We’ve all seen it. Due to ineffective (or the complete absence of) succession planning, a formerly high-flying firm loses key personnel, stops doing new deals and begins winding up its affairs. Sometimes this happens quietly, sometimes not.
Founders, who have spent years building a successful business, need to understand that to build a successful, enduring business requires, at some point and in some form, a transition to the next generation. At the same time, the up-and-coming investment professionals who comprise the next generation need to understand the founders’ mindset. The key point is this: Succession has to work for all involved if it is to work at all.
So what do you need to know to execute a successful generational transfer? First, a few options that will help to demonstrate what has worked in the past:
• The founders elect to move towards a “flatter” (admittedly top-heavy) organizational structure in which the next generation are promoted to nearly co-equal status with the founders, resulting in a relatively large number of MDs with largely similar economics and decision-making authority.
• The founders are concerned not only with their economics, but also with their legacy—and that of the firm they built—and so elect to extract less (and in so doing probably leave a little bit of money on the table) in negotiating and planning for their own obsolescence. They do this on the theory that, assuming the long-term health of the fund, a more gradual, longer off-ramp is best for all concerned, and may in fact be more lucrative for them in the long run.
• The next generation comes together to negotiate their participation (economics and governance) as a block, demonstrating the effectiveness of a collective bargaining approach and resulting in a win-win situation for all concerned.
• The founders sell the management company to the next generation—in what effectively amounts to a management buyout—for a purchase price that includes a significant amount of leverage being placed on the management company.
Learning from and building upon these approaches, consider implementing the following strategies to ensure a smooth and successful GP succession planning process that both cements the founders’ legacy and protects the firm’s economics.
Put Yourself in the Driver’s Seat
As the title of this article suggests, appropriate succession planning can increase value for all concerned. Conversely, its absence can have a destructive—in some cases, fatal —effect on the brand, franchise or fund that the founders have built. It is far better to have a plan, and to address the issue of transition in a considered fashion, head on, than to avoid, delay or ignore the inevitable and, in so doing, permit the fund to founder. So much of this has historically been done on an ad hoc basis, which makes every conversation hard and can lead to misunderstandings.
Unlike a manufacturing business (and more like a professional services firm), a private equity fund’s greatest assets are mobile: They walk in—and out—the door every day. Just as sponsors look to back the strongest management teams, LPs are more likely to entrust their monies to the strongest team of investment professionals (which starts, but does not end, with the founders). Founders understand this dynamic. For their part, the junior folks need to understand that the founders’ success was not handed to them. The founders have worked long and hard to build the firm and, as a result, frequently blur the line between fund and self in a way that makes the idea of succession planning as much an emotional exercise as it is an economic one.
Another reason for founders to get out in front of this is to avoid having the discussion initiated—or worse, dictated—by your limited partners. Managing LP expectations around succession plans, and avoiding any unrest around defections or other departures from the investment professional ranks, requires an openness and active approach to the transition of power. This needs to be tempered, of course, so as not to precipitate LP requests or demands to add personnel to the “key person” provisions of your partnership agreement before it is appropriate to do so. A delicate balance must be struck between evidencing thoughtfulness about the transition while at the same time projecting strength and deflecting any concerns about the continued centrality of the founders’ role.
Give Credit Where Credit is Due
It is often more advantageous to do “enlightened” things, and to reward, incentivize and retain talented investment professionals who have proven their worth by sharing greater economics and control. Sometimes this means carry only and at other times it means beginning to share fee income and control. Without question, compensation is key. But in each conversation consideration should be given to whether (and if so, how) to address the sharing of control and decision-making authority.
A disenfranchised investment professional, regardless of his title and compensation, is going to be less happy (and more apt to experience wanderlust) than a managing director who has a seat at the table when it comes to investment and personnel (i.e., hiring and firing) decisions. For this reason, founders might consider among the range of possible options allowing their best performers to participate in investment and management committee meetings or, if they already participate, giving them an increased voice, or vote. (But don’t feel as though they need to be given an equal vote—simply having the ability to be heard, and to participate at some level, can be enough).
Think two funds ahead and discuss specific goals, metrics and milestones against which performance will be measured and rewarded as part of the planning stages for the next raise. For example, when you’re getting ready to raise Fund III, sit down and speak with your top performers about their roles not only in Fund III, but also look ahead to Fund IV. You don’t need to commit to anything at this point, but keep your young team hungry and their eyes focused on the prize by telling them what they want to hear: that their economics and role in this next fund will be X, but in the fund after that they’ll be 1.5X (or whatever your plan may be).
Perhaps an obvious point, but succession planning—and, in particular, keeping the next generation interested and engaged—is most important in circumstances where fund performance is less than stellar. If the carry looks like it is suspect (or non-existent), it sets up a bad dynamic where your athletes are not seeing much in terms of upside (and may therefore feel overworked and underappreciated).
Virtually every new fund that has cropped up in the last 20 years was formed by professionals who used to work at another fund and, for whatever reason, decided to move on. Private equity professionals are talented, driven individuals possessed of great skill and, just occasionally, good-sized egos. Some number of personality conflicts are inevitable, as are the “I need to be my own boss” or “I can’t work for that person” feelings engendered by certain team dynamics.
In some cases, no measure of succession planning—however well intentioned or executed—will keep together those pieces which ought to be apart. And you probably don’t want to try. But where you have a good thing going, and want to ensure that it keeps going, make sure that your interactions with your team evidence—in word and in deed— your commitment to the growth and success of the fund and each individual contributing to that growth and success.
Christian A. Atwood and Andrew E. “Sandy” Taylor, Jr. are partners in the Private Equity and M&A practice groups at Choate, Hall & Stewart LLP in Boston. They can be reached at firstname.lastname@example.org and email@example.com.