Summary: Independent sponsors broker private small business M&A deals, matching sellers, investors, and operators. They operate like miniature private equity funds, typically installing a qualified operator as part of the acquisition (and occasionally operating the business themselves). New platforms can help independent sponsors raise capital to supplement an anchor investor and fill funding gaps.
I know from working in finance that there’s a quiet transition happening in the private equity world.
Experienced private equity associates are venturing out on their own to become “independent sponsors.”
Here are the basics, pros and cons, and opportunities facing the independent sponsor structure based on my experience in the space.
The Independent Sponsor Model
Independent sponsors, also called fundless sponsors, are individuals or small teams looking to acquire established small businesses. They’re called this because they do not have a fund of committed capital like a traditional private equity fund. Instead, they aim to acquire businesses without raising capital in advance, lining up investors on a deal-by-deal basis.
Most independent sponsors have strong financial backgrounds, such as with investment banking or private equity professionals. They may be experienced operators or industry veterans. They often have deep connections within the industry and established relationships with at least one source of capital.
Independent sponsor deals begin with the identification of potential acquisition targets. These are typically established, profitable businesses in the less efficient lower-middle market. Target businesses for independent sponsor deals might range anywhere from $1M to $10M in EBITDA, but commonly fall between $2M–$5M.
Sponsors then leverage their networks of industry connections to find capable operators to run the newly acquired business. Unlike self-funded searchers, independent sponsors don’t always take on an operational role at the acquired business. They approach the deal more as an private equity investor than as a search-entrepreneur.
After sourcing the deal and lining up potential operators, the sponsor brings the opportunity to both debt and equity investors. The sponsor may approach a handful of capital providers in their network, often including private equity firms, family offices, and high-net-worth individuals and capital groups. Often, a single investor will provide an anchor check of equity for the acquisition, but deals may include several capital partners.
Once the sponsor secures the required capital from investors and lenders, they can close the deal and acquire the target company. The chosen operators enter into managerial roles at the company, and typically, the investors and the sponsor assume seats on the company’s board. A common arrangement is a board with five seats, with sponsors controlling either two or three of them, depending on the deal.
The sponsor usually actively helps manage and grow the portfolio company for 2 to 5 years after the acquisition. Most independent sponsors have an exit strategy that involves adding value to the business and then selling after a few years. Often, independent sponsors sell to larger private equity funds, sending the business up the proverbial food chain, perhaps even toward an eventual IPO.
Independent Sponsor Economics on Deals
The compensation and fee structure for independent sponsor deals vary but usually fall within predictable ranges. The market terms for the industry are generally found in the annual McGuire Woods Independent Sponsor Survey.
Sponsors typically charge closing fees and annual management fees to cover their upfront and ongoing costs. Closing fees average 1%–5% of enterprise value upon the deal closing. Frequently, this fee gets rolled into the sponsor’s equity investment in the company. The management fee is usually a percentage of EBITDA, often 3%–5% annually. Both types of fees may be subject to fixed-dollar caps and collars.
Sponsors make their bread-and-butter profits through a “promote” or carried interest, sharing in the upside with investors. This often falls into a range of 10%–20% of invested capital (sometimes up to 30% for proven sponsors with a track record) with so-called “waterfall” thresholds, where the base carry increases based on performance milestones.
For example, a sponsor may receive a base 10% carry, then a 10%–15% carry above 2x multiple of invested capital (MOIC) and 8% preferred return. They may also receive a second-tier carry of 20%–25% above a 2.5x MOIC, rewarding them for exceptional performance. Some deals include a catch-up provision that allows the sponsor to catch up to the higher percentage carry when they tip over the various performance thresholds.
Independent Sponsors vs. Search Funds
Independent sponsors and search funds are both investment models based on acquiring an established small business. However, the mindset, economics, and business models differ in several important ways.
One major difference is the use of debt. Most self-funded searchers rely heavily on Small Business Administration (SBA) loans to provide the bulk of the acquisition financing. Searchers usually must personally guarantee this senior debt, which effectively ties their fate to that of the business. The use of leverage allows for attractive returns for both the searcher and investors in search fund deals.
Searchers approach their deals as an entrepreneurial venture, which is why the model is sometimes called entrepreneurship through acquisition (ETA). They typically assume an operational role at the helm of the acquired business. Independent sponsors, however, approach their deals like investors, acquiring equity and board seats but not managing the day-to-day operations of their portfolio companies.
This means searchers can only manage a single deal at a time. They’re looking for one business to run, which becomes their day job. Independent sponsors, by contrast, often construct a portfolio of 2–4 companies, none of which they’re operating themselves.
As for compensation, searchers typically keep the bulk of the equity in the acquired business, which makes sense considering they assume much of the risk. Independent sponsors have a more traditional fee structure, usually receiving 20% of the upside. Their compensation is based on performance hurdles and the preferred return offered to investors in the deal.
The economics of the two types of deals require different transaction sizes. Search fund deals typically target $500k–$2M EBITDA companies. Independent sponsors typically target larger companies in the $2M–$5M EBITDA range. Thus, these deals tend to require larger check sizes than search fund deals and cater to a slightly different pool of investors.
Independent Sponsors vs. Traditional Private Equity Funds
Independent sponsors operate a lot like miniature versions of traditional private equity funds.
There are a few notable differences.
The most important structural difference is that independent sponsors lack committed capital.
Private equity funds have a pool of capital to deploy prior to sourcing their deals. Independent sponsors source their deals first, then fundraise on a deal-by-deal basis.
