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Debt covenants (also referred to as loan covenants) are important components of the legal loan agreement between a borrower and a lender. They exist to protect the lender from risks associated with loaning funds, and to define the terms of the loan agreement so that there is complete clarity between the borrower and the lender. Debt covenants are both affirmative and negative (more on this later) and failure to comply with the covenants can lead to an event of default. Common covenants can include both operational and financial components (more on this later, too.) 

Debt covenants are also sometimes called financial covenants.

What is a Debt Covenant?

Broadly speaking, a covenant is a promise made between two parties. In the case of debt covenants, this promise is a legally binding agreement contained in the loan agreement executed by both the borrower and the lender. This occurs when an entity, usually a company, takes out a loan from a financial institution. The purpose of the loan agreement is to protect the lender and to provide guidance to the borrower on expected behavior and company performance.

Affirmative Debt Covenants

Affirmative or Positive covenants are those things the borrower agrees to do. Common affirmative covenants include periodically and timely providing financial statements, maintaining equipment or facility standards, keeping good accounting practices, paying taxes, complying with laws and regulations, etc. 

In the debt covenant agreement, affirmative covenants make up their own section. There are often many individual affirmative covenants within a single agreement, and the borrower must abide by all of them. Below are some examples of affirmative debt covenants, from a real agreement.

Affirmative Debt Covenant Examples

1. Insurance: the borrower must agree to insure all property of an “insurable nature,” including equipment, real estate, and fixtures and inventories. The insurers must be “financially sound and reputable.”
2. Payment of taxes: the borrower must pay all taxes.
3. Location of collateral, borrower name and state of organization: the borrower must keep all collateral aside from inventory in transit and motor vehicles at the set forth locations. The borrower should not remove any collateral from said locations except for inventory sold in the normal course of business. The borrower will not change its legal name and trade names without giving the bank 30 days prior written notice. The borrower agrees not to change its state of incorporation or organization.

Negative Debt Covenants

As you may expect, negative debt covenants regulate things the borrower must not do to remain in the loan— or need prior lender approval to do. This can include borrowing more debt, paying dividends, or selling crucial assets. For example, if the borrower were to sell key assets, this could affect company operations— and therefore compromise their ability to repay the lender. 

Just like for affirmative debt covenants, there is often a section in the formal agreement for negative covenants. Also like for the affirmative side, there are often many negative covenants within a single agreement. Below are a few examples of negative covenants— from a real agreement.

Negative Debt Covenant Examples

1. Debt: the borrower will not create debt other than that which is already permitted.
2. Sale-leasebacks; subsidiaries; new business: the borrower cannot enter into any sale or leaseback transaction with respect to any of its properties or create any subsidiary, or manufacture any goods, render any services or otherwise enter into any business which is not substantially similar to that existing on the Closing Date.
3. Conflicting agreements: the borrower cannot enter into any agreement that has a term or condition conflicting with this agreement.
4. Changes in accounting principles; fiscal year: the borrower must not make any changes to its current accounting principles or methods, except the ones required by GAAP. It must also acquire the bank’s consent to change its fiscal year.

Financial Covenants

Within a formal agreement, there is often a third section: that for financial covenants. These can be thought of as affirmative or negative covenants; in other words, if the borrower must maintain a set debt-to-EBITDA ratio, this is both a positive and negative requirement. The borrower must not go above a certain ratio, which is negative, and must maintain a specified ratio, which is positive. Regardless, these covenants are financial in nature. 

Since poor financial performance could impair the lender’s loan, the lender and borrower agree to a set of defined financial covenants that the lender uses to verify that the company financial performance is satisfactory. Financial covenants are ratios and calculations that are used to show performance and ability to meet interest and principal payment obligations. Examples of common financial covenants include fixed charge coverage ratio, debt to EBITDA multiple, and interest coverage ratio. We elaborate on these examples below.

