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Roundtable: Stake house

Alice Murray 24 November 2022

At a recent roundtable discussion held in London, Real Deals sister publication The Drawdown gathered together leading experts from the GP stake sale market to discuss the evolution of these transactions, and what value they can bring to private equity firms.

At the table:

Hal Ritch, founder and GP strategic advisory co-lead, DC Advisory US
Donato de Donato, GP strategic advisory co-lead, DC Advisory US
Brian Parness, partner, Weil Gotshal & Manges
Moderated by: Alice Murray, The Drawdown

The Drawdown (TDD): How did the GP stake sale market come about?

Donato de Donato (DdD): The idea of having institutional investors and strategic investors buying into alternative asset managers has been around for quite a while. There were a number of transactions done in the late 90s and early 2000s, but those were unique situations.

The GP stakes world as we know it today really came about 10 years ago, with the first few deals carried out by dedicated investors in the sector; Dyal, which is now part of Blue Owl, was one of the leaders and early pioneers in the sector, and the other ones being Petershill of Goldman Sachs and Blackstone.

It started out with GP stakes of hedge funds. However, given the volatility of hedge funds’ AUM, investors learnt quickly to look at private equity firms. Since then, the market has grown significantly, as a lot of capital has been collected by these dedicated funds and sovereign players like Wafra have also been active. Today there are also a number of middle market players. Bonaccord, for instance, is one firm that has been quite successful in the middle market. The market has expanded across many dimensions, in terms of the sheer size of the capital that's been put to work, the type of firms that are receiving that capital, and the type of transactions.

Like in any corporate finance market that we've seen in our lives, initially, there tends to be equity and debt; those are the two alternatives. Then financial innovation fills out all the white space in between. So now, if you're a GP and you want to raise capital, you have the opportunity to do a number of things. You could decide to sell a majority stake of your business to a firm that's going to help you grow, or decide at the very other end of the spectrum to raise debt capital that is completely non-dilutive.

However, there are opportunities in the white space in between, and there's been a number of firms that have raised capital in the form of “waterfall” preferred transactions that are akin to junior capital. They're non-dilutive, so the GP is not selling equity in perpetuity, but at the same time, they're not as restrictive as raising debt. In the traditional GP stake world, if you're selling 10-20% of the firm, you're selling 10-20% of the cash flows of the firm in perpetuity.

TDD: What are the key motivations for GPs to enter these transactions?

Hal Ritch (HR): One of the myths we frequently hear is that the only reason GP’s do a stake sale is to enrich themselves. Certainly, if somebody founds a business, they have a right to a return on their capital over time. They can also raise money to buy out a senior partner at retirement. There are at least 10 - 12 other objectives that GPs around the world have told us that motivated them – including to provide GP commitment capital for both partners and other junior team members, fund new offices, support new investment strategies, or even strike up an alliance with a GP stake investor.

An example of such an alliance being formed might include a name such as Blackstone. Not only does Blackstone bring real substance and a halo effect in fundraising, it can also provide access to its purchasing program that lowers the cost across that GP's entire portfolio of operating businesses. For mid-market firms especially, they can also provide expertise in areas such as HR, ESG, operations, and artificial intelligence, thus providing huge value.

Stake sales can also de-risk future fundraises, where the investor allocates to the current fund and pledges to invest in future funds. Another driver is to hedge various risks like possible tax changes. Pre-Brexit, many UK firms were nervous about the matter, and prior to the last couple of US election cycles, US firms were nervous about the tax changes, as well.

Brian Parness (BP): One other reason is putting a value on the business. Thinking about junior partners in the business that may over time be getting some distributions from cash flow, but this is oftentimes their largest financial asset and they want to know what their interest is really worth. Having a third party institutional investor put a value on the business that has never previously been done is compelling.

Of the firms we speak to, the number one use of proceeds is bringing third party capital to assist with their GP commitments. If you think about the growth in fund sizes that's been going on in alternative asset management, it requires more capital from the GP, and bringing in third party investors is a great way to help fund GP commitments.

There are some transactions that are motivated by succession planning, and giving cash to an existing founder who's no longer active in the business, but very few deals that we're seeing get printed today, particularly in this environment, are solely motivated by putting money in pockets of active founders.

HR: Another motivating factor, especially for European audiences, is having to contend with European waterfalls. European waterfalls can make GP commitment situations especially stressful, and a bigger driver of needing additional liquidity.

TDD: In what ways do GP stake buyers bring value to the firms they have invested in?

HR: GP stake sales are usually the first step in raising permanent capital for firms. We've been in meetings with younger employees, when they first hear that their firm has sold a permanent stake to a larger entity, and they’ve confessed their relief to the partners that the firm’s future has been secured.

TDD: Is there a threshold as to how small these deals can go?

DdD: Leaving aside the big three, which want to put several hundred million dollars, euros or pounds into deals, even the mid-market players are trying to invest at least $50m per transaction. If you do the math around that, thinking about the size of the stake - between 10-25% of the business, then the GP would have to have at least $1bn of AUM (and likely more for credit or infrastructure) to be a realistic candidate for a traditional GP stake sale.

There are investors that will do smaller transactions, but I would say that for a small GP that is growing fast, a GP stake may not be the appropriate corporate finance tool. The market has evolved to the point where you can do financings that are non- dilutive, and so you aren’t required to sell equity at a value that's frankly unattractive, relative to what the value could be three years from now. Nonetheless, you can still raise capital and grow the firm.

So, we’re seeing firms of smaller size that are growing fast doing financings, as opposed to GP stakes. In some cases, however, if they've established a very defensible niche within a sector or within a particular type of transactions, they may consider a sale of a control stake if the partner / investor can really accelerate their growth. In this instance, it becomes a much more strategic transaction.

TDD: Do GP stake buyers have a particular investment horizon?

HR: These are eternal funds – an interesting thing to wrap your brain around. But, financially they are betting that the GP will do well with its next two or three flagship fundraises, and if that happens, since there's no J-curve on these investments, the cumulative cash flows are going to rapidly have a positive return.

 

Disclaimer

Any views expressed herein are the views of the participants in the roundtable discussion and do not necessarily reflect the views of DC Advisory. DC Advisory may, in other circumstances and/or venues, take positions that are contrary to those proffered in this article.

Categories: Insights Expert Commentaries Geographies UK & Ireland France & Benelux Southern Europe Central & Eastern Europe Nordics DACH ROW

TAGS: Dc Advisory Roundtable

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