Transcript
Speaker: like any asset class whether it's gp stakes or venture or anything else If you're going to tie up your capital, you should command a higher threshold for expected value or expected returns, right? that's It's all related, right? If anyone is trying to sell you on the idea that you're going to have maximum returns with no risk and perfect liquidity, I think we all know that those things don't necessarily...
Speaker: fit well together or they haven't, at least historically speaking. So you have to get comfortable with what those different liquidity mechanisms look like. And depending on how much illiquidity you're willing to sit through should dictate the types of returns that you're targeting or you should expect.
Speaker: See you.
Speaker: and welcome back to What's the alternative? We've been on a bit of a break to get ready for season four and we have some exciting news. What's the alternative has been recognized as a finalist nominee. at the Wealth Management Wealthy Awards for best
Speaker: investment education podcast thank you everyone for your support and thank you for the nominations we really appreciate it we're glad that we are having an impact on your practice and you are learning from us and we look forward to another great season where you can learn more things about the ins and outs of alternative investments from the practitioners who get into the weeds with us
Speaker: Today, we have a guest from our latest asset manager partner here at Bondrium.
Speaker: Clark Edlund from Kaz Investments. He is a partner at Kaz, and he is responsible for sourcing and evaluating investment themes, as well as monitoring existing investments. He also works with outside investors, including family offices, REAs, and other institutions to co -invest with those firms in the Kaz Investments principles and shareholders. He is also a member of the executive committee. He has over a decade of investment -specific industry experience, including asset management. business development, and client relations. Most recently served as senior investment advisor and portfolio manager at a boutique -focused private equity manager. He is a graduate from Texas A and &M. with a bachelor's in economics and a minor in business administration and he is also a chartered alternative investment analyst just like me when he received his credentials in 2012 i got mine in 2011 so i was a little ahead of him
Speaker: ah But we're early adopters of the Kaia designation, which is an indication of just expertise in alternatives specifically. So I'd like to welcome Clark to the show. Thank you for being our first guest for season four. now Thank you for having me. Look, I've been a big fan of yours and the podcast more broadly ski speaking, so it's a pleasure to be here.
Speaker: Ah, we're excited to have you. And we're excited to talk to you about a really interesting topic. We've never taken on this topic before. And I think it's one that desperately needs to be discussed because it's not. the most common alternative investment strategy but we're seeing more and more of it in cas is in this space but it is gp stakes
Speaker: And because it's not that common and because of just the name, it's not always evident to investors, especially advisors when they talk to their clients, on what exactly is GP Stakes and why should they be looking at and considering investing in a private equity strategy that is focused on GP Stakes. So let's just start there. What are GP Stakes?
Speaker: Yeah, look, I think in its simplest form, a GP stake is nothing more than a ratable ownership interest in an alternative asset management firm. More of the stakes transactions that have happened in recent years have gravitated more to private market asset management firms, whereas the early innings of these transactions were more with liquid strategies, hedge funds, if you will. But the simplest way to think about this is you have owners of these asset management businesses, right? And all a GP stakes or solutions transaction is. partnering this with this manager such that you're sitting side by side with the existing owners of these businesses and what that means is when you're sitting shoulder to shoulder with the owners of the asset management firm itself is you are capturing a piece of the firm's economics not necessarily the fund economics, which is exactly what would happen if you were only a passive LP in that particular vintage. So the simplest way to think about this.
Speaker: House Economics versus LP Economics.
Speaker: Yeah, so for our audience I think most people are familiar with the concept of limited partners as almost all alternative investments, especially any sort of drawdown or closed end structure. You typically invest as a limited partner, meaning you're investing in the product, not necessarily the economics that are advantage to the general partners, which is what GP stands for. The general partners are typically the people who make the investment decisions. They are the firm itself and the economics of the firm that manages the product. so
Speaker: in a gp stake situation as clark just pointed out That's who you sit alongside. And so the economics are a little different. So let's talk about the economics.
Speaker: for a GP. Because from an LP perspective, you get the economics of the fund after whatever whatever economics are captured by the firm itself, usually through carry. And sometimes there's incentive fees and there's hurdle rates and high watermarks and all these terms that get thrown around and alternatives that we don't talk about a lot. And I think a lot of advisors are almost hesitant to ask the question because they feel like they should know. So let's talk about how the economics are structured from the GP perspective versus the LP perspective. because most advisors only invest as an LP. So the GP is a little foreign to them.
Speaker: Yeah, I think let's start with where they're similar, right? I think both constituents in that day dynamic, although they're sitting on opposite sides of the table, whether you're the LP or the GP, both folks benefit when the performance of the portfolio companies in that particular fund do well, right? a dollar gets invested, that dollar gets applied to a number of different portfolio companies. Ideally, the asset management firm or the GP will sell those portfolio companies for something more than they acquired them for. And then everyone will get their ratable share of the profits or the proceeds, right? Where the biggest differentiation is going to occur is one, the LP will typically pay a management fee.
