LP Corner: Succession

In many ways private equity and venture capital firms are a strange breed, in financial services terms at least. Nowhere else is the issue of to whom the baton of leadership is next passed approached in the same way. This might be explained by the fact, that bar the recognisable few, most private equity and venture capital firms are a collection of individuals, ten to twenty deal doers at most, that may have deliberately sought their roles, in part perhaps, for the very fact that they are relatively autonomous and not bound by the institutionalised structures that govern most of the monolithic players in the financial service industry.

The best comparator might be hedge fund managers, but even that is woefully deficient given that investors, institutional or otherwise, are free to withdraw their capital at a moment’s notice. In private equity and venture capital funds institutional investors tend to be tied in to a ten year limited partnership structure, which means if the manager changes or loses his or her edge but refuses to budge the investors cannot vote with their feet, taking their business elsewhere. While investors can choose not to commit to subsequent fund raisings, they may be some way off and so don’t solve the problem in hand.

But it is the return of the fund raising market, predicted by so many to happen this year for private equity funds and next year for venture, that has brought the issue of who succeeds to the top spots in firms to the forefront of investors minds. “Now we have been waiting for [succession] to happen in the US and Europe from the late 1980s to late 1990s. Some of the GPs are not worth £2m, they are worth £100m; many of these GPs still work extremely hard and remain remarkably focused on building great companies. Others may be more content to slow down and work more on lowering their golf handicaps. So you have to look at each firm individually,” says Hanneke Smit, partner at Adams Street Partners in London.

While institutional investors expect the general partners who make them rich to get rich too, they are not comfortable when the rewards are kept by those at the top of the firm, rather than being shared out to the middle ranking employees, who are probably doing a lot of the hard work and, in the eyes of institutional investors at least, may one day lead the firm.

This goes against the grain of private equity investing which is believed to be all about alignment of interest between the moneymakers and their investors. “First we look at who is key to the succession of the firm. Second we make sure the incentives add up. If we still feel someone is vulnerable the key man clause and no fault clause are very positive provisions. Key man is a comfort, but in practice not what you really want,” says Smit of Adams Street Partners.

But Jesse Reyes, vice president Thomson Venture Economics, sounds a warning bell. “In this cycle succession is probably going to be the biggest concern LPs are going to have. If management has not really thought about how they are going to perpetuate their success there are going to be some very hard questions as to whether they will be successful in their next fund raising rounds. It’s too late if you have not already done it to cobble together any kind of credible plan,” he says.

Although the approaching fund raising cycle is seen as a time by many institutional investors to take the succession issue to task, it is the maturity of the private equity and venture capital business in Europe that is the catalyst. Many of these business began in the early 1990, typically by those in their mid to late 30s at the time, so they are now edging into their mid 50s and the very fact of their longevity means most have made a lot of money. Since most Europeans want to retire to enjoy the fruits of their labours, institutional investors don’t expect those in their mid 50s to stay until their mid 60s to manage current fund raisings to their natural conclusion. But equally they don’t want to commit to the next fund only for the senior partners to stick around long enough to pick up the money and apportion themselves a good slug of the carried interest before drifting off to their yachts and golf courses, leaving a disgruntled and disincentivised middle rank to run the day-to-day business.

Although institutional investors are pushing succession further up their due diligence agenda they will still commit to funds where the promised returns for them are good, even though the internal dynamics and economics of the firm suck. That said most institutional investors say they are looking to build a relationship with a firm where they could envisage committing to four or five funds further down the line. This makes perfect sense given that the ongoing relationship between institutional investors and general partner enables the investor to build a comprehensive picture over time and as such means the work involved in committing to follow-on funds should be minimal compared to starting due diligence from scratch on a fund where there has been no prior relationship.

One of the reasons succession is not addressed in a timely fashion by many private equity and venture capital houses is down to the sensitivity surrounding the subject, as Jamille Jinnah, managing director of Almeida Capital, explains: “Losing control can be more of an issue than losing out on economics when it comes to succession. Emotionally it is very difficult to organise your own departure, you are planning for your position and status to become redundant. Practically, PE is a network business and transferring that network smoothly onto someone else is not easy.”

In other firms the issue is simply not up for discussion, no matter how many people try to raise it. The founding partners in one firm were reputedly jointly approached by three members of the firm’s middle rank directors seeking a greater share in the economics, or carried interest, of the fund. The split of carried interest among members of the team is generally understood to reflect the importance of each member to the team and as such is something institutional investors are increasingly seeking assurances about. In this case the story goes that no discussion was permitted and each was forced to resign and accept a pre-determined, non-negotiable settlement on the spot.

