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What Are Independent Sponsors, and Why Are They Relevant?

Joe Burkhart Saratoga Investment Corp. | September 6, 2017

The independent sponsor business model combines the rigor of traditional private equity with deal-by-deal investments and economics. Many independent sponsors pitch that their model has stronger limited partner investor alignment on issues such as fees, carry, and discretion to review each investment opportunity when highlighting the attributes of their model.

Independent sponsors’ limited partner capital generally comes from four sources: private equity firms, friends and family, hedge funds, and family offices. Depending on the deal, some sources of capital may be more suitable than others. For instance, established private equity firms with capital ready for deployment will be more likely suited for larger deals in which they can play an integral role in the deal closing and insert a representative of the firm in the acquired company in an operational function. On the other hand, family offices are more likely to participate in smaller deals; they will likely permit the independent sponsor to run the deal and expect the independent sponsor to handle the operational role post-closing.

What makes independent sponsors attractive to financial partners?

First, they provide exposure to deals that the financial partner may not have otherwise come across. The independent sponsor may have relationships stemming from an industry or geographical expertise that exposes a financial partner to previously unrecognized investment opportunities and possibly to companies that are not even officially for sale. Second, independent sponsors can offer operational and industry expertise that many investors, whether established private equity firms or otherwise, find attractive and which may ultimately contribute to the success of the investment post-close.

Why does the independent sponsor business model continue to gain momentum?

Over the past several years, aspiring private equity fund managers looking to launch funds have faced unprecedented barriers to entry. Dodd-Frank’s fund registration requirements have made it more difficult than ever for start-up funds. Also, it remains extremely challenging for first- time funds to raise capital. Limited partners generally have begun to put greater sums of capital in fewer funds and have gravitated toward well-known funds with proven management track records.

Meanwhile, there are few barriers to entry for the independent sponsor business model. Today’s experts believe there are about 1,000 firms acting as independent sponsors. Any deal professional willing to take the risk to start their own independent sponsor platform can do so. Technology and outsourced service providers will continue to make it easier and cheaper to start a platform. At the same time, the independent sponsor model continues to garner increased acceptance among lower-middle market sellers and investors.

What do successful independent sponsors credit for their success?

Axial polled their independent sponsor members to find out how they approach the market and why they chose the independent sponsor model. Below are some highlights from their survey:

  • Since independent sponsors traditionally do not invest out of funds and the market is extremely competitive, strong relationships with capital partners are especially important. Fifty percent of the independent sponsors polled said that the most important factor in their success in closing a deal was ready access to equity capital.
  • Alternatively, not a single independent sponsor cited their success stemming from strong debt relationships, likely because the debt landscape is easier to navigate. Similarly, very few independent sponsors cited success due to strong intermediary relationships, which means that independent sponsors are electing to avoid auction processes and competitive deals.
  • It seems that independent sponsors, like their funded sponsor brethren, are focused on deal sourcing. In discussing their deal pipeline, 50% of independent sponsors believe they’ll source the same amount of deals as a traditional private equity firm in 2016. Another 20% believe they’ll source even more deals than firms with committed funds. For independent sponsors with limited resources, this means they’ll need to be more creative in their sourcing strategies to gain the coverage they need.
  • Of the independent sponsors surveyed, 100% said they had some level of industry expertise that guides their investment theses. Most cited this expertise helped them move quickly to target industry verticals where their expertise permits them to source proprietary deals. Of the independent sponsors that have closed a deal within the last two years, 33% credited strong deal referrals as main reason for their success.

What are the typical economics for independent sponsored deals?

What is clear after analyzing the data surrounding the independent sponsor market is that there are “standard” economics. Markets do tend to standardize economics as they formalize, but this process seems to still be nascent in the independent sponsor space. At a recent independent sponsor conference the following structural themes were highlighted by limited partners that have invested in the space.

Closing Fees to Independent Sponsor: 0% to 3% (most require at least 50% to be rolled into deal)

Management Fees to Independent Sponsor$100K – 6% of EBITDA (largely dependent on activity level of IS post-closing and the size of the company)

Promote to Independent Sponsor: 7% to 50% after an 8% – 10% hurdle. This is a very wide dispersion. Factors that influence include hard dollars invested by the IS, time devoted by the IS to deal, and IS track record.

The chart below from Rotunda Capital shows the major differences between the three private equity models:

  1. Independent Sponsors Give Traditional PE Firms a Run for the Money, Mergers & Acquisitions Magazine, November 3, 2016
  2. The Growing Prominence of Independent Sponsors, Mergers & Acquisitions Magazine, February 5, 2015
  3. The Independent Sponsor – Capital Partner Relationship: Questions and Imperfect Answers, by Dan Negra, MTN Capital
  4. Independent Sponsor Key Economic Terms from Capital Roundtable Event (1/24/2013)
  5. Independent Sponsor Roster from Capital Roundtable Event (1/24/2013)
  6. iGlobal Forum 10/26/2016 listing of independent sponsors
  7. iGlobal Forum 10/26/2016 listing of independent sponsor funding sources

Axial is the deal network for the middle market.

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