Leadership Risk E-Book

David Cooper

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Sprache: Englisch

Seitenzahl: 321

Veröffentlichungsjahr: 2010

Beschreibung

This book is a practical guide for private equity investors. It sets out a framework for understanding, assessing and managing the risks associated with senior management during the due diligence process of an acquisition. This provides an essential input into the wider due diligence review and a sound basis for managing the investment after the deal has been done so as to maximise the chances of a successful exit.

The book comes at a time of significant growth in the field of private equity. In the UK over 3 million people (around 18% of all private sector employees) now work for private equity backed companies. It is estimated that European funds currently have somewhere between #200 and #300 billion to invest over the next few years. In the US, the whole issue of private equity due diligence is much more advanced but it is still likely that due diligence will remain a significant issue for private equity investors for the foreseeable future.

Leseprobe

Table of Contents

Title Page

Copyright Page

Dedication

Acknowledgements

Introduction

THE PROBLEMS OF LEADERSHIP RISK

THE PROBLEMS OF LEADERSHIP ASSESSMENT

THE PRINCIPLES UNDERPINNING THIS BOOK

THE AUDIENCE FOR THIS BOOK

THE STRUCTURE OF THIS BOOK

Chapter 1 - The Landscape of Leadership Risk

1.1 INTRODUCTION

1.2 THE FINANCIAL PERSPECTIVE

1.3 A BRIEF HISTORY OF RISK AND UNCERTAINTY

1.4 LEADERSHIP THEORY

1.5 LEADERSHIP RISK AND UNCERTAINTY

1.6 LEADERSHIP RISK IN BUSINESS PERFORMANCE

1.7 THE FOUR QUADRANTS OF AWARENESS

1.8 SUMMARY

REFERENCES

Chapter 2 - Overview of the Leadership Risk Mapping Framework

2.1 INTRODUCTION

2.2 OVERVIEW OF THE STAGES OF THE FRAMEWORK

2.3 SUMMARY

Chapter 3 - Planning and Preparation

3.1 INTRODUCTION

3.2 PLANNING THROUGH THE FOUR QUADRANTS OF AWARENESS

3.3 SUMMARY

Chapter 4 - Deciding What to Assess at an Individual Level

4.1 INTRODUCTION

4.2 LEADERSHIP COMPETENCIES

4.3 PSYCHOLOGICAL TRAITS

4.4 MOTIVATION

4.5 SOME COMMON CHARACTERISTICS OF SUCCESSFUL PRIVATE EQUITY-BACKED CHIEF EXECUTIVES

4.6 THE IMPORTANCE OF CONTEXT

4.7 SUMMARY

REFERENCES

Chapter 5 - Conducting Assessments at an Individual Level

5.1 INTRODUCTION

5.2 INDIVIDUAL INTERVIEWS

5.3 MULTI-RATER FEEDBACK

5.4 ASSESSING PSYCHOLOGICAL TRAITS

5.5 REVIEW OF AVAILABLE DOCUMENTATION

5.6 SUMMARY

Chapter 6 - Deciding What to Assess at a Team Level

6.1 INTRODUCTION

6.2 WHICH ‘TEAM’ TO ASSESS

6.3 THE OUTER VIEW OF THE INVESTEE TEAM

6.4 THE INNER PERSPECTIVE - TEAM DYNAMICS

6.5 THE OUTER VIEW OF THE INVESTOR

6.6 THE INNER VIEW OF THE INVESTOR

6.7 SUMMARY

REFERENCE

Chapter 7 - Conducting Assessments at a Team Level

7.1 INTRODUCTION

7.2 INTERVIEWS WITH TEAM MEMBERS

7.3 INTERVIEWS WITH OTHER STAKEHOLDERS

7.4 FEEDBACK QUESTIONNAIRES

7.5 EXISTING DOCUMENTATION

7.6 AGGREGATE DATA FROM INDIVIDUAL TEAM MEMBERS

7.7 LIVE OBSERVATION OF THE TEAM

7.8 SUMMARY

Chapter 8 - What to Assess at an Organisational Level

8.1 INTRODUCTION

8.2 INSIGHTS FROM THE FOUR QUADRANTS OF AWARENESS

8.3 SUMMARY

REFERENCES

Chapter 9 - Conducting Assessments at an Organisational Level

9.1 INTRODUCTION

9.2 THE ‘TOP-DOWN’ PERSPECTIVE

9.3 DATA FROM OTHER LEVELS OF ASSESSMENT - THE ‘BOTTOM-UP’ VIEW

9.4 SUMMARY

