Private Equity, Act 2

The relentless pace of private equity firm spinouts, a perennial force of human-capital dispersion, shows no sign of abating in this rapidly maturing industry. The specter of defecting talent presents a dilemma for private equity’s founders, who must confront the unknowable when deciding how much ownership and control to devolve to employees. It makes for a fascinating case study in decision making, and one that the French philosopher Pascal would have found to be instructive.

Many of the most senior executives in private equity today must suppress a chuckle when they hear their market described as an “industry.”

These “industry” pioneers cannot help but be amused at the vast distance between where their firms started and where they have ended up. Many of the most established private equity firms were originally formed as disposable entities to pursue ambitious, one-off investment opportunities. Over the years, as these deal shops evolved into valuable financial services franchises, their founders eventually had to ask, “What should I do with this thing?”

Consider, for example, the case of NGP Energy Capital Management, a prominent private equity firm based in Irving, Tex. Like a surprising number of other industry veterans, his firm began life as a few friends pursuing a few deals, said NGP Chief Executive Kenneth A. Hersh. Twenty-two years later, NGP has nearly $10 billion in assets under management across five investment platforms targeting the energy market. The firm has grown from four co-founders to dozens of investment and support staff. Hersh said the transition from small partnership to institutional asset management firm would have been greatly aided by a guide for navigating this sort of growth. Unfortunately, such a guide “just didn’t exist,” said Hersh.

“We were just making things up as we went along,” Hersh said. “I wish there was a book that we could have read about private equity firms that worked through three generations. But when we started NGP in 1988, the private equity business didn’t exist. We didn’t call our business a private equity business; we called it a partnership.”

As the partnership grew, NGP’s founders made a bet that Hersh says has paid off — they shared profits broadly with the next generation of investment professionals. This expanded the partnership culture and helped cement a permanent business. But it was a wager that would not have taken place had the founders been ambivalent about, or oblivious to, the potential benefits of sharing.

Across the private equity landscape, some founders have failed to communicate a clear plan for sharing the wealth of the firms they have built. Their reticence is causing their employees and, crucially, their investors to demand action.

Pascal’s Wager

The private equity industry is a relatively young one, and yet its pioneers are now aging to the point where many must confront a profound unknown — how much ownership and control should be given to the employees, if any?

It is a decision of potentially monumental consequence, and the outcome cannot be known until it is too late to change strategies. Blaise Pascal long ago proposed a “wager” for dealing with a similar — if otherworldly — unknown, namely, the existence of a punitive God. The 17th-century French philosopher noted that people must decide how to conduct themselves in this life without concrete knowledge of the consequences for the next life. But he recommended that even doubters lead lives of righteousness, because the potential downside of doing otherwise so outweighed any sacrifices that had to be made in order to be just. A life of righteousness will either send you to heaven or, at the very worst, be only its own earthly reward. A life of iniquity, on the other hand, is a wager that might just lead to eternal damnation — the ultimate downside.

Pascal’s wager addresses the sacred, but it has relevance to the more profane matter of succession planning. You could say that founders must choose between two paths — one that might be labeled “righteous” (sharing rewards and control) and the other “iniquitous” (hogging it all for thyself).

The reward for righteous sharing of franchise ownership and control should be a firm that is bigger, more profitable, more stable, more prestigious and more fun than if it was 100 percent owned by the founder. Successful sharing is dilutive to the founder but accretive to the franchise. Everyone enjoys the rewards.

However, a founder’s decision to share the firm is often driven not only by the desire to build wealth but also by the hope of a psychic reward — the satisfaction that comes from having created something that endures. As Hersh put it: “I’m a builder. I’ve had no other job besides NGP. It would be a shame when I retire to have this institution wither away. What I’d like to do is look back and say, ‘Hey, I built that.’ ”

The potential damnation for hogging would be a founder-controlled firm that stalls in its growth and becomes hobbled by employee turnover. In good times, ambitious, talented employees at these firms tend to grow resentful at their disproportionately small share of the profits and power. And in bad times, they tend to spin out at the first possible opportunity, as one does when one has no skin in a losing game.

In today’s market, a significant number of private equity firms are in danger of sinking into just such a franchise damnation. “There are a number of midtier firms out there that are having real problems,” said Kelly DePonte, a partner at Probitas Partners, an investment advisor based in San Francisco. “They stumbled before things really got bad, and it looks like they might not be able to raise another fund, or raise one anytime soon. Junior staff that has a decent personal track record may look at spinning out as preferable to assisting their elders in managing a train-wreck legacy.”

Points of Carry

The succession-planning version of Pascal’s wager is considered on a daily basis in today’s private equity industry, where talent is the only asset, and long-term private partnerships are the chief organizational structure.

