The Secret Sauce of Alignment

April 8, 2021

By Brad Mook

In our last post (Skin in the Game) we wrote about the importance of alignment between employees and owners, and how broad employee ownership can create structural and behavioral alignment. We received a lot of interesting feedback and had a number of relevant follow-on conversations, most of which fell into one of two camps: “Yes, and…” or “Yes, but…”. Many of these responses offered nuanced observations, but the foremost takeaways were (a) that employee ownership alone won’t achieve optimal alignment, and (b) that employee ownership isn’t the only path to alignment. Both are accurate. And to be fair, we’ve observed and partnered with several financially successful founders whose firms checked the box as “majority employee-owned“ but where the alignment and glue proved to be frustratingly poor over time, both for us and the founder’s “partners”.

The reality is there are other factors that loom large and matter regardless of the underlying ownership model. Things that create a sense of belief, a sense of belonging and a sense of loyalty. Things that create a sense of shared ownership in the process and especially the outcomes. Things that attract ‘A’ players… and keep them. Things that get the flywheel turning… and keep it turning.

Among others:

• Vision creates a common cause to rally around and ensures everyone knows where the team is heading. It gives employees a sense of purpose and belonging. Vision is neglected or assumed much of the time.
• Incentives motivate behavior (good or bad); proper incentives are helpful, while misaligned incentives are one of the biggest Achilles heels in business. Both parented and employee-owned managers are challenged here.
• Communication allows people to understand and fulfill their roles on the team. It gives people visibility and lets them know where they stand. Covid has made this harder and Zoom-dependent.
• Resources feed execution and improvement. Cost management is fine, but willingness to invest trumps do-more-with-less, especially in an increasingly competitive industry.
• Trust enables appropriate risk taking and the freedom to try new things, and creates an environment where employees will support one another and go to the mat to win. Trust is buffeted by poor performance, myopia, insecurity, etc.

These are all ingredients of a strong, healthy culture, which allows employees to focus on their work (as well as the things that are important to them outside their job). We are big believers that both alignment and culture enable execution—the blocking and tackling of everyday processes—and that successful execution is a big differentiator between successful and unsuccessful firms. It is amazing how many firms fall down because poor alignment or poor culture prevents them from doing the hard work well.

Gears won’t work if the teeth aren’t properly aligned.

A crew team can’t succeed if the rowers aren’t in sync. Drunken octopuses don’t win races.

We’ve seen firsthand many examples of misalignment through the years. For example:

• One-sided internal equity transitions – Sometimes sellers think they should get market or near-market value from internal buyers, since they took the bulk of the risk and created the bulk of the value. That approach doesn’t create true partners. And sometimes the buyers think they should pay nothing or near nothing for the stock, not respecting that the seller already did a lot of the heavy lifting. This disconnect—the unwillingness to either make sacrifice or recognize sacrifice—is one of the primary obstacles to smooth equity transition and lasting partnerships. In contrast, we’ve seen that materially discounted internal buy/sell multiples and seller/corporate financing appropriately balances sacrifice and benefit for both sides.
• Side deals – These often appear in benevolent dictatorships, typically in the absence of a fair and transparent compensation and ownership structure. In these situations, someone important at the firm inevitably complains about being treated unfairly and the principal quietly sets up a side deal to keep them quiet and preserve the status quo. This works in the moment, but in time it never ends well. Eventually it fosters resentment by all parties…the dictator, the squeaky wheel, and all those that weren’t in on the deal but later found out about it.
• Lack of transparency – A common pitfall that causes lack of trust is secrecy around the firm’s business metrics. Whether it’s the P&L, business development scorecard or specific client economics, management sometimes feels compelled to keep a tight lid on the firm’s financial information. Perhaps its motives are relatively benign (not wanting non-public information to become public), or perhaps more nefarious (not wanting employees to know how much money is being made at the top because they’ll demand more). But you can’t expect co-owners to act as true partners when they’re kept in the dark; they won’t trust you if you don’t trust them.

The key in all this is being able to take accurate stock of your firm’s condition and—uncomfortable as it may be—make appropriate course correction. Apply the secret sauce of alignment…develop an ownership culture, articulate a shared vision, establish dove-tailed incentives, communicate expectations and realities, provide ample resources, and create an atmosphere of mutual trust. You’ll be surprised what happens.

Skin in the Game

January 28, 2021

by Brad Mook

A while back in my career I was a capital allocator for a large manager of managers. I was fortunate to have a real-time laboratory through which to study industry practices around a whole host of issues, one of which was ownership vs compensation. I learned a lot through the experience—through my successes, failures, and the unremarkable fat middle—and strongly believe that an ownership culture provides competitive advantages over a compensation culture. You’ll get the best out of your people when they have skin in the game.

