world-leading CEOs of private companies are not satisfied just to kind of grow top-line revenue.
They are instead very focused on growing the bottom line, growing the fundamental profitability of the enterprise.
And their resolute focus on that is distinctive.
That's McKinsey Senior Partner Sasha Guy.
Private equity-backed companies consistently deliver faster, bigger gains than public or family owned companies, often transforming their performance within just a few years.
And a relentless focus on real profitability is one of the ways they do it.
Sasha and fellow partner Marla Kaposi did some research involving 300 CEOs across private equity and private capital.
By the way, they published their findings in the Harvard Business Review.
They wanted to understand exactly what PE-backed companies are doing to create outsized performance.
What they found boils down to six best practices that leaders in any sector can use.
Let's dive in.
This is the McKinsey Podcast, where we help you make sense out of the world's toughest business challenges.
I'm Roberta Fisaro, your host for today.
Marla, Sasha, thanks so much for joining the podcast today.
Thank you.
Thank you.
So first off, I want to say congratulations on publishing your article in HBR, the title, What Every Company Can Learn from Private Equity.
Marla, what inspired you to write this article?
We sought out to really understand what drives outperformance in private equity CEOs.
We know from other McKinsey research that the best CEOs significantly outperform the rest in public organizations.
And so we embarked on this effort with private equity.
What surprised you the most as you were doing this research and in your conversations with executives?
What we learned was a few things.
One is that nearly all of them were very focused on building sustainable, long-term companies, ones that would have a legacy, serve their communities, create value today and for the next buyer, and ongoing.
I think we had a bit of a mindset that said well, they must be only focused on the holding period, or a short-term mindset, and that was not the case.
One CEO even told us yes, I understand the role of cost cutting and, through labor, as well as having to, you know, deliver performance results.
But I'm a part of my local community and I will look for many other ways to cut costs before I do that within my community.
So that was a real insight for us.
And then we started seeing that repeatedly over many of the conversations that we had.
When we started to summarize what was top of mind for them, they all selected four categories that emerged in this order.
Talent, strategy and operations, private equity governance and culture.
Interesting.
So, Sasha, put this in some kind of context.
You know, what is happening in the market overall that makes this leadership topic so important?
I think the first is just how big this community of CEOs actually is.
It's been written about in various publications where they've used the phrase the world is going private.
In the U.S., at least, there is 17 private companies for every 10 public companies.
That speaks to how large this community is and how important it is to actually study what makes great private companies and what do they need to do.
And how is that different than being a leader of a publicly listed company?
The other important feature here is there's a tremendous amount of challenges facing this community of private company CEOs.
Our latest research shows around 60 of private company CEOs are actually replaced by the sponsor within the first year, two years, of their job.
That speaks to how difficult this position is.
And why is it difficult?
It's difficult because they have to deliver outsized value creation in a very short period of time.
They oftentimes are working with limited resources because they're running kind of medium-sized businesses.
They have to deal with technological change, the rise of AI.
They have to deal with trade and geopolitical issues.
And that motivates the need to really explore what are the practices that makes private company CEOs be successful.
And I'll just add when we looked at these constraints and what Sasha mentioned about the world going private, we really learned that these constraints drove a lot of creativity in terms of how these CEOs approached many of these challenges.
And even though others may not have similar constraints, They are likely to have them at some point.
And we really wanted to explore what others can learn and how they might apply these practices even without the set of constraints, and get outperformance as a result.
If folks are achieving these things at the extreme, then obviously there's a lot to mine here.
So let's dive into the six practices that you've identified in the article.
Marlo, what is full potential diligence and why might others want to adopt this practice?
The full potential diligence is taking an outsider or an investor view at your business.
It looks at both the what you're doing across various different levers that are important, such as strategic levers, commercial operating, CapEx and risk.
And then it also, at the same time, looks at operational effectiveness and governance.
So if I were an investor, not the CEO, how would I look and evaluate this business?
How might I invest in it?
Is it attractive?
Why and why not?
What we're starting to see is many of the PE sponsors are re-diligencing their business post-investment thesis more frequently and then coming back to the CEO and top team and saying we are seeing this, we are seeing that in your business.
You should address this.
What we're finding is the absolute best portfolio company CEOs are owning this process and doing it regularly on themselves and then going to the board and saying here's what we have learned about both the what and the how of our business.
Our strategy is on track off track, but also this is what we own and we want to learn as a result of the outsider in view.
Sasha, another hallmark of the research is a focus on eliminating unprofitable revenue.
