E110: How Legacy Knight Scaled $1.5 Billion in Under 5 Years

David Sawyer, Chief Operating Officer & Managing Partner at Legacy Knight : Multi-Family Office sits down with David Weisburd to discuss the top mistakes investors make in GP stakes, why middle-market GP stakes could be a game-changer for investors, and how GP stakes outperform traditional investments in 2024.

Speaker names marked ? are inferred from speaking time and the show’s known hosts — they are not voice-verified.

• 0:00Speaker 00

  Legacy 9 is multifamily office based in Texas. We launched it in 2020. In less than five years, we've scaled it to just under 1.5 billion dollars of assets.

• 0:08David Weisburd?

  What is your advantage against the large banks, the JP Morgans, the Goldman Sachs?

• 0:11Speaker 00

  What they don't have is the flexibility in the private markets to really execute on unique alternatives. Ultimately, these families, they want better access, better structures, better fee arrangements, and the banks have a lot of limitations. They can't be as nimble.

• 0:24David Weisburd?

  Tell me about GP Stakes Investing.

• 0:26Speaker 00

  It's only going to grow. It's only going to get bigger.

• 0:29David Weisburd?

  Welcome to Ten Ex Capital Podcast.

• 0:30Speaker 00

  Thank you very much, David. I'm excited to be with you and talk about all things GP Stakes Investing and Legacy 9.

• 0:36David Weisburd?

  Let's jump right in. What is Legacy 9?

• 0:38Speaker 00

  Legacy 9 is an alt-native, as we call it, multifamily office based in Texas. We launched it in 2020. In less than five years, we've scaled it to just under 1.5 billion dollars of assets, and we work exclusively with family offices, and we do that in two ways. Number one, we have what we call our legacy business, which is 100% balance sheet advice, guidance, strategy, full investments, family office services, tax and estate, et cetera. So that's the legacy side. On the 9 side of our platform, which is what I run, we curate and make investments in the alt space, private credit, private equity, venture capital, direct investments, real estate, real assets, and we provide access to those to family offices around the country. Those checks tend to be in

• 1:22Speaker 00

  the range of 20 to up to 100 million. And again, they can be fund investments, they can be anchors funds, they can be co-investments, a lot of GP Stakes Investing.

• 1:31David Weisburd?

  Sure. When we last chatted, we talked about your advantage against the large banks, the JP Morgans, the Goldman Sachs. What is your advantage?

• 1:37Speaker 00

  Those big bank platforms have a great history in the public space. They obviously have a lot of resources at their disposal. What they don't have is the flexibility in the private markets to really execute on unique alternatives. And when you're working with ultra-fiduciary families, as we do, and they like to do in their private banks, ultimately, these families, they want better access, better structures, better fee arrangements, et cetera. And the banks have a lot of limitations, both on the regulatory side and just in the way they operate, a lot of bureaucracy, et cetera. They can't be as nimble. If you want to put a fund on a private bank platform, you can't do that with 100 or 200 million. Million dollar vehicle because there are a lot of mouths to feed across the private bank platform. So they have to go with bigger managers, bigger funds, which there's nothing wrong with that, but it does limit what they can do. Additionally, you know, they can only advise on investments on their platform.

• 2:22Speaker 00

  So if a family comes to us and says, hey, I want to look at this early stage tech investment in an outside fund or, you know, direct investment, or maybe they want to buy a piece of real estate. You know, the banks are limited as to how they can advise on that, whereas we aren't. And so we are a full scope, full spectrum advisor to our families in addition to being investors as well.

• 2:39David Weisburd?

  You've been an early adopter as investor in GP stakes, both at your previous role at CAS Investments as well as today at Legacy Night. Tell me about GP stakes investing.

• 2:49Speaker 00

  GP stake as a strategy is a minority stake. In today's world, most of those are minority stakes, typically 20% or less, into private equity and private credit managers. The first wave of this strategy was into hedge fund managers. What these GP stakes funds realized, like Dial, now Blue Owl, is, you know, investing in a PE firm, if they have a 10-year fund, those fees are a lot stickier, a lot more locked up. And so your downside protection is incredibly structured and protected. And so the asset class has really grown as people realize that this return profile, buying into locked up, drawdown, structured strategy funds really was much more attractive. And so that's what we talk about today. We're talking about largely private credit, private equity and large venture capital funds.

• 3:30David Weisburd?

  And what are you solving for the managers? Why would a GP sell a part of their stake?

• 3:34Speaker 00

  There are really three primary drivers that a manager will sell. The first is just to grow the business. So funds, the bigger getting bigger. You know, a lot of firms, they had a $2 billion fund, then they went to four, then they went to eight, certainly when we had the ZERP period. And most LPs, institutional LPs, require that they have a 1%, 2%, 3% GP commit. And the truth is, they needed to keep feeding the beast, they need to keep funding deals. And so they needed actual balance sheet growth capital. That's on the primary side. Another driver of growth is as these firms want to scale, a lot of them, they can't just scale their mono-line private equity buyout business. And so what they've done is they've had strategies. They've added either geographic strategies. So maybe it's a US-based manager and they want to scale into LatAm or Europe. Or maybe it's a PE manager that wants to build a credit arm, right? And that's expensive. It's

• 4:20Speaker 00

  It's expensive to buy a team. It's expensive to pay talent or recruit what they need to do. And the third driver is really generational transfer. The private equity industry really scaled in the seventies, eighties. And so a lot of those founders are now in their eighties and nineties. There's these firms want to continue growing. They want to continue continuity at the leadership level. They've needed someone to come in as a strategic partner and help facilitate those transitions. And so there are a lot of creative ways that they've been able to do that on the GP side. But those are the three drivers.

• 4:45David Weisburd?

