Private Equity Succession Issues

The barbarians at the gate that sparked the LBO boom 25-30 years ago now are dealing with succession issues, writes the Deal in a special feature article.

See the article on this link or see below.


Time to move onby David Carey and Vyvyan Tenorio Posted 08:32 EST, 20, Apr 2006What future awaits private equity when its founding fathers retire? Will the firms hatched 25 or 30 years ago, now among the biggest names in the buyout business, flounder as their aging leaders — a generation of charismatic entrepreneurs like Tom Lee, Henry Kravis and David Bonderman who invented the LBO — exit the scene? Can the protégés who succeed them hope to match their stellar achievements?
This conundrum is no trifling matter to the investors who entrust billions to LBO firms. For years, limited partners could only wonder what lay in store, even as time inched on and the question of generational succession became more urgent.
But over the past several years, many elite firms have shuffled leadership or anointed heirs apparent, and turnover in the top ranks has accelerated across the industry as the old guard reaches traditional retirement age.
The era of transition is in full swing.
The issue really came to the fore when the news surfaced in December that Lee, 62, who hit it big in the 1990s with leveraged buyouts of Snapple Beverage Corp., data provider Experian and nutritional chain GNC Corp., would sever ties to his Boston-based Thomas H. Lee Partners LP and surrender the reins to a trio in their 40s.
At about the same time Andy McLane, the longtime No. 2 partner at TA Associates Inc., another prominent Boston buyout house, scaled back his role, and TA's CEO, Kevin Landry, confirmed that he will step down as boss in the coming months.
Since 2003, power also has migrated at Apax Partners from Ronald Cohen to Martin Halusa, and at Hellman & Friedman LLC in San Francisco from Warren Hellman to Brian Powers, while Chicago's Madison Dearborn Partners LLC tapped Sam Mencoff and Paul Finnegan to succeed John Canning Jr. one day.
The list rolls on: Since 2000, the next generation has taken charge at Advent International Corp., Warburg Pincus, Leonard Green & Partners LP and Welsh Carson Anderson & Stowe. In fact, it seems the only remaining top-flight firm led by sexagenarians not to have plotted a succession is Kohlberg Kravis Roberts & Co. Henry Kravis and co-founder George Roberts, both 62, have made it clear they won't cede authority anytime soon.
There is no question, then, that the generational handoff is well under way. But it won't be clear for years how it will reshape the business.
Indeed, the flurry of retirements is merely Act 1 of the transition. The next act will unfold gradually as the new bosses settle in and forge their own track records. And it will take formidable talent to match, let alone eclipse, their legendary mentors, especially at a time when the business is expanding and becoming increasingly institutionalized and global. The business has matured, and to stay ahead requires more than the brilliance, creativity and entrepreneurial flair that marked the pioneers. Today the industry demands not only strategic vision but bureaucratic skill. Who among the younger leaders will fill the old guard's shoes is a hotly debated topic.
"It's still too early to tally things all the way up," says Brian Wade, director of private equity for the state of Virginia's $49 billion pension fund, talking about the successor generation.
Even where the baton has been handed off, longtime bosses are still coaching from the sidelines, shaping the firms long after they've given up much hands-on control.
"You can name on one hand, with fingers left over, the big firms that have had a transition and [the once-dominant] guy is totally gone," as Erik Hirsch, chief investment officer at Hamilton Lane Advisors LLC, a buyout fund investor and pension fund consultant, puts it.
Sometimes successors shine once they are removed from a founder's deep shadow. That can be true even when the parting of the ways is downright contentious.
Take Leonard Green's split with Leonard Green & Partners, the Los Angeles firm he started in 1989. Testimony in Green's divorce revealed that he was at odds with his partners, who were infuriated in 1999 when he struck a deal to pump $300 million of the firm's money into Rite Aid Corp., a troubled retailer in which he personally held a stake. By then, Green, in his mid-60s, had virtually ceded control to its three current leaders, Jonathan Sokoloff, John Danhakl and Peter Nolan. The breakup became definitive in 2000; Green died two years later.
Their rift aside, his ex-protégés have carried on with Green's value-oriented style and have performed splendidly on their own, racking up impressive returns in a string of transactions, and boast one of the best recent records in the middle market. Says Hirsch: "Leonard Green is an example of a transition that has worked out very well."
Tom Lee's exit from Thomas H. Lee Partners, his 32-year-old firm, is one of the few complete exits. While the situation wasn't nearly as messy as at Leonard Green, it had its dash of melodrama. And strangeness.
