Fundless Sponsor

Identifies a target firm and then looks for equity-capable investors to help buy the business

Author: Rohan Arora
Rohan Arora
Rohan Arora
Investment Banking | Private Equity

Mr. Arora is an experienced private equity investment professional, with experience working across multiple markets. Rohan has a focus in particular on consumer and business services transactions and operational growth. Rohan has also worked at Evercore, where he also spent time in private equity advisory.

Rohan holds a BA (Hons., Scholar) in Economics and Management from Oxford University.

Reviewed By: Sid Arora
Sid Arora
Sid Arora
Investment Banking | Hedge Fund | Private Equity

Currently an investment analyst focused on the TMT sector at 1818 Partners (a New York Based Hedge Fund), Sid previously worked in private equity at BV Investment Partners and BBH Capital Partners and prior to that in investment banking at UBS.

Sid holds a BS from The Tepper School of Business at Carnegie Mellon.

Last Updated:September 1, 2023

What Is A Fundless Sponsor?

An individual or capital group attempting to acquire a firm without the necessary upfront equity funding is known as a Fundless sponsor, sometimes an Independent sponsor.

The fundless sponsor identifies a target firm and then looks for equity-capable investors to help buy the business. 

Structurally speaking, the independent sponsor directly invests in the project rather than employing it through a private equity fund like a pension or family fund. They will:

  • Run the business
  • Take project equity and fees
  • Give the investor a cut of any earnings

Independent sponsors are frequently investment bankers or private equity professionals who want equity ownership and involvement in the development and management of a firm. An independent sponsor's limited partner funding originates from:

  • Family offices
  • Friends
  • Private equity firms
  • Hedge funds
  • Other trusted sources

The type of the contract will determine the capital source to be used.

For instance, a reputed private equity firm with available cash will be necessary for larger transactions because they might be crucial to executing the acquisition and may often let a corporate representative take on an operational role in the acquired company. 

Smaller transactions, however, might only require family offices to participate. It is possible to assign the task of managing the deal and performing operational duties to an independent sponsor.

Key Takeaways

  • Fundless sponsors seek to acquire firms without upfront equity funding. They find investors to join them in buying a business.
  • Unlike traditional funds, independent sponsors invest directly in projects, often led by professionals from finance backgrounds.
  • Fundless sponsorship gained traction after 2008 due to regulatory changes. It offers flexibility, shorter investment times, and no uncommitted capital fees.
  • Independent sponsors attract investors looking for flexible investment options, with control over choices, shorter horizons, and no uncommitted capital fees.
  • Independent sponsors need expertise, capital, growth strategies, and lender partnerships. They are compensated through fees, equity, and management fees, benefiting both parties.

Origin of the Fundless Sponsors Model

The concept of a fundless sponsor initially emerged in the 1980s, but these sponsors were only widely known and discussed for a few years.

For a good span of years back then, they were primarily operated by savvy businesses and financial professionals with the economic connections and solid reputations to attract co-investors and fulfill obligations. 

However, following the 2008 stock market meltdown, everything changed. Big Hedge funds and family offices came under intense pressure from the government, as it tightened its authority by passing new laws like the Dodd-frank act.

With the Dodd-Frank Wall Street, Reform and Consumer Protection Act tightened controls on how financial intermediaries functioned, especially private equity firms, the little-known back channel of moneyless funds started gaining popularity. 

The Dodd-Frank Act's Volker Rule added more rules, which forced banks to explore alternate investment models such as fundless sponsors.

A small legal gap allowed banks to finance deals previously identified for funds. Nonetheless, they were not allowed to invest "blindly" in closed- or open-ended private equity funds.

Beyond minimizing regulations, this sponsor model has multiple other benefits as well, which can be understood as follows: 

1. Widely adaptable

Investors can select the opportunities they wish to participate in, such as the industries they favor or have prior experience in, enabling them to offer better support in the post-transaction phase. 

2. Shorter time frames are involved

The investment duration is shorter, preventing you from locking up money for longer than you are comfortable with. Long-term commitments may result in underperforming investments where investors are continually penalized for fees in assets with no profitable exit opportunity.

Owing to these key advantages, the fundless model grew swiftly as these sponsors started attracting more attention from investors. As a result, over a thousand companies now serve as independent sponsors.

As was previously said, many of these funds were using their capital to invest before they began to garner greater attention during the financial crisis.

The majority of the time, the practice proved successful. However, although there were many benefits, like the flexibility to adapt to any business model, there were also many drawbacks; for example, these sponsors needed a more straightforward way to raise money.

There is no assurance that they will be able to raise investment funds. Moreover, the chance of learning very late in the process that their investors have eventually opted not to commit the funds becomes another risk, and the lack of standardized regulations adds another chance.

The fact that you didn't need any money to launch a fundless fund gradually attracted less-than-qualified people to the table.

Why are investors choosing Fundless Sponsors?

Currently, the amount of private equity assets managed is at an all-time high, and so are "zombie" funds. Investor money is largely tied up in these funds, which charge fees but have yet to produce any noticeable profits in the past.

We now have the fundless sponsor model on the rise. Investors looking for a more flexible method to invest are fed up with management fees on uncommitted capital and the limitations of pooled investments.

According to the conventional private equity model, a fund first solicits commitments from a network of investors for a blind pool that frequently has no influence over specific investments and a relatively fixed time horizon of seven to ten years. 

The team then discovers deals and organizes operations with this sponsor model, then presents viable businesses to their partners for approval and investment on an as-needed basis.

In this section, we try to understand why the independent sponsor model appeals to investors, who independent sponsors are, the economics of the model, and whether this approach benefits the companies seeking investment.

