A Primer on Pledge Funds: Tire Kickers or Serious Buyers?

This is the final post in our series on private equity firm structures and how the various structures carry different implications for sellers. In the prior two posts, we discussed committed capital funds and search funds. In this post, we review the structure of the pledge fund and discuss the implications of this structure to sellers.

A “pledge fund“, also known as a “fundless sponsor” or “non-committed fund“, is a private equity investment vehicle in which the LPs provide the GPs a loose commitment of capital. (For an overview of GPs, LPs, and the GP-LP relationship, see “A Primer on the Structure of Private Equity Firms“). The LPs can provide the GPs investment parameters, but the LPs choose to invest or not invest on a deal-by-deal basis. Generally in a pledge fund, there is not an initial formal agreement between the LPs-GPs. Instead, the GPs create a limited partnership entity at the time they have identified a target company and that entity makes the investment/acquisition. LPs then have the opportunity to contribute capital to that investment entity.

Given the non-binding nature of the LP-GP relationship, there is significant variation among pledge funds. At one end of the spectrum, there are seasoned, experienced, professional investors with strong ties to deep and ready pools of capital. The GPs have established methods of deal sourcing, transaction structuring, portfolio management, and value creation. These pledge funds are serious, credible investors/buyers of your business. On the other hand, there are pledge funds that may be sincerely interested in buying companies, but lack the ready access to LPs that can ensure the certainty of close that sellers look for.

Unlike committed capital funds, the LPs in a pledge fund are NOT legally committed to provide the GPs any capital. And unlike search funds, the LPs have not made an initial investment for which they will receive a step-up in carried interest in any acquisition made by the GPs. The LPs do not have any capital at risk should the GPs in a pledge fund not make an acquisition. In short, there is nothing preventing individuals with no transaction/investment experience or an ability to raise capital from forming a pledge fund.

We have gotten pretty good at qualifying (and disqualifying) pledge funds for Membership in Axial and have developed a checklist of questions that every business owner should ask the GPs when they begin discussing the sale of their business to a pledge fund.

• How many transactions has your fund closed? A strong indicator of whether the pledge fund is serious and credible is their track record. Some highly successful GPs, preferring the flexibility of the pledge fund structure to committed capital structure, have operated as a pledge fund for 20+ years and closed numerous transaction. If this is the case, it is a reasonable assumption they understand the in’s and out’s of buying private companies.
• What are your backgrounds and transaction histories? If the fund does not have an established transaction history, it is absolutely critical to review, understand, and verify the backgrounds of the GPs. If the pledge fund is newly formed but the GPs have led the sourcing, structuring and closing of numerous acquisitions with another firm, corporation or fund, this can indicate that you are working with a serious buyer. You should not only consider the type and number of transactions closed, but also the specific role of the GPs on those previous teams. If they were associates, then they are likely greener behind the ears than if they were the leading the transaction.
• Who are the LPs and what is the relationship history between the GPs and LPs? Similar to search funds, you should feel confident asking directly about the fund’s LPs. How many LPs are there? Who are they?  What are their backgrounds? How much capital does each LP have? Are these LPs invested in other funds?  Which ones? You should also feel free to insist that the GP include several of his/her lead LPs in your discussions once things have advanced beyond the initial indication of interest stage.