Fundless sponsors find success in tough deal-making environment

With private equity firms facing tough competition for portfolio companies, buyout shops operating without funds now play a more prominent role in finding deals, according to multiple sources.

Mike Shaw, chairman of the business and finance group at Chicago-based law firm Much Shelist, said he’s seen “exponential growth” in the past decade in the number of so-called “fundless” or “independent” sponsors, which do buyouts with ad hoc backing from private capital providers instead of traditional funds.

“People figure if they find a good deal, the capital will come to them,” Shaw said in a phone interview.

And plenty of dry powder is available for this practice. Forty-seven percent (about $21.6 billion) of the $45.86 billion raised by first-time private equity managers as of September 30, 2015, has been targeted for deal-by-deal, co-investment and managed account structures, rather than traditional funds, according to Palico. In 2014, 43 percent (about $18 billion) of $41 billion allocated to new managers went to these types of vehicles.

It’s not clear how much of this so-called shadow capital goes specifically to sponsors with no funds, but the large pile of capital outside the traditional fund structure has grown.

While GPs with funds may still compete for deals with independent sponsors on some fronts, a fundless sponsor may help with knowledge of an industry niche, or its Rolodex may open doors for a proprietary deal.

Huron Capital gets about a fifth of its deal leads from fundless sponsors, according to a 2015 article in Middle Market Growth magazine, which is published by the Association for Corporate Growth. (ACG doesn’t track the number of fundless sponsors.)

How Hanover does it

Hanover Partners, a San Francisco-based shop that seeks manufacturing companies with $1.5 million to $8 million of operating income, operates without a traditional fund. The 22-year-old firm manages a portfolio of six companies in the United States.

Hanover Partners sifts through 1,000 leads a year to find deals, said Principal Aaron Aiken. The firm leads the due diligence process, manages transactions and works with executives at portfolio companies to build value.

Last year, Hanover Partners lined up an acquisition through a relationship with a retired investment banker in Texas. The banker had heard about an opportunity to carve out a small communications test equipment unit from General Dynamics.

“After the introduction from the buy-side intermediary, we and our longstanding investor partner Tuckerman Capital started talking to General Dynamics and developed a thesis with a former operating executive of the business unit to buy it,” Aiken said. “There was no formal sales process.”

The deal for the unit, which was renamed Freedom Communications Technologies, closed in April 2015. The company is now a standalone business with 25 employees.

Co-investment opportunities

Besides sourcing deals for other private equity firms, fundless sponsors also help LPs track down potential co-investments. For example, Aberdeen Asset Management is considering two direct investments from fundless sponsors, said Scott Reed, head of U.S. private equity for Aberdeen.

“It’s an increasingly relevant part of our co-investment program,” Reed said. “It’s gotten more and more competitive to source co-investments through regular GP relationships.”

Fundless sponsors who left larger firms and are looking to establish a track record before raising a fund may come up with compelling co-investments, Reed said. Since the capital is put to work right away in a specific deal, LPs may not have to wait as long to get a return on their committed capital, he added. On the down side, fundless GPs may not be able to move as quickly on an acquisition with no established pool of capital to tap, Reed noted.

Trey Muldrow, a partner at Akin Gump who has worked with fundless sponsors, said the financial structure of fundless sponsor deals varies. In some cases, a mini fund is created to do a single deal, with one or more GPs, LPs or family investment groups providing capital. Such an arrangement may support a management fee and carried interest payments, usually below the standard 2 and 20. “It all depends on the deal and it’s highly negotiated,” Muldrow said.

The rise of fundless sponsors will continue, even in the face of volatile financial markets in 2016, said Nick Russell, a partner at Tuckerman Capital, a 15-year-old private equity shop founded for the sole purpose of acquiring companies with fundless sponsors.

“We view the increase in prevalence of independent sponsors and their gain in ‘market share’ as a long-term trend, particularly in the market to invest in smaller companies of about $10 million of EBITDA and below,” Russell said via email. “[I]ndependent sponsors play an important role given this market’s relative inefficiency. We see these inefficiencies as structural in this small-company market and thus the opportunity for high-quality independent sponsors to be successful as sustainable and growing.”

Action Item: See an ACG video about fundless sponsors here:  http://bit.ly/1UOCZLd

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