by Benjamin M. Cooke, Esq. & Anthony J. Cox, Esq.
In recent years, a new brand of investor has entered the middle market private equity space: the fundless sponsor. Different than the traditional private equity fund, fundless sponsors do not have an investment fund supporting any acquisition activity. Rather, these fundless sponsors pursue deal opportunities seemingly opposite to the private equity funds that they are competing with. The fundless sponsor identifies a target acquisition and then figures out how they are going to pay for it.
In our deal practice, we have encountered fundless sponsors in a variety of shapes. Ranging from Fortune 500 executives to private equity professionals, to management team members looking to buy out ownership, this pool of potential buyers has become a real option for sellers in middle market M&A. That said, fundless sponsors have risks and considerations that typical private equity funds do not.
First, deal sponsors need to be keenly attentive to the seller and their ultimate desire to sell. Fundless sponsors often operate in the lower tier of the middle market and interact with seller’s that do not have extensive deal experience or, more concerning, have not made a final determination to sell. The deals can be privately sourced by the sponsor and the seller may not have even engaged any professionals to participate in a sale process. The risk of a broken deal is higher for a fundless sponsor because of these realities and, as a result, sponsors place personal capital at risk to cover financial, legal, and other due diligence costs in the event of a seller that walks away.
Second, independent deal sponsors need to maintain relationships with private equity participants as possible sources of capital and deal flow while at the same time even competing with them on target acquisitions. After a target is approached and, in some cases, after a letter of intent is executed, independent sponsors may need to approach private equity as a potential source of investment capital. It may even occur that private equity limited partners are interested in co-investment directly into a sponsors target as opposed to investment in the traditional PE fund. Additionally, private equity funds maintain a far greater network for sourcing deal flow and fundless sponsors are wise to tap that network if possible.
Notwithstanding the risks, independent deal sponsors are able to get deals done. The capital needed to complete an acquisition comes from a variety of sources, first among them the personal capital of the deal sponsor. Our clients have also used a combination of senior debt, mezzanine financing, and even seller financing in order to get deals over the finish line. From the sponsors perspective, the development of the capital stack can be more creative but may also need some flexibility from the seller. Alternatively, sellers working with independent sponsors should diligence the buyer’s funding sources early in the due diligence process so as not to waste time with a buyer that can’t execute a transaction.
This article provides an overview and summary of the matters described therein. It is not intended to be and should not be construed as legal advice on the particular subject.