Stakes deals – investments in alternative asset managers

October 2022  |  SPECIAL REPORT: FINANCIAL SERVICES

Financier Worldwide Magazine

October 2022 Issue

A ‘stakes deal’ is a transaction where an investor acquires a minority position (also known as a ‘stake’) in an alternative asset manager. It is important to note that the stakes investment is in the target asset manager itself, rather than in the investment funds that are managed by the target asset manager.

Thus, the stakes investor becomes a partial owner of the asset management business. This is fundamentally different than the individuals who invest in the funds managed by the target asset manager. Those individuals are customers of the target asset manager, while the stakes investor becomes a partial owner of the target asset manager itself.

Stakes deals were uncommon 10 years ago, but today have grown into a consistent component of the alternative asset manager landscape. Some alternative asset managers, most notably Blackstone and Dyal Capital, have developed specialised businesses that focus on making stakes investments in other alternative asset managers.

Why stakes deals?

Target alternative asset managers engage in stakes deals for two primary reasons: to provide liquidity to the existing owners of the business (typically, the senior investment professionals who work there) and to raise capital for expansion into new business lines or new geographies.

A stakes deal is one of the only ways to provide significant liquidity to the existing owners of the target asset manager. Many alternative asset managers are majority owned by the senior investment professionals who founded the business. More junior investment professionals may own part of the business as well, but ownership nonetheless tends to be concentrated (often, significantly concentrated) in the hands of the founders and other senior professionals with long tenures at the business.

When the time comes for the founders to retire, a significant question arises: what to do with the ownership stake owned by the retiring individuals? Creating liquidity for the founders through an initial public offering (IPO) of the asset manager is one option, but this only works for the largest and most established businesses (e.g., Apollo, Ares, Blackstone, Carlyle, KKR, etc.). Another option is to have junior investment professionals buy out the founders; but it is often impossible for the junior professionals to organise themselves into a cohesive group and raise the required amount of capital. Another option would be to simply leave the founders’ stake outstanding, but many junior investment professionals do not like the idea of the founders (or their estate planning vehicles) continuing to own a large part of the business when the founders are no longer active participants (or have even passed away).

In other words, most junior investment professionals want to take the reins and run the business themselves without the legacy overhang of the founders. The foregoing list of suboptimal options results in a stakes deal being attractive. It provides liquidity for the retiring founders, and it provides independence (to a degree) for the junior investment professionals on a go-forward basis.

From the perspective of the stakes investor, alternative asset managers provide three fundamentally different types of investment returns. First, alternative asset managers typically generate predictable and recurring annual cash income in the form of management fees. These fees are typically a set percentage (e.g., 1 to 2 percent) of total assets under management. Thus, this income is easy to predict and is reliable, particularly for asset managers like private equity (PE) firms that have long-dated investment funds where investors cannot withdraw their committed capital.

Second, alternative asset managers generate episodic, but sometimes significant, income in the form of incentives for good performance (e.g., carried interest). These incentive-based returns are much harder to predict and are much less consistent from year to year. But they are nonetheless part of the investment thesis and hold the potential for ‘home run’-type returns.

Third, stakes investors look to the exit of their investment as the final opportunity to make a return. This monetisation event is the most uncertain of the three and is often the subject of passionate negotiation with the target asset manager, which will have a strong desire to understand and restrict how and to whom the stakes investor will be able to sell its investment in the future.

Key issues in stakes investments

Stakes deals can be complicated to negotiate and document. This complexity arises for a host of reasons, one of the most significant being that the individuals involved at the target asset manager tend to be astute and clever business people who are doing a transaction involving themselves and their own wealth. In other words, the transaction is very personal, and the negotiated business points can have a direct and meaningful impact on the future lives and incomes of negotiating parties. This dynamic breeds passion, and passion often makes negotiators more emotional and less rational.

Another complicating factor is that asset management businesses tend to be ‘people businesses’, in that the asset manager has few assets other than its investment professionals. If those people leave, then the business leaves with them. This creates distinct risks for the stakes investor, particularly if proceeds from the investment are being paid to investment professionals (potentially making them very wealthy) who are expected to continue working post-closing.

Further, the target asset management firm is, by definition, a privately held business. Most privately held businesses have internal policies and procedures that are more relaxed in comparison to those of publicly traded companies. These relaxed procedures are particularly prevalent in the areas of accounting, financial reporting, cash management and conflict management. As a result, there is a greater risk of unknown issues, or improperly recorded transactions, in comparison to publicly held businesses.