Net Debt-to-EBITDA Ratio

This ratio compares a company’s net debt to its cash flow. In this instance, cash flow is measured by EBITDA (earnings before interest, taxes, depreciation, and amortization). You can read more about EBITDA here. Using EBITDA to determine cash flow is a good gauge of a company’s financial health. Comparing cash flow to net debt helps determine the likelihood that a company will be able to repay the debt. It is important to remember that this ratio handles net debt, not just debt; net debt is total debt after subtracting cash and cash equivalents. 

So what ratio is a good ratio? This depends on a number of factors, but a general rule of thumb is that a net debt/EBITDA ratio of three or less is considered good, and the lower, the better. On the other hand, ratios higher than this could be a sign of financial stress and lower the company’s likelihood of paying the loan.

Interest Coverage Ratio

The interest coverage ratio is a common financial covenant and can be defined in many ways.  One typical definition might be EBIT (earnings before interest and taxes) divided by total interest payments. This ratio offers insight into a company’s ability to pay interest on its debts. This metric also helps determine how risky it is to lend to a company. The interest in this case is interest due to any loan, or line of credit, or other borrowing.

Fixed-Charge Coverage Ratio (FCCR)

This metric assesses a company’s capability to meet all of its financial obligations. These obligations include interest, principal, taxes, and sometimes capital expenditures. Below is the equation for calculating FCCR.

FCCR= (EBITDA + FCBT)/ (FCBT + i)

In this equation, FCBT stands for fixed charges before tax, while EBITDA is a company’s earnings before interest, taxes, depreciation and amortization. The i represents interest. A high ratio signifies an increased likelihood of being able to make payments, while a low ratio shows the opposite. 

Below is an example of the FCCR part of a debt covenant from a real agreement.

Default: Breach of Contract

If the borrower does not abide by a covenant, the borrower is in technical default. Some defaults are curable— and others are not. For example, if the borrower is supposed to send the lender monthly financial statements 30 days after month end and forgets to do so, this is a technical default, that is cured once the borrower sends the financials to the lender. In general, there are little d defaults and big D defaults. The example above would be a little d default. A big D default, for example, would be failure to pay interest or principal payments when due. Big D defaults generally trigger the lender to take action. The lender could require an immediate, full loan repayment, end the agreement, or increase collateral or interest rates. The lender may also charge a default interest premium.

In Summary

Debt covenants play an important role in leveraged finance. Banks feel comfortable lending to companies because they have certain rights and protections provided in the credit agreement— including covenants. Borrowers are willing to give up certain rights and abide by the restrictions in return for access to the lender’s capital.

If you have any questions about debt covenants, send us a message— we would be happy to help.

At the first glance, private equity and venture capital appear quite similar. Indeed, they have comparable structures: in both, firms invest in private companies with plans of selling down the road and making a profit. If you own a company and are considering how outside investors could help you, understanding private equity vs venture capital is relevant.

Private Equity vs Venture Capital: the Similarities

Both venture capital and private equity firms operate in the private market. That means they either invest in privately held companies or, in certain rare cases, invest in a public company and take it private. 

In addition, both types of firms operate with a Limited Partner (LP) framework. In order to raise capital to invest in companies, the firms work with high net worth individuals, institutional investors, or foundations. These investors, called Limited Partners, agree to provide a certain amount of capital, or “committed capital”, for the investment. 

Both venture capital and private equity firms charge their LPs a management fee: typically 1.5-2% of the applicable assets. They also charge carried interest: around 20% of the investments’ profits once the minimum return is met.

And, as stated earlier, the firms have the similar end goal of selling the company at a higher price in the future, thus capitalizing on the investment.

Venture Capital Firms

Venture capital firms differ from private equity firms in a few key ways.

Company Types

One primary way is the type of companies venture capital firms typically invest in. These firms focus on early-stage companies they deem have a high potential for growth. However, there is a catch: just as these companies with an uncertain future could result in a big success, they might fail. So, while the payoff could be higher than private equity investments, the risk is also higher. Common industries for venture capital firms to invest in are technology, information technology, and biotechnology.

Investment Size

Venture capital firms typically make smaller investments than private equity firms: the initial investment is usually between $1 and $10 million. This is because venture capital firms often concentrate on younger companies that are in the earlier stages of business. However, as some successful venture backed companies grow, the additional funding rounds can become very meaningful and raise hundreds of millions of dollars.

