As more private equity firms seek to sell minority stakes, a divide has emerged between the GPs looking for investors and the LPs who are uncomfortable with the transactions.
GPs tout selling minority stakes as a way to amass capital on the balance sheet. This so-called permanent capital can be used to expand into new strategies, fund GP commitments to new funds and structure incentives for the next generation of firms’ leaders.
Many LPs argue that founders who sell their equity to third parties are diluting value for exactly those future leaders. The firms that accept minority investments also must grow assets under management for these deals to work. This raises concern among LPs that a GP’s attention will be diverted away from making great investments to expanding into new areas, where they may have less experience.
A “handful” of members have voiced concern about the conflicts of interest these deals raise, Peter Freire, ILPA’s CEO, said. “We are at the early stages of the investigation,” Freire said. He’s unsure when ILPA will finish talks with members but expects to have more to say in the next few weeks.
Meantime, Freire urges firms doing such deals to make full disclosure. All LPs should know in detail what is happening when one fund buys a stake in another, he said.
“As the industry matures, we will see more circumstances where firms have to make the decision whether they are able to survive their founders and have a viable succession strategy or not,” said Drew Chapman, a partner in the Financial Institutions Practice of law firm King & Spalding. The trend of firms selling stakes to institutional investors is a “natural progression,” he said.
Neuberger Berman’s Dyal Capital has been leading the way in buying stakes. Across three funds, the firm has $8.7 billion in committed capital; its most recent pool, Dyal Capital Partners III, collected $5.3 billion earlier this year. Dyal typically invests in large PE firms and hedge funds. It owns minority positions in several PE firms, including Silver Lake, Vista Equity Partners and EnCap Investments.
Second is Goldman Sachs Asset Management, which is raising a $2 billion fund to buy PE stakes. Petershill Private Equity closed on nearly $1 billion in February. Petershill has acquired minority stakes in Littlejohn & Co, ArcLight Capital Partners and Accel-KKR. It expects to do several more transactions, a source with knowledge of the firm said.
AlpInvest Partners, backed by Carlyle Group, and Hycroft are also raising funds for this strategy. And Blackstone Group is expected to use a $3.3 billion permanent vehicle to buy stakes in lower-middle-market firms, the Wall Street Journal reported. A quarter of Blackstone Strategic Capital Holdings LP can invest in non-hedge fund businesses, a second source said. Blackstone has yet to acquire any GP stakes but has bid on a few, this person said.
The transactions are often structured similarly. The deals are usually for 10 percent to 20 percent and usually passive: The investors are rarely involved in day-to-day operations, on the investment committee, or in staffing decisions, people said. “They’re really minority economic investors only,” an industry source said.
About 25 minority transactions have been done in the past decade, the industry source estimated. “People are expecting a fair bit of activity given the size of funds being raised,” one LP said.
PE firms sell stakes for different reasons, but the main one, observers say, is the need to grow. “Grow or die,” said one person with knowledge of such transactions.
Some larger and older buyout shops are no longer focused on just one strategy, sources told Buyouts. The GPs want the capital to launch new strategies, like credit, real estate and infrastructure. These firms, which are still private, don’t have access to the public markets like KKR or Carlyle.
For example, Riverside Co recently sold a minority stake to Parkwood LLC. Riverside is considering adding a turnaround fund or European microcap vehicle, Buyouts reported. Dyal also is buying 10 percent of TPG Special Situations. TSSP expects to use the capital to add staff and invest more in its funds, the WSJ reported.
Generational issues are another reason. PitchBook says 2,292 active U.S. PE firms have closed funds in the past five years or completed a deal in the past three. About 240 firms were launched 25 years ago, the data provider said. The executives who started these firms were in their 40s and are now approaching retirement.
Principals of large GPs often have much of their wealth tied up in the firm and want to take some out, said King & Spalding’s Chapman, who has worked on many deals involving PE stakes. Asked whether these deals are driven by greed, Chapman said they’re not because in most cases the executives retain significant stakes.
Some transactions have a put and/or call option that enables managers to buy back stakes after certain periods, he said. “This is advantageous for both parties where the investor will get to exit at some point and the GP has ability to get back the equity,” he said.
