Insight Center: Publications

How Legal Considerations Shape Succession Planning

Author: Julia D. Corelli


This chapter was first published in Succession Planning in Private Equity by PEI. For more information about this guide, please visit www.privateequityinternational.com/succession.


Much has been written about the importance of succession planning as a pillar of a firm’s culture and its ability to retain talent. Much has also been written about the importance to investors about cultivating long-term relationships that span beyond the life of a single fund. Virtually all agree that investors generally invest in teams, not just strategies, and a firm’s ability to transcend a single key team member is very important. Ironically, firms are notoriously reticent to engage overtly in the exercise of succession planning. The truth is that firms that do not plan for succession often do not last beyond the lifetime of their founders. Sadly, the managers who work for such founders often aspire to be firm leaders themselves and for their firm to be an industry participant that lasts for decades. To alleviate native reticence about succession planning, this chapter discusses some of the legal principles that influence succession planning.

A Firm’s Structure and its Fiduciary Duty

The typical structure of private equity firm is one, two or three founding partners at the top, followed by a few lead partners or managing directors who manage deals, next the middle managers or principals/directors, and then analysts and administrative personnel. For purposes of this chapter, it is assumed that there is a management company, a general partner or GP1 and a fund, each of which is a Delaware limited partnership or limited liability company, and that within the management company there are several founders, several managing directors and even more principals.

In succession planning, it is close call as to which is more difficult for managers: (i) getting from point A to point B, or (ii) identifying the most desirable point B. Figuring out what the firm is going to or needs to look like in 5, 10, 15 or 20 years is not easy and is point B for the leader(s) of a private equity firm. The first question in identifying point B should always be: according to the firm’s governance structure, who makes the decision on a new leader? That leads to a host of other questions: should limited partners (LPs) be involved in the decision? Is it realistic for founders to decide their own, albeit future, replacement? Is it realistic for managing directors to be able to impose their choice of successor? The answer to all three questions is: generally not. Investors, while interested in the outcome, should not be so integrally involved in the internal governance of the firm. Any single investor having such influence would be unfair to other investors, and yet requiring consensus of all investors could be paralysing. Founders  cannot decide on their own because they need 100 percent buy-in from the successor managers. For the same reason, the successor managers either work with the founder(s) on the plan or risk being tossed out for attempting a coup.

In reality, succession decisions must be made in collaboration between the founders and the next generation of leadership in a manner that is acceptable to investors (or else they vote with their wallets and do not sign up for the next fund). In some firms, succession planning is long overdue. In those firms, it is frequently the next generation which pushes decision-making to the fore and with considerable discomfort or downright fear that they will be pushed out of the firm. In other firms, succession planning may take the form of an annual review of an existing plan and/or complementary periodic assessments, or ‘simply’ instituting new terms and conditions for retention and recruitment while encouraging less experienced managers to develop the leadership skills necessary for managing a private equity firm.

Most fund managers understand that a GP has both a fiduciary duty of care and duty of loyalty to the fund’s investors. The management company, as asset managers and employers of people with managerial roles, whether by reason of its control, or by contract with the fund and GP, or by agency theory, assumes the GP’s fiduciary obligations to the fund’s investors. However, while it is still the subject of discussion in court opinions,2 these so-called ‘default’ fiduciary duties of care and loyalty exist under common law, are acknowledged in statute and can be altered by contract.3

Fiduciary duties play a significant role in succession planning. They are a significant impetus for the planning itself as the GP could arguably breach its fiduciary duty of care, a significant component of which is the obligation to act in the best interests of the fund, should it not have a succession plan.4 In addition, the content of the resulting succession plan is tested in due diligence reviews by prospective investors; if investors do not feel it is in the best interests of the fund, they will not invest. The keyperson provisions in the fund agreement are designed to impose a procedure that will protect the fund and its investors, if the named key person ceases to be actively involved in the fund. It is a preordained process for succession that is but one component of the GP’s succession plan. Having a key-person provision by itself should not be viewed as sufficient, even at a minimal level, to satisfy the GP’s duty of care to the fund.

The Delaware limited partnership and limited liability company statutes provide for broad authority to set terms in a fund agreement which will govern the relationship between the GP and the fund investors.5 For a while, fund managers tried to reduce or eliminate fiduciary duties through express waiver provisions in the fund agreement, reducing the GP’s responsibility to the most basic non-waivable component of fiduciary obligations – the duty to act in good faith. This quickly met with resistance in the market and is unacceptable to many if not most institutional investors. ILPA, which represents the interests of a majority of investor capital globally, in its Private Equity Principles wrote: ‘Given the GP’s high level of discretion regarding operation of the partnership, any provisions that allow the GP to reduce or escape its fiduciary duties in any way must be avoided.’ ILPA then discusses a number of points in the design of the funds terms that relate to monitoring or enforcement of fiduciary obligations. One of these – the power to remove the GP – directly implicates succession planning. Of course, if the GP of the fund is the subject of a removal vote, the time for controlled succession planning is long gone and a different kind of succession planning is likely taking over.

The Importance of Separate Legal Entities

Fundamental to understanding the succession planning legal landscape is an understanding of why funds are structured the way they are and what that structure does to the firm’s ability to thrive for several generations of leaders. The following outlines the basic structuring principles that set the stage for the remainder of this chapter.

When the fund is structured as a limited partnership, the GP is responsible for the governance of the fund. Under most fund agreements, the responsibility for managing the fund is then delegated by the GP to the management company. The GP is not, however, thereby absolved of the responsibility for fund management vis-à-vis the fund’s investors. There is no privity of contract between the fund’s LPs and the management company, though this exists between the fund and the management company. Investors will look to both the GP and the management company as entities with fiduciary duties to them.

