Sell it forward

Large profits are being generated through monetizations of private equity firms, but who benefits? Of the founders looking to cash out of the firms they have built, many want to leave enough to ensure the longevity of the firm and to incentivize younger generations of investment leaders.

The numbers are staggering. Three billion. One point three five billion. Eight hundred and eighty eight million. These are the dollar figures recently paid for stakes in The Blackstone Group, The Carlyle Group and Fortress Group, respectively. Also striking have been the size of proceeds that some of the founders of these firms have received in such events.

Blackstone's public listing, preceded by the $3 billion acquisition of a minority stake in its management company by the Chinese government, became a $1.88 billion payday for co-founder Peter Peterson, while Stephen Schwarzman pocketed $677.2 million. It's been a good run for Peterson and Schwarzman, who launched Blackstone with $400,000 in 1984.

As the founders of today's biggest private equity firms are approaching retirement ? Peterson is 81 and is due to retire next year ? of particular focus is the succession plans these dealmakers have in place for the next generation of leaders, and the longevity of the firms they founded.

What these monetization events have done is to ?set a price for the equity in the management company which allows for estate planning for the founders and provides a sense of the value of the interests in the management company held by the younger generation,? says Tom Keck, chief investment officer at La Jolla, California based private equity advisor StepStone Group.

Blackstone's top executives certainly received both instant gratification and long-term incentivization upon the firm's May 2007 IPO. The listing gave Hamilton ?Tony? James, Schwarzman's designated heir, $147.9 million. Vice chairman J. Tomilson Hill received $22.1 million, and chief financial officer Michael Puglisi got $13.4 million. James also received a 4.9 percent stake in the publicly listed entity, in which Hill has 1.6 percent and Puglisi 0.7 percent.

Proceeds from such events have also been used to invest in the business. Carlyle has grown dramatically since its investment by the California Public Employees' Retirement System (CalPERS). Six years on, Carlyle manages $75.6 billion across 55 funds. Its recent sale of 7.5 percent to the strategic investment arm of Abu Dhabi Investment Agency (ADIA) carried a price tag of $1.35 billion; CalPERS had paid $175 million for 5.5 percent in 2001.

Darby oversees succession
In 2003, Franklin Templeton acquired the remaining 87.33 percent stake in Darby Overseas it did not previously own for $75.88 million. Senior managing director and general counsel Clark Nielsen spoke with PEI Manager about what has, and has not, changed at the Washington, DCbased emerging markets specialist. ?There are two aspects of succession. One is in ownership. By having Franklin Templeton come in and become our parent company, we eliminated that ownership succession issue. That's no longer a question in anybody's mind. In terms of management succession, Franklin was very cognizant of the fact that the whole business relies on stability of our management teams.?

?We still have our own board of directors. The board of directors has not changed substantially since the acquisition?It's been very stable in terms of the corporate governance structure, the management team structure, the investment team structure. If anything, the Franklin Templeton platform makes it easier to add depth and breadth to our firm.?

?Franklin now owns 100 percent of the firm but our compensation structure is still the same basic compensation structure that we had before. That includes the sharing of the carried interest with the managers that are responsible for the funds. Before the acquisition we had a mixture of individuals and institutional owners of the firm. After 2003, we now have a single institutional owner of the firm. And that's really all that's changed.?

Nielsen declines to comment on succession plans for Brady and Frank, but says: ?We've got a very stable management structure with a very supportive parent and we don't anticipate any disruptions in the future in terms of continuity and being able to continue to run the business without interruption.?

Questions about the longevity and continuity of the firm that these events precisely intend to address, however, can be created. ?As with many successful deals, a monetization event can raise questions about how to keep investment professionals hungry after a substantial payday,? says Rebecca Silberstein, a partner at law firm Debevoise & Plimpton in New York. ?That said, most private equity managers seem to keep working even after a spectacular success.?

Succession to the fore
Like many of the activities in the private equity industry, these deals are often shrouded in mystery. The numbers thrown about in the press are impressive, but it must be noted that the sale of a ?stake? in a firm can be structured in many different ways, differentiated mostly by what, exactly, is being sold and what, exactly, the employees of the firm receive a stake in.

Where the next generation is usually most impacted is when new equity in the management company is sold. When only existing shares in the management company are sold to an external party, there is nothing left on the table for the broader employee base. In the case of Blackstone, the firm sold both existing shares and newly issued equity.

The sale of new equity often creates a permanent pool of investment capital that employees may be part of. An example of this is NGP Energy Capital Management, which sold a 40 percent stake in its management company to Barclays Capital last year, to further institutionalize its business.

?It's partners capital, like what Goldman Sachs capital was before it went public,? said Kenneth Hersh, CEO of Texas-based NGP Energy Capital Management, of the pool of capital in an earlier interview with PEI Manager. ?As the pool grows in value, it will become available for everybody in the firm, including the secretary. The idea is to maximize value on all levels. If people leave [the firm], there is a clearly identifiable number that they leave on the table.?

A pool of capital such as the one created by NGP becomes part of the structure that was owned by the managers and is now owned by a mix of the manager and the investors.

Changes to the management company will bring succession issues to the fore. ?The last thing an ADIA would want is to buy a percentage of Carlyle and then discover that a couple of the guys had walked off into the sunset with the proceeds,? says Chris Bown, co-head of the international private equity practice at law firm Freshfields Bruckhaus Deringer in London. ?They're making the investment on the back of future cash flows, not past performance. So I'm sure that part of the discussion around the investment would be a very careful discussion around the permitted level of departures, of the more senior people moving on in any given period.?