Speaker: to the general partner that is managing the fund so the biggest differentiation is the payor of management fees and then the other counterparty to that being the gp is the recipient of said management fees where i think a lot of folks don't fully appreciate the impact that can have especially in the early innings of a cookf fund commitment is the fact that when you sign a subdoc as a limited partner
Speaker: you begin paying management fees to the general partner of that fund from the moment that fund closes irrespective of how quickly or slowly that general the general partner actually calls your capital to put it to work which for some people
Speaker: can be a little bit tough to digest and as they're dipping their toes into the private equity waters, if you will. But the reality of the situation is that is the most logical way to do it because the last thing you would want to do as a limited partner is have a perverse incentive to the general partner to encourage them to call their capital unnecessarily just so they can put it to work so that they can start the clock on the management fee revenue. As the general partner, you begin collecting contractually obligated management fee revenue from the limited partners in the fund. from the moment you final close your fund typically speaking and then that's going to be for private equity whereas private credit in some cases they're typically going to charge their management fees on deployed capital as opposed to committed capital and then usually depending on this the structure and private equity there'll be some sort of step down of management fees once you're outside of the investment period and it'll shift over to being on deployed capital as opposed to committed capital so there's a number of different levers and and ingredients that go into the equation but the biggest differentiation is one is the payor of management fees, one is the recipient of management fees.
Speaker: Yeah, so... As a GP Stakes investor, Ooh. that is part of the economics of what you can expect in your return profile correct Yeah, I think that's right. But I think it goes a step further than that, because the other thing that the general partner has at at their discretion and out their back is what we call the balance sheet or which is typically mostly representative of the GP commitment, which is incredibly important because generally speaking, limited partners get more comfortable in the general partner.
Speaker: as more skin in the game so you will typically see some gps that have more aggressive gp commits
Speaker: Mid single digit, sometimes even up to double digits. Industry standards are going to be somewhere between one and four, one and five percent, somewhere along those lines. But again, it's important because it creates alignment between the two different parties. The other mechanism or the other ingredients that go into the to that equation for the general partner would just be, do they own other assets on the balance sheet of the business that are not necessarily held inside a particular fund that they're managing in a GP stakes transaction because you're side by side? side with the owners of that asset management business, you're generally speaking going to own your ratable share of the economics on all things that ownership group has as equity in, whether it's that's the management fee revenue, the carried interest, the balance sheet of the business, or anything else that the firm does.
Speaker: Yeah, so that's a ah good point. Carried interest is... Almost. It gets a bad rap. But... I think... Understanding the... rationale behind carried interest is something that's important to make decisions in terms of whether the carry is outrageous or not and carry interest In hedge funds, we would call it performance fees, but either way, it's basically participating in the success of the fund. and
Speaker: Most of the controversy around it is less on the concept of carried interest and more on the tax treatment of carried interest. so Because of that, though, that in my mind would also be a potential benefit of a GP stakes because carried interest has preferential tax treatment.
Speaker: Would you say that's accurate?
Speaker: Yeah, I think generally speaking, carry and balance sheet returns are going to be taxed at long term capital gains, whereas the management fee revenue is generally speaking going to be taxed at ordinary income. There's some other mechanisms that that that occur where the staking firms can get creative to help mitigate some of the punitive tax that comes from the management fee revenue. But each transaction is a little bit unique. I think the other thing that's really interesting when you're thinking about sitting on that side of the equation versus only being a passive LP and and a fund, if you will, is the diversification around vintage and timing. Because again, when you're sitting shoulder to shoulder with the owners of those asset management businesses, you own a radical share of your economics not just on that one vintage but all of their vintages which is great because one of the biggest challenges to just capital deployment in private markets more broadly speaking is this this element of timing right and unfortunately you never know if you're in a good bad or good bad or mediocre vintage until seven to ten years later right when the scoreboard actually matters but because you own an interest in the firm itself and you own a radical share of all those economics across all funds
Speaker: Past.
Speaker: present future, it really mitigates that timing and cyclicality that is just the natural byproduct of private markets. Because when you're in an an elevated enterprise value or valuation regime, that's a great time to sell assets, right? But not the great, best time to put capital in the ground. If you transpose those, then it's the other side. When valuations are down, that's not a great time to monetize assets, but it's a great time to put new capital to work. And again, you never really know where you are in real time if you're only on on the LP side of the equation, but if you're on the GP side of the equation, you are the beneficiary of that that that cyclicality or that diversification across time.
Speaker: So let's talk a little bit about some of the general terminology that's used when we talk about GP. So I think this is relevant not just for anybody who's considering GP stakes in general, but also anybody who's considering investing in and these types of closed end or drawdown private alternative, private placements, if you will, where we just keep talking about carried interest.
Speaker: because you and i know what it means but Let's... help our advisor audience and answer what they might consider to be the stupid question so they don't have to ask it. Let's actually define what carried interest is so advisors and their clients can understand why carried interest is actually a way to ensure alignment of interests.
