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The king is dead. Long live the king

The private equity industry has grown at astonishing speed over the last ten years. The problem is, many firms appear to have neglected one very important issue – succession.

The private equity industry in Europe is still relatively immature. However, investors are becoming increasingly concerned with succession planning at the fund management companies. This may be surprising, given that many of the senior managers are still young. In any other industry, you would expect them to have at least another ten years of active leadership in them.

So why are investors so concerned? The private equity industry has grown rapidly over the last ten years, both in terms of funds under management and people employed. Private equity is now recognised as a serious asset class for serious investors, such as pension funds. These investors want to know that their money will be well looked after for the fund's whole life.

To understand this concern, it's worth looking at the industry's development. In the early days, private equity was little more than a cottage industry. Its investors generally treated it as a fringe activity - it was fun and a welcome break from the run-of-the-mill quoted equities and bonds. The industry was pioneered by and peopled with charismatic, larger than life characters. That was part of the attraction. These characters were determined, single-minded entrepreneurs regarded as either heroes or villains for their deeds. Many of them enjoyed a wild-west gunslinger reputation and usually they had an ego to match. And, even when the private equity firm was part of a larger organisation, it was often an autonomous unit and the individual in charge would still fit the typical profile.

These characters were deal doers, first and foremost. They had a talent for attracting investment opportunities with real potential and for putting innovative financial structures in place. They were often supported by low profile colleagues who would do the detail work and who were an important component of the team.

But many of the characters were not natural managers. As their business has grown, they have encountered the same growing pains as many other small businesses. They have had to stop being deal doers in order to manage their firm. They have had to take a broader view of their business at a strategic and operational level. They have also had to think about developing their human resources in ways that were not necessary for a team of four or five people.

As the industry has expanded and deals have increased in size and complexity, so has the size of the investment management team. In some cases, the total headcount is over 50. The chief executive of an organisation that size needs to have rather more skills than deal doing.

Private equity fund managers are polarising between those that are becoming institutional in structure and those that remain small and dependent on one or two individuals. The institutional private equity management firm will have a management hierarchy, functional responsibilities, systems and procedures and, probably, a corporate culture that is deeper than one or two individuals. For the businesses that get this right, there is the prospect of a long-term future in which bosses are appointed and retire but life goes on: the company does not miss a beat and its investors will have great confidence that their investment will continue to be well managed. As some of these organisations broaden their product range there is the prospect that they will develop into the 21st century equivalent of J P Morgan or Goldman Sachs.

At the other end of the spectrum, some managers will remain as boutiques. The managers will continue to do deals and their future success will depend on how long the individuals remain motivated or have the energy for the job. Succession in those situations may make or break the business. The incumbent number two who is promoted when the original boss retires or dies may be a very good investment operator, but lack the personality that was so vital to the success of the business.

So what do serious investors in private equity funds want to see happening?

However large or small the private equity firm, it should be developing a succession plan. This should be tied in to the key man provisions in the partnership agreement. For some small managers who cannot find a suitable successor, the best solution will be to enter into an orderly winding up that liquidates the fund as quickly as possible while maximising realisations from the investments.

For larger managers, more than one potential succession candidate should be identified and groomed to take charge over a period of time. The advantage of this is that the eventual appointee does not have to go from doing deals one day to doing few or no deals and managing the company the next. With more than one candidate in the wings, it also gives some reserve for casualties through health, changed circumstances or loss of motivation. It may also create a healthy competitive environment, which will keep everyone motivated and reduce the risk of losing some good investment managers who feel they have no future. They may still depart when the succession occurs but it would at least be less disruptive.

Private equity investment has become a more professional activity in many respects. Many of the colourful characters have departed to be replaced by grey men in suits. However, succession planning is still near the bottom of the priority list despite the fact that it will be a high priority at their investee companies. Many managers now have MBA qualifications or experience as management consultants. They should know better and they need to put their own house in order.

Long live the king.

David Currie is managing director of Standard Life Investments (Private Equity Ltd). He is responsible for co-managing the private equity portfolio and the creation, marketing, implementation and operation of a $1bn private equity fund for third-party investors. Before joining Standard Life Investments Limited, David worked, most notably, for Abu Dhabi Investment Authority, where he was responsible for their European private equity programme.

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