Investment Structure

Venture capital firms frequently acquire a minority stake in the company. In other words, they make up less than 50% of ownership. This stake is usually funded with cash, in return for purchased equity, and venture backed firms rarely use debt because these early stage companies need cash to grow, and are often unable to amortize funded debt.

Private Equity Firms

As you may expect, private equity firms are different from venture capital firms in a few notable ways.

Company Types

Unlike venture capital, private equity firms invest in mature companies. Depending on the firm, these companies can vary widely in size— from $5 million to billions of dollars. While these established companies are a lower risk investment than the younger companies of venture capital, they can still need guidance to grow. For example, the company may be operating inefficiently or may need equipment updates. 

In contrast to venture capital, private equity firms focus on a wider range of industries and make more conservative investments. Thus, the potential for very large investment returns is lower than for venture capital— but so is the chance of business failure.

Investment Structure

Unlike venture capital, private equity firms typically use a combination of debt and equity. Mezzanine debt, senior debt, and seller notes are frequently used as leverage. This is because, unlike with startup companies, these developed companies are able to pay back debt from ongoing business operations. 

Private equity firms also usually acquire a majority stake in the company, or over 50%.

Beyond Private Equity vs Venture Capital

There are some investment firms that do not fit a definition. One such firm is 1719 Partners. 1719 Partners has some common ground with private equity: we aim to grow small businesses, we have the transaction experience necessary to close deals, and we have established financing connections. 

But we are unlike standard private equity firms in that we do not invest in companies just to profit from the later sale. Our focus is on our companies’ long term success, and we realize this looks different for each different business. Our mission is to always do what is best for the company, and this means investing thoughtfully and patiently. For this reason, we have no predetermined sell date. In other words, we buy to hold. If you have questions on the pros and cons of private equity, or are curious about 1719 Partners’ mission, please contact us.

An asset based working capital line of credit— or revolver— provided by a lender typically incorporates a provision called a “borrowing base”. A borrowing base is a calculated dollar value that sets the upper limit on how much money the company can borrow from its lender on the line of credit. This borrowed working capital is used to fund ongoing business operations, such as purchasing inventory needed for later sales, or to finance accounts receivable. Understanding how a borrowing base works is important for understanding how high your working capital line of credit could be. We also discuss how a working line of credit may be used in acquisitions.

What is a Borrowing Base?

A borrowing base, in simple terms, defines how much money an asset based lender is willing to loan a company. The borrowing base is calculated based on the value of the company’s assets used as collateral. However, determining the collateral value of those assets is not as simple as taking the book value. A portion of the assets may be excluded, and the lender also applies a discount factor, known as an advance rate. We will detail how to calculate a borrowing base in this post.

Collateral Types

Different types of assets can be used as collateral, such as accounts receivable, inventory, or equipment. Larger assets such as property are typically not used as collateral for a working capital line of credit. Such assets are more fitting for long term debt, like a house in a mortgage for example. In general, assets that hold value over an extended period of time— and decline in value predictably— are paired with long term debt, while assets with temporary value are paired with short term debt.

Borrowing Base Calculation

The borrowing base calculation begins with the book value of accounts receivable and inventory. Next, certain ineligible assets (as defined in the credit agreement) are removed. Finally, the value of remaining eligible assets is then multiplied by the advance rate, or the portion of the assets the lender is willing to lend against. The advance rate for accounts receivable is typically 80%, and the advance rate for inventory is usually 50%. Then these two separate values are added together to determine the borrowing base amount.

For example, if a company’s eligible accounts receivable balance is $1.6 million, then calculating the accounts receivable portion of the borrowing base looks like this:

1,600,000 x .8= 1,280,000

And if the value of the company’s eligible inventory is $1.0 million, then calculating that portion of the borrowing base looks like this:

1,000,000 x .5= 500,000

To calculate the final borrowing base value, both portions are added together:

1,280,000 + 500,000 = 1,780,000

In this situation, the company’s borrowing base would be $1,780,000. The question then becomes, what assets are ineligible?

