The Factors That Create
Outperforming Stars
A small number of
people account for the vast majority of value creation in private equity.
What
do basketball player Kareem Abdul-Jabbar, actress Cloris Leachman and Microsoft
founder Bill Gates have in common? Research conducted over the past 15 years or
so has found that, across industries, jobs and fields of human endeavour, a
small number of people are responsible for the vast majority of value creation.
Whether we call it the 80/20 rule, the “1%” of the world’s wealthiest people,
or use the formal statistical term “power curve”, whenever we measure the
outcomes of human behaviour some version of this phenomenon seems to apply.
In
the case of the people listed above, Abdul-Jabbar’s 38,000+ career points make
him the all-time NBA points leader,
Leachman’s eight U.S. Emmy Awards make her history’s most awarded TV actor,
and Bill Gates’s US$75 billion makes him the world’s richest person.
Each of these individuals has performed so far above average that they
have made the concept of “average” meaningless in their fields. In other words,
they and people like them account for a far greater portion of success than a
bell curve would predict.
I
have spent most of my career working in private equity, and statistics on the
returns of PE investments make it clear that the industry works the same way.
Intrigued by this fact, I recently completed an in-depth study of one of the
world’s leading private equity firms to find out why. Since it is relatively
easy to attribute value within PE to individual investment professionals, the
industry turned out to be a very good laboratory for this type of work, and the
findings apply across industries.
Reinforcement
of competencies
In
my paper, “Competencies, Clusters, and Star
Performance at a Leading PE Firm”, published
in the Journal of Private Equity, I found that the more
“competencies” a person has, the more these competencies reinforce each other.
For example, exceptional strategic thinkers may be very valuable to their
organisations. However, if they lack the energy to drive change, their impact
will be limited. Now, if you take the strong strategic thinker and add high
energy to the mix, you achieve “multiplicative reinforcement”, that is the two
competencies build upon each other such that each one makes the other more
powerful. If you then take the same person and give them strong influencing
skills, they benefit from multiplicative reinforcement again, moving closer to
the outperforming tail of the power curve, and closer to becoming “stars”.
Statisticians
have known for a long time that multiplicatively reinforcing factors lead to
right-tailed distributions, with a small number of exceptional actors
accounting for the lion’s share of value.
Researchers have also found that competencies can reinforce each other in
this way, and Richard Boyatzis of Case Western Reserve University has claimed that
human behaviour as well as almost all change in his Intentional Change Theory
(the concept that sparked my interest in this subject) is power-law
distributed.
Not
all value levers are created equal
INSEAD
recently published a look at private equity’s value creation levers,
called Value Creation 2.0.
These levers are the different ways that private equity firms create value for
the companies that they own, and include sales growth, margin growth, multiple
expansion, debt pay-down and the leverage effect. My study indicates that not
all value levers are created equal. Specifically, at least within this private
equity firm, extreme outperforming companies differentiate from the pack
primarily on the basis of sales growth.
Then,
similar to the phenomenon of competencies, sales growth helps to pull the other
levers and to reinforce them, creating an “interdependent-multiplicative”
effect. Interdependency means that the better you are at one value lever, the
better you will be at the others. For example, rapid sales growth can lead to
higher margins, and higher sales growth can also lead to a higher valuation multiple
if the company is sold. Multiplicativeness has the same effect on value levers
as is described above for competencies.
Underperformers
abound
The
flip side of the tremendous value created by a small number of extreme
outperformers is that a surprisingly large number of people within any
environment seem to create little-to-no value. Warren Buffett recently observed
that in corporate America, it seems that “lots of employees aren’t doing anything”.
Organisational behaviour researchers have proposed that
within a typical organisation, the top decile of workers creates 30 percent of
value, and the top quartile creates 50 percent. My study indicates that this
idea holds within private equity, and the percentages are perhaps even more
skewed than these researchers have proposed.
To
make matters worse, some employees may be so lacking in competencies that they
are caught in a negative reinforcement trap, with the interdependent
multiplicative reinforcement phenomenon working against them. If someone is a
poor strategic thinker, has low energy and is poor at influencing others, it is
unlikely that fixing any one of these will lead to an exceptional or even
acceptable performance.
Developing
and training team members
If
a small number of people create the vast majority of value, a large number create
little value, and the “average” is far less common than we would think,
then how can companies best train and develop their people? Designing
programmes to focus on the average employee or average situation does not seem
adequate. Rather, this study indicates that companies should focus on
opportunities to use multiplicative reinforcement to their advantage. For
example, they could examine what differentiates their extreme outperformers
from the rest, and use these learnings to train people who don’t quite measure
up but have the opportunity to get there. Similarly, if companies have
employees who have a strong suite of skills but are lacking in a core area
(such as the great strategic thinker who is poor at influencing people), then
training that person in additional core skills could have a powerful
multiplicative effect. Importantly, researchers have shown that
competencies can be learned.
Thoughtful
value creation
Just like in
private equity, it seems clear that across industries, different ways of
creating value are more powerful than others (e.g. sales growth is more
important than cost cutting in PE) and that the interactions between the levers
are important too. When investing in new projects, companies can take advantage
of this phenomenon by looking for opportunities that can create value through
multiple levers (e.g. a project that will both grow sales and increase
margins). On the flip side, companies should, perhaps, be suspicious of
projects that can only pull one lever.
Avi Turetsky, Alumni Board Member, INSEAD Global Private Equity Initiative
Read more at http://knowledge.insead.edu/blog/insead-blog/the-factors-that-create-outperforming-stars-4919?utm_source=INSEAD+Knowledge&utm_campaign=b8c7c54699-22_Sept_mailer9_22_2016&utm_medium=email&utm_term=0_e079141ebb-b8c7c54699-249840429#soe2gmTYoTLY51hM.99
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