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

Legacy Nine is a 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 of assets. What is your advantage against the large banks, the J.P.
Morgans, 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 GP Stakes Investing.

It's only going to grow.

It's only going to 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 Night.

Let's jump right in.

What is Legacy Night?

Legacy Night is an alternative, 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 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 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 to family offices around the country.
Those checks tend to be in the range of 20 to up to a hundred million. And again, can be fund investments, they can be anchors funds, they can be co-investments, a lot of GP stakes investing.
When we last chatted, we talked about your advantage against the large banks, the JP Morgans, 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, but 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-right-north 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 a hundred or $200 million 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, they can only advise on investments on their platform. 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 direct investment, or maybe they want to buy a piece of real estate, 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. You've been an early adopter as an investor in GP Stakes, both at your previous role at Kaz Investments, as well as today at Legacy Night.
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 the GP stakes funds realized, like Dial, now Blue Owl, is 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. And what are you solving for the managers? Why would a GP sell a part of their stake? 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.
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 one, two, 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 growth is as these firms want to scale, a lot of them, they can't just scale their monoline 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 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 70s, 80s.
And so a lot of those founders are now in their 80s and 90s. So 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.
On the topic of succession planning, let's say that I invest $100 million into you as a private equity manager. How does that $100 million help with succession planning? Walk me through that.
The way that these are typically done, there are a variety of ways you can do it. 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. 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 saving.
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.
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. 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 two founders who founded the firm in the mid-90s.
Great example 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 GP Stakes, what determines whether the deal is high quality? Obviously, valuation matters like anything else. We can touch on that in a little bit, how you come to valuation here.
But beyond that, what you really want is, 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, what's your counterparty risk here? Are people going to pay their management fees? And if you've got nothing but top tier pensions and endowments, there's a very, very high probability that 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, 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 a big driver. They can really upsize and upgrade your LP base as a manager.
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, 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 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 based turnover? What's your re-up 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 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? 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? You can look at those analyses across the marketplace, but the primary one is with that manager, are those funds continuing to allocate that? Because as you know, like 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 you want here is they, you know, if it's HIG as example, a 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 $2 billion to $4 billion. You mentioned turnover in LP base.
Is that always a negative signal in fund two, fund three, fund four? 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 can be great LPs, we're one ourselves, that's okay. But as you get bigger, if you really want to scale, the chunkier check sizes are really from institutional investors.
And so churn's okay if it's churning up and you're going up market in terms of your LP base and quality base. But obviously, if we had the biggest pinch 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. 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. Absolutely.
So Legacy and I, we typically either invest as LPs and 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're looking at the geographic diversification of LPs, because that can be a growth area in the future. 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 partnered with that team. 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 done quickly. A lot of times 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, that's a great question.
I mean, I think with the GP stakes fund, unlike with maybe 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's somewhat unique.
I'll also say 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 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 really trust in the team also on the structuring side and what they're doing. It's just a different kind of investment.
It's very esoteric, very specific. And so the teams, a lot of them, they come out of the space or they come from law firms that have done deals in the space and things like that.
So again, it's a small ecosystem, but one that's highly specialized and highly structured. Do you construct the different revenue streams in a GP stakes? 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, 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 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 half a percent a quarter every year. So on average, not every fund, but for the most part, the GP stake funds are making four distributions a year and on a roughly quarterly basis.
And that's at a minimum as a floor coming from management fee revenue. 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 manager fees.
They're not raising $10 billion funds. And the growth of teams at the large cap, it's linear, not exponential.
And so 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 third is balance sheet returns.
And so as a manager per sepid GP commit, 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 back end.
And so in the meantime, you're looking at cash flow focused returns through carried interest, balance sheet, and management fees. And on the back end, obviously, as the GP stakes 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 at, say, seven times distributive 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 real attractive nature, 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 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 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 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? In 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, in most, in most cases, particularly blue out, you know, you're looking to get your basis back and say six to eight years just based on cash flows.
So the distributions alone get you back to your basis and 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.
Cash flows being both management fee as well as carry. 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. That entity, every quarter, they may have carried interest realizations, they have management fee distribution.
So it's typically one distribution. It just depends on what the mix is that'll make it larger or smaller.
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 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.
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? 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 cashflow. And that really mitigates the J curve for these investments as well, which makes them pretty appealing.
And 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 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 10% of your basis, just on management fee income alone. Just on current and one more fund.
Current and one more fund. 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 plus one.
And 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? And the management fee revenue really is the secret sauce there as well.
Because 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 all the things that are already in the ground.
They're going to cash flow. They're going to have realizations.
So if the firm has a corporate shakeup, for example, the partners have a falling out, whatever it may be, you have 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 LPA, the LPs can appoint a manager to run the fund and wind it down, we're still going to get 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.
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 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. Is there a specific LP base that prefers GP stakes? And are there certain LP bases that will never do GP stakes? My perspective on GP stakes is a little bit unique, but 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 see it across the board, in my opinion, and that's why it's scaled pretty quickly

here.

Because again, you get the cash flows as well as the upside appreciation opportunity, and

people really love that mix.

Everybody loves 2.5 to 3.5x returns with downside protection.

Hey, we'll be right back after a word from our sponsor.

