A slice of the pie: Selling a stake in the GP

Having a third party in the capital structure of a PE fund manager can be a deal breaker for some LPs. This knowledge didn't stop CVC Capital Partners and Providence Equity Partners selling stakes in themselves last month, however.

First, CVC sold a 10% interest in its management company to Government of Singapore Investment Corp. (GIC), Kuwait Investment Authority (KIC) and the Hong Kong Monetary Authority (HKMA), in a deal expected to finance the PE firm's reported plans to expand into areas such as infrastructure, real assets and credit.

A week later, Providence announced that Florida State Board of Administration and an unnamed sovereign wealth fund had taken a minority stake in its capital structure, with the pension plan contributing $150 million. This capital is being directed towards expanding Providence's business and investing in its current and future funds.

Though HKMA represents a new entrant into this space - by dint of it having entered the PE asset class only recently - selling a stake in the management company is far from a new phenomenon. Investors such as New York-based fund-of-funds Capital Z and Singaporean sovereign wealth funds Temasek Holdings and GIC have been active in this arena for more than a decade. Global buyout houses such as The Carlyle Group have offloaded shares in their GP structures from 2007, with some starting even earlier than that.

A flurry of transactions has come to light this year - including Qatar's sovereign wealth fund Qatar Holding's purchase of a 22% stake in CITIC Capital in August - but the motivation for these deals is the same as before. Contrary to popular belief, the stake-ceding practice has little - if anything - to do with the labored fundraising dynamic which continues to play out in the US and Europe, as is evidenced by the lack of distress experienced by the GPs that have sold stakes.

Even if distressed firms were seeking backers of this nature, they would be unlikely to attract buyers, which invalidates inevitable comparisons between PE firms and the international investment banks that sold stakes to Middle Eastern investors during the global financial crisis.

"There's no amount of upside that can come from a management company stake that can make up for an underperforming half a billion investment. The tail cannot wag the dog," says Juan Delgado-Moreira, who heads the Asia office of global gatekeeper and fund-of-funds manager Hamilton Lane. "CVC, for example, are far from struggling - they have no debt as a company, are super cash-rich and have a super quality of earnings."

GP expansion

A more pertinent reason for a GP to do this is to finance its expansion into new product areas or geographies, as CVC, Providence and CITIC Capital are all doing. They may also use the capital to fund their GP commitments, or to generate cash for retiring founders or partners wishing to exit their shareholdings. For CITIC Capital, Qatar Holding was a natural choice, and after lengthy negotiations, it felt that both parties' strategic objectives were aligned.

"What we needed was an international institution that wanted to deploy a lot of capital in China," Yichen Zhang, CEO of CITIC Capital tells AVCJ, speaking of the firm's new strategic alliance. "They are interested in China and, coming from the Middle East, they have a lot of deference for government. They don't want to enter the country alone but team up with domestic players. In one shot they've teamed up with China Investment Corp. (CIC) and CITIC Group [the PE firm's major shareholders] and at the same time have access to our products and management."

Co-investment opportunities represent the principle temptation of these arrangements for participating LPs. GP backers tend to be granted the first right of refusal on co-investment deals, which are mostly undertaken on a no-carry basis and some on a zero-management fee basis as well. This gives them a greater ability to select those deals they prefer - in terms of industry, cashflow stability, leverage levels and management team - and thus better control their level of risk.

And while the GP is incentivized to exit its investments as early as possible in order to maximize its potential IRR, the LP is able to enjoy the company's cashflows and EBITDA for longer - should they choose to - instead of selling it, in some instances to another GP in their portfolio. Temasek, for example, leveraged its relationship with Hopu Investment Management to participate in a string of deals alongside the firm, including China Construction Bank, Asian Citrus, Iron Mining International and Chesapeake Energy.

In the case of sovereign wealth funds (SWFs) - particularly active acquirers of GP stakes - some harbor the suspicion that their ultimate aim for co-investing is to learn the tricks of the trade from PE firms with a view to establishing direct investment arms in the future. Luba Nikulina, head of private markets at gatekeeper Towers Watson, agrees that sovereign wealth funds are clearly trying to educate themselves as to how to engage in private equity-style transactions, as well as gaining access to deal flow, market views and industry relationships.

"Over time, straightforward deals that don't require too much hands-on attention - such as infrastructure, real assets or PE - will be more and more disintermediated," she says.

