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.