This month's challenge: A new perspective

The challenge:

When it comes to succession planning, GPs still haven’t fully figured out how to value the management company, or what that valuation means in terms of talent retention. From your market perspective, what’s the answer here?

Jonathan Harvey’s response:

Succession planning has become one of the biggest challenges facing private equity firms in recent fundraising cycles.

That increasing concern was quantified in our annual GP Trends Survey, published in December. Of the 81 senior private equity professionals polled, more than two thirds (68 percent) said that clear succession planning was critically important, but more than a quarter (27 percent) said their firms’ current plans for generational change were inadequate.

Addressing this vital area of succession planning is a strategic challenge encompassing a couple of complicated areas that are very much linked: valuing a management company and then using that valuation to secure the longevity of the firm through the introduction of younger partners.

To take the first challenge, it is well known that buying into a partnership is very expensive, especially for younger partners. Valuing what they are buying into accurately is critical, but an extremely tricky process and not one for which even we have a precise answer. The problem is that a private equity company is not like a public company or a manufacturer, for example, with clear assets and goodwill, allowing you to arrive at a valuation fairly easily.

Nonetheless, there are two options we’ve discussed with GPs: using a normal EBITDA multiple valuation or a discounted cashflow valuation. However, both methods have limitations. Principally, private equity managers do not have the diversity of investments across asset classes (real estate, infrastructure etc.) and are therefore fully reliant on management fees coming from future fundraising in the private equity sector. The lack of diversity in future revenue streams means applying any type of valuation methodology is difficult without having an in depth knowledge of the private equity sector in general.

The challenge common to both approaches is that, with private equity, you are intrinsically valuing the senior people and their ability in the business to generate successful dealflow which will in turn aide future fundraising and thus generate further management fees. Without a succession planning strategy a private equity manager can have a limited shelf life: when those key senior partners call it a day, the firm dies a natural death. So, in essence, these businesses can be a victim of their own success.

The challenge for successful managers is how they grow their business in the medium to long term to ensure sustained success whilst taking care that the equity value of the manager does not become prohibitive, thus allowing junior people to buy in and more seasoned partners to exit.

Succession planning is not an area at the forefront of many private equity managers’ minds but without a solid plan in place or the ability to attract younger partners, the firm that has been built will die with the retirement of its key partners. Therefore, if any founder wants to leave a legacy, it is essential for them to find a way to attract the younger generation and recapitalizing the business using debt to reduce equity value can be an effective means of doing that.