PE succession planning: Continuity issues

WL Ross, one of the world's preeminent turnaround firms, is having trouble with its latest fundraise. Last month, the firm announced that it would cut its $4 billion target by as much as half, having attracted little more than one-tenth of its intended corpus. A bleak fundraising environment was cited as one cause for this shift, but there is another key concern among LPs: The future of 73-year-old Wilbur Ross, Jr., himself.

Ross, the firm's founder and leading light, has yet to satisfy investors on what will happen once he retires, an event that is likely a fall within the lifetime of this latest vehicle.

Given the relative youth of Asia's private equity industry and its fund managers, few firms in the region field questions about succession planning. But Asia is still volatile. A string of high-profile cases in 2011 - in which key executives have departed for reasons related to retirement, spin outs, fall outs and, in some cases, death - has got fund managers thinking. The onus is on each GPs to show LPs that their firm's strength transcends the credibility, celebrity or track record of a single individual.

"Succession planning is really an issue of team building, and it's our view that some investors aren't paying enough attention to team dynamics, institution building and making sure you have a deep bench," says Doug Coulter, Head of Asia at LGT Capital Partners. "Building a sustainable private equity institution isn't easy - it isn't easy in the West and it's not easy in China or India either."

Getting it right

The need for solid succession protocols was underlined by Gongquan Wang's dramatic exit from CDH Venture Partners earlier this year. Wang, a founding partner of CDH Investments' early-state arm, went AWOL in May, brazenly announcing to the world via Chinese microblogging site Sina Weibo that he would be "giving up everything" to elope with his mistress. He reaffirmed his sentiments with an online music video in which he performed an apparently self-penned song called "Ode to Elopement."

The private equity community was stupefied that Wang was apparently forfeiting responsibility for the two funds, with assets in excess of $900 million, that he helped set up.

In the critical hours after the announcement, CDH Venture drafted a response to the situation, saying that Wang "is taking some time off and that both the venture and private equity fund were operating normally." It also contacted the LPs to explain that existing managers would continuing to head up operations, and made the appropriate reassurances that all investments were being handled. This came despite another public blast by Wang averring that he would not turn on his mobile phone and didn't "care if my reputation is ruined."

CDH's response seemed to suffice. "We didn't particularly panic," says one LP that is invested in CDH Venture Capital. "Yes, he's a very important guy to the franchise, but we're ultimately continuing to back this fund because we felt that the franchise is more important than the person."

To the extent to which a firm is able to anticipate the departure of key personnel it can employ strategies that facilitate a smooth transition into the next regime. The overriding priority is to address issues speedily and ensure that investors aren't left in the dark.

One high-profile example of a firm that got it right is ChrysCapital, which announced earlier this year that its founder, Ashish Dhawan, would leave private equity to help address social issues in India. Dhawan is said to have raised the issue with his team a good 24 months before his planned departure in July 2012, and released a well-crafted message to investors six months later. He told LPs that ChryCapital would undergo a management transition and be led by six experienced managing directors: Ashley Menezes, Gulpreet Kohli, Kunal Shroff, Ravi Bahl, Sanjay Kukreja and Sanjiv Kaul. Dhawan further vowed to remain at the head during this transition process.

His candor not only impressed LPs, but also helped to ensure the ongoing success of ChrysCapital as the firm raises its sixth fund. As it stands, all but one managing director - Brahmal Vasudevan, who joined in 2000 - remain at the firm, exhibiting a cohesion that transcends the CEO.

"Ashish was able to do this because he has a good team below him. This isn't the sort of move you can pull if you're not confident about the staff below you," says one source close to ChrysCapital. "Each of the executives who are jointly taking over Ashish's roles has been with the firm nine, 10 or 11 years; they're all part of the founding team and they're all managing directors. LPs know them because they've been visible in the investment process for years."

HarbourVest, upon announcing that founding Managing Director Philip Bilden would step back into a senior advisor role in 2012, was quick to assure investors that he would continue to play an active role with general partners, investors and LP advisory boards. The firm also clarified that Bilden's day-to-day duties will be assumed by Sebastiaan van den Berg, who was promoted to managing director after six years at the firm. Two additional managing directors and a vice president were relocated from Boston and London to ensure that HarbourVest maintained a deep bench during the transition process.

