Fundless vs. Funded: Pros & Cons of Independent Sponsors & Private Equity

If you have been looking into options for funding your family-owned or small business, there is a very good chance that in addition to small business private equity firms, you have heard about fundless sponsors and search funds. If so, you are likely wondering what a fundless sponsor is and whether or not it’s the right funding option for your small business.

Fundless Sponsor Models

In the past few years, the number of fundless models have increased in popularity, especially in the lower middle market. Put simply, fundless sponsors are individuals or groups that do not have any up-front financing for an acquisition, but are still seeking acquisition targets. Fundless sponsors, also called independent sponsors, do not possess committed capital and will typically raise any necessary debt and equity capital on a deal by deal basis.

There are two basic types of fundless models: independent sponsors and search funds. Whereas an independent sponsor may invest in multiple opportunities, a search fund seeks out a single to invest in. Search funds are often organized by a small group of investors searching for an acquisition target in a specific industry. Independent sponsors normally have a somewhat passive role in the acquired business. A search fund, on the other hand, will often take part in the day-to-day management and operations of the company. 

Pros and Cons of Fundless Sponsor Models

Fundless sponsor models are often seen as less restrictive and more flexible than funded models such as traditional private equity investments. Working with an independent fundless sponsor may be a good option for a business that has been struggling to negotiate more attractive terms with established private equity investment firms. 

However, there is no clear pathway for independent sponsors to raise funds so there is a greater potential risk. Their ability to acquire investment capital is not guaranteed. Adding to the increased layer of execution risk, is the potential of finding out very late in the deal that their investors have ultimately decided not to commit the funds. 

Funded Sponsor Models

First and foremost, funded sponsor models such as private equity firms have dedicated committed funds ready to invest. Funded sponsors are typically more actively involved in the businesses that they invest in. Under such a traditional model, private equity investment firms may invest capital over a period of five to seven years in a variety of companies.

The goal is to increase the value of the company and provide a strong ROI to their investors. Funded sponsor models typically focus on long-term investment opportunities where they can drive transformation and add value through strategic insight and operational support. 

Pros and Cons of Funded Sponsor Models

The biggest benefit of a funded sponsor over a fundless sponsor is that transactions will have a greater chance of going through. Funded sponsors not only have access to larger amounts of funding, but private equity firms also typically have that capital available already and are ready to finance transactions upfront. 

Funded sponsors typically have more “skin in the game”. They are figuratively and literally more invested in your business. Another benefit is that funded sponsors like private equity firms are more hands-on and can offer assistance in a variety of aspects of operating your business to help maximize its value. However, this benefit could also be seen as a potential problem if you don’t partner with someone whose ideas for running your business and goals for success don’t align with yours.

Which Type of Funding is Right for You?

It is important to be aware of the potential risks and benefits of doing business with both funded and fundless sponsors. Companies considering which option is right for them should consider how much the ability to raise funds matters to them. Will it be devastating for the deal to fall through at the last minute? When evaluating potential funding sources, businesses should also evaluate their confidence in either funding sponsor. Do you have confidence in their financing? Do they bring any strategy or operating expertise to the table? How do they enhance the value of your company?

If you are comfortable taking a bigger risk on the chance that financing will fall through at the last minute and are looking for a more passive investor, the fundless model may be a good choice for you (except search funds, which are very hands-on). If you are looking for a partner that has secured funds and a deep repository of industry knowledge and leadership skills to bring to the table, choosing a funded model like a private equity investment firm may be the right decision.