Synonyms

GP experiences; Leadership transition; LP perspectives; Succession

Definition/Description

Leadership transition in private equity firms manifests very differently from those in well-studied public companies. Leaders, especially founders, stay for unusually long tenures. Decisions of when to make a change and the identity of the replacement are determined internally with little governance or external influence, either from boards or providers of capital. Processes are bespoke to each firm and generally extend over multi-years as consensus is sought among the senior team of the right leadership for the next period given external replacements are extremely rare. Apportionment of the large economic spoils plays a large part, often leading to friction and departures. This entry studies the history of such transitions through a combination of empirical, large data analysis and interviews with limited partners (LPs) and already departed leaders of general partners (GPs) reflecting back on their own transition processes. The aim is to shed light on this understudied but important topic and inspire future research.

Introduction and Summary

Leadership transition in private equity firms is an understudied field but will become more frequent with the maturity of the industry. This article summarizes the results of three different approaches: an analysis of 260 firms in an empirical study; qualitative interviews with eleven highly experienced LPs; and qualitative interviews with eight GP founders and leaders who have experienced such transitions first hand and could reflect back, anonymously, on their own processes, choices, and outcomes.

This research shows that private equity transitions manifest very differently from those in better-studied public corporations:

  1. (a)

    Founders and leaders in GPs stay in their positions considerably longer, which can lead both to LP disquiet and turnover in the GP team.

  2. (b)

    They are more likely to move on once they are outperforming.

  3. (c)

    If underperforming, their firms are more likely to see an uplift from a transition.

  4. (d)

    Transitions are idiosyncratic, internally driven processes with little accepted best practice or governance, determined largely by the philosophy of the founder and the context the firm finds itself.

  5. (e)

    These complex, multi-year processes are frequently characterized by some frictions.

  6. (f)

    LPs have observed many sub-optimal processes and would prefer greater transparency.

Many questions still remain. The purpose of this research is to start to shine a light on an understudied subject and to kick-start the debate, thereby stimulating further research with the aim of improving the industry’s awareness of the challenges.

Background

CEO transitions in public markets (especially in the USA) are well researched. However, private equity provides a very different context for leadership transitions for a number of reasons. It is a young industry where CEOs dominantly tend to be founders. There is a low level of governance; the strong role typically played by a board of directors in transitions is almost entirely absent here. Hence, the decision to leave and how, even in the event of underperformance, is largely in the leader’s hands alone. Unlike public companies, where the board, if dissatisfied, will often move quickly to replace a CEO, in PE involuntary exits of a leader are virtually unheard of. Poor performance instead will lead to firm wind-down and ultimate failure through an inability to raise new funds.

The role of capital providers (LPs) is also weak, exacerbated by the reluctance of GPs to be fully transparent. LPs have had little ability to influence individual firm choices because of an inverse balance of power, which keeps them at arms’ length.

The scale of economics and choice about apportionment is especially challenging in private equity, with the founder or leader having a significant but generally illiquid stake in the GP where the terms of selling are often not previously established within the partnership.

Finally, the private and competitive nature of the industry has precluded transparency about different transition approaches or openness to academic research. The inclination of firms toward secrecy has also contributed to the presentation of a falsely harmonious picture to LPs.

This study builds on the work by Cornelli et al. (2019) who examined the relationship between team turnover and firm performance, using a unique data set that tracks 138 PE managers over time. It established a more nuanced and positive association between team turnover and future performance in PE than the practitioner orthodoxy, which linked superior returns to long-term team stability.

Large Sample Research

To understand empirically the evidence of turnover of private equity firms, a sample was built of the 260 largest firms that experienced turnover post-2000, in order to study their characteristics and the consequences of these changes. Two caveats are important. Firstly, it is difficult to infer causality as observed shifts in performance may have occurred anyway, without turnover events. Then, these events are often kept private, which means, despite extensive exploration, this sample is likely to be incomplete.

Several data series were gathered, including from Preqin (fund and performance data) and searches of online resources, old news databases, and specialist publications for reporting on leadership transition events.

