Insight Article Desktop Banner
 
 
Insight Article
  •  
November 01, 2022

Not All GP Stakes Are Created Equal: Growth vs. Mature Private Equity GP Stakes

Insight Video Mobile Banner
 
November 01, 2022

Not All GP Stakes Are Created Equal: Growth vs. Mature Private Equity GP Stakes


Insight Article

Not All GP Stakes Are Created Equal: Growth vs. Mature Private Equity GP Stakes

Share Icon

November 01, 2022

 
 

A general partner (“GP”) stake investment is a direct ownership interest in a private equity sponsor that is a perpetual, transferable security which can be financed, recapitalized or sold. There are many methods to acquire an economic interest in a GP at different points in its lifecycle, but not all are created equal. In this paper, we will explore how and why growth stage GP stakes offer a superior risk/return profile to mature stage GP stakes.

 
 

What Is the Difference Between a Seed, a Growth Stage GP Stake, and a Mature Stage GP Stake?

A GP stake is typically a direct, minority equity interest in the management company of a private equity sponsor (“GP” or “sponsor”). An investor in a GP stake is economically entitled to the overall cash flow profile of such GP, which is composed of management fees, carried interest, and balance sheet income from all existing and future products.

A GP stake investment can be made at any stage in a sponsor’s lifecycle. For simplicity, we will define high- level characteristics of a GP stake investment across two buckets: growth and mature. Mature stage GP stakes involve established sponsors that typically have at least ten years of operating history and have raised four or more fund vintages. By contrast, growth stage GP stakes focus on next-generation sponsors that typically have less than ten years of operating history and have raised three or fewer fund vintages.

 
 
DISPLAY 1
 
Growth Stage vs. Mature Stage GP Stakes
 
 
 

The consideration a GP stakes investor makes in exchange for an ownership interest in a sponsor can take a variety of forms (e.g., cash, working capital, preferred equity, balance sheet investment, etc.) based on a sponsor’s unique needs. In general, in growth stage GP stake investing, limited transaction consideration is directly paid out to founders with the preponderance of upfront proceeds structured as a balance sheet investment. By contrast, mature stage GP stake investing involves comparatively less upfront balance sheet commitments, but the investor will typically be responsible for making those commitments on a recurring basis in each subsequent fund vintage pro rata to its ownership interest. Over time, the cumulative commitments can exceed the one-time commitment made by the growth stage GP stakes investor.

Given the focus on younger sponsors, growth stage GP stake investing can at times be mischaracterized as “seeding.” The distinction between the two is important to clarify. In a seeding transaction, the seeding entity generally negotiates enhanced rights across a variety of economic (discounted fees and/or revenue or profit share participation, etc.) and noneconomic dimensions (transparency, capacity, right of first offer or refusal on co-investments, etc.) in exchange for a large anchor fund commitment as an LP. While these rights may resemble some of the entitlements a GP stakes investor negotiates, the hallmark characteristic of a GP stake is the creation of a perpetual and transferable security interest. Thus, while a seeder’s economic entitlements may mirror those of the GP staking entity (e.g., revenue or profit share), that entitlement cannot be monetized through a sale (i.e., not transferable) and is often limited in scope (tied to specific product versus overall firm value) or duration.

 
 
DISPLAY 2
 
A Seed Is Not a GP Stake
 
 
 

Why do Growth Stage GP Stakes Offer a Superior Risk/Return Profile to Mature Stage GP Stakes?

Attractive GP stake opportunities are expected to exist across the spectrum from growth stage to mature stage. These opportunities are driven by 1) strong business fundamentals of private markets firms that have high recurring revenues and operating margins of 40%-70% and 2) long-term tailwinds associated with private markets. Private markets assets were $8.9 trillion as of 2021 and are forecasted to approximately double to $17.8 trillion by 2026.1 While mature stage GP stakes have garnered more attention and have been the predominant focus of institutional fundraising by GP stake investors, we believe growth stage GP stakes have a superior risk/return profile. Growth stage investments offer superior alignment and better risk-adjusted pricing due to more favorable supply and demand dynamics, increased negotiating power, and operational value-add opportunities. Together with strong downside protection and the greater depth of liquidity options, we feel these features make growth stage GP stakes a more attractive investment.

