E248: The Institutionalization of GP Stakes: What Comes Next

0:00Mark, it's good to see you. Hello, David. We're here at the Future Proof Conference in Huntington Beach. It's good to have you back. It's good to be here. It's good to see everybody. What have you? I've never been here before. I've never done this. This is my first time, so go easy on me. I'll try. No promises. So let's start with Kaz. So for those who might not know what Kaz is, what is Kaz? And tell me where you are from an AUM standpoint. Describing where we are today is largely a function of where we've come from. I started at the firm about 10 years ago. We were less than$300 million in AUM.

0:32And I think I was like number 11 or 12 in the office that day from an employee headcount. And fast forward, we're over$10 billion and probably about$100,$110 from the team member count. So we've grown quite a bit. All that's focused in the private markets. We don't really invest a ton publicly. and you guys are the most active investor in GP stakes in the world. Tell me about why you guys are leaning in so heavily into GP stakes and maybe tell me a little bit about what a GP stake is. To understand why we like GP stakes, you really got to understand the theme. So if you read anything from Kaz, we talk about being a thematic investor and people use that phrase thematic or theme-based and it means different things to different people.

1:15So I'll just explain what it means for us. What it means for us is we identify a trend, something happening in the world that we want to take advantage of from a big picture standpoint, something that has a tailwind behind it. I'm not talking about a short-term thing. I'm talking about two years, five years, 10 years, or even more. And so thematically speaking at GP Stakes, what we're really talking about is the growth of private markets as an asset class. So it's pretty well documented over the last 5, 10, 20 years that the private markets have grown at a pretty significant compounded growth rate, different numbers quoted out there.

1:45I'll let people go find their own data on that. And it's going to continue to grow. It's going to be very hard to win an argument saying to be the manager of those funds, to be the GP, the beneficiary of this capital coming in, isn't a good thing with all the capital coming in. So we want to be in that position. We want to take advantage of it by owning a broad-based portfolio of GPs, private equity, private credit, real assets, and then selectively, just thinking about our firm's broader strategy, very selectively picking where do we want to be an LP in these underlying funds of these managers.

2:14So double click on that. So you're investing in a private equity fund, a private credit fund. How are these GP stakes structured and why is that more favorable than just being an LP in the fund? On the structuring side, this market has changed quite a bit. Ten years ago, when I first started at CAS, I was a 29-year-old associate right out of business school. I didn't know really what anything was in the world. I just had my first kid. Now I've got four. And so a lot's changed for me personally, and a lot's changed in GP Stakes. It used to be these firms were just basically selling common equity interest, profits interest in the business to capitalize them to move forward.

2:49That's changed to today. There's a lot of different structures out there. There's lots of different firms that are trying to do different types of structures to invest in common equity, preferred equity, NAV loans. There's a lot of different words for it. We remain focused on earning the equity of these businesses. We're not really a lender. We don't want to be a lender. I don't participate in the full upside. If I'm just a lender, I want the equity side of the ledger. And so transitioning from that, thinking about why these GPs are selling, what the opportunity is, it's growing. They need capital to grow.

3:22They need to finance these opportunities that are coming to them. They largely face the question of, okay, if I want to grow my business, if I want to increase my AUM, GP stakes requires capital, right? You have to invest a lot of money as the GP in your underlying funds. It's not like traditional asset management. Why is that? Well, think of it this way. I'm sure for the folks sitting in the audience here today, one of the first questions they ask a GP, what they're investing in, is how much is the GP investing, right? The GP commitment. Blackstone is the biggest private equity firm in the world.

3:54They manage over a trillion dollars. BlackRock is probably the biggest traditional asset manager in the world. Well, who asked how much of BlackRock's money is actually BlackRock's money, right, that they managed? Not a lot. It's a big question in private markets. So they need to help finance that growth. We can help be a provider of that capital in order to do so. Cynical people will look at the GB stakes and they say, well, you're misaligning incentives. You're letting managers take money off the table. Why are you not being adversely selected as investor in GB stakes? That's a common one that makes a number of assumptions that I think aren't correct.

