Success in succession

As the private equity industry matures, succession issues are fast becoming as much about the internal dynamics of the finance houses themselves as they are a trigger for investment target opportunities.

Ultimately, founders have to make way for their younger and less-well incentivised charges, normally through a reshuffle or a sale of the founding partners’ holdings. The price many have paid is the loss of senior partners, who leave to establish their own buyout shops. More recently, other firms have found alternative methods to deal with succession issues.

In June, US-based buyout firm Blackstone Group floated on the New York Stock Exchange in what was widely perceived to have been one way in which co-founder Steven Schwarzman, 60 earlier this year, could cash out on the firm’s enormous success but still leave plenty of incentives for the rest of the firm’s investment professionals to stay locked in.

Neither is succession just an issue for investment managers. It is also an increasingly decisive factor for returning investors. According to Coller Capital’s Global Private Equity Summer 2007 Barometer report, continuity and succession within general partner teams was cited by 85% of surveyed limited partners as a key consideration in the decision to invest or re-invest.

“Private equity firms need to have a proper vision on the ultimate succession of management through planning and development, but a lot of our industry has been pretty bad at that,” says Michael Hoffman, also 60 this year and one of the two founding partners of European buyout firm Palamon Capital Partners, which recently carried out an internal restructuring.

“Founder partners tend to hang on and on, and don’t distribute ownership,” he says. “Then they wake up at the age of 74 and they’re in the middle of a business that is losing people.”

Hoffman is in a good position to comment, having spent more than 20 years in the investment sector. “One of the older guys around here”, Hoffman first made his mark in the private equity industry when he came to London to launch Warburg Pincus’s first international office in 1987.

“Back then, the industry was mostly what we would now call development or expansion capital, including all the current large to mega-sized players,” he says.

One of four partners presiding over a “dozen or so” investment professionals in Warburg Pincus’s investment team from 1987 to 1998, Hoffman saw an opportunity when Warburg became one of the first firms to raise a US$5bn fund, significantly higher than a previous level of US$1.8bn.

“It meant a major change in terms of the sizes of deals to be done, so Louis [Elson] and I realised that we loved growth capital and felt it was an attractive space to be in Continental Europe,” he says. “We felt that if Warburg was going to move up and out, why shouldn’t we stay where we were and inherit the space.”

Hoffman and co-founder Elson took the concept for Palamon to “two or three placement agents as what we didn’t know then was how to raise money – there was an immediate curiosity factor as no-one had left Warburg Pincus to set up their own private equity fund in 35 years”.

Since then, Palamon has raised €1.1bn in commitments from third-party investors and made investments in 22 companies across eight markets – a €440m debut fund in August 1999, with two-thirds of commitments from US investors, the balance from Europe, was followed by a €670m successor in June of year.

That second fund was vital, says Elson. “We had to get it closed as there was no point in doing any of this without that second vehicle,” he explains. “Because of the economic structure of this industry, it’s littered with the walking dead, where firms just keep limping along. It was also critical that it was 50% bigger as it set us up for the future.”

With more than 40% already invested – “we’re investing at a more rapid pace now”, says Hoffman – a third fund is targeted for 2009, hence the need to restructure now.

Once the second fund had been raised, says Elson, it was time to design “phase two” of the business, which involved the two “literally sitting in a hotel room for four or five one-day sessions before bringing in our board of advisers”.

The advisers were an impressive bunch, too, including Harland Riker, founder of Arthur D Little; Olswang founder Simon Olswang; Rob Johnson, a professor at the London Business School; and Ron Sandler, former chief of Lloyd’s of London and COO of NatWest Group.

“They brought these different perspectives and helped build a knowledge base as to how we could and should work and we then spent a few months putting that together,” says Elson.

“What you are seeing in the market now is the Blackstones and KKRs of this world institutionalising themselves,” he adds. “So this reorganisation at Palamon is the first step in putting together the infrastructure for institutionalisation – a couple of founders holding on all the way isn’t going to work.”

On a practical level, Hoffman will move to a new position of chairman of Palamon, enabling him to focus on the firm’s profile in the market – Hoffman says he “still has a lot of energy” and will be involved in the business for at least the next five years – while Elson, 14 years Hoffman’s junior, will lead a newly-created operating committee, which will direct the day-to-day activities of the firm, where he will be joined by partners Daan Knottenbelt and Erik Ferm.

“It will allow us to reach down into this world class group of people we’ve assembled, to whom we’ve transferred the knowledge of how Palamon views the world in terms of investments and corporate developments, and say: ‘We’re now pushing you into greater responsibility and authority for the future development of the firm,’” says Elson. “This ties them into a real affinity and direct relationship with the firm.”

The firm’s key priority now, says Elson, is to become the pre-eminent player in the mid-market with a pan-sectoral, pen-geographic early mid-market and late-stage focus. A big part of that involves recruitment, he says, with a step up from meeting and reviewing about 70 people a year to pick two, to meeting 100 people to ultimately hire four.

It’s a delicate balance, he adds, involving maintaining and embedding Palamon’s culture while absorbing new people.

“When I step out, it will be a seamless transition,” concludes Hoffman. Other private equity firms with double-digit track records might want to take note.