Trends Watch: GP Stakes Private Equity Fund Investing

EisnerAmper’s Trends Watch is a weekly entry to our Alternative Investments Intelligence blog, featuring the views and insights of executives from alternative investment firms. If you’re interested in being featured, please contact Elana Margulies-Snyderman.  

This week, Elana talks with Lincoln Archibald, Managing Partner & Chief Investment Officer, Fund Launch Partners.

What is your outlook for GP stakes private equity fund investing? 

I believe GP stakes are one of the best ways investors can gain exposure to alternatives. An investor can participate in the stable, consistent cash flow from management fees while also benefiting from the upside of fund performance. Management fee revenue, especially in closed-ended funds, is contractual, recession-proof income that grows over time as the assets under management (AUM) of the firm increases. In addition to the income, a GP stake position provides exposure to investment performance, offering mitigated downside risk with tremendous upside potential.

Almost every investment strategy has gone through a similar cycle. Take leveraged buyouts (LBOs), for example—some of the largest LBOs were executed at the infancy of the strategy. As these investments proved to be lucrative, the middle market emerged, followed closely by the lower middle market. In GP stakes, the larger deals executed years ago have now started to yield substantial returns, paving the way for GP stakes in emerging fund managers. Based on where we are at in the asset lifecycle, we have a promising future for GP stakes investing. 

Where do you see the greatest opportunities and why? 

We see the largest opportunity at the emerging end of the GP stakes market. By partnering with managers at their infancy, we unlock significant long-term upside potential. At Fund Launch Partners, we specialize in partnering with managers day zero. By engaging with them so early, we can partner with managers at a near-zero-dollar basis, which mitigates downside risk immensely while allowing us to participate in the long-term growth of the firm. Although we have more work and direct value-add post-investment compared to larger GP stakes firms, it is well worth it. By coming in early and allocating the majority of the capital to their investment strategy, managers can benefit from 'power law' economics without assuming the same level of risk. In addition, managers will be able to navigate the complexities of fund management, mitigating their operational risks and positioning themselves for success, along with maximizing returns for our investors.

What are the greatest challenges you face and why?            

There are significant hurdles to being an emerging manager. Over the past two years, we have incubated more than 200 emerging funds. Consistent data shows that emerging managers (Funds I, II, & III) and smaller fund sizes often outperform larger, established managers. Despite this, too many allocators exclude emerging managers from their mandates.

I believe part of the issue lies in the perverse incentives at play. Allocators are heavily influenced by career risk. If an allocator invests in a well-known firm (BIG FUND VIII) and it performs poorly, they are likely to keep their job. However, if they invest in a new niche strategy or manager and the investment fails, they are likely to be fired. This risk aversion makes it challenging for emerging managers to secure funding.

One of my biggest challenges is convincing allocators that including emerging managers in their portfolios is worthwhile. We need to demonstrate that the potential for higher returns and diversification benefits outweighs the perceived risks. By providing robust data, success stories, and transparent communication, we aim to shift the perception and highlight the value that emerging managers can bring to an investment portfolio.

What keeps you up at night?

One aspect of the alternatives market that concerns me is the practice of capital calls. Private funds often call capital down as needed to maximize internal rate of return (IRR), which creates a challenging situation for investors. They are forced to keep their capital in liquid investments with lower return potential to meet capital call requirements. Moreover, in some cases, large funds never call all the capital they raise, which can be frustrating for investors.

While I generally oppose increased regulation on private funds, I believe mandating that all private funds call all capital upfront could level the playing field for asset managers. This would prevent the use of accounting and timing tactics to artificially enhance IRR and provide a more accurate representation of fund performance. By requiring capital to be called upfront, investors would have a clearer understanding of their commitments and could allocate their resources more efficiently.

The views and opinions expressed above are of the interviewee only, and do not/are not intended to reflect the views of EisnerAmper.