Out of the shadow: Captive GP spin-outs

As banks continue to divest their private equity operations amid new regulations, secondaries firms are in good position to assist in the process, writes David de Weese.

Too-big-to-fail. Stress tests. Dodd-Frank. Basel III.

Banks in the US and Europe entered the financial crisis undercapitalised and were kept afloat only by extraordinary government support. 

Post-crisis, the world of financial services and banking is entering a new regulatory environment, which is adding complexity, changing priorities and increasing government scrutiny of the industry. The drive is on to satisfy regulators, improve returns on capital, rethink balance sheet resource allocations and extend geographic reach in an increasingly global industry. 

Among the assets on the balance sheets of most large banks today is private equity, accumulated over time and for a variety of reasons.

Many of these financial institutions have built and funded successful captive management teams investing in venture, growth, mezzanine and buyout, either alone or as co-investors alongside external funds.

David de
Weese

Sometimes these investments were made to compliment commercial banking activities. Often they were made to help grow the leveraged lending business, to develop better relationships with external venture capital and private equity fund managers for lending, M&A and IPO fee generation. Occasionally, the investments were made as the sponsor portion of an investment product for high net worth and private banking clients, as well as for bank employees.

Most shareholders of publicly listed banks were unaware of these “facilitating” investments. This information was frequently buried as a single line in the footnotes of the annual financial statements, quite unlike the core business activities of the financial institutions.

Investors do not buy or sell bank stocks based on exposure to private equity and would most likely prefer to see less risk rather than more on the balance sheet. It is only in the aftermath of the financial crisis, with the debate around the “Volcker Rule” and a renewed focus on the importance of common equity and Tier One capital, that banks’ private equity activities have received special attention.

Bank regulators around the world are grappling with new methods of measuring more precisely the risk and liquidity characteristics of bank assets. And private equity is increasingly seen as a liability in determining capital adequacy.

In this new world, not only are financial institutions less inclined to support their captive private equity teams, but the managers themselves see a brighter future outside the institutional framework. 

Access to a larger investor base, improved economics, operational autonomy and control over their own destiny

In this new world, not only are financial institutions less inclined to support their captive private equity teams, but the managers themselves see a brighter future outside the institutional framework.

David de Weese

appeals to entrepreneurial investment professionals. The ability to adjust strategy quickly and expand the franchise as new market opportunities arise are clearly attractive attributes of independence. 

When the alternative is simply managing out an existing portfolio, putting the business—and the employees–into run-off mode, it is no wonder investment teams are negotiating “spin-outs”, often together with their existing portfolios of private equity assets, and supported financially by dedicated secondary buyers experienced in evaluating and valuing their diverse collections of assets—across industries, geographies, investment strategies and vintage years.

This assessment requires skill in the intricacies of multi-jurisdiction structuring, asset transfers, taxation, accounting, regulatory constraints and GP/LP agreements, knowledge which must all come together for a successful transaction. 

Most secondary funds do not wish to manage assets themselves, but require a capable general partner in that role. 

They work with the investment managers to establish an independent platform and lay the foundation for a successful firm, including providing additional capital to build value in the existing portfolio and seed the next fund.
The new manager also gains access to the secondary fund’s investor base, which can be a resource for the new GP both as co-investors in the “spinout” and as primary capital in future funds. 

The convergence of a new regulatory environment with a proven transaction structure at a time when banks continue to seek improved returns on capital, rethink balance sheet resource allocations and extend geographic reach, suggests that captive GP spinouts are not only emerging out of the shadows but will likely lead to a robust deal flow in the secondary private equity market.

David de Weese is a partner at Paul Capital.