What’s at stake?
General partner stake deals have become highly popular in recent years and investors are still coming to grips with what these transactions mean for long-term manager performance and alignment. A new academic research paper sheds light on the issue.
By Nicholas Neveling
In an interview in the summer of 2022, Michael Rees, the head of Blue Owl Capital’s general partner stakes investment platform, put into context how rapidly the GP stake market was growing. “The fish are reproducing faster than we can pull them out of the pond,” he told Buyouts, adding that the market had been expanding by 10% a year and was on track to grow from US$530bn in 2022 to just under US$750bn by 2025.
Managers that have completed GP stake sales in recent times include Inflexion Private Equity, Bridgepoint, Coller Capital and CVC Capital Partners.
These transactions, which involve the sale of a share of a private equity firm’s cash flow from its funds’ earnings – including carried interest, management fees and other revenues – raise serious questions for limited partners in these funds. They are having to assess how these deals could affect the alignment of interest between themselves and managers, and long-term manager performance.
In a recently released academic paper, Selling Private Equity Fees, Minmo Gahng and Blake Jackson studied GP stake transactions and their influence on GP-LP relations. “We started this project after we read several newspaper articles highlighting that some PE firms were selling GP stakes – claims to future GP cash flows in exchange for sale proceeds today,” Gahng says. “We were intrigued by how professionalised and mature the market for GP claims had become in recent years.”
The paper attests to the growth in this area: it finds that the fraction of PE industry AUM overseen by GPs that have sold stakes increased from 6.3% in 2000 to 31.8% in 2021. The study then analyses the kinds of firm making these transactions and what happens to a GP and its fund LPs following a sale.
Who’s selling?
One key finding is that the firms selling stakes are typically more mature franchises and among the industry’s best performers. “PE firms that have sold stakes tend to be in the top decile of GP income and tend to report above average LP performance,” says Jackson. “They also tend to be more mature firms, having raised on average about nine funds by the time they sell a GP stake.”
However, while performance and maturity signal which firms are more likely to undertake GP stake sales, a firm’s AUM is an even stronger indicator of the likelihood of a stake sale. “The single most important factor in distinguishing between PE firms that have sold GP stakes and those that have not is the level of AUM,” says Jackson. “About two-thirds of firms that sold GP stakes are in the top two deciles of AUM.”
On the large side
Buy-side and sell-side factors feed into these results on manager size. Gahng says buyers “appear to make decisions based on the expected risk/return trade-off of these investments.” Bigger firms with larger AUM have more predictable profitability from fee income and don’t necessarily have to rely on blockbuster payouts of carried interest to drive up revenues.
“A GP stake sale is primarily comprised of a proportion of a management fee stream that offers an attractive yield, carried interest, or other performance-based streams with attractive upsides, and any appreciation thereof,” explains Gahng. “Although the expected return could be higher for smaller PE firms, the risk is also higher. Larger PE firms have historically been more likely to have more robust fundraising opportunities, have been less likely to fail, and they tend to have a more institutionalised platform.”
On the sell-side, meanwhile, Jackson says firms that sell appear to have a preference for “a smaller slice of a bigger pie” over a “bigger slice of a smaller pie”. “These firms are generally raising external capital to grow larger in the future, by, for example, making GP contributions for the larger funds they raise after the sales,” he says. “So, the sell-side appears to be comprised predominantly of bigger firms, with partners and cultures that motivate growth of the firm.”
Yet there is another crucial consideration for both buyers and sellers, says Paul Newsome, partner and head of PE portfolio management at Unigestion: the size of the stake. He says there needs to be a balance between offering the buyer exposure to a meaningful revenue stream, while also sustaining attractive long-term incentives for GPs. “If you are paying out a share of the fees and carry to new investors, it restricts the carry pool for up-and-coming investment professionals,” he says. “If the stake is too large, and the carry pool for deal teams reduced by too much, that can prove counterproductive.”
“Initially, many LPs were sceptical about why a GP would undertake a stake deal. Some feared that GPs were cashing out with no benefit to LPs.”
James Newsome, Unigestion
Where’s the skin in the game?