The distinction between a fund formed as a limited partnership and one formed as a limited liability company is important and summarised in Table 9.1.

Table 9.1: Comparison between funds formed as limited partnerships and as limited liability companies
Funds formed as limited partnerships Funds formed as limited liability companies
By law, with few exceptions, a GP of a limited partnership has liability for the unsatisfied debts and obligations of the limited partnership. A fund formed as a limited liability company will have a managing member which is not, by operation of law, liable for the debts and obligations of the fund.
Fund managers earn carried interest through the GP (as opposed to the management company) in order to preserve the flow-through of tax treatment. The carried interest is thus at risk for the fund’s liabilities, which is often the reason why many managers of a fund formed as a limited partnership will put the carried interest in a special purpose vehicle which is a limited partner in the fund (the carried interest LP). Because of that, the managing member of the fund can be and often is the vehicle that receives the carried interest and there is no carried interest LP (unless one is desired for confidentiality reasons, as discussed below). Like the GP, the managing member of the fund is responsible for managing the fund and delegates the responsibility to the management company.
Particularly, if the GP does not own the carry, lawyers must advise whether the GP has enough assets to avoid piercing the liability shield through to the owners of the GP according to an ‘undercapitalisation’ or other theory. For this reason, the capital contribution made by fund managers to the fund formed as a limited partnership, which will give them that alignment of interest that many LPs look for (or at least a part of it), will be made to the fund through the GP. The remainder will be contributed through the carried interest LP. The fact that the managing member is insulated from fund liabilities can simplify the fund structure a bit, but caution is warranted as some foreign and domestic jurisdictions continue to treat limited liability companies differently from limited partnerships.
Note: This table focuses only on funds formed under US law with US investors and does not address many of the structuring considerations that would be applicable if the funds were formed outside the US or had non-U.S. investors.

The upper-tier entities that serve as the GP or carried interest LP of a fund formed as a limited partnership or the managing member of a fund formed as a limited liability company, receive the carried interest and divide it up through one or more upper-tier entities. Often, there are multiple upper-tier entities, the use of which is driven by limitation of liability and confidentiality goals as well as the desire to move carry around as people join and leave the firm.

Keeping the carried interest, fee income and governance in separate entities provides greater flexibility in succession planning. This affords more tools for use in accomplishing the goals of the firm’s compensation structure: the exposure of carry to fund liabilities can be reduced, carried interest can be completely separated from ownership of net fee income, and governance can be completely separated from all economics.

There are at least seven sources of economics for a fund manager:

  1. salary

  2. bonus

  3. carried interest participation

  4. excess management fee income

  5. transaction fee income

  6. waiver of carry on their own money

  7. waiver of management fee on their own money.

If the compensation system is open (that is, each managing director and founder is entitled to know what are the others’ salary, bonus and carried interest terms), every owner receives a full set of documents for all entities where cash is produced and distributed. In this case, there is less need for many upper-tier entities. However, if the system is a closed or partially closed one (for example, only the founders or the founders and a few others know such information), having separate entities and appropriately drafted agreements will preserve the confidentiality of one or more of the economic components listed above.

The desired level of confidentiality of information about the firm’s ownership as well as the ownership of carried interest, other economic components and governance rights should all be taken into account in defining point B, that is, what the firm is to look like after a succession plan is implemented. In this regard, managers should keep in mind that Delaware law provides significant rights to owners to examine the books and records of the entity in which they are a partner/member. Under both Section 17-305 of the Delaware Revised Uniform Limited Partnership Act (DRULPA) and Section 18-305 of the Delaware Limited Liability Company Act (DLLCA), a partner or member of a limited partnership or limited liability company is entitled, for valid business reasons reasonably related to their interest in the limited partnership of a limited liability company, but subject to whatever reasonable standards may be imposed by the GP or managing member of the entity for access to the information, to the following information:

  • true and full information regarding the status of the business and financial condition of the limited partnership or limited liability company

  • a copy (if available) of the limited partnership’s or limited liability company’s federal, state and local income tax returns for the year

  • a current list of the name and last known business, residence or mailing address of each partner or member

  • a copy of the written agreement governing the limited partnership or limited liability company, any amendments thereto and powers of attorney pursuant to which it was executed

  • true and full information about the cash and agreed value of property or services contributed or to be contributed to the limited partnership or limited liability company and the date on which each owner became a partner or member

  • other information regarding the affairs of the limited partnership or limited liability company as is just and reasonable.

There is essentially no difference between the information accessible under DRULPA Section 17-305 and DLLCA Section 18-305. The use of separate entities in the firm’s structure enhances the ability to maintain the confidentiality of ownership of carry, sharing of excess (that is, distributed) net management fees and governance, and positions the firm to resist excessive books and records requests. For example, a manager that owns carry but is not entitled to excess management fee and is thus not an owner of the management company would not have the ability to request to see books and records of the management company, but only of the carry receiving entity in which that person is an equity owner. While nothing in this area is black and white, partners and members can generally only make an information request for the information about the entities in which they are a partner or member; subsidiary or affiliated entities generally are generally off limits and cannot be included in the information request (though many have tried). Therefore, multiple upper-tier entities may keep classes of partners separated with no legal entitlement to reach information about other classes.

Components of a Succession Plan

The end result of a succession plan – point B – involves understanding a number of things, including:

  • the positions personnel occupy in the management company

  • the classes of ownership of the management company, GP and carried interest LP (if used), and each of the upper-tier entities that owns any portion of the management company, GP and carried interest LP

  • structuring the voting rights of personnel to ensure smooth transitioning and alignment of interest

  • what the terms and conditions are that will apply to ensure that the control of the firm will remain with the people designed to succeed to firm leadership

  • the current status and history of the relationships among all interested parties.

