Replacing the boss: Searching for succession

“It’s kind of like getting your parents to talk about funeral arrangements. It’s something they don’t want to do: most founders think they’re going to live forever.”

Succession planning is often spoken of as a lugubrious undertaking; one requiring complex and nuanced assessments of not just a firm’s legal structure and culture, but difficult conversations about, for starters, fairness in compensation and the future phasing out of key people in the organization. It isn’t just a slog, it’s a distraction from the core activity of private markets pros: dealmaking. The above quote is how one CFO at a small mid-market manager views the process.

The topic of succession planning hasn’t typically been seen as the purview of CFOs. But not only are they wearing more and more hats – including that of head of human resources – they are also uniquely situated to guide and smooth out the process of succession planning.

“When you’re the COO/CFO, you’re that objective voice in the room that can bring everyone together,” says Lou Sciarretta, COO of secondaries investor Kline Hill Partners. “And when it comes to sorting out the economics and governance around succession planning, you can be that voice of reason, if you’re respected and trusted, and do more than just execute on decisions that the founding partners make.”

It isn’t too surprising that some take an ‘I’ll-rest-when-I’m-dead’ approach to their professional lives. Indeed, succession planning is at the bottom of the top five priorities for alternative asset managers, according to EY’s 2020 Global Private Equity Survey, which takes the views of COOs, CFOs and heads of finance at PE firms worldwide.

And while McKinsey says the average age of leadership has fallen at many of the biggest firms – which have in recent years been subject to the greatest scrutiny on the succession front – there are certainly those, particularly emerging managers, who appear to see succession planning as necessary only when senior founders are nearing retirement age. After all, the industry has only been around some 40 years – most PE firms have relatively young management, and there’s plenty of time to plan later.

“It is kind of ironic that a lot of what are known as the middle market firms today were formed by guys that spun out of huge firms and wanted to do it on their own,” says Kate Price, partner at law firm Winston & Strawn. “What’s ironic is that many of them then repeat what they were frustrated with, which is that they couldn’t see their future within that broader organization.”

And yet some of the attention focused in recent years on the big firms appears to have rubbed off on smaller ones. Last year’s EY survey showed that the further down the AUM ladder you go, the more of a consideration succession planning becomes, with firms under $2.5 billion assets under management saying the issue has become a higher priority, while firms above $15 billion say it has become less of one.

That is likely because more and more senior executives are coming to realize that succession planning isn’t just about perpetuating the firm into the future. It’s part of the institutionalization of the asset class, and preparing a plan early has become “absolutely critical” to maintain a competitive edge, says Julia Corelli, partner at Pepper Hamilton. “It’s fundamental to a firm’s culture, and the culture is fundamental to its success.”

Getting the conversation going

Corelli, who consults with firms on succession strategies, says many of her clients come to her because they don’t have a succession plan in place, and it’s getting late in the game. One client was an emerging manager who spent 19 years operating without even a partnership agreement in place. “There were many partners underneath [the founders] and no one had the same idea about what should happen,” she says.

Putting off the development of a strategy can result in the mismanagement of more junior employees’ expectations, creating unhealthy rivalries that can take a toll on a firm. But, to the mid-market CFO’s point, it’s not an easy discussion to kick-start.

Some partners are less willing than others to make compensation structures transparent and to potentially start phasing out their own stake over time as others take up the reins.

At a panel on succession planning at Private Equity International’s CFOs & COOs Forum 2020 in January, 42 percent of attending respondents said they didn’t have a succession plan in place at their firm, most because it was “too early.” About half who did said they had it only to manage the portfolio in the event of a key person event; the other half said they did to ensure the firm as a whole survives beyond the founders.

But looking at a wider swath of the market, it seems those who did have a plan in place were in the minority. Nearly two-thirds of 616 firms surveyed by compensation specialist J Thelander Consulting this year said they do not have a succession plan. Of 577 firms that answered, 76 percent hadn’t managed a transition of LP relationships from one lead partner to another.

Increasingly, PE professionals look to the GP-stakes market as a potential means of kickstarting the succession planning process. “You certainly can’t start a negotiation about selling off a part of a management company or GP to a third party if you don’t have your ducks in a row,” says the mid-market CFO.

Such sales are, for now, primarily the turf of large players, with buying firms like Goldman Sachs and Dyal Capital Partners looking for meaningfully sized investments – and senior partners looking for big payouts – though some smaller managers have been approached.

What’s important to remember, Corelli says, is that, unless you’ve set up your succession strategy beforehand, you may end up in an unexpected place. “It may not resolve in the way you would have wanted it to if you were thinking about it without that third party also at table,” she says. “Now [the third party has] a primary and a secondary interest in it: some of their money went into the pockets of the senior people, some of the money is to be contributed to future funds. It changes the dynamics.”