  On the topic of succession planning, let's say that I invest a hundred million dollars into you as a private equity manager. How does that hundred million dollars help with succession planning? Walk me through that.

• 4:55Speaker 00

  The way that these are typically done, there are a variety of ways that you can do it. The lawyers get pretty creative on these things, but ultimately what you're doing is you're tearing out the original founder. So it's a secondary transaction. So you're not putting that capital on the balance sheet. In most instances, you're buying them out directly. Or when you do that, you're facilitating an equity buy-in from junior partners. Or you're creating some sort of future incentive plan, profits, interest on future value, et cetera. Where those junior partners can end up buying more and more of the equity in the overlying business that obviously they want to continue running for long periods of time. That's the major reason you see the secondaries or the way most often they're structured with the managers. When you have a founder selling secondary. I'll also note that one of the attractive things about doing them that way, that you can amortize goodwill.

• 5:38Speaker 00

  And so a lot of these founders take chips off, they're structured to be over a couple of years. They can maximize the tax savings. So it's really beneficial to LPs as well when you do them that way. But obviously you do want to be careful with the secondary side, right? Most of the capital that goes into these deals is primary capital for growth.

• 5:53David Weisburd?

  One of the biggest misconceptions about the space is that these firms have done a GP stake. They will never do a GP stake again. But just like a company that needs to raise money or a company that does secondary, there's oftentimes two, three rounds potentially.

• 6:07Speaker 00

  HIG is a great example of that. They've done several transactions with the BlueL. They have a very diversified partner base today. They had a big generational transfer there. You had two founders who founded the firm in the mid nineties. You know, great example where they've successfully done that. They've successfully brought up a lot of other partners and done that over a couple of different transactions with a GP stakes firm.

• 6:26David Weisburd?

  When you're investing in GP stakes, what determines whether the Deal is high quality.

• 6:31Speaker 00

  Obviously, valuation matters like with anything else. We can touch on that in a little bit, how you come to valuation here. But you know, beyond that, what you really want is, you know, do you have a very sticky capital base? Meaning, do you have a very institutional, very high quality LP base? Because ultimately, when you're looking at underwriting management fee revenues, you know, what's your counterparty risk here, right? Are people going to pay their management fees? And if you've got nothing but, you know, top tier pensions and endowments, there's a very, very high probability that they're they're going to take care of that. So that's the first thing you look at. Obviously, the team, the performance track record is critical. But beyond that, it's can they raise capital? So you can have a phenomenal track record, but if you're not able to scale your funds from two to four billion, or whatever it may be, you know, that that's a really critical component. If you can't do that, it's really hard. And that's actually one of the key things that makes people do a GP stake transaction is

• 7:15Speaker 00

  the GP stake managers have a great capital base behind them. They have global networks today, and that's that's a big driver. They can they can really upsize and upgrade your LP base as a manager. But so you definitely have to look at that. But again, the number one driver because of the management fee income and because of the stickiness and contractual nature of that is can you continue raising funds, you know, primarily larger funds on your current flagships?

• 7:38David Weisburd?

  You mentioned underwriting the ability of top LPs to continue to invest. What are some leading indicators of that?

• 7:45Speaker 00

  By the time typically a firm hits a stage where you're in the middle market or upper middle market, these are firms with five plus billion of AUM, and they're probably on fund three or four at a minimum. And so what you want to look at is, you know, between fund two, three, and four, did your LP base turnover? What's your re-up rate? Are you bringing in new high quality LPs? Do you have a huge network of high net worth and family offices that may or may not re-up in large scale? So you've got to underwrite that. You've got to see that the quality of your partners is really critical. It's just like any other business. When you look at what's your customer base look like? Is it sticky? Is it high quality? Is it institutional? What are the logos? So it's just like any other business you're underwriting. What's the customer base look like?

• 8:20David Weisburd?

  So one of the ways to look at it is you look at your customer base being the LPs, and you want to look at, A, have they continued to re-up in the fund? And B, what is their historical re-up in other funds?

• 8:31Speaker 00

  You can look at those analyses across the marketplace. But the primary one is with that manager, are those funds continuing to allocate, you know, that because as you know, like with with pensions? Endowments, they have a bucket for each strategy or asset class. And ultimately, they have their managers they like. And what you want here is they, you know, if it's HIG as an example of manager, I really love. You know, are you going to, if I'm investing in middle market fund three, am I going to also invest in fund four, fund five, fund six? Because they're great, they're best in class, they're really generating alpha in that space. So you obviously want to benchmark that firm against their peer group and then see is their LP base continuing to re up over time. So that's a really critical driver here again, because if you want funds to get bigger, you can't have a lot of churn in the LP base. You want everyone to re up and you want to go find new LPs as well. And that's how you go from two billion to four billion.

• 9:12David Weisburd?

  You mentioned turnover and LP base. Is that always a negative signal in fund two, fund three, fund four?

• 9:19Speaker 00

  Yeah, I'd say most often it is, although there are exceptions, right? If fund one and fund two are effectively friends and family, family offices, RIAs, which could be great LPs. We're one, you know, ourselves, you know, that's okay. But as you get bigger, if you really want to scale, you know, the chunkier check sizes are really from institutional investors. And so churn's okay if it's churning up and you're up, you're going up market in terms of your LP base and quality base. But obviously, if it's, you know, we had the biggest pension in the country in fund two and fund three, and they quit for fund four. You know, you want to ask why, and sometimes it's not the manager's fault. But if it's performance based or if it's relationship based, all of these firms haven't quite institutionalized their investor relations, their capital formation teams. You know, that's something you want to dig in on and dig a little deeper on.

• 10:01David Weisburd?

