Generational change is never far from the minds of the investment professionals at Apax Partners – since the early 2000s the European buyout firm has enforced a rule requiring top-level management to move on at the age of 60. In December, then 58-year-old Martin Halusa, who had been CEO since 2004, stepped down, replaced by co-CEOs Andrew Sillitoe, 41, and Mitch Truwit, 44.

The rule gives Apax, now on its third generation of leadership, a clear-cut schedule for succession planning, and its staff and investors many years notice of significant change.

“The reason for the 60-year retirement age is that people then know this is coming,” says Sillitoe. “Martin is one of the biggest proponents of this. What this enabled him to start doing in 2008 and 2009 was bring people through into leadership roles. It is important [investors] understand and know these individuals and are comfortable with the outcome.”

Generational change has become one of the biggest concerns for private equity houses and their limited partners (LPs) in recent years as many firms face pressure to hand control to younger partners.

In July 2013, Gresham Private Equity appointed Simon Inchley to the CEO role, replacing Paul Marson-Smith. In November 2013, EQT Partners replaced Conni Jonsson as managing partner with Thomas von Koch; and in January 2014 N+1 Mercapital elected Gonzalo de Rivera as CEO following the resignation of Javier Loizaga in November.

Montagu Private Equity, PAI Partners and Permira are among the other high-profile Europe-based buyout firms that have changed their top management in the past few years.

“The established industry, at least in North America and Western Europe, has been around for 35 years,” says Heather Stone, a partner at law firm Edwards Wildman. “There are a lot of firms out there where original founders are getting to the point where they are thinking about how many more funds they want to be part of.”

No surprises

Mark Calnan, global head of private equity at Towers Watson, agrees. “We are at the point in the life cycle of private equity when succession becomes a really critical item on many managers’ agenda. It’s a pretty major deal,” he says. “Many have managed this very well so far, but it seems certain that, over the next three to five years, many more will face these challenges and be tested on how they’ve structured their documents and how they engage with one another as partners and co-owners.”

For an investor, a succession plan – or lack of one – can determine whether its relationship with a private equity firm continues.

“[Succession planning] is one of the most important things we look at when we do due diligence on a fund,” says Graeme Gunn, a partner at fund of funds SL Capital. “We are trying to invest in a group for at least two iterations, so a 10-year-plus relationship. We have to consider where the firm is in its life cycle, what the leadership structure is and how they plan to bring junior people through. We spend a lot of time working with the senior team to see where they plan to take the business, and one of the key reasons we turn down funds is the lack of succession planning by founders. Unless they have addressed this point, it will become a major issue for us.”

Early discussions on who will take a firm’s helm are expected to begin years before the scheduled departure of the current leader. Investors hate unexpected news and want to know if the senior manager with whom they have entrusted their capital – and with whom they probably have a strong relationship – will remain with the business.

“You commit your money to a team you expect to execute the fund over the next five years and up to exit,” says Rainer Ender, a managing director and co-head of investment management at fund of funds Adveq. “It is an important aspect for the LPs, not only during the investment period but through the harvesting. [The GP] should clear all aspects [of succession] before they come to us. If there are unclear aspects which turn out to be different it is disruptive to their [fundraising] process.”

Whether investors are included in succession talks depends on the firm – some keep their most important LPs in the loop far in advance, while others prefer to keep the discussions a private, internal matter.

“The most important thing about succession for LPs is no surprises,” says Gunn, who adds that he appreciates it if his opinion is valued while acknowledging the appointment of a new leader is ultimately a buyout firm’s decision. “We want the move to be flagged up well in advance in an open dialogue – a year to 18 months before the next fundraising.”

Ender, on the other end, feels the talks should remain within the private equity firm, so long as the plan that is eventually presented is final.

The succession route a firm takes must be reflected in the documents related to its next fundraising, which are expected to identify the key men – the senior individuals whose departure would trigger a clause, which could in turn lead to a temporary freeze of the fund. As a firm moves towards generational change it is expected to name more than the one or two key men, as has traditionally been the case.

