Negotiating GP Stakes Deals in Times of Economic Uncertainty

From small beginnings, the market for “GP stakes” deals – where an investment adviser (a “GP”) sells a minority interest in its business to a third-party investor – has exploded over the past decade, as investors have sought to buy into the fee and carried interest of an asset class that has proven its staying power through economic cycles. Indeed, almost a quarter of investors are currently invested in at least one GP stakes fund¹.

This evolution has overwhelmingly taken place against a backdrop of record private equity fundraising. Private equity firms in the U.S. raised $176bn across 191 funds in the first six months of 2022, setting a pace that, if sustained, could surpass last year’s total fund value of nearly $340bn across 577 funds². It remains to be seen whether the appetite for a strategy predicated on ever-escalating fundraising and long-term cash flow projections will be curtailed by the prospect of more economically challenging times to come.

GP stakes investing began with investments in large, well-established GPs. In recent years, investors also have increasingly sought out investments in smaller and newer GPs, and the continued growth of the GP stakes market may turn on the ability of GP stakes investors to continue to access the middle market. In the context of market turbulence, and the expected investor flight toward funds managed by more experienced GPs with well-established track records, these middle-market GPs may have the most to gain from fresh investor capital: selling an interest in the firm may provide middle-market GPs with vital balance sheet capital to sustain and grow their businesses, secure much-needed anchor investments in their funds or facilitate a transition from a founder-led business to a more mature and stable governance structure.

Whatever the particular motivations on the buy and sell side of a GP stakes transaction, it is clear that deal terms will need to work for both investors and GPs if these deals are going to continue at anything near the recent pace in this market. And the fears and concerns of GPs and investors, which may well be heightened in the context of economic uncertainty, will need to be taken into account in negotiating the terms of a GP stakes deal.

Top GP Concerns

Governance and Interference – A GP selling a stake to a third-party investor – particularly if it is the first time the GP has participated in such a transaction – is typically keen to ensure that it does not cede too much in the way of investor consultation or consent rights. Founders and principals accustomed to directing upper tier arrangements may not want to seek approval for decisions relating to their compensation arrangements, for example. Certain types of GP stakes investors, such as strategic investors, may desire greater involvement in the firm’s governance and/or consent rights with respect to proposed changes in the GP’s structure, management or operations. The greater the governance and approval rights granted to an investor, the more important it is that the investor and the GP see eye-to-eye and have compatible business relationships and cultures.

Valuations – Third-party investment in a GP is an important value setting moment. Clearly, a GP wants to maximize value by obtaining the most attractive valuation for the business in these transactions. At the same time, however, a GP must be cognizant of other knock-on effects of valuation setting, such as compensatory transactions or relevance to personal gift and estate tax planning for founders. The volatility of various economic assets (e.g., carry or goodwill, which may be more difficult to value than fees) may also impact valuations. Divergent views over valuation can be bridged in a number of ways, including the issuance of preferred equity or debt or valuation protections.

Transferability – Similar to information access, the risk that the investor may potentially sell its interest in the GP to one of the GP’s competitors or another undesirable party is a worst-case scenario for the GP. A GP will often seek restrictions on transfers to competitors, drag rights to prevent the investor from obstructing a potential sale of the business, lock-up periods and rights of first refusal or first offer where the investor seeks to exit.

Information Access – Confidentiality concerns and the investor’s potential conflicts of interest are at the forefront of every GP’s mind in negotiating a GP stakes deal, particularly where the investor is a GP stakes specialist with interests in multiple firms including, potentially, the GP’s competitors.

Tax Structure and Considerations – The investor may have tax sensitivities (e.g., ECI or UBTI) that will require the GP to undergo internal restructuring prior to the investment. This may be taxable or have other ancillary effects on the GP and its owners. The GP may be concerned about whether taxable income or gains are recognized and their character. The structure of the investment, use of proceeds and allocation of values may all be relevant factors.

Top Investor Concerns

Alignment – An investor will want to ensure that key professionals remain economically aligned in driving the GP’s performance and that there is limited leakage of economics to insiders, particular key professionals, before the investors. In multi-strategy funds, an investor may seek to ensure that key professionals dedicate appropriate time and attention to certain strategies or business lines. In addition, particularly when investing in a newer or smaller GP with less of an established track record, an investor also may want to ensure that bonus and variable compensation is allocated in a manner that incentivizes growth and development of the GP’s overall talent pool, is aligned with an appropriate succession plan and not “hoarded” by founding partners who play a less active role in the day-to-day or overall strategic operations of the firm. Concerns around alignment of interest are key drivers of investment structures and deal terms, such as liquidity, permitted dilution, transfer restrictions, budget restrictions and distribution requirements.

