Change of guard: What LPs want to know

LPs expect a GP not only to have a clear succession plan in place which they can assess but also comfortably discuss. There are several ‘hot-button’ issues on which LPs focus. These are explained below.

The first thing to mention is that a seamless leadership transition has more to do with the culture of a firm than the succession plan itself. A strong culture is the first of these pillars and is the key element for long-term successful organizations. In this regard, LPs are looking for an indication of whether a firm is a true partnership with a shared sense of purpose, operating as a group rather than a collection of disparately incentivized individuals. Some familiar LP questions along these lines are:

• Does the firm have a set of commonly held values and guidelines for professional and commercial dealings both inside and outside the firm?

• What does the firm do to instill a consistent and durable culture?

• How is the growth of this culture fostered by the incentive structure?

Strategy steadiness

Clearly defined strategies and a common sense of purpose are other key elements that provide LPs the assurance that, with the departure of one-key person, the firm’s investment activities will not wander afield of the original mandate. This includes a team that has been schooled in the manner in which a firm executes the entire investment process – from looking for deals within its ‘strike zone’, to drawing on competitive advantages to build, identify and unlock portfolio company value, to how the firm exits investments. LPs understand this and look for the underlying signs that indicate whether a firm is taking succession planning seriously or not. Some LP questions to expect are:

• How does the firm define its core investment focus?

• Does the firm plan on entering any new business lines or geographies?

• What safeguards are in place to ensure that the firm sticks close to its articulated strategy?

• What power do different members of the team have in terms of stopping a deal from going through?

• What competitive advantages or firm characteristics make this investment focus the right one over time, regardless of who is leading the firm?

Strong internal processes

Internal disciplines that have been established and tested make it more likely that returns can be replicated in the future, regardless of the firm’s leader. Strong internal processes imply a firm that is less reliant on one individual to achieve and replicate investment success. LPs are looking for firms to define and articulate these internal mechanisms in a comprehensive way. Some familiar LP questions along these lines are:

• What are the firm’s processes in terms of investment decision-making, sourcing, post-acquisition value creation and exit planning?

• Does the firm encourage broad participation in these processes or is it restricted to a small group?

• How are junior professionals mentored, trained and developed?

• How does the management committee operate?

LPs look for GPs to define and demonstrate these pillars of stability in the day-to-day activities of the firm. In LPs’ eyes, these anecdotal behaviors go a long way in measuring the level of collective commitment to the firm’s stability and future longevity.

Communicating these issues is something that happens continuously, not just in one-on-one meetings during fundraising. Every time the firm interacts with its investors – whether at annual meetings, during quarterly updates, during advisory committee meetings or at conferences – is an opportunity to outline and underscore the fact that firms with a strong culture, a focused strategy and established internal practices fair the best over the long term. These firms are truly built to outlast their founders.

Getting the best of both worlds

Even if LPs are not specifically asking questions that betray their interest in or concerns about a specific firm’s approach to succession planning, they are nevertheless quietly observing and drawing their own conclusions. The best private equity firms realize that succession management is also a powerful tool to make the founding vision sustainable, and they are taking several key actions, including embracing the next generation.

That’s because, almost by definition, the second generation of private equity leaders is going to be different than the first. The founders, in some cases, have been flamboyant and outspoken. By contrast, new leadership of the industry seems to be quieter and more circumspect, perhaps more likely to ‘fly under the radar’. This is a quality that could serve the industry well as it enters into a new phase of its evolution. In addition, the second generation of any firm does not have their personality intimately intertwined with the firm’s image. Almost by definition, they understand the importance of creating an institution that is the vessel for the values and culture that the founders initially formulated.

It is important for GPs to believe, and LPs to understand, that succession is an opportunity through which LPs might get more of what they want – steadfastness, reliability and consistency – rather than less. Whether explicit or not, some potential LP questions are:

• Have you identified a potential successor to the current CEO?

• Can you outline the different generations of leaders at the firm?

• Do you have reasonable age dispersion across the firm?

