Raising ever-bigger funds is one way to grow a private equity firm. Bringing outside investors aboard is another. While some bulge-bracket firms, most notably the Carlyle Group, have been moving in this direction for decades, selling minority stakes is a relatively new phenomenon in the middle market. But the private equity industry is maturing, and at firms founded in the 1980s, some general partners are seeking liquidity. They are also eyeing the chance to expand.
In April, the Riverside Co., one of the most active private equity firms in the middle market, sold a minority stake in the firm to Parkwood LLC, a private trust company. In May, Accel-KKR sold a minority equity investment in the firm to Goldman Sachs Asset Management’s Petershill program. Over the last few years, several middle-market private equity firms, including Littlejohn & Co. LLC and Vista Equity Partners, have brought aboard outside investors to fund expansion.
In the case of Riverside, Parkwood CEO Morton Mandel and Riverside co-CEO Stewart Kohl have known each other for more than 10 years, and Parkwood has been a limited partner in various Riverside funds for seven years. Mandel, a long-time business leader and philanthropist in the Cleveland area, approached Kohl about buying a stake in Riverside years ago. (Riverside is headquartered in Cleveland and New York.)
“This relationship had been building,” says Béla Szigethy, co-CEO of Riverside. “Mort talked to us over 10 years ago. He was really ahead of his time. We weren’t considering this then, but as more and more general partners look for access to capital and the market becomes more competitive, we thought now was the right time to enter this type of relationship.”
“We do not want to spend the next 10 years building our next idea. This capital allows us to explore new opportunities and act quickly when appropriate,” he says.
Riverside intends to spend the capital from the deal on its new debt lending business, its deal businesses in Europe and Asia, and acquiring other private equity firms. “The most immediate opportunities in front of us are to build our credit platform,” says Szigethy. “Having said that I don’t want to ignore that there are significant opportunities in Europe and Asia. Because those opportunities are right in front of us they may take precedence.”
Buying other private equity firms and folding them into the Riverside brand has been on Riverside’s radar for some time. “We have been approached about two dozen times by private equity firms from different countries or with different specializations who were looking to join up with a firm that has a strong brand, back office and origination function. Before, we were interested in this idea, but now with this capital I can see it becoming a reality,” says Szigethy.
Consolidation within the private equity industry may not be that far off. As it becomes increasingly harder for PE firms to raise funds and grow their businesses, some firms may look to buy other private equity firms, which may allow them to offer new specializations or lines of business. Perhaps this trend is already underway. In April, Schroders announced that it was acquiring private equity firm Adveq. Adveq focuses on global small and medium-sized buyout, turnaround, and growth and venture opportunities. Until this deal, Schroders’ private asset business focused only on real estate and infrastructure. Adveq will continue with business as usual.
Parkwood’s ownership in Riverside is less than 10 percent and is a non-voting stake. Riverside expects Parkwood to continue to invest as a limited partner in its funds, although that isn’t mandatory. Mandel spent 36 years as the chairman of the Premier Industrial Corp., a leading distributor of industrial parts and electronic components.
“Fit is very important,” says Kohl. “The wrong partner can make one plus one equal less than two, while the right partner can make one plus one equal more than two. We hold Parkwood in the highest esteem. We are in tune with its mission, which is charitable. We are happy to make money to help Mort and his entity fulfill their philanthropic mission. Mort made his fortune from nothing more than the enormous human capital of Mort and his two brothers, and he does a lot of good with it. We are pleased to be partners.”
While this is the first time Riverside has taken capital in exchange for a piece of its business, it may not be the last. However, there are no plans to sell more of Riverside. Szigethy and Stewart plan to remain co-CEOs and have no plans to stop running Riverside or to make personnel changes.
The Riverside-Parkwood deal comes at a time when it has become harder for private equity firms to achieve growth as a result of increased margin pressure. Capital infusions help private equity firms grow more quickly than they could organically in today’s environment.
Over the past two years, a number of private equity firms have taken this route. In 2015, Vista Equity Partners sold a less than 20 percent stake to a consortium led by Dyal Capital Partners—a division of Neuberger Berman that focuses on making minority investments in private equity firms and hedge funds. In 2016, Dyal also made a minority investment in KPS Capital Partners. Both were non-voting ownership interests. Other firms are getting in on the action. Wafra Investment Advisory Group, a $15 billion money management firm owned by the Public Institution for Social Security of Kuwait, acquired a 10 percent passive interest in private equity firm TowerBrook Capital Partners.