Economics – Typically, the investor will receive a share of the GP’s fee-related earnings (FRE) and carried interest. FRE is most often net of expenses, which can lead the investor to seek an expense cap or approval rights with respect to the GP’s budget or particular categories of expenses that could diminish the distributions the investor receives. Concerns about expenses may be heightened where the GP has a less established track record for performance or growth. The GP may seek to carve out certain types of expenses from restriction, such as the cost of non-investment professionals or non-principals, or of new hires that may be necessary to launch new business lines or strategies. Alternatively, in some cases the investor’s economic participation may be calculated based on gross earnings, thereby sidestepping the impact of expenses on the investor and preserving the GP’s control over its budget. The investor will also often seek protections against dilution of its economics, including covenants restricting future equity issuances by the GP outside of agreed limits or pre-emptive rights.

Key Person Events – An investor buying a minority stake in a GP will not be able to dictate the size and pace of fundraising, but it will often seek protection against the risk that the core group of individuals in whom they are placing their faith – and money – may leave. An investor may perceive this risk to be heightened where the GP’s succession plan is unclear or where the GP’s revenues are primarily generated by a particular line of funds.

Non-competes – An investor is likely to want to ensure that GP personnel, particularly those receiving proceeds from the transaction (but also others with key roles), agree to appropriate post-transaction and post-departure non-competition covenants. Depending upon the jurisdictions in which the GP personnel reside, the ability to procure these protections may become increasingly challenged as states, as well as the federal government, become wary of non-competition restrictions.

Exit Rights/Restrictions – Exit rights are often heavily negotiated because of their importance to maintain continued alignment. Investors will insist on tag rights and may also require additional liquidity rights, such as put rights in certain circumstances (e.g., in the event of certain key person events). Given the rise of publicly traded GPs, an investor may seek to ensure that its economic rights are protected in any restructuring, particularly in the context of an IPO. An investor may wish to ensure that it is able to access the public market at the same time and on the same terms as others, such as the GP, its founders or other investors. Where the investor is itself a fund, the flexibility to sell its interest and return capital to its underlying investors will be of paramount importance.

Information and Access – Every GP stakes investor will require some baseline of information about the GP’s business in order to properly monitor its investment and confirm that its rights are being respected. A strategic investor looking to build a relationship with the GP may require even greater access to information and opportunities to access investment professionals at the GP and participate in the business.

Tax Structure and Considerations – An investor may be sensitive to certain types of income (e.g., ECI or UBTI), and need to structure its investment in a manner that mitigates these concerns. This will often involve one or more “blocker” entities and may require structuring or special allocations for the funds or GP entities. Investors may also be concerned with “phantom” income (and the need for tax distributions) or have special reporting needs.

Top GP Concerns

Governance and Interference – A GP selling a stake to a third-party investor – particularly if it is the first time the GP has participated in such a transaction – is typically keen to ensure that it does not cede too much in the way of investor consultation or consent rights. Founders and principals accustomed to directing upper tier arrangements may not want to seek approval for decisions relating to their compensation arrangements, for example. Certain types of GP stakes investors, such as strategic investors, may desire greater involvement in the firm’s governance and/or consent rights with respect to proposed changes in the GP’s structure, management or operations. The greater the governance and approval rights granted to an investor, the more important it is that the investor and the GP see eye-to-eye and have compatible business relationships and cultures.
Valuations – Third-party investment in a GP is an important value setting moment. Clearly, a GP wants to maximize value by obtaining the most attractive valuation for the business in these transactions. At the same time, however, a GP must be cognizant of other knock-on effects of valuation setting, such as compensatory transactions or relevance to personal gift and estate tax planning for founders. The volatility of various economic assets (e.g., carry or goodwill, which may be more difficult to value than fees) may also impact valuations. Divergent views over valuation can be bridged in a number of ways, including the issuance of preferred equity or debt or valuation protections.
Transferability – Similar to information access, the risk that the investor may potentially sell its interest in the GP to one of the GP’s competitors or another undesirable party is a worst-case scenario for the GP. A GP will often seek restrictions on transfers to competitors, drag rights to prevent the investor from obstructing a potential sale of the business, lock-up periods and rights of first refusal or first offer where the investor seeks to exit.
Information Access – Confidentiality concerns and the investor’s potential conflicts of interest are at the forefront of every GP’s mind in negotiating a GP stakes deal, particularly where the investor is a GP stakes specialist with interests in multiple firms including, potentially, the GP’s competitors.
Tax Structure and Considerations – The investor may have tax sensitivities (e.g., ECI or UBTI) that will require the GP to undergo internal restructuring prior to the investment. This may be taxable or have other ancillary effects on the GP and its owners. The GP may be concerned about whether taxable income or gains are recognized and their character. The structure of the investment, use of proceeds and allocation of values may all be relevant factors.

