Spotlight on Succession Planning
The potential for bias is why so many GPs seek the neutrality of a third-party valuations specialist
By Jordan Barnett, Director, Murray Devine
A quick, back-of-the-napkin calculation shows that among the top 25 domestic private equity firms, the average age of the senior-most active partners is 59 years. While many of the biggest names in PE have stretched their careers as long as five decades and show no signs of losing a step, it’s not lost on anyone that those who got their start in the 1980s – when the industry took off – are quickly approaching traditional retirement age. And as the median fund life now extends over 13 years, both LPs and the next generation of GPs are starting to ask difficult questions. Over the past few months, alone, such bellwethers as KKR and Carlyle Group have announced their own succession plans, which only adds further pressure.
Indeed, this heightened awareness reflects the institutionalization of the business. Twenty years ago, when private equity was still considered a cottage industry, the “key man” clause was a default term in most fund documents. Today, however, LPs want to see a depth of capabilities and a robust professional pipeline that reflects an enduring organization with a repeatable process. In effect, the key man has become the key people.
While the inner workings of succession plans tend to be as diverse and varied as the firms themselves, a commonality is the reliance on robust and independent valuations.
In fact, more and more GPs have started conducting annual valuations of their management company to appraise future income streams and ensure a seamless handover in the event of either a planned succession or an unexpected development that could put the partnership at risk. The benefit, beyond addressing limited partner concerns, is that the transparency and related mechanisms of a succession plan often lend to an ownership culture and meritocracy that supports persistent performance over time.
As part of a recent panel, we discussed these very topics. I was joined by two partners representing their private equity firms as well as an attorney who specialized in this area. The conversation was centered on long-term strategic planning with the goal of brand building for the management company and increasing the scale of the business. Succession planning was viewed as an essential part of the process to ensure the operations of the firm go beyond the life of a specific fund or eclipse the career arc of a founding partner. Valuation was also viewed as a necessary part of a robust succession plan, detailing growth initiatives and the mechanisms for shared ownership.
This is a theme that has been generating more and more interest among our clients. As part of assisting general partners execute on their succession plans, valuations are applied to a variety of transactions, such as gift and estate-tax planning, share grants or buy-ins for new partners or outside investors, and securities issued as part of management incentive plans. Regardless of the specific transaction, the net result is typically that the founding members is looking to diversify their concentrated equity position and, at the same time, attract and retain talent for the future.
To be sure, succession planning in private equity is far more than a simple HR exercise, even if the outside world only seems to focus on who may or may not be next in line. Many partnerships have begun viewing succession through the lens of risk management. They’re effectively planning for potential “triggering events” ranging from unexpected deaths and disabilities to competitive actions from unplanned partner turnover. Any one of these events has the potential to change the economics of the fund and the partnership, so GPs will look to address any structural issues that may exist and provide clarity around how they will respond to unintended consquences.
At a high level, though, these plans can cover everything from how to assign individual credit for specific investments to how carried interest is granted and allocated at the fund level. Some funds, to cite an example, will keep a portion of the carry in reserve until later in the fund life. This allows the carry to be allocated based on performance as younger professionals are invited into the economics as their contribution to the firm grows. Some firms have even established mandatory retirement thresholds. Apax Partners, to name one, set a ceiling at 60 years old, and has now navigated succession three separate times (upon the retirements of Alan Patricoff, Sir Ronald Cohen and Martin Halusa).
Valuations at the Center of Succession Planning
Underpinning any rigorous succession plan will be the valuations that serve as the foundation for each of the mechanisms dictating how ownership and future income streams are to be allocated. The methodologies that go into a valuation will always be based on fund specific factors, which imparts a certain level of subjectivity. The potential for bias, however, is why so many firms today are seeking the neutrality of a third-party valuations specialist that understands the nuance of the industry.
In determining value of an investment management firm, the valuation typically reflects a sum-of-the-parts approach, separating the income from management fees and income from performance fees to account for the differential in risk and return. Management fees, especially for mature funds, have a higher level of predictability. Therefore, the related income can be forecasted with a higher degree of certainty in comparison to performance-related earnings.
Fee-related income can be valued using a market approach, such as applying a market multiple to assets under management or net operating profit. However, the limited universe of publicly held investment managers — and the differences in scale and investment strategy – can present challenges in selecting apples-to-apples public comparables. When relevant comps aren’t available, the income approach is another common methodology to value fee-related earnings. In this circumstance, cash flows are adjusted for systematic (market) risk with discount rates determined from pricing models, such as the CAPM to determine the expected rate of return.
Carry, meanwhile, can be even more subjective since it is contingent on the performance of the underlying portfolio companies. Valuations needs to take into account a range of possible outcomes, including downside scenarios. Discounted multiples applied to performance-related earnings are based on several factors, including the target rates of return identified in LP offering documents, prior fund performance and industry benchmarks. The future value of carried interest distributions will often be heavily discounted and probability weighted to account for the high level of risk associated with earning the carry, which is generally the junior- most tranche in the capital structure.
The best succession plans, however, will find the compromise that optimizes value for both the existing ownership group and management team. In fact, as many GPs are discovering, succession planning, in and of itself, can create a virtuous circle. The process alone can instill an ownership culture in which everyone – not just the name partners or founders – have a personal stake in the business. And just as most firms look to align interests with portfolio-company management teams, succession plans create alignment internally, while demonstrating, externally, that the firm will endure. This supports brand equity and, ultimately, benefits all involved.
Jordan Barnett joined Murray Devine in 2007 and is currently a Director and an active member of the firm’s management team. Jordan serves as lead professional working across a broad range of clients, industries and engagement types. Prior to joining Murray Devine, Jordan worked as a Portfolio Manager with Sovereign Bank. He received a Bachelor of Arts degree in Economics from the University of Vermont in 2001 and a Master’s in Business Administration with a concentration in Finance from Villanova University in 2007. Jordan holds the right to use the Chartered Financial Analyst (CFA) designation.