How important is management quality to returns, really?
Our recent report "Comforting delusion or expensive blind spot? The importance of management teams in mid-market private equity transactions", drawing on data from 94 investors across 50 UK private equity houses, highlights that investors attribute two-thirds (67%) of investment returns to management quality, which is not only very high but also represents a substantial rise from 58% in 2004. This places management quality far ahead of other factors such as technology and market conditions, establishing it as the *single biggest perceived driver of investment returns.
However, that is just one perspective on debate that has persisted within the investment community for decades: just how significant is the management team in driving investment returns? An alternative perspective is provided by the insightful work of Professor Steven Kaplan.
Kaplan, in his paper A Framework for Evaluating Start-Ups: Thoughts and Evidence, presents a framework for evaluating start-up and venture capital (VC) investments built upon two key components: a strong opportunity (O) and a strong management team (T). This leads to the central analogy of whether to ‘bet on the horse’ (the company's product and market) or ‘bet on the jockey’ (the management team).
Kaplan highlights that some VCs firmly believe that the company's product and market are the key drivers of success, advocating to "Bet on the horse". He cites several successful approaches in venture capital history that align with this perspective. For instance, Tom Perkins of Kleiner Perkins prioritised a company's technological position, specifically looking for superior and proprietary technology. Similarly, Don Valentine of Sequoia, an early investor in Cisco, focused on assessing the market for the product or service, asking whether the market was large, growing, and well-defined. Interestingly, Kaplan points out that Cisco was turned down by many other VCs who considered the management team weak, yet Valentine invested anyway, seeing a huge market opportunity. By contrast, he also quotes Arthur Rock, an early investor in Fairchild and Apple, who emphasized the quality, integrity and commitment of the management team. “A great management team will find a good opportunity even if they have to make a huge leap from the market they currently occupy.”
Kaplan's own research, conducted with Berk Sensoy and Per Stromberg, delves into the ‘jockey versus horse’ question by studying 50 VC-financed firms from their early business plans through to IPO and beyond. Their findings reveal that while companies experience dramatic growth, their lines of business are remarkably stable over time, suggesting that these are core attributes. This stability of the ‘horse’ – the fundamental business and its market – across both their sample and a broader analysis of all 2004 IPOs (both VC and non-VC backed) suggests this is a general trend. Furthermore, their analysis indicates that non-human capital, such as the line of business, points of differentiation, and alienable assets, remains relatively constant, while human capital (the management team) changes more substantially.
Ultimately, Kaplan concludes with a suggestion: ‘Should you bet on the jockey or the horse? On the margin, bet on the horse’. He argues that while strong management is undoubtedly valuable, a poor idea is rarely overcome by even the best management team. Conversely, a good idea can still succeed even with a less-than-stellar initial management team, as VCs often change management along the way. Kaplan quotes Warren Buffett to reinforce this point: "When a management team with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact". This suggests that the underlying viability and attractiveness of the ‘horse’ are more critical than the initial ‘jockey’.
Conclusion
The differing perspectives presented by Kaplan and the Catalysis report raise interesting questions about the relative importance of the 'horse' versus the 'jockey' in generating investment returns. While Kaplan's research, focused on VC-backed start-ups, suggests that the fundamental business opportunity holds a slight edge, the PE investors surveyed in the more recent report attribute a significantly larger proportion of their returns to management quality in mid-market transactions. Several factors could contribute to these apparent differences:
Stage of Company: Kaplan's study focuses on younger, often pre-revenue or early-stage companies where the viability of the initial idea ('the horse') might be a more critical determinant of survival and eventual success. The "PE and management research" likely encompasses more mature, mid-market businesses where the ability of the management team ('the jockey') to scale, professionalise, and navigate complexities becomes a more dominant factor in value creation.
Investment Focus: Venture capital, by its nature, often involves backing highly innovative but unproven ideas. In such scenarios, the strength of the initial concept might indeed be the primary bet. Private equity, particularly in the mid-market, may focus more on optimising existing business models and driving operational improvements, where management expertise plays a more direct role.
Geographic Differences: Kaplan's primary research sample is US-based, while the our research focuses on the UK mid-market. It is possible that the dynamics and investment philosophies in these different geographies could influence the perceived importance of management.
Ultimately, both the underlying business opportunity and the quality of the management team are undeniably crucial for successful private equity and venture capital investments. The relative weight attributed to each may shift depending on the specific context, the stage of the company, and the investment strategy employed. While Kaplan's caution against overlooking a fundamentally flawed business resonates strongly, the increasing emphasis on management quality within the PE mid-market highlights the critical role of effective leadership in realising the potential of any 'horse'. Perhaps the most successful investments are those where a strong 'horse' is expertly ridden by a skilled 'jockey'.
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