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I recently participated in the 10th Independent Sponsors Summit presented by iGlobal Forum. Despite the economic challenges of the coronavirus pandemic, key takeaways from the summit were that independent sponsors have generally thrived during the pandemic, they continue to grow stronger as an alternative to traditional private equity firms, and the outlook for them in 2021 remains positive.
Weathering the pandemic
The COVID-19 pandemic has impacted nearly every business, positively or negatively, and some more than others. Many independent sponsors, because of their SBIC partners or because they were not caught up by the affiliation rules, could tap into Paycheck Protection Program (PPP) loans, which helped a lot. They are now emerging from the mayhem and have demonstrated that they are good business owners.
Macroeconomic factors and other variables are playing into a “frothy” market, including low interest rates, plenty of capital, and valuations that seem to have a life of their own. In some industries, we’ve seen record EBITDA multiples, while in others, EBITDA is at an all-time low. Valuation arbitrage exists – especially between smaller and larger businesses. While the 2021 outlook is for a healthy M&A market, many potential participants are wondering if there could be a “black swan” event. The medium- to longer-term implications of policies implemented by the new administration are also a consideration, but that doesn’t seem to be slowing things down.
Capital sources appear abundant
Perhaps the biggest takeaway in the still growing and maturing independent sponsor sector is that finding capital, both debt and equity, is no longer a top concern. Family offices, while still a viable provider of capital, are losing out to traditional private equity, which has stepped up in providing competitive economics. Private debt funds have flexibility in their capital structures, with many able to pick up a sizable piece of the equity needs. Independent sponsors are using placement agents more frequently, running competitive processes, and syndicating the transaction. Some might argue this is not a “healthy environment” for the independent sponsor community, and time will tell if this dynamic will cause certain capital providers to step back from the independent sponsor model.
Sure, if you are a first-time sponsor, you have hurdles to overcome in getting that initial deal financed. While there is no longer a scarcity of capital, first-time sponsors do not yet have strong relationships. Prospective capital partners are just getting to know them, and the independent sponsor doesn’t yet have an established track record or credibility. This is notwithstanding that many independent sponsors come from large, successful private equity firms.
The relationship with private equity
Historically, we saw traditional lower middle market private equity firms leading the way with independent sponsors. Due to their infrastructure and resource constraints, independent sponsors essentially served as an extension of their sourcing efforts. Many independent sponsors came with deep operating expertise, complementing the strength of their existing deal teams.
The tide seems to be shifting as larger middle market funds are jumping into the mix. Independent-sponsor-led buy-and-build platforms are emerging in fragmented industries such as healthcare, industrial, and residential services, and are being scooped up by these larger funds. The larger middle market funds like this strategy and business thesis but don’t have the time or resources to source and secure sub-$5 million EBITDA businesses.
The independent sponsor comes to the table with intimate industry knowledge, a value creation mindset, and the ability to roll up their sleeves. These platforms result in multiple acquisitions requiring easily north of $100-$200 million of equity over a three- to five-year time horizon. This is something smaller funds can’t do.
The changing influence of capital providers
Capital providers are no longer in the driver’s seat. Consequently, they must find creative new ways to differentiate themselves.
In conversations I’ve had with capital providers, they believe that differentiation relative to independent sponsors can be achieved in the following areas:
1. The runway a capital provider may give to the independent sponsor in terms of running the day-to-day and ongoing strategy of the portfolio company. The need for the capital provider to control the deal is in many times a “deal killer” for independent sponsors. They prefer an equal partner – someone who complements skills they may be lacking.
2. Sharing the deal economics. This may include including origination, carry, and annual management fees.
3. An ability to provide “dry powder” for add-on acquisitions. Just being able to close the initial platform is not sufficient.
4. A successful and referenceable track record of working with independent sponsors. During the “honeymoon” period of the transaction, it’s easy for things to go well. But what happens when situations arise and portfolio companies underperform, or the macroeconomic environment changes? How has the capital provider behaved? Independent sponsors want to be confident that the capital provider has backed more than one transaction with a single independent sponsor and operates with a relationship-building focus, as opposed to a transactional view.
Looking ahead
The future for the independent sponsor ecosystem appears bright. We should expect to see more independent sponsors emerge, existing sponsors investing in multiple transactions, and the broader private equity market continuing to embrace independent sponsors. Private equity and independent sponsors will become more collaborative, thereby leading to a win-win scenario for all stakeholders.
While there will always be a competitive element and some tension between private equity and independent sponsors, many different factors are pointing to an environment where both parties can work together to create value and thrive.
Subject matter expertise
Claudine Cohen
Managing Principal, Value360 Practice
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This has been prepared for information purposes and general guidance only and does not constitute legal or professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its partners, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.