Editor’s Letter: LPs don’t like when GPs sell minority stakes

Limited partners are not big fans of GPs selling minority stakes in their management companies. “We certainly do not encourage it,” a limited partner told me.

I come to that conclusion after numerous conversations with LPs who know the market and are committed to GPs that have sold stakes.

What’s the problem? A few explanations: LPs like their GPs to stick to the plan — they want their GPs to invest the funds in which they are committed and make the most money possible. They don’t want GPs’ attention diverted by a minority stake sale, which forces a firm to figure out how to grow assets under management to make such transactions valuable to minority investors.

“You need firms to double their AUM for the math to work,” the source said. If an investor acquires a minority stake at a 10x multiple, they need someone to buy the business at a higher multiple, or grow the business’s EBITDA.

Growing AUM, of course, is different from investing a fund well. “This creates a huge breakdown between the manager and the investor,” one source told me.

Firms grow by expanding into new strategies, such as buyout shops setting up credit units or infrastructure businesses. The concern here is that GPs start businesses outside of their expertise. This forces them to hire outside expertise or devote more resources internally to run the new strategy.

LPs also feel that in such transactions firms are selling future value in the form of streams of carried interest that should be available to the next generation of leadership. “You’re taking money off the table as the senior executive … and now you’ve got to fund growth in your platform in strategies that may or may not be the strategies that got you where you were.”

“If they’re taking money out of the business, that messes up the alignment you want to have between the GP and LP. … It’s a little troubling in that sense,” said an LP who has seen GP minority stake sales.

People who work on minority stake sales counter these concerns with the idea that they create permanent capital GPs can use to expand, and to set up incentive programs for younger executives. Third-party investors don’t want to see next-generation leadership disincentivized.

In general, GPs don’t need LP approval to sell minority stakes in their management companies, though it depends on what’s written in fund documents. However, GPs will generally let LPs know about minority stakes out of courtesy, one person with knowledge of GP minority stake sales told me.

Some LPs these days are negotiating when they commit to a fund for enhanced disclosure provisions to be included in fund documents. LPAs generally include rules around transfers of ownership stakes, but some LPs said they want more disclosure specifically around minority-stake sales.

It’s an innovation in private equity — much like secondary sales and fund restructurings — that is being greeted with suspicion by investors, but may become more routine as more such deals get done.

We dive into this issue in our cover feature in the May 15 issue of Buyouts. Reporter Luisa Beltran spoke to numerous sources about this trend and got a view from both sides of the issue – LP and GP. Our reporting found that the industry is divided between investors worried about this trend and GPs who support these transactions.

Private Equity Editor Chris Witkowsky reflects at home. Photo by Wendy Witkowsky