Team stability is no holy grail

Private equity investors often want the same talent responsible for past performance to lead future efforts. In fact a recent industry survey revealed LPs appreciate low turnover in senior management even more than sector specialisation or a hands-on approach to portfolio investments. And virtually every limited partnership agreement includes a “key man” clause guaranteeing at minimum the presence of a stud GP during the fund’s life.

No question team stability can be an important factor in consistent fund performance. But perhaps less appreciated by investors is how staff turnover can preserve that performance, or even improve it. New blood can be eager to prove their worth around the office. 

One inquisitive private equity firm, Capital Dynamics, set out to investigate just how important team stability is to performance. The firm opened its due diligence archives to London Business School academic Francesca Cornelli who then created a dataset of 56 private equity firms to analyse. The records not only provided her research team a look into each firms’ fund characteristics and performance across individual deals, but details on the key men GPs responsible for each transaction alongside their joining and leaving dates.

Somewhat surprisingly GPs marked key men make up 16 percent of staff turnover – firms to a certain degree are under pressure to preserve key GPs to highlight team stability in PPMs. Perhaps even more contrary to prevailing common wisdom, the study shows a 5 percent increase in staff turnover (including key GPs) between funds leads to roughly a 12 percent enhancement in net IRR. Firms experiencing the biggest staff shakeups between funds (those in the top turnover tercile) scored an average 26 percent IRR while those in the bottom turnover tercile netted a less impressive 14 percent. High turnover is especially beneficial during recessions, but statistically insignificant during bullish periods.

So why all the fuss around stability? The research did show what LPs intuitively suspect: turnover on a deal-by-deal basis is a poor recipe for returns. Should one or more partners call it quits before an investment is realised, the gross IRR drops to 8 percent compared to a 17 percent IRR in deals with no turnover. But as the study’s authors acknowledge, correlation is not causation. It’s more likely that GPs drop out precisely because an investment is going poorly. Why stick around when the prospect of carry is close to nil?  

What LPs should take from this study is that persistent success requires fund teams to evolve and adapt to changing market conditions. Indeed the study finds firms firing and hiring operationally focused partners in-between investment periods do especially well.

There is value in a firm’s ability to recruit promising talent or willingness to bring on different operational partners during downturns in the market. As such team stability should not be the Holy Grail investors search for.