On the podcast: The evolution of GP stakes

In this episode—sponsored by Ansarada—host Adam Lewis takes a closer look at GP stakes investing, which has become an increasingly popular strategy for private equity firms over the past few years but still remains in its infancy. Topics covered include a brief look back at the history of GP stakes deals, how the space has progressed over the past decade-plus, and how the future will increasingly focus on the middle market and opportunities outside the United States.

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Watch the full GP Stakes webinar here. Transcript Adam Lewis: Hello, and welcome back to another episode of PitchBook's "In Visible Capital" podcast, a show dedicated to examining the inner workings of the private markets. I'm Adam Lewis, a reporter for PitchBook News, and today we'll be taking a closer look at GP stakes investing. Buying GP stakes is an alternative investing strategy that involves an asset manager purchasing a minority stake in a private equity firm in exchange for a cut of their returns. These investments can stretch into the hundreds of millions of dollars, and the holding period can last 10 years or even forever. And they often have an opaque, complex deal structure. In other words, this is a niche strategy in an alternative asset world which is already niche. But it's a strategy that stretches back decades and has provided investors with consistent returns by investing in a private equity firm rather than taking over a business. PitchBook analyst Wylie Fernyhough recently discussed the history of GP stakes deals in a conversation with Craig Schortzmann of StonyRock Partners, Ajay Chitkara of Bonaccord Capital Partners and Robert Hamilton Kelly from Goldman Sachs. Throughout the episode, you'll hear from each of them on a number of topics surrounding the GP stakes landscape.

Robert Hamilton Kelly: I think people often overlook those Blackstone early deals and deals done in some of the other large now-listed PE firms. They were obviously very successful investments of their vintage. We at least think of it as starting in force in the narrowly pre-last crisis, '08 crisis and in that window after that, which is really when it started coming together in an institutional form. We as Goldman were participating as Petershill through a fund we'd raised to address that market in '07. Craig, I know well and fondly from Credit Suisse, was also active in that market, as were Morgan Stanley, who exited entirely, and Lehman Brothers, who, some derivation of which ended up forming Dyal. There was the early stage of funds looking to raise capital, which is what it's all about, and the importance of the role we play in the industry in those early large firms. But then really in an institutional investment form, looking at it as a way to partner with firms and to generate returns for LPs. We at least really think of it as a starting off in that era. Then really, the acceleration through the mid-2000s as private funds have grown exponentially to raise capital to develop their platforms and go on from there. That's a very high-level background, but maybe I'll pause there for Craig and Ajay to give a thought or two.

Craig Schortzmann: I think from my perspective, I think you hit the history exactly right, Rob. As you think about this, really starting in the mid-2000s, and then progressing to more fund form as we see today the output of that across a number of different firms who are evaluating GP stakes. Also, it's helpful to remember that this is an industry when you think about asset management broadly defined, that's growing at 10-plus percent has really been self-funding for the last 20 plus years. As you think about that, whether Blackstone and others who went public, it was in large part to create balance sheets for their organizations to help continue to invest via their GP commits and the, like, product development. This is just a new form of that as you think about the privately owned firms and how they're evaluating their own growth strategies, their own institutionalization and looking for partners, looking for capital to execute that over the long term.

Ajay Chitkara: Prior to the advent of sponsor-backed activity, you did have a situation where a lot of institutional investors were looking to allocate a lot of money to the managers, and they wanted to have a strategic stake there. Now, with the advent of sponsors, being able to help bring in more than one strategic partner to these GPs is really important. Also, the fact that just to be able to be in the midsize space and go after LPs globally is something that's important to them and they want to be in. This is something that a lot of the sponsor-backed activity players can help both on helping them think about curating a diversified LP base globally and also helping them get into different channels as private markets continue to grow.

Adam: But the strategy isn't without risks. Dyal Capital Partners, a division of asset manager Neuberger Berman, has been among the most prolific investors in the space. But they ran into trouble earlier this year when they tried to acquire Owl Rock Capital Partners in a $12.5 billion merger after Sixth Street Partners sued to block the deal, citing a no-compete clause that Dyal signed it when acquired a stake in Sixth Street in 2017. Now, the outcome of that case has yet to be determined. But Schortzmann, Chitkara and Kelly have remained bullish on the future of GP stakes deals regardless. In this next clip we hear from Schortzmann, followed by Kelly and Chitkara.

