The GP Stake
How do you buy a private equity business? What does this reveal about earning fees vs. incentivizing a fund manager to generate strong investment returns?
You are an investor putting money into a vehicle. This vehicle then can own a slice of a business whose own business is putting other people’s money into similar vehicles.
We have seen some of this before. Money that manages money that manages money. At some point Bobby builds a factory in Kansas, and that factory makes sofas. There is a legion of investment manager that stands several floors above all that and collects fees earned from Bobby’s toil, but neither Bobby nor the investment manager has much idea about what the other does.
Despite the massive epistemic distance between the two, this arrangement works fairly well. It is a rationale trade, and the folk in investment management call it “GP staking.”
It’s The Manager Silly
A private fund manager is, stripped down, a company (the management company is typically a limited liability company) that raises and runs pools of other people’s capital primarily for two things: a management fee, charged on the money regardless of how the investments perform, and carried interest, a share of the profits (classically 20% above a hurdle) if such investments perform well.
The owners are usually the founders and senior partners, holding equity through a management company (a Delaware LLC!) and a related general partner entity (also a Delaware LLC!).
The edifice of an investment management business is that it sells its investors an interest in its funds, and in the United States that interest is a security. A limited partnership interest in a private fund is an investment contract, which the Securities Act of 1933 treats as a security, which is why these funds are sold through private placements and rely on exemptions like Regulation D of the Securities Act of 1933 and on the exclusions in Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940.
So before we reach any “stake,” one should appreciate that there is a business whose entire output is the sale of securities to (usually) institutions that are willing to buy thousands of such securities.
Which is why a GP stake is not like buying a slice of an operating company. A widget maker sells widgets. A fund manager sells claims on pools of capital, and its own value is a claim on those claims.
You buy a piece of the manager (but you are not buying a factory, even if the manager owns a factory). You are buying a share of a contract to keep managing money, plus whatever that contract throws off.
The Traditional Trade
The classic arrangement for a fund that is set up to buy stakes in other investment managers is familiar to us in these pages. Someone raises a pool of capital from the usual institutional investors, and that pool buys minority, non-controlling, passive stakes in other investment managers.
10-30% of the management company and typically no control. In return the buyer gets its pro-rata share of the manager’s economics and (ideally) stays out of the way while the founders run it.
For a long time this was a small and clubby world: Dyal (now the GP stakes arm of Blue Owl), Goldman’s Petershill, Blackstone, a handful of others. (Perhaps this is not unusual, since the TAM of GP stakes is quite limited compared to other asset classes.)
The pitch to a selling GP is money in the door without handing over control: capital to fund commitments to your own funds, seed a new strategy, buy out a retiring partner, or shore up the balance sheet. This is specifically without a strategic acquirer (which could be another investment manager that is not in the GP staking business, but wants to add a specific asset class or strategy to its business) meaningfully changing how the business operates.
The pitch to the buyer is a claim on a durable cash machine.
Whether both pitches are true at once is the good question. And I like good questions!
The Cash
First, liquidity. Many GP stakes vehicles are “permanent capital,” which raises a question the industry has spent years not fully answering: how does anyone get out? You own an illiquid minority slice of a private company, and exiting means finding another stakes buyer, listing the holding company, or waiting.
The salability issue is moderated by the presence of stable cash flow. Unlike a buyout, where you buy a company, improve it, and must sell it to make your money, a GP stake investment pays you while you hold it. It generates cash from day one, because the manager’s fee is contractually guaranteed by its fund-level investors. One does not need an exit to earn a return, unlike most private equity or venture capital investments.
If the investment throws off durable cash and you never truly need to sell, the ideal owner is whoever has the least duration pressure and is happy with stable cash flows: sovereign wealth funds and large insurers have naturally emerged as competitors to GP stakes firms.
The object of patience is, in a crude way, the management fee (rather than the carried interest!).
A GP stake, on the telling of the industry’s better-known players, entitles you to three streams: management fee profits; balance sheet return, meaning the manager’s own co-investments in its funds, which hand you the gross fund return with no fee or carry taken out; and carried interest.
The whole affair is described essentially as the acquisition of recurring management fees. Notice that the carried interest lacks appropriate emphasis.
The famous part, the profit share that supposedly aligns everyone, is more of a ganache (though I like ganache on my molten lava cakes!). The entree is the management fee: contracted, long-dated, and paid whether or not the fund from which that fee is derived performs well or not.
This is obviously an alignment problem. If a GP stake is mostly a claim on fees, the incentive it rewards is gathering assets, not generating returns, because more assets mean more fees.
Fine when a founder sells a small stake and keeps their own wealth tied to performance. Worse when the deal is mostly founders cashing out, and worse again when a firm lists its holding company, at which point the former partner-owners become large public shareholders and, as several people I’ve spoken to have alluded towards, the conversation is largely about management fee surplus (a derivative of fund size).
Fee related earnings are cash flow, and cash flow affects the multiples at which these businesses trade on the stock market.
This is another way of saying, bigger fund is good fund but not always better fund.
Sometimes I think private markets are a better place for the securities salesman than for the investor.