GP capital solutions: a toolkit for private capital fund managers

Private capital managers have access to a wider and more sophisticated range of financing and growth capital solutions than ever before. From GP stakes and preferred equity, to GP financing in the form of management company (manco) and GP commitment debt facilities, each offers a different balance between dilution, leverage, flexibility and cost.

In this article, we consider what is driving demand for GP capital solutions, examine several of the solutions available, including how they operate in practice, and discuss the factors that may lead a private capital manager to choose one route over another.

What is driving demand?

Broadly, the need for GP capital solutions falls into one of three categories.

GP capital solutions

Fund managers in search of capital have access to an increasingly advanced range of financing and growth capital solutions. Typically they turn to one or a combination of GP stakes, GP financing and preferred equity transactions. 

1.GP stakes 

A GP stakes transaction involves the sale of a minority equity interest in the fund manager, or in its parent entity. The purchaser is normally a dedicated GP stakes investor (a sponsor that has raised a fund specifically to invest in minority stakes in other fund managers), rather than a strategic investor (who will usually want a majority stake, often with put and call arrangements to increase its holding over time). 

Often, the investor’s principal aim is to get exposure to the target GP’s management fees. It may also receive exposure to the house share of carried interest or performance fees, although valuations for these performance-related payments are typically less attractive than the multiples ascribed to regular management fees. Proceeds are often a mix of primary proceeds, paid to the fund manager on a subscription for equity, and secondary proceeds, received by selling shareholders (usually founders or other senior executives). The mix between primary and secondary proceeds will depend on what is driving the deal such as a need for capital to expand into new strategies or geographies, or liquidity to support succession arrangements. 

Traditional GP stakes funds have tended only to take an equity stake and not make LP commitments in the target manager’s funds. However, there are an increasing number of minority investors, including family offices and sovereign wealth funds, who can be more flexible, and it may be possible to find a counterparty willing to take a minority stake and also commit to future fundraisings. 

In terms of an exit, GP stakes fund LPs have tended to accept that most investments will not be realised within the four- to six-year horizon that is typical in private equity deals, and longer hold periods are uncommon. Exit routes did tend to follow the private equity model though, with value being realised through sales to strategic investors or other GP stakes funds, or an IPO of the target manager. However over the last decade or so GP stakes funds have developed a range of liquidity tools to help them realise value ahead of an exit.  These tools, which include securitisations of management fee income, listings of GP stakes portfolios and strip sales of portfolio interests, can provide comfort to the target manager that it is not going to come under pressure to facilitate an exit process too soon after taking the initial investment from the GP stakes fund.

2. GP financing

GP financing in its broadest sense refers to an increasingly sophisticated ecosystem of debt products at the GP or management company level. 

Unlike GP stakes, these “house” financing facilities allow GPs to raise capital without perpetually diluting ownership (i.e. avoiding giving away a share of ordinary equity), and are typically used where capital is needed for a specific purpose and for a limited period. They sit "above” the funds and are supported by the economics accruing to the GP itself, such as management fees, carry and GP commitment distributions, rather than by investor commitments or fund assets. 

Principal GP financing products include manco facilities and GP commitment facilities alongside more bespoke solutions such as member co-investment loans (where the lender to the manco finances individual employees’ co-investment commitments) and investment or carry distribution bridges (where an individual or vehicle borrows against entitlements under one fund in order to fund commitments to another).

a) Manco facilities

A manco facility is a loan to a sponsor’s manco. It sits at the top of the structure and is secured against the operating revenues and receipts of the manco. These facilities, which take the form of one or a combination of a revolving facility, a term loan and a delayed-draw facility, are typically used for a range of general corporate purposes, such as covering operating expenses and funding GP commitments, facilitating strategic acquisitions, seeding new strategies and/or, albeit more rarely, funding distributions to members of the manco.