Although all industries grow when entrepreneurs leave larger companies to start their own businesses, the investment business in general and private equity in particular seem to engender spinouts. The history of private equity can be written as a succession of spinouts, not unlike the lineage recitations in the Bible: Lehman begat Blackstone, Blackstone begat Centerbridge, etc.

Many firms started life when talented, entrepreneurial investors decided to leave the employment of a bigger firm to hang their own shingle. Over the decades, large banks in particular have had an uncanny propensity for expelling private equity talent. Jonathan D. Roth, managing director and president of Abbott Capital Management, a New York fund of funds, tells the story of how one of his firm’s two founders used to work for the private equity division of what was then Manufacturers Hanover (now JPMorgan Chase). In 1986, an industry friend approached him and said, “We should do this for ourselves.” And thus was born another independent firm.

But independent private equity firms beget other independent firms by the hundreds. The relentless spinouts over the years have populated private equity centers, like New York, London and Boston, with significant clusters of firms of all shapes and sizes.

Some market observers predict that these clusters will shrink before they grow again, such is the current scarcity of investment capital in the market. But for every firm that teeters, two new ones are created by hopeful and newly independent first-time teams. DePonte of Probitas noted that while private equity fund-raising is very difficult currently, this will not prevent a new spinout wave from happening. “I’m not saying that a ton of money will be raised by spinouts, or that it will be an easy market for them,” he said. “But I think a number of people will try to do it.”

Most private equity firms are made up of less than a dozen individuals; even the largest private equity firms have no more than several hundred employees. Perhaps not surprisingly given their firm’s investment strategy of taking equity stakes in private companies, private equity firm employees are hyper-aware of exactly how much ownership they have in each fund, in the firm itself and in the pool of profits. As professionals move through the ranks in private equity firms, they are often assigned larger and larger “points of carry,” jargon for their ownership in the potentially lucrative carried-interest fees generated by funds.

The founding partners of firms usually receive the lion’s share, if not the entire amount, of carried interest, which equals 20 percent of all profits from the fund. This is (usually acerbically) referred to as “founder economics.” One would expect this in a business where the founders themselves are the business plan and personally manage the sourcing, vetting, buying, improving and ultimately the selling of private companies. As the support staff of associates, vice presidents, principals and non-founding partners learn the tricks of the private equity trade, they precisely track the value they bring to the franchise. A professional who sources an investment that ultimately proves profitable becomes a star within the firm, and especially, in his or her own mind. Many firms carefully chronicle individual “deal attribution” track records, which are in turn used to justify any additional points of carry rewarded.

At some point, a junior private equity professional with a winning track record pauses and thinks, “I should do this for myself.” In fact, staffers begin to ponder defection the moment they first calculate that they would have been paid a lot more carried interest for leading a winning investment at a firm of their own. They then let their thoughts drift to the limited partners of their existing employer — the providers of capital for the funds. In order to launch a private equity firm, you need the support of limited partners (LPs) willing to back a new, independent fund managed by a deal-attribution hero, albeit one who was successful inside a firm with which the limited partners may already have a relationship.

NGP’s Energized Sharing

As the founder of a private equity firm prospers, he or she needs to be aware that the junior track-record builders will expect to see a greater share of the profits — to become more like partners and less like employees. Those founders who care enough about this to open up the partnership find, as did Hersh of NGP, that private equity’s brief history teaches no clear best practices for devolving founder economics. But Hersh and his co-founders threw themselves into the discovery of those best practices for themselves.

The growth of NGP, which began as Natural Gas Partners, is similar to that of numerous firms started in the 1980’s and 1990’s in that the original game plan was focused on pre-defined investment opportunities, not the building of a sustainable franchise for private investment. “We started with four people in a general partnership and raised a fund,” said Hersh. “Then we raised fund two, then three. Then we said, ‘Wait a minute, we have four funds under management. Wow, I guess we’re an asset management company.’ ”

The NGP leadership embraced this accidental destiny and sought to build an incentive plan to ensure that key non-founding professionals would continue to root for team NGP and help accumulate assets under management.

It is a vision and strategy that not only the employees of NGP bought into. In 2006, the private equity division of Barclays Bank, Barclays Capital, purchased a 40 percent stake in NGP Energy Capital Management, a bet on the long-term growth of the NGP brand among institutional investors.

Crucially, the Barclays investment allowed NGP to take a quantum leap toward binding the fortunes of its key employees with those of the firm. It created what Hersh calls a “horizontal pool,” facilitating a sense of shared mission across the firm. NGP is divided into five silos, each targeting a different investment strategy. Riding on top of the silos is the management company, which today has seven partners alongside Barclays’ equity stake. The senior employees of each individual silo have significant equity stakes in their own businesses. In addition, these senior employees are given equity interests in each of the other four silos. “They don’t have to put up money for the other silos,” said Hersh. “While their primary upside is provided by ownership of their own silos, they have a vested interest in making sure that their cousin silos do well.”

