How Operating Partners Assess Vertical Integration

It’s a ripe time in the market for owner-operators, and Deborah Smith, a managing partner with CenterCap Group, discusses why it’s important to think through the impacts before bringing a manager in-house.

For most funds with an allocator model, there is certainly great appeal to reposition as vertically integrated to attract investor interest. But the question remains: What’s the level of benefit to owner-operators who must consider abandoning their promotes, networks of investment partners, and full control of their respective businesses? While there are clear benefits to operators in terms of fundraising—elevating their access to institutional capital and increasing scale—it pays to think through impacts before moving a manager in-house.    

“Operators are entrepreneurs at heart, and they believe in the value they have built from the ground up,” says Deborah Smith, managing partner with CenterCap Group, a firm that advises both fund managers and operators on the deployment of capital and their buy-sell mandates. Smith has advised several vertical integrations and observes, “We are seeing many operators who have attractive projects that need third-party capital. They appreciate the benefits of a more reliable capital source or a permanent capital solution. For example, by reducing the burden of capital raising they have more time to focus on doing deals.”

It’s a ripe time in the market for owner-operators. Their cachet is on the rise as investors increasingly seek joint ventures, direct investment, and co-investments to access projects with “regional sharpshooters.” If the right alignment can be reached, these types of investor relationships are ideal for operators looking to retain control of their core business models. Unfortunately, many large investors are far too staff-constrained to take on these types of relationships, which are significantly more intensive from an administration standpoint.   

Getting acquired by a manager is another option for operators in search of capital, but the trade-offs will spur some complex decision-making. “As with all M&A transactions, if the synergies aren’t there and the cultures don’t fit, the marriage of manager and partner runs the risk of not delivering,” warns Smith.

A prime point is how cash proceeds will be paid in a buyout.

“Operators earn a living off their promote,” Smith says. “An operator needs to ask, ‘How is my company being valued? What is the potential buyer taking into account to determine valuation, and if we agreed on valuation when will I receive payment—today or in the future?”

There are also complex scenarios to navigate. Many operators have full ownership of their projects.  These operators have to decide if scaling up their size through vertical integration is worth giving up the full control of assets and their total return—income and sale proceeds.

A greater challenge arises from the issue of consent—especially where an operator does not have a controlling interest. “Take the situation where an operator owns only a piece of a project—say 10 percent—while Capital Partner A owns the other 90 percent,” says Smith. “If a new stakeholder, Capital Partner B, acquires the operator, will Capital Partner A consent? This bring up many more questions to consider, such as what fund manager relationships an operator will lose by going in-house.”

With current market trends, operators are well positioned to consider next steps if they are seeking integration with strong capital partners.

“There’s no question in my mind that there’s a lot of interest right now in high-quality operators with a great track record and deal access,” observes Smith, while also advising that operators pay close attention that the “synergies from selling to a fund manager exceeds what they can do on their own.”