E319: GP Stakes Investing: Liquidity, Alignment, and the Real Risk

15:54David Weisburd:You should perhaps borrow money from a bank or from another lender at the GP or not do it at all. Our capital really fundamentally is meant to accelerate the growth of the underlying managers.

16:06Todd Owens:When you think about starting new product lines, let's say you're in private equity, now you're starting private credit. Is there a way to structure these GP stakes in a way that you're only giving up the upside and the new opportunity, given that the downside is taken care of, or is it always at the parent company level?

16:25David Weisburd:That's a good question. So the answer is yes, you can structure it in such a way that the GP capital is, invests in only the GP of the new strategy. That's not an investment that cantilever likes to do because part of the critical thing in GP stakes in our view is full alignment with the partners and the principals who are running the firm. And if we buy only a piece of their business, then the alignment is not right. And so it's possible to do that. But many of those types of transactions are more structured. They're not equity. They can be a structured preferred or even a structured debt investment where the return is acceptable coming from the single strategy and where alignment is not as critical with the overall team.

17:15David Weisburd:But as equity investors in businesses, we want to invest in the entire business, not just a piece of it.

17:21Todd Owens:there's this evolving term GP solutions. So yeah, GP staking for the first decade, and now a lot of your competitors are focused on GP solutions. Give me some use cases of GP solutions that are being used in the market today.

17:38David Weisburd:Yeah, so you're absolutely right. GP solutions is the idea that there are a variety of ways that an alternative asset management firm can capitalize its manager. And so the way that we talk about a cantilever is a minority equity investment, but you could imagine a firm, and we run into this all the time, you could imagine a firm who would prefer, or which I should say, would prefer to do a debt financing. They're not selling a piece of their business. The cost of capital is effectively lower. And depending on what the use of proceeds is, that might be a more appropriate way to finance the business.

18:17David Weisburd:And so when we use the word GP solutions, it's a little bit like you can provide anything in the capital stack. You can provide equity, you can provide preferred, or you can provide a term loan. And that to me is capital solutions at the GP level. A more broad definition would also include things like secondaries, continuation vehicles, nav lending, and other products that while they don't sit necessarily at the GP the GP might use in their underlying funds.

18:55Todd Owens:You mentioned that the second most common use of GP stakes after growth levers is capital restructuring, taking out maybe partners that are no longer active, early investors that are no longer part of the fund. Talk to me about that. And how does that actually solve the problem? Aren't you just taking debt capital on the cap table and changing it to cantilever? How are you solving it? Support for today's episode comes from Square, the all-in-one way for business owners to take payments, book appointments, manage staff, and keep everything running in one place. Whether you're selling lattes, cutting hair, running a boutique, or managing a service business, Square helps you run your business without running yourself into the ground.

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22:54David Weisburd:Yeah, it's not necessarily debt capital that we're replacing, although it can be. In many instances, these firms have been created with the support of, for example, friends and family. And the firm's been around for 10 or 12 years. It's done very well, but not so well that the principals feel they can buy out the initial investors. And so our capital can provide a respectful exit for the early investors. It can consolidate a relationship from a bunch of early investors to one institutional capital partner. And that's really, really helpful in the right set of circumstances for some of these managers.

23:36David Weisburd:On top of that, there are many instances where the early investor was not, don't think friends and family, but think private equity or some other form of capital, where ultimately they need liquidity for their investment because they made it out of a 10-year fund, for example. And that fund is at the end of its life and they need to get liquidity for the investment. And so by stepping in and buying that stake, we can provide liquidity for a firm like that as well.

24:05Todd Owens:The third most common case you mentioned, taking money off the table. A lot of LPs are uncomfortable with GPs taking money off the table while they're investing to the fund. Talk to me about that. And what's a red flag? What's a red flag when somebody's taking money off the table and what's a legitimate reason?

