What is the wise WSO community's thoughts on the rise of independent/fundless sponsors as well as uptick in Family Offices? Will this play out long term and fair well against a downturn vs traditional funds?
Related Resource: WSO Family Office Database
Little Sheep, pure crickets, that's where I come in. Any of these useful?
You're welcome.
Two different discussions here, but I think they both stem from a common theme. They're both really interesting and I'm glad someone brought it up - not all of us here on WSO work in midtown and follow the recruiting timeline and wear patagonia vests and deal sleds, some of us are just out in the lower middle market in a secondary/tertiary metro trying to put good deals together.
The common theme is that there is a lot of capital trying to make its way into private companies of all shapes and sizes, and there are a lot of avenues to get there. One need only to take a look at that dry powder chart that Pitchbook puts out seemingly every two weeks to see that 1) there's a lot of growth in capital directed toward private markets, and 2) it's not getting spent fast enough. As that capital builds and builds, it creates pressure - either it finds creative ways to go to work, or it just eats away at return, through higher prices, poor decision-making, or acceptance of being paid less for the same work. I think all of the above are happening. Both of your questions stem from the "creative ways to go to work" branch.
I don't know as if there is an actual uptick in family offices. I do think there's an uptick in family offices trying to get involved in more direct investing. Instead of pooling capital a few times (maybe a family houses its funds at an asset manager, which invests in a variety of asset classes and relies on a fund-of-funds to access private equity funds, who then make the direct investment), they go "fuck it, it can't be that hard, let's stop paying all the fees to the middlemen and we'll just do it ourselves" and they hire someone from the rapidly expanding pool of moderately experienced deal professionals to do some deals.
The truth is, making good investments over a long period of time is hard, and it's always going to be hard. Can some family offices skip over the long chain and hire good people to do deals? Sure they can. But not all of them will, and there's going to be some really crappy deals made by some total morons, and some family offices will get spooked, and we'll swing back away some from this rush to direct investing. I don't know if it will be back towards traditional fund-based private equity, but there will always need to be some pooling that allows capability-low capital-rich sources to partner with capability-high capital-low groups to find and make good deals.
Some of that need to pool capital is absolutely related to the rise of independent & fundless sponsors. I'll also toss in search funds, since I think of them as a special species of independent sponsors. These are all ways for capital to get around traditional committed funds - not that committed funds are bad, but they can drive some perverse incentives and not every capital source can get comfortable with the lockup period. It wasn't that long ago that bankers wouldn't even let fundless sponsors get to management presentations because they were perceived as a waste of time - now, it's such a more widespread model that service providers (your risk / legal / accounting diligence support) are building out practices specifically to support those groups. I don't know if anyone here pays attention to or goes to ACG meetings, but you can take a quick run through ACG event schedules in any secondary market, and almost all of them are going to have something about independent sponsors this year.
I think that's a model that's here to stay. I don't think it will replace traditional private equity, but at least in the lower middle market, I think there will be a handful of fundless sponsors covering every metro in the country. In the 90s, there weren't that many people with private equity experience; but you don't have to train for 20 years to build the toolkit and relationships to do it yourself, so the number of people who can successfully put deals together and sell the idea to a funding source has grown pretty substantially. It seems like a lot of them are going and getting experience and then breaking off and going home or to somewhere they want to live and setting up a small shop.
I think search funds are a special case, and I'd love for someone here who has run a search fund to comment. I'm biased on them, because I've met a bunch of searchers, and I think the entire search fund subindustry is built on the egos of newly-minted MBAs who think they can do anything. I understand that many searches have turned out successfully, and that's great; I've also met plenty where I shake my head and wish that their parents hadn't been quite so supportive. Funding searches might be a different story, since that's turned out to be kind of like a VC approach - you shotgun money across a wide range of searchers, and you let 'em sink or swim and hopefully there's a couple of home runs in there. There's a few firms that have raised funds to do exactly this, and I think they've turned out pretty well (although I can't say I have any insight into exact terms).
I know it's a long answer, but I think it's an interesting topic. Traditional private equity is but one way for capital to reach private companies, and just as lending models built complexity over time, I think we are seeing the same thing in equity investing.
Layne, +1 SB
Thank you very much for your in depth response. What are your thoughts on working for an independent sponsor at the analyst level?
Don't.
To me the problem in this space (middle market PE and lower middle market PE) has always been that the "product market fit" just isn't there. Companies that fit the fund investment criteria (stable cash flows, great management teams, defensible market positions) don't need PE money. Companies that do need PE money don't fit the investment criteria.
I think this is true for the traditional private equity model where they read a bunch of CIMs and take in a bunch of management presentations and are more or less generalists who believe they can "get smart" on an industry quickly. For the riskiness of lower middle market deals that are hairy enough to be cheap enough to actually buy, they can't "get smart" enough to construct a vision that earns them a return.
A lot of the capable LMM independent sponsors I meet are very, very specific to an industry niche - like they know exactly how to open and run a certain size and theme and price point of restaurant concept in the Southeast. I think that knowledge allows them to expand the "risk" section of the investment criteria to be able to actually invest in companies that would benefit from PE money.
