The Corporate Tool has an interesting comment today about the negative impact hierarchies have on frank and open discussions in organizations. Emphasized is the chilling effect strong personalities are likely to have on the willingness of subordinates to speak their own minds. The paradox, of course, is that excatly the strong, outspoken superiors that are needed to get new views into the organization tend to stifle the rest of the group.
This is a very particular dynamic in private equity firms and The Corporate Tool has gotten me thinking about the merits of these systems.
The alarming thing about private equity firms is that structurally, they often have huge centrifugal forces (specialization and conflict) matched only by the equally substantial centripetal forces (outlandish compensation and the golden handcuffs in text of the partnership agreement). In this case the centrifugal force is really the inertia of a given partner's specialization.
Private equity firms, both VC and buyout, generally select and retain partners for specialized roles. Often these are along industry vertical lines. Larger firms also might have a "big name" or two who act as the rainmakers and have the connections, or are the generalists with access to capital and debt. Usually, these are the "managing partners" but it varies from firm to firm.
This is the typical structure in buyout and VC firms. It is also highly destructive.
All partners are expected to bring in potential deal flow in smaller firms. Naturally, this means that partners bring in deal flow from their particular area of expertise. It also fosters a "champion" model of deal review. The "aviation" expert, for example, will find a hot aviation deal because those are the personal connections she has. She knows the ins and outs of the deal and has a good grip on what is required to make it work. She likes the deal. She knows a few of the players in management. She immediately becomes the deal's Champion. This, unfortunately, forces her to press the deal to the other partners who, by definition, know less about the deal's merits and don't particularly care to expend the resources required to understand them. Aviation is a dead industry, they might believe. Look at all the airline bankruptcies. Let's invest in automotive instead. There are a lot of good values now that that industry is being shaken out. (I actually heard this incredibly ironic exchange among members of another firm). Complicating things, often a rather droll process for approving investments requires input from all the partners before a deal is consummated. It becomes obvious quickly the kinds of conflicts that can arise.
The consequence of big partner egos is that everyone needs a say. The deal approval process is therefore burdensome and to the extent each partner has their own favored deals and there are, by definition, somewhat limited financial resources to do deals, something has to give for a given partner to get a given pet project "through committee." The resulting debates often look remarkably like jockeying for a finite amount pork in Congress. Tempers can flare and coalitions and enemies emerge. Soon you have 7 people working together that don't actually like each other very much. They all wish they could go their own way. They are held together for another 5 years by a 7 year life span of the fund and illiquid stakes. Ugh.
The Corporate Tool Suggests:
So what can leaders do to encourage openness? Roberto suggests actively seeking dissent by soliciting it directly, having staff role-play adversaries, or even appointing someone as devil’s advocate on a proposal
Sub Rosa has done this from the beginning.
When a deal comes in the closest thing we have to an industry expert does a little briefing on the industry for two "advocates." The advocates are assigned randomly but since Sub Rosa is small, it is generally two of the same four people. The idea is to keep people who already know an industry out of these roles. This has two purposes. First, to get the junior members of the firm to learn the industry (I cannot emphasize enough how important this is to the life-cycle of the firm and how rare it is to find in private equity). Second, to avoid undue bias by the deal advocates. The concept is somewhat similar to the American jury system in this respect. One advocate is randomly "pro" the deal and the other advocate is the "risk" advocate. They get some prep time and then present their arguments to the investment committee.
It is less adversarial than it sounds. The "risk" advocate is tasked more with identifying and describing ways to mitigate risk than shooting down the deal. The "pro" advocate is tasked with making the "do the deal" case, including returns analysis, a read on the politics of the capital structure and stakeholders and developing a financing structure. The presentation is formal for the first half and then is passed into a constructive discussion phase. Is there enough return? How can we be creative about the risks we have identified? Can we get comfortable enough with them to do a deal? How?
By assigning specific roles that require advocacy from junior members of the firm we avoid the "Champion" structure and continually build both generalist and specialist knowledge in the junior members of the firm, who eventually are slated to run the place so that the existing partners can have a sort of pension from their carried interests without spending 90 hours in the office when they are 60 years old.
As a system it is not without its problems. There is the risk of it turning into a Soviet style Aerospace program if the two advocates are not constructive in their discussions, but, let me tell you, it is a hell of a lot of fun.