  Given that you're investing in the manager and management fees is the most important part of de-risking the investment. How much access do you have to existing LPs? And walk me through how much you're able to diligence the LP relationships with GPs.

• 10:17Speaker 00

  Absolutely. So Legacy Night, we typically either invest as LPs in GP stakes funds or as co-investors. But that being said, we do see a lot of the work on the co-investment side and the diligence packages. And typically, the best way to do it is you're interviewing your best LPs. You're asking why they continue to re up. You know, you're looking at the geographic diversification of LPs, you know, because that can be a growth area in the future. You know, obviously, you're looking at the continuity, the sizing, et cetera. And so, yeah, you have full access to the underlying LPs. You have full access to portfolio companies for what it's worth on that side as well, interviewing those teams. Asking why they part of that team is the, you know, is their exit assumption realistic at the fund level? So it's a pretty granular process. I'll also say that these transactions are not, they're not done quickly.

• 11:00Speaker 00

  A lot of times these, these conversations are happening over many, many years. And it's a very, very relationship oriented business because it's a small industry.

• 11:07David Weisburd?

  Is there something that would be a good GP stakes investment that would not be a good fund investment?

• 11:11Speaker 00

  Yeah, it's a great question. I mean, I, I think with the GP stakes fund, unlike with maybe a, just a mainline strategy is the fund's got to be able to raise capital. And some of the middle market teams and lower middle market teams that have wanted to enter the GP stake space, they've had to struggle raising their fund. And as an LP, you have to look at that and say, well, if you can't raise your own fund, how are you going to help other firms that you want to buy a stake in raise their funds? And otherwise they wouldn't want to sell to you. And so that is something that's a little bit different that you have to underwrite that, that's somewhat unique. I'll also say that, that again, it is very relational. You want to look at the support that they're providing to their underlying portfolios. Whereas if you're investing in a, you know, middle market, lower middle market buyout manager, you don't really have those angles and dynamics at play. So it is a bit differentiated.

• 11:52Speaker 00

  You have to understand it differently and really trust in the team also on the structuring side and what they're doing. It's just a different, different kind of investment. It's very esoteric, very specific. And so the teams, a lot of them, they, they come out of the space or they come from law firms that have done deals in the space and things like that. So it, again, it's a small ecosystem, but, but one that's highly specialized and highly structured.

• 12:10David Weisburd?

  Deconstruct the different revenue streams in a GP stakes.

• 12:14Speaker 00

  First off is a manager fee revenue. And in my opinion, that is the secret sauce of these deals. So when you buy into a manager, you know, if you invest as an LP in a fund, for example, you're going to pay your 2% on committed capital, probably through the investment period. Then maybe 2% on invested capital thereafter for the rest of the fund. Right? And so it's very sticky. You're going to pay it. It's very predictable. And so that's the first one. And that's really your downside protection. And that also is what's interesting from a return standpoint. It, it provides a private credit like return profile on the cash flows. Because typically managers, they assess that fee quarterly. So if it's a 2% fee, they're assessing, you know, half a percent a quarter every year. So on average, not every fund, but for the most part, the GP stakes funds are making four distributions a year. And, you know, on a roughly quarterly basis, and that's, that's at a minimum as a

• 13:00Speaker 00

  Floor coming from management fee revenues. So that's number one. Number two is obviously carried interest and carried interest is a huge part of the equation. You've got to have good performance. However, in the large cap managers, increasingly, they become asset gatherers and the fee related income largely management fee revenues make up a really significant portion of returns. The carried interest, it's critical. It's a really important piece, but it becomes much more important as you go down to the middle market funds because they just don't have as much margin on their management fees. They're not raising $10 billion funds and you know, the growth of teams at the large cap, it's linear, not exponential. And so, you know, they just have better margins on the management fees. So at the carry level, that's more important. Performance is much more critical in the middle market than in the large cap space. The third is balance sheet returns. And so, you

• 13:42Speaker 00

  know, as a manager puts up a GP commit, you know, we also own our percentage in that as an investor. And so, you know, if they are, you know, your 2% commitment to a fund, if they make a 2X on it, you're getting gross returns. So your 2% becomes 4%, for example. And so that's the third. And then the final one is enterprise value growth. And so that's really on the backend. And so in the meantime, you're looking at cash flow focused returns through carried interest, balance sheet, and management fees. And on the backend, obviously, as the GP stakes firm seeks to sell their stake at some point, you obviously are hoping for multiple expansion on the backend, particularly if the firm goes public. So if they buy in at, say, seven times distributable earnings, and then in five years, they go public at 20 times, obviously, you're going to get a multiple expansion there. And so that's really where the upside Moic comes from on these. But the

• 14:26Speaker 00

  real attractive nature, and again, on the return profile, is you get private credit like returns, but you also get asset appreciation over time. So you can still get the private equity like Moic, while also getting the cash flow from P, from like a private credit type style investing where you get quarterly distributions. They tend to range in the sort of high single digit to low double digit range, and it's going to vary a little bit based on the year. So like right now, you're not seeing a lot of exits, so carried interest is lower. But the management fees remain pretty stable. And so that's, that's how you primarily drive returns here. And that's why people like the investments. And we can talk about some of the hair downsides of these structures, but that's, that's ultimately what makes them really attractive from an upside standpoint.

• 15:03David Weisburd?

  In terms of the base case for investment into middle market PE, middle market credit, what's the Moic that You're targeting in your investments today.

• 15:11Speaker 00

  When GP stakes, you're looking at, again, I'd say like a two and a half to three and a half X. And the difference between the two and a half and a three and a half largely depends on that multiple expansion on the exit. So in the interim, the way you underwrite these, you know, in most cases, particularly Blueout, you know, you're looking to get your basis back in, say, six to eight years, just based on cash flows. So the distributions alone get you back to your basis in, say, six to eight years. And then after that, you're going to continue getting cash flows. So over about a 12 year period, you should expect to get, say, two X on just your cash flows. And then beyond that, it's all about multiple expansion on the exit. But historically, the exits have come at much higher multiples, and you do see a pretty good uplift on the back end from that.