4:27first off is it assumes that these are secondary transactions, simplistically meaning if a GP is selling a stake, they're not taking any capital into the business, they're taking money out of the business. And for the vast majority of transactions, that's not the case, right? It's primary capital or a combination of primary and secondary capital. And so if it's primary capital and it's dilutive, well, I'm a cynical person, right? I think people are going to do, especially in the financial world, whatever's in their best interest. And what that means is In this case, if a GP is taking primary capital into their business, they're being diluted.

5:01Why would they do that? There's really only one reason. They think they can make more money for themselves by using somebody else's money. GP stakes, I think, is a misnomer. We did a podcast and we had Michael Reese on from Blue Owl. It's a big partner of ours, and we love those guys. Thank you. You put a billion dollars. We put a billion dollars into Fund6. Big, big fan of what they do there. And we talked about how we shouldn't have called it GP stakes. We should have called it GP growth capital. Because everybody invests in venture capital. Everybody invests in growth capital of technology companies out there.

5:32And nobody worries when a company sells a stake in itself to finance their growth. Right. That's that's not a problem. But when GPs do it, it's like, whoa, wait a minute. Wait a minute. What's going on here? They're growing. Right. And so the primary capital is accretive. It needs to be accretive to the GP. Otherwise, it doesn't make sense for them to do it. Right. You wouldn't you just wouldn't do it. So I think from that standpoint, it's really just math, right? It's math around, can I take the dollar from somebody else and go turn it into more? And the sticking point here is, do I want to have a slightly smaller piece of a much bigger pie?

6:06There's really two kinds of people in the world, pie people or slice people. People who are slice people, meaning how much is my slice of the pie, they're more worried about this. They typically are not going to sell a piece to their firm because they don't want partners. They want to keep it all for themselves. Pi people are focused on making the pie as big as they can be and looking for partners to help them do that with. And at this point now, just on the adverse selection side of it, there's a lot of data out there about this, about GPs that have sold a stake in themselves. It used to be thinking, okay, if this GP is selling, what's the problem, right?

6:38They're selling because they don't want to own it anymore. Well, they're selling 5%, 10%, 15%. They're not selling 55%, 60%. That's not what I'm talking about. That's not really what we do. So in that case, you know, you can't really make the argument that there's an adverse selection because if they're selling a minority piece and then afterwards you get to observe what happens to the firm, how fast do they grow, how fast do they not grow? It actually is the opposite. The top performing GPs are the only ones that end up get to sell a piece themselves, particularly institutional buyers, because there's a wide selection of GPs out there.

7:10Many of them are right up and down this, you know, wealth walkway, I think as it's called. What exactly are you buying and what are the two or three most common uses of your investment capital? Yeah. When we invest in a GP, what we're looking for is clear, visible cash flows. So hard stop, somebody should invest in GPs, GP stakes, GP growth capital if they want cash flow, right? It should be a cash flow investment. Where does that cash flow come from? It comes first from management fee profits, right? Everybody's familiar with the 2 % management fee or whatever that number is, 1.5%, 2%. We get a very consistent yield from that management fee component.

7:50And then there's this upside that comes on cash flow from carried interest when the GPs do a good job of investing the dollars and see a return on it. And then there's additional upside in the growth and the enterprise value of the business, what you bought it for versus what you can sell your interest for or what the GP sells for down the road by how much money they raise. So it's really about fundraising and it's about investment performance. When you're deciding to invest into the manager versus as an LP, how do you look at that differently? A lot of people in the audience are familiar with being in an LP and a fund.

