Changing Faces

Planning for succession in developing businesses

Originally published in the October 2009 issue

Recent events suggest that the evolution of the asset management industry and, in particular, hedge fund and private equity firms, is approaching a key phase.

The founders of those firms left investment banks seeking control of and freedom to run their businesses. They have now reached a point of critical mass requiring some form of institutionalisation if the entity is to continue to grow. Recent high-level departures, management restructurings, trade sales and listings, some of which have been widely reported, have highlighted these developments.

To a large extent these issues would apply to any growing business. However, the position is complicated by the fact that the reputation of an asset manager is often built upon that of its key performers. At some stage, those individuals will inevitably want to retire from the business and realise the value of their work in building it. Equally, the next generation of leaders will want to take greater control. However, with the level of investor confidence in the firm and, as a result, the value of the business largely tied to the involvement of those key individuals, a smooth plan for succession is key to maintaining stability.

The industry has seen enormous growth in the number of firms being established over the last 20 years. However, alongside the many boutique practices has developed a smaller number of leading asset management businesses which have become institutions in their own right, employing hundreds of investment professionals and in many cases benefiting from a wide network of international offices and an institutional client base.

In order to continue to function effectively, those businesses need to ensure that the arrangements governing control of the business mature at a pace which provides appropriate governance and ownership structures. Arrangements made between a small number of colleagues when founding a new business are unlikely to reflect the commercial reality of how the business operates after 20 years of development and expansion.

While there can be reluctance to enter into what might be sensitive talks on changes to the firm’s operations and fundamental ownership structure, it is nonetheless important that those arrangements are subjected to regular review to ensure that they reflect parties’ expectations throughout the life of the business. This is equally as important during prosperous years, when there is hopefully enough profit to go around to keep everyone happy, as it is in times when funds are more scarce. Unfortunately, it is often not until issues of natural succession become unavoidable or if there is some sort of problem – perhaps aggravated by a decline in performance and the resulting effects on fee income – that parties acknowledge that the documentation underpinning the firm’s structure does not reflect the commercial understanding of how the business works.

As more asset management businesses reach a stage in their development at which the boutique model on which they have been operating no longer provides a sound basis for further growth, a greater number of disputes between the owners is likely. This is particularly the case where businesses have come under strain following the recent deterioration of economic conditions. It is also a function of a natural tension between founding partners who have a personal attachment to, and vision of, the business and more junior personnel who wish to develop their own ideas.

For example, while the retirement of Jon Moulton from Alchemy Partners had been planned, his recent decision to resign ahead of that retirement date and his open letter to investors, criticising the management strategy of the firm and, in particular, his successor Dominic Slade, illustrate the level of tension that can arise whenperformance suffers and a deadlock arises as to the firm’s strategy.

It can be difficult to provide answers in advance for how fundamental issues of control should be resolved. It may, however, help to avoid the negative publicity, costs and the loss of management time associated with litigation if there is at least a process in place that can be referred to in the event of a dispute, to which all parties have agreed and committed in advance.

That dispute resolution process will be bolstered to an extent if an appropriate review of governance structures and the documentation that supports them is undertaken on a regular basis. Those involved should then be working within a control structure that reflects how the business is run and how authority is distributed as a matter of fact.

Remuneration structures
That is not to say, however, that firms need to move to an institutional model of remuneration, which is a key area for potential disputes in asset management firms. At large corporations and, in particular, at the level of FTSE 100 and FTSE 250 companies, remuneration committees made up of independent non-executive directors set salaries and bonuses of executives by reference to benchmark levels of remuneration in the relevant sector.

That approach does not sit well with the ethos of the asset management sector, where fund managers expect to be rewarded on the basis of a share of the returns that they deliver to investors and where performance is readily identifiable by reference to the value of the portfolios they manage. The skill of the risk-taking professionals is the fundamental business output of these firms. For so long as there are investors who are willing to share the gains on their investments in return for high-quality advice and execution, the performance fee model seems unlikely to change in substance.

However, as firms become more institutionalised and continue to attract a more institutional, regulated investor base, we can expect to see a greater level of scrutiny of remuneration structures both from regulators and investors. The ongoing G20 discussions on the effective regulation of the financial services sector and the Walker review of the banking industry in the UK are likely to add to this increased level of attention. However, irrespective of action taken at the governmental level (and acknowledging that any such action is likely to be difficult to implement in relation to a fund management industry which is highly mobile), investors will continue to focus on ensuring the long-term alignment of their interests with those of the fund managers they retain.

The carried interest model of private equity funds already achieves that alignment to a large extent, as the carry generally only becomes payable at the end of the fund’s term, once total performance is known, or is otherwise subject to escrow and clawback arrangements if paid out earlier. Even so, investors are increasingly putting pressure on managers to reduce the fixed management fees that are charged on committed capital, irrespective of performance, illustrating the increased pressure on managers in a downturn.

In the hedge fund space, investors are equally keen to ensure that individual portfolio managers are focused on the long-term success of their fund. They can take comfort from the position of many hedge fund managers (particularly those with listed funds) of encouraging or requiring that a percentage of bonuses are held subject to vesting arrangements and/or re-invested in the relevant funds. High-watermark arrangements also provide a mechanism to incentivise the investment manager through the life of the fund. However, in the context of more general concerns around short-termism in the financial services industry, we expect that investors may seek additional disclosure from managers on the internal allocation and payment arrangements relating to the distribution of performance fees among employees than they have previously. The extent to which bonuses arepaid in cash and the arrangements governing the terms and timing of such payments may be one area on which investors focus.

