Transition time: Succession planning in private equity

The five managing partners at Chinese VC firm Qiming Venture Partners gathered in January for what was expected to be a two-hour meeting. There was one item on the agenda: deciding on a mutually acceptable compensation scheme that reflected Gary Rieschel's reduced role in the firm while still acknowledging his contribution as one of multiple key persons on the latest fund.

This meeting had been three years in the making. Rieschel, who started his investment career with SoftBank Venture Capital in 1995 and founded Qiming with Duane Kuang 10 years after that, began the transition by stepping back from leading deals. His focus switched to nurturing the firm's mid-level talent, while continuing to serve on the investment committee.

Now it was time to finalize the next step, which would see Rieschel assume the role of chairman and relocate to Seattle to concentrate on Qiming's new cross-border healthcare fund. He had spent about a month considering the situation before submitting a proposal to Kuang and his other fellow managing partners. "After about 20 minutes everyone looked at each other and said, ‘This is fair,'" Rieschel says.

When we see succession go wrong it is often because a founder just couldn’t decide on when to step back – T Bondurant French

Qiming has $2.7 billion in assets across US dollar and renminbi funds, and closed its fifth US dollar vehicle in January, not along after that meeting. Rieschel attributes the smoothness of this transition to Qiming doing what many China VC firms have not in creating a sustainable partnership structure characterized by similar compensation for the managing partners, economics that are shared broadly across the team, and a willingness to promote from within.

"Many firms in Asia were set up with a ‘strong man' leadership model. As time goes on, it is difficult for the leaders to bring newer partners into the mix, especially in terms of giving up real control on finances and voting," he says. "As a result, they don't have the bench strength. Turnover is often high and when someone leaves there is no one of similar ability to replace them."

While poor performance and spin-outs have caused some GPs to fade to the margins of Asian private equity, the transition of power between generations within the same firm is a rarity. However, as the market matures, and various founders approach retirement age, succession-planning is increasingly an issue that LPs are asking GPs to confront.

"Everyone says they want to build an enduring franchise, but carrying it out is another matter," says T. Bondurant French, executive chairman of Adams Street Partners. "The biggest hurdle is performance and that is usually the culprit, but building a successful organization is the next part. It is something that is only clear with the passage of time. If the senior partners are about to retire and they haven't done a good job of building strong people below, that prohibits the firm from being successful going forward."

The cases that attract attention in Asia do so largely due to the status of the founders or the angst that takes place behind the scenes. If there is one hard and fast rule that has been proven to apply here as well as in North America and Europe, it is this: those that leave succession planning too late - or let it string out too long - will struggle to make it work.

Follow the numbers

While succession planning is an exercise that spans human resources management, investment relations and business development, there is always a paper trail. The size of it is indicative of how much thought has gone into the process. "A lack of documentation relating to carried interest is more common than you could possibly imagine," says Dean Collins, a partner at Dechert. "Everything goes to those who have it on paper and it's their discretion whether it is shared further."

For a small to mid-size PE firm on Fund I or II, though, the focus is on creating a platform worthy of succession. It is only once that brand equity is in place or there is a need to bring in additional investment professionals that agreements tend to be formalized. Several areas require codification, but particular attention might be directed at two: the distribution of fund economics, including carried interest and excess management fees, as well as ownership of the management company that runs the firm; and dispute resolution covering the different circumstances under which someone might depart.

"We often get asked how much it would cost to put in place the equity documents and the response is they can be 20 pages or they can be 120 pages," says Justin Dolling, a partner at Kirkland & Ellis. "It depends on the size and complexity of the platform (such as multi or single strategy), the number of principals, the different levels of principals and the amount of detail you want to go into with respect to all the key aspects of the operations of the sponsor."

One gauge of whether interests in a firm are broadening beyond the founding group is the evolution of the key person clause. While on the early funds a key person event - which, if enforced, prevents new investments being made - is triggered by the departure of one individual, a second tier of professionals is brought into the fold as the vintages progress. The founder may still be categorized a super key person, but if a combination of second-tier professionals left a key person event would still occur.

