Dean, Kellogg School of Management; Donald P. Jacobs Chair in Finance; Professor of Finance
Companies that have a high level of employee turnover are generally viewed with suspicion. At best, significant churn seems to indicate an inexperienced team with low morale; at worst, an organization rife with mismanagement. After all, if everything at a company was going well, why would so many people be leaving?
The perception that turnover is bad is especially prevalent in private equity, says Francesca Cornelli, dean of the Kellogg School of Management and a professor of finance.
Investors often look to the stability of a fund manager’s team when deciding where to invest. In fact, stability is so valued that it is often stipulated contractually: investors demand “key man” clauses, which state that that they have the option to pull their money out of a fund early if certain key individuals leave. These clauses are becoming increasingly comprehensive, encompassing more partners.
But despite its bad rap, not everyone is convinced turnover is a bad thing.
After all, turnover allows firms to replace low-performing employees with higher performers and to inject a fresh set of ideas and skills into the mix. In fact, some private-equity partners believe investor demand for stability is actively hurting the industry’s ability to make personnel changes that would improve the health of their funds.
So Cornelli and colleagues Elena Simintzi, of the University of North Carolina, and Vikrant Vig, of London Business School, set out to investigate the relationship between team turnover and fund performance in private equity. They found that higher team turnover was associated with better performance in the future—whether the turnover occurred after the start of a fund or as the team was planning and fundraising for their next fund.
To Cornelli, the results speak to broader truths about teamwork in organizations across all industries. Leaders who prioritize stability above all else may do so at their own peril.
“The world is changing,” she says, “but the same people are going to stay? We need to be more prone to embrace change when it is needed and constantly bring in new skills.”
In many ways, private equity is an ideal laboratory to study employee turnover. It is extremely human-capital intensive. And it provides a unique opportunity to measure the contributions of individuals. That’s because in private equity, each partner working on a fund is in charge of specific investments. By looking at the performance of those specific investments, you can gauge the contributions of that individual.
Moreover, private equity is an industry where stability is assumed to matter. Why is this the case? “I have various theories,” says Cornelli.
For investors, a typical private-equity fund is a ten-year commitment. Funds spend roughly the first five years striking deals to purchase companies and the next five years improving and eventually selling these assets. Because the commitment is relatively long-term, investors often develop trusted relationships with the partners who convinced them to invest.
“With a hedge fund, if investors aren’t happy, they can take the money out,” says Cornelli. “With private equity, they’re locked in. There’s nothing they can do. That’s why it’s so important to whom you give the money.”
Then there is the fact that, during the lifetime of a fund, private-equity firms are fundraising for their next fund. This effectively means it is never a good time to broadcast that you are purposefully switching up your team, Cornelli explains. “To fundraise, you say, ‘We have the most amazing team.’ Then the people leave, and you either must tell investors ‘Well, we lost the most amazing people’ or ‘We were wrong; we didn’t have the most amazing team.’”
Finally, and perhaps most importantly, there is some chicken-and-egg confusion: investors may notice a relationship between turnover and performance, and assume that high turnover is causing low performance, rather than the low performance spurring the management team to make personnel changes, including bringing on new individuals to turn the ship around.
When pressed, investors may logically understand this, says Cornelli. “But in reality, people just say, ‘Oh I have that deal that went very badly. And I remember that the partner in charge of that deal left some time ago.’”
“We are too reluctant to change organizations. We feel reassured by a team that is stable, so we hold on to that stability at all costs.”
So instead, private-equity firms just avoid the confusion altogether and advertise to investors about how stable their teams are. But is this really something investors should want to hear?
In their new study, Cornelli, Simintzi, and Vig accessed 25 years of due-diligence documents from Capital Dynamics, a “fund of funds” that heavily researches private-equity funds in order to invest in them on behalf of other investors. The documentation that the researchers analyzed covered 5,772 deals in 500 funds from 138 fund managers or private-equity firms, as well as data on nearly 6,000 individual team members who served in various roles at these firms. This large dataset was then merged with fund-level data on performance over time.