Personnel Positions

At some firms, founders and managing directors are senior to principals while the reverse may be true for titles in other firms. In considering the hierarchy of titles, a firm should consider what is customary in its marketplace and address the authority granted to each position in the management company agreement or employment letters with each person, or in both documents. Doing so will reduce the risk that the person inadvertently (or advertently) binds the management company under the legal doctrine of ‘apparent authority’. If a third party would reasonably consider the person, by combination of title and actions, as having authority to bind the firm, then as between the firm and the third party, the firm will likely be bound.

Not only is having well-defined positions important to mitigate risk, it is also important for employees to understanding the pathway for elevation within the firm. This is a key retention tool. As part of the firm’s governance, the managing personnel will need to decide what approval is required to add new employees, fire employees or elevate employees from within. The answer will likely differ depending on the level of the employee subject to the decision.

In addition to the votes required for elevation from within, the succession plan should also set forth guidelines for performance criteria in determining eligibility for elevation. Such clarity and certainty will mitigate the risk of employment-related claims. For registered investment advisers, the risk of employment-related claims is one of the risks that chief compliance officers must evaluate when conducting the annual risk review required by the Investment Advisers Act of 1940 (the Advisers Act).

Ownership Interests

The succession plan should also identify the ownership interests that the various personnel will have in the management company, GP and carried interest LP, and how those interests should be expected to change over time as new funds are formed.

  • Management company. Interests in the management company represent the right to receive the amount by which management fee income exceeds operating expenses if such amount is distributed. In addition to sharing ratios, a key governance component relating to the management company is who makes the decision as to what is the excess and whether it should be distributed. When new personnel become equity owners in the management company, whether laterally from outside or elevation from within, the agreement governing the management company needs to be amended to reflect the new ownership. The amendment provision of the management company agreement therefore deserves close attention, especially how it correlates with the decision-making thresholds.

  • GP. If there is a carried interest LP, then interests in the GP are likely important to the succession plan only insofar as they relate to governance. If there is no carried interest LP, then the carry will flow through the GP and have the same considerations as the carried interest LP described below.

    A partner who joins the ranks of the decision-makers will have a say in governance at both the management company and the GP. Notwithstanding the delegation of management responsibility by the GP to the management company, there are certain actions that can only be taken by the GP because of its role as GP or managing member of the fund. For example, under the fund agreement, amendments to the fund agreement and approval of the transfer of an interest in the fund require the GP’s consent. Not all decisions are delegated to the management company, so the GP’s voting structure is important.

    In order to insulate the assets of a GP from liabilities associated with the next fund (successor fund), a separate GP is typically created for each fund. While the founders and managing directors may base the agreement governing the GP of the successor fund on the agreement of the prior fund’s GP, they have 100 percent control over the content of that agreement and do not need to think of it in terms of an amendment. While this affords great flexibility, the founders and managing directors are usually constrained by the carry ownership and voting percentages each person had in the prior fund. The prior fund’s carry structure creates expectations – which may or may not be reasonable, but are always real – on the part of members of the team that participate in or have been promised participation, or who think they have been promised participation, in carry. Any deviation from expectation requires management time and attention, detailed planning and smooth implementation. Otherwise it is disruptive to the organisation and, if that leads to dysfunction, investors can be harmed.

  • Carried interest LP. This entity is strictly a conduit for dividing up the carry earned from the fund. It is typically governed by the GP (either as managing member or general partner of the carried interest LP). Like the GP, it is replicated with each fund so that the carried interest LP of a successor fund may or may not look exactly like the carried interest LP of the prior fund.

    Key to any succession plan is the ability to look into the future and see permutations as to how carry ownership will change over time. While the carried interest LP agreement will not do this itself since it is fund specific, the employment letters or other documentation with a lateral or elevated partner will certainly address this. For example, such a letter will state that ‘You will have a 12 percent share of the carry in Fund II, our current fund, subject to five-year vesting, and can reasonably expect, assuming performance of your role is satisfactory to the voting partners, to a 15 percent interest in the carry in Fund III.’ The elevation in carry ownership may be commensurate (or not) with an elevation in title, for example, from principal to managing director. Caution is warranted here since the ‘inside’ managers will not have the same assurance of an increase in carry ownership, and the binding employment offer and acceptance may create an unhealthy disparity between personnel elevated from within and those brought it from the outside.

Voting Rights

Under Delaware law, limited partnerships and limited liability companies have great flexibility in allowing for the economics and governance rights to be sliced and diced in an infinite number of ways.6 How votes are to be cast, on what they must be cast and when they are forfeited, needs to be set forth in the governing agreement.

Voting on all matters relating to the fund which are not expressly reserved to the GP in the fund agreement is generally done at the management company level. Voting mechanics generally fall into one of two categories: (i) per capita voting (one vote per person) or (ii) percentage voting (requiring approval of X percent in interest). Many times, the percentage interests are such that it does not matter which mechanic applies for voting (that is, every person has an equal share). However, it matters where percentage interests are different. Frequently, both types are used in the same firm.

The following is a list of items typically required to be subject to a vote and how they are handled:

  • Investment committee votes. Votes by the investment committee are almost always done on a per capita basis – and depending on the size of the investment committee will require unanimous of votes (if committee is fewer than five people); 80 percent of votes (if the committee is five to seven people, that is, all but one must vote for the action); or 75 percent of votes (if the committee is eight or more, that is, all but two must vote for the action if the committee is between eight and 12 people).

