Editors’ Note: DailyDAC is proud to present its first guest blog by Avondale Strategic Partners. This article discusses how, over the past few years, competition for deal flow among private equity buyers has increased because of the entry of more players into a market that had previously been limited to the tradition PE sponsor.
The Emergence of “New” Private Equity
Karl Stark and Bill Stewart, Avondale Strategic Partners
The world of middle market buyouts has seen an emerging trend whereby non-traditional investors are playing an increasingly active role in the private equity domain. This base of investors has moved away from the conventional fund structure model and is comprised of groups such as fundless sponsors, family offices and even limited partners making direct investments in businesses. In this article, we will explore differences between these investors and more traditionally structured private equity groups.
First, what is the traditional private equity fund model? Limited partners commit capital to a fund, which is charged an annual management fee (usually 2% of the fund size). These capital sources are usually large institutional investors, endowment/pension
funds and very high net worth individuals. The fund often has a defined life and a mandate surrounding the types and size of deals it can invest in. Limited partners receive a preferred return on the amount of capital they commit, and a percentage (usually 20%) of the excess capital returned to limited partners is paid to the private equity group, also known as the carried interest.
Private equity groups identify, source and execute deals using their funds, while trying to help their investments grow faster to maximize the return on capital from an eventual
exit. One challenge with this structure is the concept of the “J-curve”, whereby the first few years of the fund basically yield negative returns for investors because of management fees, investments not yet realizing growth, or the lead time required to find and
execute quality deals. The return theoretically increases over the fund life as investments mature and the fund is monetized. Longer term, however, many private equity groups, particularly in the middle market, have developed strong value propositions for helping their portfolio companies by bringing industry expertise, operating partners and strategic growth planning to the table.
By contrast, fundless sponsors (also known as pledge funds) do not raise a committed fund, and thus do not charge up-front management fees. They may charge a fee to their portfolio companies , but only after an investment is in place. Fundless sponsors build a
network of valued investors and present opportunities to them on a deal-by-deal
basis to gain capital commitments to specific deals, rather than through an
aggregate pool of money.
Fundless sponsors operate similarly to private equity groups in most other ways with respect to trying to create value for their portfolio companies through operational and strategic guidance. In recent years, as fundraising has become more difficult and limited partners are shunning large up-front fees, more private equity professionals are shifting towards the fundless models as some of the benefits to investors become more apparent.
The difference between having a committed fund and operating as a fundless sponsor has a number of implicationsfor both the investing process and investors. Let’s start with the investment process.
Both types of groups try to develop deal flow from similar sources, but fundless sponsors have the distinct disadvantage in auction processes of not having truly committed capital early in the process, presenting an additional layer of execution risk. Furthermore, for future capital needs, it is important for fundless sponsors to prove they will have enough available capital from equity sources to continue supporting investment to grow. From a seller’s perspective, this may present enough of a risk to getting a deal closed that they choose a different buyer.
On the other hand, these sponsors do not have the same investment mandate or defined fund life as traditional funds and can often offer much greater flexibility with respect to holding period and partnership models. This may prove attractive for many sellers, particularly in the case where they are retaining equity, as fundless sponsors can often provide more patient capital to allow platform companies to realize the full benefits of a solid growth plan without prematurely exiting the business to meet fund life commitments.
From an investor’s point of view, there are a multitude of implications when choosing between traditional funds and pledge funds. First and foremost, the difference in fees has made a huge impact on the evolution of the industry. Limited partners are becoming more resistant to up-front fees, particularly in a sluggish market where quality deals are taking more time to find and close. The pushback on fees has given fundless sponsors a leg up on attracting more pockets of capital, while shifting the investor demographic by providing high net worth individuals increased access to the buyout market, rather than just large institutional investors.
Second, limited partners no longer need to tie up capital for a defined fund life to have funds available for capital calls by private equity groups when it is time to fund a
transaction. Instead, they can make commitments on a case-by-case basis. This has become an important consideration as the lagging financial markets have in some instances made limited partners unable to meet their capital calls from private equity groups, triggering severe penalties for limited partners. This also allows investors to
decide their investment strategy based on their risk appetite.
Third, in a traditional private equity fund, limited partners are investing in a blind pool of capital. They gain from the winners but also suffer the losers, with no ability to allocate risk across a portfolio. Through fundless sponsors, investors gain a great deal more visibility into investments and can select where they want to put their money.
Furthermore, the investor base touches more high net worth individuals
who may have operating experience in particular industries that can be useful
for bringing value to portfolio companies. Thus, limited partners are able to gain insight into deals and even potentially help create value for investments.
On the flip side, limited partners may not necessarily have the expertise or resources to effectively evaluate attractive middle market opportunities, in which case, traditional
fund models allow them to simplify the investment process by partnering with professionals who have a track record of success.
The industry has also seen more family offices and limited partners enter the direct investment market more aggressively. Family offices invest from a pool of capital that is almost all exclusively from a wealthy individual or family estate. These offices have shifted from allocating capital to other funds to directly investing in and acquiring middle market businesses.
The same holds true for some institutional limited partners, such as pension funds, which are taking a more active role in directly investing in opportunities through co-investments with trusted private equity managers. These investors typically take a longer-term view of investing and can be more selective since they are not under pressure to invest within a defined fund structure. However, many such direct investors may not have the bandwidth or resources to evaluate and structure transactions, making them susceptible to potentially missing attractive opportunities.
Overall, the growth of this alternative investor base has changed the M&A landscape by introducing more bidders, potentially driving up valuations and making quality deals more
scarce. But the increased amount of choice has benefited investors by improving access to private equity investing to a larger demographic, while offering more choice for tailoring one’s investment strategy. Traditional private equity funds and emerging direct investors are also finding new, creative ways to partner together to acquire and grow businesses, which benefits everyone.
Karl Stark and Bill Stewart are Managing Directors and co-founders of
Avondale, a strategic advisory and principal investing firm focused on growing
companies. Karl, based in Chicago, and Bill, based in San Diego, have a
combined 30 years of experience helping businesses achieve and sustain
profitable growth. Their strategic and financial advice helps companies unlock
the value drivers in their business and focus investment around the most
profitable growth opportunities. Avondale, based in Chicago, is a high growth
company itself, and is a two-time Inc. 500 award recipient. The authors thank Avondale’s Sameer Paul for his contributions to this article.
Twitter: @AvondaleSP @KarlStark @BillStewartASP