Sales of minority interests in private equity firms are becoming more common. We spoke with Matthew Dickman, international counsel at Debevoise & Plimpton, about the drivers and considerations for a GP thinking of selling a part of its firm.
What are some of the reasons for doing it?
The reasons for selling a minority stake vary from sponsor to sponsor, but many of these deals historically have been done to provide capital for future growth of the firm. In those transactions, an investor contributes all or a portion of the proceeds as a primary investment in the management company and general partner entities of a sponsor (typically through one or more ultimate holding entities), which the firm can then use to fund growth initiatives.
The use of proceeds is negotiated early in most transactions, but typically sponsors are able to use the capital for making new hires, raising a new fund product to complement existing funds, expanding geographically, and/or funding general partner commitments. As fund sizes have grown significantly in recent years, the ability to use this cash for GP co-investments has become more important for selling sponsors. Many of these transactions also allow the senior partners to monetize a portion of their equity in the firm, which is particularly helpful in facilitating succession planning for firms whose founders are approaching retirement.
At the same time, the selling sponsor typically maintains control and operational autonomy over the business, subject to certain limited consent rights.
What’s the best way to do it?
Sponsors considering selling a minority interest should plan ahead. These transactions are often preceded by an internal restructuring of the sponsor that is complex and can be costly. Planning early for such a restructuring can provide some tax benefits and facilitate discussions with buyers down the road. However, the timing should be balanced against the likelihood of moving forward with such a transaction to avoid incurring unnecessary costs.
One focus point in these transactions is to seek to align the interests of the selling sponsor and the investor. For example, investors in these transactions often participate in the net management fee income of a sponsor alongside the senior partners, which aligns the income streams of the minority investor and the key investment professionals at the firm. However, such alignment isn’t always possible, such as for affiliate transactions, in which case investors seek to address any potential misalignment with appropriate information and/or consent rights from the sponsor.
Investors and selling sponsors should seek to develop transaction terms that create value for both parties in the deal. For example, some minority sale transactions have deferred consideration payable over a period of years rather than all at closing. In some cases, those payments are subject to acceleration if the business needs the cash. The deferred payment allows buyers to pay a higher valuation for the same interest, particularly for staking fund buyers who are paying a preferred return on their investment. Selling sponsors benefit from the higher value and can set the payment schedule based on anticipated cash needs.
Are there other ways of raising capital if you don’t want to dilute ownership?
While minority investments in sponsors is not a new development, the number of buyers and the types of transactions in this space are both expanding rapidly at the moment. As these transactions have started to mature, we have seen a number of different structures being contemplated by buyers and sellers. These new structures include preferred equity, structured equity, synthetic interests and a combination of debt and equity. These structures can reduce the amount of dilution from these transactions while providing some downside protection for investors. We anticipate seeing more of these structures as this market continues to develop.