Ineligible Accounts

Unless deemed ineligible, the borrowing base calculation includes all inventory and accounts receivable. Generally, ineligible accounts are ones the lender views as risks on the ability of the borrower to convert to cash.

Old Accounts Receivable

When a company sells with credit, it is normal for invoices to take some time to get paid. While due in 30 days is common, some accounts receivable can creep into the 60-90 day range. When an account ages past 90 days, it can signal distress on the customer and indicate uncertainty that the customer will pay the balance. 

While it depends on the lender’s risk tolerance, most lenders will remove the entire account associated with the late payment. So if a customer has not paid a balance in 90 days, the full account associated with that customer would be removed from the borrowing base.

Customer Concentration

The more diverse group of buyers a company has, the less harmful it will be if one customer stops doing business with the company. As soon as a sizable amount of business is concentrated to one or a select few customers, the lender will be wary. This is because if a large customer fails to pay, the company’s accounts receivable balance will drop significantly, and the lender may have advanced funds based on this collateral. Now the lender will be in an over-advanced position and might require the borrower to immediately reduce the outstanding balance on the line of credit to bring it back in compliance with the borrowing base.

To reduce exposure to this risk, banks will often set a customer concentration limit, say at 25%. If a customer makes up 40% of the company’s accounts receivable, for example, 15% of the balance would be removed from the borrowing base.

Unsellable Inventory

As inventory value makes up some of the borrowing base, the ability for the inventory to be sold must be monitored. Sometimes inventory proves to be obsolete, excessive, or otherwise unsellable, while the company could still be including this inventory’s value on its balance sheet. For the inventory balance to be accurate, the company would need to remove the value of the unsellable inventory. 

To mitigate this risk, the lender may conduct site visits— to the company’s warehouse for example. This is to ensure undesirable inventory is not piling up somewhere. In addition to site visits, lenders will watch for trends in inventory sales. For example, if inventory’s time in the warehouse is typically short-lived but becomes much longer, the lender may start asking questions. 

One strategy to protect against future obsolescence is the use of inventory caps. Inventory caps are based on past sale trends: if a company typically only sells a certain portion of its inventory while the rest ages out, the value of the aged out portion would not be included in the borrowing base. The inventory cap is an estimate based on projected future performance. For example, the bank may exclude inventory that is in excess of one year sales.  As a result, the portion of included inventory could be very different from the company’s inventory book value.

Government Accounts

Any balances associated with the Federal government are typically not included in the borrowing base. This is because the company cannot sue the government for any outstanding balances.

Borrowing Base Certificate

Over time, a company’s borrowing base must be monitored. A borrowing base certificate is a formal document that governs how the borrowing base will be re-calculated over time. In other words, it sets the terms for the loan and the amount that can be advanced. Because a company’s inventory and accounts receivable fluctuate often, the borrowing base may need to be calculated often. 

For the lender to monitor the borrowing base, the borrower is required to supply an accounts receivable and inventory record at regular intervals. Such monitoring ensures the lender is only advancing what can be backed by its assets.

Borrowing Base and Acquisitions

Can a working capital line of credit be used to finance an acquisition? A line of credit is typically not an appropriate financing source for acquisitions. As discussed earlier in this post, larger assets with predictable long-term value are better suited as collateral for longer term loans. Thus, term debt should make up a large portion of an acquisition, for example 50%. If a working capital line of credit is used to finance an acquisition, it is typically a very small portion— like five to ten percent of the total sources of funds.

1719 and Acquisitions

When 1719 Partners completes an acquisition, we always have a working capital line of credit to ensure business operations can continue as usual. We recognize that this is necessary to fund a business’s liquidity needs. As mentioned above, 1719 does not rely on a line of credit to finance an acquisition; most of the financing is supplied by term debt and our equity investment. 

If you have any questions on how a borrowing base works, or about using a working line of credit in acquisitions, we would be happy to help. Simply contact us and we will be in touch.