• 15:51David Weisburd?

  Cash flows being both management fee as well as carry.

• 15:54Speaker 00

  Yeah, because the way these management companies work, and ultimately, that's what you're buying a stake in. You're buying a stake in the management company of the private equity firm. You know, that entity, every quarter, they may have carried interest realizations, they have management fee, you know, distribution. So it's typically one distribution. It just depends on, you know, what the mix is that'll make it larger or smaller. You know, if a firm has a really, really big exit that quarter, obviously, the carried interest piece of that's going to be much higher. And that's also matters for tax reasons, because the management fee income is largely ordinary income to investors, at least taxable investors like us, whereas the carried interest is typically long-term gains, as is the balance sheet returns.

• 16:28David Weisburd?

  So let's put aside the multiple expansion that takes you from two and a half to three X. Deconstruct the two and a half X in terms of the waterfall. So how much of that is guaranteed from management fees? How much of that is from carry from previous funds? How much of that is carry future funds?

• 16:46Speaker 00

  A good point to clarify here is when you buy a GP stake, in almost every case, you're buying into all the existing funds as well as future. So it's not just perspective. And that's really critical, because day one, you're going to get a lot of cash flow, and that really mitigates the J curve for these investments as well, which makes them pretty appealing.

• 17:03David Weisburd?

  And how much downside protection are we talking about?

• 17:06Speaker 00

  It obviously depends on the buy-in and where you are. But most of the models I've seen, when you test them, as long as that firm raises one more flagship at roughly the same size or larger to where they are today, you will get over a 12-year period. Almost back to your basis. So say within, you know, 10% of your basis, just on management fee income alone.

• 17:26David Weisburd?

  Just on current and one more fund.

• 17:28Speaker 00

  Current and one more fund. Because once you raise one more fund, then you've got another 10 years of cash flows that you can depend on. Say 10 plus one.

• 17:35David Weisburd?

  You get down to one X in the base case model. And what about in the really unfortunate case where they're not able to raise another fund? What's the downside protected?

• 17:44Speaker 00

  And the management fee revenue really is the secret sauce there as well, because look, if that firm completely collapses and goes under, what typically happens is they're going to wind down the fund. You're going to get, you know, all the things that are already in the ground. They're going to cash flow. They're going to have realizations. So, you know, if the firm has a, you know, corporate shakeup, for example, the partners have a falling out, whatever it may be, you have a, you know, a fraud issue, something like that. Obviously, you're still going to realize what's there. Typically, LP, LPAs have a provision where, you know, the LP, the LPs can appoint a manager to run the fund and wind it down. We're still going to get our, our interest in that economically. And so in that case, you get sort of a 12-year wind down, right, on the management fees and the carry of existing.

• 18:24Speaker 00

  And you'll get effectively back to your basis. Like I said, as long as that firm raises one more fund, you're probably in the money, right? Because assuming you still hit carry on all the funds you're, you're in today that are already in the ground, and then one more, you're, you're pretty much money good.

• 18:38David Weisburd?

  You mentioned the tax consequences of the asset class. Is there a specific LP base that prefers GP stakes? And are there certain LP bases that will never do GP stakes?

• 18:49Speaker 00

  My perspective on GP stakes is a little bit unique, but I, I've seen a very, very high demand from high net worth and family office world for this asset class. So institutional investors love it. Large family offices love this space. Some of the biggest mega family offices in the country, including sovereigns globally. They love this asset class. They invest heavily in this asset class, but it's also high net worth individuals as well. So you, you see it across the board, in my opinion. And that's why it scaled pretty quickly here, because again, you get the, the cash flows as well as the upside appreciation opportunity. And people really love that, that, that mix.

• 19:21David Weisburd?

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• 20:03David Weisburd?

  Tell me about the role of investment bankers in GP stakes.

• 20:07Speaker 00

  As I mentioned earlier, this is a really small world and I won't name names, but there's effectively one bank, maybe two, that shop all these deals if they are banked. And then there's one law firm that does effectively all of them. There are maybe two or three others that may be on the other side and there's a conflict, but it's a small universe of service providers. And over time, the structural protections that they've baked in these have gotten better and they've become kind of an industry standard now because again, you have the same law firm doing all the deals and you have the same bank shopping the president. But especially at the large cap level, you've got, you know, Blue Owl is overwhelming, you know, behemoth in the space. They've 60% of the deals in this space that have been done, have been done by Blue Owl. So they're overwhelming the 800 pound grill in the room. But in their case, a lot of times these are long-term conversations going, you know,

• 20:51Speaker 00

  a decade or more long. And so a lot of times there's no intermediary, right? And so eventually, once the deal gets done, they'll bring in the banks. But these are typically not auction processes. Now, today you're seeing more of that, but historically they're very relationship based. And it's again, it's a small universe where even if there is an auction, you've probably got two or three major players bidding on these, these, you know, stakes.

• 21:11David Weisburd?

  What are the main mistakes that investors make when investing to GP stakes today?

• 21:15Speaker 00

  Yeah, that's a great question. And when I talk to our investor base, I always try to really emphasize these are unique investments and they are not like other things you invest in. The number one thing you have to understand is they are structured as perpetual investments. They have no in-life, they're not 10-year funds, they're not 10 plus one plus one. They're, they're technically perpetual. Now, Blue Owl in particular and others have gotten very innovative in ways to provide liquidity without actually. Exting the positions, but that being said, you need to understand that their structure is perpetual. The reality is a private equity firm, very sophisticated financial investor is not going to sell a stake in their business that they know, or they think you may go flip in five years to someone that they didn't choose themselves. And so for that reason, the industry standard has become perpetual type vehicles.