 
 
DISPLAY 3
 
Percentage of Sponsors that Have Sold a Minority Interest by Size
 

Source: Pitchbook; GP Stakes Deployment Opportunities; July 2021

 
 

SUPERIOR ALIGNMENT

The primary motivation for sponsors to pursue a growth stage transaction is to accelerate product expansion and reinvest capital in the business. Thus, transaction proceeds in growth stage deals skew toward primary equity or balance sheet commitments versus secondary equity. Primary equity goes onto the balance sheet and can be used to increase the GP commitment, make strategic hires, and expand strategy offerings, or may be utilized for other growth purposes designed to enhance enterprise value. Such capital commitments by a GP stake investor provide exposure to a diversified pool of underlying assets, offering a strong return ballast and downside protection with the GP stake.

By contrast, the primary motivation for sponsors to pursue a mature stage transaction is to monetize the enterprise value of their firm, which means the purchase consideration is skewed toward secondary proceeds. While the mature stage GP stakes investor will also make balance sheet commitments on a recurring basis, with each fund vintage offering a diversifying set of return drivers, the heavy upfront cash consideration given to the founders/management teammay heighten the risk for impairment or a potentially extended duration in a downside scenario where future fundraises are reduced or go away entirely.  Various contingencies on payouts can be introduced to help reduce this risk (e.g., earnouts), but, ultimately, the return of capital and multiple generation is very reliant on the in-place fee-generating infrastructure, as the capital infusion is not necessarily being used to reinvest into the business. An additional risk factor is introduced when one or more founding principals take a reduced role or step back entirely as a part of the transaction; often in these succession related situations, the strongest historical contributors will no longer drive investment decisions and the firm’s future performance potential is less certain.

FAVORABLE SUPPLY/DEMAND DYNAMICS

There is a broad and growing universe of midsized alternative asset managers who will require financial, operational and strategic resources and who would benefit from an investment from a GP stakes firm. Private markets firms in the middle- market segment outnumber large-cap counterparts, and comparatively few have sold a minority stake.

From an addressable market perspective, there are roughly 60 firms that have raised in excess of $10 billion that remain independent (i.e., have not already sold a stake). By way of comparison, there are roughly 800 firms that have raised $1 billion-$10 billion that have not yet sold a minority interest and hundreds of GPs below the $1 billion threshold. From a capital supply perspective, there is an estimated $25 billion of capital focused on mature sponsors and an estimated $1 billion pursuing growth stage sponsors. In summary, there is a maximum of 4% of the dry powder available in the growth space as in the mature space, while there is 13x the number of available sponsors and over 175% of total addressable opportunity on a dollar basis. This suggests there is a major gap in funding for private markets firms that may be strong candidates for a growth stage GP stake transaction.

As such, valuation/pricing dynamics should be more favorable in the growth stage than in the mature stage; in a vacuum, more capital pursuing a smaller opportunity naturally implies upward pressure on valuation. Thus, mature stage GP stakes investors may need to pay up for deals or resort to investing in the stakes of lower-quality GPs, which could lead to an adverse impact on performance.

 
 
DISPLAY 4
 
Indicative Addressable GP Staking Market
 

Source: Eaton Partners, A Stifel Company, “The GP Stakes Market Outlook for 2H2021.”

 
 

NEGOTIATING POWER

Most transactions involving large GPs involve auction processes. In these cases, the GP stakes investor will likely need to be the highest bidder. Additionally, deal terms tend to be more standardized with less flexibility to negotiate transaction documents. By contrast, growth stage GP targets can be identified via a GP stake investor’s proprietary sourcing channels, allowing for more direct negotiation and therefore more bespoke transaction structures with the potential of protecting downside and maximizing value creation.

VALUE-ADD OPPORTUNITIES DRIVE ENTERPRISE VALUE

Private equity firms often seek to generate alpha by improving the operational efficiency, managerial talent, and strategic focus of their portfolio companies; lower middle market companies often benefit the most from these initiatives. GP stakes investment firms focused on growth stage opportunities will seek to generate alpha in a similar fashion, facilitating the professionalization and organizational growth of small and medium sized sponsors. GPs earlier in their lifecycles are more likely to seek out and embrace feedback around the various aspects of institutionalization recommended by a GP stakes investor. Strategic advice on business and product development can propel small to midsized GPs to move past founder dependence, increase franchise value and create a more sustainable business. This potential value creation is compelling for smaller GPs and often results in greater flexibility around the financial terms of the transaction, as the selling GP is focused on securing a GP stake investor that can also serve as a strategic growth partner. The sponsor can evaluate the relative capabilities of different GP stakes buyers across a range of areas that might be of importance (e.g., fundraising/capital formation services, product development assistance, procurement and network access, talent recruitment, access to direct fee-paying LP commitments).

