Company Culture: Private Equity's Intangible Value Creation Lever

There's one definite amid all the uncertainty in the marketplace right now -- the North American private equity industry needs to find a path forward to navigate the turbulence.

Before COVID-19, this was a competitive industry with more firms vying for the same assets in an overabundance of dry powder. Firms needed to find a way to differentiate themselves among a sea of investment companies and were beginning to turn their gaze to human capital.

Then, the challenges of the pandemic forced many private equity investors to reassess their appetite for certain risks and adjust their overall approach to underwriting. It also further underscored the urgency of firms carving out a distinct advantage in the market -- something that set their firm apart from the rest.

This reassessment produced several new elements within the rubric of private equity investment underwriting criteria. One such key element is workplace culture.

And for good reason -- intentionally cultivating a strong workplace culture can help investors unlock tangible business results.

Culture is the unique way an organization delivers for its customers, empowers its employees and ultimately defines its purpose. Gallup sums it up as "how we do things around here."

Gallup has discovered that, among U.S. employees, four in 10 strongly agree that the mission or purpose of their employer makes them feel their job is important. By moving that ratio to eight in 10 employees, corporations can realize:

• 85% net profit increase over a five-year period
• 25% workforce growth over a three-year period
• 50-percentage-point increase in employee engagement over a three-year period

And that final benefit -- the increase in employee engagement -- is a value-creation lever that affects a multitude of second- and third-order key performance indicators and business outcomes.

During a crisis, many leaders understandably focus their resources and time on cutting costs and managing working capital. In doing so, they pull resources and attention away from their most critical asset: their people. This is a grave misstep, because organizations can only improve employee engagement -- and, in turn, business outcomes -- by investing in their work culture.

To mitigate this friction, private equity-backed management teams need their sponsors' support to highlight the importance -- and financial impact -- of investing in their people during times of crisis.

In the private equity industry, where the human element of the workplace was already regarded as a secondary concern before the pandemic began, that support is all the more critical.

It doesn't take long for systemic under-allocation of resources toward human capital to quickly erode enterprise-level value creation strategies. On the other hand, strong employee motivation, cohesion and buy-in have the power to significantly drive value creation efforts.

By focusing on creating an engaged workforce, companies can enjoy distinct business outcomes, including:

• 10% higher customer ratings
• 17% higher productivity
• 20% higher sales
• 21% higher profitability

Culture as a Competitive Moat

A strong, infectious culture is a differentiator in the marketplace. Culture is the foundation on which customer relationships are built and maintained. It is no coincidence that culture is also the means by which organizations attract and retain highly talented employees.

In fact, Gallup has found that the best cultures attract the top 20% in a given talent pool. It naturally follows that employees who strongly connect with their organization's culture also consistently outperform benchmarks.

And in a marketplace with so many unknowns, the value of employees consistently delivering high performance is a worthwhile path toward organic growth. Amid turbulent markets, the efficacy of an organization's culture is a means of minimizing future loss.

In periods of disruption, with countless factors far beyond the control of the boardroom, private equity investors should explore value creation and retention levers that are within their control. Gallup not only helps clients understand and evaluate their workplace culture, but also helps them identify and drive tangible business outcomes as a result of effective human capital management.

Organizations do not have to walk the path of culture efficacy alone. Gallup's scientific approach identifies strengths and weaknesses within a corporate culture and then links them to specific business outcomes and KPIs, providing tangible means for firms to unlock their value.

Finding Opportunities for Improvement

Gallup recently partnered with a global pharmaceutical manufacturer. This organization's supply chain and production leaders were operating at target levels, but when benchmarked against industry peers and world-class manufacturing operations, they fell far behind.

Gallup performed a qualitative and quantitative review of several business aspects. After the review, Gallup identified multiple opportunities, two of which are highlighted below:

1. Managers and leaders were underused and in need of stronger leadership methods. For example, managers entered the production floor only when there was a problem or their approval was required. Gallup recommended having regular conversations with employees and provided talking points that would lead to more productive and dedicated employees in addition to addressing production problems. By having more frequent conversations with front-line staff and supervisors, managers would be more aware of employees' feelings and behavior (i.e., how well they live out the workplace culture).

Gallup also studied a select group of high-performing managers and identified eight behaviors these managers consistently demonstrated -- all eight depended on communication for successful execution. Given this and Gallup's finding that up to 70% of the variance in employee engagement can be attributed to the manager, the manager's role in organizational success is clear.

The cost of missing that opportunity? In a global climate where 85% of employees are not engaged or are actively disengaged at work, the economic consequences of this lack of engagement are approximately $7 trillion in lost productivity.

2. There was a misalignment in incentives between different departments and performance metrics. For example, production leader incentives focused solely on the number of units produced. They did not take into consideration the number of defects, a key incentive metric for quality leaders and ultimately a driver for workplace behavior. The result: End-units failed in testing due to the lack of focus on quality during production. Leaders from the respective departments were "finger pointing" and in constant disagreement due to these conflicting self-interests. Gallup identified this misalignment and made recommendations to help leadership revise the incentive structure.

Following Gallup's recommendations, the manufacturer saw an average annual gross margin improvement of 1.23%, resulting in roughly $119 million in annual savings. The company also saw a 40% decrease in customer complaints.

At a time when so much is uncertain, companies would be wise to take advantage of performance drivers that are within their control. Company culture is one such lever that results in substantial dividends -- for employees, for business outcomes and for the portfolio company's bottom line.