Lee's departure followed the collapse and bankruptcy late last year of Refco Inc., the futures broker T.H. Lee owned, saddling the firm with a $260 million net loss. But the timing was coincidental, people familiar with the firm say. In fact, Lee had largely scripted his own retirement back in the mid-1990s. Then he remarried, moved to New York from Boston and took to managing T.H. Lee from his one-man outpost far from the firm's nerve center. In 1999 he sold a 25% stake to in T.H. Lee to Putnam Investments, personally banking more than $100 million in proceeds, sources say. At that time, the firm set in motion a slow succession mechanism. By the late 1990s, Lee had largely ceased sourcing deals.
Over time, Lee generously surrendered to his partners the bulk of his share of the firm's "carried interest" — the 20% of investment profits it rakes off in incentives. By 2000, when the firm's $6.1 billion fund was raised, Lee had slashed his own piece of the carry to just over 10%, from 66% in the early 1990s. In 2003, he ceded most of his day-to-day duties to three co-presidents, Anthony DiNovi, Scott Schoen and Scott Sperling, but kept the titles of chief executive and chairman. By late 2005, T.H. Lee was gearing up to raise another fund in which he had long said he would have no substantial role.
The stage seemed to have been set, by the man himself, for Lee to deliver a gracious valedictory and withdraw. Instead, an unexpected, behind-the-scenes dustup intervened.
It seems that Lee, resisting the prospect of becoming a figurehead, was keen to start an independent buyout shop. His old partners, who held rights to the potent Thomas H. Lee brand name, viewed his plan suspiciously. They insisted he would have to set up his new fund under a different banner. The two camps further engaged in a low-intensity public-relations battle over who could claim credit for T.H. Lee's recent success. Lee's camp suggested he'd been a hands-on CEO and deserved much credit. The Boston camp suggested otherwise.
On March 17, the sides announced a departure agreement. Because Lee aims to stick to the small- and mid-cap markets, the Bostonians agreed he could call his new shop Thomas H. Lee Capital. He'll also have limited rights to use his old firm's track record to market his new fund. The two sides wished each other the best.
How institutional investors parse the conflicting messages remains to be seen. One said he views Lee's leaving as a key loss, noting: "The firm is still marketing off of Tom Lee's record in Fund I and Fund II. You take his contribution out, and they have a very different track record." But others said Lee's absence should have little impact on T.H. Lee's future performance.
All in all, it was an odd coda to a legend's long and stellar run.
Private equity has had its share of high-profile fatalities. Wesray Capital Corp., in its day perhaps the industry's top performer, didn't survive the late 1980s breakup of founders William E. Simon and Raymond Chambers. Irreconcilable differences ripped apart Golder, Thoma, Cressey, Rauner Inc. in the mid-1990s and more recently Hicks Muse Tate & Furst Inc., where investment loses aggravated the internal divide. (Each of those partnerships split in two; the successor shops still exist.)
Then there is the strange destiny of Forstmann Little & Co., led by Theodore Forstmann, whose renown in the 1980s equaled that of Henry Kravis. A year and a half ago, following catastrophic losses in telecom deals that wiped out much of Forstmann Little's capital and prompted one key limited partner to sue, Forstmann, then 64, announced he'd decided to wind down operations.
To many, his "decision" looked like an effort to paper over the firm's inadvertent self-destruction. Still, one former associate insisted the move was voluntary.
"Ted didn't see the firm as an [enduring] institution," the associate says. "He didn't see private equity as an 'industry'; he saw it as a series of investment opportunities. He never wanted to build a huge firm, never wanted to go global. The industry had evolved in a direction he didn't like, away from the best interests of investors. In the end, he decided he'd had enough."
At most other firms, of course, the survival instinct is stronger. Most of the industry's old guard hope that the firms they built will last. Limited partners and buyout executives alike say that to ensure a smooth leadership succession and increase a firm's chances of success, private equity partnerships must take some key steps.
Step One is to keep the best young talent from leaving — especially those gifted enough to lead the firm. That means paying them what they're worth. In the old days, it may have made sense for a firm led by a rainmaker or two who originated every deal to pocket most of the fee income and carry. But as buyout firms' purses and portfolios have grown, so have the partnership ranks. To hang on to up-and-coming dealmakers requires management to spread more than just the workload; founders also must spread the wealth.
That's why limited partners say they like it when older partners do what Tom Lee did and gradually shrink their share of the carry.
"We're always concerned about whether the staff is properly compensated for the effort they're making. If the senior people are all keeping the carry, that's a potential disaster," says William Franklin, who oversees Bank of America Corp.'s LP investments in private equity funds.
A second smart move, say limiteds, is for firms to set up committees that enable younger partners to help make key decisions and think through issues with more seasoned colleagues.
"More and more firms are setting up operating committees and investment committees," Hirsch remarks. "That way, they not only leverage their resources to better effect, but it makes for a smoother exchange of the baton."
