Co-written by Greg Porto who is a partner with Access Capital Partners, an investment bank focused exclusively in raising capital for independent sponsor acquisitions.
Independent sponsors (also known as fundless sponsors) have evolved into a significant group of acquirers, competing with traditionally funded private equity firms and strategic buyers for transactions.
The discussion below describes who independent sponsors are, how they compare to traditional private equity firms and why sellers would consider selling their business to an independent sponsor vs. a traditional private equity firm.
Independent sponsors are individuals or groups that buy, grow and exit companies, much like conventionally funded private equity firms. Unlike their traditional private equity counterparts, however, independent sponsors raise debt and equity capital on a deal-by-deal basis, as they do not have a committed investment fund.
Many talented operating executives and private equity professionals become independent sponsors because doing so allows them more flexibility and autonomy as deal professionals than if they were employees—or even partners—of a traditional private equity firm. Independent sponsors reason that the time, energy and expense of raising a fund and managing limited partners could be better spent sourcing and closing transactions.
Think of independent sponsors as the next level of entrepreneurship in private equity. Most independent sponsors run lean firms that are nimble and can respond quickly. They typically have fast decision making processes and sellers interact with senior deal professionals vs. more layers of contacts and a slower process at some of the larger private equity firms.
The independent sponsor has become a viable acquirer in today’s marketplace because debt and equity funding sources (mainly institutional, but also family office and high net worth) have embraced the independent sponsor model. The most successful independent sponsors have a network of capital sources, or are working with an investment banking advisor, ready to fund their acquisitions.
In many ways, independent sponsors function similarly to funded private equity firms, which is not surprising given that most independent sponsors have backgrounds in traditional private equity and the independent sponsor model is a variation of the traditional private equity model.
Similarities
The most successful fundless or independent sponsors are like traditional private equity in that they combine the rigor, sophistication and approach of traditional private equity investors, focusing on:
- Proprietary deal sourcing. The best independent sponsors work hard to source attractive businesses to acquire at reasonable valuation multiples.
- Thoughtful transaction structuring. Deal terms such as cash at close, seller notes or equity roll, capital structure (debt/equity), due diligence and LOI exclusivity are generally well thought out and reflect the opportunities and risks of the transaction.
- Systematic transaction execution. A good independent sponsor knows what diligence to conduct before and after LOI execution; has a good law firm retained to document and close; and anticipates and pre-emptively addresses any issues that may arise during the diligence process.
- Portfolio company growth and monitoring. The best private equity firms know how to provide strategic guidance and direct resources to help a portfolio company grow post close—and the best independent sponsors do the same. In fact, many have meaningful industry or situational experience that is relevant to the company they are acquiring.
- Fees. Like traditional private equity firms, independent sponsors are typically compensated with a deal fee paid at closing and management fees for board roles or regular guidance they provide.
Differences
Independent sponsors differ from funded private equity firms in some important ways as well:
- Capital is raised on a deal-by-deal basis. This is the biggest, most significant difference. Once an independent sponsor has executed an LOI with the seller, they must source the capital to close the transaction. Sometimes they have the capital lined up, sometimes they need to reach out to funding sources. The best sponsors can fund the deal from existing relationships, know how to network to find the necessary capital to close on schedule or simply work with an investment bank experienced in raising capital for independent sponsor transactions. While this may sound cumbersome, it allows the sponsor to raise capital from groups that are the best fit for the situation.
- Transaction fee. Discussed above, independent sponsors are often expected to reinvest most of the transaction fee they receive back into equity of the transaction as additional skin in the game. Typical private equity firms do not reinvest transaction fees as they are already investing capital to fund the deal.
- Management fees. Discussed above, if the independent sponsor is stepping into a day-to-day operating role, he/she will receive a salary and benefits, while an independent sponsor acting as board-level advisor will usually receive a management fee. Traditional private equity firms do not take direct operating roles, though they will hire executive management to run their portfolio companies.
- Participation in the growth of equity value post close. While traditional private equity firms will invest cash to own equity in the company post close, independent sponsors may invest little to none of their own funds. They often participate in the equity value through either a carried interest or promoted interest or common equity either vested at inception or based on timing or performance hurdles. In a successful independent sponsor transaction, the upside participation should represent the largest component of the independent sponsor's compensation package.
The major difference, and disadvantage, for a seller entering an LOI with an independent sponsor vs. a private equity firm is committed capital. Can the independent sponsor fund the deal?
The seller should look at the sponsor’s track record (have they completed independent sponsor deals before?), their background (have they completed deals before at other firms?) or if they are working with an investment bank that specializes in raising independent sponsor capital.
Beyond that dynamic, there are some possible benefits to selling your company to an independent sponsor:
- Independent sponsors are usually entrepreneurs at heart. Many sellers focused on their legacies want to leave their business to a buyer that has a similar entrepreneurial spirit. If a seller is staying on to keep running the business, then they have a partner who is a kindred spirit.
- Hands on expertise. The best independent sponsors are active participants in the growth and success of their portfolio companies. Because they typically don’t have the demands of managing or raising the next fund and they typically don’t own many companies, they tend to be more engaged, bringing their expertise and industry relationships to the companies they buy.
- Flexibility in timing the exit. Committed private equity funds have a definite life and investments generally need to be exited in a three- to five-year period to return capital to investors. The exit in an independent sponsor deal depends on how it is capitalized and who capitalizes it. There is much greater flexibility for an independent sponsor and a seller staying on and rolling over equity to work together to recapitalize the company and continue to own it long term.
For sellers and their advisors, independent sponsors can be a viable alternative to traditional private equity funds.