• 21:59Speaker 00

  Although again, they've gotten very creative with certain securitizations and things of that nature to provide liquidity in the interim.

• 22:04David Weisburd?

  What are the valuation metrics that you see used to value stakes today?

• 22:09Speaker 00

  So private equity is an asset class historically has been undervalued in the public markets. And the main reason that is carried interest. A lot of public investors don't understand carried interest. They don't understand unrealized carried interest. And as you and I know, like a Blackstone, they're going to have a lot of realizations every year. They have a very diversified business. They're going to see a lot of that. And so in 2017, when there was tax reform, a lot of the public PE firms converted to C corps from publicly traded partnerships. And so the metrics have changed as a result of that, but that was very advantageous to those firms. And the private markets have effectively started reporting the same way. And so the multiple you tend to see used to be economic net income. Now it's distributable earnings and that's a non GAAP measure, but effectively it's the cash realization in that year.

• 22:53Speaker 00

  And so that's management fees, carried interest, et cetera. And there are some offsets to that. I won't get too in the weeds on that, but effectively it's a multiple on DE. And what's amazing is as long as I've been investing in this space, the multiples have stayed remarkably consistent. They range from say six times DE all the way up to say nine times. In the public markets, those firms are today trading anywhere in the sort of high teens to mid twenties on a DI basis. So there's a pretty big amount of arbitrage to be had here. Particularly if these firms end up going public like a CVC did last year.

• 23:23David Weisburd?

  I was speaking with somebody in this space previously, and he mentioned that every GP needs to either sell a stake or go public at some point.

• 23:31Speaker 00

  I think it depends on what the GP wants. In today's world, the reality is the biggest trend you've seen is the big get bigger and more capital is going to the bigger firms. Since the pullback from say 2022 forward, that has been an exacerbated trend. So the biggest managers have been able to continue raising big funds and a lot. A lot of the other managers have struggled. So if you're a $5 billion AUM manager, you really need to get to 10 quickly.

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• 25:13Speaker 00

  That Five Space is tough to play in because more capital, more LP capital is going to bigger firms, and so you want to get bigger. So the bigger getting bigger, that's driving a lot of this. That's why Blue Owl has had so much success. They primarily played in the large-cap space. Now, that being said, now the middle-market space in the GP stakes landscape is really widening a lot. You have more firms coming in there, buying more stakes, and so I do think you're going to see a little bit different story with those. We can touch on middle-markets, GP stakes, versus large-cap because they are quite different. The reality is, there's more capital flowing in this space, and so I think more people are needing to do deals, wanting to do deals, and the reality is, they have to do that to compete, especially if you're above about a $5 billion AUM range, because you're just going to get eaten alive by the other firms that are adding credit arms,

• 25:55Speaker 00

  that are raising bigger funds, that may, and they have a large-cap fund, they're launching a middle-market fund. They're launching a small cap fund, for example. So in order to compete, you've got to be there.

• 26:04David Weisburd?

  Are middle market GP stakes deals structured differently than large cap?

• 26:08Speaker 00

  No, they're not, but I think the risks are different and the return profiles are different. So as I mentioned earlier, the management fee revenues in the large cap space are a huge part of the equation. They're super sticky. They have very institutional LP basis. And so you can really underwrite that well, and it's very dependable. It's also a bigger portion of the returns on average. Whereas in the middle market space, the firms don't have as much margin, as much leverage on that end. And so, you know, the management fees are a really important component, but they're not going to make up. For example, in the large cap space, it may be a 10% annual yield, cash on cash. Whereas in the middle market space, it may be six to seven, for example. And so the performance in the middle market is more important, not only because it's a bigger driver of the return makeup of the firm,

• 26:48Speaker 00

  but additionally because those firms are less established, they have less, they're just not named brands yet in a lot of instances. And so the performance in order for them to raise new funds is really critical. So the management fee is important, just not quite as important for those firms. The other thing too, is in the large cap space, those firms by and large now have diversified partner bases. Where in the middle market, you may have one key man, you know, founder-led business. And so you have a lot more business risk, you know, a lot more key man risk. Whereas, you know, large cap fund may have 50 managing directors, right? That are all really capable and ultimately they have a management committee and things like that.

• 27:21David Weisburd?

  Have you seen any preferred equity deals or any other types of downside protections in the middle market GP stakes deals?

• 27:28Speaker 00

  That's a new trend you're seeing, and I think it's going to be really interesting. So what's happened over the last, we'll say, three, four years is a lot of firms, they started as GP stakes firms. And now they're moving into what a lot of them are calling GP solutions funds. And I view this as the evolution of just the securitization of the GPs and private equity, which makes a ton of sense. It's one of the most sophisticated financial markets, you know, in the world. And yet, like for the first 40 years of its existence, or say 30, the GPs were pretty straightforward, right? They didn't have a lot of complexity in their GPs. That's changing. And so today now with these solutions funds that you are seeing in the middle market, 100 Point has a fund. I think Bonacord has one, the firm Arcos has one in that space, and then Blue Owl has one as well.

• 28:10Speaker 00

  They do NAV lending, they're doing structured preferred equity type deals. And so what they're all trying to be now is not just a GP equity solution. They're trying to be a one-stop GP solution firm for every private equity, private credit manager. Then go to them for debt, equity, preferred, whatever it may be. So that's the evolution you're seeing in the market, both at the large cap level and in the middle market.

• 28:31David Weisburd?