Speaker: Yeah, look, I think I would put all of them in the category of performance fees, as you mentioned earlier, and then generally speaking, When you think about liquid strategies or hedge funds, we would call those incentive fees. When you think about drawdown structures or true private equity, we would call those they call that carried interest. I think it goes above and beyond just terminology because I think when you try to
Speaker: unpackage what each of those things are and mean and do, you have to look at the other ingredients that go into determining how that carried interest or how that performance fee is actually assessed. So that's when you have to inform yourself and educate yourself on what do these different waterfalls mean, right? What is the difference in a drawdown structure between an American waterfall and a European waterfall? And why is one good for one constituent and less good for the other, right? And making sure that matches up with the hurdle rate or how how is the GP catch -up assessed, right? It's all about understanding incentives and alignment and doing everything you can to make sure you're as ah well aligned with the manager as possible. But you don't know that unless you really dissect the different terms of the offering and get a better feel for what it is that's going to drive motivations for them later on in the life of the fund, not just putting capital to work, but monetizing the asset. And that's why I think we've seen such an evolution and structures as as all of the asset management firms have. continue to come down market and open up the aperture of investors that are applicable to their funds going above and beyond the institutions, right? So we're seeing a lot of unique structuring around closed -end funds, interval funds, evergreen funds, and then how these different waterfalls are impacted when an asset management firm actually takes their carry. Do they have a lost carry forward account? Do they have a high watermark? There's a lot of different things that go into unpackaging what a... simple performance fee actually is and how it's assessed.
Speaker: Yeah, so let's dive into it. So let's say I'm an advisor. I'm looking at a strategy and again This is relevant to GP stakes because this is the economics of the GP. But let's say I'm looking at a subscription doc and I have a 20%.
Speaker: Carrie. with an 8 % hurdle. It has a high watermark and a GP ketchup. What does that mean? for the advisor what does that mean when i look at that what is 20 % carry, what's the 8 % hurdle with the high watermark and the GP catch -up?
Speaker: simplify that so advisors can look at that and know when they're considering different options. how to compare those things.
Speaker: yeah so irrespective of whether you're looking at stakes or just middle of the fairway buyout right if we're talking about a drawdown structure where a fund is going to have some sort of terminal life to it and then usually a one or two year gp extension associated with that the simple way to think about it is an investor an lp in this case is going to commit some sum of dollars to a fund right then generally speaking what's going to happen is they're going to begin paying management fee revenue on the commitment amount not the called amount from the moment that fund final closes all right and then from there the way it's going to work is as that manager calls capital from the limited partner what they're effectively doing is they've put themselves on a clock and what that that's typically going to be tethered to is what we would call a pref or a preferred return
Speaker: General middle of the fairway kind of terms there is an 8 % pref. And what that means is the manager itself cannot participate in any of the profits until they've given back the limited partner every dollar they've called plus 8 % annualized on that dollar until they've returned it. And then once they've returned it and that investor has gotten back at least a 1x DPI or distribution to paid in capital.
Speaker: plus the eight percent pref that's when you would then follow that waterfall of who gets what percentage of the profits and when so in a typical situation you mentioned the term gp catch up what that means is the the lp is going to get all of their money back first once they've gotten at least one x dpi plus their pref then what's going to happen is the manager is going to get trued up if you will if it's a 20 performance fee and a hundred percent gp catch up they will then capture a hundred percent of the economics until that the total economics equate to an 80 20 mix between the lp and the gp sometimes you'll see a 50 50 catch up where again the gp is going to capture more of the economics after the lp has gotten all of theirs plus the prep until they get to whatever that equitable ratio is that's determined but on the front end of that transaction and then from that point forward once everybody's gotten their amount that they're due
Speaker: that every new profit from there would follow that same waterfall. And to be clear, that that would look like. call the European waterfall, where the LP gets their money back first. An American waterfall would look a little bit different in that context, where the general partner will take their pound of flesh, for lack of a better term. They will take their ratable share of the profits on each distribution as it occurs, even if the LP hasn't gotten back all of their capital first.
Speaker: That's a really important distinction and
Speaker: a prep and a hurdle rate. are somewhat similar, correct? Yeah, that's right. Typically, some of this terminology is just going to be semantics, right? But you'll typically assess a PREF or a preferred return with private equity and drawdown structures because, again, there's an ongoing waterfall there. Hurdle is typically going to be associated with hedge fund structures where they can actually assess their carry on a more periodic system systemic basis. Doesn't necessarily have to follow a specific waterfall. They just have to eclipse or achieve a certain performance hurdle. in order to be eligible to share in the profits.
Speaker: And there's also... and this is again more in the hedge fund world you'll hear the word high watermark as well but that typically has more hedge fund relations there can often be clauses in these these subscription documents that involve if there's a loss.
Speaker: The GP. is unable to capture their carry until they Earned back everything that was the lp has earned back the loss so those are all things to consider not always involved in a closed -end drawdown product but just terminology that gets thrown around
Speaker: And you want to just understand the semantics there, because at the end of the day, some of these GP stake funds might be investing in a firm that has a variety of different types of product structures. And I think that's an important understanding, even though the GP stakes fund it may itself be a closed end drawdown structure. that
Speaker: actual asset manager that you're investing in could have different structures underneath of which you as GP are participating in. So that's why having an understanding of this terminology is relevant, even in a structure like GP Stakes, which would likely be closed in and a drawdown. That's a good transition to the next part of the conversation. Why GP Stakes?