The first analysis looked at the share of the 260 firms undergoing transitions during three 5-year periods, 2001–05, 2006–10, and 2011–15. The first surprising conclusion was the very low level of turnover. In any 5-year period, the probability of top leadership turnover is only about 6%. This is striking compared to the rate of turnover documented in traditional corporate structures. Bushman et al. (2010) found a 57% probability of turnover in the Standard & Poor’s (S&P) Execucomp database for the time period 1992–2005. Kaplan et al. (2009) look at successful ventures during the average 6 year pre- and post-IPO period and noted 56% of CEO changes.

It is hypothesized three explanations account for the low level of turnover. Certainly, in some cases, GP transitions may have been. Second, firms may have simply gone out of existence without showing up in the research, but it also seems clear the mean tenure of the leadership simply was also much longer.

There was also a strong temporal effect: the rate increased substantially in the 2011–15 period. This likely reflected the increased age of many founders as well as potentially the institutionalization of many firms. Once a private equity group becomes larger and more established, there is a greater confidence to tackle the challenging process of generational succession.

The next analysis on the determinants of turnover suggests that firms that undergo leadership transitions are substantially different from their peers. In particular, they appear to be larger and better performers. They are also trending better: When the difference in performance between their last and penultimate fund was studied, they have a significantly stronger trajectory. One possibility is that it is only firms doing sufficiently well that can successfully make transitions and continue to raise funds. Another possibility is that executives choose to exit while “at the top of their game”: they either are financially comfortable or feel less of a pull to remain at the firms.

The consequences of turnover were studied next, focusing on fundraising. The results here are mixed. Fundraising in the period appears to dip for firms that undergo a transition and then recover in the 5-year period after. The difference is highly statistically significant for the subsequent period. It is important to remember, however, that firms that undergo a transition are not a random sample: They tend to be larger and better performers.

Finally, the actual performance of funds around transitions was assessed, using a smaller dataset of firms that underwent transitions and have sufficient performance data. The story here is clear. The firms that experience the greatest boost in performance after the transition are those where the performance of the prior fund was low. In addition, those with sharper declines in prior performance experience a bigger boost in performance after turnover. The magnitudes of these effects are significant. However, the finance literature (e.g., Rossi 2019; Harris et al. 2014) suggests there is a considerable amount of regression to the mean in private equity performance, which might account for part of this shift.

In short, several conclusions can be drawn from the empirical analysis:

  • Turnover is relatively rare at private equity groups, though increasing over the sample period.

  • Turnover is not random. Rather, it seems to happen most frequently at larger firms, better performing ones, and firms with positive performance trends.

  • Turnover where the performance is poor seems to lead to a substantial boost in performance; conditional on the non-random nature of turnover, it does not seem to affect fundraising. While these facts do not represent the last word, they help set the context for the richer insights from the interviews that were undertaken.

LP Interviews

The empirical research was supplemented with perspectives from highly experienced LPs, in order to understand how the parties with the most capital to lose from failed processes view GP leadership transitions. The answers unanimously emphasized that leadership succession is viewed by LPs as a key determinant of future performance and trajectory. This viewpoint contrasts with that in the early days of the industry, when past performance and personal relationships dominated LP commitment decisions. Eleven large, leading LPs participated in completing a structured questionnaire together with a contextual discussion.

There were five main findings:

  • LPs are far from happy with GP performance in leadership transition, although there is a recognition of significant differences in models and contexts. They have witnessed a wide spectrum of outcomes, often determined more by struggles for power than elegant processes. Despite this, strong mutual interest typically holds the larger firms together, albeit sometimes accompanied by departures. They do though recognize that the idiosyncratic nature of partnerships defy any best practice playbook.

  • LPs believe GP founders and leaders generally stayed too long. Underlying this was a sense that leaders are often in denial, finding it hard to let go at the optimal time in the interests of the firm. They admire those leaders who chose the right time in favor of the next generation. They like the clarity and transparency of mandatory retirement periods and ages, used in a small handful of firms, as it is seen as encouragement for the next generation of leaders.

