The independent sponsor model is not new, but its popularity has really risen in the last five years. Still, for many the basics of the model remain a mystery. This article seeks to demystify the core components. We spoke to a number of independent sponsors and their advisors to lay out some of the core structures and challenges.
What is An Independent Sponsor?
For context, an independent sponsor [editor’s note: the older and more pejorative term was “fundless sponsor”] is a person or firm that acquires companies and raises funds for the deals on a deal-by-deal basis instead of a pool of committed capital. Unlike a search fund, where an individual seeks a single company to buy and then lead, an independent sponsor does multiple deals.
Behind the Trend
When people talk about the reasons behind the rise of independent sponsors, there are several reasons people usually reference for the rise in the independent sponsor model: 1) the desire by investors to avoid management fees on uncommitted capital; 2) the desire by investors to have investment discretion on each deal and custom fees/economics on each deal; 3) the desire by dealmakers to avoid the setup and management headaches of committed capital funds; 4) the desire to break out of restrictive time horizons set by 10-year fund vehicles. The rise of the model is also tied to an increasing number of business operators moving into the buyout game, enabled by new efficiencies around finding and deploying capital.
Independent sponsors make money in three main ways, but there is a huge amount of variation when it comes to the details.
- Transaction Fees: When a deal closes, the independent sponsor often collects a fee from the capital providers coming into the deal. This is frequently 1% to 3% of the enterprise value (EV) of the acquired company, but sometimes this is done as a flat fee or a percentage of invested capital rather than EV. Furthermore, sometimes this fee is required, by the capital partners, to be rolled in as equity into the investment vehicle (the acquiring entity).
- Management Fees: It is common for independent sponsors to receive ongoing management fees for overseeing the acquired company. This typically ranges from 3% to 6% of EBITDA, but variations include flat fees or even salary/bonus structures. These fees are negotiated with the capital providers and depend on how actively involved in the business the independent sponsor will be. There can also be annual floors and caps to these fees.
- Equity Promote (Carry): This last component can range from single-digit percentages up to 50%. “Tiered structures are also common,” said Drew Brantley of Georgia-based Frisch Capital Partners. Frisch is a 22-year old firm which helps independent sponsors raise money from debt and equity partners. As Brantley explained, with a tiered structure, the upside to the independent sponsor increases as hurdles are met, for example the initial return of capital or reaching 8%-10% IRR. Jon Finger, partner at law firm McGuire Woods, which has an entire practice dedicated to independent sponsors and advised on over 50 independent sponsor deals in the last two years, sees similar structures. “A lot of independent sponsors favor the simplicity of non-hurdle-based carry, after return of capital, but many of our deals utilize a tiered structure,” Finger said. However, in a recent McGuire Woods survey of 225 independent sponsor transactions, 34% of those deals had a 20% to 30% carry structure without any performance hurdles.
All three fee components are widely negotiated and often depend on the experience level of the independent sponsor, the capital partner involved, and the attractiveness of the deal.
Brantley noted, “There is no such thing as ‘market’ for fee structures. When capital providers are thinking about these three levers, they are asking themselves, ‘Are we going to be able to get the returns we need, and how can we cut the sponsor in on the economics?’ How good is the deal, what is the track record of this sponsor, and what value is the sponsor bringing to the table on this specific deal?”
Where Does the Capital Come From?
Independent sponsors turn to a wide range of capital sources, including committed capital PE funds, wealthy individuals, family offices, fund of fund investors, insurance companies, endowments, lenders, and hybrid equity/debt investors.
There are no hard and fast rules as to how much of their own capital an independent sponsor is expected to put up. It depends on the resources of the sponsor. Massachusetts-based Carwik Capital is a recently formed independent sponsor started by two former operators of chemical and metal manufacturing companies, Mike Slowik and Michael Carpenter. They are planning to put their own capital to work, complemented mostly by debt rather than equity partners.