In fact, so many private equity houses have delegated decision making to committees that they are reshaping how the industry operates, says a partner at a large West Coast firm, who views the trend favorably, as a sign the business has matured.
"Private equity has transitioned from an entrepreneurial into a more institutional industry. When I joined my firm eight years ago, I'd bet that half the firms did not have investment committees. The founding partners called the shots. That has changed. Today decision making is much more rigorous and formalized," he says.
More significant, several firms have scrapped the single-leader structure entirely in favor of what those that have done so call a partnership structure, popularly known as management-by-committee. At least one West Coast firm, Leonard Green, has embraced leadership by a group of equals. But the trend has positively swept Boston.
In addition to Thomas H. Lee Partners, most of the city's other big players are led by three or more partners: Bain Capital LLC, once led and wholly owned by Mitt Romney, now Massachusetts governor, is managed by a committee of four. Six managing partners now hold sway at Summit Partners, a firm long led by the retired founders, Roe Stamps IV and Stephen Woodsum. And six partners oversee Advent International, which Peter Brooke started in the mid-1980s before passing the reins to Douglas Brown, who retired as CEO in 2001.
"We felt there were a group of talented people who could better manage the firm than any single person," says David Mussafer, one of Advent's top six.
Another Boston firm soon will join the club.
At TA Associates, Kevin Landry, 62, will relinquish his CEO's title within the next several months. He won't be replaced. As long ago as the late 1980s, authority over pay, changes in ownership and policy devolved to a four-member executive committee on which Landry, Jeffrey Chambers, Michael Child and Brian Conway now sit. (Conway joined the committee Jan. 1, replacing the now-semiretired Andy McLane, TA's longtime No. 2 partner.)
Authority over investments, meanwhile, is exercised not by a single investment committee of fixed members, but rather by investment committees — plural — whose makeup varies by deal. Each committee has four members, including two people who worked on the deal and two high-ranking TA partners who did not. Until October 2004, Landry or Child sat on a majority of the investment committees. But Landry has handed off his duties to Bruce Johnston, a partner in TA's technology sector group.
Landry, whose firm just wrapped up a $4.3 billion fundraising, says TA is too big an operation now for one boss to call all the shots. "In the mid-'80s, I would make a lot of the investment decisions. Today we are more of an open democracy. There is no small group here that is thought to be infallible and has a monopoly on good judgment."
Like many — but by no means all — sexagenarian bosses who began prepping for departure well in advance, Landry has cut back his piece of the carried interest, from a high of 40% during the '80s to single digits today. Landry also has slashed his ownership stake in the partnership.
Carry and ownership ought logically to correlate. But at some firms they don't, with founders holding a greatly disproportional ownership stake even after they've cut in younger partners on the carry. Younger partners may not object if they get fair slices of the profit pie. But the discrepancy can pose problems when the founders transition out because they may insist on a big buyout. At a time when there is speculation that some buyout firms may go public, those with big stakes may not cede them as willingly as Lee and Landry did. Ex-leaders who have collected big buyout payments when they left include Bain's Romney, Tom Lee, Warburg Pincus' Lionel Pincus and Apax's Ronald Cohen.
Such buyouts typically are financed with debt, which can be a drag on a partnership's finances.
Transitions are likely to be smoother where a firm has periodically readjusted partners' ownership stakes to approximate their percent of the carry. Landry's TA does so, as does San Francisco's Hellman & Friedman. Limited partners say they weight this alignment of ownership when they mete out dollars.
"Like the carry, ownership is something we look at very closely," says one institutional investor. "If there's a financed buyout, it can a impose a tax on revenue for the people who stay. That can encourage some of them to leave."
What most concerns LPs is when the older generation ignores these succession issues and dissension erupts among the ranks, causing key personnel to leave. "We want to see them bring in other people who can gain our confidence in terms of the roles they can play while slowly reducing the responsibilities of senior partners selectively," says Charles Froland, managing director of Greenwich, Conn.-based Performance Equity Management LLC. "So you still have a deep and seasoned bench with staying power through the next fund. That is the challenge."
As the industry's generational succession moves into high gear, such is the provisional evidence that limiteds have to sift. Iron-clad it is not.
Information about how the carry is dispersed or personal assessments of the quality of the remaining talent are imperfect clues to a firm's future. Nor is a smooth succession a sure augur of successful investments.
At Welsh Carson Anderson & Stowe, for instance, several of the firm's limited partners decided not to reinvest in its latest fund, which is expected to close at $3 billion, about 25% less than what the firm raised in 2000. One concern was the transition from the founders to a new generation of managers whose track record may not be as stellar as the previous generation's. "People weren't rushing into it and have said no because they haven't been as successful recently as the firm had been several years ago," says one large pension fund investor. "They need some time to prove themselves out.