GP staking Investing in alternative asset managers
INSIGHT ARTICLE |
As assets under management by private equity firms have grown over the past decade, so has capital investing in minority stakes in their management companies and general partnership (GP) entities. Also referred to as “GP staking,” this alternative form of investing in the private funds industry bets on the success and growth of an asset manager’s investment firm.
GP stakes fundraising is on the rise
Source: PitchBook, RSM US LLP
Investment firms in this space pool capital to form GP stakes funds that invest in a portfolio of minority stakes in other alternative asset managers. GP stakes funds can be an attractive proposition for their limited partners because of the diversified exposure to asset managers and the opportunity to generate return from multiple streams.
As an equity owner in the asset manager’s business, a GP stakes fund is entitled to a share of the locked-in income from management fees charged to existing funds. Some upside may come from realized carried interest and investment gains from the GP’s funded commitments to its own funds. The GP stakes fund can also expect to capture the fees and balance sheet gains from future funds. An even greater payoff will result from an exit, if the GP stakes fund is able to sell its portfolio of minority stakes.
The GP staking landscape
GP stakes investments have been dominated by Dyal Capital Partners (part of Neuberger Berman), Blackstone Strategic Capital Holdings and Petershill (sponsored by Goldman Sachs). As proponents of this investment strategy enjoying the institutional backing of the major financial houses that sponsor them, these firms have enjoyed success with fundraising since the Great Recession.
This has allowed them to corner the upper end of the market by securing stakes in larger and more established firms, as well as some of the fastest-growing asset managers over the past decade. For example, Dyal Capital Partners’ website boasts of a portfolio of more than 45 GPs that manage more than $700 billion in assets with an average track record of 19 years.
But in recent years, other players have emerged. These firms have sought to unlock the same value that the top three firms have enjoyed in the upper segment by instead turning their focus on the lower and middle market. This segment presents a larger pool of asset managers that have yet to sell minority stakes in their firms.
According to a report from PitchBook, some of the firms that have raised capital for the purpose of investing in GP stakes in the lower and middle market include Investcorp’s Strategic Capital Group, Stonyrock Partners (sponsored by Leucadia Asset Management, an affiliate of Jefferies Financial Group), Affiliated Managers Group (NYSE:AMG), Bonaccord (sponsored by Aberdeen Standard Investments), Volunteer Park Capital (sponsored by Goodhart Partners), Kudu Investment Management, Capital Constellation and SP Capital.
This growing number of firms and the differentiated focus on the lower and middle segment present an opportunity for middle market asset managers that have a good track record and have demonstrated some success in growing their assets through a step-up in commitments in their most recent fund launches.
The benefits of selling a minority stake for asset managers
There are a number of reasons an alternative asset manager may consider selling a stake to a GP stakes fund. These include the following:
Scaling up: The sale of an interest in the firm may provide growth capital that can be used to fund the larger GP commitment that comes with raising larger funds as the firm expands its assets under management. The capital injection may also be used to seed new investment strategies.
Operating capital needs: The cash received may be used to invest in new strategic hires, or in infrastructure and technology needed to remain competitive in today’s world.
Staff retention: The additional funding could be useful for rewarding or incentivizing key team members. GP staking firms may also help the GP crystallize a succession plan, if one is not in place. This will ensure continuity and retain the next generation of leaders within the firm.
Liquidity of ownership interests: The owners of successful asset management firms can build significant wealth but remain cash poor as their net worth may remain illiquid in the form of unrealized interests in their funds. Selling a stake in the firm may be one way to unlock this wealth. It may also provide the liquidity needed for retiring or exiting partners to cash out.
Access to value-adding services: In the same way that private equity firms support their portfolio companies, most GP stakes firms partner with the asset managers they invest in to provide strategic and operational support in various ways. Examples include the following:
- Fundraising: Providing advice on business development and marketing strategy and opening up new distribution channels and sources of financing for the GP.
- New products: Offering market insights and feedback on the GP’s plans for the development and launch of new products.
- Operational best practices: Some GP staking firms have teams of operating partners dedicated to providing advice and support to enhance back-office operations and support the implementation of best practices for governance and regulatory compliance.
- Talent management: For GPs that are still building out their teams, GP staking firms can be a resource for finding suitable talent to fillup these roles.