The average team in this dataset had 49 individuals and a sizeable amount of turnover, with 13 people leaving during a typical five-year period. However, the “sub-teams” that worked on individual deals were generally much smaller: on average, just three individuals. Twenty-one percent of deals experienced turnover during their lifetime.
What Cornelli and her colleagues found when they analyzed the data was striking.
“When a private-equity company has a higher turnover in one fund, we observe better performance in the future,” she says. Specifically, the researchers found that higher turnover in the five-year period after the start of a fund was associated with better performance in the next five-year period of that same fund and especially in the team’s next fund.
The result is quite robust, she explains. “It doesn’t matter how much we controlled for or how we ran our analysis,” she said. “We always found it.”
The effect isn’t small, either. “If you increase turnover by one percent, you have a two-percent higher IRR,” Cornelli says, referring to a popular way of measuring return on investment. “Two percent more is a lot! It makes the difference between a fund performing well and a fund really being one of the top.”
The researchers also analyzed the impact of turnover that occurred during the planning and fundraising period right before the start of a fund. They found that turnover during this period also led to better performance in that fund and in the next one.
But interestingly, the benefits of turnover during the two time periods appear to emerge from different sources.
The most important boost in future performance from turnover that occurs during the first five years of a fund appears to come from employee departures, that is, from the firm replacing poor performers with individuals who could better manage the existing investments. (Indeed, the researchers were able to confirm that deals attributed to these leavers underperform others at the firm by 12 percent.)
In this period, “I can see short-term fixing,” Cornelli explains. “Can I get someone who is going to fix the problems that this underperformer has created?”
The benefits of turnover that occurs during the fundraising period before a fund begins, however, primarily come from joiners: the injection of new talent, who are bringing with them new skills and expertise.
Here, Cornelli sees evidence of longer-term adaptation to a changing environment. “The world is changing,” says Cornelli, “and I need new ideas, new team skills.”
To confirm their interpretation, the researchers also looked specifically at economic recessions. They reasoned that during a recession, the companies in which a fund has invested would be more likely to require a dramatic restructuring of their operations in order to adapt to the rapidly changing environment. This in turn would make it more important to have people with the right operational backgrounds working on a fund—making turnover, and the newly relevant skills it would bring, especially critical.
Indeed, as predicted, the researchers found that increased turnover during recessions in particular is associated with even higher performance in the future.
Top firms appear to utilize this strategy most effectively. One year after a recession, higher-quality fund managers (as defined by their historic performance) have more team members with the operational skills needed to restructure companies than they did before the recession. They also have higher turnover in those positions, suggesting that these top-performing funds are responding to changes in the economy by quickly updating the skills on their teams.
Moreover, top firms overall replace a larger fraction of their underperformers—even when the economy is not in a recession.
This may be because, thanks to their previous success, these firms feel less of a need to keep up appearances and can position themselves for future success. “So many firms are scared of their investors, and they don’t change people,” says Cornelli. “These top firms perform better because they are not scared.”
In Cornelli’s view, firms (and their investors) in private equity should reconsider their belief that stable teams are always the most effective teams.
More broadly, she hopes that firms in a range of industries—from financial services to scientific research to sports teams—will take note. “We are too reluctant to change organizations. We feel reassured by a team that is stable, so we hold on to that stability at all costs,” she says.
Instead of letting outmoded skills drag down a team, or settling for a good-enough status quo, she advocates that organizations look to the future and ask themselves what new skills will get them where they want to go. And then they should act accordingly.
“I’m not saying you should fire a bunch of people randomly and then you will perform better,” says Cornelli. “It’s more that organizations are loathe to change even when circumstances dictate it. They don’t consider whether they need to update the skill set of their team or bring in new talent. They eventually do change their teams, but only when it is too late.”