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.
[Editors’ Note: If you are new to private equity funds and would like to know more, we recommend reading An Initiation Into Private Equity Funds]
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. 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. Longer 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 to the table.
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.
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.
Contrasting approaches of committed funds and fundless sponsors have implications for the investing process and investors themselves. Let’s start with the investment process.
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 getting a deal closed. 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 period 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.
[Editors’ Note: Having trouble choosing a private equity fund? Read 6 Things to Consider When Selecting a Private Equity Investment]
From an investor’s point of view, when choosing between traditional 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. 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.
Second, limited partners need no longer 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. Lagging financial markets have, prevented limited partners from meeting capital calls from private equity groups, triggering severe penalties. 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 invest 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 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.
On the flip side, 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.
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 under pressure 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. 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 driveup 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.
[Editors’ Note: If you enjoyed this article, you may also be interested in reading Is Investing In Peer-to-Peer Lending the Right Move for Your Portfolio? To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure and each includes a comprehensive customer PowerPoint about the topic):
This is an updated version of an article originally published on August 12, 2019, and was recently edited by Courtney Smith]
©DailyDACTM, LLC d/b/a/ Financial PoiseTM. This article is subject to the disclaimers found here.
Co-CEO of Avondale Strategic Partners and frequent columnist for Inc. Magazine.
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