The first sign of an underperforming traditional private equity fund is bad deal flow. If private equity funds have not put in the time, energy and effort to generate volumes of high-quality investment opportunities, then they and their investors are stuck picking over less-attractive investments. It requires constant effort by the private equity fund and a solid reputation of having an ability to close deals and create value for management team owners that incentivizes sellers to present opportunities to private equity funds.
My firm, Evolution Capital Partners, has been at it for over 18 years, and as a result, we have enjoyed steady high-quality deal flow. It takes a long time to establish yourself because you need to define the deals you are seeking to invest in, and prove you have capital and the needed skills to close. Those private equity funds that don’t have good deal flow tend to stretch higher on valuation or stray away from their investment mandate to put money to work into investments.
Private equity funds’ motivation for doing so, in part, comes from the fact that in most traditional private equity fund partnership agreements, at some point, the fees earned from the partnership are based on the amount of capital put to work, not as a percentage of capital raised (typically after five years). If the money committed to the private equity fund has not been put to work, then the fees associated with uninvested capital go to zero. This is a frightening prospect to private equity funds because it could mean drastically reducing their budget, requiring them to cut staff and resulting in an inability to attract and retain talent and a loss of reputation.
A relatively new type of investment entity is a “fundless sponsor.” These entities differ from traditional private equity funds in that they do not have committed capital that they can call on demand when they want to make an investment. However, they do have one to four talented investment professionals who have a track record of investment success.
Fundless sponsor investment professionals have the reputation, as long-established traditional private equity funds do, of closing deals and creating value. Capital is readily available should the fundless sponsor successfully negotiate a binding letter of intent to make an investment. The benefit to the investor is that they are not committed to making an investment, and they have the chance to evaluate the investment opportunity themselves. Further, they do not pay fees directly to the fundless sponsor like they do a traditional private equity fund.
The theory is that traditional private equity funds are paid fees early in the partnership to generate a pipeline of investment opportunities, which has direct costs associated with it. Fundless sponsors are not paid these fees from their investors. The only compensation investors make to the fundless sponsor is performance based, which can only be calculated at the sale of the investment.
Traditional private equity funds work the same way with respect to incentive compensation, except that the fundless sponsor models we are involved with typically have a scaled incentive compensation arrangement rather than the flat fee associated more with traditional private equity funds. The benefit to the investor is that they have the chance to independently underwrite the investment themselves, determine if they believe the fundless sponsor can execute on the strategy and don’t pay management fees paid to fundless sponsors.
As a result, the fundless sponsor investment structure has gained popularity with investors’ capital at the expense of traditional private equity funds. ●
Jeffrey Kadlic is Founding Partner of Evolution Capital Partners