Legacy 9 is multifamily office based in Texas. We launched it in 2020 in less than 5 years. We've scaled it to just under $1,500,000,000 of assets. What is your advantage against the large banks, the JPMorgan's, the Goldman Sachs? 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.
Tell me about cheapy stakes investing. It's only gonna grow. It's only gonna get bigger. Welcome to 10x Capital podcast. Thank you very much, David. I'm excited to be with you and talk about all things GP Stakes Investing and Legacy Knight. Let's jump right in. What is Legacy Knight? Legacy Knight is an alternative, as we call it, multifamily office based in Texas. We launched it in 2020. In less than 5 years, we've scaled it to just under $1,500,000,000 of assets.
And we work exclusively with family offices, and we do that in 2 ways. Number 1, we have what we call our legacy business, which is a 100%, you know, balance sheet advice, guidance, strategy, full investments, family and office services, tax and estate, etcetera. So that's the legacy side.
On the night 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 2 family offices around the country. Those checks tend to be in the range of 20 to up to a 100,000,000. And, again, they can be fund investments. They can be anchors of funds. They can be co investments, Lot of GP Stakes investing.
Sure. When we last chatted, we talked about your advantage against the large banks, the JPMorgan's, the Goldman Sachs. What is your advantage? 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 is the flexibility in the private markets to to really execute on unique alternatives.
And when you're working with ultrahigh net worth families as we do and that they like to do in their private banks, ultimately, these families, they want better access, better structures, better fee arrangements, etcetera. And and the banks have a lot of limitations both on the regulatory side and just in in the way they operate, a lot of bureaucracy, etcetera. They can't be as nimble.
You know, if you wanna put a fund on a on a private bank platform, you can't do that with a 100 or $200,000,000 vehicle because there are a lot of mouths to feed across the private bank platforms. 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. So if a family comes to us and says, hey.
I wanna look at this early stage tech investment in an outside fund or know, direct investment, or maybe they wanna 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 we are a full scope, full spectrum adviser, to our families in addition to being investors as well. 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 Knight.
Tell me about GP Stakes Investing. 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 like Dial, but now Blueout, is, you know, investing in a PE firm, if they have a a 10 year fund, those fees are a lot stickier, a lot more locked up, and so your downside protection is 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. And what are you solving for the managers? Why would a GP sell a part of their stake? There are really 3 primary drivers, that that a manager will sell. The first is, just to grow the business. So funds, the big are getting bigger. You know, a lot of firms, they had a a $2,000,000,000 fund, then they went to 4, then they went to 8, 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 added strategies.
They've added either geographic strategies, so maybe it's a US based manager and they wanna 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 expensive to buy a team. It's expensive to pay talent or, you know, 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 nineties. As these firms wanna continue growing, they wanna continue, you know, continuity at the leadership level, they 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 GB side, but those are the 3 drivers.
On the topic of succession planning, let's say that I invest a $100,000,000 into you as a private equity manager. How does that $100,000,000 help with succession planning? Walk me through that. The way that these are typically done, there there are a a variety of ways you can do it. Lawyers get pretty creative on these things. But, ultimately, what you're doing is you're tiering 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, you know, an equity buy in from junior partners or, you know, you're you're creating some sort of for future incentive plan, profits interest on future value, etcetera, where those junior partners can end up buying more and more of the equity in the overlying business that that, obviously, they wanna continue running for long periods of time.
That's that's the major reason you see the secondaries or the way most often they're structured, with 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. And so a lot of these founders take chips off. They're they're structured, to be over a couple 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 wanna be careful with the secondary side. Right? Most most of the capital that goes into these deals is primary capital for growth. One of the biggest misconceptions about the space is that these firms have done a GP stake. You know, 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 2, 3 rounds potentially. HIG is a great example of that.
They've done several transactions with the Blue Owl. They have a very diversified partner base today. They had a big generational transfer there. You had 2 founders who founded the firm in the mid nineties. You know, great example where where they've successfully done that. They've successfully brought up a lot of other partners, and done that over a couple different transactions with the GP Stakes firm. When you're investing in a GP Stakes, what determines whether the deal is high quality?
Obviously, valuation matters like with anything else. We can touch on that in a little bit, how 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 gonna 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 gonna take care of that. So that's the first thing you look at. Obviously, the team, the performance track record's 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 2 to 4,000,000,000 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 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. You mentioned underwriting the ability of top LPs to continue to invest. What are some leading indicators of that?
