Financial Poise
fundless sponsors

Fundless Sponsors Appeal to Individual Investors — Fewer Fees, More Specificity

Fundless sponsors, family offices, and even limited partners are making direct investments in businesses. In the world of middle-market buyouts, non-traditional funds (or fund-like groups) are playing an increasingly active role in the private equity domain.

Fundless Sponsors vs. Traditional Private Equity

While both fundless sponsors and traditional private equity invest in private companies, their approach differs, starting with how they source investors, companies, and capital. Investor benefits differ as well.

Traditional Private Equity: Funds, Fees, and Lifespan

In the traditional private equity fund,  limited partners commit capital to a fund that charges an annual management fee, usually 2% of the fund size. Those who commit capital to the funds are usually large institutional investors, endowment/pension funds, and high-net-worth individuals.

The fund often has a finite life span and a mandate regarding the types and size of deals in which it can invest. Limited partners receive a preferred return on the amount of capital they commit. The private equity group receives a portion, usually 20%, of the excess capital returned to limited partners. This is also known as the carried interest.

Private equity groups identify, source, and execute deals using capital contributed by their investors. They try to help their portfolio companies grow faster to maximize the return on capital from an eventual exit.

Benefits to Investors

One challenge with this structure is the “J-curve.” The first few years of the fund yield negative returns because of management fees, investments not yet realizing growth, or lead time to find and execute quality deals. The return theoretically increases over the fund life as investments mature and the fund is monetized.

In the long term, many private equity groups, particularly in the middle market, have developed strong value propositions for helping their portfolio companies. They bring industry expertise, operating partners, and strategic growth planning.

Fundless Sponsors: Network Building and Case-by-Case Deals

By contrast, fundless sponsors, also known as pledge funds, execute a letter of intent and then acquire the equity to fund an acquisition. Fundless sponsors do not raise a committed fund and do not charge up-front management fees. They may charge a fee to their portfolio companies, but only after an investment is in place.

Fundless sponsors build a network of valued investors and present opportunities to them, deal by deal, to gain capital commitments for specific deals rather than through an aggregate money pool.

Benefits to Investors

Fundless sponsors operate like private equity groups with respect to creating value for their portfolio companies through operational and strategic guidance. As fundraising becomes more difficult and limited partners shun up-front fees, private equity professionals shift toward the fundless models. The benefits to investors are apparent.

The Risks and Benefits of the Fundless Sponsor Investment Process

Contrasting approaches of committed funds and fundless sponsors have implications for the investing process and investors.

Both types of groups develop deal flow from similar sources, but fundless sponsors commit capital early in the process. That presents an additional layer of execution risk. Furthermore, for future capital needs, it is important for fundless sponsors to prove they will have enough capital from equity sources to support their portfolio companies through a growth period. An equity seller could see this as a risk to closing a deal. They may choose a different buyer.

On the other hand, fundless sponsors do not have the restrictive investment mandate or defined fund life as traditional funds. They can offer greater flexibility with respect to holding periods and partnership models. This may prove attractive for sellers, particularly where they are retaining equity.

Fundless sponsors may provide more patient capital. That allows portfolio companies to realize the full benefits of solid growth without exiting the business to meet fund life commitments.

Accredited Investor’s Perspective on Fundless Sponsors

From an investor’s point of view, when choosing between traditional and pledge funds, the first implication is the difference in fees, which has impacted the industry’s evolution.

Growing Resistance to Up-Front Fees

Limited partners are becoming more resistant to up-front fees. Quality deals are taking more time to find and close. The pushback on fees gives fundless sponsors a leg-up on attracting more pockets of capital. Meanwhile, it shifts the investor demographic by providing high-net-worth individuals — not just institutional investors — increased access to the buyout market.

The Appeal of No Upfront Commitment

Second, limited partners no longer need to tie up capital for a defined fund life to have funds available when it is time to fund a transaction or incur severe penalties for unmet capital calls. Instead, private equity groups can make commitments on a case-by-case basis. The fundless sponsor model also allows investors to decide their investment strategy based on their risk appetite.

More Deal Details and Freedom of Choice

Third, in a traditional private equity fund, limited partners invest in a blind pool of capital. They gain from the winners but also suffer losses with no ability to allocate risk across a portfolio.

Through fundless sponsors, investors gain information about investments and can select where they want their money. Furthermore, the investor base touches more high-net-worth individuals. Those individuals may have useful experience in particular industries that can bring value to portfolio companies. Limited partners may gain insight into deals and even potentially create value for investments.

Conversely, limited partners may not have the expertise or resources to effectively evaluate attractive middle-market opportunities. In that case, traditional fund models allow them to simplify the investment process by partnering professionals with successful track records.

Direct Investment Know-How

More family offices and limited partners are entering the direct investment market. Family offices invest from a pool of capital almost exclusively from a wealthy individual or family estate. These offices have shifted from allocating capital to other funds to directly investing in and acquiring middle-market businesses.

Some institutional limited partners, such as pension funds, are taking a more active role, directly investing in opportunities through co-investments with trusted private equity managers. These investors take a longer-term view of investing. They can be more selective since they are not pressured to invest within a defined fund structure. However, many such direct investors may miss attractive opportunities as they lack the resources to evaluate and structure transactions.

Expanded Options Are Always Good for Investors

Investors benefit from the increased number of options. They realize improved access to private equity investing with a larger demographic offering more choices for tailoring investment strategies. Everyone benefits when traditional private equity funds and emerging direct investors find new, creative ways to partner together to acquire and grow businesses.

Overall, the growth of this alternative investor base has changed the M&A landscape by introducing more bidders. More bidders potentially drive up valuations and make quality deals scarcer. And, as more family offices and limited partners enter the direct investment market, the fundless sponsor model will further evolve as it grows.


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[Editors’ Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can view at your leisure, and each includes a comprehensive customer PowerPoint about the topic):

  1. Raising Capital: Negotiating with Potential Investors
  2. Crowdfunding from the Investor’s Perspective
  3. An Introduction to a New Yet Old Funding Alternative

This is an updated version of an article originally published on August 12, 2019.]

©2023. DailyDACTM, LLC d/b/a/ Financial PoiseTM. This article is subject to the disclaimers found here.

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About Karl Stark

Co-CEO of Avondale Strategic Partners and frequent columnist for Inc. Magazine. Share this page:

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