Structurally, these facilities have features of both cashflow and asset-backed lending and include interest cover and leverage covenants similar to a leveraged cashflow financing. However, like asset-backed facilities, they are underwritten on the perceived stability and durability of fee income, which is often derived from a diversified base of funds under management. 

Management fees are the main source of debt service and amortisation for manco facilities and are the bedrock of underwriting. These fees are contractual, recurring, long-term and payable regardless of performance. They are typically calculated on committed capital during the investment period and on invested capital or net asset value thereafter, allowing lenders to model income with reasonable confidence, subject to step-downs and fee offsets. 

When formulating the collateral package for a manco facility, lenders will take into account the relative maturity of the sponsor’s business and the size of the cheque that it is seeking.  Lenders may call for a combination of all or some of security over equity in the GP entities, the manco itself, any entity through which fees flow, security over contractual rights to management fees or carried interest, security over the GP’s LP interests (if constitutionally permitted at fund level) and distribution rights, potentially including account security and guarantees from intermediate entities in the fee chain. Given its extent, performing the necessary due diligence in respect of, and papering, the collateral package is a timing consideration, especially for fund managers with multiple, multi-jurisdictional funds.

Whilst security may be taken over the house share of carried interest, in contrast to management fees, carried interest is contingent on fund performance exceeding agreed hurdle rates and subject to clawback, and its timing of payment depends on exit activity, so carry receipts are often uncertain. As such, limited value may be given to carry in an early-stage fund, although this may change later in the fund’s life when carry entitlements may be subject to a sweep to help amortise the facility. There will be negotiation around whether a lender can take all of the security it might ideally seek, particularly where a fund manager’s fee or other income is substantial relative to the requested facility size. 

b) GP commitment facilities

A GP commitment facility is debt borrowed by the GP or an associated vehicle within the fund structure (so at a different layer of the group from a manco facility) to fund the GP’s commitment to the fund. These facilities are usually delayed-draw term facilities with an availability period aligned to the fund’s investment period and are drawn as the GP is called to fund investments. 

Repayment comes primarily from a sweep of the realisation proceeds of the investments funded, although other monies, including management fees, may be used to support debt service.  Co-investment returns (the distributions that the GP receives in respect of its own capital commitment to the fund) are central to the repayment on a GP commitment facility, however it is often the case that when GP commitment facilities are put in place there is no capital in the ground for a lender to truly underwrite against. Therefore lenders will look at other factors when underwriting the loan and structuring the relevant security package, including:

• broader recourse such as guarantees from a manco; 
• the track record of the fund manager; 
• the strategy of the fund; and 
• the loan-to-value ratio of the debt on drawing relative to the underlying investments. 

Where a facility is put in place later in a fund’s life, lenders can value the underlying assets and the GP’s share of the likely proceeds.

In terms of collateral, lenders will seek security over the GP entity themselves (whether over the shares or the partnership interests in the GP entity), the bank accounts through which proceeds flow and, where the terms of the relevant LPA permit, the GP’s interest in the fund itself. The security package for a GP commitment facility is typically narrower than on a manco facility but, because distributions depend on investment performance, as mentioned above lenders will often seek wider recourse through guarantees from members of the manco or the manco itself.

3. Preferred equity

Fund managers are increasingly exploring preferred equity as a hybrid alternative to GP stake sales or debt solutions. Preferred equity ranks senior to common equity but junior to debt, giving the provider a priority return but without creditor status. For a GP, this can potentially offer the best of both worlds: it avoids permanently giving away uncapped upside on ordinary equity (unlike a GP stake), while being more flexible than debt in terms of the repayment profile. There is normally no fixed maturity and instead, preferred equity can unwind naturally once the preferred return has been achieved, or alternatively there may be mandatory redemption triggers linked to specific liquidity events.

