Top deal killers for independent sponsors

4/16/2021 Claudine Cohen

Independent sponsor activity has remained busy throughout the COVID-19 pandemic, and capital providers continue to line up for the chance to back quality deals led by independent sponsors who in many instances source proprietary deals and form close, trusting relationships with founders.

But interest doesn’t equate with successfully closing a deal; potential deal killers abound. Knowing what they are, and addressing them in advance, can increase the certainty of close.

In a recent CohnReznick-hosted webinar, three panelists shared insights about how to manage factors that can kill a deal.

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 their top insights – click on each bullet below to skip to the relevant section – or access the on-demand recording to hear the full conversation.

When a capital provider pulls out at the last minute, it’s often because the independent sponsor confused interest with certainty of close and didn’t make sure the relationship progressed.
Interest in independent sponsor-led deals is abundant these days, and sponsors can initially see a flood of interest from capital providers. But just because a capital provider is interested in seeing your deal that doesn’t mean they have taken the steps to thoroughly vet it internally.
It’s a fine balance between managing the conversations and the due diligence that the capital provider is trying to do on the front end and understanding at what stage they are in their process and how interested they are.
It’s important to speak with different capital providers at the outset, and only lock in with a provider once you have seen multiple proposals. The capital provider must have enough information to understand the transaction and the general dynamics.
Ask probing questions to gauge the capital provider’s commitment level. What has been done internally to vet this transaction? Has it gone to the investment committee? What’s it going to take to close? What are the things that may derail the deal?
The right horse to get you to the finish line is not necessarily the one that comes out of the gate fastest. You never know why a provider might be a little slow to give you a proposal. For example, they might be tied up with other deals, but when they free up, they might suddenly realize that your deal is a perfect fit for them.
When you have two or three capital providers to choose from, it can help to have a sounding board to help you pick the best one. There is never 100% certainty, but outside advisors can give you an objective perspective.
When choosing a capital provider, chemistry is as important as economics. They can give you the best economics in the world, but if the chemistry and working relationship are missing, you may do better to look elsewhere.
That said, make sure the capital provider has some skin in the game during the pre-acquisition phase. You want a partner who will come alongside you and be committed to the deal. An expense reimbursement obligation is a typical quid pro quo when a capital provider asks for exclusivity.
The relationship-building process is critical to getting deals done. Every deal is going to have issues, but the more frequently the independent sponsor and the capital provider get on the phone to talk through those issues, the higher the likelihood the deal will get done.
Deals die or close on a multitude of factors, and you can’t judge a capital provider purely on one interaction. While there are capital providers who behave outside of the norm – for example, trying to lock up opportunities they haven’t thoroughly vetted, or pushing the independent sponsor aside after obtaining exclusivity – most want to be good partners.
Look for capital providers with a track record of working with independent sponsors, since they are motivated to protect their reputation in the ecosystem.

Meeting management is a key part of capital providers’ underwriting process, especially for potential equity partners. That is why letters of intent typically have language that indicates that the terms are contingent on meeting management.
In most cases, you want the seller to meet with one or at most two potential capital providers, to avoid giving the seller the impression that you’re shopping the deal around.
Before you introduce a capital provider to the seller, first make sure you have a strong relationship and established financial terms. Second, make sure that they have enough information to do their initial underwriting, and that they are comfortable with the deal.
The meeting between the capital provider and the seller should typically happen either right before or after you sign exclusivity.

The question of how many capital providers to bring in on a deal depends on the goals and philosophy of the independent sponsor. While some sponsors are committed to the syndication model, others believe that working with just one or two gives them the ability to move more in lockstep with those capital providers.
Each capital group that comes in will have its own set of attorneys, accountants, and other advisors. If you do intend to syndicate a deal, keep in mind that as the pool of people involved in the deal expands, so does the risk that one of the parties will start poking holes in areas that suddenly become an issue for one or more of the other parties.

There’s significant value in building a long-term relationship with a capital provider. The trust and comfort established over the course of multiple deals can increase the likelihood of deal success. Plus, you would have established documents and agreements to use as a starting point, and you would have most likely already worked through the kinks in those agreements.
But, keep in mind that just because you’ve done one deal with a provider doesn’t mean they are going to be the right partner for the next deal.
If you do go back to the well, make sure you’re asking the right questions and they’re getting enough visibility into the new target to get comfortable with the transaction.

The highest level of deal-break risk is in the initial diligence stage, when there may be problems with the quality of earnings report or surprises that surface in background checks.
Sometimes surprises occur because the independent sponsor – understandably overwhelmed with trying to balance the needs of all parties – overlooked critical initial diligence questions.
Make sure you know the top diligence questions, given the seller’s industry and company type. For example, billing and coding is a critical issue in healthcare deals, and contract-related revenue recognition is a frequent problem in construction services.
Keep this list of initial diligence questions short (5 - 10 questions). You want enough insight to be comfortable that what the company is presenting is in alignment with what you’re seeing in the data, but you don’t want to overload the seller right out of the gate.
Most importantly, immerse yourself in the seller’s industry. When developing your industry expertise, surround yourself with advisors with experience in the space. Consider reaching out to members of your network who have experience operating businesses in that industry.

Deal-making is as much a people business as it is a financial transaction. The critical ingredients of deal success are constant communication and actively managing relationships between the seller (and the seller’s advisors) and the capital providers.
The independent sponsor needs to be the quarterback. Educate the seller on your process and how you’ll bring investors to back you on the deal; manage the dynamics between the seller and the capital providers; and keep yourself in the center of the deal throughout the entire process.
Make sure the sellers are spending money on the deal by hiring their own advisors who are completing documents on schedule, as this is an indication of the seller’s confidence and financial commitment.
Know who the seller’s advisors are, and gauge their level of sophistication. Sometimes the de facto deal counsel is the seller’s corporate attorney or CPA, and that person might do a deal every few years, if at all. Advisors who are inexperienced in deal-making can make unreasonable demands that end up killing the deal.
When the seller is selecting deal counsel, suggest some firms that are the right size from a financial perspective and have seen enough deals to have the right level of sophistication. Often the seller won’t have anyone in mind and will appreciate those recommendations.
Asking for expense reimbursement in the event the seller has a change of heart can sometimes vet out how serious someone is. An expense agreement isn’t necessarily a tool for submitting claims in the case of litigation; rather, it provides you with the comfort of knowing that the sellers are committed to the process.

When a capital provider walks, it’s important to be able to pivot quickly to keep the deal on track. That’s why securing upfront interest from multiple capital providers is critical. At the end of the day, if you have a motivated seller, a capital provider walking is not going to kill the deal. You do have to answer the difficult question of why the provider walked away, and the timeline of the deal will likely be extended. But timing is almost never the thing that will kill the deal.
Don’t underestimate the power of sellers’ wanting to get the deal done. This is not an easy process, and most sellers don’t want to walk away as it would mean they have to start the entire process all over again.
The best way to mitigate deal risk is to ensure a strong relationship between the independent sponsor and the seller, and clear communication before and during the entire deal process.

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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.}