In last month’s Alternative Insight, we looked at the reasons behind the rise of GP staking – an investment strategy in which an investor or fund acquires equity interests in a fund manager, rather than one of the funds it manages. In this month’s piece, we examine some of the risks of taking stakes higher up the asset manager food chain and how to best mitigate those.
When evaluating a management firm, a GP stakes investor will need to consider:
• its track record (including its ability to source, upgrade and monetise investee companies);
• the sustainability of its business (i.e., platform diversity, calibre of investment team, incentivisation mechanics, the solidity of the GP’s relationships with the investors in its funds);
• growth prospects (management vision, deal pipeline, firm culture, future business plans);
• operational infrastructure and scalablility; and
• the level of input and influence the investor expects to negotiate (management, voting rights and information sharing).
The value of a GP stake is ultimately based on projected cash flows from existing and future funds – management and portfolio company fee income, carried interest, the provision of affiliated services, and other investment-related activities. Obviously, there is greater assurance (and, thus, lower risk) in the revenue streams from existing funds than future funds. Past performance is one of the biggest factors in the success of future fund raises, so investing in managers with strong track records helps to mitigate the risk – but this is typically priced in accordingly. Adverse market conditions can impact the timing and size of future fund raises, even if, at the same time, attractive conditions for investing prevail, so GP stakes investors will want to be satisfied that target GPs can weather shorter-term disruption.
Asset managers are, to a large extent, the people who work at them. Small or mid-size firms, in particular, rely on a core group of charismatic executives, often the founders of these firms. But to outlast the founding generation and have a long-term business, the firm has to institutionalise. The GP stakes investor must therefore look for (and, post-investment, insist on the implementation of) a credible succession plan to mitigate the key person risk inherent in founder departures. Succession planning involves a delicate balancing of egos and competing interests. One needs to diversify leadership at the top (to avoid depending overly on one or two individuals), while fostering a culture of proprietorship among the team as a whole. Founders, too, will need to be conciliated – it is common for them to take advisory sinecures with the firm after retirement, and to retain interests in the firm’s funds (e.g., a share of carry), although the firm has to be careful that enough of the incentivisation pool is left for allocation to up-and-coming team members; they are the firm’s future.
Asset managers choosing to sell a minority stake in their business to a GP stakes investor are often hoping to add a strategic partner which will help the business to grow. Wringing strategic value-add relies on both sides putting in time and work. The investor must be willing to share its experience and knowledge, e.g., on fundraising, business services, or the quirks of particular industrial sectors in which the GP’s funds invest. On the other side, the management team must nurture relationships with minority shareholders and integrate their know-how and advice into the operational side of the business. The benefit is mutual: AUM growth drives the profitability of managers, and thus the returns from GP stakes investing.
GPs will need to consider for how long a GP staking firm will hold its investment, and contemplate any exit strategy. There are several options for exit, including holding the position indefinitely until an ad hoc sale opportunity arises, a put option to sell the stake back to management, or undertaking a secondary transaction and selling to another GP stakes investor. Whatever the choice, the potential for disruption is high if not coordinated or agreed in advance. Understanding how its minority investor intends to exit may also impact on how the GP prices the deal at the outset.
The dramatic rise of GP staking since the global financial crisis, a decade ago, is indicative of the market’s belief in the staying power and relative safety of alternative asset managers, and the variety in the market, from long-established firms to first-timers and niche specialists. On the GP side, it reflects greater demand for capital (beyond that readily available to them as a close-knit partnership or quasi-partnership) and strategic collaboration.
There are plenty of signs to suggest that the strategy will remain attractive. With the era of low interest rates set to continue for a few more years at least, institutional investors show no sign of turning away from private markets to help generate better yields. For GP stakes investors, the resilience of asset managers during the COVID-19 crisis has highlighted the value in having a diversified portfolio and the benefits of steady revenue streams (such as management fees).
Meanwhile, asset managers find themselves in greater need of capital – to meet their existing GP commitment obligations and for a number of other reasons, besides. With some of the largest asset managers already having sold stakes in their firms, demand in this particular market is outstripping supply, which opens the way for emerging managers, middle-market PE firms and spinouts.
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