Fundless Sponsors Positioned To Wait Out Storm

Two years ago, the founder and CEO of a handbag and apparel manufacturer was looking to take cash out of his business. He approached Silverline Partners, a fundless buyout firm formed in 2004 by Jeffrey Muti and Melissa Nguyen.

To Muti, the deal looked great, but there was one wrinkle: Being fundless, his firm didn’t have any cash to do the deal. So he took out five home-equity loans to pay for due diligence and to write the $5 million check for his first deal. “It was a decision that went with a lot of forethought,” said Muti, a former managing director at buyout shops Lincolnshire Management and Dailey Capital Management. “And I absolutely think it was the right approach.”

Welcome to the rapidly expanding world of fundless sponsors. As the name suggests, fundless sponsors don’t raise pools of capital to fuel acquisitions. Rather, they invert the standard buyout model by targeting a company first and then raising the money for one-off deals. Despite the risks, interest in fundless deals has been growing. The method is sure to gain more appeal in a tight credit market, since fundless sponsors don’t face the pressures of having to put a large pool of money to work with the clock ticking on an investment period.

Terms can be less generous—lower carried interest, fewer fees, higher preferred returns. But those who choose this route told Buyouts that the independence is worth it. And though it’s not a new technique, today’s practitioners say its profile has risen over the past few years. The practice attracts maverick buyout pros who simply like being out on their own, or who are looking to build a track record in hopes of raising their own conventional funds. Silverline Partners, for example, would someday like to raise a $50 million to $100 million fund, Muti said.

Modus Operandi

Fundless sponsors often work out of their houses or, in Muti’s case, small offices paid for out of their own pockets. They usually foot the entire bill for deal sourcing and due diligence before approaching investors and lenders. Many of them say the biggest nightmare is broken-deal expenses they would eat if a deal fell apart. Fundless-sponsor deals tend to range in size from $15 million to $150 million.

Michael Alcamo

, a fundless sponsor and president of boutique investment bank M.C. Alcamo & Co. Inc., puts the nationwide number of fundless sponsors at between 100 and 300, ranging from individuals to small firms. The scrappy players in the fundless game tend to break down into two groups. The first consists of young bucks in their late 30s or early 40s who’ve been successful managing directors at traditional buyout shops but find their firms too top-heavy with principals. Group two consists of deal junkiesbuyout veterans who’ve tired of the fund structure after decades in the business but can’t imagine retiring.

Both camps seem drawn to the practice for the same reasons. Alcamo, who prefers the word “independent” to “fundless,” said the appeal lies in the freedom of not having to answer to 120 limited partners every quarter. With mid-market and mega-funds gobbling up most of the institutional dollars, the market for small deals is relatively underserved, according to Muti.

It also allows sponsors to pursue only the deals they’re passionate about, which was the draw for Michael Carrazza. In late 2002, he and Richard Bard teamed up and later formed Bard Capital Group, with Carrazza based in New York and Bard in Colorado. Instead of raising a fund that would require them to deploy capital to acquire 10 or 12 portfolio companies, Carrazza prefers the focused operational attention he can allot to properties in a slimmer portfolio.

“Given the amount of attention we put into each portfolio company, we can only manage about four to six transactions at any given time,” Carrazza said. “The upside is we have better control of the outcome, on average, than if we were strictly a fund manager. So we expect to do a fewer [number] of deals at a given time, but we expect higher returns for the same level of risk.”

Bard Capital has three companies in its portfolio, and one exit so far. In 2003, the firm acquired its first company, Wheelabrator Group, which manufactures surface preparation solutions for the aerospace, automotive, medical and transportation industries. Bard Capital exited the company in 2006, having overseen a rise in EBITDA from $6 million to $30 million in 30 months, according to Carrazza. The IRR on the deal clocked in at 34 percent, he added.

Carrazza, whose deals tend to be larger than other fundless operators, envisions one day raising “a small amount of committed capital from a couple of anchor tenants to have on the side.” That would allow Bard Capital to operate more spontaneously, he said.

While fundless sponsors lack the dry powder to win auctions, investment banks can nevertheless help fill a fundless sponsor’s dance card with companies they haven’t been able to pair with a traditional buyout shop. “Not all auctions are very well attended,” said a fundless source who declined to be identified. “It might just be that they didn’t find a buyer in the first aggressive outreach to the market.”

For the most part, fundless sponsors draw on their contacts within an industry for deals, and seem to prefer family businesses and small entrepreneurial ventures. “These types of deals you’re not going to see in The Wall Street Journal,” said Len Nannarone, a partner with Mintz Levin Cohn Ferris Glovsky and Popeo in Boston, a law firm that represents fundless clients. “These are true, real, low middle-market deals.”

Lining Up Money

Once a fundless sponsor has identified a target, the next step is finding investors. While that may sound like a daunting task, fundless sponsors insist it hasn’t been a problem. Most of them hail from traditional buyout shops and have relationships with limited partners they’ve previously made money for. They’re usually pitching deals to friendly faces.

Bard Capital’s Carrazza signs up the same kinds of limited partners that back any buyout fund: financial institutions, insurance companies, pension funds and wealthy individuals. Lehman Brothers recently invested with Bard Capital in the $320 million purchase of AmQuip Corp., a crane rental business.

For his part, Alcamo said wealthy individuals and some traditional buyout firms have been his firm’s biggest supporters. Among the LBO shops known for backing fundless colleagues are Great Hill Partners, Boston, Alpine Investors, San Francisco, Tuckerman Capital, Hanover, New Hampshire, and Prospect Partners, Chicago.

Silverline Partners’s Muti sees two fundraising paths. The first is to find a hedge fund or a private equity group. Delighted that a fully sourced deal has landed in their laps, they often agree to put up most of the capital. The downside, in Muti’s estimation, is that a single large investor can dominate the deal after it’s closed. For that reason, Muti often chooses the rockier road of cobbling together money from a pastiche of sources.

Debt has been rather easy to procure as well, according to many fundless sponsors. For his deals, Muti secured backing from senior lenders such as New York’s Rosenthal Business Credit and subordinated debt from Detroit’s Peninsula Capital Partners LLC.

Fundless sponsors handle terms on a deal-by-deal basis and set their own conditions. Silverline Partners, for example, takes a carried interest similar to that of the industry standard 20 percent. But Muti said his firm must clear a preferred return hurdle that’s “quite a bit” higher than a funded firm’s typical preferred return hurdle of eight to 10 percent. And while general partners usually take a 2 percent management fee on invested equity, Silverline charges none and doesn’t charge broken-deal expenses.

Alcamo said carried interest is usually lower for fundless sponsors, more like 10 percent. But, he added, some fundless sponsors charge management fees that can reach 2 percent to 3 percent of portfolio companies’ annual revenue as well as an origination fee at the outset of between $250,000 and $275,000. Occasionally, fundless sponsors are designated as the party to represent the portfolio company upon exit, a position that can generate more fee income.

Since they don’t collect a management fee on a fund, fundless sponsors rely heavily on transaction and related fee income to pay the rent for an office and staff salaries, if they have one, and recoup their out-of-pocket expenses for sourcing deals

.Fundless sponsors all argue that their investors tend to be happy with the results. “We have to make it work,” Muti said. “Fundless sponsors live or die off of every single deal. We don’t have the luxury to not make sure every deal’s a winner.”