“Firms have to evaluate how much the departing partner contributed to building the goodwill that third parties will evaluate and build into the next 10 to 20 or 30 years of fund management,” Corelli notes, adding: “If you have [a succession plan] in place before they come, they’re always going to be free to criticize what you have, but you have better control of the narrative.”

One-size-fits-one

If you’ve seen one succession plan, you’ve seen one succession plan. There is no ‘one-size-fits-all’ strategy. “It’s so dependent who your senior partners are, how old they are, what the talents of the junior people beneath them are,” as well as the firm’s future needs, says Price.

But there are a few things to keep in mind when you are navigating this.

First, it’s your ownership structure and intentions for the business. CFOs, COOs and others indicate that some firms are what might simply be called ‘identity’ firms, where the brand value is inherently tied to the founding partner. A second mid-market CFO says his old firm, where he worked for 10 years, was “never going to last beyond the founder, because he had to control all of the decisions.” When the founder had a health scare, the firm stopped fundraising, and there was no one to make a clear transition to.

That’s one reason its best to start the conversation early. Nearly everyone interviewed by Private Funds CFO agreed that starting the conversation before it clearly becomes necessary is crucial.

In part, that’s because LPs are increasingly scrutinizing succession plans, say market insiders. Jennifer Choi of the Institutional Limited Partners Association says many LPs see ‘key person’ provisions as overly broad, and thus less likely to ever be triggered, so they are putting more and more emphasis on succession planning.

Winston & Strawn’s Price agrees, saying “limited partners often bring up the conversation when making their investment decision,” and adding that new managers need to “start thinking about it at the same time that they start thinking about forming their fund.”

But LPs will largely be concerned with the stability of the funds they are invested in – perhaps why so many at the Forum responded that they have plans in place for the sole purpose of managing a key person event.

Others take the longer view as a means of ensuring the firm retains and develops talent; as part of defining and maintaining a firm’s culture.

Indianapolis-based mid-market firm HKW, which has had an official succession plan in place since 2012 when former chairman and CEO Glenn Scolnik put it on paper, is aware that it operates outside the main geographical hubs of private equity – so incentivizing and retaining talent is all the more important. “We really make sure we can retain those folks who are critical to the firm,” says partner Jim Snyder.

HKW’s plan dictates that when a person is made partner, they invest a “relatively minor amount” in the management company. All senior partners sell their interests back for the same amount they bought in for when they retire in the established age range of 63-67. That does two things, Snyder says. It helps to plan the transition of responsibilities away from aging partners. It also releases buckets of compensation that can be distributed to younger professionals.

The art of compensation

There are myriad ways to go about sharing interests in the management company. A third CFO at a mid-market firm says that when their chairman, who was sole owner of the investment advisor entity, retired, they sold the IA and created a new one, with four managing directors owning 25 percent each. But that process is highly idiosyncratic, and depends on legal and ownership structure, among other things, says Pepper Hamilton’s Corelli.

Other firms raise more or larger funds, increasing the value of the management company in order to bring younger partners into the economics of the entity. “The typical way to make the math work is to give the founder a smaller and smaller share of a larger and larger pie, so that the absolute number for the founder keeps going up, even as their percentage comes down. That’s a tricky, but important, growth equation to figure out,” says McKinsey senior partner Aly Jeddy.

Corelli adds: “That’s a hugely problematic area to drill down into, because that value [of the management company] is only a function of what’s left over to distribute after compensation and all other operating expenses of the management company are paid. Compensation may be the biggest variable and questions abound as to who has a say in whether it increases, by how much, etc?”

Corelli estimates that about 50 percent of the firms she deals with use such management company tails, where senior partners interest in the company steps down over a period of, usually, seven to 10 years. The other 50 percent use some sort of buy-sell agreement to deal with exiting managing company owners.

In Maryland, growth equity-focused ABS Capital Partners CFO, James Stevenson, says: “We don’t think there’s real value in the management company – we’re only as good as our last fund and the fact that investors are willing to invest in the next.”

As a result, ABS doesn’t ask juniors to buy into the management company, Stevenson says. “And we don’t try to pay out any value from it to senior executives who’ve been around a while.

“But we do have an arrangement between all the partners that, if the management company or goodwill of the business ever did get monetized, we would allocate the proceeds among the partners.”

Like many CFOs, Stevenson doesn’t make the final decisions on these matters, but he does advise on them heavily, with opinions he says are based on input from colleagues at other firms and market data.

