May 7, 2008

In recent years, dealmakers have put a new spin on the traditional ways private equity groups structure their deals. Rather than raising a committed pool of funds to finance investments and then searching for deals, a new breed of investors, known as fundless sponsors, are finding the deals first and then raising the money.

The State of the Private Equity Industry

Private equity continues to be a major force in M&A activity. According to Fortune magazine, private equity firms purchased 1,010 companies in 2006, compared to only 324 in 2001. That level of growth is being driven primarily by institutional investors (such as pension funds, endowments and insurance companies) and high-net-worth individuals seeking greater returns than they believe can be obtained with public equity investments.

While there are no regulatory barriers to entering the private equity industry, first-time fundraisers often find it difficult to compete with successful, proven funds. Why? For starters, raising a fund from scratch can be extremely difficult. Limited partners often would rather invest in the established funds that have delivered superior returns in the past. In addition, many limited partners, such as university endowments and pension plans, allocate a fixed percentage of their total portfolio to private equity investments, making them less likely to embrace new, unproven equity sponsors. Furthermore, when the public equity markets decline, as they have recently, portfolio values drop and the aggregate dollars available for private equity investment decrease.

There are also substantial up-front costs required to structure and market a fund. Additionally, the process of raising a fund is notoriously long. According to a study conducted by VC Experts, Houlihan Lokey Howard & Zukin, and Thomson Venture Economics, it often takes from 10 months to more than a year to market and close a private equity fund.

Rather than face these obstacles, some dealmakers have decided to forego fundraising entirely–instead focusing their time and energy on finding deals. Under this new model, the role of the fundless sponsor usually includes the following:

  • Sourcing and evaluating potential deals;

  • Preparing and negotiating letters of intent;

  • Arranging equity sponsorship for the acquisition;

  • Securing debt necessary for the acquisition;

  • If necessary, recruiting a management team to run the company following the acquisition;

  • Performing due diligence and coordinating the due diligence efforts of the equity sponsor;

  • Coordinating the closing of the acquisition; and

  • Providing ongoing support to the management team and the equity sponsor(s).

In return, fundless sponsors earn fees and other compensation in a variety of ways. They may collect a simple acquisition fee when the deal closes. In addition, they commonly receive a percentage of the equity of the transaction as compensation for finding the deal. This often takes the form of a profits interest, whereby a fundless sponsor shares in the profits of the transaction after the equity sponsor has recouped its investment and, in some cases, earned a preferred return. Lastly, there is an opportunity for fundless sponsors to collect ongoing consulting or management fees by providing post-acquisition services to the target company.

Pros and Cons of the Fundless Model

From the fundless sponsor's point of view, there are a variety of pros and cons to this nontraditional approach. One obvious benefit is that fundless sponsors can focus their time and attention on finding deals, rather than on raising a fund. Additionally, fundless sponsors are not bound by a limited partnership agreement or other similar arrangement with investors that dictates the time frame under which they must invest the funds, the types of investments they can make (including size and industry) or other restrictive guidelines. In the end, if a dealmaker is able to complete a couple of successful transactions, that track record might facilitate future efforts to actually raise a fund.

There are, however, several drawbacks. First and foremost, fundless sponsors often find it difficult to close deals because sellers may be skeptical about the ability of the sponsors to raise the necessary funds. In addition, fundless sponsors do not earn a management fee from investors to cover administrative and sourcing costs. They also face the risk of not knowing whether their investors will be willing to commit to a specific deal until it is too late.

From the perspective of the traditional private equity firm, there is concern that fundless sponsors have created even more competition to source transactions. Furthermore, unlike investment bankers who present potential acquisitions in exchange for a fee, fundless sponsors look for equity in the deal, which could end up being even more expensive for the traditional private equity firm.

On the other hand, many traditional private equity firms are choosing to work with fundless sponsors as a way to outsource some of the legwork of finding deals. In other words, a traditional private equity fund can augment its internal deal-seeking resources without increasing payroll expenses.

The Bottom Line

As equity sponsors find it more and more challenging to raise private equity funds, many have chosen to forego the fundraising process altogether and focus on targeting attractive deals. Saving valuable time and resources, fundless sponsors are living by the mantra, if you find it (a good investment opportunity), they (the investors) will come.

This article contains material of general interest and should not be construed as legal advice or a legal opinion on any specific facts or circumstances. Under applicable rules of professional conduct, this content may be regarded as attorney advertising.