Ahead of the Private Equity Wire US Emerging Managers Summit, Joe Briggs, Founder & Managing Partner at Briggs Capital Formation, provides insight for new and emerging managers on the topic of deal-by-deal structures and what to look out for ahead of raising a fund. Joe will be leading a roundtable on this topic at the Summit on 13 March.
Independent sponsors, fundless sponsors, direct deal sponsors, deal-by-deal sponsors – they all mean the same thing. Deal-by-deal is perhaps the most neutral, so we’ll roll with that one from here on.
For new and emerging managers, the potential benefits of operating on a deal-by-deal basis ahead of a potential fund launch are as numerous as they are obvious. Whether it’s building track record, developing investor relationships and demonstrating that you can source and execute interesting deals as a team, or simply getting into business quickly, utilising streamlined structures and generating early fees and carry to support the build-out of your firm, deal-by-deal can be very appealing. It’s also less of a faff than setting up and running a fund – fewer requirements for a bunch of things that begin with the letter “r”, such as reporting, registrations, rules and regulations, recruitment, risk management, relationship management, and, the most laborious of all, raising private fund capital. For some investment professionals, they may simply like the idea of working more flexibly or part-time without the need to make substantial early “toil” investments in their team, operations, infrastructure and legals.
The potential issues with deal-by-deal are less obvious and less well understood. In a tough fundraising environment, it’s no surprise that deal-by-deal is getting more attention and attracting more hype. It’s a sign of the times and there’s increasing talk about deal-by-deal somehow constituting its own “asset class”.
So it’s all the more important to step back a bit and outline some guidance and considerations for sponsors reflecting on this fundamental deal-by-deal vs. fund dichotomy:
1. Be prepared for continuous fundraising
Deal-by-deal may remove the need to spend months (sometimes years) fundraising for a fund, but deal-by-deal investing ultimately involves a continuous, rolling approach to fundraising for individual deals. If you want to do 10 deals, that means 10 different fundraises and 10 different processes to manage alongside different groupings of investors each with their own timelines and requirements on each deal. The need to shift between doing deals and finding capital can cause a real loss of momentum. Investors may generally be getting more comfortable with deal-by-deal processes, but there will always be potential concerns about the bandwidth of investors to make continuous funding decisions. There’s a certain irony here: in theory deal-by-deal should provide more flexibility for sponsors in terms of the types of company they can invest in, but in many ways the structure and process itself can be quite restrictive. Fundraising for a fund is harder than ever, but fundraising for deal-by-deal isn’t exactly a walk in the park either and it’s a much smaller addressable market.
2. Be willing to embrace enhanced deal uncertainty
If you were selling a business (or providing finance for the sale of a business), would you prefer to transact with a deal-by-deal sponsor with uncertain capital and timeframes, or a private fund with committed and deployable capital? Some sellers and brokers will always prioritise sponsors that can move quickly. Some lenders will prioritise sponsors where they don’t need to do KYC on each individual investor involved in the deal. And the heightened deal uncertainty and execution risk doesn’t end there – there is potential uncertainty for deal-by-deal sponsors with things like funding DD expenses, stomaching broken deal costs, running out of exclusivity, or securing future deal capital for follow-ons and reinvestments.
3. Be ready for investors taking a more active role
Investors and placement agents are becoming more sophisticated in the way they assess and underwrite individual deals, and they will actively evaluate each deal presented by a deal-by-deal sponsor. They look at the quality of the deals and conduct DD that gets them closer to the underlying businesses than fund investors ever would. Some investors also take an active role in investment processes, governance and ongoing monitoring, facilitated via bespoke info rights, observer rights and consent rights. This ultimately means deal-by-deal sponsors are subject to greater scrutiny and need to facilitate greater investor transparency. It’s like operating a continuous, turbocharged LPAC, which certainly helps put the alternative “passive blind pool” fund option in context.
