A fund without a fund is an oxymoron – but not in the increasingly crowded world of private equity (PE) and venture capitalism.
Financiers are using so-called fundless structures as their calling card to enter India, where an estimated 350-400 PE funds are already jostling for space.
Jaganath Swamy, a former McKinsey and Company consultant and a Wharton MBA, has used one such structure when he headed back to India after a short stint with a large PE fund in New York. He chose to launch a pledge fund after he saw that a number of limited partners (LPs) in the US were unhappy with India-focused funds.
LPs are investors in a PE fund while general partners (GPs) are the managers who make deals on behalf of LPs for a fee.
“Many Indian GPs have not been cash-conscious and invested in firms when valuations were at a peak. At the other end, there were people who were over-cautious and not done any deals at all but were earning fees on capital for doing nothing,” said Swamy.
“The second big grievance was the lack of transparency in deal structures. LPs wanted more clarity on what deals are done and why they are done,” he added.
Eight or nine months ago, Swamy and his friends started Ananta Capital Advisors as a pledge fund, a financing vehicle that came on the scene in the US in the late-1980s.
A pledge fund is an amalgam of a traditional venture fund and a loose grouping of individual angel investors who invest in start-ups. Investors provide capital to the fund on a deal-by-deal basis rather than putting up money upfront as is traditionally done – a fundless structure, in other words.
In a pledge fund, the management fee and the “carry” is calculated on the amount invested and not on the capital committed, as in the case of a regular PE firm. The “carry” is the fund manager’s share of the profits made on an investment.
LPs are unhappy at the way things have turned out after the financial crisis, said Swamy, who serves as the managing director of Ananta Capital.
“They are looking at models where they have more control where their money is invested,” he told Mint. “A pledge fund model fits their bill perfectly.”
Besides pledge funds, quasi-hedge funds and warehousing are some of the other models that LPs are using to market their funds.
“It is not just deals that are scarce, but the funds are also scarce,” said Vijay Sambamurthi, founder of Lexygen, a law firm that advises PE firms. “People who managed to raise funds in the heyday of 2007 are fine; they need to only worry about where to put their money and how to protect themselves. But people who are fundraising in this kind of market need to be innovative on both fronts.”
LPs are the primary source of funds for PE firms, typically a mix of institutions such as insurance firms, pension funds, university endowments and high net worth individuals.
“A pledge fund’s structure from an LP’s perspective is fairly convenient,” said Gopal Jain, a partner at PE firm Gaja Capital Partners. “They retain the discretion whether or not to participate in a particular investment.”
“Fundless sponsors do exist, especially in the US and have been known to operate for years,” said Srinivas Chidambaram of Jacob Ballas Capital India Private Limited. “This is an opportunistic model of intermediation. It is a hit or miss model but in a free and creative world, they will always exist.”
Seth Freeman, chief executive and chief investment officer of EM Capital Management LLC, agrees such models are common in the US, adding that the practice is actually a reversion to the way things worked before funds became popular.
The entry barriers for setting up such firms are low, he points out. “It takes little fixed infrastructure and overhead for the pledge fund or ‘fundless’ sponsors. It does not require much more than a telephone number and email address until a deal is found and funded. So, just about anyone who can get out of bed in the morning is a potential PE fundless sponsor.”
Also, managers do not need to invest a lot of time and money into drafting complex offering documents, regulatory compliance and filings as this can wait until a deal is found and indications from investors are positive.
“Small funds are also exploring with other models such as quasi-hedge funds,” said Swamy. A quasi-hedge fund, much like a hedge fund, has a smaller time horizon than a traditional PE fund and make quick entries and exits.
“Big funds like ChrysCapital had followed pre-IPO investments, now an entire fund class is emerging which concentrates on such short-term investments,” he said.
Another variant of the pledge fund structure is the warehousing model, in which the investor allocates a corpus but does not release the money. Instead, the GP has to source the deal and execute it before more funds can be allocated.
According to Lexygen’s Sambamurthi, the pledge fund structure has evolved because investors are unwilling to commit capital, given the financial environment.
In the boom days, people were doing deals faster than the market could produce them, leading to some burning of fingers, he said.
The rapid rise of the equity markets has also made it harder for PE investors. The bellwether stock index of the Bombay Stock Exchange, the Sensex, has more than doubled since March.
Also, GPs sometimes choose to work with greater flexibility; a pledge fund as opposed to a regular fund structure enables this. And if GPs share a close relationship with their LPs, it is plausible that the investors will give them the capital for deals when they need it without being locked into a fund.
However, pledge fund managers do face handicaps. “There is competition for the best deals and a fundless sponsor may not be perceived to be as credible as a buyer or investors with a fund, where the seller knows that the funded sponsor could close the deal immediately while the fundless sponsor needs to raise the money,” Freeman of EM Capital points out. This, he said, may result in the fundless sponsors getting mediocre deals or having to pay higher prices to be able to control the deal long enough to raise funds.
To be taken seriously by most sellers, particularly on large, complex deals, it is necessary to show available funding. For the fundless sponsor, the challenge is finding and successfully promoting a deal before they run out of working capital.
Also, pledge funds are currently not covered by any law and are off the radar of market regulator Securities and Exchange Board of India, leaving such funds open to potential abuse.
Traditional fund houses, however, say these structures will remain on the fringe. “If an LP can do deal sourcing, execution and exit, why should he be an LP, he should rather be a GP,” said Shailesh Vickram Singh, director at 2i Capital India Private Limited. He also pointed out that not all investors are savvy enough to deal with the intricacies of deal-making since the fund manager for a fundless fund must keep going back to the LP.
Freeman also said that most such deals will largely remain in the small- and mid-market space. Larger deals, requiring larger investors – and by extension, institutional investors – are not suited for pledge funds, he said, because an institutional investor needs a certain level of comfort and level of assurance that comes with an investment management firm.
This article first appeared in www.livemint.com on 11 December 2009.
