GP stakes: Succession scenarios

When Baring Private Equity Asia sold a 15% stake to Affiliated Managers Group (AMG) in early 2016, the proceeds were earmarked for supporting future commitments to Baring funds, improving financial flexibility and alignment between LPs and staff, and creating a mechanism for the long-term inclusion of the next generation of leaders into the shareholding structure.

“Creating shareholder value at the firm level, which is something that has already been done by several of our global competitors who have raised capital from the public markets directly or sold stakes to private investors, is a strategic tool for further motivating and aligning employees and will help to cement the partnership structure we have in place,” the firm said in a memo to LPs.

The Baring leadership team agreed long-term contracts to remain in their roles. A similar message was issued by PAG after it sold a minority interest to a fund managed by Blackstone Alternative Asset Management (BAAM) earlier this year, according to LP sources.

Matthew Dickman, a partner at Debevoise & Plimpton, has worked on a variety of deals involving funds that target investment management firms. Succession planning has featured in each one, although this doesn’t necessarily mean a full exit for a founder or even that a significant amount of cash is taken off the table. Rather, selling an interest to a third party places a value on the GP and acts as a catalyst for having conversations about succession, if they haven’t taken place already.

“Often, it is only the founders who are selling a share of their entitlement to management fees and carry,” Dickman says. “However, the investor will likely want to know what plans are contemplated when these people retire. Similarly, the next generation of investment professionals want to understand what a third-party investment means for their future within the organization.”

The right fit

This view is echoed by the investors themselves who express a preference for deals where there is a need for primary capital to be put on the balance sheet – for business expansion or helping team members join the GP commitment to a fund – and an institutionalization of the equity structure. This is likely to involve establishing terms for the departure of founders and setting up retention mechanisms for those who ultimately assume management control, and ownership, of the firm.

“Some firms are set up so that founders retain permanent equity and it’s not healthy for someone not involved in the day-to-day to be taking 10-15% of the economics. It can be beneficial to provide liquidity to those founders, but they would have completed the generational succession and had the next generation in front of LPs for a decade before the transfer takes place,” says one investor. “We are very focused on the use of proceeds and on the alignment with individuals we care about.”

Managers must also meet a string of criteria, such as a certain level of scale and depth in the investment and management teams, a strong reputation, and institutionalization in terms of internal infrastructure and compliance capabilities. In addition to that, they must have some idea as to how the business will be passed onto the next generation. 

Baring and PAG make for logical targets within the Asian private equity community in that they are well-established, relatively large, and multi-strategy. Baring was founded in 1997, has more than $11 billion in committed capital, and is currently raising its seventh pan-Asian fund. It has also raised two real estate funds and established a credit team. PAG’s private equity business is younger – Fund III is in the market – but the firm’s absolute returns strategy has been in place since 2002 and it built up a real estate division through M&A. Assets under management (AUM) exceed $20 billion.

A need for scale

Given global private equity firms with a presence in Asia tend to be listed or they already have third-party investors, the target group is limited to a few independent pan-regional players and the larger single-country managers. “I’ve heard the Dyal Capital Partners pitch, but they’ve pitched every GP in the market,” says one China-based manager. “They have a lot of capital and their model will work with anyone. Once a GP has earnings, it’s a great cash flow business.”

Representatives of these funds claim there are no strict guidelines as to minimum AUM and number of strategies, but they are constrained by increases in their own fund sizes. Dyal, a unit of Neuberger Berman, closed its third fund at $5.3 billion last year, $2 billion more than the initial target. The most recent Blackstone Strategic Holdings fund and Petershill Private Equity vehicle have corpuses of $3.3 billion and $2.5 billion, respectively. A smaller manager must have the potential to grow quickly and generate fee income for investors that need to meet the return expectations of their own LPs.

Valuation is based on projected cash flows coming out the GP across an agreed set of products – older funds and some separate accounts might be excluded – under different scenarios. “We understand financial buyers focus on a 10-year model for valuation. Management fee income generally creates a significant portion of the value in these deals because it’s so predictable,” says Dickman of Debevoise. “In some cases, it appears that investments are underwritten primarily based on management fee cashflow and anything generated through carried interest or other cash flow streams is upside.”

The other priority is diversification. Dyal names 34 partners on its website, comprising 19 private equity firms and 12 hedge fund managers. The PE relationships range from credit specialist Atalaya Capital Management, which has $3.5 billion in AUM, to established industry heavyweights like Silver Lake, Providence Equity Partners, Starwood Capital Group, and Vista Equity Partners.

As a listed entity, AMG discloses more information, although its investment scope is broader than most. It had 38 partners with $836.3 billion across more than 550 products as of year-end 2017. Aggregate fees were $5.5 billion. However, alternatives accounted for 39% of assets – of which 9% was in private equity and real assets – with the rest in traditional asset classes. The $71.6 billion increase in alternatives AUM over the course of 2017 included $20.4 billion in net client cash flows and $30.6 billion in new investments.

“Within our target universe, we seek strong and stable boutiques that offer active return-oriented strategies, such as alternative strategies and global equities strategies. These boutiques are typically characterized by a strong multi-generational management team, entrepreneurial culture and commitment to building long-term success,” AMG says in its 2017 annual report.

Outstanding questions

Two aspects of this strategy remain largely unproven. First, the value-add element of these investments is said to include assistance in product development, talent management, fundraising, and addressing the challenges that typically emerge as firms grow in scale. More time is needed to assess whether these efforts are paying off. In most transactions to date, the proceeds have gone towards future GP commitments to funds rather than expansion initiatives, according to advisors.

Second, exit pathways are unclear. Most industry participants are investing out of permanent or long-dated pools of capital. Provided LPs are happy with the yield-like returns, exits aren’t necessarily required for permanent structures. Meanwhile, GP interests held in a fund with a finite life could be spun into a permanent structure through an end-of-life restructuring. Other liquidity options include placing leverage on funds and packaging up portfolios for strategic sales or public market listings. 

To some, the uncertainty is confusing. “Across both primaries and secondaries, people invest because they see an exit pattern – an IPO, M&A, or a put option against the founder. If one of these investors in GP stakes said it had a put option on all its deals, then the limited visibility on other options might make more sense,” says James Ford, a partner at O’Melveny & Myers. “No one wants to back a Fund I if they don’t think there will be a Fund II and III.”

Nevertheless, the fundraising exploits of these firms suggest there is ample demand from LPs. Alaska Permanent Fund Corporation (APFC) is one of the prime movers. It has made substantial commitments to funds raised by Dyal and Blackstone, as well as allocating capital for co-investments. The $64.9 billion sovereign wealth fund also teamed up two other institutional investors to launch Capital Constellation, which provides capital to emerging managers in return for a share of the economics.

“We hope to leverage our unique insights into the ecosystem to evaluate which established and emerging platforms have the greatest ability to expand vertically and horizontally,” says Yup Kim, a senior portfolio manager for private equity and special opportunities at APFC. “PE platforms can have great appeal as operating businesses given their ability to scale quickly, be highly cash generative, enjoy recurring fee-based revenues, and leverage their domain expertise across product verticals.”   

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• Topics
• GPs
• LPs
• Investments
• Asia
• Baring Private Equity Asia
• PAG
• Dyal Capital Partners
• The Blackstone Group
• Affiliated Manager Group (AMG)