As GP‑stakes deals spread deeper into the middle market, the challenge is maintaining the high underwriting standards that have defined the strategy so far. The risk isn’t a lack of opportunities, but that discipline slips as firms seek additional capital.
Private equity firms are increasingly looking for solutions as liquidity and distributions have dried up. Warren Teichner, co-lead of private capital at consultant firm McKinsey, said that “there is no doubt that there will be some shift down.”
“It is natural as the trend continues to drive, GP stakes firms are very consciously investing in high-quality firms,” Teichner said, adding that the data demonstrates a very wide spread in the middle markets.
“There is a segment of the market that is very high performing, and there is a segment of the market that is underperforming, with zombie firms and the like,” he added.
“Middle-market funds have opportunities that are often harder for their larger counterparts to access, including buying companies at more attractive entry multiples and growing those companies at a faster rate,” adds Brian Vickery, partner at GP stakes firm PACT Capital Partners.
Private equity has faced fundraising challenges over the last few years, sparking rumors of industry consolidation, but the middle market remains an attractive destination for capital, according to a new report from PACT.
“Limited partners have demonstrated growing interest in middle-market funds, as evidenced by increasing capital allocations and consistent responses in market surveys,” the report notes.
The Importance of Discipline
Joseph Lombardo, global head of GP advisory at Houlihan Lokey, rejected the narrative that the difficult times PE is having will lead to even more GP stake sales.
“In the vast majority of GP stake deals it is not firms that are having trouble with fundraising,” he said. “The stake deals are for the firms that are healthy and growing.”
That discipline matters because GP stakes funds receive a portion of the private equity firm’s revenue stream from fees and carried interest. If the firm’s quality slips, both fee income and carry shrink.
Middle Market Private Equity Firms Need Scale
Middle market firms are selling stakes in part to match the organizational capabilities of their larger peers while maintaining the distinct advantages that made them successful, according to PACT Capital Partners.
While a small number of these managers have joined large platforms in recent years, hundreds of middle-market firms remain independent, and most wish to remain so, according to PACT’s report.
The firm’s founder and managing partner Christian von Schimmelmann said the case for GP stakes is actually very strong in a volatile market environment. The pressure has created growth opportunities, but managers don’t necessarily want to be forced to sell to expand or increase the size of their funds.
“Capital could help with GP commitments and allow firms to resource themselves better,” he said. “The market is probably more challenging now for people to raise capital in, but for us that adds a cyclical benefit.”
The PACT report argues that the appeal of GP‑stakes capital ultimately comes down to preserving what makes these firms work.
“Independence allows firms to maintain the culture that firm leaders have carefully crafted, stay focused on investments and processes that have made them successful, and retain sufficient economics to attract and retain top talent,” the PACT report noted.