"I think that the HarbourVest case was handled extremely well," says one Hong Kong-based private equity lawyer. "It's obvious that they had a successor in place who is homegrown from within the firm, and the transition was taking place as they were going from one fund to the next fund - there was no abruptness."

Not every firm has the luxury of time. In August, Ved Prakash Arya, managing director and CEO of Milestone Capital Advisors, was tragically killed in a freak accident. Although the company has $1 billion in assets under management, it has only be in existence four years. Arya is credited with its inception and in forging partnerships with IL&FS Investment Management and Religare Venture Capital, as well as launching independent funds.

Milestone's board of directors drafted a response to the incident within days, saying that they would meet and decide on the company's future. Official information has since been minimal, but reports emerged in October that Milestone is considering a merger or buyout. Global private equity firms, corporations seeking entry to the PE business, real estate developers and other asset management were touted as potential buyers.

"A lot of these firms have a dominant individual leading the team, but no fund can bet on any one key individual, and the unfortunate thing is that there are some firms that can't continue if they lose this key person," Coulter says.

Key man on campus

In these situations, there may be little legal recourse for LPs to get their capital back.

"In terms of legalities, you'd be surprised how little is written down in terms of succession procedures," the private equity lawyer says. "It's usually up to investors to conduct their own proper due diligence to trouble-shoot. It's certainly welcome when general partners go over their procedures with limited partners, but they're not legally bound to do so."

The one refuge that LPs generally have is the key man clause - a provision that prohibits a fund manager from continuing its investments if a designated number of personnel critical to the management team depart. For example, if three high-profile investors launch their own private equity fund, and it is decided that the key man clause will come into effect should any two depart the venture, the third is barred from continuing investments until acceptable replacements are appointed.

According to Kenneth Muller, San Francisco-based co-chair of the private equity fund group for Morrison & Foerster, in negotiating these provisions, LPs may ask about the incentives to ensure the team remains focused over the long term, and the presence of a new generation able to take over management of the fund once the incumbents depart. These incentives focus on vesting, which involves the protracted issuance of stock grants and options that incentivize key members to remain at the fund.

"LPs may want some clarification as to the type of vesting provisions utilized and how they work in the event that a member retires or leaves the firm for a competitor," Muller tells AVCJ. "LPs often state that vesting should extend over a 4-5 year period so that there are fewer incentives for a manager to move from one firm to another or retire before most of the work is completed."

Sources point out that there are a handful of scenarios in which the key man clause can be called to order. The first is dubbed the "big man fund," in which a fund is synonymous with a single key executive, generally the person who launched the vehicle. Lawyers say that, in this case, if the person is lost, enacting the key person clause is unavoidable. Primavera's Fred Hu and RRJ Capital's Richard Ong would likely fall into this category.

A key person could also transcend a fund's top executive. If, for example, the managers who are second, third, fourth or fifth on the bench are deemed critical to certain investments, the clause can be extended to cover their departures. LPs might feasibly make such demands of WestBridge Public Fund, which was set up by K.P. Balaraj, Sumir Chadha, S.K. Jain and Sandeep Singhal earlier this year on departing Sequoia India.

The most common interpretation involves an agreed combination of top managers being collectively dubbed as the key person. "From a lawyer's perspective, it's very scary for just one person to be named the key person because accidents, and deaths, do happen," the lawyer says.

Yet, for many funds in Asia Pacific that launch as a result of spin-offs led by a single person, this is the reality. One prime example is New Horizon Capital, which was set up by Winston Wen Yunsong, son of Chinese Premier Wen Jiabao, among others. The firm's third fund closed at $750 million in March 2010, well above its initial target and more than seven times the sum raised for its first vehicle. LPs included Temasek Holdings, SBI Holdings and the California Public Employee Retirement System, according to AVCJ Research.

However, months later, New Horizon confirmed - in disclosures tied to its withdrawal from a pre-IPO investment in Hong Kong - that Wen left the company a year earlier to work for a Chinese state-owned enterprise. Sources say there was no key man clause for Wen, but New Horizon hasn't gotten off easily.

"Even a lot of LPs didn't know if Winston Wen was still at the fund - there was a complete lack of communication," one fund of funds manager says. He suggests that the New Horizon will have difficulty raising funds for years to come due to this transgression of trust.

Cultivating youth

Private equity firms engage in succession planning differently depending on where they are in the lifecycle of a fund. In the early stages, for example, entrepreneurial founding partners may be required to identify and cultivate investments, while in the mid-to-late stages, the ideal leaders might be individuals who take more calculated risks and pay more attention to long-term strategy.