Speaker: Why now and why is this something advisors should? ah be considering as a way to diversify client portfolios in the alternative space.
Speaker: Yeah, so I think it all starts with diversification, right? we We touched on the cyclicality of private markets once prior and the benefit to being on the house side of the equation is you mitigate that timing risk in a fairly meaningful way. But the the other dimensions of diversification are just as important. When you invest in a diversified basket of GP stakes interest, you're going to own different types of asset management firms, right? So you might own within private equity, growth and buyout, credit, infra, real estate, etc. whatever it may be right there's a lot of different types of asset management firms out there and then you're also going to get diversification across market cap
Speaker: geography whatever it may be strategy right you got buyout growth etc so you get to check a lot of boxes in one fell swoop which i think is incredibly important because
Speaker: If you're going to venture into the private markets world, if you will, you need to do it in a systemic way so that you're touching a lot of different asset classes over time. And unless you earmark enough capital to do that in an effective way and deploy that capital in a systemic way, then you're going to subject yourself to more timing risk or more concentration risk. But if you can do that inside a GP stakes mandate, if you will, you get to check a bunch of different dimensions sort of diversification much more easily. than you would otherwise. So I think diversification is the number one thing there. And then I think secondly, as we touched on earlier, again, this is a little bit rhetorical, but is it better to be the LP or the GP, the payor of economics versus the recipient of economics? And I think for us, at least the way we've always positioned this is many advisors will view GP stakes as a picks and shovels approach to private markets because you do check so many different boxes. But again, you're also doing it from the house side of the equation as opposed to the LP side of the equation only.
Speaker: Yeah, and I think that's the interesting part. We often talk about co -invest as well. And I think the biggest difference when you think about GP stakes versus a co -invest kind of scenario is that diversification part, right? Because in a co -invest, you yourself are becoming a GP and you're participating in a specific deal or specific fund, which is quite different than GP stakes, where you are sitting aside the GP, but you are getting the diversification of different types of deals, different types of underlying investors. different vintages, so on and so forth.
Speaker: Yeah, look entirely. And and then there's to to take it a step further or a derivative of that. There's GP stakes co -investments. Right. So where you can actually co -invest along the staking firm into that asset management firm, which effectively acts as the port co in and of itself. So there's a lot of different layers when you think about GP stakes. And it's it's one of the advisors we work with. He described it as this is private equity of private equity. And I'm like, yeah, there's multiple dimensions. Right. It is a derivative of the asset class itself. It's just. capturing those economics and those exposures from a different seat in the ecosystem.
Speaker: Yeah, and and that gets into... You can have secondaries in here. You can have a variety of different ways. And in a way, if you think about... in the more traditional sense, like a balanced fund.
Speaker: where you're getting a little bit of everything across the board with different weightings potentially and different ways to get that exposure. I think that when you think about either a multi -sector or a balanced fund or a multi -strat it's sort of that but in private equity form in terms of how it sits in a portfolio.
Speaker: It is... almost like a foundational piece for your alternative investment. private equity exposure. But it can still incorporate more than just private equity. There could be private credit in there. There could, as you pointed out, be real estate. So there's all different ways. So I think of it as more of like... the balanced fund of private equity investing.
Speaker: because of the scenario. The difference being is that The firm that... making the GP stakes. investment. has to do due diligence on what the underlying is so talk a little bit about what that looks like because at the end of the day you're still making an investment there's still due diligence involved and so when an advisor is considering something like this, what kind of questions should they be asking the potential issuer as to what their due diligence process looks like?
Speaker: Yeah, these are very long dated transactions and they do not happen quickly. And if you speak to some of the the staking platforms or the staking firms, they'll tell you there's many transactions that have gotten over the finish line that have been in the making for five, 10 years in some cases. and And this is still somewhat of a nascent asset class relative to other private market asset classes. But it is it has definitely become a little bit more mainstream than it was a decade or two decades ago. But effectively what happens when a is staking business goes and looks at an asset management firm that they're considering acquiring a piece of, they have to understand and underwrite literally every single piece of that business. For example,
Speaker: These are generally speaking, tenured asset management businesses. And there's an emerging bucket within GP stakes that exists today, but it's still budding and and fairly new, if you will. But most of the transactions that have occurred have been with long tenured asset management firms. And for example, if they're on fund five, what one needs to understand during underwriting of that transaction is just because they're about to go back to market with fund five, you're not underwriting just that. That is only a piece.
Speaker: you have to start and go back further. You've got to go back and look at all of the prior vintages that still have any sort of assets in them. So a typical underwrite in this simple example would be, let's go back to fund three.
Speaker: what is still left in the ground on fund three so maybe there's three portfolio companies left in that vintage and there's three years of life left on fund three just to keep it nice and easy so they're going to look at the the discounted cash flows of the economics that are coming in from management fees and then sensitize where the portfolio companies are currently marked and where they think they will ultimate ultimately monetize they're going to come up with some sort of valuation for whatever assets are in the ground for Fund 3 and the economics they produce. Then they're going to look at Fund 4.