REFERENCE

Chapter 10 - The Review Phase

10.1 INTRODUCTION

10.2 CONSIDERATIONS IN THE FOUR QUADRANTS OF AWARENESS

10.3 THE REVIEW PROCESS

10.4 REPORT FORMAT

10.5 SUMMARY

Chapter 11 - The Address Phase

11.1 INTRODUCTION

11.2 ADDRESSING LEADERSHIP RISK AT AN INDIVIDUAL LEVEL

11.3 ADDRESSING LEADERSHIP RISK AT A TEAM LEVEL

11.4 ADDRESSING LEADERSHIP RISK AT AN ORGANISATIONAL LEVEL

11.5 SUMMARY

REFERENCE

Chapter 12 - Third-party Service Providers and their Approaches

12.1 INTRODUCTION

12.2 CONSIDERATIONS IN THE FOUR QUADRANTS OF AWARENESS

12.3 THIRD-PARTY SUPPLIERS AND THEIR APPROACHES

12.4 IDENTIFYING POTENTIAL SUPPLIERS

12.5 SUMMARY

Appendix Overview - ‘Leadership Risk: A Guide for Private Equity and Strategic Investors’

Index

This edition first published 2010

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Library of Congress Cataloging-in-Publication Data

Cooper, David.

Leadership risk : a guide for private equity and strategic investors / David Cooper.

p. cm.

eISBN : 978-0-470-66193-2

1. Corporations-Finance. 2. Risk management. 3. Risk assessment. 4. Leadership. I. Title.

HG4026.C66 2010

332.63 2042-dc22

2009054379

A catalogue record for this book is available from the British Library.

Set in 10/12pt Times by Aptara, New Delhi, India

To my mother and father

Acknowledgements

Firstly, I would like to thank all the clients, both investors and investee teams, with whom I have had the pleasure of working over recent years. My appreciation goes to the many colleagues, past and present, whose support and advice have been invaluable in developing and delivering the ideas which form the basis of this book. In particular I would like to thank Andreas Buerge, Ben Dhaliwal, William Erb, Mike Hicks, Dave Irwin, Olivia Leydenfrost, Mike Smith and Professor Richard Taffler, all of whom have helped in different ways. Special thanks also go to Ian Angell, Mairi Eastwood, Mike Morgan, James Thorne and Barry Woledge at Praesta Partners, as well as Jackie Tookey. I also value the kind cooperation of Debbie Cook and Mike Ready at Compass 360 and Jackie Wagner and Wendy Lord at Hogrefe, who helped in the provision of some of the sample outputs included in the appendices. Thanks to Pete Baker, Aimee Dibbens and Karen Weller for making the publication process so enjoyable. Finally, I thank my family, in particular my sister, Jane Cooper, for their ongoing help and encouragement.

Introduction

The aim of this book is to provide a guide for investors into one of the most crucial yet opaque dimensions of any investment - the management team. This book is premised on the idea that investors should not merely focus on assessing leadership but that it is necessary to assess leadership risk. From this perspective, highlighting the strengths and weaknesses of the management team represents just one part of a broader and more sophisticated process of identifying and mapping the risks arising from the leadership agenda of the investee company, in order to provide the investor with a clear view of the management- and leadership-related factors which have the potential to create or destroy value. By framing their review of management in terms of risks it is intended that investors will be able to integrate this information with other data to provide a rich picture of the overall risk landscape of the investee business.

