Recently, private equity titan Blackstone Group found itself in a difficult position. Over at GSO, the private debt firm it acquired in 2008, two senior executives were on their way out the door. The firm would need to approach investors in its shiny new $7 billion distressed-investing fund and convince them to allow it to continue operating.
The imminent departures of co-founder Bennett Goodman and senior managing director and head of special situations investing Jason New threatened to trigger a “key-person provision” in the terms of GSO Capital Solutions Fund III. This type of investor protection generally stops a fund from making new investments until re-authorized by the fund’s limited partners. If the fund is not re-authorized, it can no longer make new investments.
GSO named a new slate of executives for its fund in December, thereby avoiding that fate. “We received very broad investor support for changes made to reflect the evolution and growth of our business,” a Blackstone spokesperson tells Buyouts. Those investors include heavyweights like California State Teachers’ Retirement System, Teacher Retirement System of Texas and New York State Common Retirement Fund.
Dallas-based Wingate Partners did not fare as well. In October, Buyouts learned that investors had permanently halted the $250 million Wingate Partners Fund V from calling capital for new investments.
Like GSO, Wingate recently lost several top executives. Partners Brad Brenneman and Brian Steinbrueck left to form the new firm Breck Partners in 2018. Partners Michael Decker, Chris Dupre and Jesse Madigan all departed in 2018 as well. Now, the firm, which did not respond to a request for comment, faces an uncertain future.
These stories highlight the importance of succession planning to private equity. Figuring out who takes over when prominent and trusted leaders leave is critical to future success. Buy-in from LPs is critical. If they do not like what they see, the results can be disastrous. “PE firms are getting better at [succession],” says Jeff Pentland, managing director of Canadian fund manager Northleaf Capital Partners. “Managers are more attuned to it because their limited partners are.”
“It’s really been the last 10 years that we’ve gotten to a point where there are a fair number of buyout firms where succession has become an issue,” says Kelly DePonte, a managing director at placement agent Probitas Partners. “It’s sort of a natural development in an industry that is getting to be very mature.”
All of the “Big Four” private equity firms, founded in the 1970s and 1980s and anchored by a handful of charismatic leaders, have dealt with the looming retirements of those leaders in some form or another.
In 2018, Blackstone named Jonathan Gray president and chief operating officer, setting him up to take over from founder Stephen Schwarzman. In 2017, Apollo Global Management promoted Scott Kleinman and James Zelter to positions as “co-presidents.” That same year, Carlyle Group named Kewsong Lee and Glenn Youngkin “co-chief executive officers” while co-founders David Rubenstein and William Conway stepped away from day-to-day operations. Also in 2017, KKR named Joseph Bae and Scott Nuttall as co-presidents and co-chief operating officers, although founders Henry Kravis and George Roberts are still with the firm as co-CEOs. (A third founder, Jerome Kohlberg, left in the 80s, founded his own firm, and died in 2015.)
Sources tell Buyouts that LP concerns on succession encompass more than just these high-level personnel moves, but take into account multiple levels of a firm’s hierarchy and years of its history.
‘You need to keep your winners’
With the private equity industry’s massive growth and still-robust fundraising environment, failing to hold onto a firm’s best-performing staff, regardless of where they stand in the hierarchy, can be the kiss of death. “Do you want your firm to survive? Then you must figure out how to treat your junior partners,” says Christian Kallen, a managing director at Hamilton Lane.
Failing to do so can mean more than just internal atrophy. Many of the players in the GSO and Wingate stories went on to start their own firms, potentially operating in the same asset class and competing for the same LPs. In a field with a large deviation between bottom and top quartile returns, that means something. “It’s a business where some people are just flat-out better at it,” DePonte says.
LPs are increasingly interested in who is doing what at firms – and whether firms are taking steps to make sure they stick around. “When you dig down deep enough, you see there are certain people, and some of them are more junior, who are really driving returns,” DePonte says. “You’re going to have people asking… ‘Well, this guy seems to be out-performing – how are you keeping them around?’”
The solution comes in two parts: adjusting compensation to give junior managers what they deserve and providing them a clear career path.
Brian Rodde, a managing director at Makena Capital Management, describes this as “continuity of process and people.” Part of that is a preference for hiring internally. “External hires as a means of facilitating succession is a model that we think enhances risk,” Rodde says. “A lot of employees would rather see internal promotions and internal hires…hard work and good results being rewarded by new opportunities.”
DePonte says that in recent years that has meant internal promotions of high-performing managers to previously non-existent positions like “co-president,” which usually involve a larger share of carried interest. And LPs are watching. “All of that really has become more and more important and more and more a focus of due diligence over the last 15 years or so,” DePonte says.
And as the younger generation eases in, the older generation needs to be eased out. David Schnadig, a managing partner at Cortec Group, describes the dynamic as “moving up, moving down and then eventually moving out.” He adds that Cortec takes the time to walk new recruits through his or her “developmental pathway” at the firm. “A big part of succession is development and the other part is retention,” he says.
Brian Conway, chairman and managing partner at TA Associates, credits longtime CEO Kevin Landry, who died in 2013, with slowly building a culture that encourages internal development. Landry “abhorred the idea of partners retiring in place,” Conway tells Buyouts. “He looked disapprovingly at other places where you might have people who were listed as managing director or something that implied a very active role, but he knew they were a Florida resident for tax purposes, or they lived in Arizona, or they lived in Colorado or somewhere else.”
Landry developed a system at TA, which Conway says was based on meritocracy, or “tying an individual’s long-term attributed realized gains generated for TA’s investors to that individual’s ownership,” as he describes in an email. This included written criteria for how to get a promotion, sharing greater levels of responsibility with other partners, and a gradual transition to new leadership.