By the time, typically, a firm hits a stage where you're in the middle market or upper middle market, these are firms with 5 +1000000000 of AUM, and they're probably on fund 3 or 4 at a minimum. And so what you wanna look at is, you know, between fund 2, 3, and 4, did your LP based turnover? What's your reup rate? Are you bringing new high quality LPs? Do you have a huge network of high net worth and family offices that may or may not reup in large scale? So you've gotta underwrite that.
You've gotta 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 a customer base look like? So one of the ways to look at it is you look at your customer base being the LPs and you wanna look at, a, have they continued to reop in the fund?
And, b, what is their historical reop in other funds? 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 and 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 they you know, if it's HIG as example, a manager I really love, are you gonna if if I'm investing in middle market fund 3, am I gonna also invest in fund 4, fund 5, fund 6? Because they're great, they're best in class, they're really generating alpha in that space. So you obviously wanna benchmark that firm against their peer group and then see is their LP base continuing to re up over time.
So that 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 wanna go find new LPs as well. And that's how you go from 2,000,000,000 to 4,000,000,000. You mentioned turnover in LP base. Is that always a negative signal in fund 2, fund 3, fund 4? Yeah. I I'd say most often it it it is, although there are exceptions. Right?
If fund 1 and fund 2 are effectively friends and family, family offices, RIAs, which could be great LPs. We're 1, you know, ourselves. You know, that's okay. But as you get bigger, if you really wanna scale, you know, the chunkier check sizes are really from institutional investors. And so churn's okay if it's churning up and 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 2 and fund 3 and they quit for fund 4, you know, you wanna ask why. And and sometimes it's not the manager's fault. But if it's performance based or if it's, you know, relationship based, all these firms haven't quite institutionalized their investor relations, their capital formation teams. You know, that that's something you wanna dig in on and and dig a little deeper on.
Given that you're investing in the manager and management fees is the most important part of derisking 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. Absolutely. So Legacy Knight, we we typically either invest as LPs in in GP stakes funds or as co investors. But that being said, we do see a lot of the the work on the co investment side and the diligence packages.
And, typically, the 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 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 you're looking at the continuity, the sizing, etcetera. And so, yeah, you have full access to the the underlying LPs.
You you have full access to portfolio companies for what it's worth on that side as well, interviewing those teams, asking why they partner with 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. 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.
Is there something that would be a good GP Stakes investment that would not be a good fund investment? Yeah. It's a great question. I mean, I I think with the GP Stakes Fund, unlike with maybe an just a mainline strategy is the fund's gotta 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 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 gonna help other firms that you want to buy a stake in raise their funds? And, otherwise, they wouldn't wanna sell to you. And so that is something that's a little bit different that you have to underwrite that that that's somewhat unique. I'll also say that that, again, it is very relational.
You wanna 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. You have to understand it differently and 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 that's highly specialized and highly structured. Deconstruct the different revenue streams in a GP Stakes. 1st off is the 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 gonna 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 gonna 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 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 Stake funds are making 4 distributions a year and, you know, on a roughly quarterly basis. And that's that's at a minimum as a floor coming from management fee revenue.
So that's number 1. Number 2 is obviously carried interest, and and carried interest is a huge part of the equation. You've gotta have good performance. However, in the large cap managers, increasingly, they become asset gatherers, and the the fee related income largely management fee revenues, make up a a really significant portion of the turns. 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 they just don't have as much margin on their manager fees. They're not raising $10,000,000,000 funds. And, you know, the growth of teams at the large cap, it's it's linear, not exponential. And so, you know, they they just have better margins on the manager 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 3rd is balance sheet returns. And so, you know, as a manager for some of the GP commit, you know, we also own our percentage in that as as an investor. And so, you know, if they are, you know, your 2% commitment to a bond, if they make a 2 x on it, you're getting gross returns. So your your 2% becomes 4%, for example. And so that's the 3rd. And then the final one is is enterprise value growth.
And so that's really on the back end. And so in the meantime, you're looking at cash flow focused returns through carried interest, balance sheet, and management fees. Now on the back end, obviously, as the GPsex firm seeks to sell their stake at some point, you obviously are hoping for multiple expansion on the back end, particularly if the firm goes public.
