Stuck in the Middle with You: The Rise of the Independent Sponsor in the Middle and Lower Middle Market
Source:
NYS Society of CPAs
The independent sponsor (formerly known as “fundless sponsors”) is an equity sponsor that seeks to purchase (generally) privately held business with the backing of investors. However, as opposed to private equity funds, independent sponsors do not have access to pooled cash reserves and therefore must seek investors on a deal-by-deal basis. What makes this structure popular in today’s market is the difficulty for sponsors to raise capital, the access to a greater number of lower middle market and middle market deals, the perceived transparency into a transaction by an investor (i.e., the investor controls its investment decision directly) and the immediate netting of fees by the sponsor. As detailed below, independent sponsors are making great headway into the lower and middle market buyout space.
What is an independent sponsor?
An individual or more likely a team of people who invest in and raise money for a specific transaction (as opposed to a pooled investment vehicle that has raised capital through investor commitments for a number of investment transactions (thereby benefiting from a portfolio effect). Back in the politically incorrect days, independent sponsors were referred to as “fundless sponsors.”
What Are the Reasons for the Growth of Independent Sponsors?
Difficulty in raising capital for pooled vehicles in today’s highly institutionalized and segmented marketplace has resulted in the growth of deal-specific fundraising.
Most institutional investors are restrained by concentration limits (usually 10%) and minimum check sizes (generally $50MM). Using the foregoing as an example—for an institution that has both concentration limits and minimum check sizes to invest, the fund would have to have an asset under management of at least $500MM.
Family offices were once the staple of LP investors in middle market PE funds; today, however, many of these families do not want to be in a pooled investment vehicle and instead want to invest directly into deals.
In summary, reduced institutional investment support, a pull away from pooled investment vehicles, and family offices directly investing into deals have led to an increase in independent sponsor transactions.
Independent sponsors are often private equity experts or investment bankers who desire to acquire equity in the target company and gain control over the operations of the targeted company. Depending on the nature of the deal, they may seek as investors and thereby acquire capital from hedge funds, private equity firms, family and friends, or family offices. In recent years, independent sponsors have gained traction in the M&A market and have become more prominent in generating and closing on middle market deals. Even amidst the challenges of COVID-19, many independent sponsors have proven themselves to be resilient investors and have shifted their models to adapt to these challenging times [a shift that many pooled investment vehicles (i.e., traditional PE funds) cannot make].
Benefits of the Independent Sponsor Structure
The independent sponsor structure provides benefits for both the independent sponsor and the investors, making it a possibly lucrative option for both sides. For investors, the benefits of investing in an independent sponsor include more control in the project and potentially greater returns early in the investment period because upfront expenses are lower due to the lack of fund startup costs. Investors enjoy enhanced control over the investment terms and decisions as well as access to more deals.
For independent sponsors, the benefits include a streamlined structure and the ease of dealing with a single or handful of investors versus rounding up investors or raising funds from third parties such as through crowdfunding or a traditional pooled vehicle private placement. Negotiating a term sheet with one or a handful of investors is far more attractive than having to pitch and negotiate with several prospective investors; it gives the independent sponsor more negotiating leverage. Lastly, in most independent sponsor deals, fees—excepting carried interest—are generally paid at closing, so there is an immediate netting.
Deal Size
Most independent sponsors look for deal sizes in the area of $10MM-$60MM in enterprise value. The enterprise deal size, however, has increased during the last few years due to the following factors:
Over the last few years, the cost of debt (commercial banking or private debt) has decreased dramatically.
Transaction costs have held steady; with cost of debt decreasing, the overall transactions have become cheaper (although valuations have, until the COVID-19 pandemic, increased).
The model of the independent sponsor is widely accepted.
Investment bankers know that the money is there if the independent sponsor has a unique investment perspective or strategic advantage; therefore, sponsors are seeing a greater volume of deal flow.
PE firms have followed hedge funds because as the big keep getting bigger, they have grown out of investing in middle market/lower middle market deals (although pre-COVID-19, many large firms were looking to invest in the space).
Lastly, many independent sponsors are being backed by large multistrategy PE funds that are eager to deploy capital in high-quality deals, especially where those deals are led by former large PE professionals. (Many independent sponsors are former large PE partners who no longer want to deal with the rigors of running a large firm but still enjoy doing deals.) As a result, many independent sponsors are looking at deals in the upper end of the middle market (e.g., $200–$500 million per deal)—which is great news for sellers of middle market companies.
COVID-19
While virtually all businesses are reeling from the impacts of the COVID-19 pandemic, a study on independent sponsors conducted by Citrin Cooperman in August 2020 (https://www.cirtincooperman.com/infocus/covid-19-independent-sponsor-survewy-results-key-findings) shows that independent sponsors are proving to be adaptable and adept at managing uncertainty and risk. A majority (52%) of respondents with portfolio companies say the pandemic has had a negative impact on most of their businesses, and 34% say that their portfolio companies’ performance has been closely split during the COVID-19 pandemic.
Conclusion
As independent sponsors grapple with uncertainty about the pandemic, economic recovery, and changes to consumer behavior and supply chains, independent sponsors are shifting their models to include virtual due diligence with longer time frames, changes to deal terms, valuation and deal flow. Independent sponsors are increasingly focused on the adaptability and resilience of portfolio companies’ business models and management teams and are less likely to consider deals involving businesses that are heavily impacted by the pandemic. That is not to say that independent sponsors are shying away from deal-flow; rather, they are shifting their sights to new opportunities.
