The Rise of Independent Sponsors. Part 2: Blind Pool Fatigue

Last month, we kicked off a series of articles to explain the increase in popularity of the independent sponsor asset class, and why it is here to stay. The first article discussed how pressure on management fees led committed funds to move upmarket, squeezed out junior partners by limiting their current earning potential, and gave capital providers equity incentive to partner with external parties instead of adding more professionals to their staff.    

In this month's edition, we explore how the increase stems from institutional investors' increasing appetite for direct private equity investments have outshined the traditional blind pool investing. 

From a limited partners' perspective, a fund investment is a 10-12 year commitment. A $50 MM commitment is commonly divided into 10 companies, invested at roughly 20% ($10 MM) per year for five years, and then harvested after that. The fund managers do all the work of finding and closing deals, overseeing portfolio companies, completing add-ons, and seeking exits. In exchange for managers doing all the work, LPs are willing to pay a management fees on their committed (or invested capital) and a portion of its investment profits (carried interest). The LP makes its underwriting decision upfront to invest with the fund manager, signs the Limited Partner Agreement, and then funds its share of capital calls.

This strategy is low maintenance, to be sure, but also removes the ability for a LP to control or direct its investment during the fund life. Yes they supported the investment thesis and backed the manager, but no longer have a say in what deals get done, the investment pace or amounts, or exits. They must operate with standby liquidity in the event of capital calls, which limits yield on other investments, and distribution amounts and timing is unpredictable, which futures its ability to say yes to future investments. The fund manager has a fiduciary duty to adhere to the LPA, to be sure, and has an economic incentive to make successful investments, but reasonable people disagree about risk and reward all the time. So to lock up the $50 MM for 12 years, the LP needs to feel pretty good about betting on this manager in a blind pool. 

Meanwhile, as net returns to limited partners compressed over the years (partly due to perceived high fund management fees, among other reasons), more limited partners developed an appetite for making direct co-investments alongside deals led by its fund managers. As an example, a LP might make a $25 MM fund commitment under a promise by the manager to offer them $25 MM co-investment on a deal by deal basis. The LP could then flex their commitment up or down based for a particular asset. Notably, the co-investment was often available without paying management fees or carried interest to the fund manager...what a deal!

As more of these co-investments were funded, teams involved from being asset allocators to deal professionals themselves, and became more proficient in screening and underwriting new transactions, learned about industries, seller dynamics and portfolio management, while also leaning on fund managers to do the hands-on work and business-building. LPs began to fall in love with doing direct deals, and then went in search of additional private equity investors willing to do the work but with their capital. For many, returning to a blind pool no longer seemed as appealing. Kind of like Plato's "Allegory of the Cave", for those who remember freshmen year philosophy class. 

Now, consider the tradeoff of making a $50 MM decision vs a series of smaller bets. For many, they would rather have the flexibility to make incremental bets, such as $5 MM this year, $20 MM next year, etc, rather than adhering to investment pace and timing that is outside of their control, plus the added benefit of saying yay or nay to a particular company or industry. Lastly, investing in direct deals is an opportunity to "try before you buy" with an independent sponsor who might someday raise a fund (known as an "emerging manager").  

Lastly, the fundraising environment has been difficult for many fund managers and limited partners alike. LPs are not receiving enough distributions to make new commitments, so for fund managers the timeline to raise new committed funds is much longer than had been in prior years. The fund managers don't want to forego two years worth of transactions opportunities while waiting for fundraising cycles to complete, so many are completing pre-fund deals as independent sponsors. They may position themselves as "emerging managers" with a desire to raise a fund someday, although many will admit that if deal-by-deal results are successful then they might forego the headache of managing committed funds. Nevertheless, the same institutions who would've backed these managers' committed funds in prior years, are now willing to invest directly in the deal for pre-fund transactions. 

Competition for co-investment in these deals means that institutional investors have to agree to allow the sponsor to earn management fees and carried interest, or else they would forfeit an opportunity to make the investment. However, the flexibility of selecting the time, dollar amount and individual asset still makes this a worthwhile decision for them as part of their overall portfolio strategy.  

There are challenges to direct investing, to be sure, starting with all the time and effort required for deal flow! Some institutional investors have staffed up and prepared to review deal books every day/week, go to conferences and otherwise pound the pavement for deal flow just like fund managers will do. Many have become quite good at deal origination, have a process to review and pursue opportunities, and having the discipline to turn down deals like fund managers do.

Taken altogether, we believe the desire of many limited partners to invest directly into lower middle market deals instead of exclusively through fund managers, is a major catalyst for the growth of independent sponsor transactions.