Only in fairytales are endings ?happily ever after.? In private equity, the only happy ending may be when a founding partner enters into a long-anticipated and well thought-out retirement.
But even in good times, partners don't always stay for the long haul. Far from it ?as more and more capital enters the market, private equity professionals are finding more excuses to jump ship. They are leaving for other private equity firms or starting their own. Some of the highest profile departures are taking place in Asia, where global buyout funds are actively poaching senior executives from other private equity firms. Kohlberg Kravis Roberts may have lost Scott Stuart and Ned Gilhuly, who left to form their own hedge fund, but the buyout giant has gained Naohiko Kitsuta from MKS Partners in Japan, David Liu from Morgan Stanley Private Equity Asia and Ming Lu from CCMP Capital Asia. Both Liu and Lu are based in Hong Kong.
Partner departures can be as painless as a single person moving on, to the defection of an entire team. For example, half of the team at the Menlo Park-based Lightspeed Venture Partners recently left to start Opus Capital.
Rarer and far more distressing are what might be called permanent endings. Laura Barker Morse, human capital partner at Boston-based Atlas Venture says that the possibility of the death or disability of ?key men? has become a part of the overall discussion with LPs when a fund is raised. ?I remember this was not always true,? Morse recalls. ?Twenty-five years ago, one of the founding partners of a leading venture firm died suddenly. They had not anticipated this in their documents and it was very difficult for the firm. That was a wake up call for many people.?
Even so, one middle market buyout firm has not given much thought to death, although two of its founding partners are in their 80s. ?This is the first time we are thinking about some of the issues,? says a younger founding partner, as the nearly two-decade old firm is getting ready to raise another fund.
Whether the form of departure is death, or merely defection, the key to avoiding a messy situation is prior planning ?it itself is a major challenge, in part due to the fact that there is no one standard for dealing with partner departures. Michael Album, a partner at the New York office of law firm Proskauer Rose says, ?the best practice is to address it from the offset in the underlying general partnership documents. The economics can vary from firm to firm.?
When a partner leaves, at stake are as many as three major assets ?carried interest, a stake in the management company and co-investment capital. If the partner is a key man, the partnership itself might be in danger. Finally, a ?softer? item, reputational damage might ultimately prove more deadly than triggering any partnership clauses.
On the economic front, looming large in today's market is interest in the management company. As founding partners age and the private equity market booms, new partners being recruited to join private equity firms are increasingly asking for stakes in the management company, which can entitle them to proceeds of a sale or public listing of the private equity firm. Private equity firms, from Thomas H. Lee Partners to The Blackstone Group and The Carlyle Group, have in recent years sold minority stakes to Putnam Investments, AIG and Calpers, respectively, providing liquidity events for the founders. The recent IPO of Fortress Investment Group turned its founders into paper billionaires.
Without a doubt, much real and potential value is at stake when a partner leaves a firm. What happens to a leaving partner's economic interest in a private equity firm and relevant funds and investments depends on the nature of the departure, typically categorized as ?bad,? ?good? and ?very good.?
Bad leaver: Characterized by partners who leave for a competing private equity firm, spin-out or split-off, bad leavers can also be applied to partners who leave for a competing portfolio company. This term will certainly apply to partners who are terminated for cause.
?Carried interest: Partners determined as bad leavers will almost always lose unvested portions of carry in funds, but keep portions already vested. In some cases, they can leave with a reduced portion of carry.
?Management company: Bad leavers typically lose any ownership they may have in the management company.
?Co-investment: Rebecca Silberstein, a partner at the New York office of law firm Debevoise & Plimpton, says if a partner has been terminated for cause or violated covenants in the GP agreement, often management can buy the capital interest at a discount to fair market value. But even a bad leaver can be on the hook to continue funding his commitments. ?To some firms, it's important to remove the incentive for partners to bail out if there is a downturn for the fund ?or the markets,? she says.
Good leavers: Good leavers are partners who retire, leave the firm to pursue a different profession, or are made redundant by the private equity firm.
?Carried interest: Good leavers can lose unvested portions of their carried interest in funds, but may at the discretion of the partnership keep the carry. In some cases, vesting can be accelerated. Michael Segal, partner at law firm Paul, Weiss, Rifkin, Wharton & Garrison in New York says, ?if you're terminated without cause, either you get to keep what you already have, but sometimes you get a little extra. For example, you might get one extra year of vesting. If you have significant negotiating leverage, you may get full vesting if you're terminated. I've seen deals with private equity funds where they've hired a big name to be one of the top people at the fund. Those people would negotiate to get their entire carried interest fully vested if they get thrown out, but that would be a particularly generous arrangement.? This is, however, becoming less common as private equity firms and funds get bigger.
?Management company: The stakes partners own in the management company can either be retained by the good leaver, or more commonly be bought out at fair market value.
?Co-investment: Due to the size of GP capital commitments, which can run into the millions of dollars, good leavers may be required to continue funding their co-investment commitments even upon leaving the fund or private equity firm, although they may have their access to information restricted. If management chooses to repurchase the stake, the purchase price is often at fair market value. Timing matters, says Silberstein. ?If someone leaves in the first year, it's not that difficult for the other partners to buy him out at cost. But if a professional leaves later in the fund's life, when an unrealized portfolio is valued well above cost, it can be harder, especially for a new firm, to buy him out at fair market value,? she explains.
