Succession - Sarah Samuels on Generational Transitions (EP.400)

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3:11Clients of capital allocators or podcast guests may maintain positions in securities discussed on this podcast. As the first generation of investment firm founders approaches retirement age, the issue of succession to the next generation is increasingly at hand. We've seen several successful transitions of firms, many that haven't survived their founders, and an entire sub -industry arise to help facilitate generational transfers across GP stakes, structured transactions, and public offerings. With both managers and allocators thinking more about the inevitability of succession, I thought it would be helpful to share what a leading allocator who reviews thousands of managers has learned about the issue.

3:54My guest on today's show is Sarah Samuels, partner and head of investment management research at NEPC, which advises on $1 .7 trillion in assets. As part of her work assessing managers, Sarah has created a framework to analyze succession as an investment risk. She was a past guest on the show, and that conversation is replayed in the feed. Our conversation covers that framework across its three key metrics, performance, age, and and economics. We discuss the challenges of transitioning both economics and portfolio management using stories and analogies to other businesses along the way. Before we get going, here's a shout out to all the investor relations and business development professionals.

4:42Your role is one of the toughest in the industry because unlike in many other industries, the functions of marketing, sales, and customer relations rarely drive purchase decisions in investing. It's often hard to know how to move the ball forward when allocators are busy and opaque about their process. So we decided to create a Capital Allocators University experience just for you. On December 3rd and 4th in New York City, I'll be joined by your peer and superstar Rahul Mudgal, branding expert Jen Procek, founder of Procek Partners, conference wizard Ron Biscardi, founder of iConnections, and investment leaders, Sarah Samuels from NEPC, Dave Moorhead from Baylor, and Shannon O 'Leary from St.

5:29Paul and Minnesota Foundation, to help you learn best practices for understanding allocators, developing relationships with investors, and building a brand through workshops and peer discussions. You can learn more and sign up to join us at capitalallocators .com slash university. Thanks so much for spreading the word about our newest Capital Allocators University course for investor relations and business development professionals. Please enjoy my conversation with Sarah Samuels. Sarah, thanks for doing this with me. It's great to be here, Ted. Thanks for having me. So we're going to dive into this topic of succession.

6:08And I think a good place to start would be to ask, when did you start thinking about creating a framework around this issue? It's not something that's always been on my radar. And so when I think back to my early days of selecting investment managers, it was much more quantitatively oriented. And these are my days at the public pension fund. And when I went over to the endowment side, a lot of the capital was locked up into illiquid strategies. And it really became much more of a critical thinking exercise to select managers. We had to be subjective and think about the softer things. And so this was something that we focused on at the endowment and really built out that skill set there.

6:46And so when you came over here, how did you think about putting a framework on the issue of succession? Well, as you recall from when you kindly had me on your show a couple of years ago, we have a pretty rigorous investment framework here at NEPC. I believe that it marries the best of both worlds, that highly quantitative process that we use at the public pension fund and the highly qualitative and subjective process and critical thinking that we use at the endowment. So that framework is very extensive and it's upwards of 400 questions that I want each and every analyst to be able to answer.

7:20And so succession really falls into that culture and firm and organization category where we want to understand, is this going to be a going concern and what kinds of questions can we train our analysts to ask to think about this? What have been the key categories in assessing the succession of a manager? Yeah, so it's really three things that we are looking at. One is performance. The other is the key investor age. Are they approaching retirement? And then the third is the degree of next generation grooming. So those are three things that have a lot of subcategories underneath them. Let's tackle them one at a time.

7:55How does performance factor into thinking about succession? So we're looking at both short and long -term performance, and it's very important to think about succession through the performance lens. If we have an extended period of underperformance, it's going to lead to fatigue on behalf of not only the founder, who has accumulated a great deal of wealth in this organization, and may be tempted to fold and say, you know what, I've made my money. I'd love a higher quality of life. I want to be happy and hang out with my grandkids. And then also, underperformance leads to turnover. And if people aren't getting their incentive comp that's based on performance.