GP stakes investments provide these benefits even though they are minority stakes, typically below 25% and often nonvoting. This affords the GPs autonomy to run their firm based on their vision, without disrupting their team and culture, while also taking on a partner that can add balance sheet and value-creating input to grow the business.
Preparing for the sale of a GP stake
For asset managers that are exploring selling a stake in their firm, there are a number of considerations to ensure a successful outcome.
Valuation of the firm: The most common technique used to value the GP’s business is an income approach using the discounted cash flow model. This can be challenging for an asset management business because this entails projecting the future cash flow streams from management fees, carried interest and investment returns from both existing and future funds. To help build out these forecasts, asset managers should be in a position to clearly articulate return expectations and future plans.
Efficient tax structuring: Tax planning should be considered upfront to ensure the transaction is structured to be tax neutral, whenever possible, and to be tax efficient for both the GP and the GP stakes fund.
Passing due diligence: Asset managers can expect to be subjected to an extensive due diligence process by the GP staking firm. An investment track record that can be corroborated and the quality of the team will be the keys to showcasing deal sourcing and portfolio management capability and growth potential. While GP staking firms work with asset managers after the close to help them improve their business and operations, the target asset manager should aim to demonstrate some level of maturity toward building an institutional level of quality in the business operations during the due diligence process.
Alignment of interest: GPs should also contemplate their approach to dealing with questions on perceived misalignment of interests between the GP, their limited partners (LPs) and the GP staking firm. LPs are generally interested in competitive fees and ensuring that the GP maintains focus on the portfolio of the funds in which they are invested. Following the injection of capital from a GP staking firm, the GP may look to use the additional funds to launch other products, which may take away their focus for existing funds. LPs may have concerns that in order to preserve the deal economics for their minority investors, GPs may be under pressure to grow faster than is ideal or to maintain fees at elevated levels.
Exit mechanism: GP staking firms have different investment holding period expectations. It is important for GPs to consider the GP staking firm’s plans for exiting their investment, as this may have disruptive impacts down the line if not coordinated in advance. GP staking firms may hold their investments indefinitely and opportunistically explore exit options, may plan to sell the GP stake back to management or may plan to sell to other GP staking firms after a certain holding period. If this is known upfront, it may be incorporated in the legal documentation in the form call and put option features or other provisions. Understanding the GP staking firm’s exit strategy might also inform how it formulates its expected or required return assumptions, and in turn affect the way it prices the deal.
Outlook in a post COVID-19 environment
The growth in fundraising by GP staking firms and assets under management in the private funds industry suggests that GP stakes funds will continue to become more common. The impact of COVID-19 on the performance of asset managers in the first half of the year demonstrated the value of a diversified portfolio of asset managers as some managers outperformed, while others struggled. It also emphasized the benefit of having steady revenue streams to fall back on, such as management fees, which generate cash flows and help limit risk even in times of distress.
For asset managers, partnering with GP staking firms remains a viable option, as the need for capital has been elevated by the need to deploy capital to take advantage of the opportunities created by the market dislocation. GPs have sought to launch new funds and new strategies that seek to invest in distressed companies at attractive prices, or in industries that have emerged as beneficiaries from recent shifts in consumer preferences and the needs of a remote workforce.
The challenge for asset managers in the aftermath of COVID-19 will be the downward pressure on valuations, which may result in them raising less capital or selling a bigger stake in their firm than they may have had to before the onset of the global pandemic. A resetting of assumptions and inputs into the discounted cash flow models might result in steeper discounts, more conservative expectations for growth and more subdued forecasts for carried interest and investment return profiles from investments in existing funds.
GP stakes funds have become more common over the past decade, driven by the appeal of their return profile and asset managers’ demand for capital and strategic partnerships. This is expected to continue in the aftermath of COVID-19.
Previously, the GP staking landscape was dominated by a few large players that concentrated on the upper end of the market. More recently, other players have entered with a focus on asset managers in the lower and middle market.
Asset managers selling to GP stakes funds can benefit financially through the injection of funding for investing in new opportunities, improving operational infrastructure and providing liquidity for succession planning and staff retention. There is an added benefit of other value-adding services that GP staking firms offer to managers to improve their businesses without giving up control.
To attract interest from GP stakes funds and progress to a successful close, asset managers need to plan in advance how to navigate issues like valuation of the GP’s business, tax planning, the due diligence process, addressing conflicting interest of different stakeholders and understanding possible exit options to properly structure the deal.