Investors welcome the opportunity to form relationships with younger partners well in advance so they can have confidence in the next generation.

“Good founders have thought this through, and two funds before they know they are going to retire they start to introduce the next generation of people,” says Gail McManus, managing director of search firm Private Equity Recruitment.

The best succession process is a clear, well-defined and smooth handover. “The impact of getting it wrong is just enormous,” says Buchan Scott, an investor relations partner at buyout firm Duke Street. “While succession is going on there is a very significant risk that, if the processes break down, a firm becomes rudderless.”

Small print

Once a leader is elected, a raft of finer details – often tricky to negotiate – remain. These include timescale, any role the former leader might retain following the handover, and the extent to which the former leader continues to receive a share of profits from the firm’s funds and for how long. The latter can throw up significant questions about the value of the brand the founders have created and how fairly they should be paid for the name they are leaving behind.

The value of the brand also becomes an issue when the person leaving has to be paid out of their share of the holding company of the firm – a difficult negotiation highlighted by the press reports on the ongoing legal dispute over the value of a stake in UK private equity house Charterhouse Capital Partners held by a former Charterhouse executive.

“You have to come to some arbitrary cut-off point with everything,” says Scott. “You can adopt a set of rules that relate to the date of the departure, the assets in the portfolio, do something with carry. There is never one formula that works for everybody but there is no reason why people can’t come up with what is, on the face of it, a rational system.”

Nonetheless, he adds that even with a process in place, particularly where there are genuine questions about the value of a well-known private-equity brand, some parties will try to put a value of zero on these interests by arguing that it relates specifically to the individuals concerned. “Some people will say there is significant value in a name,” he says. “When people are faced with the horrible reality of succession it is a very emotional discussion. There is always scope for negotiation at what is an emotional time.”

Sillitoe says that Apax’s culture, which is seemingly more corporate than a founder-led private equity firm, means the firm’s position on compensation for departees is relatively straightforward – those departing stop receiving bonuses from the management company when they go.

“You are here to hand on the firm to the next generation, so it has been the case in the firm that whenever anybody leaves, at that point they leave their economics behind for the next generation,” he says. “It is very important. You only get that through having this very strong culture of stewardship. If you have founders in the business looking to ultimately cash out then the only way to do that is to take the firm public. To do that you need to be a diversified asset manager rather than have one particular product.”

Leadership qualities

Finding a new head, and early on, can be difficult, especially if the performance of individuals varies over the life of a fund. What makes a good leader? Gunn prefers to see a firm’s best deal executives promoted to leadership roles. “They have the respect of the rest of the firm and there is a time for them to move into a more management role,” he says. “If you put an administrator at the top that’s fine, but does it provide leadership in an investment business?”

Sillitoe agrees the best deal executives make obvious candidates. “We are a business that is very much investment led, so I think in the leader or leaders you want somebody you trust to be at the head of that process so people have respect for your investing judgement,” he says.

While succession can present many hurdles, it is essential to its success that the firm protects relationships with its investors through clear communication, ensures a smooth transition and maintains a strong reputation.

“The good examples we have seen is where the founding partners of a firm, who have been driving the business for 15-20 years, have decided it is time to hand over the reins to the next generation, but remained in a chairman or rainmaker role,” says Gunn. “You keep the expertise in-house but refocus it.”

Calnan adds that many outside parties fail to see how distracting these ongoing discussions can be within relatively small organisations. “These firms earn fees to go out and find transactions,” he observes. “Most LPs will look at how big legacy portfolios are, because that will offer one indication as to how much time is going to be spent focused on seeking out those new opportunities. But the succession issues can be an even greater distraction than managing those legacy investments, in our view. In our due diligence, having a good feel for how much of a distraction that might be is fairly meaningful.”

The importance of this element of running a private equity business is clear from the fact that investors and manager selectors put it right up with investment competence in terms of it being a focus for due diligence. Given the potential impact it can have on the culture and focus of a firm, that should come as no surprise to asset allocators.