24:25David Weisburd:That's a good question. I think it's an important, our view is that you have to underwrite the use of proceeds regardless of the use of proceeds. And furthermore, when you look at some of these firms that we're investing in, there's a lot of overlap between a personal balance sheet and a firm balance sheet. Those are not bright divisions in firms of this size or indeed in much larger firms. And so when we are underwriting a deal, what we consider is the implication of our capital being taken out of the system. In other words, taking money off the table for the principals, to use that term. And we want to make sure that the magnitude of that is not so much that we would expect the principals to change their approach, to change their commitment to their business, or really to change much of anything.

25:24And so we look very, very closely at our net proceeds that are leaving the system.

25:30David Weisburd:How does that look relative to the balance sheet of the partners who've taken the money off the table? And can we get comfortable with that risk profile? I think a red flag for us as a general matter is if we're investing in a firm where the principal is wealthy, it's unclear to us why they need our money. And so typically we would stay away from those types of situations. It's one of the reasons that we have a hard time getting comfortable with mid-sized hedge funds as a, for example, is because taking money off the table where the principal has already taken a lot of money off the table seems like a red flag does.

26:09Todd Owens:I think the devil's in the details here. There's a precedent in startup secondaries. So before it was this black mark for a founder to sell secondary. So even if it was a Series D, Series E, Series F company, VCs would not allow it. LPs were not happy with it. And then there evolved this use case where if you could get somebody to take a little chips off the table to remove some of that stress of house car baby, then you could really focus on how do we build a world class organization? Because what was inevitably happening with those startups is that financial pressure was forcing either that company to sell early or to go public early, both which were inefficient for everybody involved.

26:59Todd Owens:But there's this efficient frontier maximal result where a little money could actually help align everything.

27:05David Weisburd:Yeah, look, we believe that. And I should say that among the larger firms, more than half of them have sold GP stakes. And so the path has become somewhat well-worn. And concerns about selling a GP stake, I think, have diminished by virtue of the fact that many firms have done it. And there hasn't been a significant change in how they run their business or in what the returns are. And so I think that LPs and other investors are increasingly comfortable with it. That's not to say that there are certain LPs who remain skeptical about a firm selling a GB stake. But we do think fundamentally that our investment enhances the ability of the firm to grow, to continue to institutionalize itself, to diversify itself, to incentivize a next generation.

27:59David Weisburd:And when we make an investment, we are attempting to identify a firm that is a business, that will be in business for 10 years or 20 years and will continue to institutionalize itself. and that's really the point of our capital. If we see an opportunity where we don't think a firm is capable of doing it, that would be another red flag for us.

28:22Todd Owens:There's this art to that, which is what is a firm or maybe a founder or two and what is a business? How do you differentiate between those two things?

28:30David Weisburd:With difficulty, to be fair. That is a tough distinction to make. You get to know the firm, you get to know the principles, you get to know what they are trying to accomplish. you meet the junior team, you assess how committed they are to the business, what they see as their future with the firm. And all of those things can lead to a conclusion that it's a business rather than just an investment partnership. But sometimes, and we've seen a number of cases where we couldn't invest because it was not clear to us that it was a firm. We can underwrite lower growth in our investment model, but we have to have some growth.

29:09David Weisburd:It has to be a business. And what I say in some settings with potential affiliates is, I don't need you to double your business in five years. I need you to just be growing steadily. Doubling would be great, don't get me wrong, but I need you to grow steadily and I need you to be there in five years and in 10 years. And that's really the basis of our investment. What are you looking for in managers when assessing whether you want to invest in Zill? Any asset management business starts with returns? What is the return profile? How do they compare to other competitors? And what does that mean in terms of their existing LP relationships?

29:49David Weisburd:I mean, that's very fundamental. A second thing is, do we believe the management team? Do we believe the principals and founders want to continue to grow and build their business? We talked about that a little bit already. So that's fundamental as well. There are a lot of, I don't want to call it ticking the boxes, but making sure that all of the infrastructure makes sense, that the SEC filings are good, and all of those other things also bear on the overall underwriting. But really, asset management is a people business. You have to respect and trust the firms that you're investing in and believe that you're aligning your own interests with their long-term interests.

