John MacMurray, an experienced practitioner, has a piece in Private Equity Manager, a journal which we recommend, raising the thorny issue of partner succession in a private equity fund complex; that is how, as senior partners retire, do the seniors individually or as a group work out financial arrangements with their successors which are perceived by both the retiring and the up-and-coming asset managers as fair and equitable and economically supportable. As John points out, the issue is complex. The following is a restatement of a memorandum I prepared some years ago. As you can see, the memorandum raises more questions than it answers. But I trust it will be helpful as these issues are wrestled with by the principals and their advisers from time to time. As always, we are interested in an interactive dialogue . and all the new and creative ideas will appropriately credited and publicized.
The opening issue has to do with the asset management complex's 'brand' or a 'franchise' value, an enterprise value which is not a function exclusively of the assets under management, a value which is tied up in, among other things, a reasonable expectation that future fund raising on favorable terms will be achievable because the major sources of capital (endowment funds and employee benefit plans) naturally gravitate towards the brand names. The complicating factor is that, as with many professional service providers, the brand or franchise value is a product not only of a consistent history of performance but is also tied to the identity of the people who have driven that performance. As a new generation moves into positions of responsibility, the franchise value is dependent on the reasonable expectation that the junior partners will be able to perform as well or better than the seniors they are replacing, leading in turn to the common sense idea, widely shared, that transitions in this business are gradual . with the seniors retaining a voice in management and a gradually declining ownership position until the next generation has had an opportunity to prove itself on its own.
There does not appear to be any consistent (or "market" or "industry standard") structure in the industry for transitioning ownership and governance from one generation of managers to another. I have canvassed on occasion professionals and principals in a number of venture capital firms. No overall pattern has been detectable in those conversations. The solutions to the problem, if you will, are all over the lot; and, thus, this analysis, while profiting from other experiences, is essentially a case of first impression.
Assuming an enterprise or franchise value of the fund complex, the first order of business is to arrive at an agreed upon estimate of that value so that a discussion can proceed in a 'real world' context. The simplest and most direct way to establish that value is to attempt, or indeed successfully complete, a sale of the entire business to a strategic buyer; value is conclusively established if the fund complex in fact were to be sold. If that were to happen, however, this analysis is obviously, at an end. Accordingly, we will assume for purposes of further discussion that a sale of the entire business is either not feasible or not desirable. Indeed, given the paucity of exemplars, the comparable sale approach probably does not work. I have been involved from time to time as counsel in the acquisition of asset managers, and I am aware that, in isolated instances, managers of alternative investment portfolios, and particularly venture capital, have been sold as entities. But there are not enough benchmarks which would persuasively demonstrate, on the basis of comparable sales, the enterprise value of any given fund complex.
Assuming by some method, a dollar number has been arrived at, it obviously has to be, on the one hand, supportable out of the revenues of the ongoing business. It is unlikely that the junior partners are either in a position or in the mood to dig into their own pockets to pay cash to the senior partners in order to induce the latter to retire. Accordingly, as in management buyouts generally (and I am roughly analogizing this process to a management buyout), the trick is to find resources inside the company itself, based on assets and/or future cash flow, which will fund the transfer of wealth in the appropriate amount. Secondly, and on the other hand, the numbers should be attractive enough so that the senior partners are motivated to move gradually aside in favor of the next tier. It is in the interest of the next tier to come up with a number which is, therefore, attractive to the seniors. Further to this point, if the process works, then it should be repeatable. When I started practicing law many years ago, a family-owned company in New Hampshire looked to my then-firm for assistance in what was a very early management buyout. The business borrowed against future cash flow, paid out the existing owners (also managers) and thereby made room for a bargain purchase of the equity by the new cohort of managers/owners. What is interesting about the process is that, over the years (every ten years or so, as I remember) it has been repeated. I think the company is now on its fourth management buyout and all of them have been successful. All this to say that, if an acceptable solution is found, the second tier can look forward to benefiting from the precedent because the process (hopefully at least) repeats itself; when the third tier comes along, the second tier then will be able, a la the New Hampshire company I mentioned, to extract its fair share of the franchise value for themselves in the course of the inexorable next transition.