ABS Capital focuses on allocating carry away from retiring partners, commensurate with the value they’re perceived to bring through mentoring, sourcing deals and serving on boards, among other things. “One of the three founding partners retired in 2002 and received no carry thereafter,” Stevenson says. “It’s really based on how much value are you still bringing to the table, and there’s just a discussion and people have to all come to an agreement on that.”

That approach to phasing out carry is typical, market players say, with the allocation to a retiring partner stepping down over two, or less often three, funds. Corelli also notes that the power of having departing partners invest in future funds on a fee-free basis, providing both future compensation for the retiree as well as supporting their replacements. “It is a great marketing point for a successor team, to be able to say that our now retired founder is investing with them,” she says.

Connecting the culture gap

What most people interviewed by Private Funds CFO emphasized is approaching the compensation side of succession planning with a sense of fairness. After all, succession planning is inextricably tied in with talent development and retention.

“Don’t fear the next generation – embrace them, hire them, compensate them fairly and make them feel a part of the business,” says Kline Hill’s Sciarretta.

“There’s a lot of balance to the management of the human being in this business. That is the art of succession planning”
Julia Corelli, Pepper Hamilton

Price adds that one of the big “don’ts” in succession planning is retiring senior partners retaining a compensation that is outsized to their contributions.

And since one of the many hats CFOs often wear includes chief of HR, it’s important that their input is heard. “They’re aligned with both senior management and with the future of the firm,” Price says.

Setting the plan out long in advance of the obvious need for one not only helps to set expectations and engender a culture of professional development, it also forces firms to assess the needs and goals of the younger talent they have. “You need to understand the psychology and expectation of junior people, which has changed since 10 years ago,” says Corelli.

More and more firms are adapting to the shift in cultures by offering telecommuting or work-from-home arrangements, as well as flexible hours and time-schemes, for example, according to the J Thelander Consulting survey. Price says she has had clients call for advice, having for the first time to address what to do when a deal partner becomes pregnant.

“We’re seeing the struggle to adapt to that new value structure within private equity firms, as well as elsewhere,” she says. “But because of that, you have a really interesting opportunity with succession planning because what that means… is it’s not necessarily all about the bottom dollar” for younger talent.

Establish, communicate, review, update

“There’s a lot of balance to the management of the human being in this business. That is the art of succession planning, and it’s why there is no formula: every organization is filled with different human beings,” says Corelli. That is a key thing to remember in succession planning. Yes, you should communicate your succession plan to interested LPs. But for many firms, it’s just as important to make the plan clear to their staff – a clear path to professional development is a fundamental tenet of a strong retention record.

But as that talent does develop and progress, the plan should also be revisited and updated regularly. That component is something people often neglect, says Winston & Strawn’s Price.

“Your firm will change over time and the professional gaps that you have and the skill sets you need to develop will change over time. And so you need to constantly update your plan to assess how it’s going to work in the future and to see where your vulnerabilities are and what talent you need to hire.”

Finding heads for hats

Succession planning in the back office is perhaps overlooked compared with the task of replacing dealmakers. But, when it comes to the future of the firm, it’s just as important

CFOs are wearing ever more senior hats. Some combination of CFO/COO/CCO/CTO and/or head of human resources is not uncommon – so getting the planning right is all the more critical.

Some big-name firms have announced successor CFOs in quick succession in recent months. In November, TowerBrook said it had promoted firm veteran Jennifer Glassman to the management committee, while appointing other committee members to newly created roles. Shortly after, KKR announced that its head of human capital and strategic talent would become CFO, replacing William Janetschek after a brief transition period. That transition from human capital to finance is telling. The next month, Hamilton Lane announced it would transition Atul Varma into 22-year firm alum Randy Stilman’s CFO role.

James Stevenson, CFO of Maryland-based ABS Capital Partners, is in the last year of a three-year succession plan after some 17 years in the role. At the end of 2020, controller Robyn Lehman will step in to fill his shoes, while he takes on a part-time role helping with various functions, including potentially legal and strategic planning issues.

Stevenson is also the chief tech guy at ABS, and since that area is outside Lehman’s focus, he hired a part-time chief technology officer who he has been training, getting him acquainted with the firm and its partners. “If you’re a CFO with a small organization, you have to look at all those different hats you’re wearing and just figure out who’s best able to pick those things up. And my job has been to make sure I’m mentoring,” says Stevenson.

Mentoring is particularly important on the operations, finance and accounting sides for smaller and mid-size firms. Heramb Ramachandran, chief operating officer at Central States Water Resources, a water utility platform that will become an arm for an undisclosed private equity firm, says small firms need to find versatile talent that can step into numerous roles. “I don’t even care if they’re a CPA, quite frankly, as long as they have that intellectual horsepower” needed to perform various tasks.

