Succession Planning Is Critical for Private Equity Firms

Succession Planning for Private Equity Firms is Essential to Long-Term Financial Success

Succession planning is important for any type of business that would like to see the legacy continue after the founding members are gone. Often, private equity firms put a great deal of thought and effort into the succession planning of their operating companies, yet fail to practice what they preach when it comes to their own firm.

Succession planning refers to the process of ensuring that an organization’s operations continue uninterrupted and that its performance doesn’t suffer in the event that one or more leaders depart. A principal’s exit can be planned or unplanned, but either way, the departure can cause tremendous upheaval in the organization. Just as importantly, without proper succession planning, a change of leadership can be a cause of concern for investors and portfolio companies.

Private equity firms suffer the same consequences of poor succession planning as other types of companies. It can lead to a loss of customers, talent turnover, and reduced company performance. 

But the unique nature of private equity relationships introduces additional threats to the company when succession planning isn’t done right or doesn’t happen at all. International leadership development strategist Jenn DeWall shares, “For private equity, this can mean loss of investor trust, leading to fewer investments, instability in relationship management, and gaps in asset management.”

Why is Proper Succession Planning Important for Private Equity Firms?

It’s important for private equity leaders to understand that experienced LPs recognize that poor succession planning can be bad for their returns. Many will want to know about the firm’s succession plan during due diligence. Those private equity firms that can’t provide clear answers that reflect the careful preparation they’ve done are considered riskier investments.

This is because private equity leadership is unique. Your firm needs leaders who understand the intricacies of navigating relationships with a variety of stakeholders, including partners, investors, and leadership teams of portfolio companies, not to mention their own firm’s internal team. 

They also must be able to understand how to continue to maintain a strategic focus on value creation in current investments, while simultaneously developing new opportunities. There are not many people in the industry who have the skill and experience to understand and effectively address these factors, particularly through a period of transition.

When a leadership exit occurs in a private equity firm, there is a significant risk that the transition period will be chaotic. It can often result in key partners and/or employees leaving the organization, as well. It can also create changes in the firm’s strategic focus. These and other negative potential outcomes can impact investors’ returns, even as they are stuck in a long-term contract. 

If the ship isn’t righted quickly, investors begin to feel the burn and will react accordingly. And they should be expected to. Nobody enjoys suffering losses, in particular those that could have been avoided with better succession planning. Not only will the firm find it difficult to retain investors, it will also have a tough time bringing in new ones.

5 Private Equity Succession Planning Best Practices

Simply having a succession plan shouldn’t be any firm’s objective. There is a right way and a wrong way (really, many wrong ways) to do succession planning. In our experience, the five best practices below are essential. 

  1. Start early.

It is never too early to begin succession planning. A great example of this is the story of Blue Point Capital. This mid-sized firm had a succession plan almost from the very beginning, and was able to exercise that plan by their third round of funding.

The earlier you begin your firm’s succession planning, the easier it is to put the rest of these best practices into place. It also gives you ample time to groom your next generation of leaders, helps your firm react to an unplanned exit easily, and improves transparency and communication among investors and the internal team. When you plan for succession early on, it becomes an organic transition rather than a knee-jerk reaction.

  1. Remember that firm culture rules.

A positive firm culture is critical to effective succession planning for several reasons. First, if you’ve developed a sense of ownership and fairness in economic outcomes among your team members, they’re much less likely to react negatively to a leadership transition.

Developing a culture of open, honest communication and full transparency also helps with the transition. It means that you’ve been communicating with staff, partners, and investors openly about your succession plan so that there are no major surprises when it happens.

Further, when your firm has a culture that is focused on the professional development of employees, it becomes much easier to promote from within. This way, you’ll know that the next generation of leaders intimately understands the business, the culture, and the firm’s shared values. Developing your next generation of leaders should include a mix of leadership development training and mentorship programs.

When the time is right and you’ve identified the right people, promoting co-leaders in order to give them hands-on experience and training is very beneficial. As the founding leadership team of many top private equity firms are entering their twilight years, this approach to transitioning to the next generation of leaders is proving quite valuable. Bain Capital and KKR & Co. are two examples of top firms incorporating new co-leadership positions into their succession plans.

  1. Keep a “portfolio” of leadership contenders.

Many private equity firms create a “portfolio” of potential CEO contenders for the companies in which they invest. But this is also a good practice for your firm’s own succession planning. Some firms simply don’t have the resources or the talent pool to be able to promote from within. In that case, you will need to do an outside search for leadership talent.

Maintaining a list of potential next-gen firm leaders helps your leadership team keep an eye on their professional development and achievements over time in order to determine how well a person fits into the firm’s vision of the future. It also helps make the transition less time consuming and costly if there is an unplanned leadership exit.

  1. Develop fair incentive programs.

Including incentive programs for your firm’s next generation of leaders is a must in your succession planning. Too often, new leaders become frustrated and disenfranchised when they take on greater work and responsibilities in the firm without increased compensation, while the founder sits back and continues to take the lion’s share of economic benefit. This often leads to the successors leaving the firm prematurely to start their own firms.

Make sure your next generation of leaders are well compensated and cared for if you want to ensure your firm’s ongoing success. They need to feel a real sense of ownership in the organization, even if they weren’t the original founding members.

  1. Ensure leaders get comfortable with the idea of letting go.

Perhaps the most difficult thing for a founder to do is just let go. It’s risky to hand the reins over to young and less-experienced team members. Founders worry that they’ll watch everything that they’ve worked so hard to build crumble. It’s a legitimate concern, but one that must be pushed aside if you want your succession plan to be a success.

New leaders will likely do some things in a different way and make different decisions than a founder might. But that’s not necessarily a bad thing. It’s vital that current leaders not let their egos stop their firms from continuing on without them.

Succession planning is inherently difficult in any type of organization. For private equity firms, it’s even more so. 

The transition that takes place when a key leader exits a firm can cause a significant amount of stress and financial pain—for the private equity firm as well as investors. But putting a transparent and fair succession plan into action early on, and ensuring it’s one that focuses on the development of your internal team, can smooth the transition and make sure your operations get back on track as quickly as possible.