This book has been written during a period of unprecedented turbulence in the financial environment and, at the time of writing, the impact of this on the world of private equity remains unclear. Recent years have seen significant growth within the private equity industry. Amounts raised globally have reached hundreds of billions of dollars annually compared to tens of billions only a few years ago. The size of private equity-backed deals has also grown significantly. After several record-breaking years of deal activity, the dramatic aftermath of the credit crunch is still reverberating. It seems likely that many private equity investors will now place even greater attention on generating value from their existing portfolio of investments than seeking new deals. In any event this book will be of use.

One aspect which has not changed is the extent to which the success or failure of private equity-backed deals hinges on the performance of senior management. It is widely accepted that management is often the major contributor to value creation and destruction in private equity-backed deals. Management ultimately deliver the business strategy and produce the financial performance which will lead to a successful exit. However, the effort and attention dedicated to assessing management before and after the deal is still often very low when compared to the significant impact it can have on results.

The ability to assess management quickly and accurately is one of the key skills of the private equity investor. Moreover, the ‘gut feel’ which they often rely upon as the basis for assessing management has proved in many instances to give a sound basis for the investments they make. It is not the aim of this book to judge or criticise the traditional approaches which investors use when assessing leadership in their investee businesses. The intention is rather to recognise that, whilst many investors have an instinctive flair for evaluating people, they have fewer tools and frameworks at their disposal in this area than are available when they come to analyse other dimensions of a business. We address this by exploring the issues and risks associated with leadership assessment and presenting tools and approaches which can be applied in practice. Drawing on insights from this book, investors will be able to gain a clearer picture of the people dimension of their investments as a means to maximising the value which they are able to create.

THE PROBLEMS OF LEADERSHIP RISK

One central problem facing investors is that, whilst management play a crucial role in the ultimate performance of investee companies, the process through which this is achieved is complex and hard to predict. The high level of complexity surrounding management and leadership brings with it a high level of uncertainty and where there is uncertainty there is risk.

In this book, we define ‘leadership risk’ as:

The risk that senior management, either individually or collectively, do not have, or fail to apply the necessary capability or motivation to deliver the expected performance and/or that their leadership of the enterprise limits or destroys value.

As leadership risk is at the heart of this book it is worthwhile to consider the key elements of this definition.

• ‘Senior management’ - The contribution of the most senior team in the business (possibly the board) is seen as being central.

• ‘Individually or collectively’ - Members of the senior management team have an impact as individuals and in terms of how they work with each other.

• ‘Capability or motivation’ - The assessment of senior management is seen as hinging on two central questions: ‘Can they do it?’ and ‘Will they do it?’

• ‘Expected performance’ - The investor will usually have a clear sense of how they expect the business to perform on its journey to exit and this is predicated on an assumption that the management team will perform effectively.

• ‘Leadership’ - Even if management do have the requisite capability and motivation, their stewardship of the enterprise - the decisions they make and where they place their energy and attention - may still have a negative impact on performance.

THE PROBLEMS OF LEADERSHIP ASSESSMENT

Having introduced the elements of leadership risk we can now look at some of the problems which make it so complex and uncertain. We will then show how these problems form the basis for the principles upon which the approach set out in this book is based.

Quantification and Measurement

Investors conduct thorough analysis when evaluating investments but leadership cannot be quantified in the same way as other dimensions of the business, such as the financial or the strategic. Leadership strengths and weakness cannot be ‘measured’ as such. Moreover, it is difficult, if not impossible, to identify clear causal relationships through which the strengths and weaknesses of the management team and the ultimate performance of the business are linked. This not only makes prediction difficult, it means that, even after the event, it is often difficult to ‘prove’ which management behaviours or characteristics led to which results.

Getting Below the Surface

Another factor which contributes to the complexity of leadership from an investor’s perspective is that the key drivers of leadership effectiveness or weakness are often rooted deep below the surface. Some of the most significant issues influencing commercial success or failure will not be obvious at the time of the transaction and can remain hidden as the business is incorporated into the investment portfolio. As well as being hard for the investor to identify, these may also be difficult for the management team themselves to understand. Investors are obliged to impute the suitability and capability of leaders on the basis of interviews, discussions and track record. However, future performance will be equally, if not more, influenced by inner hopes, fears, beliefs and motivations, of which even the individual concerned may not be aware.

