The GP stakes market divides opinion. Proponents point to a rich source of fee-driven income and its role in enabling succession and expansion. Critics point to the lack of predictable exits and inherent risk of conflict that comes from limited partners being exposed to multiple funds and management companies. These arguments had remained largely hypothetical because of the immaturity of the market, but recent events have put them to the test.
In December, Dyal Capital Partners, a subsidiary of Neuberger Berman and one of the largest GP stakes managers, announced plans to merge with direct lending firm Owl Rock Capital Partners through a deal with special purpose acquisition company Altimar Acquisition Corp. The combined entity, Blue Owl, would have a valuation of around $12.5 billion.
In February, credit manager and Dyal portfolio company Sixth Street Partners sued to try to prevent the merger on the basis that Owl Rock, which is also a Dyal manager, is a direct competitor. Another credit manager in Dyal’s portfolio, Golub Capital, followed suit for the same reason later that month.
When it decided to sell a stake in its management company in 2017, Sixth Street picked Dyal over suitors such as Goldman Sachs because it was “conflict free”, Andrew Rossman of law firm Quinn Emanuel Urquhart & Sullivan, said in court: “They certainly wouldn’t have picked Owl Rock, who they’re now being put into a forced marriage with.”
Is this case an isolated incident or does it reveal inherent flaws in the GP stakes strategy? Are there ways to navigate these conflicts in the future, and what does that mean for the way these funds operate?
Though GP stakes funds have only transitioned from niche to mainstream in recent years, the concept has been around for at least two decades. Rosemont Investment Group helped pioneer the strategy, having acquired at least 30 minority stakes in asset and wealth managers since 2000. The Pennsylvania firm raised three funds dedicated to the strategy before pivoting to an evergreen model in 2018.
Goldman Sachs Asset Management launched its own GP stakes unit, Petershill, in 2007, with a view to acquiring minority positions in hedge funds, though quickly diversified into other types of alternatives managers. As of 2019, the firm had completed 27 deals and was seeking $4 billion for its fourth Petershill fund.
It wasn’t until the emergence of Dyal, however, that GP stakes really took off. Today, GP stakes funds in market are targeting $24.45 billion, according to PitchBook. The best fundraising year on record was 2019, when $9.4 billion was raised.
Dyal raised $1.28 billion for its 2012-vintage debut fund and more than $16 billion across three successor vehicles, including $9 billion for 2012-vintage Dyal Capital Partners IV. The firm is seeking at least $5 billion for Fund V and has completed over 50 acquisitions in firms such as tech giant Silver Lake, energy firm EnCap Investments and turnaround specialist Platinum Equity.
Dyal’s success appears to have inspired a raft of launches. Blackstone raised $3.3 billion for its first Strategic Capital fund, with notable deals including a 2019 investment in BC Partners. Morgan Stanley Investment Management acquired its first GP stake the same year, in French asset manager Tikehau, via a $1.4 billion fund. Aberdeen Standard, Investcorp, Wafra, Stonyrock Partners and Goodhart Partners are some of the other groups to have entered the fray.
The benefit of investing in a general partner’s underlying management company is clear. Private equity firms can be extremely profitable once they reach scale, with any new fund generating seven to 10 years of contracted management fee revenue.
“You know what to expect in those investments,” founder and chief investment officer of multi-family office CAZ Investments Christopher Zook said in October 2020. Mid-market GP stakes are “one of the most compelling areas of investment that [I have] seen in 30-plus years”, Zook added.
GPs representing 40 percent of total assets under management across the buyout, growth, infrastructure and natural resources markets had either listed or sold a minority stake as of the end of 2019, according to research from consultancy Bain & Co.
The reasons GPs decide to sell minority stakes have grown, leading to a greater array of opportunities. While they still use the market to enable succession, GPs are also looking for partners to help with product development, provide distribution infrastructure or put up cash for GP commitments. In some cases, GP stakes funds go on to become anchor investors in new funds.
