The New Urgency In Succession Planning

At the end of 2005, Kohlberg Kravis Roberts & Co. partners Edward Gilhuly and Scott Stuart, who had been with the firm since 1986 and were seen as potential candidates to one day run it, resigned to start their own company. Although the departures were amicable, the reaction among observers spoke volumes about the new importance of succession planning for private equity firms. “We’ve always been aware that Henry [Kravis] and George [Roberts] are of a certain age,” the chairman of the Oregon Investment Council, KKR’s second-largest investor, told Bloomberg News at the time, “and there needed to be strong backup.” KKR moved quickly to replace the pair on its investment committee, but succession may very well come back to the forefront if the firm follows through with plans to go public.

Like many of the most successful private equity firms, KKR is inextricably linked in investors’ minds with the mystique of its founding partners, amounting almost to a cult of personality. Think of Ted Forstmann and Forstmann, Little & Company, David Bonderman and James Coulter of TPG, Steven A. Cohen and SAC Capital Advisors, and Peter G. Peterson and Stephen A. Schwarzman of The Blackstone Group. Back in 2001, Steven Rattner, founder of the Quadrangle Group, cut to the heart of the issue: ”The question is: Is this the sort of business that revolves around one great investor, like Henry or George, to keep it going,” he told the New York Times, “or can you train another generation?” And as recently as December 2007, Moody’s Investors Services issued a report warning that succession poses a greater risk to buyout firms and hedge funds than large, publicly traded firms like Merrill Lynch & Co. and Citigroup Inc, recently rocked by sudden successions.

Why the New Urgency?

Certainly, the risk posed by succession at private equity firms doesn’t come as news to limited partners and investors. Because their money can be tied up for as long as ten years or more, with little possibility of escape, investors want to be sure that the investments are being managed by people they know and trust and who have a track record of success. In surveys conducted by the Dow Jones publication Private Equity Analyst, investors routinely cite succession as among their top concerns. And according to Coller Capital, a fund that buys private equity fund assets, the two most important considerations for LPs in deciding whether to invest or re-invest with a general partner are the aggregate performance of a GPs’ funds and continuity/succession within GP teams.

What is new, however, is the increased urgency that the issue has taken on, for two reasons. First, many in the generation of founding partners at some of the most successful firms are reaching retirement age. The issue of succession is no longer merely theoretical, and those firms that haven’t addressed life after the founding partners could face increasingly skittish investors or, ultimately, watch their companies expire.

Second, as the industry matures, private equity firms are increasingly looking for ways to monetize the value of the management company itself, which historically has been regarded as without value beyond the services it provided. But in selling equity stakes and seeking public ownership, many firms are seeking to transform themselves into large and permanent financial institutions. In May of 2007, Blackstone sold $3 billion in non-voting stock—slightly less than a 10 percent stake—to the People’s Republic of China. The California Public Employees Retirement System holds 5.5% stake in The Carlyle Group. In February 2007, the Fortress Investment Group, a hedge fund as well as a private equity management company, became the first such firm in the U.S. to launch an IPO. Blackstone followed suit a few months later, and KKR filed its preliminary IPO prospectus with the SEC in July, though at this point it is unclear when it will proceed with the offering, given market conditions. Such companies are implicitly signaling that they plan to survive and to grow as permanent financial institutions, goals which require a steady succession of skilled leaders far into the future. This trend will only grow stronger as other firms follow the leads of Fortress and Blackstone. As a result, private equity firms will not only have to satisfy LPs about their succession plans but public equity investors as well.

The Industry Stirs

In the face of these trends, some firms have begun to address the succession issue. Although the three founders of The Carlyle Group, for example, are a decade away from the company’s mandatory retirement age of 75, the firm has formed a management committee to deal with succession. In 2002 the company also brought in Lou Gertsner, who as the former chairman and CEO of IBM is experienced at dealing with the issue, as chairman.

Thomas H. Lee Partners began the succession process in 1999 and communicated its intentions to investors over several years. So in 2006, when founder Thomas Lee left the firm, it came as no surprise that the firm would be led by co-presidents Scott Sperling, Anthony DiNovi and Scott Schoen, all of whom were well-known to investors. In a testament to the successful transition, last year the firm raised its biggest buyout fund ever, its first without the founder, amassing over $10 billion in commitments.

