WHY LEAVE PRIVATE EQUITY FOR THE INDEPENDENT SPONSOR MODEL?

Author: Stephanie McAlaine, Executive Director, Independent Sponsor Forum

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Transitioning from a Committed Fund to Deal-by-Deal is on the Rise!

The independent sponsor/deal-by-deal investment model continues to grow in deal size, volume and impact throughout the lower middle market. Many of those exploring this new landscape are doing so after having worked much of their career in a committed fund.

• So, why have they left the committed fund strategy for what might appear to be a riskier deal-by-deal approach?
• What are the mechanics of these deal-by-deal strategies and how do they differ from committed funds?

We spoke to Justin Benshoof of Cervano Capital, Sam Henderson at Hullson Partners and Darren Snyder at Fremont Growth Partners – three successful independent sponsors who traveled that path - to discover how they started their journey and why, what strategies worked and the pitfalls they encountered. And to ask them - what does success really look like?

Timing is {Almost} Everything

To begin, we explored why they started down this deal-by-deal path. They all agreed that the decision was personal – that it had a lot to do with timing – where their firm was in their investment cycle and what their own personal situations were like.

Moving to an independent strategy offered each the opportunity to wear different hats simultaneously and to be challenged by the unique and nuanced nature of these deals. They also appreciated the flexibility – both personally and professionally - that comes with the deal-by-deal strategy versus a more rigid PE model. That entrepreneurial nature was also appealing.

Most also partnered with others who had complimentary background to help round out their platform and to have a valued partner to bounce ideas off of.

A Special Kind of Magic

Getting a deal under LOI with no capital takes a special skillset.

First of all, finding good deals is hard. There are many deals out there – but the good ones that truly fit your expertise and deal thesis are harder to come by.

Once you find the deal - then you need to win it. The key is differentiating yourself. Why you? What value can you add to this company and deal? Then, you have to find the capital once you are under LOI and that is also difficult.

Often winning the deal means being the highest bidder.  And that is fine so long as you can demonstrate to capital providers that you possess a unique skillset, a strong vision and plan to be able to grow this business.

Casting Your Net, But Not Too Wide

One common, costly mistake the group shared was casting too wide of a net early on to land a deal. That was an early mistake that can cause you to lose focus and time.

Networking and relationship-building is a huge part of what it takes to be successful, they said. Going to trade shows and speaking with people there – meeting founders, intermediaries and brokers – that’s a big part of finding deals. Be sure you enjoy this aspect of the job – you’ll be doing it a lot!! - it’s important to finding deals and being a successful independent sponsor.

These deals will be smaller and likely have a lot of “hair” on them as well – the bigger deals are harder to land for an independent sponsor. But the fact that these businesses need that help often means there is room for true value creation opportunities as well as multiple arbitrage which is what makes this end of the market so appealing.

Sales Pitch

Contrasting yourself with traditional private equity is important. One differentiator the group shared was that the independent sponsor model is usually more collaborative with the seller. In private equity they bring people in to drive value creation without seller input, whereas in the independent sponsor model is often a more collaborative process where consultants and others are selected together.

The drawback for an independent sponsor is not having that in-house operating, industry and functional expertise - you need to have a strong network of “river guides” who can fill in these gaps, whether they are focused on revenue growth, industry issues or legal and diligence matters, etc.

A Flood of Capital in the Market

The panelists shared their experiences with various investor types. Debt generally means less risk – those investors can be easier to source.

Private credit is newer to independent sponsor market – they are very sensitive to the experience level of the independent sponsor and won’t invest often in inexperienced independent sponsors.

SBICs can do unitranche and slide into mezz and equity investing, so they lead with debt but bring a valuable equity mindset to the investment. The SBICs will often do a portion of the equity – then PE, LPs, family offices etc. will fill in the rest.

PE will ask for control though, while LPs have no interest in control and want an independent sponsor with a PE type track record with deep transactional expertise.

Family offices come in many different stripes and are hard to put in one bucket – they often get excited about direct deals and the ability to select an investment versus investing in a blind pool fund.  On the flip side, family offices are not pressured to deploy capital so often can be slower to commit to a deal.

Everyone agreed that there is more capital coming into the market. There are a number of equity providers entering the market and the Independent Sponsor Forum Deal Series events allow you to meet vetted capital providers who are experienced, not tourists, in the deal-by-deal strategy.

Deal Sizes

$2-10 million is the usual sweet spot range for independent sponsors according to the panel. They felt that finding capital for $2 million and under deals is surprisingly more difficult than landing capital for a larger deal. It took the panel around under 10 months to get their first deals done – the industry average is usually closer to 18-24 months.

Economics and the Beauty of the Independent Sponsor Model

Economics are becoming much more standardized. Citrin Cooperman and McGuire Woods reports are good sources of information on market trends.

Economics depend – with a fully diligenced deal you can negotiate more attractive economics because the work-return ratio is better for the capital provider.  Larger capital providers generally care less about seeing deals pre-LOI, as they simply don’t have the time.  The bottom line: When you approach a capital provider in the deal process is key and dependent upon your experience and ability.

Working with a minority equity fund or SBIC may give you a lift of expertise and support, but they usually want better economics as a result - versus a family office who offers less support/expertise but potentially better economics as a result. SBICs are usually more flexible on the capital stack as well.

The three major deal economic segments in the independent sponsor asset class are quite similar to private equity these days:

1. Closing fees – these are based on the enterprise value of a deal and usually run around 2-3%. Capital providers usually expect much of it to be rolled into the transaction.
2. Management fees – these are a percentage of EBITDA, typically 5%
3. Most lucrative for independent sponsors is carried interest or the promote at 20% – these are often tiered up for outsized performance.

It all interweaves though – there are puts and takes across the three segments. The beauty of the independent sponsor model is that when you sell the company there are no delays in getting your economics, as you find in a committed fund mode such as private equity. Carry doesn’t wait until the full fund has run its course. You get paid right away.

Learning to Shave on Someone Else’s Beard

Investing on a deal-by-deal basis is vastly different from and more challenging than investing out of a committed fund.  It can also be more rewarding on multiple fronts.

Given the many potential pitfalls of this strategy, you’ll be wise “to learn to shave on someone else’s beard!”

For this reason, the Independent Sponsor Forum launched an Emerging Independent Sponsor Boot Camp – a master class to scale up those who have backable professional experience yet are new to the deal-by-deal strategy.

The entire one-day class was created and is led by successful independent sponsors whose insights, guidance and best practices will help you avoid costly missteps and broken deals, ultimately leading to higher returns.

To apply for March 2nd Emerging Independent Sponsor Boot Camp and March 3rd Deal Series in Dallas, visit this link.

To attend the ISF Deal Series in Dallas on March 3rd for Independent Sponsors and Capital Providers, learn more here.