8:31So in just that lens, how do you think about projecting versus what is? So if there has been some underperformance, but people haven't left yet, is that a risk? How do you rate that as a factor? In our experience, this is predictive. I'll tell a story. We did this analysis in one of my former roles, and we looked at every hedge fund portfolio in our program. And we presented it to the investment committee. We identified a list of GPs that were of higher concern to us on this succession framework that we built. And two weeks later, one of the firms that was at the top of our list, Highfields, announced that they were folding and turning into a family office.

9:11And how do you think about that as making a change in a manager? So we are fiduciaries for 400 plus clients and $1 .6 trillion in assets. And our job is to ensure that the strategies that we are putting our clients' dollars in are sustainable, can generate returns, and are going to be good investments for the long term. So our allegiances to our clients, that said, we view part of our job as providing feedback to managers and GPs. When you think about it, they have a sample size oftentimes of one, maybe a little more than one. But as you know from your time in your seat on the hedge fund side, Ted, you've seen hundreds, if not thousands of situations.

9:55And so that's a real advantage for someone in our seat and an investment consultant. So I could share stories about times when we've met with investment managers, identified some red or yellow flags in terms of their succession management, provided feedback to them. And then within two or three weeks, they've implemented changes. is they were so grateful. They had good intentions. They just didn't know. How do you tease out, I don't know if it's short -term or medium -term performance softness, and that question of fatigue, particularly the people on the team around the founder? So this is where meeting with the team in person is really important.

10:30You want to be able to look at the body language. You want to speak with other LPs to understand what kinds of discussions that they're having. And so it's really a matter of qualitative and then looking at those outflows. We can look at a number of different performance metrics, whether it's looking at a sharp ratio for hedge funds, a drawdown. And we really want to understand, number one, are the junior and mid -level people and even senior people getting paid? Or have they gone years without making a meaningful income because they're underwater? And number two, how likely is it that this founder is just going to wave the white flag?

11:05So that then leans into the second category of age. Fairly simple quantitative metric. What have you discovered in looking at age as a factor? This is always a tricky one because age is not something that we use as a solid metric. It's obviously very, very soft. And we need to be able to accommodate that every single person is different. And some can work very late into their careers and others maybe won't want to. But if we see a founder approaching retirement age, we're really going to look to see, have they groomed that next generation? What type of economic stake have they built up in the firm, especially with those founders?

11:40who've had the firm for 20, 30 or more years, it's going to be really tricky to see who's going to be able to buy out their stake. The next generation likely hasn't accumulated enough wealth. There's a lot of tension on price. And this is something that needs to be thought about at least five years in advance of a liquidity event or a transfer of ownership. How does the size of the firm factor into that question of age? That's a good point. I think what we're really looking at is, does the founder own 100 % of the management company or a meaningful majority? Or have they been bringing people along, offering people opportunities to buy in, or maybe provide a loan for the next generation to become owners?

12:19Have they been reducing their ownership over time? If there's a large lump sum, whether it's a boutique firm or a huge organization, it's probably going to be tricky for that next gen to buy them out, which leads to increased risk of a GP state coming in or an outside minority or majority investor, which necessarily changes is the incentives and the way that the firm culture works and what they're striving to achieve. So let's turn to this third, this big category of grooming the next generation. What are the different steps along the way? At least five years before any planned event, we want to see that next generation being brought into the fold.

12:55And that's both from an economic standpoint, as well as from a running of the business, running of the firm. So people who have done one role their entire career, whether it's picking stocks or bonds or doing deals might be very good at that. But running a firm is a completely different skill set. It requires coaching and training both from the outside and the inside. We want them to be brought into different processes to be given that power and to be positioned in a role that has autonomy in the cloud. And then we want to see a program to reduce ownership to bring that next generation into the fold.

13:28So in some cases, we've said to managers who really just didn't know about the fact that they need to be thinking about succession. We've said we really need to engage with outside counsel and we'd like to see a management group. We're bringing in that next gen into the discussions that you're having about the partnership. What are some of the best practices in identifying and training the next generation? Well, this is very hard for many investors out there, especially founders. There's a huge tie to one's personal identity and value in running a firm. You've put blood, sweat and tears into doing this.

