We typically think about private equity (PE) firms in the context of the businesses they acquire. However, a PE firm is itself a business, and often a very profitable one. So it should be no surprise that savvy investors have increasingly looked to take ownership stakes in private equity general partners. These so-called “GP stakes,” or general partners stakes, are direct equity investments (usually a passive minority ownership position) in the general partner’s management company (the legal entity through which the profits flow). Investors can negotiate these positions directly or they can invest through a specialized fund which builds a portfolio of GP stakes. The number of such funds has proliferated in recent years.

As GPs manage larger pools of assets, the balance sheet capital required to support the business may outpace the availability of reinvestable profits. For a GP, the influx of investor capital can be useful to finance larger GP fund commitments needed in future fundraises, help seed new strategies, strengthen the balance sheet in support of strategic hires and infrastructure or to help execute succession plans and buy out retiring founders.

For investors, a GP stake allows them to participate in the economics generated by the private equity fund itself, benefitting from three specific cash flow streams:

1. They will receive their share of the quarterly management fees earned by the current fund and any future funds raised. Since GPs typically raise larger funds, this means the cash flow from management fees will generally rise over time and is often viewed as predictable, bond-like income.
2. Investors will also receive their share of any carried interest earned by the current fund and future funds. Carried interest is based on investment performance and the amount and timing is uncertain; but, it has significant upside potential, particularly as funds grow in size.
3. As a minority owner, they will also co-invest through the “GP contribution” into all the fund’s portfolio companies, typically on a no fee, no carry basis.

GP stake investors typically seek to achieve an 8% – 15% annual cash yield and an overall gross 2.5 – 3.0x multiple of invested capital (MOIC). This return is expected to be realized roughly equally from management fees, carried interest and realizations on the co-investments.

Within this strategy, asset selection is paramount. A successful GP stake has three key attributes:

1. The GP stays in business for the long term.
2. The GP earns good investment results on its portfolio companies.
3. The GP raises successively larger funds. It’s a bonus for the investment if the GP can expand its business into new strategies, such as raising a credit fund or a small-company fund to complement the flagship.

To date, most of the capital raised for this strategy has focused on the largest private equity firms. (See chart below.) While that part of the market is becoming more saturated, it’s not as unbalanced as it appears. Larger firms have the ability to sell more than one stake, and more firms will grow into the category over time. Still, the clear opportunity going forward is with middle-market PE firms. Many of these managers are at a significant inflection point for future growth where outside capital can be helpful.

Historically, liquidity has been a concern in this market. It is a good cash flowing investment, but selling can be difficult. Most exits to date have been single-asset sales, typically to other LPs (limited partners) who plan to make a long-term commitment to the GP. Occasionally, the GP itself will buy the stake back. A secondary market has also begun to develop, particularly as the number of specialized GP stakes funds increases. Additionally, the public markets have recently been used to help effectuate an exit. We have seen this with the Dyal Capital and Owl Rock merger with a special purpose acquisition company to enter the public markets as well as a recently announced attempt by Goldman Sachs to take its GP stakes platform, Petershill, public via an IPO on the London Stock Exchange. Going forward this could become the preferred method to efficiently exit larger portfolios.

Investors are increasingly drawn to GP stakes as a potential opportunity to compound their capital at double digit rates over the long term. Oxford will continue to analyze this opportunity, with a close eye on potential maturation of the exit market.

Oxford Financial Group, Ltd. is an investment advisor registered with the U.S. Securities and Exchange Commission. Registration does not imply a certain level of skill or training. More information about Oxford Financial Group’s investment advisory services can be found in its Form ADV Part 2, which is available upon request. The above commentary represents the opinions of the author as of 9.30.21 and are subject to change at any time due to market or economic conditions or other factors. The information above is for educational and illustrative purposes only and does not constitute investment, tax or legal advice. No offers to sell, nor solicitation of offers to buy any securities are made hereby. Solicitations of investments and any offers to sell securities, if any, will be made only through an offering document clearly identified as such. Certain  statements in this article are forward‐looking which cannot be guaranteed. These statements are based on current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results or future performance to differ materially from those expressed or implied in such statements.