Speaker: Let's say fund four has got, in this example, seven years of life left on it because it's not as old or seasoned as fund three, but it's also not put all the capital to work. So they don't even know entirely all of the portfolio companies that will exist in that particular vintage, but they also know they have seven years of runway or seven years of management fee life left on that particular pool of capital. So they're going to DCF those economics back into some sort of current value for that.
Speaker: Then they're going to have a conversation with the management team and say, great, you guys are on fund five. They're going to underwrite what they think that firm will do from fund five on a go forward basis. So obviously the management team at the asset management firm.
Speaker: probably views themselves through the through rose -tinted lenses and they believe fund five is going to be their best vintage yet it's going to do a 3x it's going to be again a five billion dollar fund and because their investors love them they're gonna they're gonna final close at the end of this year again whatever it is the staking firm will then have to sensitize those inputs because again how does an asset management business make money
Speaker: AUM and performance of AUM, right? That's really what it comes down to. So what they need to underwrite or sensitize are those inputs. And they'll say,
Speaker: all right fund five it's a challenging fundraising environment we've heard all about it we don't think you're going to hit the target fundraise that you believe you're going to hit but we don't believe that you're going to generate the same moik because maybe your fund size is 2x the prior fund and they might not believe they can put that capital to work and again because fundraising is challenging maybe they're going to sensitize management fee revenue to start 18 months later than when the management company thinks it'll start and then they'll rinse wash repeat for any other verticals because again some asset management platforms are not monoline businesses maybe they have a private equity business and a credit business or a healthcare infrastructure whatever it may be
Speaker: But they're going to basically execute that same methodology across all lines of business. And then the further out they go into the future, the further they're going to sensitize the inputs that would generate in our economics for the asset management business that they're considering buying a piece of.
Speaker: They will take all those ingredients, throw it in the blender, turn it on and come up with some agreed upon enterprise value.
Speaker: for that firm and then of course they would always look at that through the lens of comparing it to publicly traded comps because no buyer of an asset management business would pay the same multiple for a highly illiquid asset as they would something with daily liquidity but it's all about unpackaging the different economics and deciding what type of multiple you want to assess to those different sources of return which again are predominantly your addable share of the two which commands the most enterprise value because it's contractually obligated your addable share of the 20 and the balance sheet which are going to go for lower multiples because they're a little bit more of an unknown thus they're lumpy and just harder to underwrite too
Speaker: Yeah, so I think this is a good time to... Step back. because we've talked a little bit about how the stakes firms do the due diligence and the stakes firms are the sponsors of the gp stakes fund so we've talked a lot about how the benefit of the gp6 fund is that you sit shoulder to shoulder with the GPs of these asset management firms.
Speaker: But! You as the investor are not a GP in the GP Stakes Fund. You are an LP in the GP Stakes Fund. So some of the structure that we're talking about that you are a benefactor of is also...
Speaker: Things that are... Part of... the actual structure of the fund you invest in you're the lp so you have to still consider what is The... carry on the stakes fund what's the management fee on the six months because you still have to pay that even though you are getting the benefit of the asset manager fee so i think We want to make sure that we're clear.
Speaker: that you're investing to be alongside GPs of asset manager investors in the fund. But in the fund itself, you are still an LP and the economics that are why you would invest in a GP Stakes Fund are still economics that you have to be aware of, consider and look at when considering a GP Stakes Fund, correct?
Speaker: Yeah, that's right. And it's what someone described, as I mentioned prior, private equity of private equity or PE e squared, if you will. And you are 100 percent right. In order to benefit. from the house economics of all of these different asset management firms. You're still doing that through a pooled fund structure more often than not.
Speaker: in which you are a limited partner of so in that context you then need to understand what the terminology and the guardrails and the terms are of the fund that you're subscribing to and while there's a ton to love about gp stakes more broadly speaking because you are capturing house economics on a lot of many of the best private equity and private credit and infrastructure managers in the world.
Speaker: It comes with some challenges structurally. and And what I mean by that is when you are a limited partner, traditionally, these these structures run in perpetuity, which is a very tough thing for most investors who aren't long tenured.
Speaker: pools of capital themselves. A perpetual structure may not be that big of a deal to an insurance company or an endowment or a foundation or something that's a long life pool of capital. But if you're a human. or a family and you want to deploy capital generally speaking you won't have some sort of control about how that capital is going to come back to you so what happened in the early innings of many of these gp staking vintages is the staking firms in order to get that transaction done
Speaker: There's no way they could go to a big blue chip asset management firm and say, hey, I'm going to buy 14 % of your business. But just so you know. In seven to 10 years, I'm going to sell my equity in you to someone else and you have no control over who that is.
Speaker: That doesn't work. So when we talk about the underwriting process, how I mentioned this is a multi -year and in some case, five, 10 year conversation for many, in many cases, this isn't dating.