Assuming the economics can be worked out, then there are at least two other issues to be addressed. The first, and most obvious, has to do with the effect, if any, of the change in the relationship amongst managers on the limited partner group. This is likely to be largely a matter of patrolling the partnership agreements to review the so-called "key man" provisions, plus thinking through the investor relations issue.
The next issue has to do with structure.
First, the management company is, typically, the appropriate source of asset values and cash flow to fund the monetization of the enterprise or franchise value (the "Transition Value") of a fund complex. A corollary notion is that, since each fund has its own general partner, very little (if any) formal restructuring has to be initiated in order to provide for a transition on the general partner side. The general partner for each new fund will allocate profits interests in accordance with the circumstances as then existing when such fund goes out to raise its capital. The importance of the seniors as members of the new general partner will be a function of the attitude of each towards continuing in harness, plus expectations and evaluations in the marketplace.
One elegant way to provide for succession to management company equity entails the creation of an independent vehicle for introducing associates and junior partners to ownership interests in the management company proper; call that vehicle the "Associates LLC." The members of Associates LLC will have an indirect, although undiminished, interest in the profits of the management company, in accordance with their negotiated percentages: if Associates LLC owns 30 percent of the management company and X owns 33.3 percent of Associates LLC, X then enjoys a 10 percent interest in the management company.
The idea is that, by having an Associates LLC through which the new generation of partners passes before becoming members of the management company directly, adjustments can be periodically made during "spring training," both in (i) the length of time it takes each individual to succeed to ultimate management company membership and (ii) the quantum of the ultimate partnership share one receives on becoming a full fledged member/partner of the management company. And, I have found that it is easier and more functional initially to introduce new members to the intermediate vehicle, which is controlled by the managers of the management company, and to make adjustments inside that intermediate vehicle as people leave, new people are introduced, somebody's star rises, another's falls. Before the individual becomes a full fledged member of the management company, there is a certain maturation process, while the ownership interest of that individual is fine tuned.
The second structural recommendation has to do with the creation of yet a third vehicle, call it Senior Partners LLC. The idea is to site the assets and cash flow which make up the Transition Value in a vehicle existing outside the management company. This can be accomplished either by routing assets and/or cash through the management company or diverting the same before reaching the management company and directing it to the Senior Partners LLC. The idea is that this is a vehicle 100 percent owned by the senior partners and they can invest in assets as they see fit.
In the foregoing connection, tax issues are likely to be significant. If Senior Partners LLC is itself sold in order to establish a capital transaction or its cash flow (for the same purpose) sold to a diversified syndication pool (similar to a royalty or other cash flow syndication, with asset-backed securities issued against the pool), under the Internal Revenue Code some or all of the sales proceeds may be characterized nonetheless as taxable to the selling members of the Senior Partners LLC at ordinary income rates. To be sure, the transaction may be characterized, in part, a sale of good will, in which case capital gain treatment may be available.
Another possibility is to use the cash flow into Senior Partners LLC to support a borrowing, the proceeds of which are then deployed to purchase property with, say, accelerated depreciation characteristics, the depreciation sheltering (to the extent possible), the income taxable to Senior Partners LLC. As a semi-humorous aside, I understand that the retiring partners of a large fund have bought themselves a quail farm somewhere in the Southeast; they operate it as a farm (and also a shooting preserve, I assume) and, if they qualify under the Code, are able to deduct the losses, which usually attend farming operations, on their personal income tax returns. While a quail farm might be somewhat outr, I assume there are opportunities to purchase oil and gas assets, for example, or other depreciation plays which could prove tax efficient. A related concept (which nonetheless entails some risk these days) is life insurance, using cash flow from the management company to buy the life insurance on the lives of, say, the senior partners. There continue to remain tax advantages, although somewhat diminished, to company-financed life insurance.
Whether the vehicle is life insurance or not, the last item in this memorandum is to point out that for any one of the senior partners (and it does not, of course, have to be all) who are interested, it may be possible to create assets which are used tax efficiently as the foundation for estate plans or for charitable contributions.