“He was the one who put in place this program that allowed people to, when the time is right, go on a glide scale where you don’t own any of the firm, [and] you basically get smaller ownership in one more fund and then you go to zero,” Conway explains. “He was the first person to sign up for it. If it was good enough for him, then no one could say, ‘Well, I thought we would just own this forever and get other people to work for us even if I’m not full time.’”
Most GPs and LPs that Buyouts spoke to agree. “A gradual decline in the compensation as senior partners slow down is appropriate, logical and smart,” says Jeff Parr, vice chairman and managing director of Canada’s Clairvest Group. He adds that it is critical that the next generation of leaders who have helped build the wealth of PE firms be able to share in the economics. “Those two things are linked,” he adds.
Molly LeStage, a principal and private markets consultant at Meketa Investment Group, a consultancy that serves heavy hitters like CalSTRS and California Public Employees’ Retirement System, says it all depends on what the person’s role would be going forward. “If they’re completely out of the firm and are fully retired and don’t have any role, or [are] not spending any time at the firm, then I don’t think that they should probably be warranted any economics,” she says. “To the extent that they’re stepping back into a chairman-type role and are still going to be involved in some capacity, I think you just want to have the economics reflect that and go down pretty significantly.”
But sources agree that once someone is out, they need to be out. “If succession planning is not also tied to ownership transition, then it’s meaningless,” Conway says.
Hammond, Kennedy, Whitney & Company (HKW) is an Indianapolis-based private equity firm with a long history. HKW has developed unusually hard and fast internal rules about succession. Partners are expected to retire between the ages of 62 and 67. There is an “affordable buyout” of their stakes in the firm. Retired partners keep all of the allocated income from each prior investment but cannot share in any revenue directly generated by HKW going forward, meaning they get no stakes in future funds.
Partner Jim Snyder says this benefits HKW in a couple different ways. “[Employees] know there is an upward strategy,” Snyder tells Buyouts. “It allows you to start planning well in advance because you know when it’s going to happen.”
Moreover, these rules are codified in internal documents. This plan had unofficially been the firm’s policy for a long time, but former chairman and CEO Glenn Scolnik put it in writing in 2012. The partners all agreed to it and the firm has stuck to ever since. “We’ve always viewed HKW as more about the firm than the individual person,” says current president and CEO Ted Kramer.
He feels the succession policy gives HKW and its employees clarity. “It allows us to manage our personal finances as well as our professional timeline within the firm,” he says. “We need to find young, good talent, [and] we need to retain them [and] grow them into our culture.”
Kramer says knowledge of when a succession will happen helps with that. “There’s a runway for you to be a senior leader or the leader of the firm…as a young professional, that matters,” he says.
Some LPs don’t think an age limit is necessary. “I think that every succession needs to be evaluated on a case-by-case basis,” Rodde says. “There’s many people in the investment industry whose partners would love to have [veteran leaders] around… because they’re so exceptional as culture carriers, as investors, for whatever reason.”
Most sources agree about the importance of an overlap between the old and new leadership.“Even before a succession event, it should be relatively well-telegraphed in advance, such that when it actually transpires everybody kind of understands that this is in the works,” Rodde says.
Rodde says “best practice” is a face-to-face meeting or phone call between LPs and GPs where the LPs are provided details on the rationale behind the leadership changes. “It’s important that we understand why this person earned this opportunity,” he says. “We want to understand their talents, not just as an investor but as a manager…your responsibilities grow and a lot of outstanding investors do not necessarily have great managerial talent.”
LeStage says Meketa would ideally like to know about a coming succession one fund in advance. “The funds are ten-year vehicles. That’s a long-term relationship we’re putting our clients into with the manager,” she says. “We like to know that the GPs are committed for the full 10-year cycle.”
Sometimes, a firm will unavoidably find itself dealing with an unplanned succession event. Navab Capital was raising its first fund when founder and former KKR star Alex Navab died suddenly last year. That firm was forced to wind down.
That is an extreme example at a firm in its infancy, but Northleaf’s Jeff Pentland says these “break-glass moments” are bound to happen from time to time, but the shock can be absorbed if firms engage in long-term, holistic thinking. “You just don’t want to have to deal with surprises,” he says.
Culture is key
In the end, sources say it comes down to a firm’s culture. Some firms take the time to build internal structures that will allow them to be more than reflections of dynamic leaders and some do not. DePonte dubs the kinds of leaders who do not build that internal culture “emperors” and says their firms will have a harder time surviving them. “Succession planning is always a hodgepodge” at such firms, he says. “There are firms, fairly large firms, that have died because of it.”
Conway tells Buyouts that as TA Associates recovered from a rough patch following the 2008 financial crisis, nobody ever asked him the right questions about how they did it: making strong personnel decisions over the previous years and keeping those people in place. The average partner at TA has been with the firm for 16 years.
“I absolutely think that recruiting and then retaining and incentivizing those people is critical,” he says. “If you’ve got decision-making processes which are replicable, if you’ve got ownership and incentives and all that figured out, you should have multiple candidates” when a succession event comes up on the horizon.
If that is in place, Conway says, “the firm will just keep chugging along.”
From an LP’s perspective, seeing that kind of culture in place will make a firm a more attractive investment partner – as long as it puts in the effort to keep LPs in the loop. “It’s really all about communication,” says LeStage. “To the extent that there’s going to be a [succession] event, how is that communicated to LPs and investors? How is that communicated in the firm?”
If a firm has the right people in place, following the right processes, that should more often than not fall right into place.
Update: This story was updated to reflect that a key-person provision was not triggered at GSO, as the firm negotiated with LPs to resolve the issue before the actual departure of the two executives.
Correction: This story was updated to reflect Molly LeStage’s proper title. She is a principal and private markets consultant at Meketa Investment Group, not a senior vice-president.