"It's not common for senior management to be willing to permit someone from the younger generation to be a key person who can singlehandedly trigger a key person event, but when that does happen, it's a major transfer of power - it enables that individual to grind the investment program to a halt, at least on a particular fund," says John Fadely, a partner at Weil. "This is where succession planning can become quite apparent to the LPs, as they're very focused on negotiating the key person provision. In fact, alongside the economic terms, this is probably the most important term, and it's often viewed as the most important governance term, above even removal rights."

The caveat is that there is often enough wiggle room for a founder to prevent someone from the younger generation single-handedly triggering a key person event. This underlines the importance of LP due diligence, although investors observe that there is art and science in the process. Juan Delgado-Moreira, a managing director at Hamilton Lane, says that the absence of a culture oriented towards succession planning is "as much of a red flag as whether or not you have a good key man clause."

Testing this culture involves spending time with investment professionals across the target firm, considering the role played by the founder, his motivations and value contribution, and the steps taken to ensure bench strength. It is also important to quiz the less senior team members on their level of satisfaction with compensation, prospects and working environment.

"Deal attribution is important and prospective investors should go beyond the data room to assess through triangulation the appropriate credit for transactions," says Jonathan English, managing director at Portfolio Advisors. "You try to figure out who is driving value, who has a good nose for deals, and who can make the right maneuvers when things go pear-shaped. If you aren't happy with how a person is being compensated and you think they may leave over time, you factor that into your decision."

Highly concentrated fund economics can therefore be problematic in that they do not incentivize team stability. This is all seen by many as fairly typical of Asia: there are said to be founders of PE firms in China who receive two thirds of the overall economics themselves, despite having raised multiple funds.

Anatomy of carry

In most cases, carried interest is allocated based on seniority and performance. Broad guidelines on the first portion are agreed prior to fundraising while the second portion sits in an unallocated pool - because it is impossible to tell at the outset how the portfolio will perform.

However, the balance between the allocated and unallocated portions of carried interest, and the decision process behind the distribution of the latter, can be sources of disharmony. There have been situations in which executives have departed private equity firms amid murmurs of poor treatment by greedy senior partners. It is often unclear where the truth lies. Did a particular individual fall foul of an opaque system under which they were denied their deserved share of the spoils, or did their performance not warrant a meaningful share of the unallocated pool?

This is not a challenge unique to Asia. In a paper published earlier this year, Victoria Ivashina and Josh Lerner of Harvard University revealed the results of an analysis of 700 funds from 2000-2015, most of them North America-focused. They found that the allocation of fund economics is typically weighted towards founders, with individual past performance having little impact on these allocations; the more unequal the distribution of economics, the less stable the partnership; and the departure of senior partners inhibits a firm's ability to raise additional funds.

One China-focused VC firm took the opportunity to alter its compensation structure several years ago following some turnover in the senior ranks. "Carried interest used to be allocated by seniority. I don't like that, and it's a problem for the industry as a whole," says one executive with the firm. "I told the senior partners, junior partners and some of the vice presidents that it had to be a meritocracy. Seniority carries some weight, but you are only as good as your track record."

The carried interest split is now 60% allocated and 40% unallocated. Everyone, from partners to vice presidents, has a profit and loss account that is tied to the portion of the portfolio for which they are responsible. Qualification for the unallocated pool rests on generating 2x or above on investments and then the proceeds are distributed in line with the dollar returns; anything below that is considered underperformance. Approximately 10% of the pool is allocated on a discretionary basis when the lead partner on a deal wants to recognize a certain individual's contribution.

The idea, the executive adds, is to "minimize ambiguity."This was one of two contributing factors when Navis Capital Partners revised its approach to the distribution of carried interest for its seventh fund, which closed in late 2014. The other was rewarding outperformance. "I wanted a bigger stretch between really successful partners and less successful partners," says Nick Bloy, the firm's co-founder and managing partner. "Our older way of doing things wasn't creating enough differentiation."

Carried interest has always gone to every member of the Navis team, including support staff, and this remains the case. However, for investment professionals, the carried interest pool was divided into two equal parts for Fund VII: the existing arrangement, whereby a portion is allocated based on seniority and speed of advancement, plus a new unallocated performance portion. There are set formulae for calculating an individual's share of each pool. Only those whose deals increase Navis' average return get to share in the performance pool, which is sub-divided into IRR and investment multiple categories.

