Over the past decade, the investment management industry has given birth to thousands of dynamic firms that have achieved rapid growth and profitability. Many of these firms manage hedge funds for asset-based fees plus a percentage of portfolio gains. Global hedge fund assets have surged to more than $2.5 trillion, according to a 2007 survey by Hedge Fund Intelligence, and some entrepreneurial managers have become wealth generators within a few short years after start up.

The enormous annual compensation packages of leading hedge fund managers have been well publicized. Less visible, but perhaps more valuable, has been the growth in business equity created by investment managers of all sizes. In 2007, two large managers specializing in hedge funds, Fortress Investment Group and GLG Partners, went public at stock market valuations ranging from two to three times annual revenues. Even relatively small investment management firms, with less than $250 million in assets under management, have built valuable enterprises with persistent fee-based revenue streams and high profit margins.

How Investment Managers View Their Equity

A leading provider of accounting and auditing services to the hedge fund industry, we have developed close relationships with hundreds of management firms, providing us with a "picture window" into how successful managers view their business equity. In a nutshell, we believe many managers know they own a valuable asset, but they aren't always eager to tackle the details involved in quantifying and protecting it. This is a bit perplexing, because these people are among the most astute investment managers in the world, and management company equity often represents the majority of their net worth.

Time and again, as we review with clients their business structures and documents, we see evidence of costly "accidents waiting to happen," especially if a principal or owner should die, become disabled or leave the firm (voluntarily or involuntarily). To help protect against such accidents, we work to raise clients' consciousness on two levels: 1) conceptually, by helping managers understand barriers that keep them from taking the steps that would help maximize their equity; and 2) technically, by helping clients develop and implement concrete succession planning techniques by working closely with us and other qualified advisors.

What Are The Barriers?

Imagine a small, fast-growing management company organized as an LLC and equally owned by two members. In guiding them through succession planning, we might begin by posing this question: "If either member were to die tomorrow, who would then own the firm?"

The answer usually is found within a section of the LLC operating agreement, stating something such as this:
"Payment of Capital Accounts on Withdrawal, Retirement or Death.  In the event of the withdrawal, retirement or death of a Member, such Member shall be paid an amount equal to his portion of the Capital Account at the end of the fiscal year of the occurrence of such event..."

For several reasons, this language is insufficient and does not consider all the issues that may influence the member's ultimate stake in the company, including:

1. The member's capital accounts typically are based on the book value of the management company, not fair market value. However, successful management companies often sell for a multiple of some economic driver (i.e. annual revenues).
2. Only the financial considerations are addressed, not future operational and control issues. It leaves open the possibility that a spouse, family member or other beneficiary of a deceased member could demand the right to become active in the business, regardless of his/her business experience, knowledge or acumen.
3. The language is silent with regard to the specific terms and funding methods for buying out the deceased member, and it may produce unfavorable tax consequences for the LLC or deceased member's beneficiaries while missing estate-planning opportunities. Also, it does little to align the needs of the existing members with any new member who may join.

The Cost of Inertia

Lack of focus on these issues is serious and can cause complexity and be costly to address. So, why do many management company operating agreements ignore them?

We believe the answer often involves a combination of inertia and a focus on other business priorities. When a management company is formed, capital may be scarce and succession planning is not a priority. As a hedge fund grows, members usually concentrate on maximizing its performance, while ignoring the rising "fair market value" of the business itself. Ask a typical member what the management company is worth and the answer may be: "It depends on next month's performance." With strong investment performance, more clients and assets will flow into the firm's funds, and fee-income will increase. On the other hand, with sub-par performance, the manager fears it could all collapse quickly.

Amid constant pressure to run a growing management firm and volatile investment portfolios at the same time, managers just don't put a priority on updating obsolete operating agreements, some of which were boilerplate templates to begin with. Therefore, succession planning may not become a priority until an unthinkable event occurs. We have seen members dust off old agreements when a power struggle arises between them, or when one member decides to start a competing firm. However, even if all parties are alive, healthy and relatively amicable, unwinding business equity "after-the-fact" can be costly and time consuming.

Implementing Succession Planning Techniques

Because we believe investment managers have unique succession planning needs that require specialized expertise, we have itemized below a few specific planning ideas and techniques that have worked for our clients and can be useful:

1. Get rid of "cookie cutter" documents. In regard to the death, disability or termination of a member, boilerplate templates for LLC operating agreements may not address important issues, such as: 1) the distinction between business ownership rights and management control rights; 2) different valuation formulas depending on circumstances of a termination (i.e., voluntary or involuntary), or 3) different valuation formulas depending on key metrics such as assets under management or net operating income. An experienced team of accountants and attorneys will help structure the essence of an agreement readying it for drafting so that it fits the needs of the management company and each member.