  • They wanted greater transparency into transition processes, including evidence of long-term succession planning many years ahead of the actual event. They felt they barely saw the tip of the iceberg, yet recognize this raises the important questions of the boundaries of LP involvement and the extent to which LPs should be treated as quasi-shareholders. They suspect secrecy masks a lack of actual progress. However, they are also realistic about the limitations of revealing sensitive internal GP discussions and also accept that they bear a responsibility for building closer relationships and asking the right questions. A seat on the LPAC (LP Advisory Committee) gives potentially more access to and influence on key decisions.

  • The shift in the market toward building and realizing value in the management company, lessening the traditional alignment solely through carried interest, was a challenging and emotional topic with LPs. Underlying the LPs’ discomfort is the fundamental question of what fees are for. Originally, they were intended to cover costs, but the growth of mega funds, and the tendency of fees collected to outstrip costs incurred, has led to large profit growth and increasingly valuable management companies. They are nostalgic for the simpler early days of the industry when carried interest was the sole source of alignment between LPs and GPs. Many dislike IPOs or any sale of partnership interests to third parties to monetize their equity stake. Not only does it lead to hard-to-justify cash windfalls, they feel, but it destroys intergenerational equity: There will be less carried interest and equity for the successors.

    Others go even further and argue that partnerships should be organized on a “naked in, naked out” principle: That is to say, there is no compensation as the equity is passed from one generation to the next. This approach, which has been frequently practiced in the venture capital industry and other partnerships such as large legal firms, is attractive precisely because it eases succession economics.

  • LPs protect themselves through diligence and legal provisions in different ways but are realistic about the limited redress they have failed succession processes. They interrogate more on leadership and future plans than previously, but often find it hard to pin down definitive answers. Key man clauses in particular were likened to lifejackets on an aircraft in that they are not expected to be used, but if needed there will be few circumstances in which they will be effective in protecting LP’s interests. It was apparent, however, that diligence processes are not homogenous across LPs. Not all for example insist on an emergency succession plan in the event of the leader unexpectedly having to step back or a “normal course of business” succession outline, or knowing the tenure plans of all key partners.

GP Interviews

The final stage of research involved the study of previous transitions, in order to understand the actual choices made by eight founders and leaders. Face-to-face 2-h interviews were conducted largely following a consistent set of questions. There was bias in the sample in that all bar one were headquartered in London, all were recommended because their transition was considered to have gone well and many of the events discussed were quite historic (on average 9 years elapsed) due to a natural reluctance to discuss recently completed processes on which the dust might not have settled. This matters because the GPs at that stage had not experienced the subsequent large growth in fund sizes and also the options available to monetize GP equity stakes were limited.

Although the sample was modest in size, six strong themes emerged:

  • It was especially difficult for a founder of a GP to depart, resulting in long tenures and often an influential role long after the transition.

Although all CEO departures have emotional aspects, it appears especially difficult for a founder of a GP to depart. The average tenure of the interviewees as leader was 15 years, with 25 the longest. Two firms in the sample had fixed length tenures for leaders, one requiring retirement at 60, the other with a novel revolving group of four managing partners, with the longest serving retiring and being replaced ahead of each new fundraise. Both firms found that their approach contributed to transparency internally and externally and consequently a smooth process for all parties.

Motivations for staying ranged from feeling their identity was the firm to ever-increasing targets for wealth accumulation. In retrospect, some mused that they had outstayed their welcome. Motivations eventually for leaving included pull factors (such as the desire to succeed in new fields), push factors (such as giving the next generation their chance, or an awareness of flagging commitment), and neutral factors (such as confidence in their successor).

Exiting private equity founders and leaders often successfully played influential ongoing roles such as non-executive chairman for many years, ranging between fifteen extra years and two. The benefits of leaving were seen as giving everyone a clean break without casting a shadow over their successor. Staying required large adjustments and in particular a quietening of egos, but provided this could be done, benefits were seen as helping their successor through tough times and giving LPs confidence. This contrasts with academics studying public corporations in the USA who concluded that CEOs who remain as chair or on the board of directors usually reduce the new CEO’s ability to make strategic changes or drive performance (Quigley and Hambrick 2012).

  • There is no one playbook of how to transition; these were one-off idiosyncratic events.

