11 Dec 2018
The first rule of succession planning...
Succession planning is now a must for many Private Equity (PE) firms. It's now more important than ever to have sound fit-for-purpose financing solutions that create incentives and address continuity.
Is the PE industry in danger of becoming a victim of its own success? With fund raising buoyant these past few years and no sign of a let-up, in many firms succession planning has been put on the back burner. When funds are flowing in, who has time to worry about the future?
But failure to plan ahead can derail even the most vibrant PE firm. As the industry matures and moves away from the founder/manager model, a workable succession plan for key people is becoming critical for sustained success.
Reassure talent and investors
For a start, a well-thought-out and articulated succession plan helps PE firms to recruit better talent. If people can see how they fit into the firm’s future, they’re more motivated to join, succeed – and then stay. That improves performance in the short term, which in turn facilitates further fund raising.
PE firms are often up against investment banks for key talent, where it’s much easier to see what a successful career progression looks like. So PE firms need to offer a vision of the future that is appealing to ambitious professionals.
A well-thought-out and articulated succession plan helps PE firms to recruit better talent.
A considered approach to succession planning also reassures limited partners (LPs) that the future of their investment is secure. In an asset class that is by its nature long term – and where personal relationships count for a lot – it’s crucial that LPs know their investment will remain in good hands.
Exit the founders
Succession planning is particularly relevant across the PE industry. And, as is always an issue for individual firms, this is due to its stage of development. The boom in PE began around 25 years ago and so many firms are currently being run and managed by founders who are getting older (and richer) and may be looking to exit.
In fact, our 2017/18 GP Trends report found that one in eight managing partners think they might leave their firm in the next 12 months. If they don’t have a workable succession plan in place, they could face major upheaval. Usually, a PE firm’s founder and managing partner has the closest relationship with the LPs. The founder might handle all the important meetings and calls. Firms need to be able to transfer those relationships and the brand value they represent.
The hard truth is that many firms struggle with this passing of the baton. Our previous GP Trends 2016 survey found that 45% of PE firms did not believe their investors were satisfied with their succession plan – or lack of one.
It is possible to get it right, though. A few firms have already made the transition from a founder/owner model to a more institutional multi-fund model based around a brand. Many more will face the challenge of managing that shift over the next few years, as founders retire or move on.
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"The first rule of succession planning...
…is that we don’t talk about succession planning.”
This is often the default at firms – and there are reasons for that. If it’s mentioned too early, LPs may doubt the founder’s commitment. Making promises to staff too early can also result in disappointment, if their hopes that the senior GPs shuffle off to make room for them don’t materialise.
But if succession planning is left too late, talent and LPs might have doubts about the future – or go elsewhere.
So it’s important to build a workable succession plan around the current investor base and take their views into account. In our experience, succession planning works best when the PE firm engages with LPs early and puts in place a well-articulated plan over a number of years and rounds of fund raising. Think of it as a kind of “key (wo)man assurance”.
Putting a formal process around the issue also helps to smooth the transfer of the nuts and bolts of the firm when it does happen. Handing over relationships is harder, so ease people into it. Founders can step back gradually over their last few fund raisings, easing in their successors and ensuring full court diplomatic relations are maintained.
At the same time, it’s important to ensure that identified talent becomes invested in the firm – or obtains some sort of incentive early enough that investment in their managerial, portfolio management and investor relations skills isn’t wasted.
Again, it’s crucial to manage expectations. The succession plan must be transparent and communicated clearly. The market should be made aware that an individual is moving up the chain – so it isn’t a surprise when it happens.
It’s important to ensure that identified talent becomes invested in the firm and to make sure their managerial, portfolio management and investor relations skills aren't wasted
Keeping the firm capitalised
As well as being easier for LPs to swallow, a gradual reduction in the founding partner’s shareholding over several fund raisings makes it easier to manage capitalisation levels and allow new partners to buy in.
However, if firms don’t have a system for capitalising the management company in place, it can still be prohibitive for new partners to buy in – especially right now, when valuations are so high. Founders are then in the frustrating position of having created almost too much value.
To avoid this situation, the management company must take care to manage the debt/equity split. This is where a specialist provider can help. Management company loans are not commonplace, and so it’s important to find the right partner that understands the intricacies involved.
PE firms usually require finance over a number of years, and so they need to work with a team that understands the particular dynamics of the PE industry. We have been helping a number of PE firms through succession planning financing solutions for a number of years and – unusually – have worked with both LPs and general partners (GPs).
A growing problem
Succession planning is an issue for GPs and LPs alike. If a GP doesn’t have a workable succession plan in place, LPs must still deploy their PE allocation and may have to work with a new manager with whom they are less familiar.
We believe this issue will become more topical over the next few years, as a generational shift takes place in the PE industry. Specialist, innovative financing options such as those we support our clients with will be a big part of the solution.