Speaker: these folks are getting married right they are tethered to one another for better or worse for a really long time. And if you speak to many of the staking platforms out there, they'll tell you they plan on owning these businesses in perpetuity. Now, there's different ways that these things can monetize, and I'm sure we'll talk about that in a moment. But to be abundantly clear,
Speaker: When you go into a diversified drawdown GP staking structure, you need to be prepared for a very slow capital call pace, which is a challenge in and of itself for many types of investors because they would have either dry powder drag or cash drag in the sense that they earmark a dollar for that investment. But it wouldn't be uncommon to be three, four or five years and you may only be called 40 to 60 cents on your commitment. so That's tiring for some and challenging for some because they've earmarked a certain amount of money to do this, but they're like, you're not calling it i can't put it to work so if you don't have clarity around that that can be challenging and then the distributions coming back to the limited partners in that fund can be challenging as well because again
Speaker: You don't know when. the underlying asset management firms that you own a piece of are going to monetize the portfolio companies in their fund thus it's hard to predict when they're going to create carried interest for themselves that you would then own a piece of so what's happening now
Speaker: is these staking firms are getting more creative in terms of how they create DPI for the limited partners in their fund. So what they will commonly do is they will pull other levers or grab other clubs out of the bag, use whatever analogy you want, but they will execute on strategies like strip sales and securitizations and dividend recaps and those types of things that will create cash flow back to the limited partners of their fund that does not necessarily rely
Speaker: on the portfolio companies that they've acquired stakes in, the asset management firms themselves, to exit businesses in order to create economics for them. So there's a lot of different levers that can be pulled, but the underlying message here is if you are an LP in a GP stakes fund,
Speaker: be perfectly aware of how your capital gets put to work. how it comes back to you, and then what your redemption mechanism may or may not look like.
Speaker: And it's why we're seeing an evolution in these structures. And similar to us, where we've gotten involved is it's not just what you own, but it's how you own it. Right. Owning these things and wrappers that are a little bit more LP friendly because maybe they give you more linear cash flow distributions or maybe they provide you with a mechanism that looks like a liquidity offer after a certain period of time via some sort of tender or things like that. And now we're even seeing structures out there that can literally offer these types of assets and registered fund formats. So there's a lot of different ways to own them. It continues to evolve, but they all have their pros and cons, certainly.
Speaker: And this is where I'm going to put my Queen of ah Alts crown on with the cynicism that comes with it. I like to remind advisors, our industry is very creative.
Speaker: as a way to try to help the end investor gain comfort with a certain investment style as you're pointing out we've had a lot of discussions about liquidity because of what's going on in private credit markets over the last few years. At the end of the day,
Speaker: Not everyone needs to be in these products.
Speaker: You want to have conversations with your clients about what their liquidity budget is. And I talk about liquidity budget a lot because I don't think it's a conversation advisors have enough with their clients, but it should be part of the introductory conversation of the relationship in general, which is how much money are you comfortable tying to something? Because no matter the structure of these products, they are inherently less liquid. So no matter how hard one of these stakes platforms or stakes firms wants to make it,
Speaker: Seam from a marketing perspective more liquid or create structures to enhance liquidity We want to make sure that the underlying investments of the fund are A, what we think we're investing in. So if you are investing in GP stakes, the majority of what...
Speaker: You want the fund to be participating in SGP stakes and not some of these tertiary and derivative ways in which to invest to ensure that there's some cash flow to the investor. But also...
Speaker: If your client's not comfortable with illiquidity, they shouldn't be in a product that has illiquidity. Period. End of story. There's no amount of convincing that will change that. And it's going to be painful at some point in time. There will be a conversation. that will be painful where you will try to explain to your client that they knew it was illiquid and the client will be like, but I was never comfortable with illiquidity. So I think that to your point, there are a lot of new and creative ways that firms are coming to the market with product structure. and ways in which to incentivize LPs and placate them in many ways to ensure that they're getting some return and they're not waiting the five to seven years of the J curve to get some return on their investment. But at the end of the day,
Speaker: They are a liquid and you should not necessarily expect to have immediate return of capital or any sort of income on these products. And that is an important caveat. But let's get into the next part because this is the part where...
Speaker: this despite that you would still consider investing which is the monetization and the potential upside capture and return potential of these products why anyone would want to sacrifice the liquidity and potentially lock up and not see any sort of
Speaker: capital returned to them for a year two years to your point cash drag in their own portfolio there there has to be a return consummate with the risk that you're taking of those things so let's talk about the return aspect and the monetization aspect and why ultimately it's worth it to take on those additional hurdles or restrictions if you will as an investor for what you get in the long run.
Speaker: Yeah, look, I think you hit the nail on the head and and acknowledging the fact that. nothing has perfect liquidity, right? There's varying degrees of conditional liquidity that exists. And for investment advisors, that's your job, right? You need to know how to understand what those different terms, what those different liquidity thresholds and structures and strings attached effectively mean for your client, because you you are 100%, right? I can promise you, even if the advisor sent the PPM or whatever the sub hoc was to the client, the likelihood of them a reading it and then b remembering that the terms of that conditional liquidity at some other point in the future are slim to none like any asset class whether it's gp stakes or venture or anything else
Speaker: If you're going to tie up your capital, you should command a higher threshold for expected value or expected returns, right? that's It's all related, right? If anyone is trying to sell you on the idea that you're going to have maximum returns with no risk and perfect liquidity, I think we all know that those things don't necessarily...
