It is no exaggeration to say that the last few years in private equity have been eventful.

According to Bloomberg, private equity M&A activity in 2022 dropped by nearly 40% year-over-year, down more than $800 billion from 2021. That sounds bad, but those numbers only tell part of the story. The fact is, PE hit a record high of over $2.12 trillion in investment in 2021 and even after the drop off the market remains above pre-pandemic levels. According to EY’s analysis, 2022 was the second-most active year for PE in the last decade.

And times are changing. So far in 2023, inflation remains high, interest rates continue to rise, and recession risks are still on the horizon, leaving many investors unsure about what the future holds. Bad news for the public markets, but potentially good news for the private equity sector.

That’s because turbulent markets have typically produced outsized gains for private market investors over the last two-plus decades. Case in point: During the 2008-09 Financial Crisis, PE saw a 28% peak to trough decline followed by a quick bounce back, while the S&P 500 dropped 55% before slowly regaining ground. Many market watchers expect the current environment to likewise create opportunities for PE professionals who are willing to dig deeper into the value creation levers that are available to them and focus on growth.

One of those levers, often among the most challenging for funds to talk about, involves the Chief Executives of the companies they acquire. While top performing investors are thoughtful about the CEOs they work with and examine how the role can evolve as the company scales, the recent 10+ year bull market has caused too many investors to overlook or simply misunderstand CEO blind spots during the assessment process. Can the current CEO or Founder execute on the fund’s value creation plan? How is their performance overall? What if market dynamics change? Will they be able to scale?

In many cases, the existing CEO is gifted but has personal attributes that may prevent them from being able to go the distance. Not identifying or miscalculating the magnitude of these blind spots and failing to make the call (quickly) to replace a CEO, can often be the most significant factor getting in the way of a top quartile or top decile investment for a PE firm.

And current market conditions are accelerating the timeline on many of these decisions, forcing investors to take a more critical look at their CEOs and start conversations around succession planning sooner. This approach requires a more rigorous assessment that starts earlier in the process, considers the CEO’s role in the context of the full investment lifecycle, and takes a proactive approach to CEO succession planning.

We recently spoke to some top private equity Operating Partners to understand how they are approaching transition planning for their CEOs in these turbulent times, and they shared some interesting insights and best practices.

Access CEO performance on both a quantitative and qualitative basis.

When it comes to executive diligence, there is no substitute for facetime. Many of the Partners we spoke with spend a lot of time with their CEOs both pre and post close, digging in on how they work, what help they might need, their vision for the company and more. Sometimes these assessments include more formal, in-depth interview sessions with different members of the deal team, including presentations and quantitative surveys, but the importance of interpersonal fit, even before the deal closes, is paramount. Can we work with them? Can they work with us?

However, it can be challenging for any investor to objectively review their CEO’s performance from the inside. That’s why more and more funds are using third party firms and other outsiders to perform CEO assessments. These services often include both qualitative (interviews, presentations, etc) and quantitative aspects (including critical thinking tests like the Watson Glaser Appraisal, personality tests such as the Hogan Assessment and more), enabling the fund to make a fully informed decision about the current CEO independent of any internal feelings or emotions.

Remember why you’re replacing the CEO.

Across the industry, roughly 20-50% of company CEOs are replaced by PE investors within the first two years after acquisition, according to those partners we spoke with. But, while the frequency of replacement varies, the reasons behind these decisions are fairly straightforward. Maybe they are not reaching their revenue targets, maybe they are too focused on growth and not actually making money, or maybe they do not understand what the business needs to reach its next stage. While poor performance is a common reason for replacement, many founders also simply realize that they no longer have the hunger for the business after an acquisition and prefer to scale down their role or pivot to be more product or customer facing. Whatever the case, moving on to new leadership can be a lasting solution to a range of problems post-deal under the right circumstances.

Don’t be afraid to make a change when the time is right.

There is no hard and fast rule around when to change out a CEO, but most funds agree that giving the current executive some time is generally the best practice. Typically, that means one to two years after an acquisition, though some funds prefer to act faster when they know the CEO doesn’t want to stay with the business long term. A year-plus gives the current executive enough time to get through an entire business cycle and budgeting process to give their investors a good idea of how they work and what they are able to execute on.

That said, as a general rule there is no such thing as “too early” when replacing a CEO. Either the person is the right fit for the job ahead, or they aren’t, and Partners agree that it pays to have those conversations sooner rather than later.

For private equity investors, the simple fact is that taking a decisive and proactive approach to CEO transition planning results in better outcomes, independent of economic conditions. As Warren Buffett once said: “Only when the tide goes out do you learn who has been swimming naked.” The tide is receding now, and weak leaders are being exposed. Those investors that get ahead of the problem and make the necessary changes now will be best positioned to weather the storm ahead.

To stay up to date on trends shaping the executive talent landscape, subscribe to our blog for additional insights.

Insights in your inbox

Stay up to date on the latest trends and insights shaping the executive search landscape from JM Search’s Blog.