How Fund Managers do Deals with Independent Sponsors

Who are independent sponsors?

To quote the corporate finance institute, "An independent sponsor, also referred to as a fundless sponsor, is an individual or capital group seeking to acquire a company, who does not have the equity financing needed for the transaction in advance.

In other words, contrarily to private equity investors with committed funds under management, teams working under the independent sponsor model source deals and structure operations first before bringing forward potential deals to their limited partners (or LPs) to review and invest as part of a club deal.

Independent sponsors can work with different types of fund managers

There are different types of fund managers, and only some of them would be able to work with independent sponsors. For instance, a hedge fund manager usually trades liquid, publicly traded assets and would not be the natural partner for an independent sponsor.

Family offices, on the other hand, have much more flexibility. A family office fund manager manages the wealth of a wealthy family and generally reports directly to a family member. By having the owner of the funds directly involved in the investment process, family offices can be more opportunistic if they recognize the potential of a deal.

Contrarily to private equity funds, which have a defined investment strategy that their LPs contractually agreed to, family offices can theoretically invest wherever they see fit.
Another type of fund independent sponsors can partner with are co-investment funds. These fund managers only invest in deals where the main investor is already managing the investment process and are generally much less involved in the execution of the deal, leaving that responsibility to the lead investor.

Given how co-investment fund managers operate, it can make sense for them to be matched with seasoned independent sponsors who will lead conversations, handle lawyers and advisors and be heavily involved in the deal execution.

At the other end of the spectrum, it may be harder for independent sponsors to work with regular lead private equity investors. The two reasons for that are:

1 – Lead private equity fund managers generally want to be heavily involved in the deal. While they appreciate all help in deal sourcing regarding building rapport with the seller, structuring a transaction, and executing the due diligence and legal documents, this is where they shine. They are rarely comfortable delegating this role to someone else.
In that regard, lead PE fund managers see less value in the capacity of independent sponsors to lead a deal from start to finish

2 – PE fund managers are not usually open to sharing their carried interest or giving away equity in their portfolio companies, which are generally the bread and butter of independent sponsors

To nuance how we described lead private equity investors, it's important to note that some PE funds specialize in MLBO, or Management Leverage Buy Out. During an MLBO, the PE fund provides the financing and leverage necessary for a management team to take over ownership of the target company.

Suppose MLBO PE funds generally partner with the existing management of the target company. In that case, it is not unusual that they put together a transaction with an outside CEO or management team to take over. In that context, if an independent sponsor can demonstrate strong industry expertise or has already demonstrated their capacity to grow companies repeatedly, the fund manager may see great value in partnering with them.

How to navigate a deal when working with an independent sponsor

There are two main ways for an independent sponsor to run a process.

1) Include financial deal sponsor partners very early in the process, pre-LOI, and work hand in hand in all the deal steps. This process would be very similar to working with a co-investor, and the financial sponsor can apply their own playbook on how to execute deals and even take the lead on negotiations.

This approach works well for independent sponsors who are highly operational with years of industry experience but lack M&A and deal-making experience. It is also easier for independent sponsors to work this way when they can rely on one financial partner with enough cash in the bank to finance the deal.

2) By running most of the process themselves and including LPs in the later stage of the deal only. This approach requires the independent sponsor to have deal experience and be autonomous in executing a deal. It also requires the LPs to be comfortable delegating deal execution to the independent sponsor and be ok relying on the due diligence process done by the independent sponsors.

Since fund managers are generally familiar with situation #1, we'll focus on situation #2, where the independent sponsor handles most of the process and describe each of the steps that transaction-savvy independent sponsors can take responsibility for.

Step 1: Deal flow & deal sourcing

Before executing a transaction, the first step is to find a suitable company to buy. Deal sourcing is a key element of any investment professional, and independent sponsors can be a valuable new source of deal opportunity for fund managers.

Independent sponsors will be able to source proprietary deals – valued and scarce assets in the investment world – through different channels:

Personal connections. Entrepreneurs and leaders looking for investment or an exit like to engage with people they know who understand their market and will see the whole value of the venture they built. They are well connected in the investment and M&A industry from their past as investment bankers or PE professionals because they are recognized experts in their industry.

Active networking is also part of the independent sponsor day to day.
Active outreach. With a dedicated team focused on outreach and a specific outbound strategy to identify and approach potential deals, pro-active independent sponsors manage to engage in exclusive buyout conversations that give them a clear advantage over brokered deals.

An advantage of deals brought by independent sponsors vs. M&A professionals or brokers is that independent sponsors' deals are usually better pre-qualified. Brokers' end goal is to get a transaction done, whereas independent sponsors are involved in the deal post-transaction. Their interest is aligned with the financial sponsor's, and they're more likely to have a better filtering process and bring forward a qualitative deal.

