How to manage key-person risk

Employees with skills that are uniquely valuable to a company’s success are worth their weight in gold, but what happens when they leave, taking that institutional knowledge with them?

Relying on key individuals carries risks that, if not properly managed, may cripple profits, productivity, and confidence among remaining employees. Also at stake is the company’s image, which is particularly critical for those that rely on earning and keeping trust.

“Key-man risk can sink you,” said Chris Donegan, CEO of strategy consulting company Invention Capital Associates and chief risk officer at wealth management firm Hywin Wealth, both London-based. “You can benchmark and mitigate operational risk, credit risk, market risk, and legal risk. But key-man risk is something else entirely.” It’s considered one of the hardest risks to mitigate.

A 2018 report by Morgan Stanley Research found that big banks and asset managers are among the most vulnerable to key-person risk within the S&P 500 companies on the US stock market because of “a particularly high concentration of key individuals”. Analysts looked at the risks of having a hugely important executive — such as a CEO — suddenly depart, an occurrence which, they say, is on the rise: In 2017, 59 CEOs, or 12% of the total, left their S&P 500 company, which is the highest level of CEO turnover within this group since 2006.

The report cautions investors to be aware that such change can “meaningfully impact shareholder value”. When researchers analysed the CEO departures in 2017, they found those companies underperformed the rest of the market by an average of 11% during the following 12 months — with 32% of them underperforming the rest of the market by more than 20%.

One of Europe’s largest asset managers suffered such a key-person loss in 2014. London-based BlueBay Asset Management shut a $1.4 billion hedge fund after Neil Phillips, the senior portfolio manager over the fund, announced that he was leaving the company to start his own venture. BlueBay, which managed $66 billion at the time and is owned by Royal Bank of Canada, said that closing the macro fund was in the best interest of investors and that capital would be returned.

“Some might argue that the very nature of hedge funds tends to create such situations, but I would counter by saying that many other such funds do successfully plan and execute a transition from manager to manager,” said Bruce Epstein, a senior consultant with AEBIS, a subsidiary of Paris-based management consulting firm BFD SAS.

The impact of losing a key person, he said, may be felt across all success factors: profitability, response time, productivity, image, reputation, and confidence. “The loss will definitely increase response times, as the remaining staff need to spend more time to grasp the implications that the key person would have done instinctively,” he said. “They will commit avoidable errors due to inexperience, and reputation, image, and confidence will suffer as a result.”

Losing key people is inevitable. They may take a new job, retire, suffer a long-term illness, or die unexpectedly. However, businesses can take steps to manage their exposure before a crisis hits.

“Financial companies stand the best chance of being prepared for a key-person loss, as they typically have the financial management expertise to see and address glaring risks,” said Matt Vickers, principal adviser with Snowgum Financial Services in Sydney, Australia.

Take stock of key individuals

Epstein stresses that the idea is not to diminish the importance of key roles. “It’s a very delicate balance that needs to be struck between having specialised expertise and managing key-person risk,” he said.

The goal is to identify “those few, truly critical subparts of key roles” that will need to be covered seamlessly from a business continuity perspective, even if the best person is not available, he said.

“For any theatrical performance, all the lead roles have understudies — performers who ordinarily have other jobs in the cast or crew, but who can step in at a moment’s notice if the lead cannot perform,” said Epstein. “The understudy might not be as talented as the lead, although sometimes they can surprise you, but their level of performance is adequate to allow the show to go on. I have always applied this same principle to managing key-person risk.”

Identifying those critical subparts, he said, emerges from an enlightened analysis of the actual operating business process — not how it is intended to be performed, but how it is actually performed. “This is more than just workflow,” Epstein said. “The common failure to distinguish between workflow and process is why this analysis needs to be ‘enlightened’ and not just cursory.”

He suggested doing this through a combination of observation, interviews, and an interactive examination of inputs and outputs adapted to the specific business context of the organisation and its key roles.

