For the last two years, venture capitalists have been managing crises on both sides of their business. Flailing portfolio companies desperately need their time, advice and money. Limited partners are urgently demanding answers or even their money back.
But as VCs have scrambled to keep the funders happy and the fundeds alive, they’ve neglected one of the most important parts of their business: themselves. The structure of VC general partnerships – their corporate governance – is emerging as a potential minefield these days.
Many private equity partnerships paid too little attention to their own internal structure when markets where overheated and now have to deal with the consequences at a time of general illiquidity. Some are taking ad hoc actions under pressure without the benefit of time for reflection. The results are unwise decisions that can threaten the professional future and livelihood of each partner at the firm.
Much of the recent writing on VC governance issues (ours included) has focused on VCs’ relations to their LPs. Should the management fee of a poorly performing fund be reduced to share the pain with the investors? Should the size of an uninvested fund be reduced given the new, slower pace of expected investment? Should valuation and reporting policies be modified? Should advisory board roles be strengthened? These are all issues crucial to the success of a venture general partnership. But success also depends on the management of that partnership itself.
When times were better, governance issues were far less contentious. Transitions in firm leadership were made easier by the amount of money available and expected in the future to ease retirements and departures, while keeping the next generation happy and motivated to perform. In that environment, the challenge was to get the incentives right so as to not have junior-level high performers spinning out to compete rather than staying to become the next generation of leadership. (See “The Next Generation” cover story in the June issue of Venture Capital Journal.)
But the current environment has made the pies available for division smaller, and an effective balance between generations is harder to achieve. Partners considering retiring today must balance their desire to keep a piece of the partnership’s future profits, which they will not directly help to achieve, with the realities of the times: There may be much less profit for the partnership to divide from current funds than in the past. In addition, governance arrangements now have to contend not just with generational changes but also with partner departures forced by economic circumstances. Management and governance structures must now deal with how to share the pain, not just how to share the rewards – a much easier problem.
There are multiple issues in corporate governance of private equity funds. But here are three that deserve a firm’s utmost attention:
- * Downsizing. Better known these days as “right-sizing,” downsizing involves having to let go of partners due to economic reasons. The need raises several concerns: How to choose among individuals? How to deal with individual economic claims upon forced departure? How to treat issues of future competition, non-disparagement and other non-monetary aspects of departure? These are difficult questions and issues but inaction is never the right course to take. Setting the ground rules before specific cases come up helps to set expectations for all parties.
* Organizational Scale. Many private equity partnerships are finding that they have a resource allocation problem. It could be that a partnership has too many associates relative to experienced partners in a time when many fewer new deals need to be sourced. It could be that the partnership as a whole has too little direct management experience to lend to portfolio companies in a time when it is desperately needed. These imbalances impact the ability of the partnership to operate at its efficient scale – the point where its fund size, deal activity level, and management overhead costs magically align. A good starting point for a partnership is often to consider the “how” and “who” of partnership operational management. Choosing the right managing partner(s) is just as important for the partnership as for the portfolio company.
* Succession. The longevity of a private equity partnership not only depends on showing a good track record. The partnership must be able to show good junior people a viable track for them to reach the top level of the partnership before their hair turns too gray. Managing partners need to set expectations and also plan for their own succession so that a change in leadership does not itself become a crisis.
Good governance of a private equity firm facilitates the long-term success of the partnership. But the very nature of the private equity sector offers strong, short-term temptations for less-than-good governance. The illiquid long-term limited partnerships could tempt a firm to resist making painful changes and just choose to ride things out hoping for better days to come. For example, relying on those long-term agreements, they might choose not to adjust the partnership terms to accommodate LP complaints regarding the partnership’s overhead burden and excessive management fees. Or, they might choose to downsize by eliminating junior firm members on which the firm’s future success depends in order to preserve the economic rewards for senior members, who may be less suited to address the problems at hand.
To avoid shortsighted and short-term actions, a private equity firm must do what it pushes its own portfolio companies to do: Plan strategically, in advance of crises, seeking outside counsel from experts. Developing that five- or 10-year plan to deal with internal governance issues can take months or even a year to complete and even longer to implement. But the firms that can follow their own advice to others will be the ones with the best chance to build for a long-term future for themselves and their firm.
Colin Blaydon and Michael Horvath are professors at the Tuck School of Business at Dartmouth. They are also directors of the university’s Foster Center for Private Equity. They can be reached at