8:21How is it different when you invest in a GP? Are there certain cases where it makes sense to invest in a GP and not the LP and the LP and not the GP? And how do you kind of disentangle that? Absolutely. There are situations, you probably have heard the saying, I'd rather be an owner of the business than a customer. That's true here as well. When you acquire a GP interest, you're underwriting many of the same risks, but not all of the same risks. And frankly, there's different ones. It's easy to observe investment performance, the track record. It's easy to observe the partnership. Is it stable?

8:55Do they have a longevity there? But it's more so than just what the next fund's going to be. Because when you're an LP investing in that fund, all you really care about for the purposes of that decision is what does that fund look like? What are they going to do? Who's the team that's going to manage it? What are they going to buy? That sort of thing. you're not really thinking about a vintage past that. You likely may be from an underwriting standpoint because you want to stick with the team through time. But for the purposes of that decision, it's really just what's happening there. As opposed to when you buy a GP interest, you're thinking about three, four fun vintages from now.

9:25You're thinking about 10, 15, 20 years down the road, because presumably if I'm buying the interest and I want to sell it, I need to think about who am I going to sell this to? And is somebody else going to want to buy this from me? So you really have to look out into the future. So you're not just looking at who's the partners at the firm now, but who's the second tier going to be? And who's the third tier going to be? And how is the partnership thought about bringing those junior folks up and elevating them within the organization? The one that also nobody thinks about because it's just not top of mind is the LP base and the quality of the LP base.

9:56When you invest in a GP, what you want to look at is you want to see the LP base and you want to see how sticky is that LP base, how diversified is that LP base. If one LP is 30 % of the capital, there's a lot of risk around that. If you're going to make an investment in that firm, you better know about that relationship and understand what are they planning to do, right? And what are the alignment of incentives there? Otherwise, a diversified LP base, lots of different channels, not just the wealth channel, institutional, insurance, sovereign wealth. There's a lot of different factors that go into it.

10:21An LP decision, and this kind of gets into, you asked the question earlier, I think I remember now, why is it a better way to invest in private equity? When you make an LP commitment, you may not realize this, but you're actually making a very specific bet. You're saying, I'm going to pick this strategy in this asset class, in this vintage with this manager, right? That's a series of very specific bets. And that's not a bad thing. I'm not saying that's a bad thing. There's a time and place for that. If you think you're really good at that, I would love to talk to you in the ground, right? Because we have a very high paying job for you at Kaz Investments, right?

10:55And I mean that, but it's hard. That's a very hard thing to do. I would rather diversify those risks away by picking the right GPs and owning an interest in their business because I get exposure to all of their underlying assets or almost all of them. Typically, these investments are made across the entire platform, not just cherry picking one fund at one point. It's kind of like investing into a tech startup versus investing in an entrepreneur. You know that this entrepreneur is going to be special. It might be this startup. It might be the next one. But here, it's kind of in the company. There's a lot of downside protection in these investments.

11:28Talk to me about that and specifically to talk to me about the CAS case that you guys have popularized? Contractually obligated management fees, right? That's a saying we have, and I'm pretty sure my wife has heard me repeat that in my sleep a number of times. When you buy into these private equity firms, it's locked up capital. It's the same reason why we don't really like doing it in hedge funds, because in hedge funds, they have liquidity. If an investor doesn't like the experience they're having with a hedge fund, they can redeem them. You don't get to do that in a private equity firm, right?

11:57You invest in that fund. You sign that sub doc as typically 10 years that you're in that investment plus two one-year options. And then you get into the period of time when you start haggling with the GP about when are we going to end this, right? 12 years down the road. So we think that the private asset management business has inherent downside to it that's very uncommon because of that management fee that's paid on capital commitments. It's very stable. You can run your business at a very high degree of profitability because of the predictability of that management fee, right? So that's the downside.

12:29So you can get that wrong, right? You can overpay for those fees, right? Like any other asset. But if you do it right, if you diligence it right, you're going to get a return of your capital back typically from those management fees alone. And then the upside comes from investment. So oftentimes they're getting 1x in contractual management fees. Yeah, you talk about the cash. Institutional LPs, like the endowments and pension funds, very good creditors to have as an investor and you're getting the 1x downside. And yeah, so tell me about the CAS case and how do you go about seeing whether that exists?