  How much handholding do the GP stakes funds do to these GPs? Are they sitting on boards? Are they helping with governance? Talk to me about that.

• 28:38Speaker 00

  They add a ton of value, we'll say. They don't have a lot of governance. They do have structural protections in place. A lot of them, they have put rights negotiated in in the instance of fraud, key man events, things of that nature. So that's a big protection we have. Additionally, when you look at the management company, expenses are a big part of this. And so in a lot of ways, they have structural protections that, hey, like, if you want to fly around on corporate jets all over the world and spend a fortune on huge parties for the firm, that's fine. That comes out of your bucket, not ours from an expense load standpoint. A lot of times they have margin protections baked in there. So you do things like that. But other than that, they're passive economic partners.

• 29:18Speaker 00

  I'd say that they add a lot of value, though, in areas like Blue Owl has what they call their business services platform. The middle market teams have them as well. So you really have a bird's eye view of the industry when you own 20, 30, 40 stakes. You can see comp trends, HR trends, ESG trends, strategic trends, or people adding credit arms. Or what are they doing in their firms? And so for a lot of reasons, they add a lot of value in addition to providing us as LPs in these vehicles with a lot of structural protections as well.

• 29:48David Weisburd?

  I've had multiple people tell me that the key value add that GP stakes fund does, say 90-plus percent, is its fundraising assistance. How do you feel about that?

• 29:57Speaker 00

  I think that's a huge part of it. And we at Legacy Now benefit greatly from that. So for example, a lot of times if a manager's doing a large co-investment, that they need more capital than maybe available to them in their traditional LP base. They may call a Blue Owl or a Hunter Point and say, hey, do you have any LPs that do a lot of co-invest? And we get calls like that all the time. And again, I'm not talking about a GP stake co-investment. I'm talking about a deal level. Co-invest in one of their funds. Additionally, I'll give you an example where there was a portfolio firm of 100 points in the middle market space and they were launching a very unique strategy. It was a JV. It wasn't a full new strategy and it was a small LP base. And even though we weren't an LP of that fund, 100 Point directed them to us as a prospective investor

• 30:39Speaker 00

  because they knew that we had a taste for that kind of investments and we have some internal expertise in that space. And so we get lots of good cap intro, lots of good deal flow from the underlying managers and it just creates a much warmer relationship. And so one of the primary motivators that I have as an LP in GP stakes is I just get to know a much larger universe of managers. And historically, I've ended up doing the vast majority of our allocations through those networks because you get a lot, a lot better diligence protection. You know, the team, you know that whether it's Blue Owl, 100 Point, Bonne Court, wherever it is, they've done really good work in the GP side. They've taken care of a lot of the business risk concerns, things like that. So it gives you a little bit of an advantage and a little bit of a head start when you're conducting due diligence on these managers.

• 31:20David Weisburd?

  Speaking of due diligence, how long are these diligence process on the GPs that these funds do?

• 31:25Speaker 00

  Like I said, some of these can be years and years long processes. I know one manager that has been talking with one of the shops for a decade now, for example. So a lot of times it's, we know we want to do one. We know that it's going to make sense for our business. It just has to be the right time. And so that's typically what drives it. I'd say once you get going on them, the diligence process can be six months to a year.

• 31:44David Weisburd?

  Why is it that long? Unpack that.

• 31:46Speaker 00

  You know, when you're, when you're looking at a business like that, not only are you diligencing the manager, but you're also looking at the funds. If you're, if you're trying to get to come to a valuation, you obviously have to look at, well, what's the carry going to be? And if you want to know what the carry is going to be, you have to look at all the underlying companies that are going to generate carry. And so it gets pretty granular in there to build back up to evaluation. And that just takes a lot more time than say, you know, looking at one manager or one fund or one company. It's just a different process. And so there's just an additional layer of complexity that comes along with that in order to get to a really sound valuation.

• 32:18David Weisburd?

  When do banks get involved in these long processes?

• 32:21Speaker 00

  A lot of times the firms are all talking in advance and obviously they're very sophisticated financial sponsors that they're going to hire a good counsel, both on the advisory banking side and the Legal side, but you know, they're involved throughout the process. Again, a lot of times they'll, you know, a process will happen. It's just a very small universe. It may be two, three, four bidders. You know, and it's all the GP stakes names. Occasionally you'll get a sovereign that plays in the space, maybe an insurance company here and there, but it's a pretty small universe that you're going to see bidding on these deals.

• 32:48David Weisburd?

  What are the main mistakes that investors make when investing into GP stakes?

• 32:52Speaker 00

  I think the primary driver is, is people think that these are uncorrelated to public markets. They are lowly correlated in some ways, particularly management fees, because those are contractual. They have to be paid out. The only way they're really going to be correlated is if you have like an O8 type scenario where your LP base is really, really illiquid or they're having crises. But that being said, you know, carried interest is very cyclical. So as we've seen in 2023 and 2024, carried interest is way, way down. DPI across the alternative asset world is way, way down. And obviously that's going to drive down distributions. I'll say though, the benefit of private equity, it doesn't mean necessarily that those returns are bad. It just means they're delayed. And so as long as, you know, that private equity firm is going to sell that company in a year or two, maybe, you know, the lower IRR, but ultimately the Moic, which is going to drive the carry, as long as they're above the benchmark, you know, that's still going to be there.

• 33:37Speaker 00

  And so there is a, there is a level of optionality there, but it does have correlation. I think a lot of people, they, they overlook that aspect of it. And obviously some people underestimate the long-term perpetual nature of it as well.

• 33:48David Weisburd?

  How fragmented is the LP base? Is it also a very club type deal where a few LPs gobble up a lot of these GP stakes?