When a business owner is looking to sell their company, making sure the business remains in good hands is often a priority. It can be hard to trust that the buyer will carry on the company’s legacy and provide for future success. In these cases, a management buyout can ease the owner’s concerns and help ensure a smooth transition from seller to buyer.

In a management buyout, the existing management team purchases the company from the owner or owners. Compared to other potential buyers, the management team knows much more about the company, and the seller is also familiar with the management team. This can make selling to the management team attractive to the business owner, as it is likely the company’s success will continue under the new leadership.

What Is a Management Buyout?

Simply put, a management buyout is when the existing management team “buys out” the owner(s) and acquires the company. If the management team uses debt to help finance the acquisition, the management buyout (or MBO) is called a leveraged management buyout, because it is a leveraged buyout (or LBO) transaction. As an LBO, management buyouts are funded mostly with borrowed capital, and, frequently, seller financing is used for a portion of the total consideration.

Management buyouts can occur when the company owner is ready to retire or the management team wants to take on more responsibility. The management team may want to make more leadership decisions, obtain greater financial benefits, or simply take the company to new heights of growth. The management team may feel they have the expertise necessary to guide the company to greater success, and that the most efficient way to do so is through a management buyout. It also is a way for management to have a larger stake in company success, by moving from “employee” to “owner” and sharing in the profits generated by the business.

The Management Buyout Process

Typically management buyouts are directly negotiated transactions between the business owners and the management team. It is rare to see the management team participating in a competitive situation— with multiple buyers— as most buyers want to work with an existing management team, and not bid against them. For this reason, should an owner want to sell in an auction process, the management team is commonly not allowed to participate as a buyer.

A successful management buyout may take years to culminate from the initial conversations to a closed transaction. First the owners or the team must approach the other party, then both parties must discuss valuation and deal structure. After that, they have to agree on terms, and the management team must secure necessary financing— all while everyone is still running the business. Needless to say, this process can be lengthy. As the management team often does not have the capital necessary to purchase the company, arranging for financing— both equity and debt— is usually a challenge. The management team also may conduct due diligence, but it is far less extensive than if an external buyer were to acquire the company.

Advantages and Disadvantages

As stated earlier, management’s knowledge of the company can offer many benefits. Due to this familiarity, the due diligence process is much quicker. There also may be a greater potential for future success, as management is able to assume ownership and hit the ground running. In contrast, it would take time and money to educate an external buyer on the company— and therefore, take longer to build company success. The transition can benefit employees, as well; as management rises to ownership, advancement opportunities open up. Another benefit is the assumption that the business will be run as before, which is good for maintaining employee and customer trust.

As positive as an MBO can be, conflicts can also arise. The previous owners may struggle to hand the baton to management and transfer control. At the same time, the transition from manager to owner can be challenging for the new owners, especially if they have no past ownership experience. Naturally, owning a business is different from a managerial role and this learning curve can be steep.

When it comes to purchase price, a seller may receive less than if the transaction occurred with a competitive auction. But the seller may prefer this for several reasons: they like the managers and want them to be owners, the sale process is less disruptive than a drawn out auction which includes management meetings, site visits, etc., and selling to the management team helps solidify the legacy and customer continuity versus selling to a competitor.

Management Buyout vs. Management Buyin

The opposite of a management buyout is a management buyin (MBI). In a management buyin, an external management team purchases all or the majority of a company. This is an option when the company is lacking a successor. In these situations, a new management team can provide much-needed guidance to stimulate business growth. Likewise, a succession solution enables the company to continue thriving. A MBI opportunity can be attractive to buyers, as well: the new owners have the opportunity to grow the company and create significant value for themselves.

Financing a Management Buyout

Oftentimes, the management team does not have the funds necessary to acquire the business. As stated earlier, financing the transaction is usually the hardest part of an MBO. From debt financing with banks, to seller financing, to partnering with a private equity firm, there are a variety of financing options.

Debt Financing

One option is borrowing from a bank. Typically with debt financing, the management team is expected to provide most of the capital, with the bank filling the gap. The problem is banks often view an MBO as too risky, and may not be willing to lend the funds. Banks also look for collateral and/or personal guarantees— both of which might be lacking or insufficient.