Our sponsor for today's episode is mix. Everybody loves 2.5 to private fund management at z.carta.com forward slash 10xpod.
That's z.carta.com forward slash 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'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 may be two or three 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 the produce. 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 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 two or three major players bidding on these 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 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 end life.
They're not 10-year funds. They're not 10 plus one plus one.
They are technically perpetual. Now, Blue Owl in particular and others have gotten very innovative in ways to provide liquidity without actually exiting the positions.
But that being said, you need to understand that they are structured as perpetual. The reality 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. 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 is an asset class historically has been undervalued

in the public markets. And the main reason that has 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. And so that's management fees, carried interest, et cetera.
And there are some offsets 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-20s on a DEI basis. So there's a pretty big amount of arbitrage to be had here.
Particularly these firms end up going public like a CVC did last year. 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.
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 of the other managers have struggled.
So if you're a $5 billion AUM manager, you really need to get to 10 quickly. 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 Owls 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, that are raising bigger funds, that may, they may 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.
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 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 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, but additionally, because those firms are less established, 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 basis, where in the middle market, you may have one key man, founder led business. And so you have a lot more business risk, a lot more key man risk, whereas large cap fund may have 50 managing directors that are all really capable.
And ultimately they have a management committee and things like that. Have you seen any preferred equity deals or any other types of downside protections in the middle market GP stakes deals? 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 in the world. And yet, 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, Hunter Point has a fund.
I think Bonacord has one. The firm Arctos has one in that space.
And then Blue Owl has one as well now. 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.
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. 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, you know, if you want to, 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 Bluewell 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 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, or they, you know, 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. 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 we at Legacy and I benefit greatly from that.

So for example, a lot of times I've been managers 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 state co-invest.
I'm talking about a deal level co-invest in one of their funds. Additionally, I'll give an example where there was a portfolio firm of HunterPoints 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, HunterPoint directed them to us as a prospective investor 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 better diligence protection.
You know the team, you know that whether it's Blue Owl, Hunter Point, Bonacord, whoever 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 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.
Why is it that long? Unpack that. You know, 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 trying to come to evaluation, 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, 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.
When do banks get involved in these long processes? 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 they're involved throughout the process.
Again, a lot of times a process will happen. It's just a very small universe.
It may be two, three, four bidders, and it's all the GP's take same. 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.
What are the main mistakes that investors make when investing into GP stakes? I think the primary driver 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 08 type scenario where your LP base is really, really illiquid or they're having crises.
But that being said, 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 that private equity firm is going to sell that company in a year or two, maybe a lower IRR, but ultimately the MOIC, which is going to drive the carry as long as they're above the benchmark, that's still going to be there. And so there is a level of optionality there, but it does have correlation.
I think a lot of people, 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 co-invest side. And so we've been active co-investors alongside GP Stakes firms, both at Legacy Night and prior at Kaz.
And ultimately, you do see the same faces there. You have 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 how large the asset class has become, it still is a very, very small ecosystem.
And so as a result, Legacy Night, we see deal flow in the space that 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.
They've never done them. And so I think there is a level of advantage by having expertise in this space.
And that's why the universe has stayed pretty small. It's Q4 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 billion when they did a stake transaction, 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 or lower middle market doing buyouts in the sort of six, seven times EBITDA, 50 to $100 million range, right? That's not that scalable. It's firms that are on fund one, fund two.
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 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 the strategics and selling to other managers. And so you don't see as much M&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 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. The large cap is basically go public or hold.
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 Owl 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 percent 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 Mubatala, 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 trading, although 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.
And when I say go public, I'm talking about taking the portfolio public, not a single name. You do see IPOs, CVCs, 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.

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 a smaller percentage, but it's highly predictable.
And so obviously obviously we all know private credit is 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. 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 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 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 Stone Peak, which was a huge transaction.
It's their largest transaction in Fund 5. And then obviously we saw BlackRock bought a huge stake in GIC.
I mean, 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 raise huge funds, $15, $20 billion 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, 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 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, three X with a bunch of cashflow than in their flagship funds, which by Infra standards are really good, you're probably talking about a 1.6, 1.7 MOE. 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 they're 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 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 of 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, 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 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,

you know, I got to give a ton of kudos to Michael Reese and Sean Ward and their team. But the

reality is these up and comers and Hunter Point, Bonacord, Wafra's 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 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 million stakes in these funds.
So that's a real exciting space. I think you're gonna have more players.
You have a much bigger universe to play in. 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 going to get.
Has there been evolution in portfolio construction? I noticed a lot of the early funds had four positions, and now it sounds like Lulu Owl is doing 10 positions. Talk to me about that.
Yeah, and they're even doing more than that. I think the Fund 5, which was their largest to date, it was over $13 billion.
I think they have $17 billion 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, it's just very sticky and dependable because they're going to make that nine to 11 unless they really, really mess up. And obviously the incentive fee on that, although the quantum capital is lower, it's real predictable.
And so I think blending a portfolio 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 I think that's an interesting way to do it.
You've also seen as venture has grown so much, a space that obviously you and I are particularly passionate about, 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, is very carry heavy, very return and carried less management fee heavy. But that's going to be an interesting phenomenon seeing how that develops over the next couple of years too.
You mentioned Blue Owls doing $150, $200 million deals. How does that relate to AUM? And give me a general framework for that.
It's going to depend on the manager and what their management fee is, what their margins are, things like that. But typically, 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, $200 million billion valuation.
So that's probably a $5 to $10 billion AUM firm with a two and 20 type structure. So Blue Owl is really going into what you identified as the upper middle market.
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 150 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. 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. David, this has been a masterclass 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 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. Absolutely.
Well, I took a lot of notes. I appreciate you jumping on the podcast and look forward to sitting down soon.
Always happy to be with you. Thanks a lot.
Thanks, David. Thank you for listening.
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