The best succession plans are years in the making. LPs are increasingly wary of firms that rely too heavily on a few star dealmakers rather than a clearly defined strategy. So, GPs would do well to actively mentor the next generation, letting them build a track record and help run the firm. Fund managers should also be transparent with LPs about their succession strategy, and offer them a chance to develop relationships with younger deal partners.
Key-person clauses should be written to include junior partners, and the management company documents should include ways for the next generation to buy out the founders’ stakes. But if the young talent doesn’t see a clear route to the top, that could all come to nothing.
But who wants to consider their curtain call? Most founding partners are dynamic personalities in no rush to step down. However, they could be putting their firm’s brand at risk if they act as if they will work forever.
“A lot of the firms underestimate how much of their brand equity rests with the founders,” says Rob Berick, of the strategic communications firm Fall Communications. “So they need to take the time to let younger partners build up their own credibility as leaders and dealmakers, because that brand equity isn’t so easily transferred.”
At the heart of any succession plan is a process where a firm can continue despite losing its leadership. One way to ensure that is a differentiated strategy that doesn’t rely on one dealmaker’s reputation. “The first few funds may succeed without that unique value proposition, but it can cause problems down the line,” says Berick.
High prices and stiffer competition are leading GPs to hold on to assets longer and longer. “Time horizons may be four to five years now, but they can stretch beyond that, so LPs want to know the current talent, and who’s there to take their place down the road,” says Silvi Wompa of the risk advisory firm Willis Towers Watson.
Wompa admits best practice is still developing but some firms have taken a proactive approach. “Apax Partners is clearly making succession a priority, with its requirement that as soon as a managing partner turns 60, they have to name their successor and move on.”
Culture, not countdown
This does not mean every firm needs to set a deadline, or even that GPs should name heirs years ahead of time. Succession plans are just that: plans. If the founding partners are relatively young, this means building a culture that mentors the next generation.
“The first generation already has its track record, so it has to do everything it can to develop the track record of that next generation,” says April Evans of Monitor Clipper Partners. “Because as later funds get raised, LPs will be looking for who will be leading deals in the future.” This means that older partners need to refrain from taking the lead on every deal, and let younger professionals step up.
But there’s a risk in focusing exclusively on the next generation’s dealmaking skills. Track record is crucial to convincing LPs returns are in safe hands, but any firm is more than just transactions. “I’ve seen some firms struggle when they lose a leader and no one else knows how to manage the firm,” says Evans.
One CFO explains succession plans should ensure that everyone has a good handle on the business, not just the business of investing. That often means delegating non-deal matters to junior partners to help them understand the administrative elements of a firm. “They need to make the shift from being a member of the orchestra to being the conductor,” says Berick.
To address this, one mid-market firm developed committees for various operational areas, such as IT, audit, HR and compensation. Executives take turns participating in the groups. Staff gain experience across a range of issues, while holding them accountable for the results in that area. It also cuts down on the non-transaction related meetings deal partners are required to attend.
These processes can also help discern who’s best equipped to run the firm, and who should remain a deal partner. “Good deal people are not always good managers,” says Steve Standbridge of the advisory firm Capstone Partners. When private equity was a cottage industry, he argues, a couple of dealmakers could work in sector silos and the firm would be fine. But today, the most successful organizations match the right skills with the right role, creating teams of deal partners and top-tier managerial talent.
This type of mentorship needs to be part of the firm’s culture and not something launched when it’s time to name the next managing partner. Finding leaders should be a gradual process, allowing young partners to prove themselves in boom and bust times.
“Often the fund founders have all aged together and the junior partners are left feeling there are roadblocks to their advancement,” says Berick. So, the most promising candidates leave to launch funds of their own, leaving the firm needing to hire an outside managing partner.
If firms hand the reins to an outsider, there are a few key points they must make to LPs. “Tapping an external candidate raises questions about the strategic direction of the firm,” says Berick. “Does this signal a change in investment philosophy, and if so, why?” The firm must also make the case that the candidate has the track record and experience to justify the hiring. Berick adds, “LPs may also expect that current leadership will stick around longer to guide the transition alongside the new leader.”
Eventually, the succession plan needs to be formalized in legal documents. First and foremost, there are the key-person provisions of the LPA. “We spend a lot of time trying to right-size these key man clauses to best reflect a meeting of the minds in terms of what constitutes a ‘trigger event’,” says Ted Ughetta of the law firm Nixon Peabody.