Nikulina refutes the idea that all SWFs will attempt to go it alone in 20 years' time, though, on the grounds that some won't be able to manage complex strategies in-house. "As a sovereign wealth fund, you wouldn't do venture capital, distressed debt, and certain emerging markets on your own. It will be a combination of outsourcing and building up internal expertise," she adds.

LP inequality

Regardless of the ultimate goal of those who embrace them, co-investment rights aren't popular with all LPs - purely because not all LPs get them. The right of some institutional investors to command a share of the economics of the GP is also contested. Towers Watson's Nikulina knows of some US LPs that refuse to consider investing in firms that have third-party investors. Their rationale is that their final due diligence is less likely to come back positive due to this factor, so they prefer to save money early on in the process.

While Towers Watson itself wouldn't advise clients to walk away from an investment on this basis, a GP's ownership and alignment of interest do play a significant role in assessing its ability to create value.

The fact that these transactions are negotiated in secret before being suddenly announced also causes concern, as do GP claims that they've sold a stake because they want to pursue new strategies, which implies the focus on the firm's main strategy is going to be diluted. The profile of the LP backer has an impact, too.

"Temasek and GIC are good governance institutions - they don't tend to abuse GPs or have an activist agenda that makes it impossible for other LPs to be there. They are very seasoned entities," says Hamilton Lane's Delgado-Moreira.

Despite this, a senior executive at a privately-held GP claims that despite their negativity, most LPs would prefer a private stake sale to having the management company listed on a public exchange in the way that Carlyle, The Blackstone Group and 3i Group are. "Every LP I speak to hates that," says AVCJ's source. "They generally don't like it because the incentive for the GP is to grow their funds under management and increase the management fees rather than focusing on generating a capital gain."

Seeding first-timers

Another phenomenon is for first-time fund managers to sell stakes in themselves, a circumstance much more prevalent in Asia than elsewhere due to the proliferation of virgin GPs. In providing the management company with equity - rarely more than $100 million - LPs can aid new PE firms with their start-up costs, as well as securing benefits for themselves. Rather than allowing a backer to participate in their economics for all eternity though, GPs tend to restrict the discounts offered to the first 1-3 funds.

Anchor investor-GP agreements take all manner of forms, too, so if an LP owns 25% of the GP structure, it doesn't necessarily mean they'll be entitled to 25% of the carried interest. Leading examples of fund managers seeded in Asia include CDH Investments Management, which received a significant investment from Capital Z when it launched in 2002; MBK Partners, which received a $750 million commitment from Temasek and Ontario Teachers' Pension Plan when it was fundraising for its first vehicle in 2005; and RRJ Capital Partners' sale in 2011 of a stake in the newly-formed GP to Temasek.

Many LPs wary about stake sales by established GPs view this seeding scenario as positive. The anchor investor provides some stability, and by appointing a representative to the management company's board, can prove to be a useful sounding board, supplying their partner with industry relationships and access to deal flow. Sovereign wealth funds, in particular, could represent a gateway for a fund into the Middle East, as well as insight into investing in public markets.

AVCJ spoke to a CEO at a global gatekeeper and fund-of-funds manager who remains unconvinced, however. Not only would this particular firm be unwilling to back a GP which allows its anchor investor governance rights on the investment committee, it also believes that investments of this nature reflect badly on the participating parties. For that reason it dissuades its clients from taking GP stakes.

"I don't believe it's been particularly successful for the GPs who've participated," says the CEO. "It probably comes down to the fact that the GP that needs that kind of push needs a push. If they've a good enough reputation, then they can make it themselves."

Some also question the wisdom of those LPs who have bought into GPs at high valuations without having a prospective exit route. Whether they've bought into an established GP or a first-time fund manager, their investment is illiquid and the chances of an exit via IPO are minimal: most of the large GPs - such as Providence- made solemn promises to not go public, while it's anyone's guess whether the first-time GPs will be ready to IPO in several decades' time, or simply quietly disband after a lackluster first vehicle.

The long-term value of the management companies is therefore unknown, and it's an open question whether they'll be able to build up a sustainable franchise that will last. All that is certain is that first-time fund managers will continue to sell stakes in themselves for as long as they continue to flood into Asia.

"Many of them won't do well at all," says Delgado-Moreira. "But because it's a 10-plus-year investment range and you're judging the returns in aggregate, it will take a long time and be very hard to tell for those outside those organizations."

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• Topics
• GPs
• Investments
• Restructuring
• Hamilton Lane
• CVC Capital Partners
• Providence Equity Partners
• CITIC Capital