So if they buy in, let's say, 7 times distributable earnings, and then in 5 years, they go public at 20 times, obviously, you're gonna get a multiple expansion there. And so that's really where the upside MOEC comes from on these. But the the real attractive nature again, 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 MOEC while also getting the cash flow from p from, like, a private credit type style investing where where you get quarterly distributions. They tend to range in the sort of high single digit to low double digit range, and it's gonna 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 so that's that's how you'd primarily drive returns here, and that's why people like the the investments. And we can talk about some of the pair downsides of these these structures, but that's that's ultimately what makes them really attractive from an upside standpoint. 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?
When GP stakes, you're looking at, again, I'd say, like, a a 2a half to 3a half x. And the the difference between the 2a half and 3a half largely depends on 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 your basis back in, say, 6 to 8 years just based on cash flows.
So the distributions alone get you back to your basis in, say, 6 to 8 years, and then after that, you're gonna continue getting cash flows. So over about a 12 year period, you should expect to get, say, 2 two x on just your cash flows. And then beyond that, it's all about multiple expansion on the exit. But, historically, the the exits have come at much higher multiples, and you do see a pretty good uplift on the back end from that. Cash flows being both management fee as well as carry.
Yeah. Because the way these these management companies work, and, ultimately, that's what you're 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 what the mix is that'll make it larger or smaller.
You know, if a cut firm has a really, really big exit that quarter, obviously, the carried interest piece of that's gonna 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 as is the balance sheet returns.
So let's put aside the multiple expansion that takes you from 2a half to 3 x. Deconstruct the 2a 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? A good point to clarify here is when you buy a GP stake, in in almost every case, you're buying into all the existing funds as well as future.
So it's not just perspective, and and that's really critical because day 1, you're gonna get a lot of cash flow, and that really mitigates the j curve for these investments as well, which makes them pretty appealing. And and how much how much downside protection are we talking about?
It obviously depends on the buy in and where you are, but most of the models I've seen when 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. Just on current and one more fund. 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 1 plus 1. That would down to 1 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? The management fee revenue really is the secret sauce there as well because look.
If that firm completely, you know, collapses and goes under, what what typically happens is they're gonna wind down the fund. You're gonna get, you know, all the things that are already in the ground. They're gonna cash flow. They're gonna have realizations. So, you know, if the firm has a a, you know, corporate shakeup, for example, the partners have a falling out, whatever it may be, you know, you have a a, you know, know, a fraud issue, something like that.
Obviously, you're still gonna realize what's there. Typically, l p LPAs have a provision where, you know, the l p a the LPs can appoint a a manager to run the fund and wind it down. We're still gonna 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, 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 mind. 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 pretty much money good. You mentioned the tax consequences of the asset class. Mhmm. Is there specific LP base that prefers GP stakes? And are there certain LP bases that will never do GP stakes? My perspective on GP space 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 Sovereign's 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 see it across the board, in in my opinion, and that and that's why it's scaled pretty quickly here.
Because, again, you get the the cash flows as well as the upside appreciation opportunity, and and people really love that that, that mix. Everybody loves 2 and a half to 3 x 3 and a half x returns with downside protection. Hey. We'll be right back after a word from our sponsor. Our sponsor for today's episode is Carta, the end to end accounting platform purposely built for fund CFOs.
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Come see the new standard in private fund management atz.carta.com forward slash 10xpod. That's z.carta.comforward/10xpod. Tell me about the role of investment bankers in GP Stakes. As I mentioned earlier, this is a really small world. And I won't name names, but there there's effectively one bank, maybe 2, that shop all these deals, if they are bank. And then there's one law firm that does effectively all of them.
There may be 2 or 3 others that may be on the other side when 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 in. 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 they're overwhelming the 800 pound grill in the room. But in in their case, a lot of times, these are long term conversations going, you know, 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 probably got 2 or 3 major players bidding on these these, you know, stakes. What are the main mistakes that investors make when investing to GP Stakes today? Yeah. That's a great question.
When I talk to our investor base, I always try to really emphasize these are unique investments, and and they are not like other things you invest in. The 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 1 plus 1. They're they're technically perpetual.
Now Blue Isle in particular and others have have gotten very innovative in ways to provide liquidity without actually exiting 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 gonna sell a stake in their business that they know or they think you may go flip in 5 years to someone that that they didn't, you know, choose themselves.
