Private investing is an extremely attractive industry: it has high margins (~40-60%), recurring cash flows (management fees are paid upfront), and predictable costs (overhead is relatively fixed) (1). It’s also a massive industry, with over $6.5T in private market AUM globally ($4.5T for private equity and debt alone). And it’s growing — AUM for private market assets grew by 10% in 2019, and increased by 170% in the past decade.
There is, however, a key structural disadvantage that makes any traditional private investing firm a more precarious long-term bet. With human capital as the core asset, Key Person risk precludes most institutions from instilling scalable, repeatable processes that can in turn deliver scalable, repeatable returns. Passing on the torch from a firm’s founder to his or her successor is a risky endeavor, no matter the strength of the heir apparent. Kleiner Perkins and Forstmann Little are just two of many institutions that fell from grace amid inevitable leadership transitions.
Leading a top-tier investment firm requires expertise across several disparate functional areas — and it’s nearly impossible for the chosen successor to demonstrate this jack-of-all-trades capability until he or she is already at the helm. The Key Person is responsible for a broad swath of decision-making across an organization. To name a few:
- Fundraising: Identifying, securing, and communicating with institutional investors to raise each fund. In addition, the Limited Partners need to receive ongoing detailed and accurate communication. Many demand a direct line to the Key Person.
- Investing: Identifying, evaluating, and supporting portfolio companies post close.
- Organizational management: Creating and overseeing internal processes, attracting and retaining top talent, aligning incentives through comp structures, developing strong branding, managing finances — the list goes on for all other operational activities that keep the business running.
Private investors are often able to get their initial funds off the ground because they’re actually good at all (or most) of those things. Industry veterans like Peter Fenton or Doug Leone have built credibility because they’ve successfully driven consistent performance through their strong leadership instincts. But a) there is a finite number of people who are highly skilled across each distinct function, b) these people are exceptionally well compensated, and c) jury’s out on whether the preeminence of these firms will outlive the tenure of their founders.
To mitigate Key Person risk, institutions in the next wave of data-driven PE/VC should consider debundling an exceptional leader’s skill set — and as a result, debundling the private investing process entirely. Doing so creates a much greater likelihood of achieving scalable, repeatable outcomes over time.
Organizationally, this would require one individual/team, technology product or other solution dedicated to each distinct function. For example: FTE(s) responsible for investor relations (somewhat common), FTE(s) focused on org design and attracting/retaining talent (less common), and different solutions that specialize in each stage of the investment process: sourcing, execution, and post-close value creation (pretty rare). There are some VC firms that are already leaning into this concept, i.e. A16Z’s board partners, who sit on portfolio companies’ boards and provide operational and strategic support). Data-driven VC firms will leverage technology first in sourcing- thus debundling that core skill from the black box that is the Key Person of yesteryear.
Some key benefits in decentralizing institutional knowledge and expertise:
- There is no domino effect if a leader or top performer leaves. When Mary Meeker left Kleiner Perkins, so too did other members of the late-stage investing group. There are plenty of examples of rising stars spinning off, and even taking LP relationships with them. In contrast, in a debundled organization that selects individuals who specialize in a given vertical, any single departure is unlikely to catalyze ripple effects throughout the value chain.
- There is a much bigger pond to fish in. Finding someone who is highly proficient in LP management or investment execution or thought leadership is far easier — and far less expensive — than finding someone who spikes on all dimensions. This makes hiring for new roles, or backfilling existing positions, more efficient from both a time and cost perspective.
Debundling private investing will not happen overnight, and it likely won’t be spearheaded by a Key Person that’s been running his or her business the same way for years. But as the old guard gives way to the next generation — and as technology becomes further integrated within operational and investment processes — we expect to see the formation of new models that are intrinsically built to deliver consistent and enduring impact, without Key Person risk.
(1) Pre-tax margins per Pitchbook.