In addition to bringing their operational and sector-specific experience to the table, independent sponsors have many benefits over the more conventional PE funds.

  1. More authority over the choice of investments 
    Limited Partners have a greater chance to express their views on each agreement, including customs fees and economics. Additionally, there is more flexibility on specific investments due to the curated deal-by-deal structure.
  2. No limitations on time horizons 
    Money is no longer strictly bound to a seven to ten-year time frame but is free to fluctuate with the opportunities available to any company.
  3. On uncommitted capital, there are no fees. 
    Compared to the annual management fee charged by committed capital managers, who set it irrespective of the asset performance and investment status, the fundless model's fee structure is more in line with the interests of LPs.

Why Do Fundless Sponsors Opt for this Model?

It's enticing to think about using someone else's money to buy your way into a bargain. Unfortunately, although everyone wants to do it, it takes time to execute.

Investment tactics that were successful a few years ago may be a challenge for investors today and in the coming year as economic conditions change. However, the fundless sponsor is perceived as a viable approach since it addresses many of the conventional issues.

The middle market, particularly the lower end, is handled by smaller funds and independent sponsors as more private equity companies go upmarket.

In the ecosystem of the middle market, the independent sponsor performs a crucial function in developing deals that can be implemented. 

They put in a lot of work upfront, earning the business's trust and developing the deal's structure. But unfortunately, these sponsors are only sometimes treated respectfully, particularly by private equity groups.

The same objective drives all fundless sponsors: acquiring a majority stake in a business. They must build credibility with the lender and produce value to get to that position. 

Smart lenders prefer to work with these sponsors who offer significant value. Here's how to approach it:

Make sure your offer relates to your area of expertise

These sponsors should concentrate on businesses they are familiar with and wherein they bear substantial experience. Particularly in the eyes of a mezzanine lender, knowledge is power.

You must clearly explain your investment thesis to establish credibility as a buyer. Lenders will feel more confident in your investment reasons and vision, if you have deep knowledge of the operations of a certain company and the industry, issues it encounters.

Have a significant back end 

Your deal structure must include at least 20% to 25% of seller paper or earn-out. Deals with 100% cashouts are challenging for any lender to finance with an independent sponsor.

The transaction must adhere to the lender's leverage multiples and equity stakes. The less money the sponsor has to put up to close, the larger the back end to the seller will be.

Bring some money to the table 

Sponsors need to display the need for funds. For the lender to view you as someone with means, you must have a respectable sum of money ready to deploy. 

The sponsor may need to offer the necessary funding in some cases, for example, if a company needs a new owner for their business right away.

Although you don't have to bring a check the same amount as a private equity firm would, it should still be sizable enough to give you credibility with the lender.

Develop a growth strategy

Having a fully established strategic growth plan is the best approach to being perceived as a value-added buyer.

The lender will favor you if you can construct a convincing growth tale or roll-up story. This distinguishes you from being merely a financial engineer and positions you as a business builder.

Choose the correct mezzanine lender

Choosing the correct mezzanine lender is essential because many collaborate with fundless sponsors, but not all add value. A mezzanine lender can often advance further up the capital structure and gain more in these transactions.

Regardless of the amount of money they lend, mezzanine lenders are virtually always minority shareholders. Additionally, they are more dependent than a PE fund on the relationship and business-building skills of the fundless sponsor.

How Are Fundless Sponsors Paid?

Fees paid to the sponsor upon successful completion are independent sponsor deal closing fees or transaction fees. Typically, 2% to 5% of the purchase price is paid to the independent sponsor as compensation when a transaction closes.

Most of this money is frequently rolled back into the deal, so the sponsor has some "skin in the game." 

Typically, deal fees are not intended as a source of wealth for independent sponsors or their finance partners.

Being this type of sponsor might be very lucrative. They can profit financially from a deal in various ways immediately and later. The primary means of payment for these sponsors in a contract are listed below.

  1.  Acquisition Fee: The fee is often given to the independent sponsor at closing as a portion of the deal's overall price. This proportion often falls between 2% and 3%, depending on the magnitude of the transaction.
  2. They are paid in equity.: Carryover interests or promotions are among the most common ways people acquire ownership or equity in a company. It speaks of equity aligned with the success trajectory of the business. The independent sponsor will receive a portion of the stock upon an increase in the company value by a specified amount.
  3. Management fees: Because of their involvement in the organization after it closes, the independent sponsors are compensated with management fees ranging between 3% to 7% of EBITDA.  Typically, many independent sponsors serve as the management team's advisors on strategic matters. The management fee, however, is independent of their involvement in that company daily.

Conclusion

The goal of a fundless sponsor is to buy a company without the requirement for upfront equity investment. They will start looking for investors after they have identified a target company.

These sponsors are frequently investment bankers or private equity specialists who want to buy stock in the target firm and exert control over its operations.

Depending on the specifics of the transaction, they might raise money from:

  • Family offices
  • Private equity firms
  • Hedge funds

This sponsor structure offers advantages to both the sponsor and the investors, making it a potentially profitable choice. 

Due to their increased ability to influence the company's:

  • Investment conditions
  • Investment choices
  • Initiatives

Investors may be drawn to fundless sponsor structures.

Additionally, investors have more access to agreements. On the other hand, the sponsor will experience less difficulty raising money and benefit from a simpler securities law framework.

Finally, the arrangement will financially benefit the sponsor in several ways, primarily by means of the closing fee, equity, management fee received among others.

Researched and authored by Rishabh Bhoria| LinkedIn

Reviewed and Edited by Krupa Jatania I LinkedIn

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