30:36David Weisburd:And that involves getting to know the principles and ultimately making that judgment. That's the most, I think, the most difficult and the most important thing that we do from an underwriting perspective. The firms that we're investing in are usually on their third or fourth fund. And so by definition, their performance has been good enough to get to a fourth fund. By definition, their relationships with LPs are good enough to get to their fourth fund. And at that point, you need to understand what direction they're taking the business, what they want to build, and can they replicate the success that they've had so far.

31:14Todd Owens:Like we mentioned, this art of figuring out whether they're a person or a firm in a sustainable business. How long does it take to assess that, the qualitative measures of a team and what the future of their firm looks like?

31:27David Weisburd:It can take a long time. I mean, we have for many of our investments, we are in conversations with the firm for a year or more. We have conversations ongoing today that are 18 months long. And so it can take a long time at a minimum. If we're involved in an auction process where there's a banker involved and they're speaking to a number of firms, that's a process that is pretty intensive. But it's three, four or five months, usually at a minimum.

31:56Todd Owens:So even though it's an auction, there's still a lot of dating going on to make sure there's fit.

32:01David Weisburd:There is. And the dating's important both ways. It's important for us as a minority equity investor, but it's also important for the affiliate to understand what we're motivated by. Do we have a common vision? Is this somebody that you want as your capital partner for five years, 10 years, 20 years? And that's a big step for any firm to take. And it's a big step for us to take as we're making our investment. And so we do spend a fair amount of time with the affiliates.

32:29Todd Owens:Are there cases where it's a good investment, you have downside protection, you see your path to your return, you decide to say no?

32:40David Weisburd:Yeah, for sure. I mean, that happens, has happened a number of times. Sometimes it's that we can't agree on price or that they have a higher priced offer from another firm. We lost two deals last year in each case because we were uncomfortable moving to a higher price. Both of those were great firms, but we couldn't get there from a price perspective.

33:08Todd Owens:So you invest and now you're a partner in the business. You own a stake of it. But how do you come in as a partner and provide value to the underlying GP?

33:17David Weisburd:We think about it really in three components. The first component is that our capital is by itself strategic. If the firm goes out looking for growth capital and decides to do a transaction, they need that capital to achieve some of their objectives, whether that's growing, whether it's capital restructure, the things that we talked about earlier in the podcast. So that's number one. Our capital is by itself strategic. Number two, we bring decades of experience advising asset management and alternative asset management firms. And as a capital partner, we are also a strategic partner. and we believe that we can help them think about strategic topics, how to grow, how to diversify, should we add a product, should we add a step-out investment strategy, should we hire a team, should we buy a team.

34:14David Weisburd:Those are types of topics that we have substantial experience in. And in the part of the market that we're focused on, these smaller firms, they don't always have ready access to that type of advice. And we have found that for the conversations that we have with potential affiliates, that that is a very attractive thing. And then the third bucket is really something that we'll build over time, which is to provide our affiliates with available services or offerings that can help them in their business. Many other GP stakes firms have built similar support structures. And we will, as we build our portfolio, add those as well.

35:00David Weisburd:That can include distribution, for example. That's a critical thing for these firms. It can include advice around generational transfer, another critical thing. But we will build that over time and make those available to our portfolio companies. I should have really started the answer to your question to point out that we are our capital is by itself strategic it's also passive and permanent and and so we start with can we help you but we're not going to control the business we don't want to control the business we want the principles to control the business and make the important decisions if we can be additive to that we're delighted to do it but fundamentally

35:43Todd Owens:ours is a passive type of the gp is the main character you're an advisor exactly right One of the most interesting things about GP stakes is when you invest, you're on the GP side versus the LP side. Are there strategic benefits to being on the GP side? And if so, what are some of those benefits?

36:01David Weisburd:When you're investing at the GP, you are really partnering with the founders, with the principals of the firm. It's critically important for a GP investor as well as an LP investor that the underlying performance of the funds is good. The returns are good and the core strategy that drives everything. And so there's no misalignment in that regard. But as an investor at the GP, there are potential strategic benefits. We see co-invest deal flow that we wouldn't otherwise see. We see interesting potential future investment opportunities. We can help these firms also think about other strategic things like, for example, selling the firm.