The Effect of Being Assessed

A further layer of complexity stems from the likelihood that, in contrast to other, more impersonal, areas assessed by investors, the very act of assessing the leadership team can influence the results of that assessment. When leaders know they are being assessed, they will have a strong incentive to ‘be on their best behaviour’. The very fact that a leadership team is being assessed, particularly in such a high-stakes scenario, will influence the way they perform. As a result, it is not possible for the investor, in their capacity as assessor of the leadership team, to be entirely independent of the assessment process.

Deal Jeopardy

Further problems can also arise because, if leadership assessment forms part of the pre-deal due diligence, it is often conducted at a point in the investment process when pressure is at a peak and the stakes are at their highest. There may be constraints such as lack of time and lack of access to the senior team. Investors are keenly aware of the risk that leadership assessment may be unduly intrusive and may sour the relationship between the investor and the leadership team and even jeopardise the deal itself. These and other concerns mean that, while not disputing the central role which management can play in creating and destroying value, investors approach management due diligence with considerable caution.

THE PRINCIPLES UNDERPINNING THIS BOOK

The problems described above provide the basis for the principles upon which this book has been written. The framework which is summarised below and explained in detail in the following chapters is intended to address the complexities of leadership assessment by providing a process which has depth and rigour and will enhance rather than tarnish the relationship with the leadership team under assessment.

Process and Structure

The first principle is that leadership assessment should be conducted in a thorough and systematic manner. The framework set out in the following chapters is based around a four-stage process.

Prepare - To ensure adequate preparation it is important to:

• Establish in advance what information is required from the assessment and how this information will be used.

• Have a clear plan setting out the timetable for the assessment and specifying who will be assessing whom and in what timeframe.

• Identify and remain vigilant to factors which could influence the objectivity and accuracy of the assessment.

Assess - Conduct the assessment with rigour and ensure it is as objective as possible. It is important to make a distinction between data gathering and data evaluation. Assessors should not attempt to conduct these steps simultaneously.

Review - Consider the data gathered in a systematic and impartial manner and evaluate it in the light of the wider business agenda, other dimensions of the business and the potential impact on business performance.

Address - Translate the findings of the review into plans and actions. Have clear criteria for deciding which are high- and low-priority issues and set out a clear plan of how these will be dealt with.

Assess at Multiple Levels

The definition of leadership risk refers to the impact of leadership behaviour, both individually and collectively. We suggest that leadership assessment should embrace three levels:

• The individual level;

• The team level; and

• The business or organisational level.

Multiple Perspectives

Given the complexities associated with leadership, no single data source can be expected to suffice in its assessment. We therefore suggest that data relating to different dimensions of leadership be collected from a number of different sources and then compared and triangulated in order to build a rich picture. Specifically, we suggest that data is gathered from the perspective of ‘self’, ‘others’ and ‘context’.

Depth of Awareness

The four-step process described above ensures that the assessment process is conducted in a systematic and thorough manner. In order to ensure that the assessment is as effective as possible, the investor has to look beyond the plan and take account of what is happening below the surface. In most areas of business analysis and due diligence, the focus is on the outer world (the observable, reportable dimension) of the investee business. Whilst this level of analysis is important, when it comes to assessing leadership this is not sufficient. As we will set out in later chapters, it is also important to remain aware of the influence of what is going on below the surface (which we will refer to as the ‘inner world’) of both the investee AND the investor.

Figure I.1 indicates just some of the factors which can play a role in effectiveness on these dimensions.

Figure I.1 Factors influencing effectiveness

Remember the Relationship

We referred above to the concern that leadership assessment may damage the relationship between investor and investee. It is therefore essential that the assessment is conducted in a manner which, as far as possible, will strengthen this relationship. Here, clear communication about purpose and process is essential. If conducted properly, leadership assessment can be a means by which an investor can differentiate themselves positively from their competition and maximise the chances of the success of the transaction.