Such stories do the rounds and can only inhibit others thinking of raising the subject, regardless of the culture within their firm, and add to the sensitivity surrounding the issue of succession. One school of thought is that firms that treat their staff in this way will come to be seen as private equity universities, in other words somewhere to earn your stripes, but not somewhere to stay. If this were to happen those firms will have levels of turnover that institutional investors who repeatedly bang the drum of continuity may find hard to stomach, particularly if the would-be successor level keeps departing. “If you have got good quality middle management they need to feel at some point they will have the opportunity to be at the top of the firm. If they do not see a route or structure available for them to do so then they may well not stay,” says Jinnah of Almeida Capital.

Michael Proudlock, chairman Granville Baird Capital Partners, who has spent part of his time in recent years putting succession plans in place, succinctly describes the feeling of many general partners, which in essence is that the institutional investors need to be aware of the pressure they are adding to the situation. “If you create an environment where we believe it is essential to keep people on board because of continuity by definition there is no succession. Obsession with continuity is not all healthy; some turnover is a good thing,” he says.

And Janet Brooks, director in charge of investor relations and deal flow marketing at ECI, points to one way that general partners can deal with the issue of continuity early on. “One of the major things to take care of with institutional investors is that they know and get to meet younger members of the team. They tend only to meet the most senior members of the team at fund raising, every four or five years, and as time goes on those [younger] executives have moved through the firm,” she says.

ECI Partners is a refreshing rarity; an independent private equity firm that is both open and honest about succession. Having been in the private equity business for almost three decades ECI suffered a terrible setback in 1990 when Tony Lorenz, who had shaped ECI into a private equity business, died suddenly at the age of 46. Lorenz was not only the driving force behind ECI at the time but also, in the then relatively immature UK market, something of a personality.

While the loss of Lorenz was a terrible setback it also had a profound impact on the culture of ECI, which remains today. Brooks says: “We have already had four managing partners. Since 1990 each of those subsequent changes has been very well planned. We are very open with each other about saying how long do you plan on being in this business. If you are raising a new fund you have to be able to commit to investors that you are going to be part of the management of that fund.”

Adrian Johnson, chief executive at Legal & General Ventures, has had to deal with the succession issue, although in a far more dramatic way than he would have wished. In 2000 almost half the team walked out only to resurface at firms like ABN AMRO Capital and Bridgepoint and Electra.

Johnson took the top job and rebuilt the team with a view to developing that group as a team rather than as individuals and planning for succession. At the same time he was able to shape and change the culture of the business. He says: “Succession planning and the way you develop the team are incredibly important and need to be high on the list of priorities. The mid 30s level must be developed both internally and externally to enable smooth transition. It is equally important that the culture is in place such that senior people know when it’s time to move on. This is how you create continuity and longevity in a business. In this context change is good and a business gets refreshed within an environment of a stable and consistent strategy.”

Even when succession is addressed it remains a sensitive issue and one that the industry continues to speculate over. In January this year Martin Halusa took over from Ronald Cohen as chief executive of Apax Partners and market talk ranged from how would investment policy be affected to whether or not the partnership would disintegrate without Cohen to keep it together. Partly this is Apax’s fault since, apart from a profile of Cohen in the Financial Times newspaper last autumn that outlined his plans to step down and appoint a successor, it has largely refused to be drawn on the subject.

However, for the purposes of this article, Apax has confirmed the 21 owners of Apax’s management company endorsed Martin Halusa’s promotion to CEO in a vote. This management company has been in place for several years and incorporates all of Apax’s global subsidiaries, which it has done gradually over time with the US operation last to join, less than two years ago. It is this management company, which is structured as a worldwide LLP, that holds the fund management contracts with the limited partnerships of each Apax fund in existence. As such the partnership is unlikely to disintegrate since for a team in one country to leave the Apax partnership would require that team to go and raise their own fund if they wished to remain in the venture capital business, which of course they could do but this is not as easy as walking away with an existing fund management contact. The issue is further complicated by the fact that all Apax’s recent fund raisings have been multi-jurisdictional. And Cohen has not been involved in the day-to-day investment process for some time.

The vote raised some eyebrows. It just sounds a bit too like the world of politics for some people’s liking and left some speculating whether there was campaigning involved and factions forming. This is not so much a reflection on Apax, as larger organisations generally. Kelly de Ponte, principal at Probitas Partners, explains: “When you have a larger organisation sometimes those transitions can be difficult and have competing fractions that if not handled well the losers and their adherents can split off and form a new fund.”

