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November 01, 2022

The ABCs of Private Equity GP Stakes

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November 01, 2022

The ABCs of Private Equity GP Stakes


Insight Article

The ABCs of Private Equity GP Stakes

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November 01, 2022

 
 

Private equity firms have become so widely publicized for their activities buying and selling ownership interests in companies that it is often forgotten that private equity firms themselves can be bought and sold. Specialist private equity firms that focus on acquiring and subsequently monetizing ownership interests in other private equity firms, and to a lesser extent, alternative asset sponsors more broadly, have come to be referred to as General Partner (“GP”) stakes firms. The GP stakes bought by these firms have become increasingly prominent in the portfolios of institutional investors over the last decade. These investments are compelling as private equity sponsors are often highly profitable companies in an industry characterized by secular tailwinds and consequently, stakes in these firms have distinct return drivers relative to other private equity strategies. In this primer, we will discuss the basis of what a GP stake is, the private equity industry dynamics that make this style of investing appealing, and the ways in which limited partners can access the attractive return profile offered by the space.

 
 

What is a Private Equity GP Stake?

A GP stake is a non-control, minority equity interest (typically 10%-25%) in the management company of an alternative asset sponsor (“GPs” or “sponsors”). Alternative asset sponsors invest in segments including, but not limited to, private equity, private credit, real estate, infrastructure, and venture capital. Like an ownership stake in any other private or public company, a GP stake is a perpetual and transferable security interest which can be financed, recapitalized, or sold. GP stakes investors are economically entitled to a pro-rata portion of the overall cash flow profile of a given GP, which includes three revenue streams earned by the GP across all its product offerings:

  1. NET FEE-RELATED EARNINGS (“NFRE”):
    Operating income associated with managing the business (e.g., management fees) offset by operating expenses of the business (e.g., employee compensation, office overhead costs, etc.)
  2. CARRIED INTEREST/PERFORMANCE FEES:
    Performance-based fees earned on a given product’s profits
  3. BALANCE SHEET INCOME/CO-INVESTMENT INCOME:
    Returns associated with capital invested as a GP commitment alongside limited partners

A GP stakes investor thus seeks to generate returns from the ongoing distributions related to NFRE, carried interest, and balance sheet income. Distributions of NFRE occur according to an agreed upon periodicity (e.g., bi-annually), offering the GP stakes investor a consistent yield. Carried interest and balance sheet income payment distributions are tied to investment realizations which means precise timing is not known ex-ante, but these distributions offer strong upside potential and are received alongside the sponsor according to pro-rata ownership interest. In addition to these three cash flow components, capital appreciation of the GP stake itself provides added return to the investor. A performing GP stake investment can often be monetized at an attractive price through a sale or financing event.

 
 
DISPLAY 1
 
GP Stake Economic Entitlements
 
 
 

WHY DO SPONSORS SEEK A GP STAKE INVESTOR?

As shown in Exhibit B, catalysts for GP stakes transactions are abundant, but generally arise when a sponsor is either (1) seeking liquidity for existing shareholders (external or internal) of the management company to monetize a portion of the platform’s enterprise value or (2) seeking a capital infusion to finance growth initiatives. For example, this can include scaling existing products or launching new products that may require expanded GP commitments and/or platform enhancements in the form of new hires or investments in organizational infrastructure. Beyond pure financial backing, an engaged GP stakes investor can provide insight into capital and product formation strategies and otherwise advise on institutionalizing the business. As such, depending on its precise motivations for a sale, a sponsor might be keenly focused on what strategic or operational value-add a GP stakes investor can offer.

TYPICAL TERMS OF A PRIVATE EQUITY GP STAKE

The purchase consideration for a GP stake is comprised of two components: primary proceeds and secondary proceeds. Primary proceeds represent any capital that is invested into the sponsor’s business; secondary proceeds represent any liquidity that is provided to management/existing shareholders of the sponsor. The precise consideration paid by a GP stakes investor can take a variety of forms (e.g., cash, working capital, preferred equity, balance sheet investment, etc.) and is based on a sponsor’s unique needs.

The total purchase consideration will be based on an assessment of a sponsor’s franchise value, which will be informed by traditional valuation methods including discounted cash flow and multiple analysis or some combination thereof. Each revenue stream will receive a separate discount rate and multiple which reflects the riskiness of the underlying cash flows. To project cash flows, a GP stakes investor will need to take a view on the performance and asset raising potential of a sponsor across different market environments. As such, a GP stakes investor will evaluate sponsors on a number of areas, including track record, ability to scale either horizontally or vertically, management’s leadership qualities and vision, the broader infrastructure and team that supports management, firm culture, incentive alignment and other talent retention mechanisms.1

GP stakes investors do not seek day-today control of the sponsor but do seek contractual protections to preserve the value of the economic entitlements acquired. For example, the GP stakes investor will seek protections against dilution and look to ensure that key individuals are both contractually tied and economically aligned to the business for the long haul. Other key provisions focus on the ability to generate liquidity and preserve the transferability of the GP stake. Beyond this, there are other negotiated protections and rights, such as information and sponsor access rights, limitations on expenses and incurrence of debt, cooperation covenants with respect to tax matters, and negative consent right over significant events such as changes to the capital structure.