It is critical that the investor remains vigilant and self-aware and appreciates the impact they are having.

Assessment is the Beginning of a Process

A further important consideration is that leadership assessment should focus more on the future than on the past. Achieving the growth which private equity and strategic investors are looking for is predicated on significant challenge and change for the investee management team. It is possible, and even likely, that the skills and abilities which enabled the management team to grow their business to its current state will be different from the skills required to take it to the next level and achieve the satisfactory exit. Rather than a single ‘snapshot’, which forms the basis for a one-off decision (as can be the case with financial or strategic due diligence), leadership assessment should form the first step in an ongoing process of understanding and addressing the leadership agenda upon which business success is based. The aim is that the issues identified are monitored on an ongoing basis and plans put in place to address them are fine-tuned in the light of experience.

THE AUDIENCE FOR THIS BOOK

This book is intended to be a practical guide for private equity and other strategic investors. Leadership risk is a serious issue for all businesses and, indeed, all organisations. However, in the case of private equity investors or other investors making a substantial strategic investment in another business, certain factors raise the significance of leadership risk even further:

• Given the challenging growth targets often associated with such investments, significant change is implied for the investee business, which also implies significant change and challenge for the leadership team.

• Once the investor has made the investment, it is a material event for both parties and changes the world or both the investor and investee.

• The investor will have the necessary access and control to conduct an in-depth leadership risk assessment.

• The investor will have sufficient influence to be able to drive, or at least influence changes and decisions based on the result of the risk assessment.

The tone and language used assume that the reader is already familiar with the world of corporate finance. In contrast to this, the principles and frameworks relating to the assessment of leadership risk are presented in a way which does not presuppose significant prior knowledge. The terms ‘investor’ and ‘private equity investor’ are used to refer to representatives of the business making the investment who negotiate and execute deals. ‘Investee’ relates to the leadership team of the business which is being invested in.

The book will also be of interest and value to a much wider range of businesses which are not engaging in, or subject to, investment. At the start of the book, we point out that understanding leadership-related risk takes on a special significance in environments where there is growing complexity and/or rapid change. The ideas presented here will therefore be helpful to any business experiencing rapid growth and striving for ambitious targets, in which success or failure hinges on effective leadership and any assessment or leadership development activities must be very focused and closely related to business success.

The following chapters draw on insights drawn from a range of theoretical sources, including leadership research, organisational and individual psychology, and also reflect the author’s own experience of applying these in practice. Approaches are presented in practical rather than theoretical terms so that they may be readily applied in real-life situations.

It is intended that readers of this book may draw on it as a resource to support them in addressing a number of issues relating to leadership assessment within the context of reviewing businesses in their existing portfolio or conducting pre-deal leadership due diligence. Issues covered include:

• Identifying what needs to be done at each stage.

• Planning and managing the process.

• Enabling the investor to make the best possible use of whatever time and access to the leadership team is available.

• Highlighting and addressing issues relating to planning and managing leadership due diligence.

• Communicating the process to existing and prospective leadership teams undergoing assessment.

• Evaluating and selecting third-party providers who may support the leadership assessment process.

• Using and integrating the findings of the leadership risk assessment to maximise success on the route to exit.

Where appropriate lists of representative skills, characteristics and issues are presented, this is done for illustrative purposes. None of the lists presented should be interpreted as representing a ‘universal’ or exclusive checklist. Throughout the book we emphasise the importance of context and assessing specific leaders in their own terms within the specific context of the business they are leading, so there can be no universal checklists.