And so for that reason, the industry standard has become perpetual type vehicles. Although, again, they've gotten very creative with certain securitizations and things of that nature to provide liquidity in the interim. What are the valuation metrics that you see used to value stakes today? So private equity as 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, at Blackstone, they're gonna have a lot of realizations every year. They have a very diversified business. They're gonna 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 the metrics have changed as a result of that, but but that was a very advantageous to those firms, and the private markets have effectively started reporting the same way. And so the multiple you 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, you know, in that year. And so that's management fees, carried interest, you know, etcetera. And there are some offsets to that.
I won't 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, 6 times DE all the way up to, say, 9 times. In the public markets, those firms are today trading, you know, anywhere in the sort of high teens to to mid twenties on a DI basis.
So there 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. I I was speaking with somebody in the space previously, and he mentioned that every GP needs to either sell a stake or go public at some point. 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 So the biggest managers have been able to continue raising big funds, and a lot of the other managers have struggled. So if you're a $5,000,000,000 AUM manager, you really need to get to 10 quickly. That that 5 space is tough to play in because more capital, more LP capital is going to bigger firms, and so you wanna get bigger. So the bigger getting bigger, that's driving a lot of this.
That's why Blue Isles 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 gonna see a little bit different story with those. We can touch on group middle markets GP stakes versus large cap because they are quite different.
The reality is there's more capital flowing in the 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 5,000,000,000 AUM range because you're just gonna get eaten alive by the other firms that are adding credit arms, that are raising bigger funds, that may and they have a large cap fund. They're launching a mid middle market fund. They're launching a small cap fund, for example.
So in order to compete, you've gotta be there. Are middle market GP Stakes deals structured differently than large cap? 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 are 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 gonna 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 6 to 7, for example.
And so the performance in the middle market is more important, not only because it's a bigger driver of of the return makeup of the firm, but, additionally, because those firms are less established, they have less, they're they're 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 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 that are all really capable, and and, ultimately, they have a management committee and things like Have you seen any preferred equity deals or any other types of downside protections in the middle market GP Stakes deals? That that's a new trend you're seeing, and I think it's gonna be really interesting.
So what what's happened over the last, we'll say, 3, 4 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 1st 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, Hunter Point has a fund. I think Bon Accord has 1. Their the firm, Arktos, has 1 in that space, and then Blue Isle has 1 as well now. They they do NAV lending. They're doing structured preferred equity type 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 for debt, equity, preferred, whatever it may be. So that's that's the evolution you're seeing in the market, both at the large cap level and in the middle market. How much hand holding do the GP Stakes funds do to these GPs? Are they sitting on boards? Are they helping with governance? Talk to me about that. They they add a ton of value, we'll say.
They don't have a lot of of governance. They do have structural protections in place. A lot of them, they have they have put rights, negotiated in in the instance of, you know, fraud, key man events, things of that nature. So that that that's a big protection we have. Additionally, you know, when 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, you know, if you wanna, you know, fly around on corporate jets all over the world and spend a fortune on, you know, huge parties for the firm, that's fine. That comes out of your bucket, not ours from an expense load standpoint. So a lot of times they have margin struck you know, margin protections baked in there. So you do things like that. But other than that, they're passive economic partners.
I'd say that they add a lot of value, though, in areas like, like Blue Isle has what they call their business services platform. The middle market teams have them as well. So, you know, you really have a bird's eye view of the the industry when you own 20, 30, 40 stakes. You can see, you know, comp trends, HR trends, ESG trends, strategic trends, or people adding credit arms. Are they you know, what are they doing in their firms?
And so for a lot of reasons, they they add a lot of value, in addition to providing us as LPs in these vehicles with a lot of structural protections as well. 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? I think that's a huge part of it. And and we at Legacy 9 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 that that than maybe, you know, available to them in their traditional LP base, they may call it 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 and, again, I'm not talking about a GP take co invest. I'm talking about, you know, a deal level co invest in one of their funds.
You know, additionally, I'll give an example where, you know, there was a portfolio firm of of 100 points in the middle market space, and they were launching a very unique strategy. It was a JV. It wasn't a a a full new strategy, and it was a small LP base. And even though we weren't an LP of that fund, you know, 100 Point directed them to us as a prospective investor because they knew that we had, you know, a taste for that kind of investments, and we have some internal expertise in that space.
And so, you know, we get lots of good cap and show lots of good deal flow from the underlying managers, and 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 you know the team.
You know that, you know, know, whether it's Blue Isle, a 100 point, Bonicore, whatever 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. Speaking of due diligence, how long are these diligence process on the GPs that these funds do?
