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.

RC Victorino
  • Craig Dickens
    Posted at 15:27h, 28 September Reply

    Nate good recap of the landscape. Positive alternatives especially for lower middle market companies are crucial in M&A deals. Although it’s an intermediaries job to vet the ability of suitors based on several factors including financial preparedness, to close a deal, it is wise to not limit those alternative prematurely. With such tremendous availability of capital having alternatives allows sellers to focus on other factors like fit, cultural alignment and of course financial resources.

    • Nate Nead
      Posted at 18:53h, 28 September Reply

      Thanks Craig. It’s nice that the abundance of capital allows issuers to think about the “softer” deal terms that often weigh heavy on long term goals.

  • John L. Illes
    Posted at 16:48h, 28 September Reply

    Great article Nate. Fundless sponsors provide institutional investors with a solid operational team that stays post acquisition. Too many time traditional acquisitions come up short due to owner/key manager dependence. With deep industry knowledge and contacts, a fundless team can partner with experienced capital in the space to really drive value creation.

    • Nate Nead
      Posted at 18:52h, 28 September Reply

      Thanks John. As long as the capital can be procured, it remains a source for doing deals that may eventually compete directly with private equity.

  • Sean Ostrander
    Posted at 17:42h, 28 September Reply

    Definitely an interesting analysis. I would also think that while the onus is on the Investment Banker to speed up the process and make sure they hit their milestones, I would think the need for extended Due Diligence increases. Most PEG’s like to see a track record in the company they are acquiring, and many like to see the current management team stay involved for a 6-24 month period. However, with a new management team, the investor has to vet their experience, and then trust that they’ll be able to take on the newly acquired company and continue / improve the profitability or growth trend.

    • Nate Nead
      Posted at 18:56h, 28 September Reply

      Absolutely Sean. Fundless sponsors, while they may lack the financial resources, may come with the human capital element that can attract the right financial partner. Like Craig said, the amount of capital at play these days, can make for some interesting combinations that were more rare five years ago.

  • Brian Haynes
    Posted at 18:53h, 28 September Reply

    I’ve seen some owners gravitate toward selling to a Fundless sponsor. It can make the transaction more personal and less clinical.

    • Nate Nead
      Posted at 19:00h, 28 September Reply

      Hi Brian,

      The “soft” deal terms are sometimes more important, particularly in deals where the sellers may want to take a ride with some equity and structure a deal accordingly with a fundless sponsor.

  • Walter deMilly
    Posted at 21:16h, 28 September Reply

    Great article Nate. Is a Fundless Sponsor typically expected to have at least some skin in the game? (aside from “sweat equity” or goodwill).

  • Steve Szirmai
    Posted at 16:40h, 01 October Reply

    Nice Summary, Nate!
    The interesting thing is that this affects smaller deals, lower down the price spectrum which PE firms would have ignored before. This bodes well for EBITDA multiples for good quality, smaller firms.

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