Finance, Industry Insights

The Fundless Sponsor: How It Works

A black figure searches a haystack for a needle

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.

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