Transitions involve many decisions and a wide variety of choices were made in practice, shaped by three major factors: the philosophy and motivations of the founder or exiting successor leader, a desire to protect the culture they had shaped, and the context the firm found itself in. Each interview revealed different characters and philosophies of the exiting leaders that determined their choices. The self-confessed workaholics delayed their departures the longest; the leader who believed in empowerment gave the next generation unusual space to redesign the structure of the firm; and the leaders who believed in intergenerational equity agreed to an ownership transfer that did not require the next generation themselves or the firm to become indebted. Many spoke passionately about explicit culture and values preservation, which they placed at the heart of the transition, which was the sole differentiator in a competitive PE market. The firms also existed in different contexts at the time of the transition. The strongest performers displayed the greatest confidence that the transition, however it was executed, would be well received. Other transitions coincided with complex firm restructurings, which increased the risks, the length of the processes, and the scale of subsequent partner departures.

  • They were shaped internally over many years by consensus within the firm, with little external influence.

Private equity transitions differ from public company events where boards react to many different factors, such as a firm’s poor stock performance (Kaplan and Minton 2012). In all of the PE transitions studied, consensus was developed inside the firm with rare outside guidance. The majority of GPs were either without independent boards or chose not to involve them. Instead, the firms had a strong philosophy of partnership, due to a dependency on valuable, scarce, and highly mobile skills. However, building consensus took time. Exiting leaders were very aware of the pitfalls, describing the transition as potentially explosive situation where just assuming everything would work out was dangerous. The benefits of giving the process plenty of time were strongly emphasized by almost all interviewees. On average, exited founders and leaders described their planning horizon as 5 years at a minimum.

  • Successors were always chosen from within the partnership, with a tendency to choose joint or more leaders as complexity grew.

Corporates will rarely undertake a leadership transition without comparing their internal CEO options with potential external candidates. In this study, not one of the interviewees even considered looking externally. Primacy of cultural fit and acceptance by a usually close-knit and strong-minded group of partners with options to move elsewhere precluded this. Moreover, the firms had engaged in a long process of mostly implicit candidate development over many years. This included moving people into senior partnership at the right time to learn, bringing them onto the investment or executive committees, exposing them to LPs as key value creators, and giving them opportunities to prove themselves beyond purely investing.

Joint or more leaders were sometimes chosen, for different reasons. Sometimes no one perfect candidate existed. In others, the size and complexity of the organization had increased. Particularly pertinent in private equity, star investors were often reluctant to step back from what is seen as a more fulfilling and interesting investing role to one revolving around administration and managing people. They also wanted to maintain their credibility with and connection to the core investment team by continuing to invest themselves. Hence, a joint (or three- or four-way) model could create the capacity for individuals to dip back into investing from time to time.

  • The process was rarely friction-free, with the first transition from the founder usually involving the most tension, but over time becoming “normalized” as the firm institutionalized.

The founder transitions to their first successor created more headaches largely because there were more norms to establish. Carry apportionment was well established but the sharing of GP equity typically was not, which led to uncomfortable negotiations between erstwhile partners. Succession though became smoother as principles became established as part of a general process of institutionalization. However, friction and tension in any transition were hard to avoid. All interviewees, despite feeling that overall, their transition had gone well, mentioned challenges to successful outcomes. These included the egos of PE partners, the fear of change, and the scale of power and economics at stake. They advised that preparing for difficult conversations and possible hard feelings was essential. Churn among partners can be significant; twelve partners departed in one case and seven in another. Fundamentally though, many cited a strong, positive culture as the “glue” that held the firm together. Although private equity has a reputation for individual-centric behavior, many of the firms studied felt that in their case, success relied on enough partners putting the interests of the firm first.

  • Economic apportionment could be especially fraught.

As mentioned above, financial decisions about the management company were some of the hardest in many of the transitions studied. Groups struggled with questions such as whether to build value over time in the GP or to distribute it annually, how widely to share ownership, and what to do when an equity-laden founder was leaving. Arriving at an economic deal for the exiting founder or leader required a subtle trade-off between rewarding their past value creation and not jeopardizing the success of future generations. The most challenging conversations involved the size and timing of the payout for the founder’s equity stake. These were difficult negotiations between erstwhile colleagues. A majority of firms rewrote the rules and processes after the founder’s departure, embedding what they had learned for future transitions.

Cross-References