One of my biggest “failures” as a PM was one of my best learning experiences. A boutique manager we had invested with was acquired by a larger financial services company, and was to maintain its “independence” and “autonomy” within the larger company. At a high level it all checked out, and we maintained the investment despite the change in control. For a time, all went well aside from some seemingly inconsequential skirmishes between parent and affiliate. Eventually, however, investment performance hit a tough patch, assets dipped, team members left and the firm folded. And instead of weathering a performance fluctuation with a long-term view on a high-conviction manager, we were forced to implement contingency plans and reallocate the capital at an inopportune time.

What I later learned was that the parent company had swapped out the investment team’s equity for a profit share structure, which maintained the team’s take home comp, retained some alignment and seemed like a reasonable step. What it also did, however, was create a trap door in what had been a solid foundation. Without equity value, the comp structure became interchangeable with compensation schemes elsewhere, particularly as the business experienced a decline in economics. While ownership in the entity might not have completely maintained the status quo, it would have made it harder for valuable team members who effectively became at-will employees to jump ship for similar or better money elsewhere. It just might have stopped the death spiral that put the firm out of business.

An ownership culture provides financial, structural and psychological benefits that are hard to replace. The notion of building and participating in equity value – and sharing in equity risk — can be a strong center of gravity for hard-working and talented employees. It also creates a sense of stewardship and continuity, a sense of belonging. For an industry often accused of mercenary or self-interested behavior, a tight-knit team focused on building a successful firm can be a powerful draw to clients and new employees. While not perfect, employee ownership structures can reduce conflicts of interest and agency problems, ultimately aligning owners, employees and clients toward long-term success. When allocators describe ideal scenarios, it’s hard to divine better setups.

The notion of alignment is powerful, but too often we don’t dig deep enough to understand the mechanics of alignment and too often we accept platitudes or self-motivated reassurances. The truest measure of alignment is the amount of skin you share in the same game. Much of the transaction structuring among buyers and sellers today does not meet this test; preferences, revenue sharing arrangements, and other instruments designed to separate the buyers outcome from management’s is inherently misaligning and dangerous.

At Rosemont, we invest alongside employee owners so we all have skin in the same game, and we believe in the employees owning the majority so it really is their asset. My ill-fated investment all those years ago went down a different path, and the employees—the investors—checked out, forced clients to reallocate, and left the owner with nothing. Perhaps surprisingly, I respect and remain friendly with the head of that boutique; it was a learning experience for both of us and, while the outcome was unfortunate, it was handled professionally. That said, the experience left some scar tissue and has been formative in my beliefs around best practices. Ownership matters. Belonging matters. Skin in the game matters.

Forming Partnerships in a Pandemic

September 30, 2020

Six months into the global pandemic, with little business travel happening, it’s understandable that people in our industry are finding new ways to get business done. Professionals have gotten comfortable with video conferencing, and as time drags on it gets easier and perhaps necessary to justify moving business forward without in-person meetings and on-site visits.

We speak with lots of gatekeepers and allocators about this and, while some organizations are more aggressive than others, a general consensus has formed. Approvals and hires in progress before the pandemic should proceed, as should engagements with known entities. New engagements with well-known organizations can proceed. Potential engagements with unknown entities are likely to wait until in-person and on-site visits can resume. Of course, as recent articles have discussed (for example, “Consulting Giants Get Comfortable with Mgrs They Never Met in Person“), the longer travel moratoriums remain in place the more likely the goalposts are to move.

This may be an appropriate shift in the allocator world, where decisions can be reversed relatively easily, but it’s a different story in the M&A world. It’s a lot easier to split up when you’re dating; once you get married there’s a deeper spirit of commitment as well as contractual complexity. Given it’s a tougher knot to untangle, it should warrant greater care going in. That said, we are surprised to see M&A deals getting done over Zoom in this environment, with little or no in-person interaction. Activity in the wealth management space in particular is at or near an all-time high. We see lots of banker-led activity with tight bidding timelines and high table stakes, and these deals are getting done. In our view the atmosphere is distinctly more transactional than relational.

We at Rosemont have held off on underwriting any new partnerships during this pandemic. This stems in part from our usual conservativism—we tend to move deliberately—but also from an abundance of caution given the environment. Aside from considerable uncertainty in the macro environment (global pandemic, potentially volatile election cycle, etc.), we simply won’t partner with people we haven’t met face-to-face a number times. We want long-term relationships with high-quality people and sustainable organizations, and only with those that want the same of us. Figuring that out requires time together, in person and in a variety of settings and combinations. We don’t know any other way to determine and develop confidence in the durability of character, culture and functional strength.

Industry practices are likely to continue to evolve as the pandemic wears on. Some will be temporary necessities and some will change for good. One thing that won’t change, however, is our desire to get to know people very, very well before we partner, and we believe that can only be done in person.