Despite the market being awash with capital, so-called “pass-the-hat” deals are becoming more and more prevalent in the market, M&A attorney Brent Pietrafese says.

“In a traditional private equity deal, the fund or the sponsor group has a dedicated pool of money,” says Pietrafese, a partner at Calfee, Halter & Griswold LLP. “They raise a fund and then go out and try to find deals to invest that pool of capital. These ‘pass-the-hat’ or fundless sponsor groups go out and find a deal that they like and then try to raise money for that specific transaction.”

These fundless sponsor groups are often made up of former private equity professionals who have set out to source deals on their own. With greater freedom comes greater risk, however, says Pietrafese.

“The big risk is when you don’t have a fund, there is not a pool of money there to pay for broken deal fees, as there would be with a more traditional private equity fund,” he says. “When you don’t have that pool, if a deal gets down the path and dies, you’ve incurred accounting, legal, diligence and other fees that you have to pay yourself. Those dollars come out of your pocket, unless you’ve negotiated some other deal to cover those costs.”

Pietrafese is a partner in the corporate and capital markets, private equity and wealth and investment management practice groups at Calfee. He is also co-chair of the firm’s mergers & acquisitions and wealth and investment management practice groups. His focus is consummating deals for traditional PE firms, family offices and fundless sponsor groups in a wide range of industries.

Smart Business Dealmakers spoke with Pietrafese about recent trends in dealmaking and how to avoid legal headaches when involved in M&A activity.

What are the benefits to investors and sponsors of pursuing a fundless sponsor deal?

From the investor's point of view, you know the actual business in which you are investing up front and you can also negotiate the terms of that investment on a deal-to-deal basis. This differs from an investment in a traditional private equity fund where, in most cases, you are making your investment decision based only on the PE firm’s historical track record and investment thesis. From the sponsor’s perspective, you can reach out to a different group of investors for each deal and structure the investor group and capitalization for the buyer for every deal you do in a way that makes sense. Also, for the sponsor the economics tend to be better because you are still getting paid the same way a traditional PE group would get paid, but there is less overhead and less people sharing in those economics.

How would you advise a sponsor interested in negotiating this type of transaction?

When you’re looking at potential acquisition targets, spend the time to understand whether or not the seller is ready to sell. That’s the biggest risk. Most of these deals aren’t marketed deals. The seller hasn’t gone out and hired an investment bank and said, ‘I’m ready to sell. Go find me a buyer.’ A lot of times these deals have been sourced through individual networks. They’ve approached the seller and said, ‘I think you have a really great business…are you interested in selling?’ Through those conversations, people are often intrigued. They see dollar signs and get excited to pursue the transaction — until it comes time to sell. Then they decide they are not ready to exit their business and move on to the next phase in life.

What is another trend you’re seeing in the M&A sector?

Another nuance that has become more of a staple in dealmaking are rep and warranty insurance policies. Representations and warranties are the assertions that typically a seller makes about their ability to enter into the transaction and the historical operation of their business in a purchase and sale agreement. This type of policy has gone a long way to mitigate some of the risk that comes with making deals, and in doing that, makes the negotiation process a little bit easier. Because you have a third-party insurer that is potentially indemnifying a buyer for breaches of a seller’s reps and warranties and the resulting losses to buyer, it is easier for buyers and sellers to negotiate the substance of those reps and warranties (i.e. a buyer will get broader reps about the business because the seller’s potential liability is typically capped at some portion of the deductible for the rep and warranty policy, which is a much smaller amount than would otherwise be the case without the policy). In the last 18 to 24 months, it’s become more prevalent in any deal that we do larger than $15 million to $20 million.

What is driving the growth of rep and warranty insurance

Historically, insurance companies didn’t necessarily understand the risk of covering a rep and warranty situation. It’s not a new product. But as insurers have gotten more comfortable with the risk, gotten smarter and gotten better underwriters, it’s become cheaper and easier to use. So more people are using it.

What’s the key to avoiding deal fatigue?

People that don’t do this type of work on a regular basis don’t understand all of the time and effort it takes to get a deal done. It’s a process. Evaluate the target business as best you can on the front end and don’t try to take shortcuts. While it may seem self-serving, the best thing buyers and sellers can do is to hire good professional advisers (e.g. accountants, lawyers, real estate advisors, etc.) who have done this type of work in the past, know what the market is for deals of the type you are looking at, and understand the process. Allow those people to do their jobs. Make sure they are doing an adequate level of diligence and checking the boxes. If you check all those boxes, you’ve gone a long way to alleviate potential risks down the road of acquiring a business.

To learn more about recent trends in dealmaking and M&A activity from a legal perspective, email Brent at [email protected]

How to reach: Calfee, Halter & Griswold LLP,