Neil Schaefer and his college friend and business school roommate, Burke Ramsay, came together last year to form Auricle Capital Partners, LLC, a private investment firm based on the independent sponsor model.
After 11 months of searching, they had found and pursued their desired acquisition target via the Axial platform – Austin, Texas-based Banister Tool, Inc. They secured capital to complete the deal, which closed in June 2021. Today Schaefer and Ramsay are overseeing operations, people, finances, and customer relations at Banister — more hands on than originally anticipated.
“Finding a good opportunity is the hardest challenge for any investor,” Schaefer said. “It’s difficult to move fast because you’re spending your own money on diligence.”
And therein lies the rub. Independent sponsors love the pursuit, the thrill of a new deal, and the realization that they’ve found the right business to buy. But getting to that mid-level stage before confirming the interest of outside investors takes upfront cash, usually out of their own pockets. If the deal falls through they typically lose a large portion of those funds and must regroup. “Until the deal closes, we’re at risk on those expenses,” Schaefer said. If you’re in too deep, you’ll lose a lot of sleep, he admitted.
How much independent sponsors spend before seeking outside capital runs the gamut, depending on the target’s industry, location, and the experience, bank accounts, and preferences of those searching for deals. It’s typical to pay out $25,000 to $50,000 during the search phase and “light diligence” on deal prospects, noted Schaefer. But further along in the process independent sponsors could spend between $75,000 and $125,000 in total, he said.
Jonathan Saltzman, managing partner of Torque Capital Group, a New York-based three-partner independent sponsor and private equity firm, said independent sponsors should be prepared to burn through $500,000 to $1 million before they start generating income. “You might need to spend money on accountants and lawyers before you have commitments from equity capital,” he noted.
Expenses include travel costs to the targets’ locations or trade events, firm infrastructure, initial accounting fees such as securing a quality of earnings report, industry diligence, environmental reviews if applicable, market research and studies, advisory services, deal-sourcing fees, and of course attorneys, eventually. Environmental reviews — or phase-one studies — alone can run $5,000 to $10,000 each, Schaefer noted.
To avoid going broke without knowing if a transaction will occur, independent sponsors may want to consider staging when they are incurring those expenses, advised Greg Tobben, managing partner and co-founder of St. Louis-based Access Capital Partners, a middle-market investment bank focused on raising capital for independent sponsors . In other words, independent sponsors may want to pace themselves, particularly when it comes to incurring due diligence expenses, which can add up quickly. Ideally, Tobben said, “The best way to protect yourself is to have a capital partner before you start the third-party diligence work.” Less tenured independent sponsors without a portfolio of companies tend to be more likely to stage their expenditures and put them off as long as possible, until they find a capital partner, he noted.
That’s not always possible, though, nor always the desire of independent sponsors. Schaefer and Ramsay, for instance, funded the due diligence themselves using their own capital prior to raising external capital for the acquisition. “As we built confidence for our desire to close the transaction, we were more comfortable spending money on third-party diligence,” Schaefer said. Auricle also typically won’t spend meaningful money on third party advisors without exclusivity from the seller or enter exclusivity unless it is reasonably sure it wants to close the deal.
So how can independent sponsors mitigate risk while searching and conducting some third-party due diligence, prior to the capital-raising stage? Schaefer, Saltzman, and Tobben offer the following advice:
- Have a clear investment hypothesis. Independent sponsors must define a winning investment and do some “rigorous thinking” before diving in, said Schaefer. “The first principle is to be clear about what needs to be true for the investment to be successful,” he advised. From there, create an intelligible and detailed scope of work for your third-party advisors, “so there are no surprises on either end,” he said.
- Consider a partner. For solo independent sponsors, the financial aspect of pre-funding a deal can be daunting. They should collaborate with a partner who not only could split the expenses, but bring their expertise to the table. “The best partnerships I’ve seen tend to have one foot in professional investing and the other foot in industry or operational experience — and the marriage of both skill sets is highly invaluable to those that are backing independent sponsors,” Tobben said. A solo independent sponsor could also partner from the outset with a private equity firm, which provides capital certainty and the know-how of a larger team. “The con is less independence,” noted Schaefer. For Saltzman, a partnership is less about expense and risk sharing and more about maximizing experience and creative thinking. “I don’t mind sharing economics with someone,” he said. “I expect the pie to ultimately be bigger when we’re going at it together.”
- Stage expenses in accordance with your level of confidence in the deal. Continue to spend money as your assurance in the acquisition target strengthens, Schaefer advised. “We try to be careful on how we stage our diligence and when possible don’t ramp up those expenses until we have a fair amount of conviction,” he said.
- Choose advisors wisely. When hiring attorneys, accountants or other advisors, find those who have worked with independent sponsors and can provide value throughout the process. In some cases, Saltzman said, these third-party advisors will work with clients on fees and occasionally discount or eat a broken deal, rolling the fees into the next acquisition. Attorneys with independent sponsor experience may charge a premium but will likely offer higher quality advice than a lower-priced, less knowledgeable lawyer, Tobben noted. “I’ve seen cheap quality of earnings reports that weren’t worth the paper they were written on,” he said.
- Over communicate with sellers. Maintain frequent contact with sellers so you’re “not spending money and chasing deals that you’re not likely able to close,” Saltzman advised. Deals can progress more smoothly and quickly if independent sponsors are sympathetic to the target’s owners, which inevitably can help from a financial perspective. “Selling a business is a very stressful process for any owner,” Schaefer said, “and to have a team that is sensitive to that and has been through it enough to understand the emotional aspect of selling a business is really helpful.”