(April 12, 2018)
Today, independent sponsors are a proven asset class in the middle market. Ten or twenty years ago, however, it was a different story.
“We’ve seen a big change in terms of what 2009 looked like for an independent sponsor and what 2018 looks like for an independent sponsor,” says Dan Lipson, Partner at Rotunda Capital Partners, an independent sponsor based in Washington, DC. “Back then, investment banks were hesitant to show us deals and lenders provided lower commitment levels than they did to the rest of the market. Everyone was just concerned that the capital we raised may be fleeting.”
Steve Raymond, Managing Director at New Jersey-based investment banking firm The DAK Group, agrees that times have changed. “Not long ago, independent sponsors were still operating on the edge of the private equity community. They were relatively few and far between, often fighting an uphill battle to convince target companies and capital providers of their inherent value. Now the number of independent sponsors has grown to become a unique tranche of the private equity community.”
A confluence of factors have transformed independent sponsors into highly sought-after investors in their own right. LPs have started to look for one-off deals as they have become frustrated with the high management fees associated with the traditional two and 20 investment model. In addition, family offices and institutional investors like university endowments increasingly have sophisticated teams and the correct organizational capability to evaluate investments on a deal-by-deal basis.
Previously, many, if not most, independent sponsors were would-be PE investors looking to establish a track record before raising a fund. But now many independent sponsors come to the table with decades of industry and operational experience under their belts.
“The ever increasing regulations and oversight that funds are subject to — like the passage of Dodd-Frank and certain provisions of the new tax laws — and the amount of overhead that’s required to support that, have made the funded model less profitable,” says Bob Levine, the founder of Pennsylvania-based L2 Capital, an independent sponsor dating back to 1995. “There are people like me who have extensive fund experience who are choosing not to raise additional funds, but to stay open and continue to look for deals on an unregulated basis. Because it’s easier and from my perspective, more fun.”
Specific sector expertise is often a key differentiator when it comes to finding sponsors to back their deals. “I have friends who are raising capital on a deal by deal basis on terms that are substantially better than terms that a typical fund would receive — in large part because these folks have the operating expertise or sector expertise that gives investors confidence that they’ll perform and that they deserve a bigger slice of the pie on the back end,” says Levine.
This industry expertise also means that independent sponsors can confidently pursue deals that may not be a good fit for a traditional auction process. “From a banker’s perspective, independent sponsors are more likely to focus on interesting, unique deals suitable for direct investing than mega-buyout funds that are all going after the same large-scale, bid process-generated transactions,” says The DAK Group’s Raymond.
“A lot of times the deals we do are the ones that have some hair on them,” agrees Richard Baum, Managing Partner at Consumer Growth Partners, a private equity investment and advisory firm exclusively focused on consumer and retail. “The concept may not be quite proven, the company may not be as profitable or growing as fast as it could be, it might not have a complete management team — that provides the independent sponsor with an opportunity to buy the company with a funded sponsor at an attractive price and also provide a lot of industry expertise to help the company with whatever it is lacking.”
Another advantage for companies partnering with independent sponsors is the lack of a defined hold period, says Rotunda Capital’s Lipson, which focuses on investing in family founder-owned businesses. “These businesses aren’t just looking for money. They’re looking for a partner. When you say, ‘I’m a partner, but only for five to seven years, because then I have to sell’ — well, many times that’s not what the seller wants.”
Juniper Capital Management, a Dallas-based independent sponsor founded in 2015, has closed three platform investments since inception in large part thanks to this flexibility and partnership mentality. “We spend a lot of time on human due diligence — when we decide to work with someone, we want to be in it with them. We have differentiated ourselves in the marketplace by not being on a time horizon and by giving management the runway they need to augment growth,” says Bryan Grabowsky, co-founder and managing director.
The flexibility independent sponsors offer is also a boon in an uncertain market. “If we don’t like where the market is, we don’t have to do a deal. We don’t have a ticking clock to our fund deployment,” says Lipson.
Nine years into a bull market, that uncertainty is looming. When the market turns, independent sponsors may be one of the first to take a hit.
“Right now there’s so much liquidity in the market that everyone wants to do deals, but if you have a bear market, family offices, institutional investments, and the other people we go to capital for could pull back. In this case, committed funds have an advantage. Traditionally, committed funds produce their best returns in vintage years, where there is an economic down cycle, because they’re getting better pricing,” says Grabowsky.
Committed funds also have the benefit of receiving significant management fees, says Baum, “whereas as an independent sponsor you only eat what you kill. So while you can choose to be on the sidelines and not invest — it also means you’re not generating any income.” One way Consumer Growth Partners protects against that possibility is by diversifying its revenue streams — the firm also provides advisory services to companies in the consumer and retail space to assist them in preparing for a capital raise.
Juniper Capital Management’s strategy is to double down on business development while the good times are still rolling. Their formerly two-person firm recently hired a dedicated director of business development to proactively source opportunities and develop quality relationships with potential co-investors. As a relatively new firm, they are focused on connecting with Dallas’ extensive family office community, as well as reaching a wider geography of potential sponsors through Axial. Says Grabowsky, “Our number one goal is to find quality assets and quality teams to back. I’m preparing for a world that isn’t as favorable as today’s, and in order to do that we need to have a wider group of people that we can raise money from.”