    The following are matters typically voted on by the investment committee:

    – initial investments in the securities of a company (which then becomes the portfolio company)

    – follow-on investments in, or sales of, securities issued by portfolio companies

    – other fundamental events in the portfolio company (for example, leveraged recapitalisations and reorganisations).

    Whenever a person is elevated from within to a certain level, or brought in laterally at that level, the person frequently expects to move into a position of being a part of the investment committee. The firm needs to check what disclosures were made about investment committee voting before adding a person to the investment committee. In fact, as part of a good succession plan, careful evaluation of potential changes in the members of the investment committee is needed before a fund is launched in order to craft flexible enough disclosures in the fund’s offering documents to allow for appropriate execution of the succession plan during the life of the fund. For example, many investment committees require unanimous approval from their members on the above important decisions. Unless stated otherwise, this applies during the life of the fund – which is a long period of time, perhaps 10 to 13 years. If unanimous decision-making is required per the fund’s offering memorandum, that may: (i) deter the elevation or addition of new partners to that level during that period because the group can grow too big and one detractor can exert leverage; (ii) require recent additions to not have a vote until the next fund (creating a ‘haves’ and ‘have-nots’ dichotomy); or (iii) force the voting to be on a less than a unanimous basis in order to perpetuate the firm and not risk paralysis. All of these problems are avoidable with careful succession planning at the time the fund is fundraising and by creating clear expectations among firm founders, more junior level managers and investors.

Personnel (or compensation) committee. The firm’s personnel or compensation committee makes recommendations to the partners about the people who work for the firm and their compensation. It recommends and approves new hires. Rarely are lower level personnel on this committee. Rather, the committee is comprised of a group of managing directors. They usually do not have the power to implement their decisions, but only to formulate recommendations to the voting partners/members. As a result, decisions made by this committee are usually made on a per capita basis. The importance of this committee to succession planning is obvious. The committee’s objectives and how its steps in achieving them need to be closely aligned with the ultimate point B. If the committee’s efforts are proactive and not just reactive to a need or problem, the alignment will exist and the culture of the firm will be one focused on growth and flourish in the long term.

Actions for partner/member approval. The following is a typical (and non-exhaustive) list of those actions that are required to be submitted to members of a management company for approval by its partners/members; these actions have an impact on succession planning. Members are typically taken on a percentage basis, which means that more junior partners, who usually have smaller interests in the excess net management fees distributable by the management company, can be outvoted.

– admission of additional partners/members or removal of partners/members in the management company

– additional grants of carried interest

– terms of any interest to be issued to an additional partner or carry owner

– transfer of any interest in the management company or in any carried interest

– affiliated transactions (that is, transactions between the management company and its owners, such as purchasing services from a partner/member-owned service provider)

– designation of officers of the management company

– matters pertaining to launch of a successor fund

– fundamental events, such as:

  • merger, consolidation of the management company with another entity

  • liquidation or dissolution of the management company

  • sale or other transfer of the GP interest in a fund

  • consent to any action that would constitute an event of withdrawal of any GP (or carried interest LP) under the fund’s limited partnership agreement

  • borrowing money by the management company or pledging interests in the management company

– Any amendment to the management company’s, GP’s or fund’s governing agreements.

Like most of the above, the items impacting succession planning are those relating to how the management company is to be run and how its managed investment vehicles are put in place and to be governed. How these voting rights relate to the amendment provision in the management company agreement is a critical element of making them meaningful. For example, an amendment provision that requires a 66-2/3 percent approval from management company owners may make sense if there are four voting partners with equal percentage ownership and voting approval of the listed actions requires 75 percent in interest – because 66-2/3 percent is effectively the same as 75 percent, that is, both levels require three out of the four voting partners. However, if amendments require 66-2/3 percent interest where there are six equal voting partners (that is, four of the six must agree to the amendment), this will be at odds with a 75 percent voting approval requirement (which would require five of the six). For this reason, amendment provisions should always say that if there is a higher percentage for action in the agreement, then the provision calling for the higher percentage cannot be amended without the approval of the higher percentage.7

Delaware law allows tremendous flexibility in structuring voting among partners/members of a Delaware limited partnership or limited liability company. While this is beneficial in terms of facilitating customisation, it is dangerous in terms of there being potential for not covering something or covering it only in a catch-all provision in a less than optimal fashion. Each time there is a change in the firm – best practice would say annually – these provisions need to be reviewed and re-tailored as necessary by the firm leadership.

Terms and Conditions of Ownership

The terms and conditions that govern the ownership of the interests in the management company and carry which managers own is the central pillar of any succession plan. These terms govern a person’s capital commitment to the fund, his or her carried interest ownership, his or her ownership interest in the management company, and the right to carry and/or excess management fees in future funds by reason of his or her ownership interest in the GP of that future fund or in the management company. Mostly, these terms deal with the vesting of carried interest and management company ownership interests, and what happens if the individual ceases to be involved in the affairs of the management company. Further, they deal with what happens if the individual breaches covenants of confidentiality, non-solicitation of employees, investors, portfolio company management, and/or non-compete covenants after they cease to be involved with the management company. Frequently, the terms do not deal with future dilution through the granting of future interests, intending the silence to mean that the interests are dilutable.8 As a package, these terms are critical to ensuring the proverbial and highly coveted but often ill-defined ‘alignment of interest’ among management personnel and fund investors. More and more, reviewing these terms has become a subject of an investor’s due diligence review of the firm and its management structure. How investors feel about the fairness and equity of these terms is directly correlated to how they feel about the viability of the firm’s succession plan.9

Table 9.2: Example of a succession planning matrix

What happens to

earned on
Right to
carry in
Right to

with cause
incident to
divorce or
Breach of

Table 9.2 summarises the high-level considerations that should be addressed in the terms and conditions of agreements governing a GP or management company to set forth the consequences applicable when a manager ceases to be actively involved with the management company. These form the foundation of the firm’s overall succession plan.