2. Hire a professional valuation expert. There are a number of different business valuation experts, with varying credentials and expertise.  It is important to find the right specialist appraisers with expertise in assigning fair market value to management company equity as a part of your due diligence efforts.  In order to avoid then having the cost of continuously updating a valuation, you can peg it to a specific formula or metric. For example, suppose an appraiser establishes a fair market value of $50 million for a company, and this valuation is pegged when the firm has $250 million of assets under management (AUM). The agreement could specify a moving buy-out price based on a formula (i.e. equal to 20% of AUM in this example). In other types of firms, it may be more appropriate to have a professional appraiser update the valuation periodically.

3. Avoid unintended penalties. We have seen agreements in which the buy-out price for a forced "termination without-cause" is three times greater than the price upon a voluntary termination, death or disability. Penalties should be designed to serve a clear purpose, such as promoting harmony among members or discouraging members from leaving. They should not penalize members or their beneficiaries for events beyond their control such as death or disability. In general, the purpose of a sound succession planning process should not be to promote one intended "most favorable" outcome but rather to address a range of future possibilities, including those that are unlikely or undesirable.

4. Maximize bang for the buck. The time and money spent on succession planning can be leveraged into other advantages for the firm and its members. For example, the members can consider strategies such as a self-settled asset protection trust for insulating their capital against the claims of creditors or litigants. Due to the lack of case law in U.S. jurisdictions, it is sometimes advisable to use offshore trusts. Members' individual estate-planning needs also can be integrated with succession planning.

5. Clarify and document the firm's intellectual property and processes. A management company's most valuable assets may comprise investment strategies and algorithms, research methods and data and networks of key contacts. These assets may be drawn from members' past experience, and they are often undocumented and undefined as to the firm's rights. If a member leaves the firm, a standard non-compete agreement may not ensure the firm's continued exclusive access to intellectual property. The succession planning process can define intellectual property rights and responsibilities of the firm and each individual, including contingencies that may affect the value of such rights. For example, Member A contributes a trading system for the exclusive use of the firm for as long as he stays involved. Upon termination, the firm will have the option of buying an exclusive perpetual license for $X or a non-exclusive license for $Y.

6. Overcome the "insurance phobia." Hedge fund professionals are notoriously reluctant to spend money on insurance premiums. But life and disability income insurance serves the same purpose in succession planning that hedging strategies serve in managers' portfolios-namely, they reduce the burden of unpredictable events, help to maintain continuity or management, and increase peace-of-mind. Aside from premium funding cost, another objection we have heard is that insurance death benefits cap the payout that members can expect to receive, even if the firm's value keeps growing. This can be answered by inserting a "higher of" option into the agreement-i.e., when a buy-out is triggered, the price will be the higher of the available insurance proceeds payable or the amount established by valuation or formula.

7. Be creative! Another obstacle to planning may be the members' belief that their industry, niche or firm is so unusual that a conventional succession planning process can't do it justice. For example, hedge fund firms often move opportunistically to spin off new management companies or recruit new members. Isn't it difficult to keep operating agreements and buy-out plans current in such an environment? Not always.

If the goal is to assure succession planning, there are several different techniques that can be applied.  Private options are one technique that can be used to meet provisional or special needs. For example, suppose a firm has two unrelated members who plan to buy-out each other on a death or disability. But only one is healthy enough to qualify for an adequate amount of life insurance funding. The healthy member could pay a negotiated option premium for the right to purchase the unhealthy member's stock at a significant discount to fair market value or formula value, upon death.

Disability income insurance can be another creative solution, because it can help to fill funding gaps in the event of either party's permanent or long-term disability. It may even be advisable to over-fund payments to a member in a buy-out triggered by disability, due to the extra medical costs or care that the member may incur plus the firm's cost to hire and compensate a replacement.

Advantages of Succession Planning

For investment managers, a side benefit of a comprehensive succession planning process is the perspective it can add to personal and collective goals. The realization that each member's equity in a firm has established value can help to increase the firm's allocation of resources to vulnerabilities that threaten this value, such as gaps in compliance, system risk management or disaster recovery. Planning also can help to tie goals for future increases in the firm's value to specific resource allocations for marketing, asset retention and cross-selling strategies.

This process can help to recruit new talent to the firm, and it also can increase members' confidence in expanding benefits and incentives for non-owner staff. As older members approach retirement, having a funded buy-out in place can smooth the transition in the firm's management and ownership structure without the need for contentious, distracting negotiations. Finally, if the ultimate aim of the management company is to be acquired or go public, succession planning can demonstrate the permanence and foresight of the firm's leadership and assure its continuity.

When is the best time for hedge fund management companies to outgrow their boilerplate agreements and short-term planning focus?

When its members decide to get serious about managing money-their own!