The Market for GP Stakes
For years, private equity firms have had to think creatively about how to find outside capital for their operational needs. As the few publicly traded private equity firms have seen, however, the public markets often prove to be too fickle for the capital needs of GPs. At the same time, LPs face a corresponding challenge to innovate in the ways that they access private equity firms as an investment. For the most part, these institutions have been limited to investing at the fund level, having to renew their relationship with the manager at every consecutive fundraise. Over the years, the private equity industry has evolved to solve for these two challenges through the emergence of a liquid market for GP stakes.
GP stakes involve making a private investment at the management company level. They constitute making an equity investment in the private equity firm, and investors get access to their pro rata share of all GP-level cash flows for each fund. Although these transactions have historically been limited to large cap, “brand name” private equity firms, investor interest in this type of investment has quickly moved down to the middle market. These days, there is an active market for GP stakes, as an ever-growing contingent of institutional investors has begun tapping into these investments to get long-term exposure to a particular manager. Oftentimes, these investments are tied with regular fund commitments in the manager, thus allowing the institutional investor to get access to both GP-level and LP-level cash flows from the private equity firm.
There are a number of advantages that this structure offers private equity firms. For middle market managers, one of the most salient uses of GP stake capital is as expansion capital to grow the firm or perhaps start an adjacent strategy. Opening the management company up to GP stake investments allows the firm to build a balance sheet that can be deployed not only for expansion purposes, but for any operating initiatives as needed. Furthermore, private equity firms can tap into this market to execute seamless succession planning. One of the more acute problems that managers face while planning succession is how to get the retiring professionals liquidity for their management company stakes. These situations arise when the incoming generation of firm leaders are unwilling or unable to buy a portion of the management company. The emergence of institutional investors as a reliable demand base for these management company-level interests has resolved many such situations – the retiring professionals have the option to sell the balance of the management company to an outside investor if needed.
If this structure appeals to you, what steps can you take to make your firm more “investable”? Most importantly, focus on institutionalizing your firm – especially in the middle- and back-office. This is a different ball game than soliciting fund investments – a limited partner will be interested to know that you have the proper set-up to support your fund, but they are not exposed to the operational performance of the firm as GP stakes investors are. As a result, you will need to ensure that your firm has blue-chip operations including human resources, technology, administration, auditing, reporting, public relations and marketing, etc. Remember that you are building a “firm”, not just a “fund”.
GP stakes are quickly emerging as a mutually beneficial way for private equity managers and institutional investors to deepen their connectivity to each other. Take care to ensure that you find the right institutional partner for you as you look into options to tap into this source of capital.