Founder Psychology

Each private equity firm is uniquely structured, reflecting the personal goals and priorities of the founder. While one founder may devolve his economics in the hope of growth, shared prosperity and franchise longevity, another may dismiss such a move as wrongheaded. This diversity of founder mind-sets explains the sprawl of succession stories across private equity today — the partner emeritus who will not let go; the heir apparent who takes control; the heir apparent who bolts; the firm that goes public; the firm that goes dark.

Founders would more often choose the path of righteous sharing, if it were not for their nagging doubts that sharing ultimately will bring sufficient rewards. On top of this, many founders simply believe it is impossible for broader control to enhance the value of the business. They wonder, “How can diluting the secret sauce — me — be a good thing?” They view their domination of the firm as its best chance for success and shrug off suggestions that inviting nonfounders into the ownership structure might help build a better firm as well as their own wealth.

The way a firm is structured “can give you an indication of the mentality of the founder,” said Roth of Abbott Capital Management. “Maybe there’s a firm that in its heyday was very successful and did well for its investors, but the founder doesn’t want to see it succeed beyond his active years. . . . [Abbott Capital was] blessed with founders who wanted to see the company exist beyond the active years of the founders, who wanted to build a company that would continue to prosper well after their retirements.”

Hersh divides company founders into two camps — builders of “lifestyle businesses” and builders of “institutional franchises.” “Lifestyle businesses are businesses that will be your heart and soul, that will put your kids through college, but the day you die, it’s questionable what’s left,” he said.

The founders who, by contrast, value staying power, seek to inspire a firmwide culture in which “people have to be focused on sharing ownership, and they have to be thinking about the long-term objectives and not just maximizing next week’s paycheck,” said Hersh. “They need to be taking the view that each individual interaction is for the long-term health of the franchise.”

He added that the desire to build a firm with staying power is not something that can be learned. It is simply “in somebody’s business DNA,” he said.

Clearly, the work required to build a lasting institution, as opposed to simply doing great deals, does not appeal to every private equity founder. This was vividly exemplified by Theodore J. Forstmann, the founder of Forstmann Little & Company, who, in a 2004 New York Times interview, shrugged off the demise of his once-dominant private equity firm by saying: “[I]f I thought all I was good for was to invest money for pension funds, I think I would put a gun in my ear . . . I hope to Christ that’s not why I was put on this earth. Man, I hope I have other interesting and fun things to do.”

What Limited Partners Want

Other founding general partners share Forstmann’s view — they are in this business to pursue investment glory, and if the firm that provided infrastructure for their deals ultimately fades away, so be it.

This is an entirely legitimate mind-set, but in today’s Darwinian private equity fund-raising market, limited partners are increasingly demanding that founding general partners prove they are righteous, value sharing and seeking permanence. Bottom line — it is hard to raise a new fund with iniquitous founder economics.

In any market, limited partners are anxious that the team of general partners who launch the fund remain in place throughout the decade or so it will take to see the fund’s mandate through and for the limited partners to fully cash out. The legal documents that establish funds therefore identify “key persons,” whose departures or deaths allow the limited partners to dissolve the fund and send the remaining general partners packing.

However, in today’s more risk-sensitive market, the institutions that back private equity funds are not satisfied to rely on a mere key-person clause to keep a fund-management team intact. Many now undertake detailed analyses of private equity firms’ ownership structures prior to backing new funds. LPs increasingly believe that firms led by ungenerous founders tend to lose talent, potentially jeopardizing their investments.

“Limited partners are absolutely focused today on the question of who is contributing to the success of the fund, how they are contributing and what their incentives are,” said Roth. “Part of the analysis includes looking at the various levels of people in the organization and seeing that their incentives match up with their production.” 

Enlightened Sharing

As the private equity industry re-engineers itself for a new era of growth, its pioneers have been made keenly aware that investors are looking for franchises that are built to last. A successful private equity firm that hopes to continue to flourish therefore must address succession issues. And while there is a flying-blind, Pascal-type uncertainty to succession planning, human potential is not completely unknowable. While one cannot peer beyond the veil of death, one can make an educated guess about talent.

Founders of prosperous and enduring firms must astutely deploy top talent and align the talent’s interests with those of the firm. They will recognize as folly their urge to horde points of carry. Their righteousness will be backed by a strong faith in the accretive value of opening up the partnership. And, in the short term, their convictions will be amply rewarded by eager investors who have seen enough private equity history to believe that the best determinant of long-term investment stewardship is a culture and structure of shared success.

These success stories will be thrown into sharp relief by all too many stories of denial, strife and dissolution. “The vast majority” of private equity firms will have difficulty handing the reins to the next generation, said one advisor to institutional investors. He added: “Succession is hard and very painful, and it is so much easier to just focus on the next deal.”

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David Snow is editor in chief of PEI Media, a provider of market intelligence to the private equity, real estate and infrastructure investment asset classes.