From the PEM archives: Warburg Pincus, Part Two

(Reposted from Private Equity Manager, June 2004)

What’s the secret to a successful generational change? Years of preparation and founders who are willing to let go.

That Warburg Pincus is run not by two gentlemen named Warburg and Pincus but by two gentlemen named Landy and Kaye makes the firm a rarity in the private equity world.

This is a young enough industry that most private equity firms on both sides of the Atlantic still are actively managed by their founders. The rule applies even to the oldest firms – Kohlberg Kravis Roberts, for example, is still run by Kravis and Roberts, although Kohlberg left some years ago to launch a firm called Kohlberg & Co (he's still there).

As the private equity market matures, many of its participants predict a growing bifurcation between a handful of large, dominant players with an iron grip on institutional investment capital, and a sea of small boutiques pursuing nuanced, off-the-radar-screen strategies. Firms that fail to succeed in one of these two categories, the theory goes, will gradually disappear.

As evidence, backers of the bifurcation theory point to other partnership-based industries that have gone through similar changes: management consulting, accounting, investment banking. Indeed, Wall Street is now dominated by just a few bulge-bracket firms – Goldman Sachs, Merrill Lynch, Lehman Brothers, Salomon Smith Barney, et al.

Something else to note about these big investment banks – Messrs. Goldman, Lynch, Lehman and Barney, to name a few, are long gone, but the firms they founded live on, at least in altered forms. This is the future of institutional private equity, but, with a few exceptions, there have been no generational successions to serve as examples of how we might get there from here.

The one big exception, of course, is New York-based global private equity giant Warburg Pincus.

To be sure, the firm comes from boutique roots. Long story short, it was founded by Eric Warburg and, later, Lionel Pincus assumed control. Pincus then hired John Vogelstein to do deals. Through most of the 1970s and 1980s, EM Warburg, Pincus & Co, as it used to be called, was firmly under the control of these two men. However, as the firm grew, Pincus and Vogelstein gradually instituted new structures and decision-making processes at the firm that allowed Warburg Pincus to function smoothly without the intense involvement of its founders.

This, according to interviews with the new leadership of the firm, paved the way for the eventual withdrawal of Pincus and Vogelstein from the firm’s day-to-day activities.

Pincus and Vogelstein agreed to scale back their ownership and relinquish their management of the firm they built. As one of Warburg Pincus’s co-presidents Charles “Chip” Kaye puts it, the process was a “complicated and deeply personal” one for the founders, and its outcome may have most to do with their respective personalities and values.

In 1998 Warburg Pincus was well established as a major force in private equity. It had just raised its eighth institutional fund, Warburg Pincus Equity Partners, with $5 billion in commitments. The fund still ranks among the largest ever raised and, at the time, reflected not only the explosive growth of private equity as an institutional asset class, but Warburg Pincus’s looming presence within the industry. But the successful fundraising led to contemplation among the senior partners of the firm – what next? In 1998, Vogelstein was 64 and Pincus 67. The concern was not for the current fund but the next one.

Specifically, what would investors be told about the roles of Vogelstein and Pincus when it came time to raise the next pool of capital? “Remember, when you go raise a fund, you're essentially saying to your investors, ‘I'm going to steward your money for the next 12 years,’” says Kaye.

Limited partners were naturally going to question whether their capital, a decade out, would receive the requisite levels energy and attention in the hands of two septuagenarians. Investors were also anxious to learn how younger partners were being given incentives to build their careers within the organisation and groomed to lead it going forward.

Fortunately, under the leadership of Pincus and Vogelstein, the firm had spent years creating a more institutional and professional structure for running the firm and making investment decisions, which meant a withdrawal of the two founders would be less disruptive.

Following the close of the eighth fund, a sensitive procedure began, whereby the founders had to decide how best to hand the reins of ownership and governance to a next generation.

For help they turned to two longtime friends as well as senior partners at Warburg Pincus – Dr. Harold Brown and Henry Schacht. Neither man was a stranger to the emotional, political and operational delicacies involved in dealing with succession.

Brown had years of experience at the highest levels of US government and academia, having served as the secretary of defense during the Carter administration and as chairman of the  Foreign Policy Institute of Johns Hopkins University from 1984 to 1992.

Schacht's background was more corporate – after retiring as chairman and chief executive officer of Cummins Engine in 1995, he became chairman and CEO of Lucent Technologies, and briefly served as chairman of Lucent spinoff (and Warburg Pincus portfolio company) Avaya.

Crucially, Schacht has also served on the boards of corporations that have gone through their own generational changes, both pleasant and gut-wrenching. He joined the board of The New York Times shortly after longtime chairman and CEO Arthur Ochs Sulzberger stepped down and the role of chairman was handed to son Arthur Ochs Sulzberger Jr. and that of CEO to non-family member Russell Lewis in a friendly transition.

Less amicable was a change of command at broadcaster CBS. As a longtime board member, Schacht witnessed the company's buyout in 1986 by Larry Tisch, who subsequently forced out founder William Paley.

In 2000 Schacht and Brown began quietly approaching the many professionals at Warburg Pincus  to “test the temperature” as to what might be accepted internally as a strong operating structure going forward, says Joe Landy, Warburg Pincus's other co-president. Notes Kaye of this process: “This was not a hallway conversation, but it was one that a lot of the partners in the firm were engaged in.”

After roughly nine months, Kaye and Landy were named executive managing directors of the firm, or as Kaye more casually puts it, “the core of the next generation.” Following that internal announcement, many additional details of the transition were worked out.

