Succession planning is a hot-button issue for firms of all sizes, but it is especially tricky for midmarket general partners. Over the past five years, the middle market has grown exponentially and matured quickly. But as the first generation of middle-market private equity leaders nears retirement, many firms are struggling with how to move forward, even when faced with increasing pressure from their limited partners.
“The reality is we’re getting to that point when many investors expect to see a potential No. 2 at the table, but a lot of these firms haven’t had the conversation yet,” says Kenna Baudin, who leads the U.S. private equity practice at executive consulting firm Egon Zehnder. “Investors will typically start pushing GPs around fundraising time because they want to ensure that there will be an orderly transition in place if anything happens. It can be a red flag if GPs don’t have an answer for them.”
Despite the threat of leaving investment dollars on the table, it’s hard for GPs to start thinking about the future. Many midmarket firms operate with lean teams, and adding staff may not always be feasible in the short term. The common model used at large private equity firms of transitioning from a single CEO to sharing the role with an heir apparent can be difficult if junior employees have overlapping responsibilities.
There are other thorny issues as well. Firm founders are unlikely to consider dividing up deal economics, including a share of the carried interest, with a larger group of people without some prodding or unexpected staff turnover.
“The point where this can get messy is if you have junior partners that are starting to do the math and they don’t see a pathway forward, you might start to see people leave,” Baudin says. “People need to feel fully vested.”
“Our preference is that GPs don’t start raising larger funds because that brings up a separate set of issues, including whether the return profile will be the same as it has been in the past.”
Investment Director, Aberdeen Standard Investments
Whit Matthews, senior investment director for private equity at Aberdeen Standard Investments, a global asset manager, notes that firm culture often can determine how succession planning moves forward—or doesn’t. “Obviously as investors, this is an issue we are always thinking about. We want to be comfortable with leadership over the long term,” he says. “If a GP is unwilling to engage in the discussion with us, it’s certainly a data point.”
For GPs that are willing to engage in the conversation, Matthews adds, culture is key. When evaluating a GP, he looks at the pedigree of the management team, total headcount, and overall discipline and transparency. “Firms often solve for succession plans in one of two ways,” he says. “They’ll share the economics throughout the team, or they will start raising larger funds. Our preference is that GPs don’t start raising larger funds because that brings up a separate set of issues, including whether the return profile will be the same as it has been in the past.”
On the transparency side, Matthews says he wants to be able to piece together a track record for everyone on the deal team. Even if someone isn’t leading the deal, he doesn’t want to be scrambling for information later if someone begins to take on a larger role. “Each firm is going to handle deal attribution in different ways, but we want to be able to generally figure out who did what. So there has to be a level of transparency within a process to allow you to make those assessments,” he adds.
The team at Cleveland-based private equity firm Blue Point Capital is an example of what can go right when a prudent succession strategy is in place. Blue Point, which invests in lower middle-market companies in the United States and China, exercised its succession plan by the time it reached its third fund. “For us, the transition really happened pretty organically,” says Chip Chaikin, a partner at the firm. “The junior partners did most of the heavy lifting in terms of deal execution on our second fund, took over a majority of the management company in fund three, and by fund four the transition was entirely complete.”
According to Chaikin, Blue Point was able to work through its succession plan by communicating transparently and sharing responsibility early on. “The founding team really started from a place where they didn’t have to have control over everything, so people were able to step in and take responsibility and prove that they could do it,” he explains. As a result, LPs were as familiar with the junior team as they were with leadership, which made the transition that much easier.
Chaikin, who became a partner in 1999, adds that Blue Point has preserved its team-oriented culture as the firm builds its third generation of leaders. “We’re still young enough that the current leadership will probably stay in place for a while, but we are always looking forward,” he says. “The key for us has been making sure that people understand that there is a pathway forward at the firm. It’s not always an easy conversation. Sometimes people think they are ready before they really are. But we are always honest and transparent.”
For Chaikin, managing Blue Point isn’t so different from working with portfolio companies when it comes to identifying future leaders. It’s important to evaluate how individuals manage a broad scope of activities when assessing how they create value, he says. What are they doing in addition to working on deals? How is the team dynamic? Who is willing to step in?
“One of the things about being at the smaller end of the middle market, where we are, is that you’re really partnering with entrepreneurs on a personal level—not just an economic one. The same is true for the people you work with internally each day. I think if you’re coming to this business with a focus on being a good partner to your companies, you’ll also be a good partner to the people you work with,” Chaikin says. “Not every firm operates like that, but it has worked for us.”
Playing the Long Game
Thinking holistically about a succession plan is key not only for an orderly transition of leadership but also for ensuring that deal flow and operations continue without interruption.
Kate Price, a partner in the corporate practice of law firm Winston & Strawn, notes that when she works with firms on succession planning questions, she often points out that partners should also take a look at roles like business development and origination. “There are a lot of factors to consider in developing a succession plan. Thinking holistically about the firm is important. If you have made a plan only for your senior partners and then end up with a departure of several junior investment professionals, that can be very problematic,” she explains. “Succession planning isn’t only about retirement planning. It’s also about developing and retaining talent to build a strong firm into the future.”
“Succession planning isn’t only about retirement planning. Its also about developing and retaining talent to build a strong firm into the future.”
Partner, Winston & Strawn
Price adds that the earlier GPs start thinking about a succession plan, the better. “Even if you don’t have individuals identified and prepared to step into the shoes of a founder, the earlier you think about it, the better off you’ll be when that day comes. It’s a much more difficult path to put off making a plan and then have to negotiate the details, or even hire new team members, on an accelerated timeline.”
Jody Thelander, founder and CEO of compensation consulting firm J. Thelander Consulting, agrees. She says she’s having more conversations about succession plans than ever before, but GPs should understand that if they are looking externally to find a No. 2 or to fill out the C-suite, the field is competitive. “People are interviewing for these positions. But finding top talent is difficult and working with that person after they are hired in order to give them the specific institutional knowledge they need can be a heavy lift.”
Human nature tends to dictate that we don’t make changes until we have to. But the evidence suggests that when it comes to succession planning, GPs need to be proactive.
Many middle-market firms were established by founders who left large leveraged buyout firms because there wasn’t an opportunity to take on a leadership role. Today, many junior partners in the middle market may feel the same way.
As the middle market continues to mature, founders will have to get comfortable with sharing a piece of their compensation and avoid the temptation to raise increasingly large funds to offset the cost of building a team. By bringing junior partners into the fold early and focusing on building an internal culture where individuals feel empowered to take on responsibility, midmarket GPs can ensure that their businesses survive from fund one to fund 10 and beyond.
This story originally appeared in the July/August 2018 print edition of Middle Market Growth magazine. Read the full issue in the archive.
Bailey McCann is a business writer and author in New York.