By contrast, a larger sponsor may have a more mature business that already follows operational best practices, has robust middle- and back-office resources, and may have already solved for launching new product lines and/or expanding its client base internationally. A sponsor in this case is more purely focused on maximizing its monetization value. In short, growth stage GP stakes investors can benefit not only from more favorable deal terms that are reflective of their potential value-add, but also down the line from the potential increase in firm value driven by their consultative enhancements.

SUPERIOR EXIT/LIQUIDITY OPTIONS

Growth stage GP stakes investing enjoys a liquidity advantage relative to the mature stage. This advantage is driven by 1) the differences in transaction proceeds made to secure the GP stake and 2) the end market for growth stage GP stakes versus for mature stage GP stakes.

In growth stage GP stakes investing, the preponderance of the transaction outlay is typically in the form of a preferred security or a one-time, upfront capital commitment in the sponsor’s investment vehicle, which is self-liquidating in nature and has a payback period of five to seven years. Conversely, in mature stage GP stakes investing, the preponderance of the transaction outlay is typically in the form of cash distributed to existing shareholders. The mature stage GP stakes investor will also make ongoing capital commitments to future funds pro rata to its ownership interest, but absent a sale of the stake, the payback of its capital is primarily reliant on the management fee and carried interest yield component. This payback period can become extremely long-dated if performance suffers and/or future fundraising targets are not met.

To monetize the GP stake itself, firms can pursue sales on a single stake or multi-stake basis or work with alternative lenders to secure financing against the cash flows generated by the portfolio of stakes to pull forward distributions. A portfolio of ownership interests in growth stage sponsors is generally of sufficient scale to avail itself to portfolio financing options but still small enough to allow for sales of individual stakes or the full portfolio to mature GP stakes firms such as Dyal, Petershill, Blackstone, Bonaccord, Investcorp or other buyers including the GPs themselves, family offices, institutional investors and strategics. By contrast, realizing an exit is more challenging for mature stage GP stakes firms given the sheer quantum of capital necessary to consummate a single stake or portfolio level sale.

 
 
DISPLAY 5
 
Indicative Forms of Liquidity/GP Stakes Monetization Tools

GP stakes monetization route heat map

 

Source: Pitchbook. “Monetizing GP Stakes: A Review and analysis of the GP stakes liquidity”; MSIM market views and observations.

For illustrative purposes only

 
 

Conclusion

We expect growth and mature GP stakes investments to continue to grow across the board as investors take note of this appealing asset class. High recurring revenues, high margins, and strong growth prospects make GP stakes a compelling addition to a portfolio. In particular, we see growth stage GP stakes as an attractive opportunity as they have the potential to offer superior alignment, better risk- adjusted pricing, operational value-add opportunities, and superior liquidity as compared with mature stage GP stakes.

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

DISCLOSURES

The statements above reflect the opinions and views of the Morgan Stanley Alternative Investment Partners Private Markets (“AIP Private Markets Team”) as of the date hereof and not as of any future date and will not be updated or supplemented. All forecasts are speculative, subject to change at any time and may not come to pass due to economic and market conditions. Information regarding expected market returns and market outlooks is based on the research, analysis, and opinions of the investment team of the AIP Private Markets Team. These conclusions are speculative in nature, may not come to pass, and are not intended to predict the future of any specific Morgan Stanley investment.

Certain information contained herein constitutes forward-looking statements, which can be identified by the use of forward-looking terminology such as “may,” “will,” “should,” “expect,” “anticipate,” “project,” “estimate,” “intend,” continue” or “believe” or the negatives thereof or other variations thereon or other comparable terminology. Due to various risks and uncertainties, actual events or results may differ materially from those reflected or contemplated in such forward-looking statements. No representation or warranty is made as to future performance or such forward-looking statements. Persons considering an alternative investment should refer to the specific investment’s offering documentation, which will fully describe the specific risks and considerations associated with such investment.

Alternative investments typically have higher fees and expenses than other investment vehicles, and such fees and expenses will lower returns achieved by investors. Alternative investment funds are often unregulated, are not subject to the same regulatory requirements as mutual funds, and are not required to provide periodic pricing or valuation information to investors.

