Argentum Award 2021: Adding insight to understudied topic

Among the record-number of theses received for this year’s Argentum Award, Jonatan Gustafsson and Erik Fogelström of the Stockholm School of Economics (SSE) claimed the first spot. “It is a solid empirical work that sheds light on a topic on which we only have very little knowledge about,” says the jury.

The winners of the Argentum Award 2020 are Jonatan Gustafsson (left) and Erik Fogelström, alumni of SSE. Both work in PE today: Fogelström in a RE-focused PE firm as a full-time analyst, Gustafsson as an associate at a Nordic PE firm. Photo: Private

In their thesis, the winners examined the phenomenon of minority stakes in private equity firms (“GP stakes”). More precisely, they studied the motives behind such deals and their fund-level impact on target firms. A private equity firm is called a general partner (GP) and an investor that commits capital to a PE fund is called a limited partner (LP).

“Why do GPs sell part of their ‘company’?” asks Carsten Bienz, Associate Professor at the Norwegian School of Economics (NHH) and jury leader of the Argentum Award.

“The typical relationship between GPs and LPs is a complicated one, where the GP has her own holding company where she receives her share of the funds. Fees and carry are meant to solve the complex agency issues that underlay the principal-agent relationship between the LP and the GP,” Bienz explains.

Yet, sometimes LPs purchase minority stakes in these holding companies, Bienz continues. Under what circumstances does such an investment make sense? Does it make sense at all, given that it is likely to weaken the GP’s incentives?

These questions are explored in Fogelström and Gustafsson’s thesis.

Adding insight to an understudied topic

“We both wanted to write about a new topic where we felt that we could add some relevant insights. It also helped that both are intrigued by PE and think it is an interesting field,” says Fogelström about the idea behind the project. Read the thesis here.

After receiving advice from Per Strömberg, SSE Centennial Professor of Finance and Private Equity at the Stockholm School of Economics (SSE), the pair concluded that the topic of minority stakes in PE firms could be exactly that: An understudied topic where they could add some insight.

“PE is constantly changing. As the industry and the asset class matures, it leads to changing dynamics between LPs and GPs, which is the phenomenon we study in the thesis. GP stakes allow owners to realise value and is a new way for investors to gain exposure to the illiquidity premium,” says Gustafsson.

“Before diving into this subject, we had some knowledge about the IPO of PE firms but had minimal knowledge about the phenomenon of minority stake investments in the management company by LPs,” says Fogelström.

“Rare for a master’s thesis”

The findings in the thesis indicate that the official reasons communicated by PE firms for selling a GP stake – to fund new strategic initiatives, enter new markets and increase capital commitments to new funds – are not the actual reasons. Instead, they argue that the real motivation behind selling a GP stake is for owners to realise value.

Bienz and the jury finds Fogelström and Gustafsson’s result interesting as it illustrates a problem that is becoming more urgent for many GPs: How to realise the value in the firms they have created.

“Most GPs are literally partnerships, and hence it is difficult for owners that want to leave to sell their stake in the firm. Other partners might not want to or cannot buy their stakes, yet there is almost no secondary market for these stakes. By selling minority stakes, such value can be realised,” he says.

“In addition, and this is very rare for a master’s thesis, this is one of the first, if not the first, paper to look at this phenomenon,” he adds.

Plenty of interesting findings

Gustafsson says that nothing indicated that GP stakes would mitigate the conflict of interest between GPs and LPs, which was the pair’s hypothesis.

“Instead, it is rather the opposite, since a GP stake is not necessarily welcomed by LPs and could increase the conflict of interest instead. Although we never really discussed the LP’s point of view on the conflicts of interest, we had a conversation with a Nordic LP on the topic, who was quite negative on GPs divesting their stakes and taking in new owners that do not work directly with investments,” says Gustafsson.

For Fogelström, two findings stand out:

“First, we could not find a significant increase in the size of the funds raised by PE firms after having received a GP stake investment (i.e. no significant effect on the growth rate of fund size post GP stake). This is striking since funding growth initiatives of different kinds is one of the most common reasons stated by PE firms for selling GP stakes.

“Second, only a minority of investors in GP stakes have previously invested in the funds of the same manager. This means that the reason for investing in these types of deals are only in a minority of cases, a way to align incentives in an existing LP-GP relationship. Instead, it seems like an attractive investment opportunity for investors, providing a different risk-return profile than more traditional PE-fund investments.”

The duo believes that the thesis has laid a solid foundation for future studies on GP stakes in PE firms. They hope that future studies can dig even deeper into the motivations behind and the fund-level effects of these investments.

Read our interviews with the Argentum Award winners from 2018, 2019, and 2020.