An investor looking for exposure to alternative assets generally invests in alternative investment funds and may also co-invest in the funds' portfolio companies. But a third option has hove into the public spotlight in the last decade: investing in the fund managers themselves. This is a relatively new and fast-growing part of the asset class known as GP stakes investing, and it is the subject of this article, which is the first in a two-part series.
What is "GP stakes investing"?
A GP stakes investment is the direct acquisition of a minority equity position in an alternative asset manager (GP); in other words, making an investment in the fund sponsor as opposed to in (or alongside) the fund itself. The strategy represents a bet on the future growth and profitability of the investment firm behind the fund. It has grown more popular in recent years because it gives the investor a share of returns from what may be multiple funds and accounts managed by the firm - and, thus, the advantage of diversification - rather than just the income and gains from one of those funds.
They are usually structured as the direct acquisition or issuance of anything from one-tenth to one-third of the management firm's shares. Typically, these minority stakes are passive, non-strategic and non-voting. Given that asset managers are essentially 'people businesses', reliant on fairly mobile human capital, preserving the firm's culture and compensation dynamics is often recognised as crucial to its long-term sustainability. By limiting outside investment to a minority stake, the GP's senior executives are able to maintain decision-making autonomy without disrupting the team or culture, while at the same time benefiting from a partnership with the outside investor that adds value both to its balance sheet and its business plan.
Why is it becoming more popular as an investment strategy?
Investors are always keen to invest more efficiently and reduce the proportion of their investment capital that is swallowed by fees; the option to invest at the GP level and gain positive exposure to fee flows and carry is clearly attractive. Co-investing alongside a GP can reduce fees, but investing in the GP, itself, can reverse the flow.
Early GP stakes investments were targeted at hedge fund managers, but in recent years the focus has shifted heavily toward closed-ended and long-term investment structures, which benefit from yield certainty thanks to regular management fees and accrued (but as yet unrealised) carry.
Who is doing it?
On the buy side, although a number of new players have risen through the ranks of traditional PE investors, the market continues to be dominated by three major investors: Blackstone Strategic Capital Partners, Neuberger Berman's Dyal Capital Partners, and Goldman Sachs' Petershill unit. According to a recent Pitchbook report, each of them has raised funds in excess of US$4 billion dedicated almost exclusively to this strategy. At the end of 2019, Dyal ramped up the stakes by closing its fourth fund with more than US$9 billion in capital, making it the largest GP stakes fund ever raised.
On the sell side, GP stakes investments were traditionally confined to managers with proven track records. Recent recipients of an external equity cash injection include Accel-KKR, Kohlberg & Co., Clearlake Capital Group and Bridgepoint Advisers. Nonetheless, the ever growing pool of capital available to GP stakes investing specialists is itself widening the pool of candidates.
What's in it for managers?
The primary and most obvious benefit to an asset manager of selling a minority stake is the injection of liquidity into the business. This helps the manager to:
- Strengthen its balance sheet. GPs have ongoing operational requirements and consistently need cash to invest in new strategic hires or in infrastructure and technology.
- Scale up, for instance by seeding new strategies or business lines, and also to fund GP commitments as the number and size of their funds increases.
- Capitalise ownership structure to execute succession plans. Behind every GP is a founder or group of founders who will, eventually, wish to take capital off the table and retire. An outside investment ensures continuity by providing the necessary liquidity to incentivise the next generation of talent while allowing the founders to exit.
Even though it's only a minority shareholder, a GP stakes investor can also add strategic value:
- Operational expertise or specialised knowledge. GP stakes investors can offer dedicated advice and support in back-office operations like marketing, business strategy, and regulatory compliance.
- Mediate the GP / LP relationship. With a foot in both camps, the professional perspective that GP stakes investors bring can usefully support GPs in meeting the changing demands of the LPs in their funds, on everything from fee reporting to ESG implementation.
- Assistance with fundraising. The mere presence of a highly-regarded investor in the GP's corner is often a selling point for GPs when they are raising new funds in the market. In addition, the investor can share its knowledge of the market, open up new distribution channels to the GP, and introduce the team to new sources of capital. This is especially important for first-time or emerging managers competing in a market in which the biggest names increasingly dominate fundraising.
What is in it for investors?
Taking a position in an asset manager is unique in that it offers returns from various avenues:
- Participation in investment interests through a pro-rata share of the GP commitment to the GP's underlying funds.
- Share of management fees, which have an appealing stability and regularity.
- The potential for equity appreciation as the GP's own business grows.
- Participation in the GP's carried interest in its underlying funds.
On the strategic side, GP stakes investors benefit from:
- Improved relationships with GPs, with oversight in both corporate and fund governance, and privileged access to the GP's investment and operational talent.
- Diversification of the investor's portfolio.
- Insight into the GP's own investing methodology and process.
When GPs are able to raise successor funds, the average size of the fund tends to increase, which itself boosts the income streams - fees, carry, etc. that GP stakes investors have bought into.
Investing in this asset class seems like a win-win. But as with anything, one has to be careful. In Part 2 of our series on this topic, we will examine some of the risks of taking a piece higher up the asset manager food chain and how to best mitigate them.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.