Step 2: Negotiation & deal preparation

Serious independent sponsors with investment or M&A background whose process involves LPs at a later stage will have handled all the below steps before presenting anyone with an offer to invest in their deal.

A) Build and nurture a relationship with the seller.

Any successful, drama-free transaction involves a good relationship between the seller and the buyer. This is even more true when the transaction involves any transition period during which the seller will remain active within the business to help the buyer take over.

It also helps ensure the negotiation goes more smoothly and builds mutual trust. The independent sponsors will step in and handle that relationship and continue to be the first point of contact throughout the whole deal process.

b) Review financials

Analyzing historical financial statements and operating metrics is a key step in assessing the quality of a deal. It helps understand the journey the seller went through, explains the profitability model of the target company, and helps uncover any red flags.

Independent sponsors will usually understand what to look for in financials, what KPIs to track, and how they compare to other players in the industry. This review will help build the investment thesis and better design a solid buyout offer.

c) Assessment/construction of forecast

After having a good understanding of the financial metrics and historical financial trajectory of the business, the independent sponsor team will either take management's projections as a base or build their financial projections with multiple scenarios.

By incorporating this multi-scenario forecast into their deal structure modeling, the independent sponsor can assess the different levels of risk and expected return on investment for LPs.

They will also incorporate the different levers they identified to increase the growth and profitability of the business and use a crash case scenario to assess the potential downside of the investment decision.

d) Strategic review of the market

Assessing the state of the market is key in any investment decision to understand the general macroeconomic dynamics and assess the full potential of the target company.

By spending time researching the market and talking to experts, independent sponsors can quickly form a view of where the market is going. Factors like the market's growth rate, the target company's competitiveness, and legal factors could significantly impact the business.

e) Assessment of potential synergies with portfolio companies and of areas of improvement

An additional way independent sponsors can add value is through their existing portfolio companies that would have clear synergies with the new acquisition target, but also through their core competencies as operators.

Independent sponsors generally bring operational expertise to the table, which makes them attractive to financial sponsors. Since they will be operationally involved post-acquisition, an important part of the acquisition process is identifying the weaknesses and potential improvements that the team can fix under the new ownership.

It will also help build the storytelling around the investment thesis and add arguments for why it makes sense to execute the deal and for financial sponsors to work with the independent sponsors on that deal.

f) Perform a valuation

Independent sponsors will come up with a valuation range based on the business's historical performance, forecast, market, product assessment, and potential synergies. These valuation ranges are calculated using several methodologies (e.g., Discounted Cash Flow, asset-based valuation, liquidation value, etc.) and their industry knowledge to offer a price to the seller.

Independent sponsors take extra care to get the valuation right to make sure their offer will be in line with market practice. Since they will have to convince their LPs, getting the valuation wrong and over-valuing a company is the best way to lose the LP's interest.

g) Draft LOI, handle management calls and term sheet submission

Once the independent sponsors have done their homework, come up with an indicative valuation for the business, and discuss the possible transaction with the buyer, they will put together a Letter of Intent (LOI) with an overview of how they'd like to structure the deal.
As for a valuation, this is particularly important for independent sponsors to get that part right because, with a wrong deal structure, it is unlikely that LPs will agree to follow through and finance the deal.

At that stage, the independent sponsors can develop different mechanisms involving debt, deferred payments, and earn-out mechanisms to increase the potential ROI of equity investors and make the total potential price more attractive to the seller.

The independent sponsors will also include a list of the elements that will be reviewed during the due diligence phase after the LOI is signed. They will also include an expected timeline before the closing of the transaction (generally about three months) that will give them time to perform all the checks necessary and to raise the financing and funding for the transaction.

Once the LOI is signed, the independent sponsor and the buyer finally enter an exclusive negotiation phase where no other party can get involved without the buyer's consent. This is generally the time-independent sponsors wait for to advertise and share the deal opportunity within their network of LPs

h) Negotiating and finalizing the Sales and Purchase agreement

Generally, the LOI will only give a high-level view of the deal. Once the seller and the buyer have agreed on these high-level terms, additional points of negotiation that require more time commitment from both parties are addressed during the exclusivity phase.

A few examples of these points can include

• The level of guarantees and warranties offered by the seller to the buyer
• The details of the governance for the transition period where the buyer stays involved in the business
• The nitty-gritty of the rules of the earn-out. E.g., what happens if a new buyer buys the company before the end of the earn-out period, how are the earn-out metrics defined, how is the impact of currency change considered, etc.?
• What is the level of normalized net working capital retained for the transaction?
• What is the normative level of EBITDA retained for the transaction?

Step 3: Debt financing

To increase the potential return on investment for equity holders, it is common to use debt instruments to add leverage when purchasing a cash flow-positive company. To make the deal more attractive to LPs, independent sponsors will often have connections with lenders involved in the Transaction process.

