Industry voice: What is my fund stake worth?
As investment activity in alternative fund managers experiences a significant uptick, due in a large part to more GP stake focused funds, Michael Athanason and Peter Bianco of Berkeley Research Group (BRG) explore the challenges and various approaches to valuing these complex transactions.
Investment activity in alternative fund managers has come a long way since Calpers’ acquisition of a minority stake in Carlyle in 2000. It is now a recognised private equity investment strategy and embraces market participants including PE funds, strategic buyers, large LPs, and management personnel of the funds themselves. M&A activity in this space is being driven by secular trends including:
• PE sponsors launching funds focused on buying GP stakes
• Managers looking to grow and diversify their asset base through strategic acquisitions
• LPs buying managers to utilise as investment platforms
• Founders looking for a succession plan as they reach retirement age
• Investment banks divesting their manager businesses to comply with the US Volcker Rule
In the last few years, PE funds have been particularly active in buying minority stakes in managers. The proportion of transactions for investment purposes increased from 20% in 2014 to 65% in 2017. The combination of this investment strategy gaining traction and founders looking for succession plans has resulted in the number of transactions doubling between 2014 and 2017.
Interestingly, the types of managers being acquired have shifted from a preponderance of hedge fund managers in the earlier days to PE managers today, likely due to the more stable fee streams and longer lock-up periods. As M&A activity for stakes in managers continues to accelerate, there is the potential for investors to misconstrue valuation by adopting overly simplistic approaches.
Transactions are complex
Manager transactions tend to be structured in a bespoke and complex manner, particularly when it comes to private equity. Sellers are sophisticated investors with significant experience in negotiations, resulting in complex transaction structures and often requiring granular valuations. For example, a founder of a PE manager may choose to sell only the portion of the business associated with future fundraising efforts and retain the carry in the ground, the carry associated with dry powder, and management fees associated with existing funds.
To value this bundle of rights, each portion needs to be valued separately and the transaction value would be the summation of these pieces. Since each piece may have very different risk profiles, a granular valuation may be required.
In private equity, we typically look at the value of the business in seven distinct buckets, as illustrated in Figure 1: six categories of fees and the manager’s proprietary investments. To value each component separately, it is important to consider the different risk profiles of the cash flows, allocate expenses to each category, and ensure the sum of the parts reconciles to a reasonable valuation of the whole.
Determining the rationality of value for the entire business may be done through a combination of a market and an income approach, and presents its own challenges. For example, asking five investors for a valuation multiple of a publicly traded manager would likely result in five distinct answers with a materially wide range in multiples. In addition, the investors would probably not agree on which metric is the most appropriate and why.
While managers are valued in much the same way as most companies (DCF, public comparables, and transactions), three industry-specific factors need to be taken into consideration:
1. Going-concern risk: In this industry, size matters. The level of institutionalisation, key-man risk, and LP concentration are crucial elements that must be considered when valuing a manager.
2. Understanding public and private GP comparables: Substantial adjustments need to be made to derive comparable multiples and valuation metrics. Primary ones include adjusting for the appropriate level of debt, understanding the public versus private ownership structure, and appropriately accounting for direct investments owned by the manager. BRG has a dedicated team that publishes a quarterly report on multiples and valuation metrics for public managers.
3. Understanding private manager financials: Certain aspects, if misinterpreted, could lead to material misstatements of value. Examples include the fund’s fee structure, cash versus accrued carry, profit sharing ratio for the carry, limited partnership agreements, whether the funds contemplate a European or American waterfall, and other basic facts.
As managers become increasingly recognised as an asset class themselves, and founders are given an opportunity to realise their ownership stakes, we expect more M&A activity in this space. Concurrently, the increasing pressure on fees and continuous search for alpha will push managers to invest in atypical industries, expand into new geographies, and negotiate more complex fee structures and waterfall provisions. This will inevitably increase the level of complexity for valuing managers. Interesting years lie ahead of us in the alternative asset management space, during which industry dynamics will contribute to mounting complexities in manager valuations.
The views and opinions expressed in this article are those of the authors and do not necessarily reflect the opinions, position, or policy of Berkeley Research Group, LLC or its other employees and affiliates.
Michael Athanason, Managing director, BRG
Michael has more than 25 years of experience in valuation and corporate finance advisory and specialises in advising on valuation and value management of alternative-asset portfolios. He has provided financial advice to many of the largest global PE, hedge, pension, and sovereign funds. Michael has extensive experience helping clients plan and execute major acquisition, restructuring, recapitalisation, and financial reporting projects by establishing fair-market valuation standards, procedures, and best practices in financial reporting. He has assisted many of the largest LP investors in the US and Canada with GP due diligence, co-investment strategies, and investment reporting processes.
Peter Bianco, Managing director, BRG
Peter has more than 15 years of combined experience in valuation of GP and LP interests, portfolio valuation, fairness and solvency opinions, and strategic management consulting developed within the PE transaction services space. Peter has led several GP and LP valuation engagements for PE and hedge funds with AuM of $30bn to more than $100bn in support of M&As, IPOs, and carry-for-equity exchanges. He has extensive experience providing fairness and solvency opinions in a variety of public and private company transactions, including recapitalisations, IPOs, leveraged buyouts, M&As, and ESOP transactions. He has also managed client relationships and execution aspects for portfolio valuation assignments of PE investments across the capital structure to ensure portfolios were marked-to-market in accordance with ASC 820.