36:47David Weisburd:in our part of the market, we wouldn't be surprised that a number of the firms we invest in ultimately sell control of their firm in five years or seven years or 10 years. And so we can help them think about that as well.

37:02Todd Owens:You're in a very interesting part of the market, 15 to$75 million deals. So you're in lower middle market. I'm sure you get pitched many venture capital firms that want to sell a GP stake. Like, is there some product there, whether currently or evolving, that makes sense for you guys to invest in a venture capital firm? And if so, what does that product look like?

37:23David Weisburd:So investing in venture capital businesses, we think is difficult. And the reason for that is that it's hard to persuade yourself that there's enterprise value, that there's really a business in our part of the market. it's clear to us that there are large venture capital businesses that are businesses that have enterprise value. In the smaller end of the market, it's harder to come to that conclusion. And so the bar for us is quite high when we think about investing in a venture capital business. We don't like the fact that there are a few barriers to entry. And we also don't like the fact that there are a few barriers to exit.

38:00David Weisburd:And that actually is even of the two, the more concerning. Where we've found opportunities that we like, and we have not made an investment in a venture capital business, but where we have found opportunities that we like, it's often a venture capital business that has built other parts of the business that are hard to replicate, that would take years to build. So we've seen, for example, venture capital businesses that have created an AI-generated sourcing engine for their investment strategy that has significant, has a significant database. And when we look at that, we see a business that would be hard to replicate.

38:37David Weisburd:The principals just can't leave and walk across the street and start over. And so that begins to feel more like a business to us. And it would be something like that, I think, that would open up the idea of an investment in a venture capital firm.

38:52Todd Owens:Just to play devil's advocate, you mentioned barriers to entry. What are the barriers to when it comes to private equity and private credit that are different than venture capital?

39:01David Weisburd:In other types of alternative asset managers, the barrier entry is that it can take a long time. It's a more steady progression. If you raise your first fund and do well, and then you raise your second fund and your third fund, you've really sort of created something that you can look at and audit. The same is true to a degree in venture capital, but the issue is that that second fund may make all of the principals extremely wealthy. Or that second fund might be something that performs very poorly, at which point the venture capital firm can just shut down and walk across the street, go to the beach for a couple of years, and then start over.

39:39David Weisburd:That's not investable for us. And so there are overlaps and there are similarities. But when you look at private credit or private equity or infrastructure or secondaries, there's much more of a repeatable investment process than you typically see in the venture space. Is that another way venture could be too volatile for its own good as a GP stake? Yes, that's a better way of putting it. It can be too volatile, both on the upside and the downside.

40:08Todd Owens:If you could go back to 1990 when you had just graduated college and you started at Goldman where you became a partner, what would be one piece of advice you'd give a younger Todd that would have either accelerated your career or helped you avoid costly mistakes?

40:21David Weisburd:I talk a lot to folks who are starting their career on Wall Street. And what I talk to them about is really a couple of things. Number one, invest in your network. If you go to work at a place like Goldman Sachs, the people who are sitting around you and the people that are in your analyst class or your associate class are going to do amazing things. And so spend time and be deliberate about building out your network because whatever you do in the future will benefit from those types of relationships. the second thing I tell people is do something that you enjoy if you hate your job you're not going to be good at it and it's a waste of everybody's time so find something that you love to do and you will enjoy it of course but you're also going to be better at it and so that's the second I think piece of advice that I give to folks and then the third thing is there's a There is a career arc for most people and significant investments at the outset pay dividends in the long run.

41:31David Weisburd:And so be prepared to work really, really hard, particularly in the early years of your career. And you have to trust that that will pay dividends in the long run.

41:39Todd Owens:Absolutely. Well, Todd, this has been an absolute masterclass. Thanks so much for jumping on the podcast and looking forward to continuing this conversation soon.

41:46David Weisburd:David, I appreciate the time. Thanks for having me on.

41:48Todd Owens:That's it for today's episode of How to Invest. If this conversation gave you new insights or ideas, do me a quick favor. Share with one person in your network who'd find it valuable or leave a short review wherever you listen. This helps more investors discover the show and keeps us bringing you these conversations week after week. Thank you for your continued support.