THE STRUCTURE OF THIS BOOK

In Chapter 1 we consider the risk landscape in which leadership risk assessment takes place and develop the themes and principles summarised above in greater depth. In Chapter 2 we introduce the elements of the four-stage leadership risk mapping model and begin to build a high-level map of the assessment process. Chapter 3 is concerned with the first stage of the model - planning and preparation - and we set out techniques which can be used to plot the critical leadership path to exit and show how this can be used to specify what needs to be assessed. The following chapters cover the assessment process itself. Chapter 4 looks at how to decide what should be assessed at an individual level and Chapter 5 looks at how to actually approach individual-level assessment. Chapter 6 explores how to decide what to assess at a team level and Chapter 7 looks at how to conduct team-level assessment. Chapters 8 and 9 deal with assessment at an organisational or business level. Chapter 10 deals with the process of analysing and interpreting the results of the assessment and producing a high-level map which charts key elements of leadership risk. Chapter 11 describes how to address the results of the review and sets out the principles of translating these into development plans so as to ensure that the insights generated by the process inform the ongoing leadership and success of the business. Finally, Chapter 12 covers the potential use of third-party consultants and provides a snapshot of the market place for relevant services. See Figure I.2 for a graphical representation of the book’s structure.

Figure I.2 Chapter overview

1

The Landscape of Leadership Risk

1.1 INTRODUCTION

One of the central ideas upon which this book is based is that, in order for private equity investors to maximise the chances of creating value in their investee companies, it is better to focus on assessing ‘leadership risk’ rather than simply assess ‘leadership’. Although the distinction between leadership and leadership risk may seem a minor one, it is in fact highly significant. The assessment of leadership is a fairly narrow activity focused on certain key individuals whereas leadership risk is much broader and takes as its starting point the chain of value creation and destruction. Whilst the primary emphasis of this book is related to how leadership risk can be assessed and managed, the current chapter sets the scene by considering the question of why leadership risk represents the problem it does. Before introducing the leadership risk mapping framework, which is described in detail in the following chapters, the current chapter is therefore dedicated to a consideration of the landscape of leadership risk which confronts private equity investors and the problem of how best to make sense of that landscape.

We will argue that, to manage risk of any kind it is important to minimise uncertainty and raise awareness of the variables which may enhance or inhibit success. To make effective decisions it is essential to have a broad and deep understanding of the territory in which one is operating. This is critical in providing the insight required to ask the right questions and identify which areas require attention. It can be argued that the most serious risks facing any business are those which are not already in the awareness of the management team or stakeholders. In such situations, where the boundaries of the risk map are too narrowly drawn, there is a false sense of certainty and security. Several of the dimensions of leadership risk which will be explored in subsequent chapters fall into this category.

Irrespective of the particulars of a specific investment, there are two general problems associated with leadership and leadership risk which often arise in the context of private equity-backed businesses. Firstly, in rapidly growing businesses, the future is always different from the past and, ultimately, the extent to which the business is able to anticipate and adapt comes down to leadership. When unexpected leadership issues manifest without prior awareness or preparation and there is insufficient time to explore these in sufficient depth, decisions may be taken which lead to extreme or inappropriate measures. Secondly, in fast growing businesses, leadership assessment and development is often seen as a low priority and does not appear on the investor’s ‘dashboard’ as being a significant dimension through which the business is driven. As a result, the topic of leadership often begins to attract attention only when it becomes a problem. Significant leadership-related decisions may therefore be rushed and made on the basis of an inadequate understanding of the links between business performance and leadership. When such decisions are rushed in this way it becomes difficult to evaluate the possible consequences, or other possible options in any depth. We will explore the problems related to rushed leadership-related decisions further in Chapter 2.

We begin this chapter with a critical examination of the ‘dominant lens’ which is used to understand business - that of accounting language. We will highlight some of the many advantages which accounting representations offer whilst also indicating some of the limitations of this perspective. In particular, we will suggest that the apparent rationality of accounting is much less robust under conditions of rapid change, complexity and uncertainty - which are the conditions surrounding many private equity investments. We will also explore the issue of uncertainty further and its links with the history of the development of the idea of risk. Having identified some of the problems arising from the use of accounting under conditions of risk and uncertainty, we will also consider why the leadership agenda associated with private equity-backed businesses often poses a particular problem. Having set out the limitations of both an accounting perspective and a leadership perspective we will then make the case for using the leadership risk framework, not as a means of managing risk in a formal sense but as a useful metaphor for identifying and addressing some of the critical issues which can create or destroy value in private equity-backed businesses.