Bown continues: ?At the same time, I would expect that they would also want to be confident that the successor generations who are coming through have a good share of the remaining equity in the fund for their own benefit and so as to incentivize the younger generations.?

Outside entities considering investing in a private equity firm's management company will often buy the right to receive a percentage of carried interest in future funds. They will often closely negotiate not only their own rights to a percentage of carried interest in future funds, but an increasing share of carried interest to be claimed by the non-founders at the firm.

?In that example, the investor would say, 'It's all very well for you two guys [owners] having all of this carry. But we need other people who are going to share in it because we need other people to be incentivized to work for you and to come along afterwards and to help to create a bigger business and drive your investment success.' And they would say, 'So we must insist you no longer hold 80 percent but drop your percentage to 50 percent, and the other 30 percent should be available to the other members of the team,? says Bown, outlining a hypothetical scenario should an investor buy the rights to 20 percent of any future carried interest streams.

?It's something that happens naturally within private equity funds,? Bown continues. ?If I was an outside investor coming in, then I would want to make sure that was definitely happening.?

Spreading the wealth
How the wealth in a monetization event is spread depends on the culture of the firm, says Debevoise's Silberstein, who has counseled clients in a number of these transactions. Silberstein has seen a wide range of approaches: at some firms the distributions have been held very closely among the senior most professionals, while proceeds have been shared more widely at other firms.

Distributions of proceeds will be delineated in a contractual agreement between the owners of a private equity firm. A limited liability company will have an operating agreement that describes the sharing of profits.

According to Blackstone's S-1 filing, $3.9 billion of the proceeds of its IPO and sale of non-voting common units to the Chinese government was used ?to purchase interests in our business from our existing owners, including certain members of our senior management? Accordingly, we will not retain any of these proceeds.?

It wasn't only Blackstone's owners who gained from the public listing. Under its 2007 Equity Incentive Plan, the firm also said it intended to grant 37.7 million deferred restricted common units to its non-senior managing director professionals, analysts and senior finance and administrative personnel (?Non-SMD Professionals?). Another 1.1 million phantom deferred restricted common units were granted to its other non-senior managing director employees (?Non-SMD Employees?).

Indeed, one of the reasons for Blackstone's public listing was ?to expand the range of financial and retention incentives that we can provide to our existing and future employees through the issuance of equity-related securities representing an interest in the value and performance of our firm as a whole.?

The granting of phantom equity by the management company to employees can make bonus plans for firms that want to spread incentives more widely among its employees easier to administer. ?It makes the administration of the management company and the general partnership much simpler,? says StepStone's Keck. ?It's less of an issue with the GP because it really only has revenue when there's carried interest distribution. But the management company has lots of expenses and lots of revenues. If you have to prepare hundreds of K-1s [tax forms] for a very large number of members, that gets to be very complicated.?

As with any incentives, realizations are subject to restrictions; they act as ?golden handcuffs.? At Blackstone, the full realization of the vested units of equity owned by Schwarzman, Peterson, James, Hill and Puglisi are subject to a three-year staggered schedule. Non-SMD professionals will receive their grants over a period of up to eight years following the offering, while non-SMD employees are subject to a three-year timeline. All grants are subject to vesting, provided that the employee does not breach restricted covenants or is terminated for cause.

Interest in carry
With such large sums going to so few people in these monetization events, will this create discontent among the wider number of employees ? who are not owners ? at the firm?

?No? seems to be the consensus. ?Listing a firm's equity on a public exchange or a 144 [private placement] exchange potentially provides liquidity for the founders, recognizing the value they have created. It can also allow younger partners greater visibility into the wealth they are creating, providing an incentive for them to stay with the firm longer, which may enhance the longevity of the firm, and therefore increase the value,? says Keck.

With the percentages that have been sold in the management company in the minority, typically under 20 percent and in most cases under 10 percent, the effect on the rest of the firm is limited. The capital that these investors contribute, and importantly, the connections they bring, can only help private equity firms pursue deals and new business ventures, which, in turn, generates even more carry and income opportunities.

?The thing that most people want and aspire to is an allocation of carried interest,? says Kelly DePonte, a partner at San Franciso based private equity advisor Probitas Partners. ?There's a big difference between ownership in the management company and a financial professional getting carry. The fact that David Rubenstein may be getting money in his pocket from ADIA or CalPERS for selling a stake in the management company doesn't really affect you that much.? But only if the next generation of leaders stay and continue to be hungry.

A piece of the Oaktree
Los Angeles-based investment giant Oaktree Capital Management recently raised $700 million by selling 13 percent of its shares on Goldman Sachs' GSTrUE private exchange. Howard Marks, Oaktree chairman, spoke with sister publication Private Equity International about the advantages of a private listing. ?I felt when I saw alternative investment management companies starting to go public, starting with Fortress, that several would, and that those who did would have an advantage over those who didn't ? mainly in hiring and retaining and motivating employees, but also for acquisitions of other money managers.?

?I think that failing to do so would have turned a great positive, which is Oaktree's broad employee ownership, into a negative,? Marks said, explaining that in the firm's first 10 years of business, it turned over one third of the firm to 80 employees. ?And if they see Apollo and Fortress and Blackstone going public, and they see their stocks are extremely valuable, they could resent it if we wouldn't make our company stock valuable.?

?So I thought we should be among those with a liquid currency, but we chose the private route rather than the public route.?