Dancing to the same tune?
During the last 15 years or so, a handful of very large US managers have made a considerable amount of money buying stakes in other private equity funds. Market leaders such as Dyal Capital, Goldman Sachs’ Petershill unit and Neuberger Berman have typically targeted US-based, large-cap funds.
Mid-market European firms had little reason to contemplate the who, what, how and why of these transactions, assuming they were too small to be stake sale targets. Not any more. Between April and June 2023, Coller Capital, MML Capital and then Synova all announced sales of GP stakes. These are just the deals that were made public.
The change in tack by GP stake investors is partly due to an oversaturated US market and fresh opportunities in Europe. Why target second and third tier managers in the US when you can get a premier manager in Europe for a cheaper price?
“This particular product only works if the target firms are top tier, as the investor is investing in perpetuity,” says Donato de Donato, managing director and co-head of GP advisory at DC Advisory. “They can’t afford to invest in a firm that is middle of the pack, particularly in a very crowded fundraising market.”
So if you are a top mid-market manager who hasn’t been solicited yet, expect a phone call soon. But what is really in these deals for you, and what does it take to complete them?
Alignment of interest
GP stake sales were initially seen as a way to raise capital and possibly select a new seed investor for a future fund. As the market grew, the motivations and drivers for these deals expanded too, to include succession, upgrading tech infrastructure, improving operational capabilities, team retention and expanding a firm’s investor network.
Fried Frank partner Andrew Rearick, who specialises in M&A and private equity, says GP stake sales is an umbrella term describing a range of different transactions.
“Different investors may have different views on how any private capital partnership would work,” Rearick says. “Choosing the right dance partner is all important [for a sponsor].”
Many of these deals start with an unsolicited approach. If you are a GP that targets off-market companies in order to benefit from information asymmetry, an approach from a GP stake investor will make you want to assess your options.
“If you want to strike the best possible deal, you will want to speak to more than one party,” Donato says. “This is not a universe of 50 to 100 potential buyers like for a corporate private equity auction... you could be talking about between a handful and a dozen potential buyers.”
According to market participants, the most crucial aspect of any deal is ensuring a culture fit and alignment of interests. Donato says he has seen examples of bad culture fits discovered too late in the transaction process to realistically abandon the deal.
"We always advise our clients to spend time getting to know potential GP stakes investors, in terms of what they bring to the table, their personality, what other firms they have invested in, and whether they have delivered on what they have promised in terms of value added services,” Donato says.
Finding time to properly kick the tires can prove challenging though. The deal process has to work around ongoing sponsor investments and divestments, as well as fundraising timetables.
“The people negotiating on the sponsor side are often the most senior partners and C-suite management who have a day job that doesn’t typically involve negotiating an M&A deal around their own firm,” says Rearick.
Getting the details right
Though GP stake sales have principally been a vehicle for raising capital, valuation is rarely the deciding factor. A CFO involved on the sell-side in a recent GP stake transaction said they spoke to all potential bidders active in the market, and every offered valuation fell within a tight range.
Whereas an LBO assumes an exit in five years, GP stakes investors base theirs on 15-20 years or don’t even assume an exit valuation. Instead, valuation is largely based on annual cashflow.
“A lot of GP stakes investors are targeting an IRR of high teens or 20ish percent,” says Donato. “Total return usually comprises a cash yield of 10% that is from management fees, with the remainder of their return based on expected growth of AUM and pro rata share of carry distribution.”
A tight range of valuations could be an argument for having a small number of bidders or conducting a direct deal. The CFO who spoke to all potential buyers only admitted one bidder into the firm’s data room, with confidentiality in mind.
While Donato says there have never been any leaks ahead of agreement on any GP stake deals he has worked on, Sunaina Sinha, global head of the private capital advisory at Raymond James, says confidentiality is always a concern in these deals, “especially if the buyer of the GP stake owns or plans to own direct competitors”.
While there are always provisions in the documents around the use of confidential information, Rearick says it is equally important the sponsor assures “themselves that the staking investor has the processes and protections in place to ensure its confidential information isn’t misused”.
As these deals are typically passive minority investments, consent rights are minimal, reserved for egregious expense expenditure. The CFO involved in a deal this year said their investor was very interested in uses of private jets – a non-issue for their European mid-market firm.
Given the sophistication of the deal participants on both sides however, deals tend to be heavily negotiated.
“While a traditional M&A deal might have a term sheet of three pages, these transactions have term sheets, which are preliminary by definition, that can easily be 25 to 30 pages long,” Donato says.
New buyers as well as sellers are emerging. As this article was being written, the Nieland Family Office acquired a stake in HPE Growth, a firm whose fund is invested in Nieland-founded tech unicorn PPRO.
“We are seeing interest from strategic buyers (usually operating in related industries) where a GP stake can provide exposure to the firm’s pipeline/portfolio as well as to form potential strategic partnerships,” says Singh.
The GP stakes umbrella is also being stretched to cover non-dilutive financings, where capital is raised against the same management fees and carry collateral but for a finite period.
“They can be structured as a waterfall preferred, or debt,” says Donato. “I think we will see a lot more of these, as they are dependent on management fees from existing funds and much less dependent on the size of the next fund.”
Given the challenges of fundraising and exits, this expanding universe of liquidity solutions is a welcome development. Though picking a partner that won’t step on your toes remains paramount.