To stake or not to stake: GP staking vs. alternative liquidity solutions

 
Enter GP staking. A now well-established solution to this liquidity challenge, it is estimated that tens of billions of dollars have been raised by GP staking funds for the purpose of making minority investments in private equity sponsors. While we are also seeing strategic control transactions with some regularity in the market (e.g., one asset manager acquiring control of another), this article will focus on sponsors selling minority investments to GP staking funds, whose investment strategies are to acquire interests in GPs for the purpose of providing liquidity to the GP. There are numerous considerations to take into account when deciding whether to bring on a GP stakes investor, one of which, of course, is what alternative liquidity solutions might be available. 

In this article, we will briefly discuss GP staking transactions and the relevant considerations in determining whether to sell a GP stake. We will also discuss how these transactions compare to an alternative non-dilutive liquidity offering that is rapidly growing in the U.S. market and elsewhere: structured preferred equity investments.

What is GP staking?

A GP staking transaction is the investment by a third party in a GP or fund manager. These transactions are typically structured as minority equity investments. For the sponsor, a GP stakes investment provides access to cash that does not need to be repaid. For the GP stakes investor, their investment entitles them to an enduring portion of the management fees and/or carried interest. 

A critical (and often misunderstood) component of GP stakes transactions is that they are frequently structured as subscription transactions. A significant portion of the transaction proceeds are used by the third-party investor to subscribe for new equity interests in the manager or general partner, resulting in an injection of capital into the business (these transactions are not typically structured as secondary sales, and the principals are not cashing out at closing and riding off into the sunset).  

Sponsors may use this influx of cash to fund the GP commitment, launch new investment offerings and/or expand into other markets. For some additional background on GP staking, read our previous bulletin.

Of course, GP staking offers both advantages and disadvantages for the target sponsor. While it serves to provide the manager with some immediate cash proceeds, it also requires the sponsor to sell a permanent interest in itself. This can often only be done once by any particular sponsor, due to limitations on selling stakes under the governing fund documentation. These limitations are driven by the view that fees and carry should be paid to the investment team, and not to a passive party that isn’t involved in the day-to-day business of the fund. This particular concern is one that may be shared by existing fund LPs, which is why assessing LP appetite for a sponsor to undertake a GP stakes transaction is relevant in evaluating such transactions. However, this concern can also be unfounded. For sponsors seeking strategic support, a transaction with the right GP stakes investor, including certain passive majority stakes investors, can offer increased market presence and expand a firm’s resources and network by bringing an outside investor to the inside. A sponsor gains operational insights while maintaining strategic control. And for the GP stakes investor, these transactions offer meaningful influence with limited economic exposure.

Preferred equity solutions

As private equity investing evolves, a new alternative has entered the market. Structured preferred equity solutions are starting to take up market share in the world of sponsor liquidity transactions. Whereas GP stakes investing involves selling a permanent equity piece of the sponsor, preferred equity offers a non-permanent, non-dilutive alternative.

Similar to GP staking transactions, preferred equity solutions involve the investment by a third party in the manager or general partner. However, instead of investing in the same interests owned by the principals of the fund and earning fees and carry alongside those principals, the investor buys a newly created preferred security, entitling them to a preferred return. 

Rather than purchasing a piece of the sponsor, the investor will buy a preferred security that is redeemed once the preferred return is achieved. This approach offers protection to both the sponsor and the third-party investor. The preferred return isn’t payable if the fund doesn’t generate enough money—maturity and repayment are dictated by cash flow, meaning there is no maturity date—which may make this solution more appealing to a sponsor than a loan, depending on its terms. And the appeal for the investor is that they have priority to be paid first when the fund does perform.

The principal advantage of preferred equity solutions for sponsors is they are non-dilutive. An investment fund manager or general partner can increase its liquidity without giving up any equity. Further, the preferred equity transaction can often be completed more expediently than a GP stakes transaction, since buy-in from the investment team and existing fund LPs, as well as restructuring the ownership of the general partner or investment fund manager, are not table stakes for a successful preferred equity deal as in GP staking investments.

Conclusion

GP staking transactions and structured preferred equity investments offer two compelling solutions to sponsor liquidity challenges. While they could appear to be competing alternatives, in some cases they may in fact be complimentary, and some sponsors may find it desirable to pursue both at different times during their lifecycle. A viable strategy could be opting for a GP stakes investment and later using the preferred equity solution to buy out the GP stakes investor. When determining whether to participate in a GP stakes transaction or preferred equity solution—or both—investors and sponsors will want to consider several factors, including their investment horizon, appetite for strategic involvement, liquidity cushion, risk profile, LP support and, of course, the value proposition and terms of any particular transaction, among others. As we observe trends in the GP liquidity market south of the border, we expect to see increased interest in these transactions among Canadian sponsors in the years to come.