Seller Note

The previous owner may be willing to issue a seller note, which allows the buyer to repay a portion of the purchase price over an extended period. Thus the financing will come out of the business’s future success, bridging the gap between the full purchase price and what the management team is currently able to finance themselves or with a traditional senior loan.

Mezzanine Debt

Another option is mezzanine financing. Although mezzanine financing comes with higher interest rates, it is a way to obtain capital without the backing of collateral. Because mezzanine debt is more expensive than senior debt, it often complements other methods of primary financing.

Private Equity and Management Buyouts

When a bank is reluctant to lend capital, partnering with a private equity firm to complete the buyout can be a good option. Private equity firms have capital and relationships with debt providers to help finance the transaction. Once the transaction is complete, private equity firms can offer support for business operations.

However, it is important to investigate the private equity firm before initiating a partnership to make sure the firm and the buyer’s goals are aligned. When the firm and the new owners are working together toward a common goal, the company can reach new levels of growth.

 F/S Manufacturing and 1719 Partners

F/S Manufacturing is an agricultural equipment supplier specializing in designing, manufacturing, and assembling top-quality liquid material handling equipment. This specialty equipment includes sprayers, mixing tanks, liquid or fertilizer storage tanks, hose reels, tenders, and trailers. Since its founding in 1990, the company has been a trusted resource for the agricultural industry’s needs.

F/S Manufacturing’s senior management had worked at the company for a long time and knew the company very well. When they wanted to become owners, they partnered with 1719 Partners to facilitate the management buyout. 1719 is excited to support the new owners and take the company to even greater success. We believe the company is positioned to expand its product line beyond the current offerings, and we look forward to seeing F/S grow.

Final Thoughts

Management buyouts can be intimidating and complex, but with the right strategy they have a high potential for success. Open communication between the buyer and seller as well as the buyer with any partners is important for a successful MBO. Partnering with an experienced buyer of small businesses can increase the chance of a great outcome. If you are considering a management buyout or have questions about the process, 1719 is happy to help. Contact us to be in touch.

Over the past several years, a new investment vehicle has become prominent in PE investing: the fundless sponsor. What is a fundless sponsor? At the most basic level, unlike traditional committed capital PE funds, fundless sponsors are PE investors who set out to identify and invest in businesses without the prearranged backing of committed capital. This lean model provides several benefits to the general partner and the investors. As this model has gained popularity, two distinct investment vehicles have emerged: the independent sponsor and the search fund.

Independent Sponsors

An independent sponsor in private equity refers to an individual or a small team of investors who source, negotiate, and structure acquisitions of companies without having a committed fund under management. Instead of managing a pool of capital from limited partners like traditional PE firms, independent sponsors typically raise equity on a deal-by-deal basis from a network of high-net-worth individuals, family offices, or institutional partners once they’ve identified a target company. In addition, the independent sponsors typically arrange for all debt financing necessary to complete the acquisition.

At first glance, the independent sponsor model provides desirability due to its flexibility, fee structure, and deal-by-deal capital raising basis. The model offers several unique benefits compared to traditional private equity, which appeal to sponsors and the investors who back them.

1. Greater Flexibility

• For Sponsors:
  • Deal-by-Deal Focus: Independent Sponsors reserve the right to pursue investment opportunities on a case-by-case basis. They are not bound to the pressures of deploying committed capital within a specific time horizon. As a result, independent sponsors can be more intentional, “cherry-pick” the best opportunities, and pass on the less attractive ones.
  • Longer Hold Periods: Because Independent Sponsors are not held to the traditional fund lifespan of ~7 to 10 years, they can be more patient and hold investments for longer, leaving no value behind at the time of a liquidation event.
    * Investment returns are not commingled.
• For Investors:
  • Deal Specificity: Investors can choose exactly which opportunities to invest in, allowing them to align more directly with their strategic goals.
  • Smaller Capital Committed: Investors can write smaller checks on a per-deal basis, as opposed to the large commitments typically required by traditional PE funds.

