Private equity firms are people businesses. They sell themselves to their LP customers, wrapped in strategy and branding. The investment judgments they make are concentrated to an inner team. In contrast, a “company” or “business” might have a CEO, CFO, COO, CTO and CMO, and there will often be an executive board.
No private equity partnership is run the same way. Almost all of them have relatively flat structures. Most of the managers are deal-doers. Most striking of all, the partners usually gain most of their incentive through carry, not their partnership shareholding.
LPs’ focus and concern on the senior managers is reinforced by the need for “key man” clauses in the fund’s legal agreements. Dropping the baton in leadership transition can be terminal for private equity firms. Either LPs will treat the new leadership as a first time fund, which can be a disaster; or the inward-looking politics caused by leadership uncertainty and ill-prepared succession will hit returns, which can be nearly as disastrous. I discuss ways to not drop the baton here.
Understand the animal you are dealing with
Most senior private equity partners were involved in founding their businesses. Some even name the fund after themselves. Most company directors were not. The industry is surprisingly young, and I would suggest no fund founders give a second thought to leadership transition for the majority of their tenures. Companies think about it continually.
Learn from what major companies are doing
Major companies like GE, Shell and IBM will spend years planning CEO transition. It is one of the chairman's main responsibilities. They will ensure this issue is debated with the incumbent chief executive so the broader business and its shareholders are not left in the lurch when the transition crystallizes.
Get realistic on the unique challenges of a partnership
Unlike a 'company', a partnership has infinite variations. Consider the ingredients: private equity firms are usually founder-led businesses; have headstrong “player managers”; hold a high concentration of power; embody little to no non-executive governance; and live in a relatively young industry not used to multiple leadership transition cycles. It is a potentially potent cocktail.
Start the process of sharing carry and responsibilities early
Senior partners should start the process of sharing carry and responsibilities with junior partners early to retain them and see who can deliver. They will expose younger partners to LPs years before the subject of transition arises. They will work with experts on team profiling to understand what sort of personality is needed for the next phase of the business, and know the qualities needed to run a team are different to making investments.
Be self-aware and have a strong sense of teamwork
In a company, it is the chairman's role to oversee this. As most private equity firms don't have a chairman, it is down to the self-awareness, teamwork and vision of the senior team to transition successfully. I feel (and hope) I have all three, but I still have a chairman just in case. And my investors certainly feel more comfortable because of it.