Amid the soaring markets of the past few years, some in the asset management community have faced a conundrum. Investors have demanded better performance, but asset managers who pursue alternative strategies, like hedge funds, have struggled to keep up.
The result is that many hedge funds have closed down, rolled up into a family office or returned outside capital. Now, an emerging form of investment in private equity, called GP stakes, is gaining the interest of investors.
Large new funds are dedicated to investing in GP stakes, or minority interests in general partners of funds.
Investors see private equity as an opportunity to invest for the long term as a safe haven to avoid short-term risks. As talk of yield-curve inversions, coronavirus and global economic uncertainty dominates the public airwaves, investors are taking their capital and investing with private equity managers.
A number of large, mature investors have created funds that take minority stakes in general partners of both open-end funds, which are mostly in the hedge fund community, and closed-end funds, or those related to private equity.
Goldman Sachs, Dyal Capital Partners and Blackstone are among the large asset managers that have raised funds dedicated to investing in GP stakes, according to PitchBook.
Shifting to private equity
The first GP stakes investments focused on hedge fund managers, but attention is now shifting to private equity managers.
The reasons for the move away from hedge funds are their shrinking assets under management, underperformance and the ability by limited partners to withdraw capital from hedge funds.
From 2015 through 2016, the primary GP stakes targets were 40% to hedge funds, 50% to private equity and 10% to other investment strategies. The past two years have seen a major shift, with 80% of the deals now focused on private equity.
On top of investment funds, there is anecdotal evidence showing that family offices, pension funds, sovereign funds and high-net worth investors are showing interest in these investments for greater access to top-performing managers.
An example of this is CalPERS’ acquisition of a minority stake in the Carlyle Group back in 2001. The banking sector may possibly get in on the action as well because of the recent discussion and proposal to modify the covered funds rule under Dodd-Frank. That rule limits banks’ ability to invest in hedge funds and private equity.
The minority interest
There are several reasons why a private equity manager might be willing to share a minority stake, according to PitchBook:
- Liquidity for succession planning
- Operational assistance and greater resources
- Wider network of allocators and other fund managers
- Encourage development of new funds and products
On the other hand, there could be increased pressure to increase the assets under management. After all, the two sources of income to the general partner, as well as the minority interest holder, are management and performance fees. Minority investors, though, could be concerned regarding a misalignment of interests if the managers are engaged in other activities.
For minority investors, ownership in a general partner allows them to diversify their portfolio as well as generate annual returns. Depending on the type of general partner, most likely private equity, they will receive a steady stream of management fees and performance fees when realization events occur.
The ability to build a relationship with the general partner in a closed fund allows minority investors access to their talent and operations. On the downside, liquidity down the road if a minority investor wants to sell out is not guaranteed.
What does this mean for the middle market?
The number of deals in this sector have increased, according to PitchBook. As more investors come into the mix, there are fewer top-performing managers or asset gatherers that would be ideal for an investment.
The takeaway: Our expectation is that there will be opportunities for smaller managers, or those with up to $2 billion under management, if they have a good track record and a growing asset base. These managers should soon be hearing more knocks on the door. There are a number of issues that will need to be hammered out, like valuation, level of activity in management, voting rights and information sharing. But we see the opportunities coming.