It is quite common for these terms and conditions to involve the forfeiture of unvested or vested carried interest and for the governing agreements to dictate how the forfeited piece will be reallocated among the continuing members of the management team. Caution is warranted, however, as retaining too much discretion over the carry reallocation can result in phantom income tax to the recipient of the reallocation. If the reallocation is sufficiently preordained, that is, it is clear from the agreement who is to receive it, then the adverse tax effect should be avoided. If the continuing managers retain discretion over how it is to be reallocated, the reallocated piece will be considered a new grant and if the interest constitutes a capital interest10 at the time of the reallocation, the recipient will be taxed on the value of the capital interest received (see discussion below regarding the tax effect of granting capital vs. profits interests) unless it is simultaneously converted into a right to future profits in the amount of what would have been the capital interest.11

Putting Successors in Place

Knowing they have a duty to examine, if not resolve, the issue of succession planning periodically, fund managers have three potential and fundamental options as to how to put successors in place within a management company:

  1. elevate from within

  2. hire laterally

  3. do neither and retain the status quo.

Each is a potentially right answer. However, the answer most consistent with fiduciary obligations is to elevate from within because, if a fund manager cannot elevate from within either (i) he/she does not have the right people working there (or must justify why those working there are not suitable for leadership roles in the firm), or (ii) is sending a clear signal that he/she intends the fund not to continue after he/she is gone, which is antithetical to most investors’ goals for a long-term relationship with the firm.

‘Do-Nothing’ Approach

Often, the founder continues to own 100 percent interest in a management company many years after the firm was founded and believes, rightly or wrongly, that the strategy is tied to him or her and his or her personality, and all of the success of the firm is due to his or her leadership. With this singular approach, the founder believes the ability to capitalise on an investment opportunity may exist only as long as he or she is involved. If investors are aligned with the founder on this point, then succession planning is moot. However, situations where the ‘do-nothing’ approach is appropriate are very, very rare. For the rest of the world, a do-nothing approach where the founder keeps 100 percent ownership of the management company, even if he or she shares carry with the team more broadly, is problematic, because it is: (i) inconsistent with fiduciary obligations, (ii) misaligns the management team with investors; and (iii) is, absent unusual other contractual arrangements, ineffective in attracting and retaining talented personnel.

Lateral Hiring

The prospect of hiring laterally at a high level may send a message to investors that the right people do not exist within the firm to fulfil the fund’s strategy or who could run the business if something happened to the firm’s leadership. However, it was the team depicted in the fund’s private placement memorandum that was a basis for the investors’ investment decision. Appropriate disclosure of intended additions to the team is thus very important. This will put pressure on the negotiation of the key-person provision in the fund agreement. If investors are focused on strong investor rights under the key-person provision, it will be an illuminating indicator about how they feel about the next generation of management in the management company. For example, if the investment activity is automatically suspended upon a key-person event tied to one person, and a high percentage in interests of investors is required to approve a replacement before any investment activity resumes and/or they get to nominate the replacement, it could be a message that the next generation is viewed as weak, or at least not ready to take over. On the other hand, if investors push to include managers in the key-person provision who are not senior people in the firm, it will be just as good of an indicator that they consider that person to be critical to the succession plan of the firm. Senior management should then ensure the right incentives are in place to keep that person in the firm. Reading these tea leaves correctly is incredibly important to GPLP relations and the firm’s succession plan.

Hiring a new manager laterally is certainly hard on the selection and recruitment end, but it is often much less complicated on a long-term basis than elevating someone from within. Lateral hire documentation will usually consist of an employment agreement or letter and signing on through joiner to the agreements governing the management company and the GP or carried interest LP. The new lateral does not experience the agony of determining the content of those agreements in the first place. On the other hand, many of the same legal issues discussed below in the context of an elevation from within are just as relevant to the lateral hire.

Elevating from Within

Assuming that a voting and carry ownership construct is in place that aligns the management team with investors when it comes to attracting and retaining top talent, the following legal issues associated with bringing new individuals into ownership positions whether they hire laterally or from within need to be considered:

  • valuation of the management company or GP when interests in it are granted

  • the tax effect of issuing capital interests vs. profits interests

  • voting/blocking rights.

When a transition occurs by elevating from within, it often comes simultaneously with an update or a recast of the agreements governing the management company and/or GP or carried interest LP, making it a difficult and time-consuming process that delays the actual elevation, frustrating many in the process.

An elevation from within can be undertaken in the form of a management buyout, whereby the interest of the founder(s) is redeemed in part to bring it into scale with the desired point B ending ownership level. If structured properly, the redemption will receive capital gain and instalment treatment. Alternatively, the succession plan might be achieved by issuing multiple grants of capital and/or profits interests over time that dilute down the prior owner(s) (with subsequent grants expressly not diluting prior grantees of interests).12 Such profits interests in the management company can be formulated in two ways: (1) an interest that entitles the holder to distributions in excess of the then current value of the management company (essentially the same as a management buyout but leaving the founder as an equity owner rather than turning him or her into a creditor), or (2) an interest that entitles the holder to distributions of revenue streams that do not yet exist (that is, future funds’ management fees). Either way, the issuance of only profits interests is usually a much longer, slower and more evolutionary process to getting to point B because economic and governance sharing in the desired proportions is a long way off. By contrast, a management buyout transaction has immediate effect on the governance side, albeit with a large creditor who may still have considerable sway over governance decisions. A management buyout usually subjects the management company to a relatively significant amount of debt (the amount of which equals the value of the interest being redeemed for a note) which is paid over time to the owners being partially redeemed. The debt has the added benefit of depressing the value of the management company for purposes of later grants to new managers coming into ownership positions, making it easier to issue interests that are true profits interests but which still have governance rights.