Can you say more about this?
Why is this so important?
World-leading CEOs of private companies are not satisfied just to kind of grow top-line revenue.
They are instead very focused on growing the bottom line, growing the fundamental profitability of the enterprise.
And their resolute focus on that is distinctive.
And so if you take that lens and you're resolutely focused on profitability, it causes you to look at your business in different ways through different lenses.
And one of the lenses that we have heard of time and time again is product or customer profitability starting to slice and dice your business based on the individual products you sell or the customer segments that you sell to.
So I'll give you just one quick example to kind of bring this to life, right?
A particular company that we were working with.
They had 20 product categories and they never looked at it at the product profitability level.
But once we did the fundamental analysis, to kind of allocate all the costs to the different products, like the front office costs, the back office costs, sales costs, everything to the individual products.
It was very illuminating.
They discovered nine out of their 20 products were actually unprofitable.
And by removing those nine unprofitable products they were able to drive free cash flow up by more than 17 and add significant capacity that they could reallocate to their profitable products to grow that.
So that's an example of what we mean by eliminating bad revenue.
Revenue went down a little bit, but profitability went up dramatically in this situation.
And that's a little bit of the logic that we have seen private equity CEOs take to deliver outstanding performance.
How hard is that to replicate, say, for public company CEOs?
So it's the same logic.
You have to say how much time is being used, how much energy does it take, how many people are allocated to that particular job versus this
So you have to do a little bit of what I would call plumbing and spade work to get it set up.
But whether you're public or private, there's no difference.
It's the same logic.
It's the same process.
It really challenges the mindset that we hear from many leaders that all revenue is good revenue.
You first have to be willing to challenge the core belief that all revenue is good revenue.
Look at the numbers and then be willing to take action against that.
Sasha, you also highlight the need in this article to clean sheet the labor pool in order to work more efficiently, more effectively.
But that's not just about cost cutting, right?
What does this best practice entail?
What we found, what Marla and I found, is when you talk to the leading private equity-backed CEOs...
And they say, what should be the cost of my finance function or my sales organization?
I actually don't care what the cost is right now.
I want to build it from the bottom up.
And that's where this word clean sheeting comes from, right?
I'm going to take a fresh look at what it should be.
So what do you actually do?
Well, you do a few different things.
One is you kill low ROI work.
You centralize groups rather than having a disparate set of call centers and a disparate set of service centers.
You bring them together under a consult with better supervision, tends to improve performance.
And if you reallocate work from lower to higher performers, you can improve productivity and save costs as well.
And then you rebuild the organization.
And, based on all of these levers, you say okay, what should this organization look like to actually deliver the service or the capability for the best possible efficiency?
When you do this, you're actually able to deliver significantly better customer experience, employee experience, because high performers want to work with other higher performers right.
And oftentimes you can reward those people more for the performance they deliver.
And all of those things results in a healthier organization, not just a more efficient organization.
Sasha, one question there.
How often do PE company CEOs sort of engage in clean sheeting?
Is it something that you do frequently?
Is it something that you just do one time and let it go?
How should CEOs think about clean sheeting?
Yeah, I think they tend to do it in a few specific instances.
I think the first instance is oftentimes as part of the full potential diligence.
So they're building what's called a VCP, which is a value creation plan.
And as part of that, they'd say okay, if we clean sheet a few of these different functions, what could we potentially get in terms of effectiveness and efficiency?
Another period is typically getting closer to the midpoint of the hold period.
So remember, private equity hold periods are typically between call it five to seven years.
And then finally, towards the end of the whole period, when they're looking at a sale transaction, they may want to quantify what the upside potential is for the next buyer that they could harvest and then potentially gain some of that in the sale price.
Marla, I'm going to switch gears a little bit.
I wanted to get into a discussion about talent and culture.
You know, one might assume that PE portfolio companies would need to focus less on this, given the short term timeframes and so forth.
But is that really the case?
Interestingly, it is not the case, and it is a huge priority.
The best CEOs really focus on having a what we call fit-for-purpose leadership team.
There's two important questions.
Am I holding them accountable and do I know that they have the expertise and the ability to deliver on what is needed in the absolute short term?
The second question is a more interesting one, which is if I start to look ahead, even a three or four year time period to the end of the hold period or for the next buyer, then is this still the right team that can deliver on those ambitions and that value creation plan?
Oftentimes the answer is no or it's a mixed.
And then they put that discipline in place to execute against that.
Having the right team is one of the most important drivers of performance.
