GP stakes: A matter of ownership

“This is an area where I never want to be on the record because it would create speculation,” says a founder of a mid-size Asia-based private equity firm. “But yes, we have been approached and we haven’t seen an arrangement that makes sense. While we are philosophical about intergenerational and sustained positions, we haven’t seen a deal that adds value in return for future rent forgone.”

Anonymity is a standard request from PE executives when asked if they would consider giving up equity in their firm to a third-party investor. This is a sensitive area. Any move to “sell future rent from the business at an upfront price” – by giving someone a permanent share of the fee streams – might be regarded as transformative: it facilitates succession planning, it enables more people to participate in the GP commitment to a fund; and it can seed new investment strategies.

Equally, it could send out completely the wrong message: founders cashing out with little thought to the future; relationships potentially ruined with LPs that insist on all the carried interest going to the investment team; and a general sense of uncertainty as to where the firm is going. No one wants to put themselves into play so publicly. And if they do see the value in signing up a strategic partner, they want to communicate the reasoning with care.

Selling a stake in a private equity firm is not a new phenomenon. Several of the region’s oldest and best-known managers might not be in existence today if they hadn’t traded partial ownership for anchor LP commitments. Seeding remains a small but active part of the landscape in Asia, although these agreements are highly bespoke. There is no industry standard definition as to what rights having a GP stake constitutes or how long they should last.

Meanwhile, the “fund of firms” model is gaining traction globally as the likes of Dyal Capital Partners, The Blackstone Group, Affiliated Manager Group (AMG), and Goldman Sachs-owned Petershill Private Equity build up portfolios of interests in established managers. So far two GPs in Asia have taken on investment in this way – Baring Private Equity Asia and PAG – but more are likely to follow as the industry continues to mature.

“It’s an example of innovation, slicing, dicing and aggregating different aspects of cash flows. That’s why the secondaries industry has grown so much – packaging up a bunch of LP interests to provide liquidity where previously there was none,” says Nick Bloy, a managing partner at Navis Capital Partners, which bought out its third-party investor four years ago and has no interest in taking on another. “Why can’t you package together a group of GP interests as well? There’s upside in them if the GP is doing well and growing.”

Accelerated development 

The most recent high-profile sale of a GP stake in Asia involved secondaries specialist NewQuest Capital Partners. TPG Capital took a one-third interest in the firm, with NewQuest receiving shares in TPG. The transaction was brokered at a global level within TPG and positioned as part of the private equity firm’s ongoing efforts to add new investment strategies.

From a NewQuest perspective, the motivation was expansion. The firm has already rolled out fund restructurings alongside its existing direct secondaries offering and there is a desire to target additional sub-specialties. TPG offers access to resources and expertise that can help address the challenges that come with adding scope and scale.  

Several LPs and advisors that have worked with NewQuest expect the TPG influence to be felt most keenly in fundraising. The firm closed its third vehicle at $540 million in 2016, up from $316 million in the previous vintage, but the investor base remains relatively concentrated. There are fewer than 20 LPs in total and four account for 60% of the corpus. “If they want to raise $1 billion for their next fund, now they have the distribution power,” one LP says.

Darren Massara, a managing partner at NewQuest, declines to go into specifics. “We have a pretty good idea of what we want to achieve over the next 5-10 years, and without TPG, it could take us double that time,” he says, noting that the partnership followed two years of talks during which the two firms established they shared a common view of the Asian PE market and similar corporate cultures. “As the secondary landscape continues to evolve, TPG’s experience in building a multi-strategy firm will be incredibly valuable to us.”

If selling a stake in the GP typically comes near the start of a private equity firm’s life or at a stage of relative maturity as founders consider succession, NewQuest does not conform to type. Capital raising is not a problem (Fund III closed at the hard cap) and the firm has yet to reach a stage where transitioning to the next generation is a priority (no money has been taken out of the business following TPG’s entry).