12:59One of the things I think that separates CAS from a lot of other firms out there is our alignment of interests with our LPs. We talked about this earlier this summertime. We've got collectively now our team and our shareholders have about$700 million of our own money invested in our own vehicles. And GP Stakes is the biggest piece of that. Of the 10 or so billion we manage, six of it is in GP stakes. So we have a lot of our money invested in this. My money, right? Hard-earned money that I never really thought that I would have at this point in time in my life, but I do. So what's goal number one?

13:30Don't lose it, right? Don't lose it. So the CAS case goes like this. We ask, and if you were to pull aside the leaders of the firms here that we invest with, say, okay, talked about this CAS case. What we ask them to do is show a model that says, okay, this GP that has a very successful track record of investing the last 20, 30, 40 years of raising more money, investing well, generating a profit for investors, they raise one more fund after we invest, one more fund. And it's at a fairly substantial size, not huge growth, but at a nice size relative to their last fund. Because if you don't think they can do that, you shouldn't invest at all, period, right?

14:07That's like a hard stop. So they raise one more fund and that fund exits at cost, meaning there's no carry off of that next fund. So you just get the management fees that come in from it. And their existing portfolio, you circle it and say everything exits right where it's marked today. Nothing goes up, nothing goes down right where it's marked. And if you do the math of what I've just described, this firm that has this great track record over time, they stop making money for investors. That day we invest, meaning there's no more profits generated for investors. to just get the fees from the existing portfolio and everything else is in the ground.

14:40And in that case, we feel pretty confident that we're gonna lose a little bit of money, but not like anything else. Because what you're basically talking about is this business, if you invest in any company out there that makes widgets, they don't make any more widgets or every widget that they make breaks for the people who bought it. That's a pretty bad case, right? And in that case, we get back somewhere between 20, you know, we lose about 20 to 40 % of our capital. And that's our downside. Curious about online trading, but haven't taken the first step? You're not alone. and plus 500 futures is a great place to start.

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15:37Check it out at plus500.com. Trading and futures involves risk of loss is not suitable for everyone. Not all applicants will qualify. Plus 500, it's trading with a plus. That's the base case when you look at a deal. What are you trying to do if everything goes right? Ultimately, this comes back to underwriting and underwriting is a very simple exercise that says, what are my given assumptions? That those assumptions then generate an outcome. And in this case, well, we want to underwrite from a, there's really two key risk factors. I said them already. One is fundraising growth, right? So how much money does this firm raise?

16:08And two is investment performance. Let's talk about the fundraising growth. We see some base cases from various sponsors that want us to invest with them. And they say, okay, this firm is going to grow fee-paying AUM by a 17, 18 % compounded growth rate over the next five to 10 years. And their investment performance is going to be consistent with what they've done in the past. And in that scenario, we generate a 20 % internal rate of return and a 3X multiple on our money. And we go, trash. No, thank you. Why? Because that's too aggressive. Your assumptions around what's going to happen in order to generate that target return, they're too aggressive.

16:45We want to see a very moderate growth rate in fee-paying AUM and investment performance actually below where it's been historically speaking. Because ultimately, if we're thinking about the downside, we have to plan for things to not go as well in the future as they have gone in the past. And so that's really what our base case looks like. And in that scenario, We want to see a high teens, low 20s internal rate of return and a three to four times multiple on our money. That's for true base case. And then there's always the management case. Right. It always looks a lot rosier than that. And really what you're trying to get a sense of, if things go wrong, what's going to happen?