Lastly, most alternative asset managers are structured as pass-through vehicles from a tax perspective. This means that, for US federal income tax purposes, the entity itself is not a taxpayer, and instead all income and loss of the business is passed through to the individual partners and reported as personal income or loss of the partners on their individual income tax returns. This usually results in the tax structure of the business being advantageous to the individual partners (including the stakes investors), because there is only a single layer of taxation rather than a double layer. But it also typically results in the tax structure being complicated, depending on the structure and tax sensitivities of the stakes investor.

Managing risk

From the perspective of the stakes investor, the features of stakes deals make for an attractive investment, albeit one with distinct risks. If those risks can be managed, the investment will generate stable and predictable cash flow (i.e., annual management fees), occasionally with outsized returns (e.g., incentive fees and sale proceeds), while the prospect of losing money over the long term is less than in comparison to many other investments with similar return potential.

A robust diligence process is one of the core tools used by stakes investors to manage risk. The process will focus on validating the financial model (e.g., projections) of the target business. This exercise includes examining both the historical financial performance of the target asset manager, and also the investments made by the underlying investment funds managed by the target asset manager. If the funds make investments in public equity or debt securities, it can be fairly straightforward to conduct diligence on those investments. On the other hand, if the funds are investing in unlisted securities, or are making PE-style investments (e.g., purchasing whole private companies), it can be difficult and time consuming to diligence those investments and make predictions as to their future performance and potential to generate incentive fee returns.

Financial diligence will also focus on the compensation paid to the investment professionals at the target asset manager. Compensation expenses are almost always the most significant expenses of asset managers. Thus, the stakes investor needs to understand what the investment professionals have been paid in the past, and what they expect to be paid in the future. The stakes investor also needs to understand how compensation-like expenses are handled, such as costs for private air travel, club dues, charitable donations, personal security services, client entertainment, office décor and apartment leases. From the perspective of the stakes investor, these compensation-like expenses are ways that the investment professionals can ‘earn’ money from the business that should, in the view of the stakes investor, be shared with the stakes investor.

Another tool used by stakes investors to manage risk is having contractual relationships directly with senior investment professionals at the target asset manager. For example, it is common for stakes investors to insist that the senior investment professionals sign non-compete and non-solicit agreements with the asset management business, and that the stakes investor itself has the power to unilaterally enforce those agreements. Stakes investors will also often demand that investment professionals have a minimum amount of money invested in the target asset manager or funds managed by the target asset manager. This minimum investment provision is designed to ensure that the investment professionals are financially aligned with the stakes investor. Lastly, it is common for the stakes investor to require new employment agreements between the target asset management business and the senior investment professionals. These employment agreements are usually of a multi-year duration, and include significant financial disincentives for the investment professionals to leave the business.

Finally, another common tool used by stakes investors to limit risk is to include unusually detailed contractual definitions of what the stakes investor is entitled to receive for its investment. Traditionally, equity investors in a business are entitled to a share of ‘profit’, with profit being defined generically as the money left over after the business has paid all of its expenses. Many stakes investors have realised, however, that this generic definition of profit leaves them exposed to expense manipulation. For example, investment professionals could conclude that, for security purposes, it is necessary for them and their families to utilise private air travel (even for personal matters), and that the business should pay for that private air travel. Many stakes investors would consider that type of air travel to be pseudo-compensation, and thus not a true expense of the business that the stakes investor should bear.

Similar risks are present with related-party transactions. For example, assume the spouse of one of the investment professionals has started a diligence investigations firm. The target asset management business then hires that firm to perform diligence on its potential investments. If these services are performed competently, and the pricing is at arm’s length, then this type of transaction does not present problems. On the other hand, if the pricing were unusually rich for the spouse, then the stakes investor would likely see this expense as a form of pseudo-compensation to the investment professional.

Stakes investors can protect against these types of risks by precisely defining how ‘profit’ is computed. The stakes investor is then entitled to a share of that defined ‘profit’, even if a different definition is used for accounting or tax purposes. In that regard, it is not unusual for the definition of ‘profit’ to span several pages of the legal agreements, as the stakes investor attempts to protect itself against all manner of expenses and other conveyances of pseudo-compensation.

 

Jonathan Corsico is a partner at Simpson Thacher & Bartlett. He can be contacted on +1 (202) 636 5839 or by email: jonathan.corsico@stblaw.com.

© Financier Worldwide

BY

Jonathan Corsico

Simpson Thacher & Bartlett

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