3 things GP stakes firms want

“There's still a real under-allocation to alternatives, and if you find the right private capital managers, it’s always going to be interesting,” said Charlie Ruffel, co-founder, managing partner, and chair of Kudu Investments a private investment firm that takes minority stakes in other asset managers (also called “GP stakes”) in a recent episode of The Distribution podcast.

The number of GP stakes sales—those transactions where an investor acquires a minority interest in a fund management company—is relatively small but growing. In North America, 44% of PE firms are considering a GP stake sale in the next two years, according to the law firm Dechert. Large actors in this market, such as Blackstone, Wafra, and Blue Owl, have moved into buying control interests in other funds. But in the small- to middle-market private capital managers, minority stakes sales provide important benefits to both the investor and investee firm. The deal entitles the investor to a share in GP’s economics (the 2-and-20 of fees and deal gains), while the investee firm receives a pool of capital.

Christopher Zook, founder and CEO of multi-asset manager CAZ Investments, explained this deal type’s popularity in a recent episode of Juniper Square’s podcast The Distribution. CAZ includes GP stakes among its investment strategies.“The LPs in a private equity fund are contractually bound to the fund. That management fee income is going to continue [being paid to the manager] regardless of the firm’s performance. Eventually, of course, the fund must perform, but the risk-reward ratio of a GP stakes investment is so good because of that cashflow consistency,” explained Zook.

With their consistent cash flows, GP stakes funds fit well into the portfolios of high net-worth retail investors. Benefits include:

• Strong returns with downside protection: While the fee stream offers less upside than a fund’s overall performance, it is less variable. It’s also less subject to the J-curve: fees start flowing immediately after the fund closes. But investors in GP stakes also share in the fund’s gains (carried interest or “promote”). Overall returns, assuming average performance, can reach 7% to 10%. Even if the fund manager does not raise more capital, the stake it has sold can recover as much as 90% of its original cost, according to analysis from PitchBook.
  

• Long life: Unlike investing in a fund, which requires reinvestment every four years as new funds are raised, owning a share of the GP lasts at least 10 years, if the investment has been made through a fund. For LPs, though, exiting the position can be a challenge.

• Strong alignment of interests: Typically, LP and GP interests are aligned through carried interest/promote, but that alignment increases in the sale of a GP stake.
  

For many GPs, selling a stake offers distinct benefits. The purchase price provides a pool of patient capital. This can help a fund manager resolve succession issues by, for instance, buying out a partner who wants to retire. It can also resolve one of the thorniest issues of a successful fund manager: as a firm succeeds, its funds grow. But the GP match also grows—and with illiquid assets, the GPs may not have the necessary cash.

Along with supplying capital, many GP stakes investors offer advice and, sometimes, networking opportunities with other firms in their portfolio. As Ruffel explained, “We add value to many elements across a business...We host an annual gathering for C-suite members of our 30 portfolio funds.And we also have one-on-one conversations with the CEOs and CFOs of our partner funds, sometimes weekly but at least quarterly.”

Along with establishing trust with the management teams, GP stakes firms also need to assuage concerns of the portfolio funds’ LPs. Ruffel said, “We have to convince the LPs to understand that the firm they originally invested in is fundamentally unchanged, hopefully just improved.”

But a GP stakes fund isn’t going to bail out a struggling operation. Commented Ben Ruffel, Director of Distribution Strategies for Kudu Investments (and Charlie’s son), “We don’t take a GP stake just because they’re trying to raise money. We won’t get involved with a firm in distress.”

“We’re looking for firms that are going to get to $10 billion regardless, but they’ll do it faster with us,” said Charlie Ruffel. That is, GP stakes investors want to provide capital to funds that need advice and funding to turbocharge strong performance.

In general, GP stakes firms seek the following characteristics in their investee firms:

1. Fee-generating firms in asset classes such as real estate, private equity, or credit. Kudu Investments, for example, seeks funds with $1 billion to $5 billion in AUM.
   

2. Successful teams on a strong growth path. They need to be driven and passionate, but also willing to work in partnership to accelerate their performance.
   

3. A keen interest in performance improvement. GP stakes investors are passive minority investors and want to stay that way, but they’re eager to provide advice and networking opportunities. In the words of Charlie Ruffel, “We’re not interested in getting into the kitchen in these businesses.”
   

GP stakes investments started with large institutions and funds purchasing stakes in large operations. In July 1998, American International Group (AIG) acquired 7% of Blackstone Group’s management company for $150 million, entitling itself to the same proportion of the fee stream and committing to participate in the firm’s future funds.

Mega funds like Blackstone are now major players in GP stakes transactions but often buy firms in their entirety, as mentioned above. Smaller GP stakes funds now target opportunities on the smaller side of the middle market as well. These boutiques typically operate like a standard private markets investor, raising money from LPs and investing from a fund with a 10-year life. A few, like Charlie Ruffle’s Kudu, have pools of permanent capital, which offers a more flexible time horizon.

With their favorable risk-return characteristics and downside protection, GP stakes funds meet the growing needs of HNW retail investors seeking exposure to private markets. According to CAZ Investments’ Zook, “The average large family office has 40% of its assets in private markets. The average HNW investor has 3% of their assets in private markets. The best risk-reward is to own the firms that will be managing those assets because it’s better to receive the 2 and 20 [fee and carry] rather than pay it.”

In the GP stakes niche, boutique funds and firms can outperform. Charlie Ruffel commented, “There's a tremendously bright future for boutiques who can demonstrate that they can do one thing and do it really well.”

Selling GP stakes can accelerate the growth of firms that are already well-positioned. GPs who sell a stake to the right investment partner will access management advice along with the capital to turbocharge a strategy that has already proven successful.