The investment strategies described in the preceding pages may not be suitable for the recipient’s specific circumstances; accordingly, you should consult your own tax, legal or other advisors, both at the outset of any transaction and on an ongoing basis, to determine such suitability.

This is prepared for sophisticated investors who are capable of understanding the risks associated with the investments described herein and may not be appropriate for the recipient. No investment should be made without proper consideration of the risks and advice from your tax, accounting, legal or other advisors as you deem appropriate.

Morgan Stanley does not render tax advice on tax accounting matters to clients. This material was not intended or written to be used, and it cannot be used with any taxpayer, for the purpose of avoiding penalties which may be imposed on the taxpayer under U.S. federal tax laws. Federal and state tax laws are complex and constantly changing. Clients should always consult with a legal or tax advisor for information concerning their individual situation.

This material is only intended for and will only be distributed to persons resident in jurisdictions where such distribution or availability would not be contrary to local laws or regulations.

MSIM, the asset management division of Morgan Stanley (NYSE: MS), and its affiliates have arrangements in place to market each other’s products and services. Each MSIM affiliate is regulated as appropriate in the jurisdiction it operates. MSIM’s affiliates are: Eaton Vance Management (International) Limited, Eaton Vance Advisers International Ltd, Calvert Research and Management, Eaton Vance Management, Parametric Portfolio Associates LLC, and Atlanta Capital Management LLC.

This material has been issued by any one or more of the following entities:

EMEA

This material is for Professional Clients/Accredited Investors only.

In the EU, MSIM and Eaton Vance materials are issued by MSIM Fund Management (Ireland) Limited (“FMIL”). FMIL is regulated by the Central Bank of Ireland and is incorporated in Ireland as a private company limited by shares with company registration number 616661 and has its registered address at The Observatory, 7-11 Sir John Rogerson’s Quay, Dublin 2, D02 VC42, Ireland.

Outside the EU, MSIM materials are issued by Morgan Stanley Investment Management Limited (MSIM Ltd) is authorised and regulated by the Financial Conduct Authority. Registered in England. Registered No. 1981121. Registered Office: 25 Cabot Square, Canary Wharf, London E14 4QA.

In Switzerland, MSIM materials are issued by Morgan Stanley & Co. International plc, London (Zurich Branch) Authorised and regulated by the Eidgenössische Finanzmarktaufsicht (“FINMA”). Registered Office: Beethovenstrasse 33, 8002 Zurich, Switzerland.

Outside the US and EU, Eaton Vance materials are issued by Eaton Vance Management (International) Limited (“EVMI”) 125 Old Broad Street, London, EC2N 1AR, UK, which is authorised and regulated in the United Kingdom by the Financial Conduct Authority.

Italy: MSIM FMIL (Milan Branch), (Sede Secondaria di Milano) Palazzo Serbelloni Corso Venezia, 16 20121 Milano, Italy. The Netherlands: MSIM FMIL (Amsterdam Branch), Rembrandt Tower, 11th Floor Amstelplein 1 1096HA, Netherlands. France: MSIM FMIL (Paris Branch), 61 rue de Monceau 75008 Paris, France. Spain: MSIM FMIL (Madrid Branch), Calle Serrano 55, 28006, Madrid, Spain. Germany: MSIM FMIL (Ireland) Limited Frankfurt Branch, Große Gallusstraße 18, 60312 Frankfurt am Main, Germany (Gattung: Zweigniederlassung (FDI) gem. § 53b KWG). Denmark: MSIM FMIL (Copenhagen Branch), Gorrissen Federspiel, Axel Towers, Axeltorv2, 1609 Copenhagen V, Denmark.

MIDDLE EAST

Dubai: MSIM Ltd (Representative Office, Unit Precinct 3-7th Floor-Unit 701 and 702, Level 7, Gate Precinct Building 3, Dubai International Financial Centre, Dubai, 506501, United Arab Emirates. Telephone: +97 (0)14 709 7158).

U.S.

NOT FDIC INSURED | OFFER NO BANK GUARANTEE | MAY LOSE VALUE | NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY | NOT A DEPOSIT

Latin America (Brazil, Chile Colombia, Mexico, Peru, and Uruguay)

This material is for use with an institutional investor or a qualified investor only. All information contained herein is confidential and is for the exclusive use and review of the intended addressee, and may not be passed on to any third party. This material is provided for informational purposes only and does not constitute a public offering, solicitation or recommendation to buy or sell for any product, service, security and/or strategy. A decision to invest should only be made after reading the strategy documentation and conducting in-depth and independent due diligence.