Craig: I think it's a continuation of the institutionalization of this industry. It's very much a cottage industry. If you look at what has occurred on the long-only side and the wealth management side, they continue to build institutions past their founders. I think the alt space generally is in the early days of this and stepping into firms in this middle market at a pivotal moment in their life is exciting for us to partner with them, to help them understand the path that is most appropriate for them. Candidly, the current market opportunity is right. We're very excited about what we're seeing in the marketplace. We're excited about the rationale for opportunity sets to engage with management teams and helping them continue to build those franchises. We saw similar dynamics post-financial crisis, called the 2009 to 2011 time period where firms were evaluating their own balance sheets, evaluating growth strategies, evaluating how to continue to build the institution. When we see those hallmarks, that was an attractive point in time to be investing. We think this is going to be a great vintage as well. We're excited for the inaugural fund. We see a lot of great things in our pipeline that give us great hope.

Robert: I'd say if I narrowed it down to one or two things, it's really just volume and quality of opportunity ahead of us. I think when you think about the transactions done to date, a lot of those are on the larger end of the spectrum. Think of those as the pioneers; the middle market is still really yet to be unlocked. There's just a great range of super high-quality GPS to partner with. That'll keep us busy for a few years to come.

Ajay: I think that there's a micro and a macro factor that gets me excited by that. I think if you look at the micro factors, just the growth and the quality of these GPs in the mid-sized space. Meaning like, if you just look at their ability on a bottoms-up basis that grow their core strategy, just given their current LPs and their targeted commitments that they want to make to them, their ability to add adjacent strategies and grow out their organizations, and doing that with a minority partner that has the capability of being able to help them globally, I think is exciting to us. These are obviously organizations that exhibit stability, profitability and a lot of growth. That's exciting because there's a lot of work to be done, and we can continue to help these guys grow over the next decade. Plus I think the second part of it is the macro tailwinds are very strong. If you look at both the large general manager space, as well as the midnight space, they're both growing at very healthy clips. I think there's a couple of things that are misunderstood about the large manager space versus the midsize space, which is they're saying, "Oh, big funds would be unreasonable; large management space are taking all the assets." This is not like the hedge fund space where you would typically look and say, "The top 10 guys are going to take 40% of the market share." This is something where if you analyze that space, probably you'll see that the market share by the large managers. Yes, I think you can take that through even the top 100 GPs. I think market share has been flat. If you look at the top 25 GPS, I think they're actually down over the last nine years by 1%. The midsize space is very healthy. They continue to do that. I think what's happening is there's been a dynamic around, if you look [at] the median size that are close by our funds going back from 2014 to 2018, I think it was $280 million. Then in 2019, it jumped to $450 [million], I think is the number. You can see that there's been a calling because what's happening is all these LPs want to be able to do more with one manager and allocate more money to them. I think that's what you're seeing, and that's an exciting piece. I think that mid-market space now is something that is coming into focus.

Adam: 2021 is expected to set records for GP stakes deal activity. And more than $20 billion is currently being raised across GP stakes funds. Granted, a majority of those transactions will come in the United States middle market, rather than Europe and Asia, where the strategy is still in its infancy. That said, investors can expect more opportunities to arise for GP stakes investing across the globe in the coming years.

In this next clip, PitchBook's Wylie Fernyhough asks our guests to weigh in on the global landscape. We hear first from Schortzmann, then Kelly, then Chitkara.

Wylie Fernyhough: We've seen a lot of deals in North America, notably fewer in Europe and even fewer in Asia. Much of that may be explained by the number of private capital firms in each region. I'd love for you guys to talk about maybe the relative attractiveness of each of these geographies and how you think about deploying capital across the globe.

Craig: I think we would all be remiss not to acknowledge that if you look at the deals done today, they have been very much focused on the large mega-cap. If you look in those parameters, there's maybe a half a dozen folks in Asia, maybe a dozen in Europe, and then the rest are really US-oriented. If you look at the pure demographics, it is in the favor of more US transactions as a general matter. To date, now, when you look at the middle-market segment, I think there's a lot more opportunity set just given the scale of the markets, whether it be Europe, Asia, relative to the US. I think you will see more transactions being executed there. For Stonyrock, we have a global mandate. We will evaluate opportunities everywhere. We have the resources, and the capability, and candidly the standing and relationships to do so. Again, I think that will change over time as the middle market continues to evolve. I think there are great opportunities in both other geographies beyond the US. That's at least our view of the world.

Robert: I think it's worth reflecting for a start that just within the US alone in the middle market, there is still a huge opportunity. The penetration rate is still very low. But yes, there are suddenly those European and Asian opportunities as well. I think Craig's right to say that's a deeper band than is true at the large end of the market with mid executing on a mid-market European firm right now.

Again, we think, those funds can be pretty attractive as part of an overall portfolio. Again, you got to be pretty cognizant of differences in Asia or Europe in the way people run their funds. The different exposures they have, be it in currency risks or other elements that filter through. They're definitely a different risk profile. As long as you know what you're looking at and you have the bandwidth to pull in resources, to pull in checkings of people who know them in their local markets to understand the local deals, then I think you can you can operate globally.

