Reshaping the GP shareholding landscape

Until recently, merger activity between private equity firms still bore undertones of the financial crisis, when the market saw a flurry of mergers between troubled private equity firms.

However, private equity is maturing as an asset class and thus the shareholding structures of private equity firms are being reshaped. Not all change is driven by firm-specific events such as generational transition; GPs are also beginning to see strategic advantages both in merging with counterparts and selling minority stakes to other investors.

Indeed, a recent report by Triago highlights the growing trend of mergers among GPs. According to a white paper published by the private equity service provider, more than 150 M&A transactions involving private equity firms have taken place since 2005, with 65% inked across the past five years. Breaking this figure down, Triago data indicates that 15 deals have been completed annually since 2010, with an all-time high of 25 deals recorded last year.

Show of strength
The figures quite clearly indicate a change in industry perception towards GP mergers. Following the financial crisis of 2007-2008, mergers were not so much a strategic option, but a defensive response, and GP consolidation was usually undertaken from a position of weakness rather than strength. But as the industry evolves, private equity firms appear to be drawing inspiration from the strategies of portfolio companies and are altering their behaviour.

"GPs are a very proud, idiosyncratic lot that have historically based their identity on their unique ability to identify and invest on insider information," says Virginie Bourel, partner at Triago. "They've seen these abilities as a barrier to merging and have instead seen it a sign of weakness to sell out."

But having weathered the financial crisis and finding themselves positioned in more favourable investing climes – with markets across sectors largely having rebounded – a handful of GPs have completed landmark deals that have contributed to shifting acceptance and interest in M&A activity. It also means GPs have been able to increase resilience and diversification, merging with counterparts to improve strategic opportunity and develop products in new asset classes or geographies.

GPs are a very proud, idiosyncratic lot that have historically based their identity on their unique ability to identify and invest on insider information" – Virginie Bourel, Triago

"When LVMH's private equity arm merged with consumer-focused private equity firm Catterton in January 2016, the firms did this from positions of strength for strategic advantage in geographies," says Bourel. "Deals like this have removed the stigma surrounding mergers."

US-headquartered GP Catterton, LVMH and Groupe Arnault Holding merged their private equity and real estate operations into a new global consumer investor, L Catterton. The new private equity house incorporated Catterton's $5.5bn in managed assets and the respective €1bn and $500m managed by LVMH's private equity and real estate arms, L Capital and L Real Estate. With LVMH especially strong in Europe, the GP said it was seeking to strengthen its buyout and growth position within the consumer space across Europe, North America, Asia and Latin America.

Meanwhile, the €310m merger of Eurazeo and Idinvest Partners in February this year created a new force in the GP world with €15bn in assets under management and showcases some positive outcomes from manager pair-ups. The deal was completed on the premise that a strong capital base and diversified LP base are key for growth, and with internationalisation as an over-arching theme associated with the merger. Historically, Idinvest's LP base has been predominantly French, with some European and a few international investors. With the backing of Eurazeo, Idinvest strategically hoped to gain credibility through getting a more diversified LP base on board.

Gaining traction
The slew of activity among GPs in recent months gained traction late last year. In November 2017, investment firm Green Arrow Capital wholly acquired Italian GP Quadrivio Capital. The investment formed part of Green Arrow Capital's plan to diversify its portfolio of alternative assets across Europe.

Most recently, French asset manager Natixis Investment Managers acquired European private credit specialist MV Credit Partners in June. A month earlier, in a deal with similar strategic rationale, hybrid equity and debt fund manager ESO Capital bought lower-mid-market growth capital investor Core Capital. The consolidated group, which had previously worked on deals together, intended to offer a broader range of hybrid capital products ranging from senior debt to equity.

"The merger was driven by a motivation to achieve scale by investing across the capital structure, ranging from senior debt to senior equity," says ESO founding partner Stephen Edwards.

"LPs are looking for fund management businesses that can scale in an increasingly sophisticated market. Those who can play the risk scale want to see proof of ability to deliver across strategies and, through the natural evolution of the private equity industry beginning in the early 1990s, there is now enough data to separate the profitable players from the pack," says ESO founding partner Alex Schmid.

Satellite strategies such as ESO's do not shy away from offering a range of products and services including distressed deal packages. An underlying demand for capital continues to fuel the private equity industry, and there is appetite for flexible approaches that can offer both equity and debt funding.

