Key considerations for hedge fund succession planning – Part II: Leadership transition involves a maze of complexity
By Joel Press, Press Management – The transition of leadership in the private world of hedge funds is incomparable to corporate America, requiring both a deft touch and significant forward planning. The founders of successful hedge funds will have invested years, often decades, building the business in their image. When it comes time to handing over the keys to someone else, it can be a hugely emotional affair so picking the right leadership has to be approached very carefully.
There are a number of key global considerations:
1. Is there someone inside your organisation – or multiple people – you think can take over the reigns of the firm? What do you expect the new leadership to be and what sort of qualities, and character traits, will you be looking for? You’ve got to implicitly trust that person, or leadership team, to not only be capable of advancing the strategy and continuing to deliver performance; they also need to be capable of running the business. And most importantly the Founding member that is leaving must trust that the new leadership can manage the founder’s money also. It is key that the Founding member send a message to investors by leaving their money in the fund, demonstrating by example that they believe that their money will be well managed.
2. If the person or persons are not currently in the firm, how do you go about recruiting them? Where do you find them? What are the odds they are going to have your implicit trust? If you do look outside of the firm, I would suggest it’s better to bring two or three leadership people on board very early in the transition process. Then, hopefully, one of them will prove to be successful over the long term. It is, however, unusual to appoint someone externally to fill the leadership role, as you would see in corporate America. I’ve never been involved with any client where this has happened; it’s always been an internal transition of leadership. My experience is that the leadership shift is to individuals that have been at the firm for minimum of 3 to 5 years allowing them to learn and understand the responsibilities required for the new role.
3. Once you’ve transferred the leadership responsibilities, what controls – if any – do you want to maintain, in respect to the way the firm is run? Do you want overall approval on big day-to-day issues such as staff bonuses? Do you want control over the investment strategy, over new fund products, over capital raising initiatives? You have to determine what governance controls are appropriate for what you think is right for the firm. Then, you have to hope that the new leadership agrees to them all.
4. Think through the economic interests that are going to be associated with the leadership transition and franchise value of the firm.
5. Finally, convey the leadership transition to the firm’s investors to check that they have trust in the new leadership. They have to believe that this new person or person(s) are going to be as good, if not better, than you at running the firm and protecting their capital interests.
I advise people that a good timeframe to undergo leadership succession and work out all the details can take up to two years.
It is imperative that the right steps are taken, as highlighted above, before you make any official announcement of your departure. Do not inform investors until you know, 100 per cent, that this is real and that you are committed to transferring leadership. It is also important that investors know the new leadership well so that the transfer of trust is seamless.
There are plenty of examples littered throughout the last decade where founders of prominent hedge funds have struggled with putting the next generation of leadership in place. It is inherently more difficult than people realize and if things become too distracting the firm’s performance can suffer. No-one can say for sure what the stress on the Founder is in trying to think through their own issues in relation to succession planning but putting in place a sensible timeframe can go a long way to ensuring the process goes as smooth as possible.
When I do succession planning with a client, I believe it should be private and that no one should know anything about it until the Founder and the new leadership team are ready to announce it. That way, there is no ambiguity about the future direction of the firm.
Often, you are going to look to appoint a senior member of the firm to take over the CEO role. This might be your CIO, for example, but will they want to handle the myriad non-investment business issues that come with being CEO? They might be brilliant at managing the investment team but there will be a constant demand on how the firm navigates ongoing regulatory and compliance issues, legal issues, technology issues, investor relations and capital raising issues, HR issues and so on.
Asking your senior investment person to add the responsibilities of business-wide management to their primary role investing, can often be devilishly difficult. The position of running the firm, and the investment portfolio, and continuing to strive for excellence…not everyone wants that responsibility or may be good at it.
That’s why, in some transitions, there is a high turnover of people. When a member of the team becomes the CEO, they may have difficulty in the changed relationship from being a peer to becoming the leader. How they manage that transition is complicated and carries tremendous pressure. They may have different views than the Founder on the compensation packages of analysts and portfolio managers, and what their value is to the firm; are they earning too much, or not enough? One sees this often in sport where successful football players end up becoming managers, and the relationship sours because they’ve been unable to switch their mindset.
My advice to founders the growth of those chosen to lead is a two or even three years process to train the next leader(s) so that they have time to understand exactly what the role involves, and how they might need to change their mindset.
When considering governance controls, it will always depend on the individual. There’s no set rulebook to follow. Some founders are happy to have very little day-to-day control after the transition, some have powers that are designed to fade out over time, while others might have a more intense governance control framework; after all, they have significant capital at risk.
Determining the economic interests is also very complex.
Even when overseeing an orderly transition, what are you going to do with the wealth that you’ve accumulated in the firm, which can often be substantial?
There are several things to think about: How do you define franchise value of the firm (management company)? If it’s worth billions and the founder owns 50 per cent, who’s going to have the funds to buy out the founder’s interest in the enterprise? The new management is not likely to have the capital to buy the founder out. Can the founder sell their economic interests to a large asset manager? Possibly. When you sell to a larger organisation they usually want the founder to stay around. Is that acceptable? Will the senior personnel stay in the case of a sale? What is the economic structure of the transaction?
Where there is an internal transfer of leadership sunset payouts are the preferred method of compensating the departing founder. The structure of the payout over time must also provide the new leaders the opportunity to be successful. The size of the payout cannot strangle the firm. The structure of the payout to the founder should also include terms that provide for future events after the founder is gone such as a future sale of the business by the new leaders. Consideration should be given to: Does the founder retain a permanent ownership interest in the firm in the case of a sale? Or does the ownership interest step down over time? Do the payments made to the founder prior to a sale reduce the sale proceeds they would receive? The sunset terms must anticipate many potential future events.
In addition to the economic and governance concerns there are extensive tax and estate considerations that need to be part of the structuring. They are complex but critical to terms that also need to be factored into the agreement.
The franchise value of a firm that is not public is nonexistent until there is some event to create value such as a sale, going public as some have done, or a sunset provision.
Ultimately, it comes down to finding the right balance of economic interests, determining how long those economic interests run for, and also determining what happens should the firm be sold five years down the line.
Everything has to be fairly done, and everyone has to understand it. All of the decisions have to be carefully thought through, qualified and documented.
The bottom line is that finding the right person, or people, who can adjust to the pressures of running a hedge fund while continuing to deliver performance for investors, is not at all easy.
There is a maze of considerations to think about. Putting the proper time and effort over a significant period (usually a minimum of about a year), maintaining a strict code of privacy, and recognising that this is not going to be easy, can go a long way to in accomplishing the Founder’s objectives.
Part III will discuss what happens should the founder pass away unexpectedly and what is needed for the firm to survive.