Private equity firms have long been interested in investing with independent sponsors because of the prospect of getting into an under-the-radar, and thus less competitive, deal. A more recent trend has been the rise of interest from family offices to work with independent sponsors, and vice versa. With deep pockets and flexible time horizons, family offices can be a great fit. However, family offices are not without complications. They can be slow to make decisions. Furthermore, when the family office is run by a professional manager, rather than the original wealth generator, the independent sponsor can find themselves needing to cut or even split their fees, because the manager needs to layer their own compensation economics on top.
Raising capital is tricky. Brantley said, “Many independent sponsors underestimate the capital raise side of this business, and often confuse interest in seeing your deal with certainty of close.” It takes a lot of effort to involve many potential partners, but as Brantley notes, “If you only show it to 1 or 2 people who are ‘interested’ and they walk away, your deal can fall apart. Most people have a war story where a deal fell apart because the capital fell through.”
Jon Finger added, “Just because you have a deal under LOI at what you think is a good price, that does not mean it is fundable. Of deals that reach an exclusive LOI, in our experience recently, two-thirds to three-quarters are actually getting closed, which is indicative of the market we’re in and how aggressive capital is being deployed.”
“Of deals that reach an exclusive LOI, in our experience recently, two-thirds to three-quarters are actually getting closed”
Firms like Frisch have emerged to help sponsors position and market their deal to capital partners, gather competitive proposals from equity and debt investors, and assist with structural terms. There are also specialty events, such as the annual Independent Sponsor conference run by McGuire Woods, and both Axial and McGuire Woods run smaller more regional events.
Who Is Becoming an Independent Sponsor?
While former PE investors and investment bankers can successfully become independent sponsors, ex-operators have a distinct advantage. “When you are an operating executive who knows a space, that’s extremely valuable,” said Finger. “Domain expertise makes your leverage in negotiations with both the seller and capital providers much stronger.”
Michael Carpenter of Carwik also noted, “Operational experience really helps with due diligence, as well as convincing a bank to work with you. And it is a requirement for SBA loans.” However, Finger noted that experience with M&A and financing transactions is also really important, especially when it comes to gaining the confidence of capital partners.
The other consideration is whether you start an independent sponsor firm as a solo founder or with a team. When Slowik decided to form Carwik, he looked to bring on a trusted, complementary partner. “I thought about doing this individually,” he said, “but felt that doing it with a peer would be invaluable. Together, we could give each other emotional support and work together building our portfolio companies. It would be more fun and we would have more success.”
Every time we talk to a new private equity team, whether they have a committed fund or are funding on a deal-by-deal basis, we hear a common refrain: the hardest part of this game is deal flow. Many overestimate the strength and reach of their personal networks, and underestimate the amount of work it takes to expand their reach and coverage (hint: Axial can help). For buyers who intend to stay disciplined, this is particularly relevant in today’s competitive environment. You have to look at more deals simply because you’ll get outbid on many interesting ones.
Another tricky part of being an independent sponsor is managing the time frames around closing a deal. Brantley noted, “Time frames and deal terms become hurdles, and you need to plan ahead. Strategics and committed funds can move very fast, but unless you have 100% of your capital lined up prior to LOI, you will need additional time to get to close. We always recommend at least a 90-day exclusivity period, with an automatic extension. We also caution independent sponsors against getting too specific, especially around deadlines, in the LOI, because capital partners might have their own due diligence questions.”
There is another challenge related to the other two: the negative bias bankers have against independent sponsors. Let’s be honest — this bias is not totally without cause. Bankers obsess over certainty of close. Independent sponsors often require longer time frames for diligence and negotiation and there is always risk that their capital falls through. However, the reality is that both strategics and committed funds stall during due diligence or pull out of deals all the time. With the rise of highly credible independent sponsors, both in terms of capital connections and deal proficiency, as well as exceptional operational backgrounds, this negative bias among advisors and brokers has softened. We expect that to continue improving.