• 33:56Speaker 00

  There are definitely some huge players, particularly on the co-invest side. And so we've, we've been acting co-investors alongside GP stakes firms, both at Legacy Night and prior at CAS. And ultimately you do see the same faces there. You have some, some pensions from other parts of the world that get engaged here. There are a couple of mega family offices that get engaged here. A couple of state funds are very active in this space. So you do see some of the same players. And what's interesting is again, considering, you know, how large the asset class has become, it still is a very, very small ecosystem. And so as a result, you know, Legacy Night, we see deal flow in the space that, you know, in any other asset class, a firm of our size and maturity is not going to see. But it's just because a lot of LPs don't know how to diligence these deals, you know, they've never done them. And so, so I think there is a, a level

• 34:40Speaker 00

  A little advantage by having expertise in the space and that's why the universe has stayed pretty small.

• 34:44David Weisburd?

  It's Q4 2024. What's the arb in GP stakes today? What's the best opportunity to invest into GP stakes?

• 34:51Speaker 00

  Great question. I am really excited about the, we'll call it the upper middle market firms. Because what's happened, you've seen the large cap managers, they've all scaled. You've seen these firms grow tremendously over the last decade. A lot of that was ZERP driven, of course, but I think the days of you seeing like a Clear Lake Capital, where they were at seven billion and they did a stake transaction and now they're at 70. You're not going to see a ton of those, in my opinion, at least if interest rates remain pretty high. I mean, the asset class has become a bit more saturated. But that being said, I think you are going to see a real good growth story with some of these middle market managers that are scaling. And so let me define that. I'm not talking about a middle market manager, lower middle market doing, you know, buyouts in the sort of six, seven times EBITDA, 50 to 100 million dollar range, right? That's not that scalable. It's firms that are on Fund One, Fund Two.

• 35:36Speaker 00

  They're raising multi-billion dollar funds at that stage, but they haven't hit that AUM level to where they're truly global institutional. So I think that's a really interesting play. And the other one, the reason why I think the middle market is really compelling, particularly on the private credit side, I'll say, is because one of the growth trends here has been private equity managers buying private credit teams. General Atlantic bought one last year from Hunter Point, for example. That was a good transaction. And you're seeing this because as large cap managers want to diversify their asset base, the middle market firms have an exit strategy that the large caps don't, which is selling to strategics, you know, and selling to other managers. And so you don't see as much M and A at the large cap space between themselves, but you are seeing large cap managers buying smaller credit manager.

• 36:17Speaker 00

  Maybe it's a large cap buyout shop buying a middle market team if they integrate well and things like that. So I think the middle market is a real attractive opportunity, you know, not only because it's just so huge, probably about 4,000 firms, but also because I think they have a much clearer exit picture. Unlike at the large cap space, it's still not super clearly defined.

• 36:35David Weisburd?

  The large cap is basically go public or hold?

• 36:38Speaker 00

  Yeah, and I mean, they've done some creative things and we can touch on that whenever you want to. But, you know, for example, like Blue Al Fund Three, we have all of our capital back in distributions. At this point, they've done securitization where they issue. You know collateralized notes, insurance buyers love that product and that can be a 20 or 30% distribution on invested capital. So that's a pretty chunky deal. You can sell portions of a firm. Blue Owl sold half of their stake in Silver Lake to Mubadala, for example, a couple of years ago. That was a good partial exit. So there are some transactions happening. But again, the public market has historically not been that great. Peters Hill, most prominently, the Goldman Sachs GP stake strategy, that has not traded particularly well in London over the last couple of years. And I think that that poor

• 37:22Speaker 00

  trading, although it has some hedge funds in some things that make it a little bit different, but it hasn't traded particularly well. I think that has limited the other firms from wanting to do something like that. When I say go public, I'm talking about taking the portfolio public, not a single name. You do see IPOs. CVC is the most recent example. You probably got some other ones coming up soon where Blue Owl bought a stake and then that firm went public, thus creating liquidity for the stake.

• 37:45David Weisburd?

  GP stakes, you could theoretically invest into any type of GPs. How would you rank the opportunities that today between the different asset classes?

• 37:52Speaker 00

  I think the larger you go, the more attractive credit can be because it just cash flows so well, right? And the carried interest is much more predictable. It's a smaller percentage, but it's highly predictable. And so obviously, we all know private credit has just ballooned as an asset class over the last decade. I think there's tons of opportunity there. They have a lot of options for liquidity. You know, I think that's a very dynamic market today. Maybe right now, there's a little bit too much dry powder sloshing around. We're seeing that in sort of covenants and deal terms. But that being said, I think, I think long term, it's just such a great asset class to play in. Again, in the buyout space, there's a lot of competition. There's some great names and there's going to be some great growth stories coming out of the middle market there. But by and large, I think the credit shops can aggregate a lot of capital. And from a return standpoint, between the fees and a much more predictable incentive fee carry structure from their returns, it

• 38:37Speaker 00

  just creates a really attractive investment.

• 38:38David Weisburd?

  What about real estate, growth equity, venture capital?