But what all these transactions have in common is the notion of using third-party investment to achieve goals in an accelerated timeframe – whether that means seeding a first-time fund, helping an established GP scale up, or facilitating succession for a mature player. The question managers must ask themselves is simple: Is selling a stake in the GP necessary or worthwhile? The answer is usually more complex, and it can vary markedly based on individual circumstance.

AVCJ put the question to a range of Asia-based middle-market private equity firms in the context of succession. Most said they had been approached by the likes of Dyal or Blackstone, or by bankers offering to intermediate a transaction. “We are not interested in the slightest,” “We haven’t received a pitch that we found attractive,” and “We are not ready,” were among the most common responses.

“It’s still a little early in the evolution of things, but as we move to the next vintage it could be something we consider,” says the founder of a firm that has more than $1 billion in AUM across several funds. “Our carry economics are well distributed within the organization and we’ve done that without changing ownership of the firm. We’ve been talking to LPs for a while about getting more ownership to junior members of the team. We have a fair amount of flexibility with that and with potential third-party shareholders.”

Strategic considerations

Nearly every firm AVCJ spoke to has received one-off propositions from LPs about selling equity in the GP as part of an anchor commitment to a fund. Advisors are unequivocal in the guidance they give to private equity firms on this issue: avoid giving up a stake in perpetuity if you possibly can.

“Fund managers are usually aware of the risks and careful not to give a piece of the GP to anybody, but when a client asks about this, I almost always advise against selling. They might need the money, but it could hurt the fundraise. Certain LPs will not want to commit if they think another investor might impact the GP’s decision-making process,” says Lorna Chen, a partner at Shearman & Sterling. “My suggestion to clients is that they figure out what the other party is asking for.”

Many LPs don’t have the mandate to invest in fund managers and still more choose not to because of potential conflicts of interest. However, this demand is increasingly coming up in anchor investment negotiations between small to middle-market private equity firms and Asian LPs. Family offices and Chinese financial institutions are said to be among the keenest to secure ownership in the GP. Their motivations range from wanting a share of the economics to accumulating investment expertise to gaining priority access to co-investment opportunities.

Understanding these needs is important because it’s possible they can be met without giving up equity on a permanent basis. Indeed, a stake in the GP might not be what the investor wants at all.

“One of the biggest potential misunderstandings in our industry is what ‘GP’ actually means in terms of the breadth of the roles and the economics,” says James Ford, a partner at O’Melveny & Myers. “Some people think it means having an observer seat on the investment committee and share of the economics. Others define it in the legal sense, where there is a different GP for every fund. Services are provided from outside and in practice the GP doesn’t really take decisions. And even if there is a holding company, it might not be the level at which you offer a stake to a cornerstone LP.”

A holding company – in which the third-party investor holds a minority interest – is the most efficient structure from a legal and operating perspective. It controls the management entity, absorbing the management, transaction and advisory fees that accrue to the sponsor once costs have been covered, and then a separate agreement covers carried interest. 

However, there is a lot of variation in how these deals are put together and complications can emerge in the small print. For instance, in the absence of parallel governance agreements, a passive holding company investor might have no control over the budget and strategic decision making at GP level. Salaries and other operating expenditures could soak up all the management fees. Meanwhile, carried interest could be siphoned away before it reaches the holding company level.

“If you don’t express what you want in the right way, a 10% stake in the GP might amount to very little,” says Justin Dolling, a partner at Kirkland & Ellis. “There could be no voting rights and no distribution rights, with management fee income being consumed by salaries and bonuses, and the carry being paid out directly to the team.”

Fiduciary obligations tied to existing funds are another potential obstacle. Limited partnership agreements and side letters often place a threshold on the amount of carried interest a manager can distribute outside of the GP itself and the investment team. This is intended to preserve alignment of interest between GP and LP, but in doing so, it might restrict the flow of capital to third-party investors in the firm.

