Fundless Sponsors Amid Today’s Liquid Private Equity Market
With a traditional equity business model, private equity firms turn to outside investors to raise capital for a fund, which is then spread across several investments. These investments are sourced and researched by the firm’s managers, and are seen as the most logical and worthwhile investments for the fund. Private equity firms also typically collect a management fee in order to pay salaries and support operations.
In this model, LP’s are legally responsible for funding the private equity firm’s investment decisions; yet don’t have much say in these decisions.
This model has worked for years, and is still effective for private equity firms that are capable of raising capital successfully.
However, today’s global climate introduces new challenges to both private equity firms as well as private businesses looking for funding.
More capital is being raised yet not invested
According to Preqin, as of March 2015, $1.22 trillion of committed capital in the world was still waiting to be invested into deals. Combine that with an increase in zombie funds (funds that tie up capital by holding assets beyond the official holding period with no clear strategy for raising additional funds) and it’s clear that private equity firms are facing a difficult time.
The result of all this held capital is that the best deals are getting bid up. This has led to an opportunity for niche investors (including fundless sponsors) to go after the lesser-known (but perhaps just as lucrative) deals.
What is a fundless sponsor?
A fundless sponsor is someone (or a group of people) who doesn’t have up-front financing for an acquisition, yet still seeks out acquisition targets. Somewhat similar is the search fund, which raises a smaller amount of capital to fund the deal sourcing and diligence process.
The number of fundless sponsors has skyrocketed in recent years, as former private equity executives leave firms that can no longer raise funds. These execs are striking out on their own, and are using their expertise in their niche industry, alongside with their personal contacts and relationships, to win over smaller deals that private firms would have normally looked over.
But why have these models become so popular in recent years, at the expense of the traditional model?
Private companies have become extremely conservative with their fundraising strategies, because of their concern for inadvertently violating securities regulations. Their concerns revolve around all of the new regulations – in response to the financial crisis – that have come to light. Foreign firms have also found the landscape difficult to navigate.
That’s where a fundless sponsor becomes so attractive. They can provide deal flow by acting independently with their own networks of investors, or with established private equity firms. An experienced fundless sponsor has deep connections within an industry and can provide unique access to deal flow that may typically go overlooked by a larger private equity firm.
A fundless sponsor can be a benefit to a private company because the sponsor can provide much needed managerial and operation expertise. LPs are able to negotiate fee terms in line with the approval of a specific deal. These deal fees are typically payable once capital is deployed, which is seen as a benefit to LPs, who will have the ability to invest into deals of their own choosing, while simultaneously benefiting from the support and resources of a seasoned investor.
Fundless sponsors at a glance:
· Can earn acquisition fees
· Can share in carried interest profits
· Can collect ongoing management or consultant fees
Inherent Flaws of a Fundless Sponsor
Of course nothing is without flaw. For example, fundless sponsors may not be able to acquire the required capital to invest in sourced deals. With fundless sponsors, the chances of a deal transacting are not as high as with a traditional model.
Fundless sponsors don’t have the capital upfront, and this might serve as a stumbling block when trying to negotiate deal terms or when scouting the best possible deals. Sellers, as well, may not be quick to work with an investor if the required capital needed isn’t guaranteed.
Traditional Private Equity Firms vs. Fundless Sponsors
Rather than see these as competing models, it’s best to look at them as independent of one another. Traditional private equity firms will continue to get access to the most popular deals; however, the global climate is encouraging the rise of the flexible fundless sponsor model, which will prove its place in the industry.
Fundless sponsors – by their very nature – will pursue smaller deals that big private equity firms deem as a waste of time. At the same time, fundless sponsors typically contain an increased layer or risk because the existing owners and management team are generally less sophisticated.
Fundless sponsors succeed when they leverage their personal relationships and expertise in the industry to compete and move up market. As they move up, they are likely to begin to compete directly with private equity firms. This will especially be the case as private equity continues to move down market to find “diamond in the rough” deals.
I would expect the market for fundless sponsors to continue to expand as creative financing options concurrently broaden. Such an expansion will place an even greater burden on investment bankers and M&A advisors to ensure deal timelines, speed and execution remain in check, particularly if we’re representing a sell-side M&A deal. And while the complexity is not likely to diminish anytime soon, I would hope access to capital to loosen as new options for fintech make the world of acquisition and deal financing that much more streamlined.
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