14:04And I use the term ego not in a negative way, but it's one's value, one's sense of worth. It's very difficult to hand that over and to think that the next generation could do it as well as you are. So the first is surrounding yourself with team members who you believe can do your job someday. As I always say, I want to be surrounded by people who are smarter than me and much more capable than me. That's not easy for every person. So that's the first thing. The next is thinking about engaging with outside counsel. There's a lot of different ways to do these types of things. And we want to make sure that if you're the founder and the owner that you're forecasting to that next gen, what's coming and that you have plans for them to take over.

14:42How about the mentorship of being a leader in an organization? Well, that's a great point. And I think it comes from both mentorship, one -on -one, elbow -to -elbow within the organization, because every organization has nuances. But it also, in my mind, should include having an executive coach. Because this is unlike any other area of our jobs. We don't go to school for years. We don't sit for CFA exams. We don't go to grad school to learn how to manage people necessarily. Oftentimes it's the person who has a zone of genius in doing deals and then they're asked to manage people and they have no idea what to do.

15:22They throw spaghetti against the wall to see what sticks and a lot of damage can be done in the meantime. Wellington has a wonderful program where they are basically providing in -house executive coaching and a leadership program for managing directors and even some partners to learn about these skills and other organizations support a coach. The other key part of this is always going to be the economics. If you're looking at an organization and just trying to see how the current economics are shared, what rates as good in terms of your assessment of a manager and what's on the other end of the spectrum as bad?

15:58So the economics, we can break them down into carry ownership of the management company. Of course, we want to see carry distributed among the people who are doing the deals. That's table stakes. We're going to match the attribution, who's doing the deals and creating the value, and are they getting appropriate compensation? Because they're going to leave. We see it all the time if they're not treated fairly. So we want to make sure the carry distribution is there. And then when we think about ownership of the management company, that is a bit of a puzzle where we're tying it back to the investor age.

16:25If they're in the early 50s, late 40s, if they own 100%, that's fine. We want to make sure that it's on their radar to be thinking about transitioning that ownership. Another soft indicator is the naming convention of the firm. If it's somebody's last name, it's a bit of an indicator that perhaps there's maybe going to be some difficulty in imagining a firm without them. And it does happen. The name can stay, but it oftentimes is more difficult. And then when it comes to the succession plan, we want to understand what is the formal internal succession? Who are they training up to be their backup?

16:57And then we want to understand if something happens unexpectedly and they're incapacitated or gone, where will their ownership go? And oftentimes it's going to go to the family and to an estate. And we've actually seen situations where you have a daughter or a son who has no idea what the investment industry is owning this firm and lack of clarity in terms of who's going to run it and how. On the carry piece, let's say the year to year, you have the spectrum of some firms who, let's say it's an eat what you kill model, the people who are generating the profits in that year or some period of time get the economics.

17:31And then others that say, no, these are longer term. Everyone has to buy in on some version of shared ownership. How do you think about what works best? There are some strategies where you what you kill can make a lot of sense. So something where people can operate in a fully autonomous way. More often than not, we're looking for a team based approach. And so we want to see alignment there because there can be some real perverse incentives when you're motivating people to operate in a siloed way. When you get to this period where, let's say, the economic side of the succession, maybe they've groomed the next generation, they're ready to take leadership, but there has to be some economic transaction.

18:10What are the different ways you've seen that flow through an organization? So there are lots of different ways that this can be constructed, but I think the most important thing to recognize is that there is going to be tension and that everyone is going to feel as though they're leaving something on the table. So there needs to be a price at which the founder will sell and at which the next generation will buy. And the challenge is that you're going to continue working together. This isn't like doing a deal with an outside organization. There can be real cultural damage done if it's not handled extremely carefully because the founder will likely feel that they're leaving something on the table and they might need to in order to provide an accessible ownership entry point for that next generation.

18:53So you really need a solid third -party valuation provider that has lots of transparency so everyone can see what's going into that. And that's going to be what are the comps that you can look at that are available. Multiple valuation approaches, whether it's a DCF or transaction -based comps or looking at those types of things. And then the other way that we've seen is that NextGen buys the ownership directly from the founder with capital that they've accumulated in their personal wealth. Eight times out of 10, I would say they don't have enough money to do that. So the firm can provide a loan to the next gen to buy in.