In doing so, parties do need to be conscious of the need to balance the aim of appropriately incentivising individuals against the need to ensure that payment is not made for failure. Where economic conditions are such that an individual fund manager has effectively lost all hope of realising a performance fee, firms and their investors need to be realistic about how that fund can effectively be managed in the future. This may mean that the parties have to acknowledge that to maximise value a fund should be put into an orderly wind-down in advance of any fixed term or that new arrangements should be put in place. Although investors may be reluctant to let a manager off the hook for the ongoing provision of its management services and to realise losses in an early liquidation, a commercial decision needs to be made as to the benefits for any of the parties in continuing otherwise.

The loss of a performance based incentive which forms the bulk of an individual’s long term remuneration can act as a catalyst for disputes as to the direction that the business should take, particularly where individuals feel that responsibility for losses is shared unequally.

Key individuals
The nature of the asset management industry is such that, even in larger firms, responsibility for portfolio management for a particular fund will often be concentrated in the hands of a relatively small number of investment professionals. In the many more boutique firms, the overall control and influence of the principals is often viewed by investors as being key to their decision to invest in the first place. Investor confidence in the ongoing management of their funds is, therefore, linked heavily to the trust that they place in key individuals at the firm. In that context, the use of key-person provisions in management arrangements becomes significant.

For open-ended hedge funds, the ability of investors to redeem their interests in the fund reduces the need for key-person provisions. However, for private equity funds and for closed-ended products, fund terms often provide for the early termination of commitment periods or for the board of the fund to have a right to terminate the management agreement with the fund manager, to the extent that a key-person ceases to be involved in its management. Clearly, this can give an individual significant leverage in any dispute between colleagues as to how the fund should be run, given the potential effect of the departure of a key individual.

It also reflects the commercial reality that the abilities of such individuals form the basis for the firm’s mandate and that without them on board, effectively investors will not receive the same service that they expected when making a commitment to the fund. The role of key individuals is often so central that their departure can lead to a wind-down or restructuring of the fund. In September 2009, for example, PAI Partners faced significant disruption as a result of the announcement of the departure of two its most senior principals in the wake of significant write downs. It has been reported that those departures will trigger key-person clauses in the fund documentation, which has raised the prospect of investors being offered a significant reduction in the level of their commitments to the fund as an alternative to winding it up.

The general terms on which a firm employs its key individuals are, therefore, key to the business and should be reviewed on a regular basis. Market practices for good and bad leaver provisions, which govern an individuals rights on leaving a firm according to the reasons for their departure, as well as those relating to more general restrictive covenants given by employees, have developed to very sophisticated levels. Care needs to be taken to ensure that provisions designed to protect the firm will be judged to be a legitimate protection of its interests rather than an unenforceable restraint on trade.

More generally, firms should undertake a regular review of any key-person clauses relevant in their fund documentation so that they keep pace with developments within the business. This should ensure that the correct people are identified as the key individuals involved in the management of a given fund from time to time.

With founding partners now approaching retirement, the need both to incentivise the next generation of talent and to reward the principals who have overseen the growth of the business made either an IPO or a sale to a listed parent an attractive option prior to the current recession.

Founding partners of asset management firms have used entrepreneurial leadership to build the goodwill of their business, for which they will want to receive value even if their day-to-day involvement in investment decisions may have reduced.

BlueBay Asset Management’s London listing and Polar Capital’s AIM listing are good examples of managers of a certain size seeking to combine the advantages of the availability of external capital with a potential exit for stakeholders. More recently, Blackstone’s 2007 IPO and KKR’s long-discussed New York listing show similar drivers at work in the private equity field. Managers considering IPOs should, however, be mindful of the potential for increased disclosure obligations for listed entities, particularly in respect of employee remuneration, in the wake of the Walker review and current G20 discussions.

The current economic crisis and lack of investor appetite for IPOs will, at least in the short term, limit the ability of firms to access the equity markets, although there are signs of a potential revival in this market.

In the meantime, with financial institutions generally seeking to restructure their balance sheets, we expect to see further consolidation in the asset management industry through trade sales, such as the sale of Insight Investment Management to Bank of New York Mellon by Lloyds Banking Group, which was agreed in August 2009.

As noted in the August edition of The Hedge Fund Journal, firms such as Brevan Howard, which sold a strategic stake to Swiss Re in 2007, may be able to use the listed securities of their investors in structuring incentive schemes for personnel at the underlying level, which can also be attractive.

While it may be difficult to plan exits too far in advance, a general founder exit strategy is important to how a firm’s governance structure develops and becomes increasingly so as the horizon for such an exit nears. Again, we would expect asset management firms to address their founder exit strategy as part of their regular business reviews and to ensure that their structure is adapted as appropriate to reflect that strategy at the appropriate time.

It is inevitable that disputes between management and, potentially, between management and investors, may arise from time to time, particularly where poor performance is creating tension within the business. More generally, recent events at firms like PAI Partners and Alchemy – and more general market sentiment – all underline the importance of structured succession planning to the stability and continued growth of asset management businesses.

Maintaining and documenting governance and control arrangements that reflect properly the developing nature of the firm is essential to ensuring that the succession process runs smoothly and for managing the impact of any disputes or, preferably, avoiding them in the first place.


Mark Geday is a partner and Stephen Newby a senior associate in the asset management group of Herbert Smith LLP, focusing on M&A, IPOs and fund raisings. Andrew Taggart is a partner specialising in employment, pensions and incentives.