How to Diligence a PE-Backed CFO Opportunity

July 24, 2020
  • According to Deloitte, sponsor-backed CFO turnover is as high as 80%. A CFO’s ability to select the right opportunity (or wisely avoid the wrong one) is thus essential. 
  • Sponsors and CEOs cannot be counted on to provide the full picture during the interview process. 
  • Discerning CFO candidates conduct multi-dimensional diligence to ensure the right fit for all parties.

An executive’s future marketability inside private equity can dramatically rise or fall based on a single career move. 

Many otherwise capable CFOs have experienced career derailment after failing to uncover fatal organizational flaws during the diligence process. 

The decision to take on any PE-backed CFO opportunity deserves intense deliberation, yet many candidates settle for cursory diligence. These individuals falsely believe sponsors will be forthcoming about every relevant complexity associated with the role. This oversight has stymied careers and destroyed fortunes in would-be wealth creation. 

Sponsors typically default to providing minimum levels of information unless an executive actively drives for deeper diligence. While this is not done with malicious intent, it is the reality.  

Candidates cannot rely on the firm to volunteer all the materials and information required to make an educated decision, nor can they expect to derive a true understanding of the opportunity purely via internal perspectives. 

Determine the Company’s Risks and Momentum 

Obtaining an accurate snapshot of current financial performance is a baseline objective of adequate diligence. 

Yet viewing a company frozen in time reveals little about its underlying momentum. Many executives fail to appreciate this nuance, only to enter a deal with their equity underwater. 

The situation is almost always more challenging than first meets the eye. Quarterly and yearly trends provide invaluable context around the company’s financial performance. In terms of financial documents, a review of the recent board packet and the last four quarters’ results constitute table stakes.  

Candidates should also strive to vet the common pitfalls that can kill a deal which may not be evident in high-level financial statements. 

Most LBOs have leverage multiples of 4-7x EBITDA. Clarity on debt covenants, liquidity risk, and sponsor appetite for additional investment is therefore paramount. Keep in mind the company’s growth strategy (organic versus acquisitive) will also impact debt multiples and covenants over the lifetime of the deal.

Strong leaders have failed when markets are flawed. Key factors here include marketplace health and customer concentration. One real-world example saw a sponsor lose the asset to the bank when an otherwise “healthy” $50 million EBITDA company lost its largest customer to bankruptcy. This customer accounted for 40 percent of the company’s earnings and within 180 days of it going under, all of the asset’s shareholders were wiped out.

It is better to submit a request for specific financials and get denied than to operate under the assumption the firm has provided you everything required to make an informed decision. Most sponsors will appreciate the detail orientation exhibited via thorough diligence. 

Though fund-side benefits of detailed candidate diligence may seem obvious (the placement possesses an immediate head start on their diagnoses of organizational issues, for example), emphasizing these factors may help candidates gain access to more information. 

The true risk-reward mix of an opportunity cannot be fully evaluated without an investigation into the company’s culture and human capital.  

Do they retain talent? Do their ethics align with your own?  

Key insights can be garnered from interviews with management, particularly a company’s commercial leaders. While navigating the interview process, view key players at the company as not just people you hope to impress, but as potential future partners. Solicit their expectations for the CFO role. 

Back-channel information is a powerful diligence tool. 

Read press releases from the company and investigate social media chatter. Utilize anonymous review sites like Glassdoor, keeping in mind disgruntled employees (or ex-employees) are often more vocal. Find customers, industry insiders, or ex-employees willing to speak with you. One CFO candidate probed an opportunity with a dental service organization by reaching out to an investment banker who specialized in DSOs. 

Evaluate the CEO’s Longevity and Suitability as a Partner 

A CFO’s upside hinges on their fit with the CEO. 

Candidates must first seek to identify if the current CEO has the sponsor’s support. Many capable CFOs have been excised from deals because a replacement CEO enters the company and opts to bring in a CFO from their own network. 

Savvy CFO candidates must draw conclusions about the affiliated CEO’s longevity. Key items to diligence include: 

  • Could the CEO be nearing any level of retirement? 
  • Does the sponsor seem to support the CEO? 
  • Does the CEO have support inside their organization? 
  • If deal performance has been less than stellar, how much of that shortfall does the sponsor place on the CEO? 
  • Is the company’s founder still in the CEO role? If so, does the fund expect them to get to exit?