As an alternative, an investor that wants a share of the economics might be satisfied with a contractual arrangement that entitles it to an effective discount on fees – but stops short of giving a legal right over the GP. These arrangements often lapse after a certain amount of time or a certain number of funds. A PE firm might have the option to redeem an investor if its ongoing contributions to funds fall below an agreed level. Meanwhile, preferential access to co-investment could be formalized through side letters or the creation of a separate account.

When an investor sees equity in a private equity firm as a means of developing its own direct investment expertise, an amicable solution could be seconding executives to work alongside the team or holding regular briefings with senior management on macroeconomic conditions, sector trends, and pipeline opportunities. “I’ve negotiated deals where the LP wants a one-hour call with everyone above managing director level, just so they can get market insights,” notes Shearman’s Chen.

Idiosyncratic approaches

Even among global funds that specialize in backing investment managers and unequivocal in their desire to take permanent stakes in GPs, there is wariness about leaving holes in the net. This is especially true when a holding company is absent from a deal structure and the investor must work through every fund to ensure its contractual rights to cash flow streams are being observed.

One industry participant familiar with Dyal’s documentation describes it as comprehensive, covering many of the governance and economic issues that could arise from initial investment through exit. On the other hand, Jennifer Graff, a partner with Debevoise & Plimpton in New York, has worked on some seed funding agreements that ran to 150 pages and others that stop at three, despite having failed to include the most rudimentary protection provisions. “There is no set way of doing this. The relationship between the seeder and the seeded manager is so idiosyncratic,” she says.

Idiosyncratic is a fitting adjective for Asia as well. Across many aspects of private equity, the region’s relative immaturity means strategies that are already established in other parts of the world have yet to find their feet. The pursuit of GP stakes is no exception. With the global funds yet to achieve meaningful traction with succession-oriented solutions and sophisticated seeding platforms non-existent, the market comes across as incoherent and experimental.

The status quo will not last and in this respect the earlier comparison to secondaries is apt. The secondaries market in Asia is often described as being a decade behind Europe and it is only in the last two years that it has really begun to come to life. Perhaps GP stakes will follow a similar path. 

These arrangements will likely only appeal to a subset of managers, but a key factor influencing the speed of acceptance is the extent to which they are positioned as constructive partnerships rather than passive investments. For mature firms, this may come with a recognition of the role third-party investors can play in enabling expansion as well as resolving succession. For their younger counterparts, it is about being offered strategic input, not just a shortcut to a first close. 

Plenty of GPs establish strategic partnerships with certain LPs – but so far relatively few have taken those relationships to the next level.  “We had one client that was reticent, and I said, ‘They aren’t asking you for anything, they just want to develop an understanding of your investments,’” says Mounir Guen, CEO of MVision. “Now, every investment that GP makes is shown to the LP towards the end of due diligence and the LP comes back with ideas and makes relevant introductions. It has become a nice symbiotic relationship.”   

 

SIDEBAR: The first movers

Kuala Lumpur 1998. Three executives from Boston Consulting Group’s Asia ex-Japan practice decide to enter the private equity business, leveraging the skills and knowledge they have accumulated through advising corporates in the region. They were entering unknown territory. PE investment in Asia over the three preceding years was around $4 billion – compared to $200 billion in 2017 – and Southeast Asia accounted for just 13% of that. 

Navis Capital Partners has gone on to accumulate more than $5 billion in assets under management (AUM) and the GP is targeting $1.75 billion for its eighth fund. But raising $68 million for Fund I, at a time when many people weren’t convinced that a buyout strategy could work in Southeast Asia, required assistance. HAL, a Dutch investment holding company, helped capitalize the management entity and accounted for half of the first close on Fund I. In return, it took a 25% stake in the GP.

“It was a couple of chapters into the Asian financial crisis and they were instrumental in getting us started – a bit like a joint venture partner, but more passive thereafter. Without them, I don’t think we would have raised the fund,” says Nick Bloy, a managing partner at Navis.