A second means of quickly getting to point B is for a manager to ‘buy-in’ to the management company. Whether a management buy-in is appropriate depends on the circumstances of the management company: (i) does it need cash, (ii) what happened when past managers joined, (iii) does the management buy-in adhere the manager to the firm better (from a psychological standpoint), and (iv) is it an affordable endeavour for the new manager. Under most partnership and limited liability company statutes, a partner or member does not have to pay money to own a partnership or membership interest.13 The same is true under IRS rules and case law: a person does not need to contribute capital to the entity to be treated as a partner for tax purposes.14

The valuation of the management company is fundamental to either the management buyout or management buy-in transaction. In a management buy-in transaction, a manager pays (or becomes obligated to pay) an amount equal to the fair market value of his or her share of the management company in exchange for a newly issued capital interest. It is a capital interest – that is, equivalent to owning stock in a corporation but with flow-through tax treatment – because, if the management company were to liquidate the next day, the manager would receive a liquidating distribution equal to the value of the capital interest received (which should equal the amount paid). The manager will have a tax basis in the interest equal to what he or she pays and distributions not in excess of that tax basis (as adjusted by profits and losses) will not be taxable. However, the profits, if any, earned in the management company will be taxable on a flow-through basis to the management company owners. Because managers may not have cash to fund the buy-in, the purchase price may be loaned to the manager and paid back over time through offsets against distributions. Under state partnership and limited liability company law, as well as under federal income tax law, this is just as effective as paying cash; the manager has simply borrowed the purchase price from the management company. However, if the loan is ultimately forgiven (for example, upon a termination without cause), the manager/debtor could have debt forgiveness income. Careful planning is required on both sides.

Valuation of the management company involves valuing the ‘brand’ of the firm as well as determining its balance sheet equity value. Cash is often distributed annually in firms, except for a portion needed for expenses in the following year (or shorter period) or for contingencies, which keeps current value aside from brand equity relatively low. Just as with options granted over time to corporate personnel, valuation of interests issued to fund managers needs to be consistently determined over time.

Management buy-in and management buyout transactions are both customary ways to bring new members into the owner group of a management company, and to get them quickly to the level of ownership desired. Either can be used, or in combination with the grant of interests in the management company, the value of which is depressed by the debt burden. By using all three strategies, the ownership of each individual at the desired relative size can be achieved relatively quickly.

Yet another technique to bring new owners into the management company is a cross purchase from the owner(s) whose interest is decreasing in the succession plan. The purchaser(s) are the owners being elevated to partner/member status. The net effect is the same as in the management buyout and management buy-in, and the selling owner should have capital gain treatment. However, the purchaser may need to rely (like in the management buy-in) on distributions which fund the cross purchase, whereas in the management buyout, the management company’s redemption is the first cash user, before distributions, and the obligation is more readily financeable. Selling founders thus may prefer to be creditors of the one entity they know well, the management company, rather than of multiple purchasers in a cross purchase.

In connection with new managers coming in, it is often the case that the management company agreement needs to be amended. This is especially true where a firm goes from one owner to multiple owners. In determining what the new management company agreement needs to deal with, the following should be revisited:

  • do the provisions in place still work now that there are additional, or at least different, managers on board?

  • can a partner be terminated without cause? Upon what vote and is it only after a minimum period of time?

  • what is the definition of cause for a partner and how does it compare to the definition of cause that was applicable to the person being elevated when they were an employee?

  • should the new manager have a right (or should his or her estate) to income from funds formed prior to his or her elevation?

  • should the manager be given credit for years of service as a more junior manager when determining rights to funds formed after he or she is elevated?

  • does the change in status change his or her vesting, right to income streams if he/she leaves, or different carried interest shares?

  • what changes to ownership of carry need to be made or promised for the next fund to ensure he or she stays on the trajectory indicated by this elevation?

When and if the manager leaves the management company, other than any rights to residual income for some period of time, the ownership interests in the management company are generally not retained and become available to grant to the next manager who comes in. After he or she leaves, the departed manager has no say in governance and usually will only retain a right to receive his or her capital account balance as of his or her termination date. The circumstances of the departure may warrant forfeiture of some or all of that capital account balance. If the departing partner has a positive capital account balance because of undistributed income earned prior to the date of departure, remaining entitled to that is generally fair and equitable absent compelling circumstances associated with his or her separation.

As a retention tool, many management companies offer managers the opportunity to earn their way into entitlement to continued distributions after their departure from the management company. These distributions may continue either for a period of years after departure, or for the remainder of the term of each fund in existence at the date of departure. Such rights pay cash to departed partners and, for obvious reasons, need to be carefully crafted so as not to impinge upon the opportunity for future growth in the firm.

All of the above paragraphs in this section ‘Putting successors in place’ relate to succession within the management company. However, the right to carried interest is as important, and in some firms more so, to the newly elevated manager. The grant of carry in the fund that exists at the time the manager comes on board, may be a capital interest in part and profits interest in part, or it may be all profits interest. It depends on whether the carried interest is in-the-money or not at the time of grant. To the extent that it would be a capital interest in part, it is possible, as mentioned above, to make the capital piece dependent on profits and thus have it all be received tax-free as a profits interest, but that position is not without risk and valuation of the underlying portfolio of investment assets is determinative of this issue. Assuming it is a true profits interest and the recipient has zero tax on its receipt, the interest should still be subject to vesting and the answers which are put into the succession planning matrix above as they pertain to carried interests will apply.