Why are GP Stakes Appealing Investments?

A GP stake affords an investor access to companies with potentially high recurring revenues, high margins, and strong growth prospects driven by secular tailwinds in fundraising.

PRIVATE CAPITAL SPONSOR MODEL TENDS TO BE HIGHLY CASH GENERATIVE

The private market sponsorship model benefits from strong business fundamentals. The income stream from management fees and carried interest can be both steady and substantial.

Management fees are recurring in nature and extend through a fund’s life, offering a contracted revenue stream for a decade or longer. Carried interest revenues are tied to ultimate investment performance gains, and are thus variable in nature, but offer considerable upside potential. Sponsors have operating margins of 40%-70% and very high cash flow conversion as their business has very limited capital expenditure needs.

SECULAR TAILWINDS IN PRIVATE MARKETS

Private markets assets under management (“AUM”) increased by $6.2 trillion from 2010-2021, growing from $2.7 trillion to $8.9 trillion over the referenced period, representing a compound annual growth rate of 11.4%.2

Private markets AUM is forecasted to experience continued growth driven by increased allocations from institutional investors and upside potential in the form of retail investors, who represent a pool of over $50 trillion3 and have historically been an underserved segment by private markets. According to Preqin, AUM in private markets is anticipated to approximately double to $17.8 trillion by 2026; within private markets, private equity represents both the largest share of firms and the fastest growing in terms of AUM, a trend that is anticipated to continue.

The GP stakes industry is expected to continue to grow as a natural consequence of the expansion in private markets more broadly. As private markets have continued to swell, the ability of sponsors to self-finance operations is reduced, creating increased demand for the solutions offered by GP stakes firms.

 
 
DISPLAY 2
 
Potential Motivations for GPs to Seek a GP Stake Investor as a Partner
 

For Illustrative Purposes Only.

 
 

How Can Investors Access GP Stake Investments?

GP staking has been around since the 1980s, but the practice was infrequent and largely limited to institutional investors buying individual stakes in private equity managers often for strategic purposes (e.g., reserve capacity in future fund vintages). For example, Blackstone sold a stake to Nikko Securities in 1988 and CalPERS acquired a 10% stake in the Carlyle Group in 2001. Banks also participated in the space, buying hedge fund stakes to realize business synergies (e.g., prime brokerage).

In the late 2000s, a dedicated and formalized fund management industry developed with the emergence of bulk GP stakes buyers like Goldman Sachs Petershill (2007) and Dyal Capital Partners (2011). Similar to the banks, the original GP stakes firms were primarily focused on hedge funds, but the strategy has evolved to include all alternatives with a marked shift over time to private capital strategies, and in particular, private equity, private credit and real estate. Today, established market participants generally have longstanding fund-of-funds, secondary, and/or private credit businesses, translating into deep relationships with hundreds of sponsors, which can facilitate a successful execution of the strategy. Additionally, sponsors are focused on partnering with funds that project credibility to the broader marketplace and that have durability, which helps explain why the most significant firms in the space have been connected to banks or large alternative asset managers.

 
 
DISPLAY 3
 
EBIT Margins by Sector
 

Source: Capital IQ

 
DISPLAY 4
 
Private Capital AUM Growth
 

Source: Preqin Pro. 2022 Data Pack

 
 

The existing fund offering landscape, which includes products launched by Petershill and Dyal, provides a means for limited partners to access the economics of GP stakes that might otherwise be unattainable given the size (often $100 million to $200 million or more per GP stake investment) and complexity of these transactions, which involve a considerable amount of negotiation and legal documentation. The industry is still evolving and has considerable room to expand as the preponderance of capital raised has been focused on mature GPs and institutional participation remains limited.

Limited partners that would prefer a more hands on approach but face internal resourcing constraints may also consider pursuing a joint venture/anchor or seeding arrangement with a GP stakes specialist.

Partnering with such a group may afford limited partners greater visibility into the GP stakes transaction process and provide other ancillary benefits including preferred economics and/or co-investment rights.

 
 
DISPLAY 5
 
Market Map
 

Source: MSIM Private Markets Team. For illustrative purposes only.

 
 

Conclusion

As the private equity market continues to grow, GP stakes are slated to follow. The GP stakes market offers the opportunity for compelling returns relative to other private equity strategies. An investment in the space takes advantage of the strong capital raising tailwinds in private markets and allows an investor to participate in the fund economics of private capital sponsors which can be quite meaningful. Given the compelling return drivers and flexible entry points, we see GP stakes as an area of private equity where investors should take note.

 
 
Michael Shedosky
Managing Director,
Morgan Stanley Private Credit & Equity
Brian Farrell
Executive Director,
Morgan Stanley Private Credit & Equity
 
 
 
 

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