Asset Manager Describes Pros and Cons of GP Stakes Investing, Which Clients Should Consider Investing and Three Steps for Advisors to Get Started
William Webb Ellis is a name not easily recognized until you know that at the age of 16 while attending the Rugby School, young Ellis decided to blatantly disregard the “no hands” rule of soccer as he picked the ball up and ran with it.
Ellis changed the game – and in a few weeks when you watch football on television, at tailgate parties or at Friday night local school games, you can thank Ellis for his inventive play that gave birth to Rugby and several other forms of football, including the American and Canadian versions we enjoy every fall.
Like Ellis, a few decades ago an unnamed investor in the rapidly evolving private equity world decided not to invest in a limited partnership, but instead take a minority stake in the general partner (GP) of the deal – the private asset management firm itself – and by doing that changed the game.
Other private equity firms, asset managers and investors followed the idea and expanded on it, bringing more popularity and innovation to “GP stakes” investing while widening the investor base.
An Asset Manager Committed to the GP Stakes Space
One such asset manager is Houston-based CAZ Investments, with approximately $3.8 billion in assets under management, representing a tenfold increase in seven years, and approximately 2,200 co-investors across 47 states and 13 countries.
The firm holds almost $3 billion in capital commitments to GP stakes investments, making it one of the largest allocators to GP stakes vehicles in the world and one of the most active investors in this space.
Lifelong Houstonian Christopher Zook, the Founder, Chairman and CIO of CAZ Investments, which he founded in 2001, has over 30 years of investing experience in traditional and alternative assets, and chairs the Investments Committee of the State of Texas Pension Review Board.
We spent time with Zook to understand the pros and cons of GP stakes, the types of clients it may suit and how an advisor can get started in GP stakes investing.
WSR: How did GP stakes investing emerge in the private markets? What needs are the private equity firms trying to fill with GP stakes that they couldn’t fill with other types of fundraising? How fast is this space growing?
Zook: While GP stakes have existed for decades, institutional investment in GP stakes gained prominence in the early 2010’s with Dyal Capital Partners, with an initial focus on hedge funds. In the mid-2010’s, Dyal & others began investing in private market firms due to several attractive characteristics.
Long-term, contractually locked-in management fees, performance persistence, diversification, significant cash flow and the growing demand from institutions are just a few of the attributes we and others find attractive.
Firms that choose to sell a stake have many potential motivations, some of which include funding increased GP commitments, launching new adjacent business lines, succession planning, capital structure reorganization, expanding distribution efforts, operational best practice assistance and corporate strategy.
This is one of the fastest growing areas in private equity, and we estimate that approximately $30 billion has been raised from institutional investors to invest in private market GP stakes over the last decade.
WSR: What makes an investment in GP stakes unique from the investor’s point of view? What are the advantages and disadvantages of GP stakes investing?
Zook: In our view, GP stakes offers investors an extraordinary opportunity to invest in private markets with differentiated benefits:
- Significant cash yield from three sources: locked-in management fees, carried interest and balance sheet returns
- Owning at the GP level can provide meaningful vintage year, geographic, sector, asset class and enterprise value diversification
- Downside protection from contractually obligated management fee cash flow
- Participation in the growth of private markets, which have exhibited a 13% compounded annual growth rate of assets under management from 2005 to 2021 and are projected to double again from 2021 to 2026, according to Preqin
- Established businesses with strong operating margins from management fees alone and considerable economies of scale as they continue to grow
The primary disadvantage for certain types of investors would be lack of liquidity or defined exit, which we believe is substantially mitigated by cash flow, as well as a growing variety of potential paths to exit.
WSR: What type of investor are GP stakes investments appropriate for? What wealth level should they be at to consider GP stakes? Where does it fit in the investor’s portfolio? What should be the investor’s risk appetite and time to retirement?
Zook: We believe GP stakes investments are appropriate for the vast majority of qualified investors, including institutions, endowments and foundations, single and multi-family offices and high net worth investors. This would include investors that meet the definition of “Qualified Purchaser.” Structures typically exist for both taxable and non-taxable investors.
We view GP stakes as an appropriate cornerstone allocation of an investor’s private equity portfolio, based on the rare combination of downside protection, upside optionality and attractive cash flow. The cash yield makes the asset class an interesting potential component of some investors’ fixed income alternatives bucket.
Ultimately, we see the strategy as having equity upside with credit-like downside protection and cash flow. We would thus argue that GP stakes may be more appropriate for a wider variety of investor risk appetites than more typical private equity buyout strategies.
WSR: What three steps can an advisor take who wants to get started providing GP stakes investing for clients?
Zook: First, break through misconceptions. Advisors must help clients break through common misconceptions, beginning with understanding both paths to exit and why a GP would sell a stake. Once investors appreciate various potential forms of liquidity, alignment of interests and variety of possible motivations, they can make a complete assessment of the asset class.
Second, get educated. There is excellent information available from a variety of sources that will help an advisor learn about the risks and benefits of GP stakes investing. We are happy to help with that education as well as provide third party research and data to help advisors determine whether GP stakes are appropriate for their clients.
Third, understand your options. As the asset class has developed, an increasing variety of investment structures have been created to facilitate capital deployment. In addition to understanding the underlying investments, advisors must understand the various structures that exist and the pros and cons that go with each type. Of particular importance are fees, investment minimums, liquidity terms, pace of capital deployment and cash flow profile.
Janeesa Hollingshead, Executive Editor at Wealth Solutions Report, can be reached at firstname.lastname@example.org