The exponential rise of independent sponsors in the last decade has brought forth both interest and confusion from investors. Who exactly are these deal wranglers chasing companies across the Wild West of private equity, and how can we as investors understand their approach and value-add?
An 'independent sponsor' or 'fundless sponsor' refers to a private equity team that raises capital on a deal-by-deal basis, rather than a standby pool of commitments. Under this model, investors weigh the merits of each individual transaction, instead of allocating to the broad themes of a fund mandate.
Our Nextvest investment community has a strong affinity for independently sponsored transactions, as we exclusively allocate capital on a deal-by-deal basis. In the course of reviewing hundreds of these deals, we've come to identify two kinds of independent sponsors who bring distinctly different value to the table: The Institutional Sponsor and The Operator Sponsor.
Their approaches are revealing and distinct. Equal in capability, very different in execution.
The talent migration of pedigreed individuals from name-brand PE shops into independent sponsorship creates what we call the ‘Institutional Sponsors’. As the largest private equity firms grow ever-larger, a rising number of mid-level deal professionals are logjammed, competing for a limited number of partner-level seats. Disenchanted, the most industrious spin-off to build their practices independently, scaling down in deal size and breaking into the open and inefficient territory of the lower-middle market.
Known for their quality of buy-side underwriting, their deals are presented in expertly polished materials. Often these sponsors have spent years presenting meticulous investment memos and financial models to demanding investment committees. Varying in format, but consistently revealing depth of thought from industry macroviews to minutia in the financials, their memos also detail clear post-close plans for the company and a path to exit.
The initiatives are not always transformational, but often repeatable 'blocking and tackling' maneuvers such as up-leveling the financial controls, upgrading the IT, and redesigning the sales process.
Operating partners may be brought in, but this Sponsor’s own role is fundamentally in overseeing the asset from 10,000 feet. That vantage point is typically a board seat. The ability to view the company holistically allows the Sponsor to add key adjustments in strategy, course correcting and reacting properly to situations in which management may simply be too close to detach. Often, these Sponsors will have a value-add rolodex which they bring to the table as management seeks to execute various initiatives.
In this way, the Institutional Sponsor behaves like a major PE fund would: delivering their value not in operating the asset at the CEO-level, but in purchasing at a good price, overseeing it, and, ultimately, exiting it.
Even in fees, the Institutional Sponsor justifies a model reflective of the fund approach. Deal expenses are recouped at closing, an annual management fee pays for ongoing costs, and carry, over an appropriate hurdle rate, is the golden carrot which aligns to investors on the back-end. This Sponsor arrangement most closely resembles the ‘2 & 20’ structure.
In the weeds and inner workings of operations, the expertise of executives and consultants are refined over years. They develop a deep familiarity for metrics and best practices, settling into an intuition about 'good' and 'bad' companies and where the weak links hide.
As a leader in any company knows, running the show is easier when you are the operator and owner. Buying a company alongside investors, an Operator Sponsor will also invest an asset in the transaction often more valuable than dollars: time and focus. Joining the management team as CEO, CFO, or COO, this Sponsor will take a day-to-day role in the company.
The Operator Sponsor is guided by hands-on experience. Paramount in their decision-making are the people, operating metrics, untapped opportunities, and value deltas of improvements. If they can see enough places to build fundamental business value, and have the confidence and capability to execute in those areas, they often see payoff. To their credit, improving the machine should improve the outcome.
Their capabilities enable them to execute the most transformative of strategies, like shifting revenue models, entering new markets, or integrating vertically. And, the outcomes can be just as radical. Their economic goals will reflect their exuberance, often taking only a market or below-market salary from the business, but, upon exit, the fruits of their labor command additional split tiers. Baseline performance may give 10% carry, a great outcome 20%, and exceptional 30%+.
Between the two kinds of independent sponsors, either can win and either can lose. This isn’t a battle of styles, but a scale of consideration. An asset and sponsor are a package deal and must be evaluated in tandem. What one requires, the other must deliver.
In the best cases, when both the asset and the sponsor are exceptional — and exceptionally well-suited for each other — the combining of value creates the opportunity for multiplied effects on investor returns.