Because of the increase in deal activity, private equity firms see the appeal in selling minority stakes in their firms. The first reason is there is a consistent need for capital at the fund level. General partnerss have to make commitments to their funds. As older GPs funnel out and newer GPs have to put up capital, there can be a gap because the younger GPs simply can’t uphold their end of the bargain. Many times the older GPs are lending capital to the new generation of GPs. However, capital gained from a minority sale can help fill that gap. Additionally, private equity firms need capital to grow. “Private equity firms sometimes use the investment to broaden the ownership base, including bringing on the next generation. A minority sale can ease a generational transfer issue. It also gives private equity firms the option of expansion,” says Sean Ward, co-head of Dyal Capital.
An initial public offering is the alternative to a minority sale, but there is no guarantee of a successful offering. Going public is pricey, and it gives many companies unwanted exposure. “While we certainly purchase at a discount to public market valuations, our managers also don’t have to deal with the expense and other headaches of being a public company. They also benefit from the opportunity to establish deeper relationships with our broad array of institutional investors and the strategic assistance of our dedicated operational team,” says Ward.
The trend of buying stakes in private equity firms started with the largest private equity firms many years ago. For example, in 2000, the Carlyle Group (NASDAQ: CG) sold about a 5 percent stake of itself to the California Public Employees’ Retirement System (CalPERS), which was, and remains, a limited partner with the firm. Then in 2007, Mubadala Development Co., a sovereign wealth fund of the Abu Dhabi government, bought a 7.5 percent stake in Carlyle for $1.35 billion. At the time, that deal was met with resistance. The Carlyle Group came under fire for the sale. In fact, a California state legislator had written a bill to block state pension funds from investing in firms partially owned by sovereign wealth funds of governments with poor human rights records. The deal ultimately went through. Both CalPERS and Mubadala reportedly tripled their investment when Carlyle went public in 2012.
“The reasons for selling a minority stake in a firm vary from wanting a liquidity event and getting cash off the table to wanting to work in partnership with a firm. In our case we never sold a voting stake, but it gave us capital to grow and expand,” says Christopher Ullman, a managing director with Carlyle.
Many larger private equity firms and banks followed suit around the same time. The China Investment Corp., which controls $200 billion in sovereign wealth funds, took a $3 billion stake non-voting stake in the Blackstone Group (NYSE: BX). Abu Dhabi’s sovereign wealth fund invested $7.5 billion in Citigroup (NYSE:C), the largest U.S. bank. Singapore’s government put $9.72 billion into UBS, the big Swiss bank. Apollo Management (NYSE: APO) sold a little less than 10 percent of itself to the Abu Dhabi Investment Authority, a long-time limited partner.
While this trend first started making headlines when the largest firms such as Carlyle and Blackstone did it, Dyal Capital Partners has been quietly buying minority stakes in private firms for almost 20 years. Founded 19 years ago, today the firm has bought stakes in EnCap Investments, HIG Capital, Providence Equity, SilverLake, Starwood Capital Group in addition to Vista and KPS. Many of the deals were completed in 2016.
The firm has raised three different funds and has $8.7 billion of capital under management. Dyal originally started by buying stakes in hedge funds, but started including private equity firms after doing what the firm thought was going to be a one-off deal with Providence, but soon realized that this was a strong new line of business.
Dyal has no plans of letting up anytime soon. In December 2016, the firm closed on $5.3 billion for its third fund, surpassing its target of $2.5 billion. Dyal is the largest firm taking passive interest in private equity firms. Its limited partners include large institutional investors like the State of New Jersey, the State of New York, the State of Minnesota and The Alaska Permanent fund. Sovereign Wealth Funds are also investors.
Limited partners are showing a strong interest in taking ownership in private equity firms, which makes sense. The capital goes directly into the private equity firm, meaning there is no J curve and there is consistent yield unlike investing in a fund where are fees and a typically long period before distributions begin. In fact, according to an internal review by CalPERs, the pension funds private equity returns were 12.3 percent over 20 years, but they would have been 19.3 percent without fees and costs. The pension fund is looking to make changes. However, there is a downside to investing at the firm lever: there isn’t necessarily a liquidity event to look forward too and capital can be tied up for a very long while.
That said, it’s interesting to note that as the largest private equity firms have grown they are now also taking stakes in smaller firms. Just last year, Goldman Sachs (NYSE: GS) through its Goldman Sachs Asset Management Petershill program, jumped into the business raising $1.5 billion to buy minority interests in private equity firms. In 2016, Littlejohn & Co. LLC sold less than 10 percent stake to the firm. The Petershill group also bought a minority stake in ArcLight Capital Partners.
Also in 2016, Blackstone officially closed a $3.3 billion fund to buy minority stakes in hedge funds and private equity firms. The firm has taken positions in four hedges funds to date. Blackstone has taken a minority stake in Marathon Asset Management, Magnetar Capital, Solus Alternative Asset Management and Senator Investment Group. They have not made an investment in a private equity firm yet.
“We are not the first to do this, and we won’t be the last,” says Szigethy. “It might be something we see more of going forward.”