There’s a critical decision you have to make if you want (or already have) exposure to private equity as a part of your portfolio — does your chosen manager deploy capital through a fund structure vs. do they pursue a deal-by-deal strategy?
We would never claim there’s a one-size-fits-all solution, but there are key considerations with either path you choose (hint, we do have a preference).
In a traditional private equity fund, the General Partner (aka Fund Manager) pools and deploys capital from Limited Partners (aka, investors). The fundraise usually has a stated investment objective that typically outlines target geographies, industries, and/or company sizes.
In this model, once your capital is committed to the fund, you lose control over which specific businesses the manager chooses to invest in (otherwise known as “Blind Pool Risk”). That may or may not matter to you, depending on your individual preferences. But some investors prefer more control and knowledge of where/how a fund allocates their investment dollars.
In a deal-by-deal model, a private equity manager first identifies an attractive investment target and then raises money… specifically to purchase that company. Fundraising happens for each individual deal, and an investor knows up front (and can choose based on that knowledge) which underlying portfolio company(ies) they want to invest in.
In a deal-by-deal model, individual investors ultimately exert more control over the investment decision than a traditional fund structure allows. While the fund manager still chooses the investment candidates, you, as an investor, can choose whether or not to join an opportunity that’s presented to you.
Every fund is different, but for the most part, private equity funds have 7-10 year lifespans. In practice, that usually looks like deploying capital for the first 3 years of the fund’s life. That’s followed by a 2-4 year holding period in which the manager tries to improve and grow the business. The final 2-3 years are spent exiting the investments (at what you hope is a solid return).
It can be beneficial to know how long your money might be tied up, to be sure. But the downside of this proscribed lifecycle is that it can lead to short-term decision-making by the manager when the fund nears its end of life.
Some deal-by-deal sponsors follow a similar, timed approach, but the nature of deal-by-deal allows for more flexibility with time horizons. At City Different Investments, we underwrite for an indefinite hold period. We evaluate (and often avail ourselves of) attractive exit opportunities as they become available, but we believe removing traditional time constraints allows us to be better long-term partners to both our investors and our portfolio companies.
By its nature, a fund diversifies investors’ capital into various businesses and exposures. The fund spreads the risk-reward profile across numerous investments, shifting the burden of diversification onto the fund manager.
On the other hand, in a deal-by-deal approach, the risk-return profile is isolated into single investments (unless you join multiple deal-by-deal investments). This can be good or bad, depending on how the specific investment performs.
Deal-by-deal investing shifts the diversification responsibility and burden back onto the investor. If you want diversity across multiple private equity opportunities, you have to join multiple deal-by-deal investments.
Traditional private equity funds can deploy capital into attractive opportunities quickly, which is a big advantage. In a fund structure, investors commit capital to the fund up front. The fund then calls for that investment at either set intervals or as attractive opportunities arise. Because the capital is already committed to the strategy, the fund manager only needs to call on its investors to wire funds — this means a fund can react quickly to attractive opportunities.
In a deal-by-deal approach, a private equity sponsor first finds an attractive opportunity and then raises funds for that specific deal. This can sometimes slow the process because the sponsor has to balance conducting due diligence with fundraising. If funding is slow to materialize, deals can sometimes fall apart at the finish line.
The alignment of interests between the General Partner and their investors provides a final difference between a fund and deal-by-deal approach.
There are plenty of ways to compensate a General Partner, but the predominant structure with the fund approach is “2/20” (meaning a 2% management fee and 20% carried interest, which is a share of profits).
The 2% management fee provides the General Partner with a revenue stream while they search for opportunities (or wait to realize an exit from a portfolio company). It’s not usually contingent on the performance of the investments themselves, though. An investor could still end up paying a substantial management fee even if their investment doesn’t meet expectations.
Deal-by-deal private equity managers can also choose various ways to structure their compensation, including some component of management fees and or carried interest. However, the way we at City Different approach deals is that instead of tying our compensation terms to a management fee, we tie it directly to the investment's performance (this approach is relatively common among deal-by-deal sponsors). We favor this approach partly because it fully aligns incentives between the manager (us) and the investors (you).
We chose the deal-by-deal approach for our City Different Acquisition Strategy (in which we acquire lower-middle-market businesses). We believe the structure allows us to:
Yes, there can be some risks associated with the slower capital deployment of a deal-by-deal model, but we have been successful at raising capital for our deals so far. That gives us the confidence to say that we can mitigate many of those risks.
We know individual investments present isolated risk-reward profiles, but we’ve developed a robust and thorough deal-sourcing methodology that unearths differentiated and attractive investment opportunities. Investors always have the option to diversify their private equity exposure across multiple deals if they so choose.
If you’re interested in learning more about our private equity approach (or just have questions about private equity in general), I’d love to chat with you. As the Director of Private Investments here at CDI, I work extensively in private equity investing and would love to share my knowledge and answer any questions you may have!
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