Ajay: Yes, and so for Bonaccord, we do invest globally. As I mentioned earlier, two-thirds of the universal private market GPs sit in the United States. There's plenty of opportunity. That penetration is been pretty low. Obviously, 30% sitting in Europe and maybe 10%, the rest of the world. If you're looking at that breakdown, we have started looking at opportunities in Europe, and we've looked at a few in Asia. We will look to try to execute those over the coming 12 months, but there are opportunities now that are popping up. I think this is something that's been more accepted by US GPs to take that leap of bringing in a minority partner. I think the Europeans and Asians are coming around to that.

Adam: With the number of GP stakes deals increasing, more investors have entered the market. But the overall number of investors still pales in comparison to the number of private equity firms competing for buyout, growth and other alternative asset deal types. That means fewer auctions that drive up prices and more time spent getting familiar with the management team you're investing in. In this next clip, we hear from Wylie Fernyhough, then Robert Hamilton Kelly, followed by Craig Schortzmann and Ajay Chitkara.

Wylie: There are several other middle-market GPs stake firms that are on this call today, as well as some family offices and select strategics that are interested in buying stakes in the middle market. Can you tell me how competitive these deals are?

Robert: I'd say just high level and Craig can take a different view from me here. He and I have been operating this market for 10, 15 years, and I'd say, every year, there are two, three, four, five new GPs stakes players. When you sit here today, there's really five or six of us operating at any scale. What does that tell you? It tells you that a lot of people think it's a very easy space to transact in and actually find it tougher. The tough side I think is not necessarily raising the capital, the investment opportunity is fantastic. Of course, LPs are getting interested in allocating to strategies that pursue it. The tough thing is having high-quality GPs you want to partner with because, not necessarily at any price, but their focus is they're going to be bringing someone into this firm, the firm they have in many cases started and run and run between the partners. It's the first and probably the only time they will do that. They want to know that is, one, a good personal group who they're going to be operating with. That's going to add value to them over time, but also critically, that's actually going to be there over time. Because if they end up selling a stake to some phantom organization that falls over in a year or two's time, they got a mess on their hands in terms of their capital structure.

That's really one of the key reasons why it's been hard for people to get into the space. I think while, yes, of course, there are a number of firms that execute through auction, and a number of peers turn up to those auctions and will bid. The majority of our transactions 65%, 70% of our transactions is just proprietary. They're just one-on-one in conversations so much less competition. I think the broader point to consider is when you put that in the context of the wider private equity industry as a whole, we may have, at worst case in a hotly contested auction, four, five, six different people involved in the conversations with the firms. If you look at the average private equity buyout auction, you probably have 15 or 20 different bidders there. Actually, when you look at it in the wider context, yes, absolutely people are kept on this by some level of competition. It's really not as fanatic as others of private capital markets.

Craig: Yes, I think people always look at, I'd say the news headlines, but it's somewhat of a rotating door when you actually see who is trying to get into a business first, who is actually an established in a business. Having started back in 2004, obviously, watching Petershill come onto the scene in 2007, and then obviously moving over to Blackstone in 2013, and helping them launch their GP stakes business. There's an evolution, but when you look at the number of actual participants who are established today, it's quite literally a handful. To Rob's point, they can test option maybe five, and that tends to be at the larger end of the spectrum. When we're talking to folks and if I look at our pipeline, there are literally only a handful of opportunities where there may be another conversation being had, it's much more proprietary. After a decade-plus in the business, you know who you have confidence in, you know who you want to partner with. That's not to say that you don't get inbounds and introductions all the time, but you build those rapports over a number of years to really facilitate the pipeline growth and the execution of a strategy like this. I always joke and say, you don't just show up on a street corner, shake a bag of cash and say, "Who wants to do a deal?" That is not how this business has worked. You build relationships, you build that trust. I joke when we call it the pro bono work that we all do on a day-in and day-out basis for the moment that a transaction is appropriate for a firm, and then that conversation is kicked into high gear.

For us, I don't see us bumping into any of the folks on this call. Candidly, back to the broader dynamic, if you're looking at 2,000 managers globally in the middle market, there's a lot of opportunity for us to find the people that we truly believe we want to partner with and do so on a proprietary basis. I'm not concerned about that, at least in the next vintage two or three as the case might be.

Ajay: For somebody who's sat at Suisse, really going back to 2005 with billions of dollars to provide growth capital to alternative investment managers and going through this financial crisis, and then having to go out and raise a fund and deploy committed capital, those are two different things. I think these guys are making a great point. There are our target influence. Whether that's a pressure lease, we're using from our balance sheet to go do it, that's very different than going out and having to raise a fund and in raising LP capital and then deploying that. The other further point is, yes, it is a deep universe. The way we look at it, there's plenty of room for competitors, but people are going to be looking for partners. These are [...] smart, private equity, private markets players. They're going to want to get an idea about price discovery, but on the margin, they're looking for the best management because at the end of the day, they're selling at most, maybe 20% of their business; they're retaining 80%.

