Private equity assets under management are at an all-time high. But so are “zombie” funds. These are funds where investor money is essentially tied up, assessing fees, but hopes of garnering a profit from these funds have dissipated.
Enter the rise of the independent sponsor model. Investors fed up with management fees on uncommitted capital and the restrictions of pooled investments are turning toward a more flexible way of investing.
In the traditional private equity model, a fund starts by first asking a network of investors to commit to a blind pool, often with no control over individual investments and with a relatively set time horizon of seven to 10 years. With the independent sponsor model, the team sources deals and structures operations first before bringing forward potential deals to their partners to review and invest on a case-by-case basis.
Here, I’ll demystify the independent sponsor model further: why it’s attractive to investors, who independent sponsors are, economics, and if this model is actually good for the companies seeking funding.
Why Are Independent Sponsors Attractive to Investors?
Independent sponsors have several advantages over more traditional PE funds in addition to bringing their operational and industry-specific expertise to the table.
- More control over investment decisions. LPs have a greater opportunity to voice their opinions on each deal, including custom fees and economics. The deal-by-deal nature also allows greater flexibility on specific investments.
- No fees on uncommitted capital. Their fee structure is more aligned with LPs’ interests, especially compared to the annual management fee charged by the committed capital managers, who charge regardless of whether funds are invested or not.
- Lack of restrictions on time horizons. Money is no longer tied up in a strict seven to 10-year period but can ebb and flow with the tides of each individual company’s opportunities.
Who Are Independent Sponsors and Why Do They Choose the Independent Sponsor Model?
Independent sponsors generally come from three main areas.
- Private equity professionals who want to transition from the committed capital model to a deal-by-deal model, often allowing them to be more involved in the deal and benefit from greater financial incentives.
- Investment bankers who want to access equity ownership and transition to a more active role in developing the companies they help fund.
- Industry experts or seasoned entrepreneurs who have “walked the walk” before and can bring valuable expertise to the businesses acquired.
As Gretchen Perkins of Huron Capital Partners highlights in the Citrin Cooperman 2019 Independent Sponsor Report, “It’s far more valuable when [independent sponsors] bring industry or operations experience and connections or if they bring with them someone to be CEO or chair the board who has long-term knowledge and experience in that industry.” Individual sponsors commonly take an active management role at the firms they invest in. This makes them very attractive to their hands-off capital partners, who are more inclined to act as strategic advisors but not necessarily looking to be involved operationally.
The Investment Structure of an Independent Sponsor’s Deal
The most common method to structure deals in the US involves the creation of a Limited Liability Structure (LLC) in which the independent sponsor and the capital partners will invest their funds. That LLC is structured and taxed as a partnership, and the relationship between the partners as well as the post-transaction role of the independent sponsor are governed by the operating agreement of the partnership.
In cases where there is debt involved in the financing of the deal, a holding company will generally be necessary to hold the debt in this entity.
Independent Sponsor Deal Structures
From a legal standpoint, the independent sponsor model has several advantages from the General Partner’s (GP) perspective. First, the absence of funds under management allows for fewer administrative obligations and fewer costs associated with accounting, compliance, and regulation. On top of that, under more traditional blind pool private equity models, the GP cannot deviate from executing deals that fall within the investment strategy defined and agreed upon in the LP’s agreement. Under the independent sponsor model, GPs have more flexibility to be opportunistic and to structure creative deals.
Taking an example from my own experience at independent sponsor HoriZen Capital, we often see SaaS companies that are still under our $500,000 annual revenue threshold. However, when we strongly believe in the potential and quality of the product, we can structure deals where we first act as advisors providing our expertise to help the company grow, take an equity position once we deliver upside, and offer an exit to existing owners down the line.
How Do Independent Sponsors Get Paid?
The general economic structure of independent sponsors consists of:
- A closing fee - paid upon the completion of a transaction in recognition of their role in sourcing the opportunity, structuring the deal, and execution.
- A management fee - paid in exchange for the independent sponsor’s involvement in the operational management of the target company.
- Carried interest or “promote” corresponds to a share of the capital partner return on investment paid to the independent sponsor in case of a successful exit. Carried interest generally represents a significant portion of the independent sponsors’ revenue and plays an important part in aligning their interest with their LPs.
