Denice R. Preston
Assets under management for private equity have reached a record. But, as is the case with “zombie” funds. These are funds where the investor’s money is tied with fees and assessments, but the hopes of making profits with these funds have waned.
It is time to consider the model of an independent sponsor. Investors tired of managing fees for uncommitted capital and the limitations of pooled investments are moving to a more accessible and more flexible method of investing.
In the conventional private equity model, the fund is formed by inviting investors to invest in an uninvolved pool, typically having no control over individual investments and with a 7 to 10-year time frame. In the model of an independent sponsor, The team sources deals. It organizes operations before presenting possible values for its partners to review and then invest on a case-by-case basis.
In this article, I’ll explain the independent sponsor model in more detail, why it is attractive to investors, who the independent sponsors are, the economics of it, and if the model benefits those companies seeking to raise funds.
Why Are Independent Sponsors Attractive to Investors?
Independent sponsors have a variety of advantages over conventional PE funds. They also can offer their specific industry and operational knowledge on the market.
A greater degree of control over the investment choices. LPs have more opportunities to voice their opinion on every deal, which includes custom charges and economics. Deal-by-deal also gives greater flexibility about specific investment options.
No charges for non-committed capital. Their fee structure is more in line with LP’s interest, particularly when compared with the annual management fees charged by committed capital managers, whether the funds are invested or not.
There are no limitations on time perspectives. Money is no longer tied to an unrestricted seven-to-10-year period but may ebb and flow according to the pace of the individual companies’ opportunities.
Who Are Independent Sponsors, and Why Do They Choose the Independent Sponsor Model?
Independent sponsors usually have three primary areas of influence.
Private equity professionals that want to move from the traditional committed capital structure to the deal-by-deal model usually allow them to be more actively involved in the transaction and benefit from higher financial rewards.
Bankers in the investment industry wish to be able to own equity and move to an active involvement in the development of the businesses they fund.
Experts in the field or experienced entrepreneurs who have “walked the walk” before and have the experience to add value to purchased businesses.
According to Gretchen Perkins of Huron Capital Partners discussed within the Citrin Cooperman 2019 Independent Sponsor Report, “It’s far more valuable when [independent sponsors] bring industry or operations experience and connections or if they bring with them someone to be CEO or chair the board who has long-term knowledge and experience in that industry.” Individual investors typically play a leadership role in the companies they are investing. This makes them appealing to their more passive capital partners, who tend to be strategic advisors but do not always want to get involved in the operational side.
The Investment Structure of an Independent Sponsor’s Deal
The most popular method used for structuring deals within the US involves the formation of an LLC or Limited Liability Structure (LLC) in which the independent sponsor and the capital partners put their money. This LLC is structured to tax it as a partnership, and the relationships between the partners and the post-transaction roles of the independent sponsor are defined by the operating contract of the association.
If an element of debt is part of the deal’s funding, a holding company is likely to be needed to keep the deficit within this entity.
From a legal standpoint, the model of an independent sponsor offers several advantages from the General Partner’s (GP) viewpoint. The first is that the absence of funds under management means fewer administrative burdens and expenses associated with accounting and compliance as well as regulation. In addition, in the more conventional blind pool models of private equity, the GP can only execute transactions that conform to the investment plan defined and stipulated in the agreement between the LP and GP. In the model of an independent sponsor, GPs can make decisions based on opportunism and create innovative deals.
In my personal experience with the independent company HoriZen Capital, I frequently encounter SaaS companies below the $500,000 annual revenue threshold. Suppose we believe in the quality and potential that the service offers. In that case, we may create deals in which we serve as advisors, providing knowledge to help the business expand, then take on an equity stake once we’ve delivered the growth potential, and then allow owners who have already purchased in the future.
Closing Fee
The amount paid to the independent sponsor after the completion of a transaction typically can be between 2% and five % of the purchase cost. Capital partners usually anticipate a substantial portion of the fee for the transaction to be put back into the trade. This is a sign of the sponsor’s confidence in the deal’s value and guarantees the alignment of interests.
Carried Interest
My research indicates that the carried interest structure has the most significant fee element variability. Carried interest refers to a portion of the capital partner’s earnings distributed towards the sponsor independently before the pre-determined return on investment for the capital partner.
A straightforward example of a carried-interest structure for independent sponsors:
A hurdle rate of 8% is generally accepted.
The majority of the percentage of carried interest is between 10 and 25%.
Carried interest agreements typically have the “catch-up” provision.
Comparison to M&A and PE Funds’ Remuneration Structure
To evaluate the costs, M&A advisors typically charge the client a monthly retainer cost (between $5,000 and 20,000 in a quarter to cover smaller transactions) and a success charge added on top. The most common practice in the market for success fees follows that of the triple Lehman Formula, where the price is 10 percent of the first million plus 8 percent of the second million, and the list goes on, and then 2 percent of all deals over $5 million.
Similarly, PE funds with committed capital are required to pay an annual management fee, which is usually two percent of the money invested, and also receive a carry interest generally dependent on the fund’s performance. Certain PE companies offer management fees to portfolio companies in exchange for their advisory and strategic role, but there is growing opposition from LPs to these fees.