In this context, Jason Chan, M&A consultant at Mercer, says that firms are becoming increasingly active in the early stages of a fund, around the time when LPs are conducting due diligence or are engaged in pre-deal signing.

"Emphasis during the due diligence phase, together with the target company, will focus on understanding the current incumbent's experience, behavior and skill set based on the business requirements going forward," he says. "Following the acquisition and into the managing of the investment, PE firms focus efforts on attracting, retaining and developing top talent at all levels."

This includes identifying high-potential employees and next generation leaders, and paying more attention to career development, performance management and cultural fit.

Muller notes that, if a firm is serious about succession planning, it must spend time marketing the accomplishments of the younger generation of managing directors to LPs. The goal is to make the investor base comfortable with these professionals and confident in their ability to take over decisionmaking for a private equity franchise.

This marketing process involves allowing younger managing directors to present at annual LP meetings, encouraging senior directors to acknowledge the accomplishments of younger staff in written marketing materials, and demonstrating to LPs the ways in which participation by younger personnel in the decisionmaking process is mutually beneficial to all parties concerned. This further means that younger managing directors will be more likely to be named as "key manager" in key person clauses.

There is a danger in this, however. One private equity lawyer says that addressing the issue of succession at a premature age would cause undue concern. "If you're at Fund I and you're already talking about a succession plan, it would send the wrong message and it would be a waste of your time and energy," the lawyer says.

A better approach to mitigating unforeseen succession problems is to be continuously mindful of team stability. An obvious starting point for LPs carrying out due diligence in this area is the distribution of carry. If one key executive is in line to walk away with the majority of a fund's carry, this leaves little to be shared among the remaining, more junior, members of the team. For many funds with a definitive key person, these personality managers may even be allocated a portion of carry after they relinquish their daily duties. If there isn't enough cash to incentivize staff, movements will happen.

This is important because encouraging talent within a firm to replace a departing executive is significantly preferred to recruiting from the outside, sources say. Not only does it confirm that team dynamics are intact, but it is also an indication of confidence in the talent and culture of a fund.

"When these things happen, you really have to promote everyone from within - it's all team sensitive and you'll definitely drive the younger guys away if they think that they can spend 10 years at a firm and still not get promoted," one GP confirms. "The biggest issue is that you've got to be fair and make everyone feel like they're contributing to something greater in a fund that will last."

SIDEBAR: The gray zone

When seeking out fund managers, does age ever come into play?

It is a gray area. Doug Coulter, head of Asia Pacific private equity at LGT Capital Partners, says that investors generally have no reservations about investing in a fund whose leader is aging. The proviso is that there is a clear understanding of a fund's processes and the role other professionals will play should that leader decide to retire.

But discussion on the subject isn't always the most candid, which is a cause for concern.

Several of the major global buyout firms have succession issues: The Blackstone Group's Stephen Schwarzmann is 64, KKR's Henry Kravis and George Roberts are both 67, and TPG's David Bonderman is nearly 70. Those that have gone public are, to a certain extent, obliged to address shareholder concerns on the matter queries.

According to KKR's corporate governance guidelines, "The CEO reports annually to the board on executive management succession planning and makes available, on a continuing basis, his recommendation on succession in the event he were disabled." The board and other committees in turn review succession planning to ensure that the appropriate people are in place should one of the top-level incumbents depart.

"It's not so much that they don't have an answer to the question as whether investors will believe the answer given to them," says one global fund-of-funds LP. "I may not be doing them justice, but if I had to give money to a group that is identical but run by 40-50 year-olds.. well, it's a tough question."

In Asia, mangers tend to be younger, but that doesn't mean they are immune to problems. According to one private equity lawyer, fund managers ought to be aware of their surroundings.

"In the context of succession planning, fund mangers should take a step back and decide what appropriate staffing looks like. If you're 55 years old, and everyone else around you is 55 years old, you have a staffing issue," the source says. "If you're 55, and your number two guys are in their late 40s, and your third through sixth are in their 30s, that good staff configuring."

 

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• Topics
• GPs
• People
• HarbourVest Partners
• ChrysCapital Management
• Milestone Capital Partners
• WL Ross & Co.
• CDH Investments Management
• New Horizon Investment Advisors
• Appointments
• GPs