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!