ASIA PACIFIC

Hong Kong: This material is disseminated by Morgan Stanley Asia Limited for use in Hong Kong and shall only be made available to “professional investors” as defined under the Securities and Futures Ordinance of Hong Kong (Cap 571). The contents of this material have not been reviewed nor approved by any regulatory authority including the Securities and Futures Commission in Hong Kong. Accordingly, save where an exemption is available under the relevant law, this material shall not be issued, circulated, distributed, directed at, or made available to, the public in Hong Kong. Singapore: This material is disseminated by Morgan Stanley Investment Management Company and should not be considered to be the subject of an invitation for subscription or purchase, whether directly or indirectly, to the public or any member of the public in Singapore other than (i) to an institutional investor under section 304 of the Securities and Futures Act, Chapter 289 of Singapore (“SFA”); (ii) to a “relevant person” (which includes an accredited investor) pursuant to section 305 of the SFA, and such distribution is in accordance with the conditions specified in section 305 of the SFA; or (iii) otherwise pursuant to, and in accordance with the conditions of, any other applicable provision of the SFA. This publication has not been reviewed by the Monetary Authority of Singapore. Australia: This material is disseminated in Australia by Morgan Stanley Investment Management (Australia) Pty Limited ACN: 122040037, AFSL No. 314182, which accept responsibility for its contents. This publication, and any access to it, is intended only for “wholesale clients” within the meaning of the Australian Corporations Act. Calvert Research and Management, ARBN 635 157 434 is regulated by the U.S. Securities and Exchange Commission under U.S. laws which differ from Australian laws. Calvert Research and Management is exempt from the requirement to hold an Australian financial services licence in accordance with class order 03/1100 in respect of the provision of financial services to wholesale clients in Australia.

Japan

For professional investors, this material is circulated or distributed for informational purposes only. For those who are not professional investors, this material is provided in relation to Morgan Stanley Investment Management (Japan) Co., Ltd. (“MSIMJ”)’s business with respect to discretionary investment management agreements (“IMA”) and investment advisory agreements (“IAA”). This is not for the purpose of a recommendation or solicitation of transactions or offers any particular financial instruments. Under an IMA, with respect to management of assets of a client, the client prescribes basic management policies in advance and commissions MSIMJ to make all investment decisions based on an analysis of the value, etc. of the securities, and MSIMJ accepts such commission. The client shall delegate to MSIMJ the authorities necessary for making investment. MSIMJ exercises the delegated authorities based on investment decisions of MSIMJ, and the client shall not make individual instructions. All investment profits and losses belong to the clients; principal is not guaranteed. Please consider the investment objectives and nature of risks before investing. As an investment advisory fee for an IAA or an IMA, the amount of assets subject to the contract multiplied by a certain rate (the upper limit is 2.20% per annum (including tax)) shall be incurred in proportion to the contract period. For some strategies, a contingency fee may be incurred in addition to the fee mentioned above. Indirect charges also may be incurred, such as brokerage commissions for incorporated securities. Since these charges and expenses are different depending on a contract and other factors, MSIMJ cannot present the rates, upper limits, etc. in advance. All clients should read the Documents Provided Prior to the Conclusion of a Contract carefully before executing an agreement. This material is disseminated in Japan by MSIMJ, Registered No. 410 (Director of Kanto Local Finance Bureau (Financial Instruments Firms)), Membership: the Japan Securities Dealers Association, The Investment Trusts Association, Japan, the Japan Investment Advisers Association and the Type II Financial Instruments Firms Association.

 

This is a Marketing Communication.

It is important that users read the Terms of Use before proceeding as it explains certain legal and regulatory restrictions applicable to the dissemination of information pertaining to Morgan Stanley Investment Management's investment products.

The services described on this website may not be available in all jurisdictions or to all persons. For further details, please see our Terms of Use.

Not FDIC Insured—Offer No Bank Guarantee—May Lose Value
Not Insured By Any Federal Government Agency—Not A Deposit

Subscriptions    •    Privacy & Cookies    •    Your Privacy Choices    •    Terms of Use

©  Morgan Stanley. All rights reserved.

Morgan Stanley Distribution, Inc. Member FINRA/SIPC.