A fundless sponsor is an investment fund that lacks committed equity capital required to complete acquisition transactions up front. Unlike private equity firms that already possess equity capital to finance transactions, fundless sponsors must raise equity and debt financing on a deal-by-deal basis, after signing a Letter of Intent (LOI).
Sometimes, a fundless sponsor may work with private equity firms to finance transactions together and share the returns they receive. This is partly because fundless sponsors are likely to gain access to deals that private equity firms may never get to see otherwise, but may be interested in financing.
Origin of the Fundless Sponsors Model
Fundless sponsors emerged in the 1980’s, as investors looked for alternative ways to invest their money. Such sponsors were not very popular before 2008, when the fundless sponsors business model started gaining traction. Here are some of the reasons for the rise of fundless sponsors:
After the 2008 financial crisis, key players in the financial industry faced increased regulations as the regulators exercised their authority to try to prevent a recurrence of the financial crisis. One of the most important regulations was the Dodd-Frank Wall Street Reform and Consumer Protection Act, which tightened how financial intermediaries operated. One of the most affected institutions were private equity firms, due to the nature of their operations, which were considered too risky.
The Volcker Rule, pioneered by former Federal Reserve chairman Paul Volcker, prohibited banks from financing private equity transactions. The increased regulations forced investors to look for alternative investment models such as fundless sponsors where they invest in already-sourced deals.
Underperforming equity funds
When funding private equity firms, investors are looking to earn high returns within a reasonable period, exit the fund, and invest the profits elsewhere. However, sometimes private equity firms tie up the limited partner’s capital in several underperforming portfolio companies for a longer period than was expected. This puts investors in a precarious position, as their investments are tied up in several portfolios while they are still paying periodic management fees to the private equity firms.
Such inefficiencies cause investors to look for better alternative models that cure the ills of private equity. Fundless sponsors look for funds after signing an LOI, which reduces the holding period for investor’s funds.
Direct competition from would-be investors
Private equity firms typically source funds for their operations from individual and institutional investors, which include wealthy families, pension plans, endowment funds, and state-owned entities. However, due to the deemed inefficiencies of private equity funds, many of these investors have been abandoning private equity in favor of direct investments.
Some investors operate as fundless sponsors, where they source for deals and invite other interested parties to co-invest in the identified lucrative portfolios. Apart from the capital injection, target companies also benefit from the managerial and operational expertise of the investors. The investors pay management fees only after the deployment of capital and not when the fundless sponsor receives the money.
Benefits of Fundless Sponsors
Recently, the number of fundless sponsors has grown steadily, mainly due to the benefits attributed to them. The following are the benefits of investing in fundless sponsors:
Fundless sponsors are flexible, and they are designed to meet the needs of the owners. Once the sponsors have identified viable businesses to invest in, they invite interested investors to partner with them. If the business owners are looking for a new owner for the business, the fundless sponsor may provide the required capital as well as industry expertise to help in the transition.
The financial structure and terms of the transaction are also flexible and are negotiated on a deal-by-deal basis. The amount of investments in each firm will depend on the revenue model and expected cash flow margins.
The diversity of the fund model
Unlike in private equity, where investors are limited in the kind of investments the firm makes, a fundless sponsor allows investors to decide the kind of investments to invest in. If an investor does not like investing in a particular industry, the fundless sponsor will not obligate them to participate.
Instead, it actualizes the transaction with interested investors who provide a significant proportion of the capital, as well as operational and industry expertise to portfolio companies in their industry of expertise.
Search Fund vs. Fundless Sponsor
The fundless model comprises two main types of firms – a search fund and a fundless sponsor. The search fund concept started in 1984 at the Stanford University Graduate School of Business. Over the years, the university studied more than 177 search funds from its alumni of elite MBA programs. A search fund is formed by young MBA graduates or aspiring entrepreneurs who use the fund to raise money from high net worth investors interested in private equity investments.
Once a target is identified and the LOI is executed, the fund principals go to search-stage investors to raise capital to complete the transaction. A search fund acquires companies valued at $5 to $30 million, and the principals take an active role in the day-to-day running of the business after the acquisition. The investors also provide guidance in managing the business.
On the other hand, a fundless sponsor takes a more passive role in the acquired business; they do not take part in the day-to-day running of the business as is the case with search funds. Fundless sponsors are experienced acquirers such as former private equity CEOs, and their goal is to find companies to add to an existing portfolio and take ownership stakes in each of the companies.
They participate in the value creation of the acquired business, as well as the capital appreciation of the investors who provide financing. The fundless sponsor’s fee is paid on an ongoing basis, and it typically ranges from 3.5% to 7.5% of the acquisition’s EBITDA.
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