2020 has posed countless challenges for the deal-making community, from the impacts of the COVID-19 pandemic to the uncertainty surrounding the 2020 election. But independent sponsors have been able to shine in this environment. 

In a recent CohnReznick-hosted webinar, three speakers deeply familiar with the independent sponsor community shared what they’ve seen in this year’s market and how independent sponsors have continued to successfully negotiate, close, and finance deals.

• Claudine Cohen, Managing Principal, Transactions and Turnaround Advisory, CohnReznick LLP  

• Drew Brantley, Managing Director, Frisch Capital Partners
• Thomas Zahn, Partner, McGuireWoods LLP

Read on for a quick overview of the top insights they shared in 11 key areas – click on each bullet below to skip to the relevant section – or  access the on-demand recording to hear the full conversation.

Deal activity

• After a strong late 2019 and first quarter of 2020, there was a decrease in deal activity beginning in March as COVID-19 hit and sponsors focused more on their portfolio companies, and on navigating new liquidity challenges. 
• Deal activity accelerated starting in May and June. The heightened level of activity is expected to continue into 2021.
• The dynamics and uncertainty surrounding potential policy changes under the incoming presidential administration are fueling deal activity. The continuing impact of the pandemic does not seem to be slowing deal activity as investors adapt to the environment and work toward deploying the large amounts of capital available to invest.

Deal sourcing

• In the absence of conferences and their potential for one-on-one meetings, many independent sponsors have been reaching out to companies directly to build proprietary sourcing relationships. It can take a lot more time and effort to develop those relationships and to get deals to close, and the results of due diligence may not be as curated as they would be if there was a broker or banker involved, but it can be a successful approach.
• Business brokers continue to introduce independent sponsors to deal flow, and an increasing number of deals are being sourced through investment bankers. 
• Amid the challenges of the pandemic, there have been opportunities for independent sponsors to pick up broken deals through a broken deal process.

Virtual management meetings

• Though most meetings are being held remotely, there is still a desire for groups to meet face-to-face, even if for a limited period or later in the process than what would have been normal before the pandemic. Today, management meetings are taking creative forms, from being conducted outdoors at a beach pavilion to having half the management team in a restaurant and the other half on video. 
• It seems that in-person meetings are leading to more engagement and relationship-building among the sponsor and seller, thereby resulting in a smoother path to closing.

Industry preferences

• Service-based businesses are currently attractive to investors, as are asset-light businesses that have consistent revenue regardless of COVID-19. 
• Healthcare services, particularly home health physician services, have been very active both in terms of new platforms and add-ons, including independent sponsor-led transactions. 
• More broadly, there has still been a lot of activity in business services, and in manufacturing and distribution, especially direct-to-consumer models. 
• The dip that some expected to see in the housing market hasn’t occurred: There has been an uptick in deal flow in businesses related to housing and development, single-family homes, etc.
• Deal activity has slowed in the restaurant and traditional energy industries. 

Distressed transactions

• Earlier in the pandemic, some were predicting that there would be a high number of deals involving distressed companies. Fewer distressed situations have made it to market than expected. Government stimulus programs to help struggling businesses may have provided the money and time to prevent more. 
• The number of distressed companies may increase in late 2020 or early 2021, especially as coronavirus cases continue to rise and restrictions may be tightened.
• The few distressed investment opportunities that have come to market have typically involved traditional private equity investors with existing platforms who see an opportunity to buy cheap and drive synergies, and who have resources to support operating challenges and a greater appetite for risk. Most independent sponsor transactions have involved healthy companies. 

Partnering with private equity and family offices

• Partnerships between private equity funds and independent sponsors have increased during the coronavirus pandemic. 
• Private equity groups, and other groups with committed pools of capital, have been warming up to the idea of independent sponsors as great deal sources, and as good partners that might be able to take over some of the “heavy lift” of one or two of their portfolio companies so that they can focus on other deals. 
• There has been less deal activity involving family offices, as many have tended to be a little more cautious in 2020.
• Deal economics have changed. Family offices have traditionally been perceived as offering better deal economics for independent sponsors, but recently there has been more variation in the economic packages that are being negotiated between independent sponsors and institutional funds.
• Still, in the family office community, favorable economics are often the product of relationships that independent sponsors developed over time. When working with less familiar groups, family offices may be hesitant to pay fees, and may want to share in fees, or not give some of the fees that people might think are more traditional economics, or as higher tiers of promotes. Institutional groups are simply more accustomed to fees, which are part of their deals, and are willing to be more aggressive on the front end on the economics. 

