Strategies now focus on taking stakes in firms, but exits are a question
A small cadre of money managers is amassing billions of dollars to take stakes in private equity firms, a trend that raises the question of how they plan to exit those investments.
Managers such as Neuberger Berman Group LLC have been taking minority interests in alternative investment managers since around 2012. Most started with hedge fund managers but now are moving on to private equity general partnerships with their most recent offerings, which are often closed-end funds. The strategy is expected to be a way for investors to get long-time access to high-performing managers while paying lower fees.
Dyal Capital Partners is Neuberger Berman's business unit dedicated to take minority interests in managers. In February, Dyal closed an oversubscribed $5.3 billion fund, Dyal Capital Partners III. Dyal has close to $9 billion in assets under management.
In December, Dyal collected $250 million capital for its next fund, Dyal Capital Partners IV, from the Minnesota State Board of Investment, a returning investor that oversees a total of $89.5 billion in state public pension and other assets. Officials previously had committed $175 million to Dyal's third fund.
Dyal's strategy is not unique. Blackstone Group LP's Blackstone Strategic Capital Holdings Fund and Goldman Sachs Group (GS) Inc.'s Petershill line of funds also take minority stakes in private equity, hedge funds and other alternative investment firms.
Managers are targeting double-digit returns. Petershill Private Equity has a 20% internal rate of return target with two times return on invested capital, according to minutes of the March 30 New Mexico Public Employees Retirement Association, Santa Fe. (New Mexico PERA committed up to $150 million to the latest Petershill fund.)
More managers considering
Private equity firm Capital Dynamics Inc. is considering the strategy, as are many alternative investment managers that invest on the alternative investments secondary markets, said Joseph Marks, the firm's San Francisco-based managing director and global head of secondaries.
"There's been an acute and sizable interest in acquiring general partnerships," Mr. Marks said.
The fact that veteran money managers such as Neuberger and Goldman Sachs are dedicating multibillion-dollar funds to the strategy is evidence of investor demand, Mr. Marks said. But there are questions to consider, he said.
"My issue is … when you are buying into an ongoing entity, how do you get out of them?" Mr. Marks said. "It's easy to get in, but hard to get out" of investments in alternative investment firms.
Anthony D. Tutrone, New York-based managing director, global head of the alternatives business at Neuberger Berman, said all of the funds in the marketplace have a choice on how they structure exits. The strategies include selling the minority interest back to the firm or selling to other managers that also take stakes in alternative investment managers.
For example, last year Goldman Sachs sold an $800 million investment in hedge fund managers to money management holding company Affiliated Managers Group Inc. The stakes had been held by Goldman's first Petershill fund.
Some managers retain rights to force an initial public offering, but those rights always come with limitations based on market realities, Mr. Tutrone said.
Other managers might have evergreen funds that never have to exit or funds that make their only money on getting a slice of the fees the general partner charges, he added.
No matter the exit strategy, most firms earn cash flows by getting a share of carried interest and balance sheet investments, Mr. Tutrone said. He declined to say which exit strategy Dyal uses.
However, exits are key for private equity managers with stakes in money management firms, said Charles B. Burkhart Jr., founder of Rosemont Investment Partners LLC, West Conshohocken, Pa., a private equity firm that specializes in taking stakes in traditional money managers.
"We are making money quarterly from revenue share or profit distributions, but as with all PE investing, you don't make the majority of your return until the exit. So the exits become quite important," Mr. Burkhart said.
Rosemont's typical exit strategies have been either puts or calls that are executable in five or six years from the date of the investment, or sales to a third party.
"We have never sold a firm against its will. All sales are driven by management," he said.
Switching to evergreen fund
Rosemont executives have decided to switch from investing through private equity funds to raising a larger evergreen fund, he said. Rosemont, which focuses on small to midsized managers with $1 billion to $25 billion under management, closed its last private equity fund — the $130 million Rosemont Partners III LP — in 2013. Mr. Burkhart said Rosemont is targeting $250 million to $500 million for the evergreen fund, which would most likely be invested over five to seven years.
"In an evergreen vehicle they (exits) should matter less because you are compounding cash flows over longer periods of time," Mr. Burkhart said. "Our goal in moving to an evergreen fund is to adopt a (Warren) Buffett-like approach with a limited number of quality firms with no specified duration and to exit opportunistically."
What's more, executives at some of the money management firms were wary of a private equity firm taking a stake, he said.
"One problem is that a number of excellent prospects had no interest in talking with us in a private equity construct. They told us that `we don't ever want a gun to our heads.'" Mr. Burkhart said.
Whether in an evergreen or private equity fund, some investors like to invest with managers that take stakes in money management firms because many strategies distribute cash from management fees.
"The high cash-flowing nature" of Dyal's funds was an attractive attribute for the $76.6 billion New Jersey Pension Fund, according to a memorandum to the board in 2015 when it committed up to $200 million to Dyal Capital Partners III LP and another $100 million to a co-investment separate account managed by Dyal Capital Partners. The separate account did not close until August 2017.
The memo also underscored the relatively low management fee of less than 1% with less than 15% carried interest based on certain return assumptions. The memo indicated the pension fund, an investor in Dyal's first two funds, was getting cash flow from a share of fees charged by the managers as well as from portfolio company exits. The memo did not mention Dyal's exit strategy for its own investments.
Not all investors convinced
But not all investors are sold on the strategy. In a presentation to the New Mexico State Investment Council in 2016, the $23 billion endowment's private equity consultant highlighted that returns from Dyal Capital Partners III LP were expected to be generated by cash yield, according to the minutes from the council's Feb. 23 meeting.
The investment council in a split vote, decided not to follow the recommendation of its investment committee, staff and consultant LP Capital Advisors to commit $75 million to the fund, which was the first of Dyal's funds to invest in private equity firms and hedge fund managers. One reason voiced by at least one of the council members was the lack of a clear exit route.
Exits can also depend on the terms of the original deal, said Andrea Auerbach, managing director, a managing director and global head of private investment research at Cambridge Associates LLC in the Menlo Park, Calif., office. An alternative investment firm sometimes will negotiate a buyback at a predetermined rate, she said.
Selling stakes in alternative investment firms is not new and the challenge of how to exit has always been there, Ms. Auerbach said.
What is new is that money managers now have dedicated strategies for taking stakes in private equity firms. New funds devoted to taking stakes in general partnerships are "crystallizing the challenge," she said.
However, given the "enormous profitability of a private equity platform," cash flows in the form of a share of the firm's fees and profits make exits "the icing on the cake," Ms. Auerbach said.
These cash flows are multiplied as firms raise multiple funds across various strategies, including private credit and real estate.
Some investors stay away from the strategy because they think managers that sell stakes are shifting the alignment of interest away from their limited partners, she said.
Ms. Auerbach said her concern is that the capital from selling the stakes is used to provide an exit route for the alternative investment firm's executives who produced the firm's returns rather than reinvest the money back into the firm.
"Private equity is all about the people," she said.