Regulatory Action Items

Whenever the management changes in an investment adviser registered with the Securities and Exchange Commission under the Advisers Act, the management company will need to consider whether an updating amendment to the firm’s Form ADV will be required. Amendments to Form ADV fall into one of two buckets: annual amendments or other-than-annual amendments:

  • Annual amendments are due each year within 90 days after the end of the management company’s fiscal year. For most management company’s, this means they are due by 31st March. In these amendments, all responses must be updated and the manager must summarise the material changes in the firm’s brochure.
  • Other-than-annual amendments are either required to be made ‘promptly’ if certain information becomes inaccurate or if other information becomes ‘materially inaccurate’. Specific instructions of what triggers an ‘other than annual’ amendment are in the instructions to Forms ADV.

In short, implementing a succession plan can trigger the requirement to amend the firm’s Form ADV promptly because it would be considered a material change, or at least one would not likely be able to say it definitely is not a material change; erring on the side of disclosure would be prudent in that situation. That means that the management change is not likely to be kept confidential, and therefore the firm would be well advised to deal with the change from an investor relations perspective early on.

What Happens When Things Go Wrong?

Designing and implementing a succession plan is challenging because of the many strong personalities involved. It involves careers and thus can be extremely emotional; it requires consensus-building sometimes among a large group of people. If it does not work, firms can quickly go from building to parting ways and negotiating separation  agreements. Occasionally, such turns for the worse end up in litigation, which can be time-consuming and expensive.

Managers should be aware that costs associated with resolving an intra-manager dispute are generally not covered by fund indemnification provisions. Investors generally believe that they pay management fees to managers to compensate them for managing assets; managing their own complement of people is strictly within the manager’s responsibility. The argument resonates with logic and, if raised, usually prevails. Insurance may provide some backstop for employment-related liability, but policy coverages need to be reviewed to determine what employment-related claims are covered.

In addition, even if no claim for indemnification is or would ever be made, there is a growing body of legal theory that the dispute would need to be disclosed to investors.15 If the dispute is material, such that it is interfering with the operations of the manager, or renders the group so dysfunctional that it cannot deploy capital or manage existing investments, it will need to be disclosed. It does not matter that it did or did not go through a formal dispute resolution process such as litigation. If the management team is unable to perform the function for which it is collecting a management fee, investors need to be informed. The overhanging responsibility to make that disclosure is often a key incentive to negotiate a settlement of the dispute. If the disclosure occurs, investor relations are bound to deteriorate and there may be little left to salvage.


Succession planning is not a quick process, and it must be a constant one. Without persistent attention to the issue, the difficulty of it can be overwhelming. Two categories of events trigger implantation of succession plans: precipitous events (that is, life happens and it happens suddenly sometimes) and events that are foreseeable. Without appropriate succession planning in place for precipitous contingencies, fund managers have to scramble to right the ship. They may lose opportunities for investment still in formulation and may lose team members who lose faith in the firm. For foreseeable circumstances, succession planning is a little easier, but only a little as the number of ‘what ifs’ to be dealt with seems endless. In either case, if the planning is done, the event or eventuality will trigger only implementation and not design, and the team of senior managers, junior managers and investors will have a much greater potential for success. From a legal perspective, managers should know that, with due attention to succession planning, they are satisfying their fundamental fiduciary obligations to their fund investors and mitigating risk.


1 The term general partner or GP as used in this chapter is intended to mean either the general partner of a limited partnership or the managing member of a limited liability company.

2 See Auriga Capital Corp. et al. v. Gatz Properties, LLC, C.A. No. 4390-CS (Del. Ch. 27 January 2012) (Strine, C.).

3 See Delaware Revised Uniform Limited Partnership Act Section 17-1101(d) and Delaware Limited Liability Company Act Section 18-1101(e).

4 For a brief discussion on the duty to disclose in the context of public companies, including the duty to disclose issues that affect succession, and how that shapes the regulatory environment for other fiduciary duty cases, see ‘Executives Beware: Duty to Disclose Rising’ in WestLaw Business, 3 February 2009.

5 This statement is an overgeneralisation of an area that has been hotly litigated in the courts. A broader discussion is beyond the scope of this chapter.

6 See DRULPA Section 17-302(b) and DLLCA Section 18-302(b).

7 DRULPA Section 17-302(f) and DLLCA Section 18-302(e) are explicit that such provision must be expressly stated in the limited partnership or limited liability company agreement, and that, once stated, it will only apply to those actions in the agreement which expressly require the higher percentage vote.

8 Interests will always be dilutable unless the agreement expressly states otherwise. If different classes are used, it is a simple process to make one or more of the classes not be affected by the grant of interests in another class. Frequently, such protection is given to a class that represents a certain carry percentage that is a ‘pool’ to be granted to employees of the firm.

9 The author is aware of no empirical data on this point but bases this statement on anecdotal discussions with multiple fund managers.

10 Even if the interest was originally just an interest in profits, at the time of this event, it could be a capital interest for tax purposes. Whether it is a capital interest is most often tested by a hypothetical liquidation: if the reallocated interest would entitle the recipient to value if the fund were liquidated immediately after the transfer, then it is a capital interest.

11 The effectiveness of this technique is not free from doubt. While some recipients may be protected in this manner, the forfeited capital account value has to go somewhere, and where it goes will likely result in an income inclusion unless it is so preordained as to have effectively been a part of the terms and conditions of the interest received initially. Even where it is preordained by contract how the forfeited piece is reallocated (whether it was vested or unvested), it is not entirely free from doubt whether the phantom income is avoided. The general view is that: (i) the forfeiture should not result in the recognition of income by the recipient managers, and (ii) the reallocation of carry percentages pursuant to an existing economic agreement should not constitute a transfer to which Section 83 of the Internal Revenue Code applies. Therefore, no new Section 83(b) election would be required. The GP’s (or carried interest LP’s) tax return preparers should definitely be consulted to ensure they agree with this position.