• 38:42Speaker 00

  Yeah. You know, Inpra is an interesting one that I think is attractive right now. Blue Owl bought a big stake in Stone Peak, which was a huge transaction. It's their largest transaction in Fund Five. And then obviously, we saw BlackRock bought a huge stake in GIC. I mean, these are huge funds. People are really wanting Inpra. Exposure, they generate a ton of fee-related income in the management fee space because they raise huge funds, 15, 20 billion dollar funds, and their carry is really big and chunky. The returns aren't massive. They make one fives, one sixes, one sevens, but the quantum of capital is so large that they're just highly profitable businesses. So that's an attractive space. I'll also say, and I haven't touched on this, I think that a lot of strategies, and Infra is a great example of this, from an LP standpoint, going through

• 39:25Speaker 00

  a GP stake is a much more attractive way to get exposure to the asset class than just an LP stake. So for example, using Stone Peak, the GP deal is a much more attractive return profile, call it like a two, two and a half, 3X with a bunch of cash flow than in their flagship funds, which by Infra standards are really good, you're probably talking about a 1.6, 1.7 Mo. And you're only in that fund with those assets, whereas if you're at the GP level, you've got diversification exposure to all of their funds and all of their assets. And so there are asset classes where I think it's much more advantageous to get exposure through a GP stake than others. So Infra is a great example of that. I think it's an exciting space. Real estate as well, I mean, they can aggregate assets a ton. So they can grow AUM pretty dramatically. But as we saw in the last couple of years, there's some real estate managers and some of the few managers that I've seen GP stakes deals

• 40:10Speaker 00

  get done in that haven't performed particularly well, it's in real estate because of the last few years.

• 40:14David Weisburd?

  What else excites you about the GP stakes market today?

• 40:17Speaker 00

  You know, the reality is they're new entrants. And so I think new entrants in terms of funds playing in the GP stake space, I think that's exciting because they have different strategies, they have different ways of doing things. Blue Owl has been the overwhelming winner in this space over its history. And they've also been very innovative. And so I gotta give a ton of kudos to Michael Reese and Sean Ward and their team. But the reality is these up and comers in Hunter Point, Bon Accord, Waffra is in the market with a fund. And so I think they're going to be really exciting because they're playing in a space that it's a bigger market, the middle market. You're going to see some interesting winners that grow out of that space. And so I'm really excited about it. Even Blue Owl now is finally moving in the middle market. They got anchored by a partner in Abu Dhabi

• 41:01Speaker 00

  to launch a middle market fund for their strategy too. So now that's a $2 billion fund. For example, they're buying maybe 100 to 250, 300 $100 million stakes in these funds. So that's a real exciting space. Think you're gonna have more players. You have a much bigger universe to play in. And I think learning about these new firms that are growing and scaling that you've never heard of, I think is a real exciting time, especially as an allocator, because it just creates a bigger universe of deal flow that you're gonna get.

• 41:25David Weisburd?

  Has there been evolution in portfolio construction? I noticed a lot of the early funds had four positions, and now it sounds like Blue Owl is doing 10 positions. Talk to me about that.

• 41:34Speaker 00

  Yeah, and they're even doing more than that. I think the Fund Five, which was their largest to date, it was over 13 billion. I think they have 17 now. And so they're getting bigger. They're also having a better mix of private credit. And as I mentioned earlier, private credit GP stake is a lot more dependable. The cash flows, you know, it's just very sticky and dependable, because they're gonna make that nine to 11 unless they really, really mess up. And obviously, the incentive fee on that, although it's the quantum of capital is lower, it's real predictable. And so I think blending, you know, a portfolio with with some upside equity positions, and then some really sticky, high cash flowing credit positions is a really attractive portfolio on the GP stake side. So, you know, I think that's an interesting way to do it. You've also seen as venture has grown so much, you know, a space that obviously you and I are particularly passionate about, you know, you have players like NEA selling stakes and Iconic selling the stake.

• 42:20Speaker 00

  And so I think that space will be interesting as you've seen growth stage venture scale. That's a different return profile altogether, too, is very carry heavy, very return and carried less management fee heavy. But, you know, that's gonna be an interesting phenomenon, seeing how that that develops over the next couple of years, too.

• 42:35David Weisburd?

  You mentioned Blue Owl is doing 150, 200 million dollar deals. How does that relate to AUM? And give me a general framework for that.

• 42:41Speaker 00

  It's gonna depend on the manager and what their management fee is, you know, what their margins are, things like that. But but typically, you know, again, if you're talking about a 20% stake in a firm or a 15% stake, so we'll say 20 to keep it easy, you know, 200 million, billion dollar valuation. So that's probably a 5 to 10 billion dollar AUM firm with a 2 and 20 type structure.

• 43:01David Weisburd?

  So Blue Owl is really going into how what you identified as the upper middle market.

• 43:06Speaker 00

  Upper middle market, yeah. So I'd say upper middle market, meaning 4 billion plus, say 4 billion to 10 billion. Above 10 billion, that's kind of what you classify as large cap. So just to give you some perspective here, 10 billion plus, you're probably talking about 125 to 120. Fifty managers, depending on who's in market right now. Whereas in the middle market, we'll call it 2 billion to 10 billion. That's several thousand managers. So like say 3,000. And then you have obviously smaller than that. That's another several thousand. So it's a huge universe. It's, I mean, again, the large cap is super tiny. Everyone knows everyone. Everyone knows who's talking to who about a deal. Whereas in the middle market, there's a lot more room to uncover some gems under rocks and things like that.

• 43:43David Weisburd?

  David, this has been a masterclass on GP stakes. What would you like to share with our listeners?

• 43:48Speaker 00

  As I said, it's a great asset class, private credit like yield with private equity like upside. So it's really appealing. You just need to know what you're doing. You need to understand that you're going to be in a long time. But other than that, it's a fantastic space. You rarely see something with that kind of downside protection. So I would encourage everyone to at a minimum, take a look at the space because it's only going to grow. It's only going to get bigger. I really appreciate you having me, David.

• 44:07David Weisburd?

  Absolutely. Well, I took a lot of notes. I appreciate you jumping on the podcast and I look forward to sitting down soon.

• 44:13Speaker 00

  Always happy to be with you. Thanks a lot.

• 44:14David Weisburd?

  Thanks, David. Thank you for listening. The 10x Capital Podcast now receives more than 170,000 downloads per month. If you are interested in sponsoring, please email me at [email protected].