Like I said, some of these can be years years long processes. I know one manager that that has been talking with one of the shops for a decade now, for example. So a lot of times, it's it's we know we wanna do one. We know that it's gonna make sense for our business. It just has to be the right time. And so that that's typically what drives it. I'd say once you get going on them, the diligence process could be 6 months to a year. Why is it that long? Unpack that.
You know, when you're when you're looking at a 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, you know, trying to get come to evaluation, you obviously have to look at, well, what's the carry gonna be? And if you wanna know what the carry is gonna be, you have to look at all the underlying companies that are gonna generate carry.
And so, you know, it gets pretty granular in there to to build back up to evaluation, and that just takes a lot more time than, say, you're looking at 1 manager or or, you know, one fund or one company. It's just a different process. And so there's just an an additional layer of complexity that comes along with that in order to get to a really sound valuation. When do banks get involved in these long processes?
A lot of times, the firms are all talking in advance, and, obviously, they're they're very sophisticated financial sponsors that they're gonna hire good counsel both on the 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 2, 3, 4 bidders, you know, and it's all the GP Stake's 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 gonna see bidding on these deals. What are the main mistakes that investors make when investing into GP Stakes? I think the primary drivers 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 gonna be correlated is if you have, like, an o eight 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 gonna drive down distributions.
I'll say, though, the benefit of private equity 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 gonna sell that company in a year or 2, maybe, you know, a lower IRR, but, ultimately, the MOIC, which is gonna drive the carry as long as they're above the benchmark, you know, that's still gonna be there. And so there is a there is a low, 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. 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? There are definitely some huge players, particularly on the coinvest side. And so we've we've been active coinvestors alongside GP Sticks firms, both at Legacy Knide and 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. Couple state funds are 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 Knight, we see deal flow in the space that, you know, in any other asset class, a firm of our size and and maturity is not gonna 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 of advantage by by having expertise in this space, and that's why the universe has stayed pretty small. It's q 4 2024. What's the arb in GP Stakes today?
What's the best opportunity to invest into GP Stakes? 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 7,000,000,000 when they did a state transaction, now they're at 70.
You're not gonna see a ton of those, in my opinion, at least if interest rates remain pretty high. I mean, the asset classes become a bit more saturated. But that being said, I think you are gonna see a real good growth story with some of these middle market managers that are that are scaling. And so let me define that. I'm not talking about a middle market manager or lower middle market doing, you know, buyouts in the sort of 6, 7 times EBITDA, 50 to a $100,000,000 inch. Right?
That's not that scalable. It's firms that are on fund 1, fund 2. They're they're raising multibillion 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 really interesting play. And 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 100 Point, for example. That was a good transaction. And you're seeing this because as as large cap managers wanna diversify their asset base, the middle market firms have an exit strategy that 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.
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's a really 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 picture. Unlike at the at the large cap space, it's still not super clearly defined. At a large cap is basically go public or hold.
Yeah. And, I mean, the the they've done some creative things, and we can touch on that whenever you want to. But, you know, for example, like, Blue Isle Fund 3, 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 of a firm.
Blue House sold, half of their stake in Silver Lake to Mubadala, for example, a couple years ago. That was a good partial exit. So there there are some transactions happening, but, again, the the public market has historically not been that great. Peters Hill, most prominently, the Goldman Sachs GP Sake strategy, that has not traded particularly well in London over the last couple of years.
And I think that that poor trading, although it it has some hedge funds and 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. CBC is the most recent example.
You probably got some other ones coming up soon where blew out a stake, and then that firm went public, thus creating liquidity for the stake. GP stakes, you could theoretically invest into any type of GPs. How would you rank the opportunity set today between the different asset classes? 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 it's 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 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 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 and there's gonna 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 just creates a really attractive investment. What about real estate, growth equity, venture capital? Yeah. You know, Infra is an interesting one, that I think is attractive right now. Blue Owl bought a big stake in Stonepeak, which was a huge transaction. It's their largest transaction in Fund Fund 5. And then, obviously, we saw BlackRock bought a huge stake in GIC.
I mean, the these these are huge funds. People are really wanting infra exposure. They generate a ton of fee related income in the management fee space because they they raise huge funds, 15, $20,000,000,000 funds, and and their carry is really big and chunky. The returns aren't aren't massive. You know, they make 1 fives, 1 sixes, 1 sevens, but the quantum of capital is so large that that the they're they're just highly profitable businesses. So that's an attractive space.