Not all GPs primarily rely on agreed formulas for allocating carried interest. Australia-based Pacific Equity Partners (PEP) uses a model based on demonstrated performance through the life of the fund. The specific amount for each individual is decided through peer review over the life of the fund. This is seen as the best fit for an internal culture in which the dominant identity is the firm, not the individual.

Tim Sims, one of PEP's founders, identifies three elements that underpin this approach. First, the firm operates through an apprenticeship model. It hires experienced graduates from consulting firms and investment banks, exposes them early on to the full workings of the investment process, and expects them to master those skills as they move through the organization. Second, there is a general recognition of the different skills and talents of individuals as they contribute to the deal process and how those can be put to use in combination. Third, the mechanics of the investment process is so ingrained that the people involved are interchangeable.

PEP has 25 investment professionals and about 10 managing directors, including four founders. Within the managing director group is an upper echelon that safeguards the company culture; admittance is limited to those who have been around long enough to show they fully buy into the culture and want to sustain it.

"Succession planning must be deliberate and gradual, and it must continually re-evaluate the people combinations that are emerging. It is too simple to take two people who work well together and assume that when you remove a generation of the firm the chemistry will still be there," says Sims. "You need to ensure that the culture of the firm is not subsumed by some personality culture-based style, which is easy to do, given the stakes are so high. If that happens then you will struggle as ambitious people look out for their own interests because the firm doesn't."

More than money

In this sense, succession planning is about more than just retaining talent through the equitable distribution of carried interest from funds. In the most recent edition of its Asia Pacific PE compensation survey, Heidrick & Struggles found that most respondents at partner and principal level thought their firms were effective in communicating compensation policies. As to whether succession plans were in place for senior leaders in Asia, the majority of respondents either didn't know or said they did not.

Michael De Cicco, a partner with Heidrick & Struggles, describes succession planning as "a time bomb, the biggest problem facing PE firms that they aren't talking about." With this in mind, he expected a positive correlation between a lack of transparency regarding compensation and uncertainty over succession planning - i.e. dissatisfaction with payment, or a lack of clarity on payment policies, is seen as symptomatic of a failure to ensure the next generation of leadership is in place and motivated to stay.

One explanation for the lack of correlation is that material steps to give this next generation an ownership interest in the firm and a say in its operations is just as important a component of succession planning as compensation. This is also where transitions are mostly likely to go wrong.

"Even if economics are evenly distributed, there is the question of power. At what point does the founder cede control of the firm's management, its future, hiring and so on, to other partners? When we see succession go wrong it is often because a founder just couldn't decide on when to step back," says Adams Street's French. "A bit of that could be characterized as ego. Someone who has founded a firm might want to spend time on a winery or collecting art, but it is a tension point."

Perhaps the most significant indicator of a transfer of power taking place is change in ownership of the management company - an area where Ivashina and Lerner found greater inequality between senior and junior ranks than for carried interest. There are various methods of redressing the balance. Several of the PE firms have gone public, allowing founders to sell down their stakes and providing a mechanism for equity to be awarded to others. Selling a stake in the management company is another option.

The most common route is revolving equity, whereby a departing founder or partner sells their interest management company and is paid out over an agreed period of time through ongoing - but incrementally reduced - participation in the economics of subsequent funds. The next generation of leaders then buy into the management company, typically at some kind of discount, financing the purchase by borrowing from the firm against future compensation streams.

The alignment of interests is intended to deliver a smooth transition, but problems arise when the dynamic between the older and younger generations fractures. At the heart of these tensions are differences over the speed at which the handover of power should happen and how much, if any, of the management company should stay in passive hands. Central to this is the value contributed by the founder ahead of and during the transition period.

A classic case - a version of it is currently being played out in an Asian firm - involves a founder who has moved into a fundraising and investor relations role, leaving the director-level executives to look after the investment program. The founder wants to retain control of the GP on the grounds that he is indispensable to the fundraising process, but the directors oppose this, saying they are creating most of the value.