1.2 THE FINANCIAL PERSPECTIVE

Accounting is widely recognised as being the ‘language of business’ and financial data will always be the central reference point on a private equity investor’s ‘dashboard’. Financial analysis supports decisions about which opportunities to explore, which investments to make and how much to pay. An understanding of the numbers guides the many decisions made both by the investor and the investee management team on the journey through to exit. The accounting view is so dominant that it is taken for granted. However, but for the purpose of the current discussion it is useful to examine the characteristics of accounting which make it so appealing, and highlighting some of the critical functions which accounting language performs:

• Enabling communication - accounting represents a highly convenient ‘universal shorthand’ which enables the quick and straightforward description and communication of widely differing scenarios in equivalent terms.

• Establishing a sense of order - accounting creates a clear sense of balance, order and structure and so forms the basis for ‘rational’ management and control.

• Reducing complexity - the way in which accounting achieves the above functions is by reducing complexity and, in reducing complexity, creating a greater sense of certainty.

• Managing the ‘problem’ of time - underpinning the above functions of accounting, the way it solves the problem of time which is described below.

One of the central themes of the current chapter is the link between complexity, uncertainty and risk. A central challenge facing a private equity investor is how to make decisions about a business as it moves from a ‘known’ past into an ‘unknown’ future. To understand and manage risk it is necessary to view what is known in the present in terms of its future implications. Indeed, it could be argued that the basis for successful business planning and management is rooted in a view of the business which unites past, present and future. Businesses are able to achieve precisely such a view through the use of accounting systems.

The language of accounting reduces past and future business events to equivalent terms, linking them seamlessly and giving a sense of continuity. Beyond that, it offers the enticing possibility of playing with time. Alternative accounting treatments can provide alternative accounts of the past. They can also be used to generate an infinite range of future scenarios. Accounting systems present the past, present and future in a consistent way with financial statements and management accounts showing what has gone before and business plans and budgets indicating what is to come; both time periods are expressed in equivalent terms. Any given moment - past, present or future - can be frozen and expressed in terms of assets and liabilities in a balance sheet. The objective and impartial flavour of accounting language makes it an ideal framework upon which to build a ‘rational’ view of the world.

Accounting therefore provides a guideline for rational management, reduces complexity and provides a sense of order. However, this sense of certainty comes at a price and so brings with it a number of problems, not the least of which is the simplification entailed in translating the complexities and uncertainties of business reality into the neat order of numbers. For over half a century, researchers have suggested that, in practice, accounting frameworks are used in different ways depending on the level of uncertainty which prevails. In situations where the business being accounted for is relatively stable and there is a high degree of clarity about the cause and effect relationships which create value, accounting lends itself well to the function of building understanding and making decisions. However, the more rapid the rate of change in a business, the greater the difference between its past and future and the more complexity there is, the less useful accounting language is as a basis for making decisions and making sense of the business. Here, although accounting provides the same sense of order, what is actually happening is a process of post hoc rationalisation. Major decisions have to be made on the basis of incomplete or ambiguous information and only afterwards can any degree of certainty be achieved. The scenario confronting private equity-backed investment teams and the general partners who invest in them almost always involves significant change and uncertainty. The closer one gets to this scenario, the more decisions are based on ‘leadership inspiration’. As a result, a proper understanding of ‘leadership’ becomes more important as the basis for understanding and managing the business.

