonson
Vice President, Tecum Capital


For instance, if an executive team intends to re-shore their operations, have they completed similar projects previously in their career? Are they familiar with the SOPs to create and execute against a plan? And do they have the people and the technology to pull it off?

A change-readiness analysis will ensure the right people are in place to see these efforts through. If adopting new digital manufacturing capabilities is integral to the thesis, recruiting experienced talent should precede the build-out to avoid costly and timely mistakes.

Culture
Perhaps no other area is more critical to “change readiness” than culture; and no other component across the human capital continuum has been more disrupted by the pandemic.

The lockdowns represented a crisis scenario in which leaders had to improvise; post pandemic, many are dealing with new expectations related to work flexibility. In some cases, hybrid structures in which employees spend a certain amount of time in the office can represent a compelling compromise. More common, especially in manufacturing and industrial settings, the executives’ offices will sit dark and unused during the workday, while those on the floor are expected to clock in every morning on time. This creates two different cultures with two different sets of rules.

In these scenarios, senior leaders should be accountable and emerge from behind the “COVID Curtain” to address the cultural breaches threatening growth.

Cultural assessments were already one of the more subjective areas for sponsors. Bonvenuto, for instance, noted that as part of their due diligence, they’ll look for cues in unlikely places. If the bathrooms aren’t well maintained, for instance, that can represent a warning sign. Also, how leadership interacts with staff can be just as telling. Eye contact, he says, is important

But an even better gauge that speaks to a strong culture is the cadence and transparency that characterizes corporate communications. When employees don’t have a view into what’s happening at the corporate level, their imagination will fill the gaps, creating paranoia and speculation. Communication is particularly critical ahead of any new initiative when routines change and employees are asked to take on new responsibilities.

Embracing a Strategic Mindset
It’s a new era, and investors working under finite timelines need to have a strategy in place at the earliest stages of an investment to assess and manage human capital – today, the risk is too high to overlook the talent factor. I’ve said it before, but if a company’s recruiting strategy is to post advertisements on Indeed.com, they’re already behind the curve. If they’re not investing in their employees, educating and upskilling the best candidates and then offering a path for advancement, the revolving door will only spin faster. And if business leaders are unwilling to let go of certain standards that don’t reflect on-the-job demands, they’re almost certainly overlooking attractive pools of qualified candidates.

Ford Motor Co. recently did away with requirements for college degrees in certain functions. At the same time, Ford also recently launched a trade school near its electric vehicle plant in Tennessee to teach skills required for its next generation of cars. The company recognizes a need to “feed its workforce.” But this underscores the resources and desperation of the competition in today’s labor market.

Make no mistake, the battle for people will only grow more intense as the Baby Boomer Generation races
to retirement and Generation Z proves to be more unpredictable than the workforce that came before them. While the largest companies have the resources to pour into human capital; small- and middle-market companies have the agility and speed to try new things. They just need to diagnose the root of the problems and from there can win the war for talent through a more thoughtful, creative approach.