Succession Planning for Alternative Investment Funds

As a large generation nears full retirement age, many wonder what’s next and what they can do to enable a well-organized transition and exit from a company where they have spent their careers.  

A good succession plan can identify and address risks, ease investors' concerns, and help foster the organization's long-term future.  

Key Highlights:  

• Succession planning is important for alternative investment funds to have a smooth leadership transition, protect capital, and maintain investor relationships and organizational stability. 
• The process involves assessing current operations, identifying potential successors, and formalizing clear transition plans to address expected and unexpected departures. 
• Best practices include starting early, developing a well-documented plan, regularly updating it, and seeking professional advice to ensure comprehensive and compliant succession strategies. 

What is Succession Planning?  

Succession planning is the process of identifying key positions within a business or organization and developing a plan of action for individuals to assume those key positions.  

In the context of alternative investment funds, this involves establishing a roadmap for transferring leadership, ownership, and key responsibilities to maintain the fund's success and stability.  

Preparing a company for talent transition should begin long before the departure occurs. Departures often happen unexpectedly, and without a plan in place, they cause significant disruption in the business. 

A comprehensive plan addresses potential departures due to retirement or unexpected events. It goes beyond naming a successor and instead includes a process for developing talent, transferring knowledge, and maintaining the firm’s culture and values.  

However, there are other options available as well. For example, passing the ownership to a family member such as a spouse or children which could provide tax benefits, including deferring potential capital gains tax, utilizing available lifetime gift exemption and avoiding potential future estate taxes.. And further, the family of the successor might have the reins to appoint an external party to a management role who has an asset management background to ensure the business is successful.  

Another option is selling the business, which is also subject to capital gains tax. The buyer is likely to retain key individuals integral to the business’s success. Often, the buyer invests in only a portion of the business, with the original owner diluting shares over time.  

A succession plan can also entail a management buyout, typically funded through private equity. There are also tax implications that come with this.  

Finally, there are times when the owner does not want to pass the business to anyone else and therefore, they opt for a voluntary liquidation which entails shareholders passing a resolution voting in favor of this option and appointing a liquidator to spearhead the winddown.  

Why Succession Planning is Important for Alternative Investment Funds 

Alternative investment funds, such as hedge funds, private equity, venture capital, and real estate investment firms, know that a successful transition is paramount to preserving capital and maintaining a lifetime of relationships.  

The absence of an effective, well-thought-out succession plan can cause unwanted attention internally and externally. For example, the co-founders of hedge fund titan Two Sigma Investments reached the point where the firm cited the ongoing rift as a material risk to the organization in a regulatory filing. According to the filing, the co-founders had failed to agree on a succession plan and define roles and responsibilities for C-level executives and investment management professionals.  

An event like this can cause internal turmoil among employees who might feel overlooked and cause investors to wonder about their prospects, as the organization has not adequately prepared them for the future.  

The SEC has proposed rules, emphasizing the importance of written business continuity and transition plans for registered investment advisers. The rules were designed to make sure that investment advisors have plans to address any operational risks that could significantly disrupt their business and minimize potential investor harm.  

What to Consider During Succession Planning  

Assessment and Planning  

The first step in developing a succession plan is to assess the current situation and define the goals and objectives, such as maintaining continuity, maximizing value, or preserving key relationships.  

A key focus is identifying “key person risk,” especially in founder-led or small organizations, where losing a central figure could disrupt operations.  This stage also involves evaluating the fund’s financial health and organizational structure.  

Fund Strategy  

It is also important to consider the fund’s investment strategy when putting together a succession plan. A long/short equity hedge fund’s plan might be different than a quant fund’s, for example. Further, a private equity fund’s plan will vary from a hedge fund’s due to less liquid investments.  

Successor Identification and Development  

Next, potential successors are identified from within or outside the organization. It’s important to define the skills and experience needed for each role and to implement training and mentoring programs to prepare successors for leadership.  

The Transition Process  

This phase involves transferring responsibilities, either gradually or immediately, depending on the situation. Clear communication with stakeholders helps maintain trust. Defining roles and responsibilities during the transition can help create a smooth handover.  

Documentation and Formalization  

Finally, the plan must be formalized through updated operating documents. Establishing clear governance and control structures creates accountability and continuity post-transition.  

Key Stakeholders in the Succession Planning Process  

Effective succession planning involves several key stakeholders, each with a unique interest in the outcome.  

Fund Managers/GPs 

The general partners or founders are responsible for initiating the succession planning process. They are vested in the fund's continued success and preserving their legacy. As they pass the torch to the next generation, they also want to maintain the relationships built with investors over the years to benefit everyone.  

Investors/LPs 

Limited partners or investors provide the capital for the fund and are concerned about the stability and performance of their investments during and after the transition. They need confidence in the new leadership's abilities to manage the fund effectively. Lately, the lack of succession plans amongst asset managers has been a major concern for investors and has contributed to consolidation in the industry as managers have prioritized other parts of the business with thinner profit margins, for example, investing more resources in marketing, legal costs for robust compliance programs, private equity firms figuring out how to deploy capital, etc.  

Employees 

Changes in leadership and ownership affect the fund’s employees, including portfolio managers, analysts, and operational staff. A well-communicated succession plan can help maintain morale and retain key talent.  

For larger organizations, the advisory board, board of directors, human resources group, general counsel and other senior management should participate in this process.   

Best Practices for Effective Succession Planning for Alternative Investment Funds  

To mitigate any challenges and to create a successful transition, consider the following best practices:  

• Start early and be proactive: Succession planning should begin well before any anticipated departure. This allows time to identify and develop successors and address any potential issues. Additionally, identifying the successor publicly before a planned departure is often beneficial, so relationships with investors may be maintained.  
• Develop a clear and well-documented plan: The succession plan should be formalized in writing and clearly outline the process for transferring leadership, ownership, and responsibilities. This document should be communicated to all key stakeholders.  
• Regularly review and update the plan: The succession plan should be reviewed and updated periodically to make sure it remains relevant and aligned with the fund’s goals and objectives. This is particularly important for alternative investment funds, where market conditions and regulations can change rapidly.  
• Seek professional advice (legal, financial, and consultants). Funds should seek guidance from legal, financial, and succession planning specialists to make sure that the plan is comprehensive, compliant, and tailored to their specific needs.  

Start Your Succession Plan  

A carefully planned transition can strengthen employee morale and help develop an organization’s culture. With an increasing number of retirees expected within the next decade, a well-designed succession plan can put an organization on a continued path of success after a key event or departure.