The obvious key people are those with high-ranking positions. However, Epstein noted that they may not necessarily be leaders or managers, can work in any department, and may not even be a designated expert.

“Key people tend to be the formal or informal ‘go-to’ folks, often unsung heroes, upon whom their teammates rely on a daily basis,” he said. “They know where to find information, who knows what, and which are the best methods and tools in any circumstances.”

Have plans in place

Companies can help manage a key-person loss by having a plan in place, as well as an insurance policy on that person to defer the financial risk when applicable; a person’s age or a serious medical condition may prevent someone from being insured. Vickers suggested insuring an amount that aligns with the person’s value to the company.

“The policy is owned by the business and premium funded by the business at ‘cents on the dollar’ of potential benefit in the event of a key-person loss,” Vickers said.

Succession planning ensures that staff is recruited and developed to fill key roles. That’s easier said than done, though. According to the report Hays UK Salary & Recruiting Trends 2018, while 57% of accountancy and finance employers planned on recruiting staff during the upcoming year, 76% cited a shortage of suitable applicants as their top recruiting challenge.

“You can’t replicate existing talent, so it’s best to recruit for future needs and the infrastructure as it evolves,” Donegan said.

Spread knowledge through cross-training

Geraint Davies, founder and managing director of Montfort, a financial planning firm based near London specialising in cross-border solutions, said a company is only as good as its team. That is why he aims to spread knowledge and responsibility among his employees, essentially creating a key team instead of a key person.

“Focus must be on nurturing teams and their cooperation, rather than any individual pursuit that can be damaging and inefficient for the company’s future growth and development,” he said.

At Montfort, advisers manage a team of paraplanners and support staff, and often consult with others outside the firm such as UK taxation specialists, Davies said. Montfort’s own three-pairs-of-eyes approach reduces exposure to key-person risk, and “clients are assured their finances are in fact being looked after by a wider team rather than an individual,” he said.

Because smaller companies tend to have fewer written procedures and less documentation of work in progress, Epstein suggested that tacit knowledge be shared among all employees. Having key people document and systematically checklist what they are working on helps manage the risk.

If they are still with the company, it is beneficial if they mentor co-workers so they may duplicate the key person’s tasks. But Epstein warned that those in key roles may hesitate to share their knowledge, which has likely taken years to acquire, for fear of being replaced.

An alternative model

It may be that the solution lies in taking a completely different approach. Dana Minbaeva, a professor of strategic and global human resource management and the vice-president for international affairs at Copenhagen Business School, said too much focus is placed on the danger of losing a key person. Her alternative: Shift the focus to strategic positions.

“The idea that there are a certain number of individuals that are crucial for business success has been central to much of the early thinking about talent management. This idea assumes that individuals make organisations smart. Usually, it is the other way around,” said Minbaeva, who is also founder of the university’s Human Capital Analytics Group, a nonprofit research project that helps companies build and sustain competitive advantage.

She added that because of increased labour market dynamism and the rising trend of job hopping, losing employees becomes unavoidable.

“Organisations that place too much emphasis on how not to lose a key person may fail to think strategically about how that talent can best be deployed in the organisation,” she said. “In our research we have been arguing that there should be a switch from focusing too much on a ‘superhero’ or ‘star’ employee to evaluating the strategic positions.”

Minbaeva said there are three key characteristics of these positions:

• They relate to company strategy and have a direct impact on the effectiveness of strategic implementation.
• They exhibit high variability in the quality of the work carried out by the people who occupy them.
• They require unique, company-specific know-how, tacit knowledge, and industry experience that cannot be easily found in the external labour market.

And focusing on strategic positions, she said, minimises the impact of losing one person. “Individuals come and go, but positions stay with the organisation,” she said. “We can develop, enlarge and even move the positions within the organisation, across locations.”

Anslee Wolfe is a freelance writer based in the US. To comment on this article or to suggest an idea for another article, contact Drew Adamek, an FM magazine senior editor, at Andrew.Adamek@aicpa-cima.com.