Why there’s room for smaller GP stakes managers

London-based investment firm Goodhart Partners held an undisclosed first closing on its debut GP stakes fund Volunteer Park Capital in August. The firm is targeting $200 million for a vehicle that will fund GP commitments and expects to hold the final close on the vehicle in the second quarter of next year.

Goodhart is in the final stages of completing its first investment in a US-based emerging markets private equity manager, which is raising its second vehicle.

Sister publication Private Equity International spoke to Michael Daley, a portfolio manager at the firm, to find out more about its investment thesis and investors’ attraction to the GP stakes market.

Why has the GP stakes market taken off in recent years?

It’s a very attractive place to invest as a private equity asset class. First, when they reach scale these are very profitable businesses. Second, they have very attractive operating leverage. Any new fund raised generates significant revenues that don’t always require a lot more expenses. Third, there are barriers to entry for these types of businesses. New GPs have high barriers to getting their first fund off the ground.

Fourth, and probably the most important and attractive aspect of this business, is the long-dated contractual management fee revenue. When you raise a fund, you’ve got seven to 10 years of management fees that you know will be there barring some sort of early exit event. This makes investing in the GP interest industry very attractive from a down case scenario perspective.

What concerns do you get from investors about the strategy?

LPs ask us why GPs need our capital. Or why would a GP sell a part of its business? Our answer is they need the capital.

A typical scenario for a mid-market private equity firm is that they launched Fund I – which wasn’t a large fund. The partners were probably funding the business themselves, paying salaries and rent and they had to make a GP commitment. Then, they raised Fund II and maybe now they are at break even, but must make additional GP commitments. And now they are getting ready to raise Fund III – which is probably going to be the largest of their funds to date – and they have to write a $15 million-$20 million GP commitment that they just don’t have.

The question we get ultimately is, why not just finance this through debt? The answer is that these partners are already so levered to the success of their underlying fund and business that taking on more debt massively increases their personal leverage to their business, to a point where it might actually erode alignment with LPs.

The second question is: how will LPs react to a minority investor? I think that’s a bit more nuanced, but the LP community has become more accepting of minority investors as long as a couple of things are met. These include keeping the minority stake small, where the investor adds value, and the investment maintains LP-GP alignment, and ensures the overall exposure of the underlying partners is unchanged.

The minority equity partner needs to be additive to the business. We think Goodhart can be helpful in many ways, the most tangible is providing distribution support, particularly in Europe, which is very helpful for boutique US managers who have a hard time accessing the region.

On alignment, what we are doing, at least in part, is buying a piece of the least aligned economics of the business, management fee income. The proceeds are used for GP commitment, which is the part of the business most aligned with the LPs.

Is the firm involved in the GP’s investment decision-making process?

No, we don’t get involved in those decisions. This has been a very strong ethos of ours. We can be helpful in the way they think about managing the business. But if we believe that we might know more about the types of investments that they make, then that is not the manager we want to partner with.

We will, of course, have some governance in the firm but it’s reasonable and appropriate.

What’s the exit strategy?

We don’t underwrite exits or include exit valuation when we do a deal. That means every investment we make must achieve our target of between 15 percent and 20 percent net returns without realizing any enterprise value.

A very simple base case for us is, if we invest in a firm at their third fund we would expect that they will raise a Fund IV and Fund V. We essentially value the business on that assumption. That being said, we do believe, with experience, that some of these firms will have some sort of liquidation event.

The PE firm itself is acquired and we tag along. It could be that our stake is acquired by someone who could potentially be more strategic, or that management has done well and they come to the table to buy us out.

The difference where we play and the where largest investors in the space play is being able to truly add value to the smaller firms is critical, particularly in distribution.

Michael Daley is a Seattle-based portfolio manager of boutique investment manager Goodhart Partners.