While merger activity among GPs has spiked, data by Triago also indicates a hike in GPs selling minority stakes. One third of all deals since 2005 have been minority transactions, and more than 90% of these have been motivated by strategic and business development goals, according to Triago's white paper. A first wave of minority stake transactions arose in 2007-2008 and was spearheaded by Asian and Middle Eastern sovereign wealth funds, such as CIC and ADIA, but also large family offices. These buyers acquired strategic minority interests from flagship managers such as Carlyle, Blackstone and Apollo.

LPs are looking for fund management businesses that can scale in an increasingly sophisticated market" – Alex Schmid, ESO Capital

More recently, other institutions have also sought to invest, which has prompted major players, including Goldman Sachs, Blackstone, Neuberger Berman and AlpInvest, to raise minority stake funds to tap a new market. These specialised GP stake vehicles have been actively seeking to invest in a maturing market – and offer innovative investment opportunities for LPs. Originally conceived in the hedge fund world, the minority stake funds have trickled into the private equity sphere and, by Triago's account, GP stake funds have contributed around 70% of all minority transactions since 2015.

Says Bourel: "While GP majority stake transactions are led for business and strategic reasons, minority transactions more often than not stem from the needs of founders to transition." Founding partners can be reluctant to relinquish control of their firms, but often are open to third-party shareholders. By retiring or cashing out, they have found a way to bring capital into the business, and to keep talent in house.

"With a high level of assets under management, the fees will be high, and third-party capital can be used to pay out younger partners and keep talent within the GP management team," says Goodwin Procter partner Ajay Pathak. More established GPs are looking to add capital into the fund as high-profile founders that led the business will command an equally notable capital allocation for their stake. It also demonstrates a maturing asset class.

"Institutional funds management is now an asset class in and of itself. Minority stake investments signal that it is much more the norm to be able to put a value on this asset class," says ESO's Schmid.

"GPs are faced with the question of whether their business has value beyond one or two leaders'" says Edwards. "They need to transition and create permanent value."

There are also other reasons driving GPs to sell stakes. Private equity can potentially attract more capital than some other asset classes, but private equity houses also need to ensure what is operationally required to attract big tickets.

For example, newly established French GP Ring Capital held a first close on €140m, with Tikehau Capital investing for a 25% minority stake in the firm in January 2018. The move was operationally positive for both investors. Ring Capital won credibility among other LPs and benefited from Tikehau's experience, as well as its established network and existing investors. Tikehau said it would also tap Ring Capital's research and development capabilities in the technology sector, the only market it invests in, when acquiring companies and managing its growth capital. Additionally, Tikehau offered an exit route for portfolio companies of Ring Capital. Indeed, according to Ring Capital, Tikehau was initially considered an LP before the decision was made to bring the investor on board as a 25% owner.

LPs on board
Indeed, LPs are a driving force in the changing private equity landscape. According to Coller Capital's recent Global Private Equity Barometer, 40% of LPs have invested or have considered investing in funds that take stakes in GPs. The trend is still more pronounced in the US, although there has been some recent discussion about it in Europe, with LPs attracted to returns and features offered by these funds.

The specialised GP stake vehicles raised by Goldman Sachs, Blackstone, Neuberger Berman and AlpInvest have been designed in a way to provide significant external capital to management companies. More specifically, GP stake funds have access to management company dividends and can collect potential revenue from carried interest, as well as further AUM growth. GP stake funds generally preserve the independence of the management team and its investment process, as they usually adopt a passive role through non-voting rights.

GPs are faced with the question of whether their business has value beyond one or two leaders. They need to transition and create permanent value" – Alex Schmid, ESO Capital

At the same time, GP stake funds also offer a range of services to support managers. For example, they offer access to their own LP base to help their managers fundraise. This could be a potentially valuable service for first-time strategies or emerging managers. Theoretically, GP stake funds can also support product development and planning – such as operational assistance, talent management and training, or sharing support functions; for example, risk, compliance and accounting.

In reality, the effectiveness of these potential services has yet to be tested. But the popularity of the fundraising is significant. Part of Neuberger Berman, the Dyal Capital team closed its Dyal Capital Partners III on $5.3bn in February 2017, almost triple the size of its initial fund. Triago estimates that given their size, these vehicles could enable tickets between $100-600m to medium and large-cap managers.

It remains to be seen whether the minority stake fund vehicles, which have built their structures in a similar vein to traditional private equity closed-ended funds – with four- to five-year investment periods – will complement the asset class. Minority stake funds are yet to deliver exits. Additionally, a long-term and traditionally illiquid private equity market poses many questions when it comes to exit scenarios for GP stakes. Market observers say some GPs may buy back stakes, or the stakes could be sold on the public market – although for now, the US is more likely to see sales on the stock exchange than Europe.

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