And we see in all of our research that the right teams outperform significantly along the way.
What's interesting is, many organizations might embark on a culture change that could take three, five years.
It takes a lot of work and a lot of time to truly drive change.
But private equity CEOs have to ruthlessly prioritize what will make a difference within the context of the holding period.
Governance and ownership.
They're among the most significant differences between private and public companies.
What do the best PE CEOs do here that would be relevant for others and why?
So the best CEOs in this case really take stakeholder management as driving towards making the board a value-creating role, as opposed to compliance or box checking, etc.
They establish real trust one-on-one, starting with the chair and with each member.
They're very transparent, obviously.
Nobody likes surprises.
We hear that all the time.
But They're out in front of most things with the board.
They're having far more interactions with the board than for a year.
In some cases I've heard from CEOs, I'm meeting monthly with the chair.
I'm meeting weekly with the chair.
I'm meeting weekly with the board.
So it's a very much more dynamic collaborative partnership as opposed to really thinking about it as board versus management, which is what we talk about a lot, especially on the public side.
And in that case there's areas of ownership versus operational power that CEOs and boards have to sort out.
There's decision rights.
So, for example, when is the board offering direction versus advice?
A lot of this tends to be the human dynamics of collaboration and stakeholder management.
And so they end up being really good at that.
And it takes time.
It is a real-time commitment and it requires deeply understanding how to engage with each of them and how to engage with boards.
Right.
So actually, Marla, that's a great segue to another question.
Sasha, I'm wondering the phrase, treat your time as capital.
What does this mean for a CEO and a senior leader?
One of the things we've discovered when we talk to the leading CEOs is they are highly, highly intentional and structured about what they do and where they get involved and where they don't get involved.
And so we ran a little experiment with a sponsor, a private equity sponsor, that had more than 100 companies.
And we surveyed the CEOs of more than 100 companies.
And we asked them, how should you be spending your time in an ideal world?
And the CEO said that in an ideal world, I should be spending probably 10 of my time on my own thinking about the business and about 15 of my time in internal meetings.
And then we said okay, now let's talk about how you think you actually are doing.
What's your day-to-day like?
And they said, well, to be honest, I think I'm spending double in internal meetings.
I'm probably spending 30% of my time in internal meetings.
And I'm probably only spending 5% of my time thinking on my own.
Then we actually got access to their Outlook calendars and we actually crunched the numbers and we found out the amount of time they were spending on their own thinking was actually zero, which means they had precious little time to be spending on customers, thinking about strategy, thinking about culture and all the other things that we talked about.
So that's why we use the phrase treat your time as capital.
Capital is scarce.
Capital is precious.
For both of you, we can take turns here.
Marla sort of.
At the end of the day, what did the research reveal?
As you know, kind of the core attributes of the best PE CEOs.
I'm going to answer this question a little bit differently more about leadership and less about the practices.
What we heard from the CEOs we spoke to when we asked them what do you believe made you successful and helped you achieve your role as a CEO?
We heard some pretty surprising things, I think, for us.
One of the favorite quotes that I have is a CEO told us it's the most intense learning experience you will ever have.
So you need to prepare to learn more so than anything else for yourself.
And it's not about getting there.
Once you're there, it's just the start of this experience.
And they told us things like continuous learning humility, stakeholder management, the ability to really reflect and be self-aware of what they're doing.
Sasha, any reflections on sort of these core capabilities of the best PECEOs?
Maybe I would just kind of close with the last one, which in some ways is the most fundamental, at least for me, which is ambition.
I don't think we can discount the importance of waking up every day and striving to reach full potential.
Not just full potential of the business, but also full potential of yourself as a leader.
How good could I be?
How effective could I be?
How inspiring could I be to the people around me?
Just that mindset of kind of wanting to stretch yourself in order to empower and create something special in your business and in your team is worth a lot of currency.
It's worth a lot of currency, because that's what's gonna allow you to learn from your mistakes, pick yourself up when you fall, you know, find good people, because guess what?
Ambitious people want to work with ambitious people, right?
And building that positive virtuous cycle that results in really high performing teams.
It sounds obvious, but it actually is quite deterministic in terms of the rest of the outcomes that you want to see when you build a high performing business.
Thanks so much, Sasha.
Thanks so much, Marla.
This has been a great conversation.
Thanks for the conversation.
Much appreciated.
Thanks so much for listening to the McKinsey Podcast.
I'm Lucia Rahilly.
And I'm Roberta Fasaro.
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