There is no evident fall out from Apax as a result of Halusa’s appointment and an Apax insider refutes any charges of politicking saying Halusa has been understood within Apax to be the heir apparent since before the start of this millennium.

“Succession is very hard and I don’t think you can see one answer that involves all firms,” says Smit of Adams Street Partners. Part of the reason for this is often that the founder has grown up with the business and effectively ends up having a finger in every pie, whereas often these roles need to be split when he or she retires. One such example being Otto van der Wyck, who founded BC Partners; when he retired in 2000 his role; figurehead and lead investor within the business, administrator and investor relations, were split between several within the enlarged group.

For some the issue of who should succeed is a preoccupying issue, largely because the middle level directors of today don’t look anything like their predecessors who went on to run the business. Many firms candidly admit as much, as Smit of Adams Street Partners explains: “In buyout firms some of the CEOs say some younger people are very bright but they know nothing about running a business. So they are outsourcing the operating experience and do the financials in-house. You get mixed feedback on that model because you have to get right operator to start with.”

But some general partners don’t want to go, even when they spend considerable chunks of time away from the business, and don’t see why they should share the economics of the business they see as their own. As Jinnah indicates, many will get away with that stance. “I would not over exaggerate LPs’ influence on succession. LPs’ bargaining influence increases when a number of factors come together i.e. performance issues and succession at the same time.”

In some respects it’s easy to see that individuals who spend their life buying and selling businesses would find it hard to pass their own business on, effectively free of charge. This is probably more true of those firms that have built up a considerable management fee income, this alone provides them with a basis for valuing their interest in the management company, let alone things like goodwill and brand, which they will rightly feel would not exist without them. How true that remains as the business moves into its second decade and fresh blood has come into the business and matured, is up for debate.

Legal & General Ventures and Granville Baird Capital Partners are semi-captive and as such are subject to internal investor pressure, but their willingness to deal with succession should not be viewed solely in that light. “Because we are owned by an American organisation there is expectation that they would like the organisation to continue in the long term. We as a group of people have always believed that the business must continue after us. That would be the case whether we were owned as we are or if we were an independent company,” says Proudlock of Granville Baird Capital Partners.

But what is a private equity or venture capital firm really worth? Not much according to most since it’s made up of people and if they were risk-free value added purchases then the trend for financial institutions to allow their in-house private equity teams to spin out for independence during the 1990s might equally have been characterised by sales to other financial institutions instead. But that hasn’t stopped some seeking to realise the value of the management company. David Rubenstein, founder and managing director of The Carlyle Group, was reasonably vocal during 2000 about his desire to float the group, but the markets fell away before he could get there.

Several others have sold percentages of the management company to institutions. Most recently Pantheon Ventures, the independent and global fund-of-funds investor, sold its management company to investment firm Russell. Market talk has Pantheon approaching Russell as a way for the founders to monetise what they had built up in the Pantheon business. The arguments seem stronger and the risks somewhat mitigated in buying fund-of-funds player as opposed to a private equity of venture capital firm. With fund-of-funds most of the upside is in the management fees and the institutionalised, research-based methodology of operating a fund-of-funds business more akin to retaining knowledge and contacts within the firm rather than the often personality and contact driven nature of private equity and venture capital relationships and investment activity.

Plus selling the management company of a private equity or venture capital firm can devalue what the successors in the firm take on if the management company is bound to pass some of its management fee and carried interest over to the owner of partial owner of its management company. Apax, for one, appears to have gone a long way to solving this problem. There are 21 individuals that make up the partnership that controls Apax’s management company and when each member retires or leaves their interest is sold back to the firm. Share of the partnership is not equal but reflects the contribution of the individual to the firm. By imposing a mandatory retirement age of 60 the firm has also sought to head off any hangers-on.

For those firms that get succession right, having the name of the founding partners over the door is not even a problem; Kleiner Perkins being a case in point. It’s phenomenal success won’t apply to many firms but the principal remains. “Initially all firms when they start up are very dependent on the founders. Once success is under their belt and the firm gets associated with those successes, as opposed to the individual, so it has helped those firms to address succession,” says Smit of Adams Street Partners.

Seasoned commentators suggest the issue of succession is probably more problematic for venture funds than for private equity firms, particularly the larger you go up the deal size in private equity. This is because buyout techniques are seen as a commodity and as such can be passed on. Sourcing the right opportunities at the right price is the real key to success here and that will be tied up to a certain extent in the individuals running these firms. But on the venture side there are no techniques to learn and as such a firm needs to prove and maintain its value added to continue to attract entrepreneurs and general partners alike.