How to play the private equity game without a fund

In 1998, Scott Dickes left his job as a vice president at a private equity firm and embarked on the quixotic journey of a fundless sponsor.

A fundless sponsor (or “independent sponsor,” per a more recent conceptual rebrand) is an investor that pursues a deal without the security of the committed capital in a PE fund. A typical timeline for an independent sponsor starts when a PE professional spins out of an established investment shop, spots an asset that shows some potential, negotiates the acquisition, and scrambles to get the equity financing and leverage later.

An independent sponsor bypasses the woes (and stability) of a commingled fund, taking on a single or handful of investors—usually another private market firm or a family office—for a single deal.

Turns out you don’t actually need a fund to play the private equity game.

The independent sponsor structure is a catalyst into dealmaking for emerging managers during a tough fundraising period. Under current conditions, LPs are wary to invest with established, commingled PE funds, much less first-time fund managers, who control a small percentage of fundraising dollars. In the past year alone, private capital fundraising dropped 30.9% and private equity saw a 16.6% decline, according to PitchBook’s Q2 2023 Global Private Market Fundraising report.

Independent sponsorships have certain advantages in this type of environment. In particular, they’re raising a much smaller pool of capital than commingled fund targets, said Ryan Schlitt, CEO of placement agent and advisory firm Aviditi Advisors. In June, the Credit Suisse-alumni-founded placement shop helped Albion River, an independent sponsor focused on investments in defense, raise $400 million in equity commitments.

Schlitt said more than 60% of the first-time fund managers his firm has met with this year had engaged in dealmaking prior to exploring a first-time fundraise. The pre-fund deals help the independent sponsors gather investors, who—if the deals generate strong returns—will be more willing to commit capital to their subsequent investments.

“Many of the people who are independent sponsors have left established organizations and have a track record of experience,” Schlitt said. “But I think a lot of the investment community is looking for these managers to build out their teams and infrastructure as well before they commit blind pool dollars to their strategy.”

In his early days as a free agent, Dickes sourced target assets, brought in some backers to finance the transactions and closed four deals. Eventually, the project turned into a fund I, then a fund family, then a series of funds that became Hadley Capital, a PE firm that acquires small companies in manufacturing, business services and distribution.

This is the ideal trajectory for a fundless sponsor just starting out. Eventually, your operation grows into a firm with an established track record of returns for LPs.

What’s in it for investors?

For the investors who back independent sponsors—typically family offices, mezzanine funds that co-invest and high net-worth individuals—the structure allows for a higher degree of control over the deal and asset than they would otherwise have in a fund.

“In a commingled fund, you’re going into a blind pool and you’re trusting the track record and investment judgment of the manager to make decisions for you,” Schlitt said.

In a relationship with an independent sponsor, an LP is directly involved in the deal selection criteria, funding and the investment decision itself, Schlitt added.

Often, capital providers will require the independent sponsor to contribute equity—usually the sponsor’s own money or equity rolled over from closing fees of previous transactions—to fund the acquisition.

Stiff competition for assets

Still, competition is high for the assets independent sponsors pursue, as PE and VC buyers seek to capitalize on opportunities in all segments of the market. For Dickes, this means that the same independent sponsors who are inquiring about receiving an infusion of equity backing from his PE firm are competing with it for acquisitions.

In some cases, a fundless sponsor will win the competitive bid, then turn around and ask their defeated competition to fund the acquisition. Dickes said his firm has gotten inquiries of this nature but has passed on them.

“They’ve outbid us, and now they’re asking for us to invest with them. And they want fees and carried interest and everything else, so the economics just don’t work out,” Dickes said.

Independent sponsors also face potential challenges from which more established firms are often insulated. The biggest risk draws from the fact that these investor types don’t have the level of dry powder that PE firms do; in fact, they have none.

For example, if a PE firm wants to complete an add-on acquisition for one of its portfolio companies, it can allocate parts of its budget to the transaction. In the case of an independent sponsor, an add-on would require an additional infusion of capital.

“Under the independent sponsor, there’s flexibility, and in some cases, they do a better job than a PE firm. But the PE firm has the money,” Morris said.

Featured image by Joey Schaffer/PitchBook News