Very good leavers: The departure of very good leavers is normally precipitated by events outside the partners' control, such as death or disability.
?Carried interest: Jason Glover, partner at London-based law firm Clifford Chance, says that terms of very good leavers are an enhancement of good leavers. Very good leavers may get an additional year of vesting, and sometimes they can keep their entire carried interest in funds.
?Management company: ?To the extent a partner has a real equity interest in the management company, there may be puts and calls on the repurchase of his interest triggered by departure, death, disability or involuntary withdrawal ?and the economics on the repurchase can vary depending on the trigger event,? says Proskauer Rose's Album.
?Co-investment: The co-investment can be bought out at fair market value by the GP, or be turned into a passive investment held by the departing partner's estate.
Quite often, a departing partners who will continue to serve their fiduciary duties or service portfolio companies can continue to vest, keep or even earn additional carry, but not typically if they join rival. The founding partner of the middle market buyout firm says he disagrees with this penalty: ?If somebody goes to another firm, let's assume they've been working for three years, if you backend load the vesting so they have to be here for the commitment period and the vesting period, I think they should keep what they earned even though they go to a competitor in the first three years.?
The practice of allowing a departing partner to retain carry is increasing across the industry as well as on both sides of the Atlantic. Mark Hoble, principal, human capital at Mercer Human Resource Consulting in London notes that the only significance between Europe and the US with regard to carry these days can be found among smaller venture capital funds: ?Historically, [partners leaving] UK venture funds would have lost it [their carry], but now you tend to find within new funds and new carry schemes being set up, they're following the US models. When people leave, they retain their carry,? he says.
Aside from economics, a partner's departure can set off a host of other effects. If the ?key man? clause is triggered, the fund can be suspended, or even closed. KKR's Euronext vehicle, called KKR Private Equity Investors, has the following provision: ?The departure of any of the members of KKR's general partner, including Henry R. Kravis or George R. Roberts, or a significant number of its other investment professionals for any reason, or the failure to appoint qualified or effective successors in the event of such departures, could have a material adverse effect on our ability to achieve our investment objectives. The departure of some or all of those individuals could also violate certain ?key man? retention obligations specified in the documentation governing KKR's private equity funds.?
Partners who leave to join a competitor or to start their own firm must be aware of two additional issues: covenants and ownership of track record.
Most GP agreements have standard covenants for noncompetition, non-solicitation of investors and employees, and non-disparagement, and these can make it very hard for a partner to be hired by another private equity firm. ?It provides a chilling effect on the relationship with a potential future employer because whenever there's a lawsuit for a violation of a non-compete, the lawsuit is not just against the employee. In fact the lawsuit often is not primarily the employee, it's against the new employer,? Paul Weiss' Segal says.
Segal continues, ?Whether or not it's enforceable can be not as important as the litigation threat it holds over a new employer, which can make the new employer want to hire the person less.?
Only if a partner is leaving a fund in the process of crashing and burning, as it were, is it less likely that the restrictive covenants are enforceable.
The partner's track record generally belongs to the private equity firm, but Clifford Chance's Glover notes that investors are becoming increasingly savvy about doing due diligence, attributing deals to the actual dealmakers rather than merely evaluating overall funds. Even if the departing partner is legally prevented from using his track record at his new firm, investors often have his individual statistics from due diligence carried out in respect of his former employer, consequently making the possibility of ?spin out? an easier prospect than has historically been the case.
Good GP agreements should address the subject of legal fees in the unfortunate event that a partner and his former firm get involved in a lawsuit. Proskauer Rose's Album says that there are a number of cases in which the Delaware courts have ordered firms to advance legal fees to a departing partner who has been sued by the firm, because the dispute fell under the terms of the broadly drafted advancement and indemnity provisions.
Hence, Album advises private equity firms to ?make sure there are appropriate carve outs in the indemnification and advance provisions in the management company agreement so that there is no duty to indemnify and advance in connection with partners who may violate their fiduciary duties in connection with their departure.?
Although terms of the relationship are outlined in the GP agreement at the start of a fund, it is crucial to note that these are usually renegotiated at exit in a separation agreement. ?Especially for senior people, terms are frequently negotiated at departure no matter what the GP agreement says,? explains Jennifer Burleigh, partner at the New York office of law firm Debevoise & Plimpton. ?Circumstances can change dramatically from the day the GP agreement is signed to the day they leave the firm.?
An abandoned private equity firm may win every battle with a former partner in the partnership document and a court of law, but lose in the court of LP, portfolio manager and public opinion. As such it is important to have a plan around ?messaging? in case a partner leaves.
Peggy Roberts, director of organizational development at Riverside Company, a Cleveland- and New York-based middle-market buyout firm, advocates transparency. ?What we've done historically is to do an announcement to our LPs and to talk about it in our next quarterly report and conference call. We also reach out to the management teams and boards of the portfolio companies that partner was responsible for and say, 'This is the transition and this is who at Riverside who will look after you going forward.' That's an important step to take,? she says.
There are few hard and fast rules on how to deal with a partner's departure, but most agree that it is in everyone's best interest to work it out amicably. This, of course, can be difficult, given the circumstances. As Silberstein sums up, ?These are people who were colleagues or even partners. It's more just than the money.?