19:30Or there could be an equity participation agreement where you come in and you get an ownership percentage and your stake in the firm, you participate in the valuation increase from that point going forward. So it costs $0, but you also come in with $0 in equity and you participate in the future equity. There's a lot of legal work that can be done on recycling provisions. So when someone retires, how their ownership gets distributed through the organization. So the really successful firms that we've seen have a decent amount of partners and distributed ownership. You can't get there right away.

20:04But at NEPC, we have 50 partners. Wellington has well over 100. And those are the stable firms that can live on because they've got a broad ownership base. And they've said over time, we're going to reduce the founder's stake by some pace. It could be a big transaction that gets them from 100 % to 50 % and then down 5 % each of the next number of years until they're done. What are some of the pitfalls you've seen of firms trying to execute some type of economic transition? Well, it's not a pitfall so much as something that really is a catalyst for potential big change in the organization, which is having an outside owner come in.

20:46in the form of GP stakes or a strategic investor or going public and IPO -ing. Let's walk through those different types of third -party transactions and try to look at the pluses and minuses. Let me start with GP stakes. GP stakes are super, super common, and it's happening at an increasing pace. I've seen research that suggests that $60 to $70 billion has been raised for GP stake funds. The uses of that are going to be varied. So it's not just going to be used for buying out the founder and providing a liquidity event. It can be used for that. But it could also be used to invest in technology and infrastructure.

21:23It could be used to fund new types of strategies and new geographies or seed new investment strategies. But essentially, that GP stake, GP, the fund that's underwriting this firm, has a return expectation. And they've done their analysis on what they believe the return could be. There's two components. There's the stable management fee, and then there's the more variable carry. And they have different ways to evaluate that and come up with a projected return for themselves. But they're going to want to grow that base. And oftentimes there's pressure to scale and diversify the revenue streams, which can be a big distraction for folks if they have to manage a smaller fund, lower middle market buyout pool, and they've only been doing megas for their entire career.

22:10If they branch out, they can distract people and dilute their attention. And then the other challenge with this is just that it necessarily means that there are going to be different deals that have to be done if there's more dollars to put to work. And that track record that you're buying, yesterday's track record may not be repeatable. How about the IPOs? There aren't that many of them, but there are a couple of organizations that have gone public with mixed success. IPO -ing is a lever for sure to pull, and it can make a lot of sense. It, of course, puts a whole new set of regulatory burdens on an organization, and it puts that quarterly earnings pressure on the organization.

22:53So again, it's going to be ripe with potential pitfalls, and it's something that we, in our investment framework, we don't say there's one ownership structure that's better than another, but we have an awful lot of questions if something is publicly held or a portion of it is floated. What about certain, usually larger scale LPs making a strategic investment into a GP to help with that transition? I think that can make a lot of sense. There are a lot of public funds out there who their argument is, if we're paying these fees, we might as well participate in some of that and get it back, whether it's a perpetual investment or if there's some sort of exit.

23:30The question is, have these LPs got the experience and are they equipped to make these types of investments and value them appropriately? What have you seen across different strategies? So you think about long only, maybe hedge funds, private equity, venture capital, in terms of the ways they've gone about succession and lessons they can learn from each other. We have so many stories of both really well -run succession and very poorly run and everything in between. And so I'd love to tell a story about comparing and contrasting two founders who handled their succession stories very, very differently.

24:10So the first one is Oak Tree, very well managed. This is a large private markets GP, you know, focused on all sorts of things and founded in the mid -90s. So been around for a while. They thoughtfully saw the need to begin transitioning ownership. And they had a number of liquidity events, including selling a percentage to clients and then to institutional investors via private placement, and then ultimately via an IPO. And they floated 6 % of the company. So at this time, the co -founders were in their mid -60s and mid -50s, respectively. They reduced their ownership in the company to sub -15%, which is really meaningful.

24:44And it's something that we like to see, that small ownership. This really equipped the firm to begin to be fully self -reliant and be able to be sustainable in the long term. And just as importantly as transitioning the economic ownership, they began to transition their decision -making authority to that next generation. And they formally named people to be CIO. And in decision -making roles, the founder still sits on the board. But the next gen has been elevated to a co -CEO structure. So now the firm is nearly 30 years old, and it's very clearly going to be able to continue to run. And we contrast that with another one.