James Almond

UK buyout firm Lyceum Capital dropped plans to raise its fourth institutional fund and shifted to a deal-by-deal model at the beginning of 2018. The firm, which made the decision because fundraising was tougher than expected, joins a growing group of managers who have decided they don’t need steady management fees and the security of a dedicated pool of capital to win and invest in deals.

Investing deal-by-deal may sound like a crazy idea in an industry where taking a 2 percent cut of any capital raised for a blind-pool fund is the norm. Proponents of the model believe it is anything but.

“It’s tough to get started because people question whether you can raise the money. It’s not as straightforward as people might think,” says James Almond, a partner at London-headquartered Duke Street, which shifted to the fundless sponsor deal model in 2012. “You need a dedicated fundraising-type function as well, and some good limited partner relationships with co-investors who are happy to work on that basis.”

Almond says once you can prove you’re able to raise capital for a transaction and successfully manage assets, investing deal-by-deal can deliver more attractive economics for a GP than managing a fund. Teams can’t sit back and live off management fees, but have to hunt for attractive deals. Fundless sponsors also tend to know their assets better because they undertake more in-house due diligence and spend more time with a potential target, rather than to outsourcing it to a third-party provider. The result? More hands-on portfolio management and potentially greater value creation.

The icing on the cake is that deal-by-deal can deliver higher – and more frequently paid out – carried interest for managers because underlying investors aren’t being charged management fees. This can be an attractive proposition for younger members of a team who don’t have to wait 10 years until they see their first carried interest cheque, Almond argues.

Small and nimble

Christopher Good, a partner who focuses on private funds at law firm Macfarlanes, says the notion that firms resort to the deal-by-deal model when they have exhausted all other options is inaccurate.

“The assumption is that you’d always want to raise a fund because it gives you stable fee income and allows you to plan for the long term,” Good says. This isn’t necessarily the case; fundless sponsors can run smaller and nimbler teams and can have fewer fund and regulatory reporting requirements. He also agrees that the model can bring better alignment.

“They’re very incentivised on each deal and don’t have to wait on a whole fund carry to pay out. Each deal has its own set of economics which don’t depend on the performance of other deals,” he says.

Some market participants still see the strategy as a sign of manager failure, but that is beginning to change.

“There used to be a suggestion that it was all doom and gloom, that deal-by-deal is hugely inferior to a blind-pool fund, but actually, is it a better option for some managers than spending a lot of time raising a 10-year fund and being locked into terms that are really unattractive?” says Good. “With a select group of like-minded backers, you can get out and start to look for deals, giving up the security of a closed fund for the enhanced incentives of deal-by-deal economics.”

Several firms have done just that in recent months. The latest to make the switch is Los Angeles-headquartered Gores, which raised its most recent flagship fund in 2011 and has no plans for another institutional fund, according to media reports.

Sterling Partners shifted to deal-by-deal in 2017. This has opened up the variety of deals the firm can target in terms of industries, stages of growth and structures, co-founder and chairman Steven Taslitz told Private Equity International.



The model can also be very attractive for LPs. Whit Matthews, a senior investment manager at Aberdeen Standard Investments, which invests with fundless sponsors and emerging managers, says the model is popular with institutional investors. Such investors may be disenchanted with the traditional fund model, or they may find it difficult to get into traditional funds because they’re too small, as is the case for some family offices.

Fundless sponsors are also a great source of dealflow as they often find deals below the radar, Matthews adds.

“They’re the ones that are less likely to participate in auction processes. They’re often the groups that are able to create deals as opposed to finding deals as a function of having a less traditional capital source, of having less traditional dry powder sitting in your pocket,” he says.

Whereas the economics of a fund are set in stone in a limited partnership agreement, fundless sponsors have different agreements with each of their investors. Carried interest can range from between 15 percent to more than 20 percent in exceptional circumstances. Some firms’ managers will have pre-agreed terms with some of their investors so when an opportunity surfaces they can act quickly, while other investors prefer to negotiate terms on a deal-by-deal basis.

In the absence of management fees, some sponsors charge monitoring fees. Duke Street, for example, typically charges 1 percent of equity invested which is borne by the portfolio company.

The downside

The deal-by-deal model is not for everyone. Challenges include sponsors having to raise capital each time they see an opportunity, as well as convincing intermediaries and sellers they are a serious bidder. They may also have a tougher time attracting younger talent, as convincing professionals who are starting out in their careers to join a firm that doesn’t have a steady stream of income derived from management fees can be tricky.

Market sources agree paying for abort costs – which are usually borne by the fund – are one of the biggest downsides of deal-by-deal. It’s helpful to have balance sheet capital for this, and managers can also agree to share abort costs with their co-investors if a deal progresses past a preliminary stage. Managers also approach the costs differently; for Duke Street, which now operates a hybrid fund and deal-by-deal model, it typically bears 50 percent of the costs and splits the remainder pro rata between its co-investors.

For Almond, the benefits of not being tied to a restrictive fund are clear. Duke Street has invested in seven deals via this model since 2012, worth more than £1 billion ($1.4 billion; €1.1 billion) in combined enterprise value.

“Deal-by-deal carry is a huge driver, particularly for younger members of the team,” Almond says. “Seeing real carry come through is quite a difficult drug to get off.”