The empathy gap
29/01/2003. Source: Independent Direction. Garry Sharp

Private equity is primarily about backing the right management. But some managers and investors fail to see eye to eye. Garry Sharp of Independent Direction says venture capitalists should try harder to understand what motivates managers.

‘I wouldn't give him a job as a lift boy,' remarked the chief executive of a (very successful) buy-out company when I asked him about the investor representative on his board. I heard other comments in a similar vein while researching a book recently, when I questioned a variety of entrepreneurs who had raised private equity funding.
 
The most negative and pithy remarks were centred on three main areas: the impenetrability (and sometimes apparent illogicality) of the private equity firm's decision-making process; the lack of practical business experience of many investment executives; and the tendency for investors to try to mould propositions so that they fit whatever the market fashions are at the time.

Before I alienate my existing and prospective client base, let me make it clear that I am not going to conclude that all venture capitalists are useless. And I know from experience that, for their part, some management teams are capable of feats so unfathomable that even a freshly-minted MBA in braces and cuff links would notice that something was awry.

But I do believe that many private equity practitioners would be more effective if they made a greater effort to feel - and I mean feel, not just appreciate intellectually - the pressures, concerns, irrationality and emotions which drive the entrepreneurs and management teams they back.

I've called this the ‘empathy gap' - the gulf between the investor whose career has long been about salaries, job interviews and risk-free carried interest, and the management team who are taking huge personal risks in an environment they only partially understand.

We are not talking here about going native, or losing sight of the fact that investors' and management's objectives, perceptions or interpretations may differ. I am arguing that a better understanding of the emotional dynamics of management teams is a powerful tool both for securing investments in the first place and making them perform better once the deal has been completed.

Before concluding that you know all about dealing with entrepreneurs and skipping to the next article, ask yourself if you have ever:

• revisited, late on in due diligence, an aspect on which the management would justifiably think you had been satisfied much earlier;
• introduced your more senior executives late in the process, who then have to pick up afresh aspects of the proposal which the more junior people missed, or misunderstood, in the initial stages;
• introduced changes in terms or conditions late in the day, perhaps due to the (perfectly valid) input of an investment committee;
• asked for more information on a specific topic urgently, got distracted by something else and done nothing with it for a week;
• introduced your favoured non-executive candidate to the management team two days before the deal is due to complete.

The reality is that such things can happen for good, or just unfortunate, reasons, and in many cases simply reflect the caution and the care with which investments are made.

But the management team does not understand that - they have no experience of how the process looks from the investor's perspective. The 50-year old heavyweight CEO will sit down and debate strategy with somebody 20 years his junior who knows next to nothing of his markets, because he understands that it's an essential part of the process. But when unexpected or apparently illogical messages emerge from the equity decision-making mechanism, he or she is going to be seriously discomfited. A crucial - and high-risk - stage in a career built on an ability to control and anticipate is dependent on decisions which can't be controlled and seem impossible to predict.
 
All this puts emotional pressure on the CEO, which, if not handled correctly by the investor (who is simply following from his perspective a logical and sensible series of steps), can have seriously damaging consequences to the relationship.

The issue is exacerbated by many management teams' suspicions that the investor has some sort of hidden agenda (forcing a merger with another portfolio company or radically changing the terms at the last minute seem to be the most common paranoia).

But the reverse also applies in equal measure. Why does a management team accept a ludicrously geared structure, which means that one slip up will put ownership into a bank's hands, just so that they can claim a few more points of equity at the outset? Why is running a new Mercedes so important to somebody who, if his business plan is to be believed, will be worth millions in three years' time? And why do they insist on managing the information they give us? Can't they see that we know we're not getting the whole story?

The private equity executive is driven by a clear set of objectives: to make as much money as possible for employer/ partners and self. A good deal flow, funds to invest and possession of the requisite skills lead to healthy prospects of achieving this, even when some mistakes are made along the way.

But members of the management team are in a very different boat, quite apart from the fact that in most cases this will be the only shot they get. And it is not only about getting rich. The hunger for status, for control, to make a mark, to be a local hero, to prove previous employers wrong, to impress the spouse and to be an icon to the children - all of these are important drivers.

So the VC who says, ‘Well, we forced an early exit - management didn't like it, but they cleared a million each so I don't know what they're whingeing about,' may have won that battle but, I would argue, is missing a vital weapon in the investors' armoury - the ability to empathise with the management team and appreciate what it is that really drives them.

And one day that VC will be blindsided by a management team whose true motivations and objectives he failed to appreciate.

Copyright @ 2003 Real Deals

Garry Sharp is managing director and founder of Independent Direction.

Independent Direction specialises in recruiting independent directors for private equity-backed companies. For more information please visit www.indep.co.uk

This article appeared in Real Deals. For further information please visit www.realdeals.eu.com