Debt financing can be found externally, but it can also be structured directly with the buyer as part of the deal in the form of a seller note. This is particularly common with sub $5m software and internet businesses where the seller agrees to be paid part of the purchase price over several years and to earn interest (generally around 6%-8% annualized) on the outstanding amount.

Seller notes commonly have better terms than bank loans since they are part of the deal negotiation, and sellers understand that they can help make the deal happen.
Earn out, which we mentioned previously, can also be used to limit the amount of cash required at the close. Also, correlating the price paid to the actual performance of the business buyers can reduce their risk of overpaying for a low-performing company and use the cash generated by the business post-acquisition to fund the transaction.

Step 4: Due diligence

The level of knowledge of the internal team will determine the extent of due diligence that the sponsor can perform. While all independent sponsors should have enough knowledge to conduct financial analyses and draft a proper LOI in phase 1, due diligence requires a much better understanding of analytical finance, accounting, legal, and tax. Independent sponsors with operational expertise may lack the in-depth knowledge required in these areas.

In most cases, external experts are hired to handle the due diligence. Also, it is important to have a neutral third party reviewing the business and sharing objective insights about risks and potentials.

However, since the independent sponsor generally does not receive any fee until the deal closes, they will wait to make sure their LPs signed off on the deal and committed to investing the money before spending money to hire legal and financial advisors.

The cost of DD is generally recharged to the acquired company post-acquisition. However, if the deal fails, the acquiring party must bear the cost, which may be quite expensive for an independent sponsor who does not have funds under management and does not collect a 2% annual management fee.

Private equity funds, on the other hand, have a budget for deals that do not go through post-due diligence. Sometimes independent sponsors can agree with their capital partner that the financial sponsor will finance the cost of due diligence and bear the risk that comes with it.

Step 5: Post-transaction operations

One of the big advantages of working with independent sponsors for fund managers is the operational and industry knowledge they bring. They're typically highly involved post transaction compared to more traditional fund managers who only take a board seat and get involved from a surface-level standpoint a couple of times a year.

Similar to search funds, independent sponsors have walked the walk, used their years of experience to design a playbook they can use to replicate their past success, and failed enough to avoid repeating common mistakes. They also have industry connections, suppliers they've worked with in the past, and more.

Once the transaction has been consummated, the independent sponsor team will work with the seller to take over their operations and relationships with partners and suppliers. Then they will work to implement the strategy they designed during the buyout process, starting with the quick wins they can execute to make the operations more efficient and more profitable.

Common fee structure of independent sponsors

Understanding the fee structure of independent sponsors is important for any fund manager looking at partnering with them because it can often create friction. Since fund managers and PE professionals are already charging their own LP management fees, partnering with a sponsor can be tricky due to the extra cost and a share of their profit.
Financial sponsors need to be confident that the extra value the independent sponsor team brings outweighs the cost of partnering with them.

In a nutshell. The commonly accepted independent sponsor fee structure is composed of 3 elements:
- A closing fee is paid once a transaction is consummated
- A management fee is paid based on their operational involvement post-deal
- An upside bonus or carried interest based on the return on investment paid back to the LPs

Closing fee

They represent 2% to 5% of the transaction amount. It may be able to go up to 7% for smaller transactions.
LPs commonly expect the independent sponsors to further align interest by reinvesting a large part of the transaction fees into the deal. It is equivalent to saying that the independent sponsors get a share of the equity of the acquired business as part of their closing fee.

Management fee

The fee paid to the independent sponsor for their role in operating the business post-transaction generally represents between 3% to 7% of EBITDA, sometimes with a minimum and a cap.

Carried interest

Carried interest % are highly variables depending on deals, independent sponsor track record, and relationship with their LPs, but the most common range on the market ranges from 10% to 25%

Carried interest generally has an 8% hurdle rate attached, which means that independent sponsors only get their bonus payment once LPs get at least 8% annualized return on investment (IRR)

Including a catch-up provision as part of the carried interest agreement is also quite common. This means, for example, for a 10% carried interest with an 8% hurdle rate, as long as LPs have not received 8% IRR, the independent sponsors get nothing.

Above 8%, the independent sponsors will receive 100% of the proceeds until their total share of the proceeds equals 10%. After that, any additional profit will be split 90% for LPs-10% for the independent sponsor.

Why might it be worth it to work with an independent sponsor?

Overall, a fund manager working with an independent sponsor who can execute a transaction autonomously is a bit like having an outsourced team that can bring more business in and does the work.

While, as in every relationship and hiring process, the hardest part is to get to know how a team works and whether they'll be a good fit for your organization, the huge advantage for a financial sponsor is to work with independent sponsors on a recurring basis is that it considerably reduces the inherent risk of investing in a new management team when taking over a business.

The team is generally the single most important part of a business, and being able to rely on the same team with a proven operational track record for several deals can prove invaluable for fund managers.