Private equity funds focused on ‘GP Stakes’ – equity stakes in alternative asset management companies – may be well positioned to benefit from the recent cooldown in private market fundraising activity.
Many private market GPs are under strain, in part as a result of weaker-than-expected capital raising through 2022-2024. This may create exceptional opportunities for investors to gain exposure to the GPs themselves. Yet investors must be selective and rigorous in their approach.
GP staking is an unconventional strategy
At first glance, alternative investment GPs may seem unappealing to the typical private equity investor. These are talent-heavy firms, light on IP/inventory/real assets, operating in a sector with low barriers to entry. Investors are not usually expecting large multiples – although they may be feasible, particularly where the company has high recurring revenues. And, with minority stakes being the norm, investors are not expecting to press for major changes.
Yet GP Stakes can offer something very unusual in the private equity world: strong yields, typically around 8-12%, which is broadly in line with senior secured credit. These are explicitly contracted for and backed by the firms’ management fee revenues. This provides a rather unique—and diversifying—return profile within a private equity portfolio. Investors can also think about the way in which those yields result in a softer J-curve.
Due to its distinctive characteristics, this is a sector dominated by specialists. There are now more than fifteen funds dedicated to GP Staking, currently seeking to raise nearly EUR30 billion. Together, this group is responsible for the majority of relevant dealflow; although non-specialist private equity funds do sometimes invest.
Private market fundraising decline
Investors’ allocations to private market GPs grew dramatically in the post-GFC decade. The volume of capital raised by private market funds in calendar year 2021, for example, was five times larger than the figure in 2010. While major surveys of institutional investor sentiment agree that allocations to illiquid strategies are broadly still undergoing a positive trend and new investors continue to enter the space (wealth managers, for instance), the pace of capital raising has visibly slowed. Fundraising in 2023 was at its lowest level since 2018, for example. Moreover, GPs have also faced pressure at the other end of the funnel, with difficulties exiting their stakes at the desired valuations and timeframes.
Strains are particularly visible among smaller and mid-sized GPs – the typical hunting ground for GP Stakes investors. We anticipate some upheaval, corporate change and consolidation. The winners, however, will be able to boost market share and ultimately benefit from the investment industry’s long-term structural shift in favour of private markets. A cash injection from a GP Stake can give firepower that contributes to success.
Finding the right opportunities
When trying to select the most attractive GPs in which to invest, one interesting aspect to consider is the way in which the new investment will be used by the GP. The capital be used, for example, to support talent acquisition/retention, develop new sources of fundraising or provide the GP’s commitments to its own funds (private markets funds typically require a minimum % commitment from the asset manager to demonstrate alignment of interest).
One interesting aspect to think about is the way in which the investments will be used. Our recent analysis has indicated that, while managers’ strategies differ greatly, a very sizeable proportion of GP Stake capital is often used to provide the GP’s commitments in its funds. This is not, in and of itself, a red flag: using a capital injection to pay for GP commitments allows the firm to launch new vehicles or raise a larger vehicle than they might otherwise have been able to deliver, supporting strong ongoing management fee revenues. The side effect, however, is that only a modest amount of the capital raised is being directed towards spending that will enhance capabilities, coverage, team, or other ‘operational improvements.’ The GP Stake investor—who, after all, will hold only a minority stake, which places them in a relatively passive position—should be clear on the GP’s overall development trajectory.
Eyes on the exits
One of the most common criticisms levied at the GP Stakes sector is the challenge of obtaining exits – a difficulty that can be exacerbated in periods of industry stress. Exiting is not, of course, a challenge confined to the world of GP Stakes: much of the private equity sector is facing challenges on this subject (supporting a rise in continuation funds, GP-led secondaries and so forth). Interestingly, GP Stakes funds raised a few years back tended to have a perpetual approach, without firm expectations around exit timeframes. Newer vehicles, however, are tending to adopt a more conventional (exit-oriented) mindset than their predecessors.
Conclusion
This is an interesting time to examine GP Stakes funds, as well as other strategies that benefit from current trends in the alternative investment management industry (such as NAV financing). Yet investors should prioritise very high quality due diligence: a GP Stakes manager must have the ability to choose well-positioned GPs, underwrite them through ongoing cycles and deliver credible exits in line with expectations.
The writer is Anna Morrison, managing director, private markets at London-based investment consultancy Bfinance