“Many of today’s deals are much more about investing into the business,” says Joseph Lombardo, head of private equity GP advisory at Houlihan Lokey. “Firms on Fund II and III maybe haven’t realised much carry and in order for them to raise larger vintages they need to fund larger GP commitment obligations. If a firm is launching a new product, making a large GP commitment demonstrates conviction in the new strategy and can significantly increase LP interest on the fundraising side.”
Just as Private Equity International was going to press, Sixth Street’s motion to block the Dyal-Owl Rock merger was denied by a Delaware court, the same outcome that Golub faced in a New York Court three weeks earlier. Both cases were strong vindication for Dyal, with Delaware judge Morgan Zurn describing the acts of litigation as “part of a calculated effort to muck up the transaction to force a buyback”.
PEI understands that the transaction is now set to complete in the middle of the second quarter.
Though the case has cleared its legal hurdles, its impact will continue to resonate. It has already affected the way lawyers think about transfer rights, with more explicit language around the scope of these rights already coming into force, says one lawyer with experience doing GP stakes deals.
While Golub and Sixth Street have to go along with the merger, a stake sale could still be on the cards, PEI understands.
“It’s got to be a high price,” says a source close to Dyal. “Sixth Street went from $17 billion [in AUM in 2017] to $51 billion today.”
The resounding judgments will almost certainly discourage any other partner managers from trying to challenge the merger via the courts.
Regardless of the legal outcome, the case has caused disquiet among LPs and partner managers. Some of Dyal’s LPs, concerned about a lack of clear exit horizons, say they wanted to see more distributions before committing to its latest vehicle.
“The long-term nature of GP stakes means Dyal cannibalises its future funds with each raise because it ties up LP capital,” says one US LP.
Dyal responded. In June last year, it securitised the management fees of 10 GPs in its 2015-vintage Fund III by bundling up their future cashflows and syndicating them among 20 investors in a $1 billion deal and carried out a similar process on Fund IV, PEI understands.
Goldman Sachs’ Petershill unit did something similar the year before, returning capital to LPs in its Petershill II fund via a $350 million securitisation. As of November, Dyal was also exploring a GP-led secondaries process on Fund III, the status of which is unclear.
These efforts have made investors less worried about duration than they were, the LP says. However, several sources expressed dismay that in doing nothing to monetise the companies in Dyal’s funds or create liquidity for limited partners the proposed merger fails to put the needs of its investors first.
“The only monetisation it is providing is to the owners and management of Dyal Capital,” says the head of an investment consultancy that advises some of the largest LPs. “Today’s liquid SPAC markets are being used for the benefit of the GP and not for the benefit of the LPs, many of which were hoping for an IPO or similar to provide an exit someday.”
Dyal points out that the exit of Owl Rock from Fund IV results in a substantial unrealised gain for LPs in that fund. PEI understands the multiple on exit will be around 2x, producing $600 million-$700 million in distributions to LPs.
How the Dyal-Owl Rock merger played out
3 Dec, 2020
Dyal announces merger
Dyal Capital Partners says it plans to merge with credit manager Owl Rock Capital Group via a SPAC (Altimar Acquisition Corp) and become a $13 billion publicly listed company. “The founders of Owl Rock and Dyal would lead the standalone firm, and the investment teams and processes would remain unchanged. The Owl Rock and Dyal founders, alongside Neuberger Berman, the parent of Dyal, would own meaningful positions in the combined business,” the parties say.
17 Feb, 2021
Sixth Street pushes back
Sixth Street Partners, a private credit firm in which Dyal owns a stake, brings a lawsuit to try to prevent its minority owner from merging with Owl Rock, which is itself a Dyal partner manager. Sixth Street wants to exclude its stake from the deal, according to a letter sent to its LPs. To complicate matters, the Altimar SPAC is backed by HPS Investment Partners, another credit firm in which Dyal owns a stake. A representative for Dyal and Owl Rock says Sixth Street’s claims are “baseless”.