From this perspective, it can be argued that when it comes to understanding and managing risk, the value of an accounting frame of reference decreases as the rate of change and the degree of complexity increase (see Figure 1.1)

1.3 A BRIEF HISTORY OF RISK AND UNCERTAINTY

The issue of risk and uncertainty and the distinction between the two extends well beyond the world of accounting and it is useful here to consider briefly how these themes have developed over time. Over the centuries, human beings have responded in differing ways when confronted with the inevitable uncertainty of events and the consequences of decisions. There has been a general tendency to assume that things which are more readily quantifiable are more important than things which are more nebulous and subjective; and more time is devoted to analysing those aspects which are quantifiable than those which are not. By their nature, investment decisions revolve around uncertainty and risk and it is important for investors to recognise the boundary between the quantifiable and the unknown. In his book Against the Gods, Peter Bernstein notes: ‘Today, we rely less on superstition and tradition than people did in the past, not because we are more rational, but because our understanding of risk enables us to make decisions in a rational mode.’

Figure 1.1 Accounting, risk and uncertainty

A key distinction, highlighted by the economist Frank Knight early in the 20th century, is that between risk and uncertainty. The statistical frameworks which had been developed in the preceding centuries were often too firmly rooted in the analysis of probability applied to games of chance, such as roulette or dice. In this context, probabilities can be established with some precision, and risk assessments can be made. However, in business and the wider economy, there will always be factors that are unknown, unquantifiable and unexpected. For all the apparent rigour and scientific method in applying probability theories to the real world, they are essentially irrational to the extent that they exclude factors which cannot be quantified. Knight wrote: ‘Uncertainty must be taken in a sense radically distinct from the familiar notion of risk, from which it has never been properly separate. It will appear that a measurable uncertainty, or risk proper, is so far different from an immeasurable one that it is not in effect uncertainty at all.’

The ever-present element of surprise means that any attempt to extrapolate from the past frequency of events is inherently dangerous. Techniques developed from areas where probabilities can be accurately calculated may be pleasingly neat, but that does not mean that they can automatically be translated to other areas merely because data can be generated to be able to perform the calculations. In the real economic world, even if certain patterns appear to be stable, there is no guarantee that they will continue.

In a similar manner, Knight’s contemporary John Maynard Keynes argued that the probabilities of events in the real world are not subject to tools of measurement. In 1937, in The General Theory, Keynes wrote: ‘The game of roulette is not subject to uncertainty. The sense that I use the term is that in which the prospect of a European war is uncertain, or the price of copper and the rate of interest 20 years’ hence, or the obsolescence of a new invention. About these matters, there is no scientific basis on which to form any calculable probability whatever. We simply do not know.’

Keynes was scathing about the reliance of classical economics on past events, arguing that the unstable and dynamic nature of an economy means that the mathematical patterns established in the recent past may have little or no relevance today, as the underlying context has changed, and the players never have perfect information.

The implication of this dimension of risk - or more accurately defined, uncertainty - is that a different kind of assessment is needed. In business contexts there has traditionally been a bias towards managing and analysing aspects of the company that are measured, over those that are harder to quantify but may be equally influential. However, the true measure of a robust risk management framework is not the depth and complexity of analysis it generates but the extent to which it can embrace and facilitate understanding of those factors which ultimately influence performance and can create or destroy value.

The distinction between risk and uncertainty is perhaps at its most stark in the area of leadership risk Leadership risk is uncertain and complex because it relates people and their capacity to lead businesses, and this is a complex and uncertain process. Although leadership can have a significant impact on business performance, the mechanism by which this occurs is opaque so that precise causal relationships cannot be discerned. As a result, predictions cannot be made and probabilities cannot be calculated. Moreover, the drivers of human behaviour, actions and reactions lie below the surface and may not even be within the awareness of those concerned. As we will set out in the final section of this chapter, such problems are not insurmountable and the leadership risk mapping framework described in the rest of this book can provide a way forward.

The above discussion suggests that the value of accounting, as a means of truly managing and understanding business and risk, diminishes as uncertainty and complexity increase and, indeed, the whole issue of the distinction between risk and uncertainty is problematic. It can be argued that, the more uncertainty there is surrounding a business, the more the success or failure of that business hinges on the leadership capability of the senior team but, as we will explore below, the whole concept of ‘leadership’ also represents something of a problem.

1.4 LEADERSHIP THEORY