Dangers of chauffeur knowledge: Getting the right people on board in private equity

December 2020
By Ezrul Ekram Ismail, Senior Manager, Corporate Finance, PwC Malaysia

Mark Planck, the renowned physicist, travelled around Germany after winning the Nobel prize in 1918 to give lectures on quantum mechanics. Due to the repetitive nature of the lecture, his chauffeur memorised it and suggested to Planck that he would conduct the lecture instead whilst Planck wears the chauffeur hat. Planck liked the idea. That evening, the chauffeur conducted a long lecture on quantum mechanics in front of a distinguished audience in Munich.

One physics professor asked a question. The chauffeur responded, “Never would I have thought that someone from an advanced city would ask such a simple question. My chauffeur will answer it.”

This chapter from Rolf Dobelli’s book ‘The Art of Thinking Clearly’ is something I can relate to based on my experience in the private equity (PE) space and observations that I have made over the years. I believe that it is critical to have real knowledge instead of ‘chauffeur knowledge’. A razor sharp assessment on a potential investment in a particular business is key, whilst having a clear idea on what to fix and how to fix a particular business post investment so as to make the exit thesis more attractive.

Striking a good balance in the composition of an investment team

A sound investment in a PE fund hinges on two crucial elements. The first component is the ability to source deals or rather quality deals, and the second component in which I feel carries more weight is an intimate knowledge of a particular business or an industry. On that score, there should be a good balance in the composition of an investment team that can bring these two important elements together.

In regards to the second component, one would be able to have a vantage point on the inner workings of a particular business, the pain points, risks, culture and more importantly, areas of improvement. With several years of experience in these areas, they would give valuable insights on not just the macro, but also the micro environment of a business. These are critical insights in the investment evaluation process up to the post investment action plans.

Oftentimes, the recruitment process favours someone from an investment banking, investment analyst, or management consultancy background, who fits the ‘deal maker’ or ‘number cruncher’ criteria perfectly. While it is true that their profiles and experiences are crucial for deal sourcing purposes, their knowledge about a particular industry and business would probably be limited due to a lack of hands on experience in running the day to day operations of a business.

This could potentially be dangerous especially during the investment evaluation process, in which non-intimate knowledge about a particular industry would be insufficient for the investment team to come up with a sound investment thesis as well as a strong value creation plan for the target company. There is a real need to have someone with the relevant experience to challenge the process and lead robust discussions around risks and the investment thesis.

The importance of operating partners

To guard against chauffeur knowledge, Warren Buffett coined the phrase ‘circle of competence’ - to have the self-awareness of our own aptitudes, and the perimeters of what we understand and do not understand.

Previously, financial engineering was the key theme in the pursuit of generating a handsome internal rate of returns for the fund, such as recapitalisation of the balance sheet, the right capital structure and ultimately the famous leverage buyout which was very popular in the 80’s. Over the years, the importance of financial engineering is slowly being replaced by the importance of operational improvements.

Thus, bringing in operating partners ensures that PE investors are playing within their own circle of competence, and leveraging on their strengths to drive returns for the fund. Operating partners are individuals who have deep experience in a particular industry whilst having the track record in growing a particular business - they have the Mark Planck knowledge instead of chauffeur knowledge. These are the ex CFOs, CEOs or Heads of Department of a company.

Having earned their stripes, they can give better insights during the investment evaluation process as they have a better pulse on the market and are well read about a particular industry. More importantly, they would understand the risks involved in an investment, how to mitigate those risks and the exact value creation plans to potentially be put in place based on their years of experience.

Building good relationships

The mindsets of PE investors and founders can be profoundly different, however, maintaining a good working relationship is crucial throughout the investment period. PE investors rely on the abilities of the founder and management team to carry out growth initiatives for existing minority investors, therefore trust and confidence are the foundation of the relationship.

At times, conflicts arise between the PE investor and the founder when it comes to making critical business decisions. For the founder and management team, frustrations may stem from being told what to do by someone with limited industry or business experience i.e chauffeur knowledge, which creates a lack of buy-in. Founders may also be reluctant to relinquish control of the business they created and uniquely understand.

Moreover, management may be bogged down by extensive reporting requirements which are perceived as unproductive, as the time used to prepare these reports could be better used for other productive pursuits of the company. At business performance reviews, PE investors that only look and deep dive into retrospective data without having strategic inputs to the management team would cast further doubt on the added value that PE investors can bring to the table.

Friction can lead to tense and tangled relationships. The business owner may be of the view that it is no longer worth the effort to pursue the crucial initiatives in the business and they potentially would not want the PE investor to reap and ride on the benefits as well. Thus it is important to manage expectations early on and to detail out the responsibilities that each party is expected to bring into the venture. Finding common ground to grow the business is key.

Conclusion

As the story shared in the beginning shows, the difference between Mark Planck and his chauffeur lies in the amount of time and effort they have committed to understanding the topic of quantum mechanics. Similarly in a PE setting, within the deal, it is important to have industry knowledge to execute operational improvements and drive returns. We can achieve this by first understanding our circle of competence and bringing in the right people with the relevant experience to develop a robust value creation plan.