Speaker: fit well together or they haven't, at least historically speaking. So you have to get comfortable with what those different liquidity mechanisms look like. And depending on how much illiquidity you're willing to sit through should dictate the types of returns that you're targeting or you should expect to receive, at least for us at Kaz.
Speaker: Our threshold is if we're going to lock up money for a long period of time, we would better be targeting at a minimum of a 2x and a 20 plus net IRR. GP stakes, more broadly speaking, fortunately, have meaningfully exceeded those return metrics over time. We've been in the space for about a decade or so now. So we're certainly one of the more tenured investors there. The reason the private market comps don't carry the same beta or correlation that the public market proxies will is because it's a different set of ingredients that drive the enterprise value, the marks of the asset management firms. And what I mean by that.
Speaker: is because we sit on the house side of the equation, the existence of AUM is more important than the performance of their AUM. So that's why they're going to measure and mark differently. And then the other thing that's just a personal pet peeve of mine when we talk about different me measuring sticks, if you will, for different types of assets, for different types of structures.
Speaker: is make sure you're measuring the performance of a fund based off of the type of structure that it is. Use IRR and MOIC when it's applicable. Don't use it when it's not, right? Talking about a drawdown framework. So it's incredibly important.
Speaker: That if you're looking at a GP stakes drawdown structure, that you look at it through the framework of an MOIC and in an IRR, if you will. Whereas if you're looking at an evergreen structure, that's a fully deployed pool of capital from day one, as opposed to one you have to stage into over time. Someone on the cover could look and say, hey, the IRR of structure A is 22, but the performance of structure B on a fully deployed, fully invested compounding pool of capital is 17.
Speaker: I'm taking the 17 all day every day. Right. Because. You can't eat IRR. You can eat DPI. Right. And I want to have a mechanism where I know.
Speaker: all of the dollars that i've earmarked are getting some sort of P and &L attribution to them from the get -go as opposed to an IRR that may be on a not a meaningfully invested pool of capital. so understanding how they're measured and how they're structured are as important as anything else that you would look at when you think about the liquidity of these assets and tethering that to the expected rate of return that you're looking to achieve.
Speaker: And I actually am gonna... go on a bit of a tangent, but This is... related a little bit that also is worth noting with interval funds. We run into this a lot, interval funds.
Speaker: Because they have tickers and trade -on exchanges and not... Bye. Take that back. They don't necessarily trade on exchange. but Because they have tickers, because they're... quote unquote, more liquid. with the quarterly redemption of windows and things of that nature, people look at the returns because they're published on a monthly basis and they're always seem disappointed. But the point you're making is that many times these interval funds are products that are investing in things that.
Speaker: really normally would go in an IRR structure versus a daily liquid structure. And so comparing, say, a venture capital fund that has a stated IRR and you can see historic vintages and whatever.
Speaker: And you can know where you're going there. Versus they have to actually mark a nav. and have some returned even if they haven't Actually... exited anything.
Speaker: That looks really bad compared to an IRR, but it doesn't mean that they're doing anything different. It's just the mechanism of which they have to. report performance so i always like to remind people of that when it comes to interval funds because interval funds are hard because they do report as if like a normal evergreen fund on their websites but In actuality, they really should be considered more like an IRR product, even though that is not a ah statistic that you ever see associated with interval funds.
Speaker: But I digress. To your other point, these conversations about liquidity and understanding, and as you were saying, most clients aren't going to read the PPM start to finish. They're relying on the advisor to do that. One thing I think all advisors should be doing whenever they're considering any kind of private placement product.
Speaker: Whether it be an evergreen private placement, something that has like... non -daily liquidity so a lot of hedge funds have like monthly liquidity quarterly liquidity or so on and so forth interval funds or the like is have the conversation prior to making the investment And then...
Speaker: You know cemented in your IPS Your investment policy statement should have some measure around that so that in the event that the client comes back to you and says, but I didn't understand.
Speaker: The IPS sits there as the mechanism for which you've memorialized all of this. And so I think that liquidity budget conversation those conversations about call what to do with money that hasn't been called yet things of that nature should be memorialized in the investment policy statement for everybody's benefit and more importantly from the advisor benefit just from a regulatory perspective if it ever advisors Very good advisors you get one upset client and all of a sudden you have a complaint
Speaker: and you have the regulators coming at you. Having these things memorialized, I think is really important because you want to make sure that your client was aware, but also that it's documented that the discussion happened and in a way that the client can reference as well.
Speaker: So with that we're getting to the the time we have allotted and I think What I'd like to do now is From your standpoint, why should advisors be considering GP stakes?
Speaker: why now and then if there's anything you think i miss as we're trying to educate our audience on this product which is fairly new to the advisor audience because prior to this gp stakes As you point out, it's a niche.