If the CEO appears to be in place for the foreseeable future, determine the lens through which they view CFO importance. 

Is the CFO a strategic partner or more of a tactical resource? Much can get lost in translation from one opportunity to the next, so seek to understand how this CEO defines concepts like “business partner” and “strategic CFO.” Soliciting specific examples of how the CEO has partnered with CFOs in the past can quickly differentiate hollow words from operational reality. 

Extract the CEO’s thoughts on the PE firm, deal partner, and alignment of expectations to date. Unhealthy friction between the CEO and sponsor signals trouble.

Funds expect a CFO to present a unified public front with the CEO yet actively challenge them in private. CFO candidates must determine if the CEO will allow them to deliver on those expectations.

Sample questions for a prospective CEO partner include: 

  • What are the biggest investment thesis challenges you are facing? 
  • How do you envision the CFO adding the most value to the company? 
  • How would you describe the governance model and operating style of the PE firm? 

Internal interviews, internet research, and back-channel dialogue can all add clarity to your perception of the CEO.  

For example, how do they portray themselves on social media?  

Former associates of the CEO can provide priceless information. Ex-employees will often be eager to share a candid assessment of life under their former boss. Utilize tools like LinkedIn to identify and initiate such connections.

Assess the Nature of the Sponsor 

Sponsor governance models can vary wildly between firms. 

Is the sponsor operational or investment-minded? Are they hands-on with management or more strategic? How do they prefer to interact with CFOs? 

Explore if what you hear from the sponsor on the underlying investment thesis and selected playbook is echoed by portfolio company management.  

Each sponsor has a different spin on what a great CFO means to them.  For example, do they favor FP&A bias or accounting? Sponsors expect CFOs to support their CEOs but to also serve as a transparent partner to the Board.  There are delicate nuances here that should be vetted.  

How does the sponsor support their CFOs?   

This topic is often overlooked. A survey from Accordion found 92% of PE professionals believe they meet the expectations of portfolio company CFOs, yet just 29% of the portfolio company CFOs agree.

Determine the sponsor’s track record. 

Questions specifically around IRR and MOIC performance – both at the fund level and for companies akin to the opportunity in question – will yield vital information and make a positive impression. 

Sponsors have finite resources and struggling portfolio companies tend to receive more hands-on attention. Seek to identify any disruption inside the portfolio that may impact the level of governance affiliated with the role. 

Cross-Examine the Deal Partner 

Vet the deal partner and specific deal team. These key actors are often more important to assess than the sponsor itself. Per a report from McKinsey, “the deal decision-maker (in LBOs) is about four times as predictive as the PE firm in explaining differences in performance.”  

Back-channel information is the best method of vetting a firm, and the most pertinent insights will come from managers who worked under the specific deal partner in question.  

Question the deal partner on their track record of success and verify their answers as best as you can. High-achieving funds are not inherently free of poor partners, and it is imperative you do not act on the reputation of the firm alone. 

Determine the make-up of the board and understand what they explicitly expect from the CFO. Identify what they believe the previous CFO did well and where they fell short. 

Prospective CFOs who sense a significant disconnect between themselves and the firm should steer clear of the opportunity. 

Follow Diligence with Decisive Action 

The great dilemma of diligence is that both your knowledge of the role and your likelihood of cognitive bias increase as you get closer to landing the position.  

A CFO candidate may not see an opportunity for what it truly is until the eleventh hour; at that point, momentum and the desire to “win” the job often overwhelm logic. 

Discerning candidates know walking away is sometimes the best possible option.

The number of PE-backed companies in the U.S. has doubled over the past ten years, and there is a record amount of dry powder aggressively looking for deals. If you do opt to pass on an opportunity, do so respectfully – word travels fast in the PE world, and it is best not to burn bridges. 

If you do intend to take the role, substantial diligence allows you to do so on less ambiguous terms. It also provides powerful information for compensation negotiations and provides a valuable head start on helping the company succeed.

Falcon provides C-suite talent solutions for middle market private equity firms across North America. Follow us on LinkedIn.