Rather than relying on the protections of a security package, preferred equity providers will normally seek to protect themselves through veto rights over a list of reserved matters. For example, these may cover the incurrence of debt or the issue of equity ranking ahead of the preference equity. In concept these reserved matters resemble the “negative controls” that are also commonly sought by GP stake investors, but the set of reserved matters sought by a preferred equity provider are typically narrower than for a GP stakes investor, as the preferred equity investor already benefits from the structural protection of the preference economics. 

Importantly, preferred equity solutions and GP stakes are not necessarily mutually exclusive. For example, a GP stake investor may take both ordinary equity and a preferred equity stake. Furthermore, preferred equity can potentially be used by private capital managers as a bridge to facilitate a future GP stake or control sale at a higher valuation. If a manager backs themselves to be successful and grow, preferred equity can be used to accelerate that growth without giving away uncapped upside in the form of common. Once the preference has been repaid, at which point the business has grown, that manager can then look to implement a GP stake or control sale at a higher valuation. Conversely, preferred equity may also be used to finance the buyout by a manager of an existing GP stake.

Choosing the right route 

For GPs seeking capital, deciding on a route forward is often a trade-off between the dilution of ownership and taking on leverage: a GP stake dilutes ownership and gives the investor potentially uncapped upside, whereas debt or preferred equity gives away only capped upside but ranks the provider ahead of returns to common equity holders. GPs will also consider other factors such as:

• Market signalling and support: provided that communications with LPs are handled with care, LPs often see GP stakes transactions as a reassuring vote of confidence for a GP. This endorsement can help with recruitment and fundraising. Furthermore, the ancillary support that GP stakes investors may be able to provide, such as fundraising expertise, investor relations assistance, back-office support and best practice advice (for example on ESG or AI), can be particularly helpful for smaller fund managers.

  Some LPs prefer GP commitments to be funded in cash rather than through specialised financing facilities. Diligence questionnaires typically ask whether the commitment is funded from the principals’ own capital, therefore GPs using GP commitment financing should consider how this will be presented to investors. Preferred equity, by contrast, is non-permanent and does not dilute ownership, so it avoids some of the LP perception and internal partner considerations that may be associated with a permanent minority stake sale.

• Linkage to fundraising: traditional GP stakes funds have tended only to take an equity stake and do not make LP commitments to funds managed by the target manager. However, given the increasing number of market players including family offices and sovereign wealth funds, transactions increasingly incorporate a more explicit link to fundraising. For example, stake investors may be given a call option allowing them to increase their stake if they can facilitate a certain level of commitments to a target manager’s funds.

  GP financing and preferred equity may be linked to fundraising (albeit indirectly) through the GP commitment itself: LPs increasingly view a sizeable GP commitment as a signal of alignment, and GP financing facilities and structured preferred equity can each provide capital to help fund that commitment.

• Deliverability: of the range of capital solutions available to GPs, each has their own intricacies but GP stakes deals are generally harder to execute. The investor sits further back in the waterfall, has less certainty on returns and no security, so will generally want more diligence and place an increased weight on its relationship with management. For UK based managers, FCA change in control approval will generally be needed if the investor acquires 10% or more or 20% or more of the fund manager (depending on the type of authorisation that the target manager holds), adding a few months between signing and closing, and where entities within the target group are also regulated in other jurisdictions, consents may also be needed from those regulators further extending the timeline. Portfolio-level regulatory, national security or FDI consents may also need to be considered, although these are less common than on majority acquisitions.
  
  For GP financing, GPs should start by reviewing their fund LPAs to determine whether LP consent is required to grant security over the GP’s interests, and traditional manco lines of credit can come with restrictive features such as personal guarantees, clean-down provisions and short-dated maturities. 

Conclusion

Demand for GP financing and growth capital is increasing and is being met by a growing range of solutions. The boundaries between GP stakes, debt solutions and preferred equity are becoming increasingly blurred as the market matures. Private capital managers can now combine various tools in bespoke ways to meet their requirements. However, choosing the right route requires careful consideration of economics, control, timing and deliverability. Early engagement with advisers will help private capital managers to secure the solution that best fits their needs.