Leadership transitions within private equity firms are icebergs: sometimes the tips are spotted in the distance, but the vast majority are usually out of sight and only significant in a catastrophe. Large crashes became well-known, but even then information is largely anecdotal — stories passed around with cocktail glasses. Most leadership transitions float past, largely hidden from view. However a working paper from researchers at Harvard Business School (aptly subtitled The Economics within the Private Equity Partnership) has quantified the inputs and impact of the mechanics of leadership transitions at private equity firms. It’s an interesting read, and it turns out there is a lot beneath the surface.

The study had three main findings: the allocation of fund profits to individual partners was driven more by founder status than performance; this inequality in fund economics directly leads to an increase in turnover among the potential successor generation of senior partners; and these departures had significant negative effects on the ability of the private equity firm to raise future capital. In other words, too often a fund will focus on short-term founder compensation to the detriment of the firm’s longevity and stability. Founders received more money, but their legacies were damaged.

This pattern is particularly incongruous as the partnership structure for investment funds is intended to provide stability: better mentoring, closer collaboration, and smoother transitions than other ownership structures which too often set factions against each other. Part of the surprise for the authors is that, in a sample of over 700 private equity firms, the pattern of unequal pay is extensive.  As was the impact: when partnership transitions falter and turnover is high, the firm often has trouble attracting capital for future funds.

The authors go to considerable lengths to quantify their findings (from a summary article):

The average founding partner grabbed a much larger share of the carried interest than the average non-founder: 19.2 percent compared with 11.3 percent. Similarly, a founding partner had an average ownership stake of 30.8 percent, compared with the average non-founder’s stake of only 13.6 percent. […]  senior partners who stay have much higher carry stakes than those who leave—16 percent versus 9 percent. The difference in ownership stake is even higher: Senior partners who stay until the next fund have 23 percent of the ownership, whereas those who leave have only 13 percent.

In one of those “we grew the pie smaller” moments, it’s clear that poor leadership transitions often hurt both sides: existing founders have difficulty raising additional funds, while exiting partners are likely to find it difficult to raise a comparable fund given their lower reputations and status. Plenty of private equity firms find opportunity in the leadership transitions for private business; many of those business should also be asking about potential transitions at their potential owners. If you wait until you can see the iceberg, it’s usually too late.