Today, traditional mid-market players are facing increased competition from fundless sponsors — but also finding allies in them. Rising from relative obscurity, these sponsors have gained ground in recent years due to various factors, including growing support from private equity firms seeking attractive deal opportunities.
A key component in the upward trajectory of these fundless sponsors, also known as independent sponsors, is the ease of becoming one. “The trend of increasing numbers of fundless sponsors continues from eight to 10 years ago,” says Michael Shaw, a principal from law firm Much Shelist, P.C. “There have been more and more of them entering the marketplace given that there are very few barriers to entry.” Compared to raising a fund, he says that the track record and experience of an independent sponsor is not as important, and they can get good deals and have relationships with both equity and debt capital providers.
Nurturing relationships with different dealmakers and finding the right deals are keys to a fundless sponsor’s longevity and success. James Hill, a partner at the law firm Benesch, Friedlander, Coplan & Aronoff LLP, also believes that the increasing trend of fundless sponsors is going to continue. “There are currently a number of managing directors and managing partners who do not have a bad track record but are tired of raising funds and the limited partners have been tougher on terms,” Hill says. “They are now partnering with family offices and are looking through the cracks to find deals.”
Role of the Fundless Sponsor
Fundless sponsors look for acquisition targets before having the committed capital in place to complete the deal.
These sponsors take on many forms and are in the business for different reasons. “There is a current dichotomy in the universe of independent sponsors, with the distinguishing factor being the aspirations of the sponsor,” says Jarrett Turner, managing partner at private investment firm Soundcore Capital Partners.
He says that the majority of fundless sponsors have a preference for keeping their teams small and focusing on doing one-off deals in perpetuity. Others are doing similar deals in order to build a track record with full attribution in order to lay the groundwork for raising a future committed comingled fund. “Some of these firms, like Soundcore, raise capital for each ‘one-off’ deal in a traditional fund structure with a mandate that each fund be used for a specific platform investment,” Turner says. “In this way, they are able to include multiple LPs in each deal, which helps forge working relationships prior to raising a larger fund. Also, operating in this way allows firms to build out a cohesive team, and demonstrate an ability to execute as a unit ahead of raising a commingled fund.”
Striking Up a Relationship with PE
Independent sponsors that choose not to go it alone often find that private equity firms are keen to partner with them as a way to source hard-to-find deals. But private equity firms must approach the relationship with measured steps to make sure that they are not getting the short end of the stick in the transaction.
Independent sponsors typically source capital on a deal-by-deal basis. “There are independent sponsors who partner with one-stop-shop private equity firms that will back the entire equity,” Much Shelist’s Shaw explains. “Both fundless sponsors and private equity look at the specific economics of each deal. Private equity looks into whether their share in the economics of the deal makes sense given the inclusion of an independent sponsor. Sometimes it makes sense to partner with independent sponsors so they can fund more deals.”
Deal sourcing is a big part of why these arrangements are advantageous to private equity firms. “Private equity firms have been open to independent sponsors as an alternative to using brokers,” Benesch’s Hill explains. “But, independent sponsors do not want a ‘finder’s fee’ and they want to participate in the company operations. Independent sponsors are helping these firms source deals given the competition from strategics. Another aspect is that companies in 2016, with rare exception, have been mediocre in quality (but not all), with 2014 and 2015 have had the best companies to offer.”
There are other beneficial aspects to consider as well. Shaw explains that for generalist private equity firms, independent sponsors can bring industry and operational expertise to the table. Some of these sponsors have an involvement with the company on an ongoing basis following the closing. “There’s not necessarily a particular industry where these deals are more dominant,” Shaw says. “However, with a complex industry, there is more room for a specialized fundless sponsor to add value versus a generalist private equity firm.”
One of the factors driving an increase in the number of independent sponsors is the rising level of interest from limited partners as a way to co-invest.
“Some limited partners are co-investing directly into companies rather than purely investing in private equity funds,” says Scott Hart, a partner at global private markets specialist StepStone. He explains that for limited partners that do not have sufficient deal flow, co-investments with fundless sponsors provide an interesting way for them to make direct investments. Additionally, after fundless sponsors have established a bit of a track record, they can end up raising a dedicated fund. “If successful, some limited partners that decided to co-invest with these sponsors on a deal-by-deal basis may also ultimately make investments in the dedicated fund.”
On StepStone’s part, Hart says that they prefer to look at independent sponsor deals done outside of a more competitive process. “In these situations, they may be able to convince the management team or seller that they are the right partner for the business because of their industry expertise,” he says.
In today’s strong fundraising market, and given how well-capitalized private equity firms are, fundless sponsors “have to prove their expertise if they are going to go head to head with an established private equity firm that can offer certainty of closing,” Hart says.
The arrangement has to be well suited to the needs of the investor, although the criteria to participate in the investment are not set in stone. “Typically what we are looking for in a direct investment is a situation that is attractive on its own and that is a very good fit to the experience of the sponsor who will drive the investment going forward,” Hart says. “We might also look at the past transactions that they have done, but it’s more on a case-by-case basis.”