A trigger event is a situation where certain key personnel are no longer available to run the business, so there is a suspension of investment activity. Trade groups like Institutional Limited Partners Association have lobbied hard that if a trigger event takes place, there is an automatic suspension of the investment period, as opposed to requiring a majority or other vote of LPs to apply the brakes on investing.
Often as a firm grows, subsequent funds will include a larger group of “key people” to avoid such triggers, so where it may have begun with two or three senior partners, the group may grow to five or six. “Some LPs will push back and argue that they’re investing on the basis of those few key partners,” says Ughetta. “But often, the firm can approach the LP Advisory Committee with a proposed replacement and have them approve that new key-person, rather than require all LPs to vote on the matter.”
Firms can get ahead of the game by introducing younger partners to LPs. Allowing juniors to present at annual meetings or during quarterly reporting calls is a good way to do this. “Larger LPs of the fund may have more frequent one on one meetings and those meetings provide a great chance for them to get to know the younger partners as well,” says Evans.
Succession culture should be communicated to LPs over the life of the firm, but when should LPs be told a more formal plan is underway? Most market participants agree that, at the very latest, this should be during the fund before the one where the founder will step back. In most cases, that gives LPs three to four years to get comfortable with the new leaders.
“That’s a good time to introduce the next generation of leaders to LPs,” says Berick. “This allows the current leadership to say, ‘We’re not going anywhere, but for the good of the firm, we’re stepping back to let these younger partners do what they do best.’” This message can bolster a firm’s reputation to LPs which might be concerned it is losing the next generation of talent.
But it’s not only the LPs a firm needs to worry about.
Firms often neglect the management company documents in succession planning. “Unlike GP entities, that are self-liquidating as deals get sold and the firm realizes value over time, the management company entity doesn’t have an easy mechanism for transferring ownership from the founders to the next generation,” says Ughetta.
Founders should examine the best route for allowing younger partners to buy them out and reflect that in the documentation. When it launches its first fund, the management company is in a break-even scenario as the management fee is used to pay for start-up costs, salaries and other expenses. But over the life of subsequent funds there’s greater chance for an excess in management fee, which increases the value of the management company.
“Calculating the fair market value of the management company can be tricky,” admits Ughetta. “So the founders need to think about the valuation process for when a buyout takes place.” That process is far easier should a private equity firm decide to go public, as the likes of KKR, Carlyle and the Blackstone Group have.
“For those not accessing the public markets, it’s important to draw up the guidelines for that buyout process, including any long-term payment arrangements since it may be harder for junior partners to pay the full price upfront,” says Ughetta.
A succession plan, however, isn’t worth the paper it’s printed on if founders refuse to share the economics. In some cases, founders step away from the day to day activity without changing their compensation.
One advisor warns against founders still taking a big portion of the money after they’ve gone part time. And if the younger professionals are under-compensated, they are unlikely to be able to buy out a management company stake.
The real danger is a talent exodus when the founders refuse to build a sustainable firm. If smart, driven deal partners don’t see a path to the top, or at least compensation commensurate with one, they will often leave to launch their own firm.
“Spin-offs by younger team members may prove even more successful as they’re able to take a more niche investment approach or devote more time to addressing ESG issues that might never have been a priority at their former firm,” says Wompa.
There’s an argument to be made that private equity firms don’t need to last forever, so succession planning is not about maintaining a dynasty, but ensuring that talent and LPs stick around for the next few funds. ?
Private equity CFOs are often given an array of tasks beyond that of a traditional financial officer. This leaves a wealth of institutional knowledge in the hands of a single person, which means that any exit can leave a firm scrambling to replace them.
“The deal partners are constantly talking with one another, so there’s a shared knowledge amongst them,” says Evans. “But there’s only one CFO, so there needs to be some effort to groom a successor to allow for a smooth transition.”
Much like succession planning for the front office, younger members of the finance team need exposure to higher-level conversations. One CFO outsources the day to day fund administration, so their team is left to higher level matters such as portfolio monitoring, diligence and even some regulatory matters. This way a comptroller can begin to understand the nuances and complexities they may face as a CFO.
And offering a path for growth can also help limit staff turnover on the operational side as well. “My people like to learn and be challenged, so developing them keeps them engaged,” says Evans.