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Successful succession planning: Thinking about tomorrow today

A private equity firm must pay attention to the concerns and needs of both its senior managers and its junior managers in developing a successful succession plan, according to Stephen Mears of Testa, Hurwitz & Thibeault.

A firm that is able to strike the proper balance between these two groups will be better positioned for long-term success that will ultimately benefit the entire general partner organisation as well as the limited partner investor base.

As the private equity industry has grown and matured, one of the key issues facing fund managers and limited partners alike is the matter of succession planning by fund managers. For fund managers, succession planning helps to ensure a smooth transition from one generation of managers to the next and, ultimately, the continued existence and growth of the private equity firm that they have devoted much of their lives to building. For limited partners, succession planning by a fund group is important because an investment in a private equity fund represents a long-term commitment. Limited partners want to be sure that the private equity firm can attract and retain the best managers, that the fund managers who are actively involved with the fund's portfolio have sufficient economic incentive to make the fund successful, and that any changes in fund management will be accomplished smoothly.

Succession planning involves a careful balancing of the concerns and needs of a firm's founding and senior managers, on the one hand, and its more junior investment professionals and managers, on the other hand. The founding and senior managers want to be properly rewarded for their efforts in building and growing the firm, and this may include rights to continue to participate in fund economics after these managers have begun to wind down their active involvement. These desires must be balanced against the need to provide increased economic benefits and firm governance rights to junior managers and investment professionals in order to develop the next generation of managers for the firm.

When it comes to succession planning, there really is no "one size fits all" approach. Rather, the elements of any particular private equity firm's succession plan will depend on the unique history and inter-personal dynamics of that firm. However, the following are some of the topics that should be considered and addressed by a private equity firm as it considers succession planning issues.

Allocation of Carried Interest. How is the general partner's carried interest divided among the fund managers? Should the amount of carried interest allocated to founding and senior managers reflect not only their anticipated contribution to the success of the current fund, but also their "franchise value" - i.e., their efforts on prior funds and in building the firm? Should founding and senior managers have a right to participate in the carried interest of funds formed after their active involvement with the firm ends? Still, a private equity firm needs to be sure that there is enough carried interest remaining (after taking into account the interests of founding and senior managers) in order to attract and retain the junior investment professionals who will become the next generation of managers for the firm.

Vesting. Does the firm have an appropriate vesting schedule for the mangers' ownership of the carried interest? The last few years have seen both increased turnover at private equity firms and a return to the view that private equity investing is a long-term endeavor, with significant work remaining to be done on a fund's portfolio even after the fund has ceased making investments in new portfolio companies. Fund managers who are nearing retirement may seek a shorter-term vesting arrangement that reflects their intention to wind down their activities after the first few years of the fund's existence. However, if too much ownership vests too quickly, there may not be enough invested carry to properly reward those managers who have to take on additional work in the later years of the fund's life.

Governance. Do junior managers participate in decision-making or is the firm still run entirely by the founding and senior managers? It may be a difficult adjustment for founding and senior managers to cede some of their control over the firm. This may be necessary, however, in order to ensure a smooth transition from one generation to the next, and to provide the career advancement opportunities necessary to attract and retain the best junior investment professionals.

Clawback Matters. How does the firm propose to manage clawback risks in future funds? Senior managers, who may have already achieved significant wealth through prior funds and who desire to avoid dealing with clawback payments in their retirement years, may favor approaches that limit early distributions to the managers in respect of the carried interest in future funds. This may conflict with the desires of more junior managers who have not received significant distributions from prior funds and who may be inclined to leave for a competitive firm that offers the promise of earlier distributions.

Key Person Provisions. Are "key person" provisions in a fund's partnership agreement consistent with the firm's succession plan? Key person provisions are typically triggered when certain identified fund managers or a certain number of fund managers cease to be actively involved with the fund's activities. Common consequences of triggering the key person provisions are termination of the fund or a prohibition on investments by the fund in new portfolio companies. Key person provisions are more likely to be triggered if they are tied to individually named senior fund managers who may be considering retirement. In order to avoid such an occurrence, it is important for a private equity firm to develop a next generation of managers that the fund's limited partners will also accept as key persons. It is then important for the firm to provide the appropriate rewards for this next generation of managers that will cause them to stay with the firm.

Management Company Ownership. What happens to the founding and senior managers' ownership interests in the management company for the funds when they retire? Is there an opportunity for junior managers to become owners of the management company?

Historically, the management company was viewed as having little value independent of the services performed by the managers because its net earnings (generally from management fees paid by the private equity firm's funds) would not be accumulated, but instead would be paid out annually as compensation to the managers. Accordingly, there was not a great deal of emphasis placed on who owned the management company and, when an owner left the firm, his interest in the management company was often repurchased for a nominal price.

However, recent transactions in which institutional investors have purchased stakes in private equity management companies have shown that, at least in the case of well-established firms, there is value in the franchise name and management fee income from current and future funds and that this value can potentially be monetized. This has resulted in increased attention to ownership of the management company. Since much of a private equity firm's franchise value will be the result of many years of work by founding and senior managers, members of this group may be less willing to accept the historic nominal price buy-out of their management company interests when they retire. Instead, these managers may want to have a continuing ownership interest after they retire, or at least a right to benefit from any liquidity transaction with respect to the management company within a certain period of time after their retirement. At the same time, junior managers are more likely to want the opportunity to become owners of the management company in order to potentially benefit from both the franchise value and continued income stream they are helping to create.

Conclusion. A private equity firm must pay attention to the concerns and needs of both its senior managers and its junior managers in developing a successful succession plan. A firm that is able to develop a plan that strikes the proper balance between these two groups will be better positioned for long-term success that will ultimately benefit the entire general partner organization as well as the limited partner investor base.

This article is reproduced with permission of Testa, Hurwitz & Thibeault, LLP. For more information about Testa, Hurwitz & Thibeault, LLP, please contact www.tht.com

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