However, while the structure is rather standard, the economics can widely vary from deal to deal. For each deal being negotiated on a case-by-case basis, often with different capital partners, the details of the remuneration structure of the independent sponsor can significantly change.
Drawing from my own experience, I have laid out below what I believe is the closest to reflect market practices. Please note that these practices generally apply to deals involving target companies generating at least $10 million in annual revenue and $1 million to $2 million in EBITDA. For smaller deals, fee % and structure would likely be slightly different.
The fee paid to the independent sponsor upon completion of a transaction generally ranges between 2% and 5% of the purchase price. Capital partners often expect a significant amount of the transaction fee to be reinvested into the deal. This demonstrates the independent sponsor’s confidence in the quality of the deal and ensures interest alignment.
My research suggests that the carried interest structure has the most variability of all fee elements. Carried interest is a percentage of the capital partner’s profit redistributed to the independent sponsor past a pre-defined return on investment to the capital partner.
A simple example of a carried interest structure for independent sponsors:
- 8% hurdle rate is widely accepted.
- Majority of carried interest percentage falls within 10-25%.
- Carried interest agreements often include a “catch-up” provision.
The most common calculation is to charge a percentage of the target’s EBITDA. These fees usually lie between 3% and 7%, and the agreement often includes a floor and cap.
Comparison to M&A and PE Funds’ Remuneration Structure
To compare the fees, M&A advisors normally charge a small monthly retainer fee (in the range of $5,000-20,000 per quarter for smaller deals) and a success fee on top. The market practice for the success fee is the double Lehman Formula where the fee corresponds to 10% of the first million + 8% of the second million and so forth, and 2% of everything above $5 million.
Similarly, PE funds with committed capital charge an annual management fee normally corresponding to 2% of the capital committed and receive a carried interest generally based on fund performance. Some PE firms charge management fees to their portfolio companies for their strategic advisory role, however, there is growing resistance from LPs for these charges.
But… Are Independent Sponsors Attractive to Potential Investees?
While I’ve established the many ways an independent sponsor model can be beneficial for the investor, if it isn’t attractive to the company being invested in, the quality of the deals will obviously not be very high, and thus, returns will be low. So, does this model actually work for the companies seeking funding? When structured properly, I believe so.
The benefits of the independent sponsor model to potential companies seeking funding include:
- Decision-making independent of other pooled investments. The best time to exit will be up to individual variables and parameters of the state of just one company—irrespective of what a pool of other companies is doing.
- As mentioned previously, independent sponsors are generally experienced operators. They can provide an exit opportunity to current owners and take over the operations where most traditional PE firms will require current operators to stay active in the business. Independent sponsors can also allow current owners to exit and retain shares in the business to benefit from the upside they deliver.
- A lot of entrepreneurs out there are looking for “smart” money. They want to partner with investors who bring not only capital but skills and a network. Where a lot of institutional investors will only take a seat on the board and provide strategic guidance, independent sponsors will provide active support on day-to-day operations and operationally contribute to the growth of the company.
Despite these positives, the major drawback is clear: Will the independent sponsor actually be able to raise the necessary funds to close the deal? For this reason, it’s important for investees to do their homework on their sponsors—looking at a deal-maker’s history is usually a good starting point.
Understanding the basics
In the traditional private equity model, a fund starts by first asking a network of investors to commit to a blind pool. With the independent sponsor model, the team first sources deals and structures operations before bringing forward potential deals to their partners to review and invest on a case-by-case basis.
More control over investment decisions, greater flexibility on specific investments, no fees on uncommitted capital, and lack of restrictions on time horizons. Money is no longer tied up in a strict 7-10-year period but can ebb and flow with the tides of each company’s opportunities.
a) Decision-making independent of other pooled investments; b) Independent sponsors are generally experienced operators; c) A lot of entrepreneurs are looking for “smart” money and want to partner with investors who bring not only capital but skills and a network.
For investors and investee companies alike, the major concern with the independent sponsor model is the uncertainty that comes with raising the funding and actually being able to close deals.