No two situations are alike. There are private equity firms in Asia where fundraising and investment duties are split between founders and directors and harmony remains. Similarly, while in certain scenarios a senior executive who is reluctant to retire is moved into a chairman-style role that facilitates a graceful exit, it is wrong to characterize all founders as resistant to change.

For example, Thomas Kubr, executive chairman of Capital Dynamics, is uncomfortable with younger professionals pushing too aggressively for ownership. "Just because they can do a few good deals, it does not mean they understand what it takes to build a firm. I love people who spin out - they are putting everything on the line - but I don't like younger guys gunning for ownership of an existing firm without having made any sacrifices," Kubr says. At the same time, he is sad to see firms die as a result of founders hanging on too long because it destroys a lot of brand value.

The only real solution is careful preparation, which is why LPs are increasingly raising the issue with portfolio GPs in Asia, even though founders may have years left in them. One obvious step that can be taken is to ensure a reasonable spread of ages within the upper tiers. Qiming has a 20-year spread across its five managing partners; while Rieschel is 60 and Kuang is in his 50s, the other three are early to mid-40s.

This is of particular importance in venture, given the role played by younger team members in tracking technology trends and working with entrepreneurs that are close to them in age, but PE firms are not immune to demographics. Navis' Bloy notes that neither he nor co-founder Rodney Muse is close to considering even a part-time role, and they are younger than two of the four-strong senior partner team.

"In five years or so, we need to identify the next generation of managing partners, probably three in number, and start streaming more equity to them," he says. "A future managing partner is not necessarily a current senior partner. I don't think it is in anyone's interests to have a managing partner serve in that role for a couple of years and then retire. It's a significant transition of a long-term responsibility - we are making a 10-year or more commitment to our LPs."

Cult of personality

The challenge for most private equity firms in the region is to get past whatever cult of personality may exist around the founders. Several of the larger indigenous Asian GPs - such as Affinity Equity Partners, Baring Private Equity Asia and PAG Asia Capital - are most immediately recognizable to many within the industry by the people that lead them rather than the firms themselves. The question remains whether these businesses would survive if one of the founders was hit by a proverbial bus.

None of these GPs has any problem fundraising, which suggests LPs are comfortable with the answer, or perhaps neglecting to ask the question at all because they want a piece of a popular fund. Yar-Ping Soo, partner and head of the Asia investment team at Adams Street Partners, puts herself in the former category. "Part of our job is to ask about the economic split and talk to all the team members, and not everything is what it might seem from the outside," she says. "A dominant character can still be generous, not just in terms of carry but also in terms of power."

Indeed, a prevalent theme of Asian private equity in recent years has been institutionalization. On one hand, regulatory compliance and LP reporting requirements have obliged GPs to pour more resources into back office operations; on the other, the sheer amount of capital raised - in some cases across multiple strategies - has created organizations that are more consistent and substantial. Most of these firms can point to their recruitment efforts and systems upgrades and claim to be robust.

Asked what would happen to the firm in his absence, one senior executive with a regional fund responds: "The partners would meet among themselves and elect a new leader but I can tell you right now how that vote would go. It would be a five-minute discussion."

Such bold statements may apply to some of the larger firms, but it remains to be seen whether their smaller counterparts can manage transitions without an exodus of talent or a drop in returns. Various industry participants believe this will happen, as Asia follows a similar evolutionary curve to North America and Europe. Doug Coulter, a partner with LGT Capital Partners, questions how much longer we have to wait.

"There was an idea that as the industry matured and more firms entered carry mode, there would be less movement as people saw the opportunity to stick around and get rich. But it hasn't really happened," he says. "Private equity is the ultimate people business - no matter how strong your databases, nothing can replace the knowledge of your investment professionals. And these people are still walking out the door."

SIDEBAR: Spin-outs - No succession

Such is the longevity of the senior team at IDG Capital Partners they are known in some industry circles as "the immortals." A byproduct of this stability at the top is executives further down the roster getting itchy feet - there have been at least two spin-outs from IDG.