Top Investor Concerns

Alignment – An investor will want to ensure that key professionals remain economically aligned in driving the GP’s performance and that there is limited leakage of economics to insiders, particular key professionals, before the investors. In multi-strategy funds, an investor may seek to ensure that key professionals dedicate appropriate time and attention to certain strategies or business lines. In addition, particularly when investing in a newer or smaller GP with less of an established track record, an investor also may want to ensure that bonus and variable compensation is allocated in a manner that incentivizes growth and development of the GP’s overall talent pool, is aligned with an appropriate succession plan and not “hoarded” by founding partners who play a less active role in the day-to-day or overall strategic operations of the firm. Concerns around alignment of interest are key drivers of investment structures and deal terms, such as liquidity, permitted dilution, transfer restrictions, budget restrictions and distribution requirements.
Economics – Typically, the investor will receive a share of the GP’s fee-related earnings (FRE) and carried interest. FRE is most often net of expenses, which can lead the investor to seek an expense cap or approval rights with respect to the GP’s budget or particular categories of expenses that could diminish the distributions the investor receives. Concerns about expenses may be heightened where the GP has a less established track record for performance or growth. The GP may seek to carve out certain types of expenses from restriction, such as the cost of non-investment professionals or non-principals, or of new hires that may be necessary to launch new business lines or strategies. Alternatively, in some cases the investor’s economic participation may be calculated based on gross earnings, thereby sidestepping the impact of expenses on the investor and preserving the GP’s control over its budget. The investor will also often seek protections against dilution of its economics, including covenants restricting future equity issuances by the GP outside of agreed limits or pre-emptive rights.
Key Person Events – An investor buying a minority stake in a GP will not be able to dictate the size and pace of fundraising, but it will often seek protection against the risk that the core group of individuals in whom they are placing their faith – and money – may leave. An investor may perceive this risk to be heightened where the GP’s succession plan is unclear or where the GP’s revenues are primarily generated by a particular line of funds.
Non-competes – An investor is likely to want to ensure that GP personnel, particularly those receiving proceeds from the transaction (but also others with key roles), agree to appropriate post-transaction and post-departure non-competition covenants. Depending upon the jurisdictions in which the GP personnel reside, the ability to procure these protections may become increasingly challenged as states, as well as the federal government, become wary of non-competition restrictions.
Exit Rights/Restrictions – Exit rights are often heavily negotiated because of their importance to maintain continued alignment. Investors will insist on tag rights and may also require additional liquidity rights, such as put rights in certain circumstances (e.g., in the event of certain key person events). Given the rise of publicly traded GPs, an investor may seek to ensure that its economic rights are protected in any restructuring, particularly in the context of an IPO. An investor may wish to ensure that it is able to access the public market at the same time and on the same terms as others, such as the GP, its founders or other investors. Where the investor is itself a fund, the flexibility to sell its interest and return capital to its underlying investors will be of paramount importance.
Information and Access – Every GP stakes investor will require some baseline of information about the GP’s business in order to properly monitor its investment and confirm that its rights are being respected. A strategic investor looking to build a relationship with the GP may require even greater access to information and opportunities to access investment professionals at the GP and participate in the business.
Tax Structure and Considerations – An investor may be sensitive to certain types of income (e.g., ECI or UBTI), and need to structure its investment in a manner that mitigates these concerns. This will often involve one or more “blocker” entities and may require structuring or special allocations for the funds or GP entities. Investors may also be concerned with “phantom” income (and the need for tax distributions) or have special reporting needs.

GP stakes deals are bespoke arrangements that should be tailored balancing the respective priorities of the parties involved. A period of economic uncertainty is likely to heighten the concerns that both parties have going into deals that historically have been executed in a buoyant market. Careful negotiation of key terms will therefore be more important than ever.