Focusing on retention

Succession management boils down to the retention of the firm’s employees. Managing both the departure of the founder and the appointment of the next firm leader can have unintended consequences equally difficult for the firm to handle. It is a time of uncertainty for firm employees. The manner and timing of the succession announcement – namely who the successor will be – needs to be appropriate and thoughtful. Not everyone is going to become the firm’s CEO, but that does not mean that the peers of the new leader have now lost out.

Overall stability of the partnership – retention vs. attrition – is something that LPs are also concerned with, independent of who the CEO is or if the founders are still involved. While not everyone can be destined for ultimate leadership of the firm, if the firm’s culture is strong, its partnership is cohesive, its investment focus is defined and its policies, process and procedures are in place, the succession of one individual will not threaten the rest of the group. Some familiar LP questions to anticipate could be:

• Is there a rivalry within the next generation of leaders for the top spot?

• How will the firm handle the fallout when one is chosen and the other is not? Will there be departures of key individuals?

Keeping the founder(s) close

Creating an arch of continuity between generations is not just about embracing the younger generation, but also keeping the founders engaged with the firm and/or industry in an ongoing, constructive way. The firm needs to help those individuals enter retirement gracefully, thanking them publicly and underscoring the idea that they remain close and will act as an ongoing spiritual influence.

This graceful shift is as much for them as it is for the LPs who are watching this process closely for clues about the nature and cohesion of the partnership. These retiring founders are, by their nature, dynamic and driven, and will always be extremely helpful in an ongoing role as ambassador, thought leader and mentor.

Promote diversity

More attention on developing new profiles for private equity’s new guard is increasingly on the agenda of the more innovative firms. White men in their forties, with Wall Street investment banking experience and shiny MBAs from brand-name business schools cannot possibly have a monopoly on great private equity investment decision-making.

However, promoting diversity goes beyond gender and color issues. It also encompasses the development of a culture and investment team that reflects a broader spectrum of experiences, insights and capabilities required to be successful in an environment that is more competitively intense, regulated, socially conscious and technologically networked.

Closing thoughts…

In fairness, there are a handful of experienced LPs who maintain that firms which spend the most time on succession planning may be the ones that have major challenges.

Nevertheless, buyout firms have become harder to manage and octogenarian leaders like Warren Buffett are the exception rather than the rule. As a result, investors today “care a lot about who will succeed the kings of private equity”, as one advisor put it. And even Buffett was quoted in a Vanity Fair article as saying that succession “is all we talk about” at board meetings. The fewer uncertainties a GP presents to an LP, the better. Succession is one of the biggest uncertainties that a GP has to manage during the course of its existence and whether it is handled properly can affect that existence in important ways.

LPs are concerned that the departure of a firm’s founder(s) casts doubt on its ability to deliver the predictable returns that LPs have come to expect and on which they rely. As a consequence, LPs expect to see that a firm exhibits all of the signs of a mature organization with an institutionalized culture, investment focus and way of doing business – the combination of which assures the repeatability and consistency of what an LP has learned over decades to value about its investment in the GP.

GPs must devote serious thought and attention to the delicate issue of succession management or risk giving rise to negative perceptions that can have profound contractual consequences or negatively affect fundraising success. To ensure the long-term sustainability of a firm, a GP must first have a compelling and well-articulated vision of what the firm is trying to achieve; second, build a team of talented individuals with integrity and good judgment who are bound together by a clear set of values; and third, clearly establish priorities within the firm, balancing structure and process versus a partnership governance model and the entrepreneurial spirit inherent in a deal-oriented business.

We are entering a new inflection point for private equity where the next generation of leaders will be stepping into the shoes of the old guard. The transition underway holds the promise of recreating the entrepreneurial energy which is the foundation of the industry. Some firms may find it challenging to adapt and will shrivel away with the passing of their founders. Disappointingly, these firms without perpetuity will share a number of common traits including the inability to maintain a clear vision, uphold a culture, adhere to core values or create a differentiated brand.

On the other side of the divide, those firms on their way to leadership transitions should understand that succession holds the potential for great opportunity. In effect, it affords the next generation of good people the platform to reinvent the firm and thereby avoid the cardinal sin of any organization, especially one devoted to private equity: becoming stale.