4. Be disciplined with investment parameters, selection and management
Deal-by-deal sponsors have a lot of freedom with how they operate their firms. Fund sponsors are held to very different standards, especially when it comes to the expectations and requirements of institutional fund investors. Just ask any good funds lawyer what the difference is between an LPA for a fund and an LPA for deal-by-deal. With no fund, there are no formal requirements on investment policies and restrictions, or portfolio construction and diversification. Investors are not backing the sponsor’s vision for their broader thesis, strategy and market opportunity, they are looking directly at the deals. This can present serious disadvantages for any deal-by-deal sponsor that wants to one day raise a fund. They might not have instigated the practices, policies and investor protections that set them up for the rigors of institutional investor due diligence. They may get lazy and end up establishing some entrenched bad habits and practices. They might not have refined their vision, values, thesis, differentiators, processes or reason to exist. “We back quality management teams with proven business models” might be good enough for deal-by-deal, but it won’t cut it for a fund pitch.
5. Be aware of changing investor sentiment and allocations
A lot of investors that commit to deal-by-deal do not commit to first time funds (and ones that say they do can be surprisingly good at changing their minds). These commitments are rarely stapled (although some anchors and seeders do provide capital to warehouse deals ahead of a fund launch). Investor behaviour is very hard to predict and can often seem irrational, especially to new sponsors that got used to certainty of capital at their prior shops. Deal-by-deal requires sponsors to tap into what investors currently think is hot or in vogue at any given moment – the changing whims and tastes of the FO, HNW and SBIC crowd. Some deals may simply be too complex for these investors to get their head around (deals that funds can always look at and take their time to underwrite). The fact that a lot of deal-by-deal transactions are hairier and scrappier than fund transactions doesn’t help either – they may just be too much for investors to diligence and digest under time pressure.
6. Be careful you don’t get addicted to the deal-by-deal carry
One of the most appealing features of the deal-by-deal approach is the deal-by-deal carry. While deal-by-deal structures don’t cater for reliable management fees on committed capital, the prospect of rapid carry (and potential “super carry”) can more than compensate for this to help the sponsor keep the lights on and retain hungry talent. The flip side for investors is that they are forced to assume their own losses – there is no netting off of carry across the portfolio on bad deals like there is for a fund. The prospect of transitioning to a fully-fledged fund model can end up being too much to ask for groups that get too used to certain deal-by-deal perks. There are some deal-by-deal firms that internally structure their businesses a bit like a fund, with pooled carry and internal fund “vintages”, which can mitigate this.
For some new and emerging managers, setting out deal-by-deal may feel like the only option – essentially a case of “deal or die”, or “deal or no deal”. Put bluntly, it’s virtually impossible to raise a new fund in the current environment without pre-fund deals already executed by the same team. But there’s an important distinction to make between working on pre-fund deals with a view to raising a fund with potential seed assets, and setting out as a dedicated deal-by-deal sponsor, where you may be setting other wheels in motion (or, more likely, getting used to not having certain wheels in motion). At the end of the day, the founders of investment firms are all entrepreneurs in their own right – it’s just some are more suited to the constant hustle and opportunism of deal-by-deal and some are more suited to building the institutional apparatus and model of a fund.
Ultimately, sponsors should think long and hard about what is right for them and what it is they are trying to build. Which route is more scalable for us? Where do we see the most momentum? What’s the vision for our firm, our team, our legacy? What do our investors and advisors think we should do? Do we have the depth of track record and quality of early backers that are required to launch a first time fund? If not, do we have the (increasingly common) option to partner with a more established deal-by-deal sponsor to help get us going on a deal-by-deal basis?
Whichever structure a sponsor ends up with, it’s clear that both approaches have something to learn from each other. Deal-by-deal sponsors may not be subject to the same restrictions and requirements of a fund, but they would do well to behave a bit more like they have one, especially if one day they intend to pursue that path. And fund sponsors might want to consider providing a bit more deal-by-deal style disclosure and transparency for investors, something that is certain to go down well in the current environment of increased investor scrutiny and requirements.
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Want to learn more? Join us at the Private Equity Wire US Emerging Managers Summit on Wednesday, 13 March at Convene 101 Park Avenue, New York. Apply for your pass here.
