Limited partners are no longer focused solely on committing capital to an investment fund. Increasingly, they want a stake in the firm itself.
Taking a minority interest in a private equity firm or other asset manager has grown in popularity among limited partners in recent years. Now many are setting their sights on the middle market, where PE firms are eager to use the capital to pursue new strategies and to support succession planning.
Investing in the management of general partners has been around in some form for decades, led by limited partners seeking a share of the management fees and carried interest earned by private equity firms. Today, one in six LPs invests in funds pursuing so-called “GP stakes” investments, according to findings from Coller Capital.
Bain & Company’s 2019 Global Private Equity Report said funds targeting GP stakes have raised $17 billion collectively and are on pace to raise another $14 billion more. To date, most active GP stakes investors—including The Blackstone Group, Goldman Sachs and Neuberger Berman—have bought stakes in well-established private equity managers tied to big, successful funds. But as the model proved itself at large buyout firms, many investors began adopting strategies to target smaller firms.
GP stakes funds have pivoted to the middle market, in part, as they seek to put growing piles of dry powder to work. In addition, the middle market offers greater variety for investors. Private equity firms in this segment outnumber their large-cap counterparts and employ a diverse set of strategies across geographies.
To capitalize on the opportunity, earlier this year a team of veteran GP stakes investors announced they were launching Stonyrock Partners, which will target GP stakes in middle-market investment firms. Together, Stonyrock’s leaders—Craig Schortzmann, a Blackstone alum, and Sean Gallary, who was previously at The Carlyle Group—have made 20 investments in asset managers over their careers. They say the opportunity in the middle market is significant as this segment of private equity continues to grow and mature.
This isn’t new territory for all investors. Lovell Minnick Partners has been investing in asset managers and financial firms in the middle market for 20 years. Over that time, it has completed over 50 transactions.
Jason Barg, a partner at the firm, isn’t surprised to see new entrants investing in GP stakes in this space; Lovell Minnick Partners has long seen the appeal. “Middle-market firms tend to offer a broader range of strategies for us to invest in and there are still inefficiencies throughout the market,” he says. “We like that because it gives our portfolio companies the ability to generate outperformance and build up through acquisitions.”
“OUR VIEW GENERALLY IS THAT THE GP STAKES SPONSORS ARE COMING TO THE MIDDLE MARKET.”
Founder and Partner, Sixpoint Partners
Barg adds that Lovell Minnick views specialization as a key part of long-term growth among financial firms. Middle-market firms tend to focus on a particular area, either through their investment strategy or through the services they offer. Specialization can take many forms, whether it’s providing financing exclusively for a specific sector, pioneering strategies and investment products, or creating new sponsorship structures.
The firms that have attracted GP stakes investors tend to be high performers with a strong track record, according to PitchBook, whose data show the average capital raised for a firm that has received GP stakes investment is $23.4 billion, compared with $1 billion for a firm that hasn’t sold a stake in its management.
Selling a piece of themselves can create a virtuous circle for top performing firms as they seek commitments for future funds. Buying a stake in a GP can be seen as an endorsement from a limited partner and send a signal to other investors that a firm has strong growth prospects, which can help attract other investors.
THROWING A LIFELINE
For limited partners, buying a stake in a private equity firm allows them to share in the firm’s success through a share of fees and an appreciation of their equity stake. By taking an interest in the firm itself, LPs avoid the risk involved with committing to an individual fund and can reallocate the resources they would otherwise spend on capital calls and due diligence for each fund they commit to.
For many private equity firms on the other side of the deal, the proceeds from selling a stake have become a lifeline.
According to Investec’s 2019 GP trends study, private equity partners say it’s growing harder to maintain their personal stake in ever-larger funds. Investors tend to prefer GPs that have “skin in the game,” requiring that a PE firms’ partners commit personal capital into each fund they raise. This is easier in middle-market funds compared with a multi-billion-dollar Carlyle fund, to be sure. But it can be difficult to make a sizeable commitment while providing capital to support business operations and compliance efforts. Selling a stake to an outside investor can remove some of that pressure by providing capital to grow the business while freeing up more GP dollars to align with fund investors.
GPs also say selling stakes is often more efficient than going public, which requires increased reporting and significant work to file for an IPO.
Eric Zoller, founder and partner of Sixpoint Partners, an investment bank that provides advisory and financial services to middle-market firms, says Sixpoint is advising more firms than ever before on GP stakes sales. “Our view generally is that the GP stakes sponsors are coming to the middle market,” he says.
Zoller attributes the shift to a recognition that middle-market private equity firms have more growth potential than their larger counterparts. “From the sponsor side, with the middle market you’re catching firms right at that inflection point as they are scaling up,” he says. “There is an embedded growth opportunity. It’s different from large managers where they hit that growth level long ago.” Scaling up can mean a specialist firm adds a related sub-specialty, opening up new investment opportunities. It could also mean raising larger funds, or building business partnerships that enhance a firm’s offerings to portfolio companies through operational support or financing solutions.
Some GPs are also using stakes sales to support succession planning, according to Zoller. Many middle-market firms are at a critical point where their founders are approaching retirement. Once they leave, their firms will have to reckon with how to replace the capital provided by the founder. Selling a stake in the firm can lessen the blow and help founders create a path for their eventual exit.
As GP stakes sales have become increasingly common, they’ve also helped spur innovation in GP financing more broadly.
According to Doug Cruikshank, head of fund financing for Hark Capital, a division of Aberdeen Standard Investments, GPs are becoming more open about using outside capital. “It’s definitely been an evolution,” he says.
Hark Capital offers middle-market GPs a product called net asset value loans, based on the strength of their portfolio companies. NAV loans can be used in a similar way to GP stakes capital, but they are typically divested in a shorter time frame. “Our model gives GPs an option to bridge some of those financing gaps without having to give up equity,” Cruikshank explains. NAV loans can be used more than once—presenting an alternative source of financing for GPs that aren’t ready to give up a long-term stake in their firm.
Another strategy, known as seeding, is also gaining ground as investors look for ways to get involved with GPs even earlier. Through seeding, investors provide capital to first-time funds in exchange for equity in the firm, usually charging either low fees or none at all.
Sixpoint Partners recently launched an affiliated company—SP Capital Partners—to invest in GP stakes and to seed deals with middle-market GPs. According to Zoller, a seed investment is akin to taking a GP stake, but in a less mature firm. SP Capital wants to see a clear growth trajectory and a proven management team. “Seeding has always been very beneficial for early-stage investors because they get a piece of equity and a piece of the economics,” Zoller says.
Even as GP financing strategies like GP stakes, NAV loans and seed funding gain traction in the middle market, they remain relatively new, and it’s unclear how they’ll be impacted by an economic downturn.
Lovell Minnick’s Barg points to observations his firm has made over the past two decades. “Private equity investments tend to be uncorrelated from economic cycles,” he says. “We’ve been invested for two decades, so we have seen the cycles.”
Still, the firm has factored a possible recession into its models in anticipation of such an event. “We always include the possibility in our diligence and we try to support companies that we think are going to weather the storm,” he says. “You have to trust your underwriting.”
Bailey McCann is a business writer and author based in New York.