They want to know how they're going to maximize that 80% that they're retaining. Then, the last thing I'd say is that the barriers to entry are high. You can't just come into this business with $50 million as a commitment to your fund and say, "I'm going to start up." You need to start up with hundreds of millions of dollars in order to do this, especially if you're going to go after the midsize space. Again, I think there's a very big difference between putting a press release out and having firm capital to go do this versus actually going out and raising a fund, deploying that capital, creating a partnership and bringing other value to these partnerships. Again, just from the reason why we chose to carry on our business at average standard, is again, having a footprint of operating in 50 different countries with all the market intelligence that we can bring to these companies. At the same time being in those channels of retail, institutional and wholesale. At the same time, then being able to help them leverage all the know-how that we have in terms of strategic and product development. Those are things that are really important, and so just coming up with some cash to be able to go do a deal isn't going to be that easy.

Robert: Teeing on to that, Ajay, your point, if we were talking about the large end of the market is very different. This is why we're all so excited about the middle market is, as Craig says, we will have our tentacles as relationships out across firms who we think are excellent potential partners. We're talking about investing in their firms with and very rarely will our tentacles touch. There's just a lot of opportunity in that mid-market, versus the larger deals where they are pretty much one by one, every single one of them on auction process, run by bankers and with a bunch of characters turning up.

Ajay: The last thing I would say is, there's a lot of guys who are going to claim that they're going to go after, they're raising midsize funds, but the reality is they're not necessarily investing in midsize managers.

Adam: GP stakes investments can be double the typical holding time compared to a private equity investment. While some may view that as a barrier to liquidity, others argue that offers more flexibility for the GP stakes investors because they aren't necessarily beholden to a strict timeline. Options for liquidity can range from anything from asset sales, to dividend recaps, and more. We asked our guests to share potential monetization options for GP Stakes as well as how they think about timeframes. Here's Kelly, followed by Schorztman and Chitkara.

Robert: We've, obviously, returned over $2 billion of cash to our investors over the years, partly through our first fund, the number of individual positions sales, as well as a portfolio sale to AMG in 2016. Certainly, those other portfolios, syncratic sales are possible routes to liquidity over time, but we raise funds with no finite life. We really think of it as just a long-time perpetual partnership today and going forward. The other routes that are available are, financing's raised to do a dividend recap effectively on a portfolio. We did the first one of those last year, and Dyal followed shortly afterwards. Like their returns after in a meaningful way to investors. It's not the next set. It's not a full liquidity. I think from that perspective, investors are able to these days have roots to their own liquidity in a much more meaningful way than when Craig and I started out a long time ago, where they can sell their interests on the secondary market. That's suddenly a viable route for LPs to get out of positions these days, if they wish. Then, lastly, coming back to the comment on the publicly traded funds, there is also the potential route towards a long-term IPO of a diversified vehicle. We think it's very viable. We probably say that with the confidence of Goldman Sachs Investment Banking division sitting behind us and having done a little work over the years. That has extraordinary returns potential associated with it. If you think we underwrite to target returns, assuming exited entry today, having achieving anything like those kinds of X and multiples, is obviously a big value creation event. We also don't think you need that to be generating great mid-teens cash yields, income-based cash yields and great ROIs.

Craig: Just to jump off of Rob's statement, at the end of the day what we're all creating are highly diversified, high free cash flowing vehicles against StonyRock. Here's a permanent capital vehicle. We don't need to sell assets. Obviously, we will be cognizant of what the market may bear over the next decade, whether it be selling an asset or overlooking to be sold to a broader strategic conglomerate, the light may be. Rob has been part of these types of transactions. I also have been part of these transactions in my latter years at Credit Suisse. We all have experience in evaluating what the market opportunity set will be. Again, first and foremost, find those partnerships that are strong, durable, viable, creating lasting institutions that creates cashflow stream for LPs. That is a self-amortizing structure where you don't have to be beholden to a sale event, but we'll all be opportunistic and starting off would be opportunistic and on a forward-looking basis. Whether it be asset sales, whether that be refinancing, so like all of which are at our disposal.

Ajay: Look, we're a little different. We fully anticipate [providing] liquidity to our investors within their fund license go to 15 years. We do think at the end that will be a split cap where some investors will want to stay in those investments and others will want to exit them. I think our fund size is an advantage and some of our organizational capabilities, and in the closed-end fund space or things that are capabilities that we'll bring in bear. Clearly, the dividend recap, the listening, sell the whole portfolio. We're doing a second here, viable options as mentioned. We do think that, given the size of the portfolio that we're putting the other, it's going to be advantage of wanting to sell it at some point if it's needed.