Golub follows suit
Credit firm Golub Capital, another Dyal portfolio company, also sues to block the merger, claiming the new entity will have access to confidential information about Golub’s business that it could use to the firm’s detriment. The same month, Golub sends a letter to Dyal saying it will halt distributions and redirect the cash towards other growth initiatives.
Judge approves document discovery
A judge approves a motion from Sixth Street’s counsel that Dyal produce the partner manager contracts it holds with HPS and RXR Realty. The motion was brought in response to testimony by Neuberger COO Andy Komaroff that Dyal sought consent for the merger from these managers. Sixth Street alleges that Dyal “acknowledged” that HPS’s transfer restrictions applied to “upstairs”, or company-level, transactions. If the language is the same as in Sixth Street’s agreement, it should have been asked for permission, Sixth Street argues.
Parties go to court
A Delaware court hears Sixth Street’s case. The judge expects a conclusion before 19 April.
Judge rejects Golub request
A New York judge denies Golub’s request to halt the merger temporarily. The argument that the 2018 partner manager agreement does not allow Dyal to move ahead with the merger is “wildly implausible”, the judge says. Golub says it will continue to explore its legal options, including a possible appeal.
Judge rules against Sixth Street
A judge says the credit manager failed to demonstrate that the merger would cause “irreparable harm” to its business. The transfer agreements in its contracts did not relate to “upstairs transactions”, he adds. The judge describes Sixth Street’s bid to buy back its stake as “lowball” and says that the litigation, and that of Golub’s, were intended to “muck up” the merger to force a buy-back.
The merger also highlights the intricate web of relationships cultivated by certain LPs. PEI is aware of numerous LPs that are invested in Dyal funds as well as the funds of multiple GPs in which Dyal owns a stake. At least one LP ticks both these boxes and is also an investor in the firm sponsoring the SPAC, HPS Investment Partners. This is an inevitable consequence of the relatively small universe in which GP stakes firms operate.
“When you have a multi-affiliate model and that model is predicated on continuing to intermediate capital and continuing to buy more and more stakes, sooner or later you start competing with one another,” says a former employee of Dyal who still works in private equity, adding that this problem is not unique to Dyal or GP stakes.
Two smaller GP stakes firms tell PEI that larger funds have approached some of their partner managers, offering to buy them out for a healthy multiple. This suggests larger firms are moving down market and targeting secondary opportunities. Portfolios of minority stakes have been sold before, but this is a relatively new phenomenon, PEI understands.
Several sources bemoan the bad publicity around the Dyal-Owl Rock merger and worry it could discourage LPs from investing in the GP stakes market. Although the deal is now highly likely to get done, some see it as indicative of a frothy market reaching its peak.
“SPACs tend to have a ‘moment’ after which you don’t hear about them for five years,” the former employee adds. “This could be that moment, when the valuations got out of control and the dynamics went haywire.”
Recent events highlight the limitations of the high-growth, large-scale model of GP stakes investing, but the idea of buying minority stakes in asset managers remains attractive. Plenty of less-established firms are looking for a partner that can provide the infrastructure and network to boost their fundraising and procurement capabilities. Lombardo from Houlihan Lokey says these “value add” services will become an investment priority as stakes firms look to differentiate.
In March, Azimut Alternative Capital Partners invested in HighPost, a private equity firm founded in 2019 by members of Jeff Bezos’s family. AACP acquired an initial 12.5 percent interest, with the option to increase ownership to 24.9 percent. The deal was described as a “capital-raising relationship”, facilitated by parent Azimut Group’s distribution platform, which covers institutional and private wealth clients across 18 countries.