And keeping them means, like in other areas of succession planning, communicating a clear path of professional development. Ramachandran says less emphasis is often put on retaining financial talent, but it can actually be harder to keep it, as inevitably smaller teams means fewer opportunities for advancement.

Louis Sciarretta, COO of Kline Hill Partners, also emphasizes professional development – he is proud that five former employees are now CFOs at other firms, he says. “You can’t retain everyone on a private equity finance team. You want to ensure that you’ve created a finance process that’s repeatable, that you have good governance and that you can insert competent people into the role because they know what the responsibilities are, who they’re reporting to and what they need to accomplish.”

Importantly, when you’re looking for that next senior CFO or COO, “hire people better than yourself,” Sciarretta says. “The industry is only getting more complex.” And keep communication open and well defined: “You need a transparent review process, with open and honest feedback that’s reciprocal. It’s important that we all have a roadmap to get better.”

The handy use of GP stakes funds as a succession tool

Successions may not be a major impetus for most GP stakes deals, but managing generational change in private equity firms is nonetheless vital to minority investors, writes Kirk Falconer

GP stakes funds – which acquire minority positions in private equity firms in exchange for a share in income – have emerged strongly in the past few years, engaging some of the industry’s biggest names. Between 2014 and 2018, Bain & Co reports, 119 managers sold pieces of themselves to raise capital, more than double the number over the prior five years.

Additional minority interests were sold in 2019 by shops like BC Partners, HGGC, Oak Hill Capital and Owl Rock. The buyers were often one of the market’s top three investors – Blackstone’s Strategic Capital Holdings, Goldman Sachs’ Petershill unit and Neuberger Berman’s Dyal Capital Partners.

To back their transactions, GP stakes funds have been amassing in dedicated pools ever larger amounts of third-party capital. Late last year, Dyal raised a record $9 billion-plus for its fourth fund, bringing the total secured by the top three to nearly $24 billion, sister title Private Equity International estimates. New offerings by Blackstone and Goldman Sachs could add at least $7 billion.

Funding successions

Proliferating GP stakes deals and capital pools are often linked to generational change in PE and the need for firms to renew leadership through succession planning.

Bain’s 2019 global PE report cites successions as the “primary motivation” of PE managers selling minority interests. Without GP stakes funds, the report says, firms have few options for monetizing the large ownership and carry interests of founding partners nearing retirement.

Successions, however, are not usually in the publicly cited reasons for doing deals. Bain attributes this to PE firms avoiding the appearance that they are “cashing out the team responsible for historical performance.”

Not everyone agrees a direct link exists between PE successions and the majority of GP stakes deals. Michael Rees, founder and head of Dyal, tells sister title Buyouts this perspective “couldn’t be more inaccurate.”

In Dyal’s experience, Rees says, the number of transactions with a succession focus account for about 4-6 percent of the total. Even when PE managers are actively planning for a succession while selling a minority interest, it is rarely “the main driver,” he says.

Instead, PE firms mostly seek permanent minority capital to bolster the balance sheet and fund other priorities, such as GP commitments to new offerings and strategic growth initiatives, Rees says. For Dyal, funding GP commitments to “ever larger funds” is the single largest category, making up 60-70 percent of all deals.

Betting on longevity

Even if successions are not a major impetus for most GP stakes deals, the topic of managing generational change in PE firms is nonetheless vital to GP stakes funds. GP stakes funds essentially make long-term bets on PE managers and their ability to perform and generate continuous income streams from carry and fees. Key to ensuring this is strong firm-level leadership with a plan for eventually handing over control to younger principals.

When evaluating a deal, Dyal views issues relevant to longevity as “cornerstone criteria,” Rees says. One measure of a PE firm’s commitment to long-term sustainability, he says, is a “succession mentality” embedded in the culture – driving everything from sharing economics to attracting and retaining talent.

Once invested, Dyal continues discussions with a firm’s leadership team about ways to handle longevity concerns, Rees says. Dyal’s business services platform, a post-investment advisory group that helps its partners meet developmental goals and adopt best practices, is central to this effort.

The pre- and post-investment processes of GP stakes funds like Dyal give assurance to LPs that a PE firm’s succession challenges are being addressed effectively, Timothy Clark, a partner in Goodwin’s private equity group, tells Buyouts.

Clark, who advises PE shops on minority interest sales, says that by “doing their homework” buyers contribute to LP perceptions that a manager is on a healthy and long-term trajectory. GP stakes funds, in other words, lend the “good housekeeping stamp of approval.”

GP stakes funds have up until now paid most attention to top-tier PE managers. The evidence suggests, however, they are diversifying investment activity, including looking at smaller-size firms and building a mid-market presence.

As this happens, Clark says, the result could be not only better capitalized firms across the PE spectrum, but more of the “right conversations” about succession planning.