FundFire: Direct Investing Push Puts Spotlight on Deals-Only Model

Tom Stabile May 24, 2017
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More private equity investors and managers are starting to embrace a "fundless," deal-by-deal model as a viable investing option – and not merely as a stepping stone for new teams needing to prove their chops on the way to raising a future fund.

There are still few assets and players active in the "independent sponsor" market that uses private equity techniques without the cumbersome blind pool fund, but awareness and interest has grown fast, says Anthony Luchetta, v.p. at Ocean Avenue Capital Partners. His firm, which raises institutional investor capital and deploys it through a multi-manager model, often prefers using fundless sponsors over commingled funds.

"The number of independent sponsors has grown significantly in recent years," he says. "We’re seeing groups pop up all over at conferences, networking events. There are strong tailwinds for the model, and we expect to continue to see the market grow and see new sponsors pursuing this model."

More participants and a loose but growing consensus on general operating principles and standard terms for deal-by-deal approaches have given the model more credibility, says Jabbar Abdi, managing partner at Sidereal Capital Group, a manager in Summit, N.J., using a fundless sponsor set-up.

"The industry has matured so much," he says.

The concept has been shedding its profile as a quirky offshoot as more investors scout new ways to get private equity exposure, says Peter Martenson, partner at Eaton Partners, a placement agent that recently launched a direct investing deals team alongside its core funds marketing business.

"We’re absolutely seeing more fundless sponsors as it becomes a much more accepted part of the ecosystem," he says. "We think it’s going to become a much bigger part of private equity. It used to be looked down upon – what you do if you can’t raise a commingled fund – but now people see it as a venue for smart [professionals who] like to work independently."

Fundless sponsors are benefitting from a broader spike in interest in ways to fill up on private equity assets without the high-fee, long lockup fund model, which has led to more assets in co-investments – where limited partners (LPs) put capital directly into deals alongside a fund – and to more direct investing without a private fund manager. A recent Cerulli Associates study found greater interest among U.S. institutions to draw from techniques used by their Canadian peers, which rely heavily on direct investing.

And many private equity investors have used deal-by-deal models to test out new managers, with a recent Palico poll finding 70% of limited partners that invest in first-time managers today committing more via these structures than they had three years ago.

That greater willingness to look beyond commingled funds was one factor encouraging Eaton to launch its new five-person team that will source four to six direct private equity deals annually, Martenson says. It already raised nearly $500 million in four opportunities in the power and energy sector, and sees a potential audience of insurance companies, family offices, foundations, endowments, and even a few pensions for future deals, he says.

"We’re following where LPs want to do things," he adds. "LPs have asked for co-investments, and now a number of them want to lead deals or co-lead deals. They want to get closer to the companies, make their own investment decisions, and our role is to underwrite the opportunities."

Those same kinds of investors are potential candidates for the fundless concept, which can take on various forms. Some are truly broken out as single-shot transactions where managers have to raise capital for each deal independently, while others are bundled in a "pledge fund" format, in which investors reserve capital ahead of time but can decide whether or not to deploy it in any individual deal the manager presents.

One of the main draws in either format is using these managers to find deals, the key component that most institutions wouldn’t be able to replicate even if they tried to build an internal investment team, says Jeff Baehr, CEO at RueOne Investments, which last year launched a platform of direct investing deals.

"There is an increased desire and capability to tap into independent sponsors as a source of deal flow," he says.

Fundless sponsors are also more likely to find interesting, unique deals suitable for direct investing than mega-buyout funds that are all going after the same large-scale, bid process-generated transactions, Baehr says.

Investors also find the economics of fundless models more attractive, Luchetta says. The typical arrangement tilts toward rewarding the manager for producing the long-range returns on each deal, and not on a steady churn of management, monitoring, and other ancillary fees, he says.

Sidereal uses an increasingly common model where it collects fees during a deal’s life cycle directly from the portfolio company, so that the investor is not putting out its own capital up front, Abdi says. The firm only takes its performance cut after returning investor capital and meeting a hurdle rate, he adds.

The model may also be attractive to more portfolio managers who see setting up a private equity fund as an increasingly burdensome task because of compliance and infrastructure demands, Martenson says.

A few firms such as Rotunda Capital and Liberty Hall Capital Partners have built long-term businesses out of the deal-by-deal model. While Sidereal may look at raising funds in the future, the fundless model has benefits, allowing the manager to gain carry in each completed deal immediately without having to wait for the entire fund to wind down or worry about clawback provisions, Abdi says.

But the model may not gain wide traction or ever become a big chunk of the private equity market because it is inherently an inefficient way of raising and deploying capital, says John Nicolini, managing director and senior consultant at Verus.

"I don’t see that many LPs wanting to go around looking at pledge fund structures they don’t already know well, because then you have to not only underwrite the team but then wait for a deal you find attractive," he says. "I can’t see this being a trend that takes off. You may save on economics and some LPs may want a seat at the table on their investments, but they’ll probably be a minority that doesn’t just get that through co-investments."

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