Pacific Current raised a permanent capital fund in 2006 to acquire stakes in emerging managers, exited via a merger in 2014 and switched to investing off balance sheet. Today it has stakes in 15 managers worth more than $80 billion in AUM in sectors ranging from credit to real estate and forestry. In 2016, it took a $4 million stake in newly launched Fort Lauderdale-based public equity investor GQG. As of the end of 2020, GQG had $62 billion in assets. “We are not getting much exposure to the underlying strategies; the real risk we are taking is fundraising risk,” says Curtis Yasutake, vice-president of private equity for Pacific Current. “It can be LP-like risk if you buy a lot of carried interest. We tend to focus our economics on management fees in order to maintain alignment with LPs.”
Almost every deal involves the purchase of carry, which as a percentage tends to be equal to or lower than the amount of fee-related earnings sold, PEI understands. The proportion of FRE sold tends to be in the range of 10 percent to 24.9 percent.
The benefits of investing in GP management companies directly, without a fund to intermediate, are as clear today as they were in 2001, when California Public Employees’ Retirement System bought a stake in Carlyle Group for $175 million. For GPs, these investors bring the added benefit of being able to offer primary commitments on an ongoing basis.
“We have an investment horizon, an embedded duration that allows us to invest capital for long periods of time,” says the head of private equity at a US pension. “And these deals tend to be cash generative. It’s an industry you understand and you can do without bringing conflicts to the table.”
The ageing of the industry promises to create more opportunities for stake sales. A number of large, top-performing fund managers are set to face succession issues over the next decade. Coller Capital, GTCR, PAI Partners and Summit Partners are among the most attractive targets for GP stakes firms, according to 2019 research by PitchBook. A number of medium-sized funds are likely to enter the big leagues over the same period.
“We have all dedicated our lives to asset management,” says one GP stakes manager with experience as an allocator. “We all like to think that we have the ability and experience to identify a great target when we see one.”
– UPDATE: On 3 May 2021, Dyal was granted approval by its LPs to combine with Owl Rock via the Altimar Acquisition Corporation SPAC. The SEC has also given the go-ahead to the deal, which would create a listed manager with $51 billion in AUM. If Altimar’s stockholders approve on 18 May, the deal will close the following day.
How GPs can protect themselves
The conflict between Dyal and Sixth Street is already causing lawyers to rethink the language in GP stakes contracts
We asked Brian Parness, a partner with Weil Gotshal & Manges, about the factors GPs should consider before selling minority stakes.
Here are his tips:
Read agreements carefully
Look closely at LP agreements and side letters. Sometimes LPs will have negotiated for consent rights upon the sale of a minority stake. The minority investor has few protections other than economic rights. In short, the GP cannot divert contractually guaranteed money away from the investor for its own benefit. Most contracts contain provisions that allow the minority investor to get their money back in the event of a significant departure or seriously adverse event, such as enforcement action from the authorities.
“[There should be] a very keen focus on who your partner is, what value-add they can provide and in what circumstances they can exit without your permission,” Parness says.
Understand the liabilities
When buying an equity stake, the GP stakes buyer is sharing the expenses related to the business. It needs to be clear from the outset which expenses the buyer is subject to and which it is not, says Parness. In addition, the GP stakes buyer’s liability for the salaries of the senior team should be capped. The team can be paid more, but the minority investor will not be on the hook.
Difficulties can arise when a fund manager wants to extend its platform by bringing in a new team with high economic demands. This can put the squeeze on revenue that should go to the minority investor and force the parties to renegotiate their economics. These situations rarely lead to litigation but are a cause of friction, Parness says.
Under the Advisers Act, taking a 25 percent stake in a fund manager represents a change of control and requires the consent of limited partners. As well as keeping the stake below that threshold, it is important that the minority investor remains passive. “You’ll want to make sure the investor is not involved in day-to-day business, not on the investment committee and not involved in hiring and firing,” Parness says.
Consider your options
There are a number of ways to cash out of a fund management company or procure capital for growth without having to sell a minority stake. GPs should think carefully about their capital structure and consider a variety of solutions. “Not every deal is a perpetual equity stake,” Parness says. “It could instead be a form of debt financing or preferred equity financing.”