A source familiar with the transition says that as their ownership of the management company devolves, Pincus and Vogelstein will receive steadily diminishing shares of the firm's earnings. While he declines to specify the firm's new ownership structure, Landy says that Warburg Pincus has made a “great step forward – we have a much flatter ownership structure than we ever had historically. As you might expect, Lionel Pincus and John Vogelstein had founder economics for many years. Some of the senior partners now have slightly bigger shares than they had before.”

Adds Kaye: “The way this transition came off, it enabled a whole generation of people – all of us
who grew up at the firm over the last 10 to 20 years – to feel as if there were a collective opportunity to take this phenomenally interesting platform and make it something that could be even more special over the next decade or two.”

NEW FUND, NEW TEAM

This enthusiasm among the new generation of Warburg Pincus apparently was not lost on its limited partners. In 2002 amid a generally “catastrophic” fundraising environment, the firm closed its tenth private equity fund on $5.3 billion – a vehicle that investors knew would be managed by the new generation of leadership at the firm.

Kaye and Landy say their firm has a long history of a gradually flattening its operating structure, and this made the generational transition easier. “What we didn't do was simply take the emperor and replace him”, says Kaye. Instead, the “emperor” endeavoured to slowly replace himself.

Warburg Pincus was formed in 1966 when Pincus assumed control of the firm created by the merger of Eric Warburg's private investment house and Lionel I. Pincus & Co. A year later, Pincus hired Vogelstein, a Lazard partner, to lead the firm's investment activities. As the firm evolved over the next two decades, the two men developed a symbiotic working relationship that saw Pincus in charge of raising capital and Vogelstein in charge of investing it.“While Lionel and John wore many hats, most investment decisions basically came up to John,” remembers Landy, who joined the firm in 1985. “It was very much a founder-oriented environment.”

But Kaye and Landy claim that Warburg Pincus’s founders had a “vision” for a private equity firm that went well beyond that of a two-man cult of personality. “Lionel and John always had it in their heads to professionalise and institutionalise the private equity business,” says Kaye. “That's a phrase that I remember hearing here 20 years ago.”

GROUP DYNAMICS

As Warburg Pincus' fundraising and investment activity gathered momentum, the decision to institute changes at the organisation was equal parts necessity and virtue.

In 1980 the firm raised just over $100 million for its second fund. In 1983 it raised $341 million, and three years later it raised $1.17 billion. Vogelstein wanted to build out an investment programme that involved expertise across a range of “domains” and he knew he couldn't be master of them all.

Before Warburg Pincus closed its next fund on $1.7 billion, Vogelstein hired Rod Moorhead, Sidney Lapidus, Howard Newman and William Janeway to lead distinct industry groups. The hirings meant that not every key decision would run through Vogelstein. “It was significant because it was really the onset of decentralisation of decision-making,” notes Landy.

The hires served to flatten the investment infrastructure at the firm. Moorhead was tapped to run a healthcare group, Lapidus formed a media and business services group, Newman led an energy group, and, in a move that would distinguish the firm as a major player in the field, Janeway lead a new technology investment team.

Today Warburg Pincus counts nine industry groups, all of them add-ons to the model formalised by the hiring of the original industry group heads. Speaking of the early days of this model, Landy says: “Each partner in these groups understood their sectors and the unique advantage of operating in a vertical structure, while at the same time conforming to the firm's investment strategy, which was overseen by John Vogelstein.”

After it raised a $5 billion fund in 1998, Vogelstein, Pincus and the growing roster of senior partners began to hire professionals to specialise in tasks once performed by deal partners with varying degrees of effectiveness. The firm’s chief financial officer, Tim Curt, who joined in 1998, notes that his group of accounting and fund administration professionals began to grow significantly after the $5 billion fund closed. Today, 15 people report to Curt.

Another relatively recent addition to the Warburg Pincus infrastructure is Jim Neary, who joined in 2000. Neary leads the firm's capital markets team, which essentially acts as an in-house investment bank to the firm's many portfolio companies and deal professionals.

Nancy Martin and Stan Raatz lead a technology due diligence team that vets technological issues on prospective and existing portfolio companies. In 2001 the firm hired Julie Johnson Staples to coordinate marketing, branding and communication strategies among the portfolio companies and for the firm itself.

The geography and sector group heads, as well as some of the “shared services” leaders, comprise what Warburg Pincus calls its executive management group, the body over which Kaye and Landy preside, formally running Warburg Pincus where once Pincus and Vogelstein called all the shots. Thanks to steady moves toward this group management model, says  Kaye, “by the time the succession question arose, I think this firm was mentally prepared for it.”

THE CHOICE

For the record, Pincus and Vogelstein continue to serve as chairman and vice chairman,  respectively, of the firm, but are no longer involved in its day-to-day activities, although their enormous Rolodexes are always available. Kaye says the founders consciously decided to see that the firm they built out lived them. “People assume that all firms will professionalise, but my own opinion is that it's a choice founders have to make,” says Kaye. “Some firms will always be a reflection of talented, great men, and will rise and fall with their degree of interest and health.”

Kaye notes that people who spend their lives building a business – any business – do not tend to be the sort that easily let go of it. “The notion of giving your firm away doesn't always strike founders as the most obvious tack,” says Kaye. “You can devolve day-to-day responsibility for things, which I think a lot of people have been quite successful at. But then there's the issue of how you devolve economics and governance, and those are the more complicated questions, ones that most people don't want to talk about.”

The key to Warburg Pincus's successful transition, then, may be that Pincus and Vogelstein did talk about it and, ultimately, did agree to give their firm away.

(Reposted from Private Equity Manager, June 2004)