This gives independent sponsors and their investors much more control over the investment terms and the business decisions of the acquired company. By contrast, investors in private equity funds commit their capital before the deals take shape and must accept the terms the fund proposes.
Private equity funds typically employ larger teams. This typically includes entry-level associates, directors or principals, and sometimes multiple layers of hierarchy in between. They also employ full-time analysts to research potential acquisition targets and monitor industry trends for opportunities. Independent sponsors are usually self-funded, operating solo or with very small teams during deal sourcing.
Private equity funds target larger deals on average. Most independent sponsor deals target $2M–$5M EBITDA businesses (on average, sometimes up to $10M). But private equity funds target companies above $5M in EBITDA, and often much more, with practically no upper limit.
Many private equity funds use a 2-and-20 fee structure. They charge investors 2% of assets under management (AUM) and 20% of returns generated above a given threshold (the hurdle rate). Independent sponsors charge comparatively modest fees, usually a small fixed management fee plus a percentage of the upside based on performance.
Of these two, the independent sponsor business model costs investors much less in fees. The 2-and-20 private equity structure skims a percentage off the top regardless of the investments’ performance. But independent sponsors’ fixed management fees typically only cover their costs. They usually only make meaningful profits by sharing in the upside with investors when their deals go well.
Benefits and Downsides of the Independent Sponsor Model
Like any investment strategy, the independent sponsor model has its pluses and minuses. Your mileage may vary, but in general, these are the biggest pros and cons.
Pros
- Sophistication: Independent sponsors tend to have a sophisticated understanding of finances, investing, or both. Investors in independent sponsor deals also tend to be pretty savvy, on average
- Greater control over investment decisions and terms: Private equity funds usually dictate terms and leave investors with little say in the decision-making in the acquired company. But independent sponsor deals revolve around a single investor or small group of investors, and thus offer more room to negotiate the terms of the investment. The investor typically ends up with seats on the board at the acquired company, ensuring greater influence over the company’s direction.
- Lower risk profile: Independent sponsor deals can be structured in various ways to protect investors from downside risks. This gives them a lower risk profile than most search fund deals.
- Quality operators: Independent sponsors and investors in their deals benefit from having hand-selected talent at the helm of the acquired company. Part of the sponsor’s job in brokering the deal is to install the best possible operators, hand-selecting candidates based on their skill, knowledge, and connections to the industry.
Cons
- No committed capital: The lack of a committed fund from the outset leads to the risk that independent sponsor deals could fail to raise sufficient capital to close. A deal failing to close is costly for sponsors, both in time and money. Sponsors must incur the upfront costs of deal sourcing, including legal expenses, business reviews, financial audits, and other due diligence. These expenses are wasted if a deal fails to close.
- No personal guarantees: In search fund deals, the searcher often personally guarantees the senior debt and stays on to operate the business. This ensures a high degree of alignment between their interests and those of investors. Independent sponsor deals don’t rely on SBA loans or personally guaranteed debt, so the operator or the sponsor could potentially walk away, even if it means eating a loss (and ruining a reputation).
- Requires a well-capitalized personal network: Most independent sponsors already have connections to a deep-pocketed network that might include private equity firms, family offices, or wealthy friends and family. If your network is limited, so too are your fundraising opportunities. You can only go back to the same well so many times.
Raising Capital as an Independent Sponsor
How to find independent sponsor investors
By far, the biggest challenge for independent sponsors is raising the capital required to close a deal.
In the past, independent sponsor financing had to rely almost entirely on the sponsor’s personal networks. They needed connections with high-net-worth individuals (either friends or family members), family offices, and institutions with $5M–$50M to deploy. No easy task.
Since private equity firms and wealthy family members don’t grow on trees, it’s always been challenging for even the most talented dealmakers to gain access to adequate capital. It all depends on who you know.
On the other side of the coin, investors eager to participate in private business acquisitions have no central marketplace to gain access to these deals. There’s an established ecosystem in private equity circles that can be difficult for new investors to access.
Today there are new tools that help sponsors and investors connect. CapitalPad is a great resource for helping independent sponsors raise capital. They’re a great option for supplementing an anchor investor to fill a funding gap.
CapitalPad helps independent sponsors raise capital in two ways.
First, the platform attracts investors looking for access to private search funds and sponsor deals. These are smaller-dollar investors, but CapitalPad will wrap a group of them into one special purpose vehicle (SPV) to let them invest in a sponsor deal. That means the sponsor won’t have to deal with multiple individual investors, instead dealing only with the single manager of the SPV.
Second, if there’s remaining allocation they can’t fill up, CapitalPad will introduce sponsors to other, larger funds that are looking to allocate to these deals. It’s an instant networking level-up that gets you in front of a fresh batch of qualified investors you might not otherwise have access to.
CapitalPad doesn’t charge independent sponsors a fee for either service. Instead they only ask that CapitalPad investors get priority for the allocation. CapitalPad takes its fees as a carry, sharing in the upside along with the investors on the platform. That’s a pretty good deal for all involved.
Final Thoughts
Independent sponsors are becoming more popular than ever, thanks in part to the advent of tools like CapitalPad to help sponsors reach eager investors and secure funding to ensure deals close.
Independent sponsors bring tremendous value to the M&A landscape. Their industry knowledge, connections, and operational expertise all help them to craft successful deals that benefit all the parties involved.
It’s been a path to business ownership and investment that I’ve been excited to follow and learn about. I hope that sharing what I’ve learned about how independent sponsor deals work enables more aspiring sponsors and investors to get involved in this promising space.
