By Benjamin Horney
Law360 (February 9, 2018, 5:25 PM EST) — Leadership transitions at private equity firms are happening with more frequency as founders age toward retirement, but the process of putting together a succession plan that will unfold without a hitch is no easy task and requires counsel that can simultaneously manage delicate egos and navigate tricky legal issues.
The private equity industry has blossomed into a major moneymaker in the decades since it first sprouted, but many of its founding fathers are contemplating how to ride off into the sunset of retirement while also enabling the firms they formed to outlast them. Meanwhile, even those PE founders who aren’t quite ready to call it quits should be thinking about a succession plan, since younger executives will always be chomping at the bit to take over the reigns and build up their equity stakes in order to make more money.
There are a number of legal issues that must be dealt with in order to ensure a smooth succession plan, including determining what the retained interest of the departing founders will be and how the economics will work over time, but the most important aspect is making sure that all involved parties are happy with the outcome, according to Jonathan Bender, a corporate partner at Wilk Auslander.
“Like every other deal, there’s a limited amount of the pie,” Bender told Law360. “You’ve got the old guard that built the firm; they feel like they built it and they own it. But you need the next generation, and they want a bigger piece of the pie. Somehow, you need to be able to incentivize the next generation to come in and continue building up the firm, but you can’t just push out the old people.”
KKR & Co. LP, Apollo Global Management LLC and The Carlyle Group LP are among the big-name private equity shops that have announced succession plans in recent months, but the trend of arranging a plan for when founders decide to hang it up is not confined to just the top-tier PE firms, and not every firm makes public that they have a plan in place.
“It goes down all the way,” Bender said. “It’s happening at all different levels.”
There is a lot of detailed legal work involved in a proper succession plan, and every situation is likely to have a different outcome when it comes to the specifics, meaning even the most intelligent private equity executives would be wise to lean on their lawyers to move the process along and help manage the various egos involved.
Usually, the first topic of discussion is how exactly the current leadership will bow out. In some cases, they leave the firm altogether while retaining certain interests that will provide them with capital gains in retirement. Other times, as younger executives take on roles like CEO or CIO, elder statesmen will start to have less responsibility while being given titles like executive chairman or senior adviser.
“It’s a discussion that takes a very long time to unfold,” said Peter Gilman, a partner with Simpson Thacher & Bartlett LLP. “It really depends on the dynamics of the firm.”
It isn’t a light discussion either, as the decision on who will become the face of a firm once its founder has exited stage right can be the difference between continued success and complete failure. The rest of the firm must be on board with who is taking over, but they aren’t the only ones that must be considered. Limited partners, also known as the investors who contribute capital to private equity funds, are also important players, because they retain the right to stop investing with a particular firm if they no longer believe in the people leading it.
“What’s happened these days is that the industry has clearly focused on the fact that people are the most important part of a private equity firm,” said Peter Martenson, a partner at placement agent Eaton Partners. “It used to be that people thought if you had a nifty strategy, it didn’t matter who was turning the crank.”
Even if a client is fairly certain that everyone will be OK with the new leadership that has been chosen, timing is still of the essence. Announcing a succession plan right before your client is looking to raise a new fund, for instance, could scare away investors, Gilman said.
“The last thing you want to do right before raising a new huge fund is putting news into the market that investors are going to need to digest,” he said. “Usually, the opportune time to do it is when you’re not fundraising and are not on the eve of fundraising.”
Once the people part of the succession plan is set in stone, lawyers will be called upon to dig through fund documents old and new in order to determine exactly what other steps need to be taken. While there can be a multitude of potential matters to handle, they all really boil down to making sure that everyone gets an appropriate chunk of dough.
“The big one is always cash,” said Michael Fieweger, chairman of Baker McKenzie’s global private equity practice. “Because the founders tend to have large stakes in these enterprises, the new generation needs to figure out a way to fund redemptions of interest from departing folks.”
That can be done in a number of ways. For larger firms, listing shares is an option that can provide publicly traded currency in the form of stocks that can be used to help transition ownership to the new generation, Fieweger said. In other cases, a portion of the firm might be sold to an institutional investor, rather than on the stock market, in order to provide sufficient cash to buy out the senior executives who are retiring.
Another option is to come to terms on an agreement under which ownership, as well as the interest and carry from funds that go along with it, will be shifted to younger leadership over time.
“That always comes with a bit of negotiation around how that control is actually going to change hands,” Fieweger said. “These are not, by nature, people who give up control.”
When it comes to fund documents, key man provisions are one of the important matters that must be examined. A key man provision is a stipulation prohibiting a private equity firm from making certain investments if one or more named key people fail to devote a set amount of time to their job. Those named in key man provisions typically include the top executives at a firm. In some instances, depending on the terms of a fund agreement, previous key man provisions will have to be tweaked to reflect the leadership change.
“You don’t want to inadvertently trip a key man provision,” Fieweger said.
All of the details that come with a given succession plan should be well-documented, with lawyers typically writing up a multipage contract containing all the specifics of how the plan will work. And it doesn’t hurt to separately put together a one-page summary featuring the most important aspects of the plan that can be shared internally throughout the firm, as well as with limited partners and management at portfolio companies, Martenson said.
“We certainly encourage everyone to have that clearly laid out for people,” he said. “It’s helpful to external investors and it’s certainly helpful internally. Internally, people don’t always have the best perspective. There can be some cynicism as to what their future is.”
–Editing by Aaron Pelc.Back to News