Similarly, Blackstone in the lead-up to its eventual IPO established a clear succession plan and communicated it to the investment community. In 2002 the company brought in Hamilton E. “Tony” James, who had a 25-year track record of success at Donaldson, Lufkin, & Jenrette, where he had risen to chairman of the firm’s mergers and acquisitions and private equity holdings. After Credit Suisse First Boston acquired the company in 2000, James chaired the merged firm’s global banking and merchant banking unit. He was well known in the investment community and at Blackstone the fact that he worked directly with founding partner Schwarzman marked him as the heir apparent. In 2004, the company named James president; Schwarzman became chairman and CEO, and founding partner Peterson became senior chairman, further signaling the investment community that the founders were making room for a successor. The company’s intentions became official in 2007 when its prospectus for its IPO declared that James would eventually succeed Schwarzman and that Peterson would retire by the end of 2008.

Adopting Best Practices

Because Blackstone, Carlyle, THL and other private equity firms are each unique in their histories, sizes, and cultures, there is no one-size-fits-all approach to succession planning. But implicit in their examples and in the experiences of other firms there are some proven best practices for succession planning in this unique industry:

* Relentlessly focus on bringing the best and brightest into the firm. This principle is of course the motherhood and apple pie of human resources. Nevertheless, it bears underscoring in an industry where the myth of the irreplaceable hero-leader is precisely the problem. Succession planning shouldn’t be simply a matter of publicly naming an all-star successor, but a coherent system for attracting, developing, and retaining a steady stream of talent and thereby earning a reputation among investors as an enduring and stable institution, especially in an age of monetizing the value of the management company itself. Traditionally, many firms have hired junior people directly from the top-tier business schools and have brought in more senior people from top Wall Street firms and other high-profile financial institutions. But the definition of “best” should of course conform to the nature of the individual firm’s business. In 2000, for example, KKR refocused its business on improving operations in its portfolio companies and reorganized the firm into industry practices, a move that Henry Kravis said changed the firm’s hiring practices. “Many of our people—who I think are among the very best in the industry—have a broad range of strategic, consulting, operating, and finance backgrounds and come from operating corporations rather than Wall Street,” he told the European Private Equity & Venture Capital Summit in February 2006. “Over the past five years, all of our senior hires—with one exception—have been executives with extensive industry experience.”

* Provide opportunities for next-generation leaders to emerge. High-potential leaders should not only be identified early on, but given significant responsibilities that allow them to acquire the experience they will need to one day lead the firm. Firms like Blackstone and Carlyle, with multiple funds and businesses, of course have the luxury of being able to let such leaders run a fund or a business unit like financial advisory services, mergers & acquisitions, mezzanine or real estate investment. Smaller firms can give these next-generation leaders the opportunity to serve on the investment committee and participate directly in investment decisions.

* Expose next generation leaders to limited partners. To begin to build the relationships and the trust with potential investors that are essential for successfully attracting them, next-generation leaders should not only be given significant responsibilities but also given opportunities to get in front of investors.

* Make your succession plan transparent to LPs. Given the increased urgency with which potential investors view succession planning, it’s not enough to send implicit signals. Publicly designate a likely successor, a team of successors, or field of candidates from which the successor will come.

* Communicate your succession plan well in advance. Because the investment cycle required in private equity is so long, investors increasingly want a clear picture of your firm’s succession plans years in advance of the transition.

* Push equity ownership down in the organization. Spreading the wealth among high-potential leaders, such as through larger percentages of carried interest, certainly gives talented people great incentive to remain with your firm. But the ultimate incentive is an equity stake in the management company, which of course means a stake in all of the company’s funds. For example, Blackstone, in its filing with the Securities and Exchange Commission, cited its desire to add to the company’s compensation package as one of its reasons for seeking public ownership.

* Carefully manage the layers of talent below the next-generation leaders. Although investors usually focus only on top decision-makers, careful talent management at all levels ensures that those decision-makers, who may not emerge until 15 or more years down the road, are not only the best but also the best prepared.

Francisco J. Paret is a consultant in the Financial Services Practice at Egon Zehnder International, one of the world’s leading senior-level retained executive search firms, where he works primarily on private equity and investment/corporate banking assignments. Before joining Egon Zehnder in 2005, Paret was an investment banker for 15 years. Paret holds an MBA from The Wharton School of the University of Pennsylvania, and a BSBA with concentrations in international management and finance from Georgetown University, where he was a recipient of The Dean’s Citation for outstanding leadership. The author can be reached at or in our New York office at 212-519-6000.