2. Lower Management Fees

• Closing Fees: Traditional PE firms follow the 2 and 20 fee structure (annual management fees of 2% of committed capital and 20% carried interest on investments). Because independent sponsors don’t manage a pool of committed capital, they forgo the 2% fee. Instead, they earn a closing fee when deals are executed, often a percentage of the transaction, ranging from 1.5% to 3%.
• Annual Management Fees: Independent sponsors also earn an annual management fee for each portfolio company, often a percentage of EBITDA, ranging from 3-5%. These fees are paid by the portfolio company directly.
• Carried Interest: In addition to personal equity investment, independent sponsors participate in carried interest. Similar to the traditional PE model, carried interest ranges from 10% to 25% and uses either IRR or MOIC to identify the hurdle rate.

3. Access to Unique Deals

• Independent sponsors often have strong industry relationships and unique networks, allowing them to source proprietary deals that may not be available to larger PE firms. They can focus on smaller or niche deals that may fly under the radar of larger funds, leveraging personal relationships or expertise in specific sectors.

4. Closer Alignment of Interests

• Performance-Based Compensation: Sponsors’ compensation is often heavily based on long-term gains from investment returns on personally committed capital and carried interest. This results in a strong incentive to ensure each deal is successful and that long-term gains are realized.

5. Better Economics for Sponsors

• Since independent sponsors do not manage large teams or infrastructure associated with traditional PE funds, they often operate with lower overhead, allowing for potentially better economics if the deals are successful. Independent sponsors can capture a larger share of the equity or carried interest than they might in a larger PE firm.

6. Stronger Relationships with Portfolio Companies

• Because Independent Sponsors typically work more closely with management teams, they often build deeper relationships with portfolio companies and their employees. This hands-on involvement can lead to more customized strategies and a more substantial alignment between the fundless sponsor, the company, and investors.

Search Funds

A search fund is a popular investment vehicle in which an entrepreneur (the “searcher”) raises outside capital from investors to search for, acquire, and operate an existing business. The search fund model is designed for entrepreneurs who want to own and run a business but don’t want to start a company, and who don’t have enough personal capital to complete the acquisition on their own. It offers a path to entrepreneurship through acquisition (ETA), typically targeting small to medium-sized companies with stable cash flows.

The Search Fund model is typically segmented into the “Search Phase” and the “Acquisition Phase”.

• Search Phase

  • During this phase, the entrepreneur raises a small amount of capital from investors ($300k-$800k) to finance the search process, which can last one to three years. The capital covers the entrepreneur’s living expenses, due diligence costs, travel, legal fees, and other expenses related to identifying a target company.

• Acquisition Phase

  • Once an attractive investment is identified (typically a well-established, profitable company with steady cash flow, growth potential, and EBITDA between $1M and $5M), the entrepreneur raises a larger amount of capital from their original investors to acquire the target business. Investors typically put up the majority of the capital for the acquisition. At the same time, the entrepreneur may invest a smaller amount of their own money, and in return, they receive equity, carried interest, and management control.

The search fund model is a proven path for entrepreneurs to procure and run an established business with the backing of experienced investors. It provides a structured framework to raise capital, find acquisition opportunities, and receive mentorship while mitigating some risks associated with a start-up. However, it requires patience, resilience, and operational capabilities to succeed.

Independent Sponsors vs. Search Funds

Both fundless sponsor models described above provide the opportunity for individuals or small teams to source and acquire businesses with the backing of outside capital. While each model is fundless, they differ in that an independent sponsor does not manage the portfolio company daily. Instead, a sponsor relies on professional management, often existing firm leadership, to continue growing the business. This allows the sponsor to ultimately own a portfolio of companies, offering high-level strategic guidance and expertise. Oppositely, in the case of a search fund, the investor-entrepreneur is an operator who manages the business daily. Because many search fund entrepreneurs are earlier in their careers, the model allows them to build managerial skills and acquire deep industry knowledge to take to their next venture.

If you have any questions on fundless sponsors, contact us and we would be happy to help.