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. This includes fundless sponsors, family offices, and even limited partners making direct investments in businesses.
The traditional private equity fund model is where 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. A portion (usually 20%) of the excess capital returned to limited partners is paid to the private equity group, also known as the carried interest.
Private equity groups identify, source, and execute deals using capital contributed by their investors, while trying to help their portfolio companies grow faster to maximize the return on capital from an eventual exit. One challenge with this structure is the concept of the “J-curve,” where the first few years of the fund essentially yield negative returns for investors because of management fees, investments not yet realizing growth, or the lead time required to find and execute quality deals. The return theoretically increases over the fund life as investments mature and the fund is monetized. Longer term, however, many private equity groups, particularly in the middle market, have developed strong value propositions for helping their portfolio companies by bringing industry expertise, operating partners, and strategic growth planning to the table.
By contrast, fundless sponsors (also known as pledge funds) do not raise a committed fund, and thus 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 on a deal-by-deal basis to gain capital commitments to specific deals, rather than through an aggregate pool of money.
Fundless sponsors operate like private equity groups in most other ways with respect to creating value for their portfolio companies through operational and strategic guidance. In recent years, as fundraising has become more difficult and limited partners are shunning large up-front fees, more private equity professionals are shifting toward the fundless models, as some of the benefits to investors become more apparent.
The contrasting approaches of committed funds and fundless sponsors have a number of implications for both the investing process and the investors themselves. Let’s start with the investment process.
Both types of groups try to develop deal flow from similar sources, but fundless sponsors have committed capital early in the process, which presents an additional layer of execution risk. Furthermore, for future capital needs, it is important for fundless sponsors to prove (to their potential portfolio companies) that they will have enough available capital from equity sources to continue supporting their portfolio companies through a growth period. From an equity seller’s perspective, this may present enough of a risk to getting a deal closed that they choose a different buyer.
On the other hand, fundless sponsors do not have the same kind of restrictive investment mandate or defined fund life as traditional funds, and can often offer greater flexibility with respect to holding period and partnership models. This may prove attractive for many sellers, particularly where they are retaining equity. Fundless sponsors can often provide more patient capital to allow portfolio companies to realize the full benefits of a solid growth plan without prematurely exiting the business to meet fund life commitments.
From an investor’s point of view, when choosing between traditional funds and pledge funds, the first implication is the difference in fees, which has made an impact on the evolution of the industry. Limited partners are becoming more resistant to up-front fees, particularly in a sluggish market where 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, while shifting the investor demographic by providing high-net-worth individuals – and not just institutional investors – increased access to the buyout market.
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. Instead, private equity groups can make commitments on a case-by-case basis. This has become an important consideration as the lagging financial markets have, in some instances, made limited partners unable to meet their capital calls from private equity groups, triggering severe penalties for limited partners. The fundless sponsor model also allows investors to decide their investment strategy based on their risk appetite.
Third, in a traditional private equity fund, limited partners are investing in a blind pool of capital. They gain from the winners, but also suffer the losses, with no ability to allocate risk across a portfolio. Through fundless sponsors, investors gain a great deal of information about investments, and can select where they want to put their money. Furthermore, the investor base touches more high net-worth individuals who may have operating experience in particular industries that can be useful for bringing value to portfolio companies. Thus, limited partners may gain insight into deals and even potentially help create value for investments.
On the flip side, limited partners may not necessarily have the expertise or resources to effectively evaluate attractive middle-market opportunities, in which case traditional fund models allow them to simplify the investment process by partnering with professionals who have successful track records.
The industry continues to see more family offices and limited partners enter the direct investment market. Family offices invest from a pool of capital that is 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.
The same holds true for some institutional limited partners, such as pension funds, which are taking a more active role in directly investing in opportunities through co-investments with trusted private equity managers. These investors typically take a longer-term view of investing and can be more selective, since they are not under pressure to invest within a defined fund structure. However, many such direct investors may not have the resources to evaluate and structure transactions, making them susceptible to potentially missing attractive opportunities.
The increased amount of choice benefits investors by improving access to private equity investing to a larger demographic, and offering more choices for tailoring investment strategy. Traditional private equity funds and emerging direct investors are also finding new, creative ways to partner together to acquire and grow businesses, which benefits everyone.
Overall, the growth of this alternative investor base has changed the M&A landscape by introducing more bidders, thus potentially driving up valuations, and making quality deals more scarce. And, as more family offices and limited partners enter the direct investment market, the more the fundless sponsor model will continue to evolve as it grows.
Co-CEO of Avondale Strategic Partners and frequent columnist for Inc. Magazine.
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