The tax consequences in the year of the forfeiture should be that the issuing entity would, pursuant to its governing agreement, allocate its items (including gross items) to the forfeiting and non-forfeiting founders as necessary to cause the capital account of each to equal their revised distribution entitlement. This potentially will result in the continuing non-forfeiting owners receiving large allocations of income/gain (to account for the fact that their capital accounts did not previously include the forfeited percentage). While this allocation will increase the tax liability of these individuals, this should generally not be an issue because: (i) the character of the income may potentially be long-term capital gain and (ii) as the allocations of income arise from the fund, the fund will make sufficient tax distributions to the GP or carried interest LP and that entity will make sufficient distributions to the individuals to provide enough cash to cover the tax. This point should be confirmed, however, with a close review of fund and GP (or carried interest LP) documents. To the extent that the GP or carried interest LP does not have sufficient items to eliminate the disparity between the recipients’ capital accounts and their distribution entitlements, the GP or carried interest LP will shift capital from the forfeiting member’s capital account to the non-forfeiting members’ capital accounts. Because this shift arises as a result of a pre-existing deal agreed to by all partners (and not one put in place in close proximity to the forfeiture), such shift should not be taxable. However, there can be no assurance that the Internal Revenue Service (IRS) (or other taxing authorities) will not assert that the shift is taxable as an accession to wealth. The risk may be that the IRS (or other taxing authorities) will view the non-forfeiting managers as not having paid tax at ordinary income rates on the amount of the shift.

Finally, the increased carry percentage/shift of capital should not be viewed as a transfer of property for purposes of Section 83, as they are arising as a result of the pre-existing deal agreed to by all partners (that is, not by way of a new amendment) and nothing is being formally issued to the nonforfeiting founders. However, there can be no assurance, in the absence of any guidance on this issue, that the taxing the IRS will not assert that these items constitute a new transfer of property subject to Section 83. If the increased carry percentage/shift of capital is viewed as a new transfer, remain subject to forfeiture and no Section 83(b) election is made, all amounts received will be ordinary compensation income and, upon vesting, the value of the increased carry percentage/shift of capital will be ordinary income at such time.

12 It is a longstanding tax rule in most jurisdictions, embodied within the policy of Section 83 and its progeny, that the grant of a capital interest results in current income to the interest recipient. On the contrary, the grant of a true profits interest (that is, one with no value on a liquidation test basis) does not result in a current income inclusion.

See Rev. Proc. 93-27, Rev. Proc. 2001-43, and Notice 2005-43. To the extent it is determined that an interest should be treated as a profits interest pursuant to Rev. Proc 93-27, as clarified by Rev. Proc. 2001-43, the recipient should be issued a K-1 by the partnership for the year of receipt even if there is no income allocation to him or her for that year.

Rev. Proc. 93-27 generally provides that the IRS will not attempt to tax the transfer of a profits interest, provided the profits interest is one described therein. Rev. Proc. 93-27 defines a profits interest as a partnership interest (a) received in exchange for providing services to or for the benefit of a partnership, and (b) that would not entitle its holder to a share of the proceeds if partnership assets were sold for their fair market value and the new proceeds were distributed to the partners in liquidation of the partnership, as of the time the interest is received. The Rev. Proc. also provides that a profits interest will be taxable if (i) it relates to a substantially certain stream of income from partnership assets; (ii) within two years of receipt the partner disposes of the interest; or (iii) the profits interest is an interest in a publicly traded partnership.

Rev. Proc. 2001-43 clarifies Rev. Proc. 93-27 by providing guidance for profits interests that are subject to forfeiture (subject to vesting). Generally, Rev. Proc. 2001-43 provides that a service provider will be treated as receiving an unvested profits interest on the date of grant provided that all parties treat the service provider as a partner upon receipt of the interest, the partnership does not take a deduction with respect to the interest upon vesting, and all other conditions of Rev. Proc. 93-27 are satisfied. No Section 83(b) election is required pursuant to Rev. Proc. 2001-43.

Notice 2005-43 was issued in connection with the Service’s promulgation of proposed Treasury Regulations under Section 721 of the Internal Revenue Code (the Proposed Regulations) and it provides a safe harbour consistent with taxation of partnership interests under Section 83 of the Code. Pursuant to the Proposed Regulations and Notice 2005-43, upon receipt of a profits interest that is not vested (in whole or in part), tax practitioners usually advise that the recipient make a Section 83(b) election (taking the entire interest into income in the year of receipt, rather than as it vests, so that, due to the zero value of the profits interest, no income is recognised. However, the law is still unclear as to whether an 83(b) election is required as the Proposed Regulations have not been finalised.

Under the law, without taking the Proposed Regulations and Notice 2005-43 in account, no Section 83(b) election is necessary. In addition, it is important to be aware that Revenue Procedure 93-27 (as clarified by Rev. Proc. 2001-43) leaves open whether the receipt of a profits interest for services on behalf of someone other than the issuing partnership is a taxable event.

13 DRULPA Section 17-301(d) and DLLCA Section 18-301(d).

14 See ‘Defining ‘Partnership’ for Federal Tax Purposes’, in Tax Analysts, 12 May 2011.

15 See Welch v. Barach, No. 12–P–1308 (Superiors Court, Massachusetts, 8 August 2013).

Julia D. Corelli

The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.