Why Independent Sponsors Can Be A Better Way To Invest in Private Equity
Independent Sponsors are rapidly penetrating the Private Equity market and are now involved in nearly half of all middle market transactions. These groups invest in each deal individually,rather than through ten year committed funds (affectionately known as “blind pools”). As this trend accelerates, it is also helping high net worth investors (“Investors” with >$1MM of investable assets) access and fund deals where they can earn better returns with more control over deal selection, less risk of delayed liquidity, fewer fees and more transparency. These are not high flying, venture capital “club deals” with lottery style risk and return; these are generally established, profitable middle market companies which are managed through trusted relationships, distribute current income and provide investors with timely access to a company’s detailed information. This “Transparent Capitalism” is yielding enormous advantages for Investors; they can make their own decision about each deal and pick the ones which coincide with their interests and values and which are better timed and sized to their liquidity. Deal quality is self policing as each investment must stand on its own merits and Independent Sponsors are under no required timetable to invest uncommitted funds.
Independent Sponsors are not tied to a single funding source and can select Investors who offer more than just money. The best ones often focus their fundraising efforts on Investors who can add value through their expertise, background and relationships. Investors can be more than passive bystanders; they can serve as consultants, board members or just interested parties on the lookout for new customers or key hires. Their questions, insights and involvement can actually aid in the due diligence process and improve investment outcomes over time. They are the opposite of “dumb money”. In Transparent Capitalism, Investors become engaged, informed and focused on a smaller number of deals rather than participants in widely diversified, passive investment portfolios managed or selected by third parties. Transparent Capitalism also enables a virtuous cycle. Investors can use these networks to share in deal referrals with other like-minded groups to gain access to a larger number of higher quality transactions than they could otherwise find and invest in individually.
Investors in the public markets face a sobering prospect of lower returns as interest rates have plummeted, earnings growth has slowed and stock performance has declined over the last decade. They would gladly trade some short term liquidity in return for access to Private Equity opportunities yielding double digit annual returns, but most Investors have little ability to indentify or underwrite these investments on their own. The majority of large Private Equity funds (often sold to individuals through brokers with a high fee structure) require a 10+ year commitment before you even know the identity, valuation, timing and structure of the investments. Furthermore, the surplus of capital in the large buyout market has depressed the returns of these large funds which, on average have underperformed the returns of the lower middle market funds. Hence, the growth of Independent Sponsor networks is creating a much needed realignment of investment opportunities by combining an Investor’s capital with his or her expertise and network of relationships.
Investors historically invested the large majority of their assets in the stock and bond markets and only a small percentage of their assets (“fun money”) went to private deals that were perceived as high risk but high reward for those that worked out well. However, these deals often created adverse selection risk by focusing on earlier stage investments (or, my favorite, speculative real estate). Generally, the further away from the Sponsor’s personal network or industry they went to seek funding, the more likely the deal’s risk/return characteristics were mismatched or exorbitantly favored the insiders. Independent Sponsors in established, profitable middle market companies, putting their personal capital to work alongside Investors, mitigate the risk of adverse selection and provide an important investment discipline.
The advent of Transparent Capitalism is turning traditional investing upside down. Investors can take matters in their own hands and invest a much larger portion of their assets in fewer companies where they can leverage their industry knowledge and relationships. Capital has become cheap and oversupplied in most capital markets and Investors have come to accept capital preservation as a more modest and realistic goal for their institutionally managed money. Investors are realizing that their future wealth will be created by their own business or from private investments coming out of their own network. Independent Sponsors enable Investors to pick their own deals within a trusted network and favor investment structures that mitigate risk. Investors sacrifice liquidity but gain access and influence with their Sponsor or Management team. These investments often yield current income, improving liquidity and providing Investors with some financial cushion in a distressed economic environment.
Individual investing in private companies is not a new concept. The Independent Sponsor model in Private Equity is just another step in the ongoing financial disintermediation of personal investments from the institutional model; improving transparency and efficiency and leveraging the growth in information technology, a form of social networking with financial objectives. Transparent Capitalism mimics the benefits of the merchant banking model of the 1800’s by ensuring that investors’ interests are closely aligned (ie. Everyone is writing a check and has money at risk). The model takes advantage of trusted networks that need to maintain each party’s reputational status. By pooling talent and capital, Investors’ ongoing business relationships and investment results are strengthened, generating transcendent franchise/network value. Importantly, Transparent Capitalism can function as an evergreen source of investment opportunities and funding for the Investor network, with proper incentives for all parties’ active involvement towards a successful investment result.