Regarding the fundless sponsor model, I think it provides PE shops (especially smaller LMM funds) the opportunity to be more prudent and patient with their investment decisions. There isn't a timeline to put capital to work which can help take away the temptation to pull the trigger on buyouts during times of extremely high valuations. You would hope that because of this, their portfolio companies would have been acquired at cheaper valuations and would be more likely to weather the storm of a downturn.
However, having capital locked up for ~7 years can obviously help funds stay afloat during a downturn until things turn back around. I know a principal at a fundless sponsor (LMM) and they have only purchased 2 companies in the past 14 months (they're usually at 5-6 per year) due to high valuations. They're obviously not happy about the lack of deals, but they are content knowing they're not overextending themselves, which has been a factor contributing to the longevity of the firm.
Very interesting topic and I have seen tremendous growth in both areas in recent years. I think both will continue to exist, but as Layne Staley pointed out, it is really a function of capital overhang. Right now capital is abundant and even some traditional private equity funds have made the decision to support fundless sponsors who have deals under LOI as another avenue to spend their funds/ever-growing pile of dry powder. I think the fundless model will continue for the foreseeable future, but there will likely be a shakeout in the fundless market during more challenging economic times. No one knows when that will be, but the fundless model as it currently exists only works so efficiently during boom times. As stated previously, the market acceptance of fundless sponsors coming to management presentations and being taken seriously when they submit IOIs/LOIs is only going to continue as long as bankers and sellers believe the funding is there. Much different story when they start to question if the fundless sponsor actually has the money lined up.
The problem is threefold - first I think the "dual carry" concept is going to bite some LPs and institutional investors in a slower growth/downside case. P/E is likely going to see return compression overall given the current price and growth environment, but many GPs and LPs still think we are in an environment where 2x+ ROICs and 20%+ IRRs will continue to be the norm. Carry usually has return hurdles associated with it, but for funds that are investing in fundless deals, there is usually carry associated with both the fundless sponsor and the GP/institutional investor. Paying dual carry is much more palatable for LPs when the firms are buying strong companies at good prices during a market upswing and making 2x/3x/4x returns. Paying top-of-market multiples when the economic/growth picture isn't quite as rosy, the quality of inventory for sale is degrading, with two layers of carry is a recipe for LP disappointment. This will take a longer time to correct, because the funds will need to see some realizations and LPs will need to reevaluate if they want to support these types of deals in the future. The second issue is that I would argue many of the institutional investors that jumped into the fundless game have not spent much time thinking about a "downside case" beyond a return standpoint. The problem with fundless deals is that unlike a traditional fund, if a fundless sponsor investment goes poorly, the fundless sponsor often has less incentive than a traditional fund to manage through and try to resuscitate its bad investment. Without long-term LP relationships at risk, pooled carry and a committed fund for management fees, the fundless sponsor has little "hook" to continue working a deal if he realizes there is likely no carry at play for him, and is far better suited trying to find another platform especially if lenders have turned off the management fee. Some fundless sponsors also have little/no personal investment in the deal beyond rolling deal fees. For institutional investors that have 10, 20, 30+ fundless sponsor deals in their portfolio, it could be a rude awakening if/when they realize they have to play sponsor and manage the deals themselves to try to preserve their capital. Some traditional funds are well suited to do this, but many of the funds that are investing in these deals are not. Lastly, we have been in an environment of record LBO volumes for several years. If/when the market slows down, I think fundless sponsors are at greater risk of being "crowded out" by traditional sponsors in auctioned deals. Good fundless sponsors will still find ways to land proprietary deals at attractive prices, but I think it will be more challenging for fundless sponsors to be taken seriously in widely auctioned deals when we are not in a period of such "abundance".
All that said, there are a number of well-trained, successful independent sponsors who will continue to do very well and attract capital for their deals. While there is definitely a difference in quality of managers at the traditional P/E level, the difference is even starker in the fundless sponsor realm. I personally would invest in fundless sponsor deals with the right team, structure, target, etc. but I think the number of fundless sponsors in the industry is going to decline and the lower quality ones will be exposed.
Regarding family offices, they have many similarities with fundless sponsors and often support these types of deals. The major difference is that family offices often created their wealth by successfully owning and operating businesses versus being a "deal guy". For this reason, they are well suited to support both fundless sponsor deals and make direct investments. However, I think the challenge for this model is finding professionals who are good at sourcing and finding the right targets. While some sellers/management teams might like the prospect of never having to go through another sale process and being owned by a family for a long period of time, many managers are realizing the power of private equity to generate significant personal wealth through management option pools and flipping the company every 3-5 years. Family offices are going to have to get creative with phantom equity and other economic incentives to continue to be an attractive alternative to traditional P/E. I know several execs who are on their second or third private equity rodeo. However, as long as family offices can find the right talent to source quality opportunities, properly incentivize their deal teams and portfolio company managers, and find the right portfolio companies to invest in, this model is likely to continue.
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