"There are probably more spin-out GPs per head in Asian private equity than anywhere else in the world," says James Ford, a partner at O'Melveny & Myers. "It is not much different to the founder mentality of Asian, and particularly Chinese, corporates. People just hang on. If you don't like it, go start your own business."

The explosion of interest in China's tech sector has helped the likes of Banyan raise capital from an LP community that can be highly skeptical of first-time funds. But Asia has a track record of spin-outs that stretches back to the early 2000s when a spate of captive PE units within banks went independent. Since then, there have been phases of spin-out activity in markets such as India and China, often involving the country teams of larger platforms.

"You might find a team within a pan-Asian platform and there is only a limited allocation to the market they are investing in and they might want to go off on their own and raise a bigger pool of capital to pursue the deals they are seeing in that market," says Albert Cho, a partner at Weil. "Economics may be part of it but uniformly it is the desire to make their own mark on the market."

The succession planning burden falls back on the firm these executives are leaving as LPs question whether there is sufficient replacement talent. This weighed on TPG Capital's last fundraise - Weijian Shan went to PAG Asia Capital and Mary Ma relocated to Boyu Capital - and turnover is likely to have an impact on the next cycle of pan-regional fundraising. KKR, for example, must show it can fill the void left by David Liu and Julian Wolhardt, its most senior China dealmakers, who plan to start their own firm.

Global firms can point to their institutionalized systems and processes, but this is not of comfort to everyone. "It is a problem when the GP thinks the brand speaks for itself thus placing more emphasis on the organization, not the underlying investment professionals," says Jonathan English, managing director at Portfolio Advisors. "I think you should be very keyed in on these issues and do the work required to make an informed decision on what impact these moves might have on the organization overall."

SIDEBAR: Passives - Selling a stake in the GP

When Navis Capital Partners was founded in 1998, a European family office called HAL accounted for a large part of the first fund and took a stake in the management company as well. About three years ago, HAL decided it wanted to sell, resulting in a buyback that is still in the process of being completed.

Nick Bloy and Rodney Muse, the co-founders of Navis, led the acquisition of shares from HAL and Rick Foyston, another co-founder who scaled back his involvement in the business in 2007. A portion of that equity is now being sold on to other investment professionals at partner and senior partner level. "We set a low valuation multiple and we said no one had to write a check: they pay for it over time as a formulaic deduction from the annual bonus, from dividends, and from carried interest," says Bloy.

While a passive investor's decision to sell its stake in the GP has facilitated a transition in ownership at Navis, it is more common for this element of succession planning to be initiated by a third party buying into a PE firm. The valuations paid serve as guidance when founders allocate equity in the management company to up-and-coming investment professionals.

"If I tell you I will give you 50 basis points of the management company you might think I am kidding - what you really want is 50 more points of carry," says Juan Delgado-Moreira, a managing director at Hamilton Lane. "But after another investor comes in and buys a stake at a certain valuation, that 50 basis points of the management company is now really worth something."

For Affiliated Managers Group (AMG) and Dyal Capital Partners, participation in these deals has become the basis of a business model. AMG has taken minority stakes in over 30 public and private managers since 1994 and has more than $700 million in assets under management. Earlier this year the firm acquired a 15% stake in Baring Private Equity Asia. The proceeds were earmarked for future GP commitments to Baring funds, improving financial flexibility, and succession planning.

"Creating shareholder value at the firm level, which is something that has already been done by several of our global competitors who have raised capital from the public markets directly or sold stakes to private investors, is a strategic tool for further motivating and aligning employees and will help to cement the partnership structure we have in place," Baring said in a memo to LPs.

The rationale for these investments is to tap into the affiliate managers' fee streams, which means that feasible targets must be of reasonable scale. AMG also has to be confident in the succession planning it is facilitating: if it is contributing to a transfer of power within a PE firm, it must have conviction in the ability of the next generation to deliver consistently high returns.

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• Topics
• GPs
• LPs
• Fundraising
• Performance
• Asia
• Navis Management
• Qiming Venture Partners
• Pacific Equity Partners
• Adams Street Partners
• LGT Capital Partners
• Portfolio Advisors
• Affinity Equity Partners
• Baring Private Equity Asia