The succession dilemma: getting buy-in

Successful GPs wishing to leave a legacy need to make it easier for junior partners to buy equity in a firm, writes Jonathan Harvey of Investec Fund Finance.

Investec’s most recent GP Trends Survey released at the beginning of the year quantified the scale of the succession issue facing the industry. While a clear majority of respondents (68 percent) agreed that clear succession planning was critically important, a little more than a quarter admitted that their firms’ current plans for generational change were inadequate.

It is no surprise that, due to the distinct lack of forward planning, the LP community has concerns about funds’ ability to withstand the departure of key managers. The uncertainty at Italian GP Clessidra following the death of its founder and chief executive Claudio Sposito is one recent example of key man risk.

In our survey, only 41 percent of GPs were able to say that their LPs were happy with their firms’ plans for succession. The majority of the rest of respondents (53 percent) were unsure what their LPs thought about their plans, indicating a lack of communication between GPs and LPs on the issue.

The rise of the star manager, someone who has made it through multiple successful fund raising cycles, has given rise to an unintended consequence: extremely high equity valuations for successful management partnerships.

For many management firms, this will be a point of pride but for anyone intending to leave a legacy behind, these valuations can be extremely problematic. A high equity valuation is a prohibitive barrier for junior partners looking to buy-in to a manger and take the firm forward after the exit of the founding partners.

The valuations issue has two key strands to it. First, how do you value the private equity firm itself? Unlike a listed or manufacturing company, for example, coming to an agreement on an accurate figure is difficult as the valuation concerns people and not assets, particularly those people’s ability to generate a return for LP’s. For obvious reasons, this involves a number of intangibles.

There doesn’t seem to be one industry wide consensus on how to effectively value a private equity house. Both EBITDA multiple and discounted cash flow valuations present a number of limitations. The lack of diversity of revenue streams stemming from the typical lack of asset class diversification means that a deep knowledge of the private equity sector is essential.

The second issue, once an accurate valuation has been calculated, is how to make a firm more accessible to younger partners wishing to buy equity. Private equity companies can become a victim of their own success in this regard: as their pedigree grows so does the valuation, making it increasingly difficult for the younger generation to get on board. Having a manager worth £100 million ($145 million; €130 million) is simply inefficient, as it represents an astronomical buy-in cost.

The solution, which has been used to help a number of companies with this issue, is for firms to regularly recapitalise with debt, usually every three to five years or at the same time that they add a new fund, thereby keeping the equity value of that fund down. That hypothetical £100 million manager, whose value now consists of 50 percent debt and 50 percent equity, for example, could then bring the buy-in cost down to a far more manageable level, in this case from £10 million to £5 million for a 10 percent share.

This option can be extremely helpful for managers looking to extend the life span of a firm and leave a legacy. However, it is essential that the process is undertaken with complete transparency when it comes to LPs. As identified earlier, LPs may not be engaged with or aware of GPs’ succession plans, and as a result it is important to establish an open line of communication when these decisions are made. If this strategy is employed as a means to support succession planning and talent retention, then LPs should be supportive as long as the entire process is transparent. Hopefully, a few years from now, funds will have a better understanding of their LPs’ positions on their succession plans.

While succession planning has not been front and centre in the minds of GPs, it is something everyone must consider. Do you want your firm to fade with your retirement or do you want to leave a legacy behind? If the latter is the case, and you have experienced some success in the private equity industry, then it is essential to reduce the firm’s equity value to attract and retain younger talent. Recapitalising with suitably structured debt is the way to do this.