I'll also say, I haven't touched on this, I I think that a lot of strategies, and Inpro is a great example of this, from an LP standpoint, going through a GP stake is a much more attractive way to get exposure to the asset class than just an LP stake.
So, for example, you know, using Stonepeak, the GP deal is a much more attractive return profile, call it, like, a 2, 2a half, 3 x with a bunch of cash flow than, you know, in their flagship funds, which, you know, by infra standards are really good. You're you're probably talking about a 1617 MOA, 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 their their asset classes where I think it's much more advantageous to get exposure through a GP stake than others. So Impris is a great example of that. I think it's exciting space. Real estate as well. I mean, they can aggregate assets a ton, and so they can grow AUM pretty dramatically.
But as we saw in the last couple years, there's some real estate managers and some of the few managers that I've seen GP stakes deals get done in that haven't performed particularly well, and it's in real estate because of the last few years. What else excites you about the GP Stakes market today? You know, the reality is they're new entrants.
And and so I think new entrants in terms of funds playing in the GP Stakes space, I think that's exciting because they have different different strategies. They have different ways of doing things. Blue Owl has been the the overwhelming, you know, winner in this space over its history, and and they've also been very innovative. And so, you know, I gotta give a ton of kudos to to Michael Reese and and, Sean Ward and their team.
But the reality is these these up and comers and Hunter Point, Bon Accord, Wafers in the market with a fund. And so I think they're gonna be really exciting because they're they're playing in a space that it's a bigger market, the middle market. You're gonna see some some interesting winners that grow out of that space. And so I'm really excited about it. Even Blueout now is finally moving in the middle market.
They got anchored by by a partner in Abu Dhabi to launch a middle market fund for their strategy too. So now that's a $2,000,000,000 fund, for example. They're buying maybe 100 to 250, $300,000,000 stakes in these funds. So that's a really exciting space. I 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 really exciting time, especially as an allocator because it just creates a bigger universe of deal flow that you're gonna get. Has there been evolution in portfolio construction? I noticed a lot of the early funds had 4 positions, and now it sounds like Lulu Owl is doing 10 positions. Talk to me about that. Yeah. And and they're even doing more than that.
I think the fund 5, which was their largest to date, it was over 13,000,000,000. I think they have 17 now. And so they're getting bigger. They're also having a better 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, you know, they're gonna make that 9 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 I think blending, you know, a portfolio with with some upside equity positions and then some really sticky high cash flow and credit positions is a really attractive portfolio on the GP stake side. So, you know, I I think that's an interesting way to do it.
You've also seen as venture has grown so much, you know, space that obviously you and I are particularly passionate about. You know, you have players like NEA selling stakes and ICONIC selling the stake. 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. It was 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 years too. You mentioned Blue Owl's doing a 150, $200,000,000 deals. How does that relate to AUM? And give me a general framework for that. 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 a 20% stake in a firm or a 15% stake, so we'll say 20 to keep it easy, you know, $200,000,000,000,000 valuation. So that's probably a 5 to $10,000,000,000 AUM firm with a 2 and 20 type structure. So Blue Isles are really going into how what you identified as the upper middle market. Upper middle market. Yeah. So I'd say upper middle market meaning 4,000,000,000 plus. Say 4,000,000,000 to 10,000,000,000.
Above 10,000,000,000, that's kind of what you classify as large cap. So just to give you some perspective here, 10,000,000,000 plus, you're probably talking about a 125 to a 150 managers depending on who's in market right now. Whereas in the middle market, we'll call it 2,000,000,000 to 10,000,000,000. That's several 1,000 managers. So, like, say, 3,000. And then you have obviously smaller than that. That's another several 1,000. 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 some gems under rocks and things like that. David, this has been a master class on GP stakes. What would you like to share with our listeners? As I said, it's a great asset class, private credit like yield with 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 gonna 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 gonna grow. It's only gonna get bigger. I really appreciate you having me, David. Absolutely. Well, I took a lot of notes.
I appreciate you jumping on the podcast, and I look forward to singing down soon. Always happy to be with you. Thanks a lot. Thanks, David. Thank you for listening. The 10X Capital podcast now receives more than a 170,000 downloads per month. If you are interested in sponsoring, please email me at david@10xcapital.com.