Three years later, CDH Investments went through a similar process. The captive PE unit of China International Capital Corporation (CICC) was spinning out for regulatory reasons. Four anchor LPs took a bet that private equity – then unproven in China – would find its legs and backed a $100 million fund. Two of those investors, GIC Private and Capital Z, requested a stake in the GP in return.

Navis and HAL had a constructive relationship – HAL continued investing in the PE firm’s funds and offered strategic assistance if an investment fell into its area of domain expertise – but it ended four years ago with a buyback. Somewhat unusually, this take-out of the passive investor facilitated succession planning at Navis. Bloy and Rodney Muse, his fellow managing partner, acquired HAL’s position and then started a process that has seen non-founding partners took partial ownership of the GP. They cover the cost by forgoing a portion of carried interest and bonus payments.

GIC Private and Capital Z still hold stakes in CDH, which now has $18 billion in AUM across multiple strategies. “If you have enough bargaining power you don’t give up equity, but they were the first ones in the market and there was no other way to get it done,” says a source familiar with the firm. “In some situations, there is a tension when economics that would normally go the deal team go to a passive investor. LPs might be lost because of that structure because they don’t see an alignment of interest.”

 

SIDEBAR: The serial seeder

Brummer & Partners likes to be first. It pioneered hedge funds in the Nordics and has since built up a SEK125 billion ($18 billion) business that spans Europe. The expansion strategy involves identifying independent managers and taking joint ownership of each fund. Brummer provides capital, experience and infrastructure, while the manager contributes investment expertise.

About 10 years ago, Brummer applied this model to Asian private equity, targeting emerging markets with attractive growth profiles where it could leverage early-mover advantage. The Frontier Fund raised the first Bangladesh-focused PE vehicle in 2009, securing commitments of $88 million. A second fund of $104 million followed in 2014. In the meantime, Brummer had started scouting for managers in the Philippines and Navegar closed its debut vehicle at $119 million, also in 2014. 

“We were able to rely on Brummer’s institutional back end and we went through a subset of Brummer LPs and asked them if they wanted to invest. After approaching other institutional investors as well, together with the managers we were able to raise decent-sized funds and hire the best possible teams,” says Anders Stendebakken, a managing director with Brummer. “It only works if everyone gets something out of the partnership. That is very much core to our business.”

These firms are run as 50-50 partnerships, but with a general understanding that Brummer will gradually reduce its stake – and share of the economics – with each new fund. All Brummer’s upside is expected to come in the form of carried interest. Indeed, the firm is willing to underwrite some of the set-up costs if the management fees are insufficient to cover key expenses such as recruitment.

There are a handful of groups in the US that do serial seeding. According to Jennifer Graff, a partner at Debevoise & Plimpton, these investors typically take a share of the revenue from the fund they are seeding as well as from all future products launched by that manager. At some point between years five and 10, the manager will have the right to take out the seeder. 

“In the six to 10-year range, they expect the investment to start paying off,” Graff says. “The manager starts small, but the seeder has connections to help them increase their fund size. There is an expectation that it could go from $100 million to $1 billion in short period of time.”

Several placement agents are looking to enter the seeding space. SP Capital Partners – an offshoot of Sixpoint Partners – recently raised a $200 million fund to support spin-out managers, while Park Hill Group has a similar initiative in the works. These platforms are expected to focus primarily on the US and Europe, not Asia. “I see situations in Asia where people partner with individuals or institutions to get started, but I don’t see it happening in a systematic way,” adds Stendebakken. 

• Tweet  
• Facebook  
• LinkedIn  
• Google plus  
• Save this article  
• Send to  

• Topics
• GPs
• LPs
• Investments
• Fundraising
• Asia
• NewQuest Capital Partners
• Navis Management
• TPG Capital
• Dyal Capital Partners
• The Blackstone Group
• Affiliated Manager Group (AMG)