Valuations for these deals aren’t that compelling, but the investments can help put permanent capital on a firm’s balance sheet, the industry source said. The investments will often boost the GP commitment, with many funds jumping to 4.5 percent from 2 percent, this person said. “Most of these folks have plenty of money,” the person said. “Greed isn’t a primary driver at all.”
Kevin Campbell, managing director for private markets at DuPont Capital, isn’t a fan of PE firms selling stakes.
Such deals, he said, raise a host of problems, including whether the new investor has voting rights and has input on daily operational issues like hiring and firing. There’s also the possibility that third parties may seek to increase their ownership.
Campbell says many PE and VC firms can function off the capital they raise and don’t need outside funding. “They don’t need to monetize their management company to survive or thrive. They don’t need it to excel,” he said.
Where succession is concerned, selling to third parties may enrich the GP who’s exiting, but it doesn’t help the young executive who is trying to build the firm, Campbell said. This executive doesn’t get more ownership of the management company than he already had. “Instead of dealing with a partner near retirement, now [they’re] dealing with a new institutional partner who may not behave the way [they] want them to,” he said.
One co-founder of a middle-market PE firm said most PE-stake sales are designed to put money in the pockets of the founders and senior partners. “This, by definition, limits the amount of carry and management fees which are available to compensate younger members of the firm,” the GP said.
Then there’s conflicts caused by selling GP stakes to a third party. Neuberger, for instance, has a huge LP business, a different investor said. Now, Dyal is buying stakes of GPs and recommending them to their client base. “How many of the funds has [Neuberger] supported in its other business?” asked a second LP.
Dyal’s investors are content with its dealmaking, a person familiar with Dyal’s thinking said. In fact, having Dyal invest in a GP can mean lower fees for its LPs (that also invest in the PE firm), the source said.
“There is a built-in benefit to allocating capital to managers that have sold a stake to Dyal,” the source said. (One critic, upon hearing the lower-fee justification, quipped: “That’s like saying if you buy part of the [New York] Knicks, at least you save money on tickets.”)
Goldman Sachs also has to navigate potential conflicts with this strategy. A sought-after M&A adviser, Goldman could exert influence over the processes involving Petershills’ GPs, sources said. The 148-year old firm does business with many different hedge funds and private equity firms, a source familiar with Petershill said. Goldman, the source said, has architecture to mitigate issues that may arise, the person said.
Goldman has “big Chinese walls between its investment teams,” according to the person familiar with Goldman Sachs Asset Management.
Where’s the exit?
Buying stakes in PE firms isn’t a new trend. Several sources pointed to CalPERS, which acquired stakes in several PE firms, including Carlyle, Apollo Global Management, Silver Lake and TPG, in the past decade. Carlyle and Apollo went public, which enabled CalPERS to sell its holdings in secondary sales. Silver Lake ended up buying back the stake held by CalPERS in 2013.
CalPERS’s return on the Silver Lake deal is unclear. The pension system either took a $100 million loss on its Silver Lake investment or it broke even, according to press reports. CalPERS declined comment.
CalPERS invested $60 million in TPG Ventures, the predecessor fund of TPG Growth, in 2001 and still holds the stake, a seventh source said. Given CalPERS’s experience, some wonder how firms like Petershill and Dyal will exit.
Dyal’s funds are permanent capital, so the firm doesn’t have to exit, the second source said. Dyal intends that its investments remain long-term relationships that are cash-flow driven, the person said. Some LPs don’t want their money back but want to be partners in a well-run firm that isn’t levered, the industry source said. “If you build it well, they will hold it,” the industry source said.
But if it does have to sell, Dyal, along with Goldman and Blackstone, expects to follow the path set by Affiliated Managers Group and exit through an IPO, sources said. (Interestingly, Petershill sold stakes in five hedge funds to AMG last year for $800 million, Bloomberg reported.)
Single investors, or state plans, don’t really have the same strategy or range of exit options that Goldman or Blackstone will have in the future, observers say. “A lot has changed since 2000. There are many more buyers of GP interest and much more transaction activity,” the second source said.
— Chris Witkowsky contributed to this report
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