Speaker: product to begin with but also even more niche when you consider that it's only recently been available to this channel of distribution Yeah, I think that's right. And for those of you who want to learn more about GP stakes, there's a plethora of resources out there. I know we actually will have ah a white paper available on the Bondrian platform for those who want to download that and then review it and again. it's
Speaker: fund agnostic. It's just talking about the industry as a whole. And it will touch on, I think, what a lot of the early questions were surrounding the asset class, which is like, why would an asset management firm sell? What are the use of proceeds? I think a lot of those things have been addressed maybe too much at this point and put to sleep. And I think folks are comfortable there. But the biggest reason is there is no other strategy out there, at least in our opinion, that exists that is going to get you the amount of diversification that you would want to get out. side of a fund of funds, but without a lot of the downside of a fund of funds, if you will. In its essence, GP stakes is nothing more than, again, capturing private market exposure from a better seat in the ecosystem, the house side of the equation. We still want the assets that the asset management firms we invest in to perform well, because that generates dp DPI for investors so they can re -up to the next cycle and around the flywheel keeps turning. But again, the number one thing you need to know here is when you're on the house side of the equation, the existence of AUM is more important than the performance of AUM. Whereas if you're only a passive LP in a private equity fund, you need that manager to get some sort of multiple on invested capital in order for you to benefit. If you're the house, that doesn't necessarily have to be a true thing, right? You're getting paid management fee revenue, irrespective of how fast or slowly you call the capital or how well or poorly you deploy the capital. Now, that's not a reason to just own every asset management firm under the sun for the sake of owning it. Security selection still matters and you still have to be comfortable with the management team, et cetera, et cetera. So there's a lot that goes into that. But at the end of the day, it is a picks and shovels approach to private markets that can check a lot of different boxes. I know you had alluded to it earlier about like, where does it live in an asset allocation context? And I think the beauty to GP stakes.
Speaker: is it's a little bit chameleon like in the sense that it can do a number of different things some people we've seen put gp stakes not necessarily in credit but maybe in an alternative income bucket
Speaker: Because while it is not credit, it has credit like attributes with respect to the cash flow, because, again, the management fee revenue is predictable. Right. And you own ah a share of that. And that will generally speaking underwrite to a mid single digit cash on cash yield. And then when they create.
Speaker: carried interest or incentive fees, performance fees, more broadly speaking, depending on the type of asset management firm it is, then that's going to unlock incremental capital to the owners of those businesses or the staking platforms themselves. so It is just a way to, I think, benefit from private market exposure that's differently than being locked into a single vintage in a single asset class with a single manager and reliant upon hoping that particular vintage is a strong vintage
Speaker: Yeah, and I think the fund to fund the comparison is an important one. The benefit of the fund to fund is that you can fire a manager at any time if you set it up as a separate account structure where they're working on your...
Speaker: banking platform and your custodial platform and not their own. You don't have ah a ton of risk in terms of other investors and how a fund might be liquidated or things of that nature. But the downside of a fund to fund investment is you're paying the management fee and the
Speaker: two and 20 of every fund inside of the fund and the fund itself where that is not the case with gp stakes so there's pros and cons to both but they sit in that same bucket i also think gp stakes in general tend to be more diversified fund of funds can get really focused on certain i want to invest in mid -market private credit so it's a mid -market private credit fund of funds whereas gp stakes can be much broader than that because you're looking at the underlying investment firms themselves which may themselves have diversification across so i think that is a good place to end the conversation what our audience
Speaker: has seen across the episode is a lot of the the terms that we use need some additional definitions so you'll see that throughout the episode we've put that in in the video so that you don't have to go to investopedia not that i don't love caleb silver and investopedia and look up all the terms but that is a good resource if you do feel the desire to do that. But we wanted to simplify that a little bit. And I want to thank you, Clark, for participating today, for introducing our advisors and our listeners to the concept of GP stakes.
Speaker: And can you just tell us where we can find more information about CAS investments and some of the resources you mentioned? As you put pointed out, some of these resources will be available on the Bonnerian platform for advisors that are members and part of the Bonnerian ecosystem. But for those who are not, where can they can go to find this information? Yeah, casinvestments .com. No shortage of information there, not only regarding GP stakes, but many of the other verticals where we've got our team and shareholders capital deployed, whether that's sports, energy, venture, etc. But yeah, I think the best starting spot would be right there on on your platform where white papers, case studies, and all of our quarterly updates live now.
Speaker: Fantastic. well Thank you for your time. And thank you everyone for listening. We're super excited for this next season of What's the Alternative. We have some really exciting news coming in the very near future that I can't wait to share with you. And as always, remember to like and subscribe if you have ideas or concepts that we haven't discussed or that you would like discussed in greater detail. please leave a comment and let us know. We appreciate your support. Thank you again for nominating us for The Wealthies. We...
Speaker: are glad that we're making a difference in your practice and helping you become more educated in the world of alternatives. And until next time, I am Shana Orzick -Sissel, the founder and CEO of Bond Marine Capital Management.
Speaker: And this is What's the Alternative?
Speaker: The opinions expressed on the What's the Alternative podcast are for general informational purposes only. and are not intended to provide specific advice or recommendations for any individual or an Any specific security. This is only intended to provide education about the financial industry. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. Any past performance discussed during this podcast is no guarantee of future results. The guests featured on this program are participants on Bonnerian Capital Management's platform. As such,
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