Asset manager M&A remains strong: investor focus on GP stakes investments

Torys Quarterly: M&A Trends 2021

Institutional investors have long relied on third-party asset managers/fund sponsors in private equity and other alternative investment strategies (fund sponsors) to obtain access, as an investor, to specialized asset classes.

Of late, we have seen these institutional investors become increasingly interested in the fund sponsors’ own businesses, and this has led to numerous sponsor-side investment transactions and arrangements. Such transactions where an institutional investor acquires a minority ownership position in a fund sponsor have become known as GP stakes investments.

While each of these transactions and arrangements inevitably involves bespoke terms, the common theme is that the institutional investor will acquire an ownership (economic) interest in the fund sponsor and have some level of governance rights, but for the most part the day-to-day operations of the fund sponsor will remain unchanged and in the hands of the fund sponsor’s existing management team.

For first-time fund sponsors, an institutional investor as the sponsor’s “anchor investor” may help a successful fundraising, providing benefits of a large initial commitment and introductions to other capital sources, enhanced confidence and market credibility.

GP stakes investments have benefits for both the fund sponsor and the institutional investors. Selling a minority stake can provide liquidity to the fund sponsor and allow them to back new business initiatives or otherwise build value. The fund sponsor may also benefit from the investors’ specialized expertise. On the other hand, most investors that make GP stake investments are well established alternative asset investors who benefit from access to top-performing fund sponsors and the right to participate in a portion of fund economics (management fee and carry).

GP stakes investments fall into two broad categories: 1. those with a first-time fund sponsor and 2.  those with an established sponsor. In both instances, alignment of interests between the fund sponsor and the investor is essential.

Key considerations in GP stakes investments

For first-time fund sponsors, the fundraising process is often very challenging. Having an institutional investor as the sponsor’s “anchor investor” may greatly assist achieving a successful fundraising, by providing tangible benefits of a large initial commitment and introductions to other capital sources as well as intangible benefits of enhanced confidence and market credibility. For its part as an anchor investor, the institutional investor may wish to acquire an interest in the sponsor, so the investor can further share in the success of the sponsor and its fund.

For established sponsors, different considerations arise. Business imperatives tend to be the key drivers: a deeper relationship with an institutional investor could provide better access to capital; or the sponsor team may be looking to address personal liquidity or succession issues; or the sponsor and the institutional investor may identify synergies or growth opportunities that would best be pursued on a combined basis.

Structuring and executing these transactions and arrangements is complex. In many ways, the investment by the institutional investor is more akin to a direct private equity investment. The institutional investor should thus consider which of its internal teams is best suited to lead the transaction and manage the investment going forward.

The go-forward governance framework will be critical. In some cases, the institutional investor may be a passive investor with limited governance rights other than regular reporting. In other cases, the institutional investor may have full governance rights including board representation and customary investor veto rights.

Potential conflicts of interest need to be addressed upfront in a way which does not impede the institutional investor in its own investment activities.

Regulatory and reputational considerations also need to be analyzed. An institutional investor’s acquisition of a significant interest in a registered investment adviser may trigger change-of-control considerations under securities legislation (including, in the U.S., the Investment Advisers Act of 1940), the funds’ partnership agreements and the side letters entered into between the fund sponsors and its other investors. U.S. asset managers cannot assign an advisory agreement without client consent, and assignment of the advisory agreement is deemed to occur if there is a change of control of the investment adviser (i.e., more than 25% of the adviser’s voting securities). In such situations, consent of the fund’s investors should be obtained by the fund sponsor in advance of the transaction unless the partnership agreements or the side letters allow for advisory committee consent. Some partnership agreements and side letters contain even a lower threshold for change of control of the adviser and its affiliates. In minority transactions that fall below the applicable thresholds, absent a contractual requirement, consent of the other fund investors or the advisory committee would not be required. As to reputational matters, the institutional investor will need to be comfortable with the sponsor’s management team, as in the eyes of the marketplace, the sponsor and the institutional investor could (perhaps unfairly) be viewed as the same organization.

In addition, having an interest in a sponsor will inevitably raise conflict issues. For example, the institutional investor will, through its other investing activities, likely compete with the sponsor’s fund for investment opportunities. These conflicts need to be addressed upfront, in a manner which does not impede the institutional investor continuing its own investment activities (whether in markets related to the sponsor and its fund, or not).

Conclusion

Asset manager M&A transactions can provide significant benefits to the sponsor, its management team and the institutional investor. We expect there will continue to be significant interest from all sides to explore and complete these transactions.

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