Deal terms, conditions, and control

• An increasing number of investment groups want to see some type of meaningful investment from the independent sponsor in addition to rolling part of the fee. That’s especially been true on the funded group side; a lot of institutional groups want to be able to tell their LPs or their investment committees that the sponsor has cash at stake as well. 
• The actual amount expected from an independent sponsor, though, is different for every group: An early-career sponsor with less liquidity wouldn’t be expected to provide as much as someone later in their career with more liquidity and success.
• Independent sponsors should keep in mind that that the capital contributed doesn’t need to be their own money. It can be pulled together from friends and family, bosses and colleagues. The ability to bring a little bit of capital that's meaningful moves the needle.
• In terms of how much control is expected in the deal, there is variance depending on where that request is coming from. It may be less of a discussion factor for more control-focused buyout funds, where there’s an existing expectation that the fund will be leading or maybe splitting responsibilities with the independent sponsor, but it’s certainly a variable in deals with non-control groups such as mezzanine funds. 
• There always must be conversations about control mechanisms regarding when to buy and sell, hiring and firing, the C suite, the capital structure, etc. But what can be more fruitful is focusing the conversation on the partnership, what each party wants to do and how they can work together, finding areas where they’re complementary.
• Sponsors should remember that the funded group is partnering with them for a reason, whether it’s a transaction they like or experience or another value-add to help grow the venture.

Winning deals in a competitive process

• A key component to independent sponsors’ success is that they really spend the time to get to know the sellers. Compared with funded groups that may ask higher-level questions, independent sponsors have more engaged conversations with sellers, thus giving the independent sponsor an advantage. 
  • Many sellers have grown their businesses from the ground up, and invested not only money but also a great deal of time, passion, and hard work; they might also have misconceptions of funded sponsors and private equity as coming in and tearing up businesses. 
  • Especially for first-time sellers, the people (i.e., the buyer) are just as important as the price. The ability and willingness to take the time to really connect and build a relationship with the seller is critical.
  • In cases without the luxury of that time, though, aim to have capital lined up and ready to backstop the deal even before it’s time to submit a letter of intent (LOI), so there’s more certainty of close.

Considerations for first-timers

• Except maybe in the case of an independent sponsor that spun out of a fund and already has an extensive track record, getting that first deal done is fairly critical. It is helpful for raising capital on subsequent deals. Some capital sources, especially more traditional LP-type capital or minority investors, like to be able to look back at the last handful of transactions and see what's happened.
• The most important factor is not the experience level of the sponsor but rather the quality of the opportunity: having a good angle on the deal.
• The bigger picture of what value the independent sponsor is bringing to the table matters, too: Whether it’s their first or third deal is less relevant if the sponsor has been in the industry or vertical for 20 years, and has any type of C-suite or operating experience or vertical expertise. 
• A capital provider’s job is to put money to work; they don’t want to run companies. So, if an independent sponsor can show that value-add, the provider will likely want to do the deal with them, regardless of whether it’s their first, fifth, or 500th deal.
• While it’s fair to say that a first deal may be a little bit more difficult to execute, the due diligence is the same whether it's a first deal or a third deal; having three under your belt doesn't guarantee that the fourth will be a home run. 

Due diligence

• When looking at a deal right now, there can be uncertainty about what constitutes acceptable adjusted EBITDA-C – earnings before interest, tax, depreciation, amortization, and COVID-19 (EBITDA). 
• Early in the pandemic, it was generally recommended to analyze numbers that were pre-pandemic, except for in industries especially devastated by the crisis. Now it’s more difficult, as diligence periods may include shutdowns, ramp-ups coming out of shutdowns, and possibly even second shutdowns.
• It’s not enough to just layer in adjustments to get to pre-COVID-19 levels; the specific circumstances of the case must be taken into consideration, and then can lead to differing assessments as there’s a high level of subjectivity involved.
  • Is the company in ramp-up? How does that compare to where they were last year, and where they were tracking before COVID-19, toward the end of February?
  • What has changed in the business (e.g. operational or fixed-cost structure) and in the industry as a whole? What does the future look like, in terms of both the industry’s conditions and the business’s pipeline and backlog? 
  • For company customers, how have they been affected? For example, if a customer is still ramping up and there’s a lag in their business, that may cause a lag in the vendor’s business as well; how long might it be before that customer is fully back up? 
• In some cases, the working capital side has been more challenging than assessing pro forma EBITDA. Businesses may have unusual inventory levels as they worry about supply chain disruptions. They may be putting off paying their vendors to conserve cash, or their customers may be putting off paying as they conserve cash.
• Be sure that assessments take into consideration any PPP loans or other pandemic-related relief, and how those programs’ processes, timelines, and provisions may come into play.

Timing the close

• Timing is a common concern in this space: There's an exclusivity period in an LOI, and people get very focused on the specific dates that are in there, and sometimes lose track of the bigger picture. Keep in mind that if capital is in place, the process is moving along, and third parties like legal and accounting are generally working toward those milestones, it’s uncommon for a deal to fall apart because it moves past that deadline. 
• This year, sponsors utilizing representation and warranty policies in transactions should note that there have been reports of longer timelines than normal in the underwriting process, for two main reasons: One, insurers are being inundated right now amid the current acute deal flow, and two, there’s a growing trend of insurers starting to be more aggressive on terms, and conducting more thorough diligence calls than the “yes/no” formality calls of the past. Where a year ago it might have been possible to squeeze in the underwriting process and be done with the rep and warranty policy in 10 days, it could be weeks now. 
• It’s probably a good idea to leave extra time for any diligence being performed; if a transaction is not far along by early December, completing a transaction by year-end is most likely not feasible. Even heading into 2021, with the pandemic still raging and a vaccination taking time to reach the broader population, expect diligence to take longer and for the deal environment to remain as it has for the last six months of 2020.