In a traditional private equity business model, a private equity firm raises committed capital for a fund from outside investors. The firm will then deploy that capital into investments that its General Partners (”GP’s”) sources and decide are worthwhile. In order for the firm to pay salaries and support operations, a management fee is collected (typically a percentage of assets under management) and also a performance incentive is paid, as a share of profits, often referred to as “Carried Interest”. In this traditional model, Limited Partners(“LP’s”) have limited say in the investment process and little recourse to debate the merits of an investment decision. LP’s in fact have a legally binding obligation to fund the GP’s investment decisions. This is great for traditional private equity firms that can successfully raise capital. They can focus on the execution of their investment mandate. In this model, LP’s are trusting the GP’s competence and specialization of the firm as a professional investor.

However, private equity firms are operating in a particularly difficult climate. Debt is plentiful and cheap, and fierce competition for the best deals are causing prices to catapult. According to Preqin, there is a record amount of dry powder held by private equity firms. This means private equity firms are holding capital that have been raised, yet not invested. As of March 2017, private equity firms held over $1.78 trillion of committed capital worldwide, just waiting to be invested in deals. Additionally, there’s a growth in what the industry refers to as “zombie funds”. These funds tie up capital by holding assets long after the official holding period or “Sunset Period” expires, with no clear plans to raise additional funds. Zombie funds generally hold underperforming portfolio companies, that would not be profitable if sold or upon an full exit.  As a result of all this held capital, the best and most popular deals are getting bid up, leaving room for local and more niche players to pursue lesser known but potentially lucrative deals. 

This has caused the number of Fundless Sponsors to increase substantially over the last few years.  Fundless Sponsors have come in to fill  a deal-flow void.  A Fundless Sponsor is an individual or group that seeks out acquisition targets, without managing a traditional  fund, and generally do not have the financing up-front in order to complete the transaction. They may typically raise a smaller amount of capital, oftentimes principal capital in the range of $250K-$500k, to fund the deal sourcing and diligence process. Once a target is identified, the Fundless Sponsor then creates a LOI, the terms of which give them the time to raise capital from funds and other capital sources. This locks the Fundless Sponsor into the deal but also starts the “clock ticking” on the deadline to consummate the deal.   

There are other factors contributing to the growth of Fundless Sponsors. New financial regulations in response to the financial crisis created a more regulated and scrutinized fundraising environment. Although recent legislation like the JOBS Act supports the opening up of the private capital markets, private companies are increasingly skittish and conservative about inadvertently violating securities regulations. Deal flow is crucial in the private equity industry. Fundless sponsors can act independently with their own networks of investors as well as provide this deal flow to established private equity firms. Good Fundless Sponsors can be well-connected deal professionals with industry experience. These individuals can be embedded in a local marketplace and provide access to proprietary deal flow that lies under the radar of large private equity firms. Also, personal relationships go a long way in the private equity business. Good Fundless Sponsors can provide these relationship links to larger private equity firms, if they are well-connected and experienced within a niche industry.

Many times the benefit of a Fundless Sponsor to the target company will be an ongoing mutually beneficial relationship where the Fundless Sponsor add tremendous value, providing significant managerial and operation expertise.  Investors have the opportunity to negotiate and agree on fee terms in conjunction with the approval of each specific deal. Fees also tend to be only payable once capital is actually deployed. This aligns interests nicely, as an Investor will have the benefit of directly investing into a deal of their choice, while also taking advantage of the localized support and deal-sourcing expertise of an investment professional.  

Generally, the Fundless Sponsor’s fee structure mirrors that of a commitment fund with a few differences.  Fundless Sponsors may earn acquisition fees, may share in the management fee and carried interest of the private equity firm, or they may collect ongoing consulting fees, equity ownership, management fees or carried interest, independent of the investors.  

Potential Pitfalls in the Fundless Sponsor Model

There are a few potential pitfalls to the Fundless Sponsor model, however.  Inherently, a Fundless Sponsor may not be able to acquire the necessary capital to invest in all of their sourced deals. The likelihood of the deal transacting being lower, by not having the capital upfront, a Fundless Sponsor’s leverage is much lower when negotiating deal terms or sourcing deals. Sellers may be skeptical to do deals, with Fundless Sponsors when they may not believe that the necessary capital can be acquired. That being said, significant industry factors are giving rise to the Fundless Sponsor’s flexible model and their ability to source and create value in transactions.  Traditional private equity firms should associate with Fundless Sponsor, as a new paradigm of getting access to the most popular deals. 

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