17:22And if things go relatively right, what's going to happen? Knowing it's really you're going to be wrong on both of those. It's going to be somewhere along the spectrum. I mean, we have a famous now saying, at least internally for us, of the downside. If we get comfortable with the downside, the upside takes care of itself. We just need to be focused on seeing a return of our capital, particularly in the GP stakes world. It's got an inherent level of downside protection that we think is uncommon. One of the biggest criticisms over the last five years in the GP stakes industry is the lack of liquidity.

17:55When do you actually get your money back? There's been a lot of evolution around this in the last even couple months. Tell me about that. Yeah. So one of the other things about our business that I think is attractive is as investors ourselves. So we think about how do we want to deploy our own personal capital and then invite you good people to join us with us is structure, right? Many of the investments that we would want to make, we like the investment, but the structure around it, I'm sure folks here have seen that. There's just something about the structure that makes it challenging, right?

18:28That you can't get comfortable with. and the one in GP stakes, the one attribute has been this illiquidity, right? This thought that you have a very long dated investment that has no defined end date, no term to it, because many of them don't, and no way to get out. And so we've pioneered new structures to help investors get that liquidity via tender offers and secondary processes and things like that, that we manage ourselves as opposed to forcing LPs to figure that out by themselves. What does that mean practically? So I invest in CAS. It's 10 years from now. I want to take out the money. What are the options?

19:00Yeah. So one of the benefits of our model is that we have about 7 ,800 individual investors, about a little under 500 investment advisory firms in all 50 states and about 40 countries around the world now. That is a very fragmented LP base, right? And if you are a market participant, having that wide and fragmented of a market participant base is actually your friend, because there's a lot of different ways that you can think about getting liquidity, right? So we run an annual secondary process every year for our funds, and if people can opt into that, they can buy, they can sell. We actually have built it into the architecture specifically of some of these vehicles where they can raise their hand and say, hey, I want to take out all of my money, some of my money, in addition to the inherent levels of liquidity that come with GP stakes, which is a current cashflow yield.

19:51So the way I think about it is, okay, I'm going to get my money back on the average GP stake deal in probably seven or eight years, right? And just - You're getting the management - And just cashflow, right? Every quarter. All that comes out. So I got my principal back. And then from there, it's, okay, how long do I want to hold this for? All the while, you should see a capital account that's appreciating along the way. And heads, you're happy and you're getting a nice yield. I would say if you're getting a 10, 12 % yield at that point, what else are you going to go do with that money, right? to go replace that cash flow.

20:19But if you want to, then you can say, hey, I'd like to take some of this money out. I'd like to rebalance. You can do that. So I agree wholeheartedly on GP stakes. I have a lot of my own money in GP stakes. The next topic, sports, I disagree with you on. So we're in Lakers country right here in Huffington Beach. They just sold for a record$10 billion. Why is that not the top? Give me the bull case. Well, time will tell. I think if you look back at history, that's been said many times. Many times people have said, surely this is the top. How much more valuable can sports franchises get? There's really, ultimately there's one reason why any asset goes up or down in value.

21:04There's one. It's supply and demand. I don't care what anybody talks about from market fundamentals and operating profits and all this type of stuff. That's all a secondary factor to somebody else thinks that this is going to be valuable and there's more of those somebodies and the people who want to sell it and therefore the price goes up. Now, that applies in the sports world in a number of different ways because it's about capital. If you look at the, I'll give you guys an interesting statistic here. If you go back to the year 1990, there were 102 franchises in baseball, hockey, football, and basketball, right?

21:42Those four leagues, 102. There were 270 billionaires in the world, okay? So that's about 2.7 billionaires for every sports team. Fast forward to today, there's 124 franchises in those same four leagues. add in soccer, you get it to about 152. There are 2 ,700 billionaires. So the rate of growth of the number of billionaires in the world to the number of sports teams is significantly different. There's about 17 times the number of billionaires as there are sports teams. So when you think about, so that's like the money side of it. And we'll use that as just a simple proxy. Then you get into the actual fundamentals of this business and you look at how they make money and whether or not they're profitable and all these different factors.