As GP stake deal volumes have grown, LPs have had to grapple with two main concerns: what the proceeds are being used for; and whether stake sales could compromise LP-GP alignment in any way. If a firm sells a portion of its future fund profits, for example, LPs may be concerned that it is reducing its skin in the game. LPs might also be concerned that a GP stake sale could see senior partners cash out.
“If there is a sense that the LP is providing fees to manage the assets, but the GP feels it can monetise that instead, that definitely makes LPs feel more nervous,” says Imogen Richards, partner and head of primaries in Pantheon’s European PE team. “Selling out everything and not reinvesting is a red flag. Retaining skin in the game is really important.”
However, Gahng and Jackson’s research suggests this is unlikely to be the case. It finds that proceeds from stake sales tend to be used to finance GP fund commitments and hiring new team members. “After selling stakes, firms tend to increase the level of their GP commitments to subsequent funds, and their count of employees and offices rises,” Gahng says. The study also appears to show that GP stake sales do not, in general, affect alignment. Jackson notes that when firms use proceeds to finance commitments and recruitment, AUM increases with no decline in performance relative to other similar firms. Newsome adds: “Proceeds from GP stake sales are also used to fund recruitment and to launch new sub-strategies. If you are an upper mid-market firm and you want to launch a small-cap fund, you have to recruit people, and that requires investment.”
“This means that, if anything, firms create more value – in absolute terms – for their LPs after selling GP stakes,” says Jackson. “So, while it’s reasonable to suspect that these deals could leave LPs worse off because GP incentives are diluted, in fact, sophisticated buyers seem to do a good job of selecting PE firms where selling a small stake won’t have a sufficiently dilutive effect.”
This finding reflects a shift in LP perception in recent times, according to Newsome. “Initially, many LPs were sceptical about why a GP would undertake a stake deal,” he says. “Some feared that GPs were cashing out with no benefit to LPs.” That has changed as it has become more evident that managers see a stake transaction as a way of solving issues, he says, including buying out founding partners and smoothing succession, or providing more cash for GP commitments.
All this suggests that GPs need to be transparent with LPs about the strategic reasons for a stake sale. “There can be very good reasons for a stake deal, which can benefit the GP and the investors, but communicating the motivations is key,” says Richards. “LPs really need to be able to understand the rationale and gain comfort that alignment is still really there.”
Growth ahead?
Today’s challenging macro-economic backdrop may mean that the GP stake market encounters some headwinds over the short-term. However, according to Jackson, it will remain a “practical channel” over the longer-term for easing the financial constraints firms face, and so it looks set to grow further. “We expect stake sales to increase in frequency, especially as GPs and LPs become more comfortable with the transactions,” says Jackson.
And beyond these deals, Gahng says there are many more compelling areas of inquiry that he and Jackson would like to pursue. “PE firms are increasingly important economic entities and this could open the door to questions studying their valuation, industrial organisation, competition, and collaboration,” he says, adding: “Stay tuned!”
In their paper Selling Private Equity Fees, Minmo Gahng (Cornell University, SC Johnson College of Business) and Blake Jackson (University...
Florida, Warrington College of Business) examine the impact of GP stake sale on GP firms and their fund LPs. Drawing on commercial databases and regulatory filings, the academics created a detailed panel of PE firm-level operations and performance, covering 2,862 firms from 1990 to 2021. They then paired estimates of PE firm-level income with data points, such as GP contributions, the number of employees, and states and countries of office locations.
The research finds that firms with better fundraising and performance track records tend to be those most likely to undertake GP stake deals, although the level of AUM is the main distinguishing factor between PE firms that sell GP stakes and those that do not. It also finds that among firms that have completed stake sales, AUM increases by 84% and income by 64% on average in the first 10 years after transactions have taken place, with every US$1 of proceeds raised associated with an increase of US$18 in AUM. The academics also observe that following a GP stake sale, firms tend to expand into different asset classes, such as real estate and private debt.
Alongside such expansions, PR firms increase investment in staff by around 25% and in offices by about 15%, and firm insiders substantially increase their commitments to new funds. Finally, with the caveat that the results are not necessarily causal but may be related to the ability of buyers and sellers to screen investments, the authors find that there is no negative effect on performance following a GP stake sale.