Independent sponsors in the modern PE industry
by Alex Billias
It’s no secret that in recent years, the private equity (PE) industry has become fiercely competitive. Fundraising still remains near all-time highs, and the largest funds are continuing to get larger. But more money chasing fewer deals is driving up valuations to levels not seen since the financial crisis, and fund managers are facing increasing difficulty in deploying the massive amounts of capital they’ve raised, let alone achieving the same level of outperformance for which the industry historically has been known.
On the investor side, some limited partners (LPs) are questioning whether traditional PE funds with their 10-12 year lives are worth their (not insignificant) management fees, and are increasingly looking for more flexibility in their PE investments. This has prompted many larger LPs to pursue direct and co-investment opportunities with no fixed investment time-horizon. Partly in response to this trend, some GPs are increasingly offering investment vehicles outside their primary funds. In general, these vehicles take two forms: GP-directed funds that are typically parallel to primary funds and invest in similar securities as the main fund; and discretionary funds, where LPs have some control over decisions to invest in one or more transactions. But despite their increasing popularity, these vehicles are certainly not one-size-fits-all – a recent study found that there are significant differences in their performance. The best performance in both GP-directed and discretionary vehicles was recorded by larger, experienced LPs who are typically seen as sophisticated (endowments, insurers, and private pensions). Thus while some LPs may benefit from these products, many others, either with fewer resources or less experience in PE, are left with relatively few options that generate strong performance and meet their investment preferences.
For instance, family offices, often concerned with wealth preservation, are less interested in receiving periodic distributions as GPs exit portfolio companies than they are in achieving long-term capital growth. While PE offers a longer investment time horizon than some asset classes, along with the potential for outsized returns, family offices are still concerned about issues like the possibility that GPs may make suboptimal exit timing decisions to coincide with fundraising needs, whether to wrap up a fund or to boost IRRs. Similarly, large insurers and pensions have long-term liabilities that they need to match with equally long-term assets, but typical PE funds may fail to fully satisfy their investment preferences and still subject them to the same sorts of problems family offices face.
In response to both the challenges GPs are facing and the changing preferences of LPs, some GPs have turned to products beyond traditional, co-investment, and discretionary funds in an effort to better address specific LP preferences. For example, although they have existed for many years, long-lived and evergreen funds are two structures that are gaining popularity in today’s PE environment. Long-lived funds may have a life of anywhere from 15 to 30 years, whereas evergreen funds are essentially unending. Other long-term structures, like professionally-managed private capital holding companies with investors as shareholders, offer similar long-term investment opportunities.
But shifting LP preferences have unlocked opportunities for alternative approaches to PE beyond the traditional PE firms, funds, and related products. In particular, independent (or “fundless”) sponsors, who have always operated in the shadow of traditional PE funds, may be able to capitalize on many of these trends.
Independent sponsors work on a deal-by-deal basis, sourcing investment opportunities to present to prospective LPs. LPs have the right to opt-in or out of individual deals, which gives them more flexibility than investing through blind-pool PE funds.
The independent sponsor model most closely resembles the early days of PE, where investors would identify promising companies in an opportunistic (and somewhat ad-hoc) way. Modern independent sponsors often have prior PE experience, or conversely are looking to build a track record before raising a traditional PE fund. As a result, independent sponsors range from seasoned sector specialists looking to do deals in a particular space to young entrepreneurs trying to find their footing in a competitive industry.
Independent sponsors also pursue a variety of structures, from solo, entrepreneurial GPs managing day-to-day operations of a single investee company to quasi-PE models with multiple investment professionals managing a portfolio of companies. Yet despite spanning a spectrum, many independent sponsors share the potential to benefit from shifting industry dynamics.
For instance, because independent sponsors do not have committed capital like traditional PE funds, there is little pressure for them to deploy capital just for the sake of putting investor money to work. And even though independent sponsors may lack the diversification benefits offered by a traditional fund via its portfolio of companies, the higher risk of failure in the deal-by-deal model helps ensure both deal quality and high sponsor engagement.
Incentives are further aligned by the typical fee and carry structures seen in independent sponsor models. When sponsors charge management fees, they’re based on invested, not committed, capital. Although this could incentivize independent sponsors to find deals quickly to begin charging fees, the “all-eggs-in-one-basket” nature of the model helps mitigate the risk of doing deals simply to generate fees. Moreover, most of the sponsor’s compensation comes in the form of carried interest, which often includes performance-based thresholds (for instance, 20% carry after a 1x return plus an 8% hurdle, plus an additional 10% after 2x, etc.). From an investor’s perspective, potentially lower fees relative to a traditional committed fund structure along with greater interest alignment with the sponsor, makes the independent sponsor model an attractive economic option.
Once capital is invested in a deal, there is little pressure to exit prematurely. Although independent sponsors need to show successful exits to build a track record, the lack of exit timing pressures associated with traditional fundraising, the allure of staying in a high-performing deal, and the risks and difficulties associated with sourcing another “winner” allow sponsors to stay in deals until it makes the most economic sense to exit. This dynamic allows returns to compound over the long-term, which matches the investment preferences of many LPs.
Even though the independent sponsor’s deal-by-deal model necessitates greater due-diligence on the part of both the sponsor and prospective LPs, investors ultimately benefit by gaining access to what are often proprietary deals with a high chance of success. As a result, independent sponsors possess a unique opportunity to attract LPs by offering them a way to augment the returns from traditional PE funds via more flexible, long-term structures that offer significant economic benefits to both the LP and the sponsor.
Having worked with many different types of LPs and GPs (including independent sponsors), Bella Private Markets has significant experience in guiding both investors and managers alike through a constantly evolving PE industry. From establishing a PE program for the first-time investor to creating a strategic growth map for experienced managers, we partner with clients as trusted advisors to help them face their unique challenges in the dynamic PE landscape. For more information about how Bella may be able to help your team, feel free to reach out to us at firstname.lastname@example.org.
 Lerner, Josh and Mao, Jason and Schoar, Antoinette and Zhang, Nan R., Investing Outside the Box: Evidence from Alternative Vehicles in Private Capital (August 15, 2018). Harvard Business School Entrepreneurial Management Working Paper No. 19-012; Harvard Business School Finance Working Paper No. 19-012. Available at SSRN: https://ssrn.com/abstract=3230145