There is a strong perception amongst institutional investors that staff turnover is a bad thing. And mostly for good reason: LPs expect the investment professionals to whom they entrust their capital will stick around to make sure their investments are successful. However, LPs are getting savvier, and developing more nuanced conclusions about how they perceive turnover. And they’ve got some hard data to back them up. Recent research from Capital Dynamics and the London Business School shows that a healthy level of staff churn can actually be positive for performance.
The report, which looked at staff turnover and performance at both fund and deal level, found teams which experienced (some level of) turnover from one fundraising to the next performed better in their next fund. For turnover at the fund level, the report looked at the entire firm, except for the back office. They found that a one percent increase in turnover led to a 10 percent increase in subsequent net internal rate of return (IRR). The study, which averaged net IRR across funds with the highest and lowest terciles of turnover, also found that funds with the highest turnover produced a 25 percent net IRR on average, while funds with the lowest turnover had an average IRR of 11.5 percent.
Nonetheless, just because LPs are more willing to accept that turnover at a firm isn’t always detrimental to performance, they still see it as a red flag. Expect LPs to do some digging.
It’s getting personal
It starts with finding out exactly why staff is leaving, stress LPs. In fact, more investors are feeling comfortable enough making this a point-blank question during due diligence.
“One of the standard due diligence questions now is ‘who of your senior investment staff has left in the last five years?’” says Kelly DePonte, managing director at placement agent Probitas Partners. To gather more information, many LPs will want to speak directly with the departing partner to hear both sides of the story.
For fund managers, the conversation can be difficult. Staff turnover is a sensitive area, resulting in some GPs hiding any brutal details of why someone left from inquisitive investors. Despite their efforts, LPs say they’re wise to the practice. “Managers are very discreet in what they tell you about why so-and-so has left. But once you start looking at performance attribution you can sort of see it yourself,” says John Gripton, managing director and head of global investment management, Capital Dynamics.
This has led Capital Dynamics to pore over GPs quarterly reports to get a better understanding of who at the firm is really driving performance. “There is a collective responsibility and an investment committee that approves the deals so it is not altogether the fault of somebody if something goes wrong,” qualifies Gripton.
Even firings made for the “right” reason – say poor performance – can be a worry for LPs. “You have a concern that the senior management at the fund either doesn’t know how to hire people or doesn’t know how to train them up. That is really telling, if you have too much turnover for the right reason, have you really got the right people at the top of the fund?” says De Ponte.
And performance is not the only factor that contributes to staff turnover, meaning LPs are asking other questions to get to the bottom of why someone left.
This means that LPs have been asking for more details on the economic split of the team: they want to know who is getting carry and how much carry they are getting, says Adam Turtle, co-founder of placement agent Rede Partners, who adds that LPs also try to understand if people leave for non-monetary reasons. For instance a frustrated partner can leave for status reasons or because they feel their opinions were not being valued. “In the past people were a lot more opaque but that has changed, LPs won’t let you get away with that anymore.”
This can be seen with the formation of Central and Eastern European private debt fund manager Syntaxis Capital, which saw part of the investment team spin-out from another debt fund. “One reason we left the old firm back in 2005, was because they made it clear to us that a path to ownership in the management company was unimaginable,” says Thomas Spring, founder of Syntaxis. “So for us we understand that to get and keep the best people, we have to provide a trajectory to partnership for everybody, so the professionals we hire can clearly see the potential to make partner at some point.”
Only dealmakers will do
As of now, the trend hasn’t trickled down into less senior staff. Sources say investors tend to keep their focus on rainmakers or senior management. The Capital Dynamics study helps explain why. The study broke down the turnover by dividing all professionals into three groups, based on their previous experience: operational, financial and private equity. The operational group had experience in running operations, the financial group mainly had experience in banking and the private equity group had prior experience in private equity. Between funds, the higher turnover of professionals with private equity backgrounds resulted in a drop in performance.
“There are the analysts and associates and some will go off to business school and some return, some don’t, so we don’t attach too much importance to that turnover,” confirms Gripton. “We are less concerned about the back office or investor relations, it is the investment professionals where we really spend our time.”
But, as more and more fund managers try to impress LPs with an army of operational experts – and research suggesting turnover of these professionals is healthy for the firm’s performance – what do investors think about operational churn?
One GP says: “It’s important to not instill the feeling that operating partners have a shelf life.” Whereas, Gripton says that he expects to see higher turnover of operational partners because they are often more mature professionals that have already had a career and are perhaps working on a part-time basis. “They are not going to be there for 20 years, and their knowledge is not likely to be relevant for that length of time either. They will become out of date and out of touch in their own industries over time so we do expect to see turnover there.”
No need to necessarily panic then when someone leaves, for even LPs now agree that some churn – the right kind of churn – can actually be a good thing. GPs just need to be prepared to answer questions about the bad churn.
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