Many independent sponsors boast of having proprietary deal flow but lack capital to close deals. Buyout firms with committed funds, by contrast, have the capital. What they need is more deal flow, and many are open to teaming with independent sponsors under the right conditions.
Conditions of late have been right for at least two buyout shops, continuing an industry tradition of funded-fundless partnerships that appear to be proliferating as good deals get harder to find.
New State Capital, the Larchmont, New York, firm that started life as an independent sponsor in 2013 before transitioning to a funded sponsor, this month closed the first deal of its $255 million second fund in partnership with an independent sponsor.
Meantime, Detroit-based Huron Capital has done two of the three deals in its non-control Flex Equity Fund alongside independent sponsors. Led by Partner Douglas Sutton, the $142 million pool closed earlier this year.
Over the years Huron Capital has also partnered with independent sponsors several times through its control-style funds, including on Aquamar Holdings, a seafood distributor formed via two acquisitions in summer 2017.
Funded sponsors point to a number of advantages of working with independent sponsors. “It’s quite remarkable how large and robust” the independent-sponsor market is, said Gretchen Perkins, partner of business development at Huron Capital. (The Guide to Independent Sponsors, published this fall by Buyouts Insider, profiles 175 firms, most of them active acquiring companies with enterprise values under $50 million.)
“We market to [independent sponsors] very heavily,” said Perkins. “We want to be top of mind with [them] because they find deals we don’t find” — usually outside an investment banking process.
In a hat tip to the operational chops of many independent sponsors, Sutton added that “they have resources to stay active [in companies] and help manage the investment. It allows us to leverage our resources internally a little better.”
No surprise that a disadvantage of working with independent sponsors is their appetite for fees.
Lacking committed funds to draw management fees from, independent sponsors typically take a success fee on closing a deal. On top of that they may charge their portfolio companies a percentage of EBITDA as an annual management fee, and they typically receive a tiered carried interest that ratchets up after hitting performance hurdles.
Just how much these fees eat into the returns of the funded sponsor’s limited partners is subject to negotiation and varies from deal to deal.
The upshot is that the deal’s potential has to be such that it delivers the returns that LPs expect while overcoming the higher fees. Perkins said that the number one reason that deals with independent sponsors fall apart is that they’ve agreed to a valuation that’s higher than Huron would like.
Sutton added that it’s also important to make sure incentives stay aligned. If independent sponsors have only a little skin in the game — and many do — they lack the downside risk that funded sponsors have exposure to. Will they move on when the going gets tough? That’s a question that has to be addressed.
The question of who controls the deal also has to be resolved. Most independent sponsors work with passive investors and have a taste for controlling their portfolio companies, although John Kim, senior principal of New State Capital, said that some independent sponsors are really more about finding deals and don’t mind giving up control.
Independent sponsors also may hand over the keys if they see New State has enough to offer. In the case of Ontario, California-based Martinez Steel Corp, independent sponsor Isleworth Capital Partners had a letter of intent to acquire an auctioned company when an investment banker friendly with both Isleworth and New State suggested that the two work together.
As it happened, New State, which acquires companies with $8 million to $30 million of EBITDA, was familiar with Martinez Steel and was able to move quickly to a close. It also had in-house resources — partners with expertise in marketing, strategy, finance and lean manufacturing — that the company needed.
In the end the deal came together and closed Nov. 9. The owner of Martinez Steel rolled over equity into the company, which acts as a steel subcontractor on major building projects. Isleworth put in some equity, while New State put in the majority of equity for its usual control stake. Both firms will have an active role in managing the company.
The plan, said Kim, is to help finance the company’s expansion into states outside California and possibly make add-on acquisitions.
Huron Capital has an easy answer for independent sponsors that want control: It can invest out of its new non-control Flex Equity fund. In its latest non-control deal, according to Sutton, Chicago-based independent sponsor KCM Capital Partners, whose partners Huron Capital executives knew and liked, had drawn a bead on a company whose seller was looking for a partial exit and growth capital.
The company, Edison, New Jersey-based Atlantic Beverage Co, operated in an industry, food and beverage distribution, that Huron Capital was familiar with. In fact, a former CEO close to the firm pitched in on due diligence of Atlantic Beverage and ultimately joined the company’s board.
KCM Capital brought in Huron Capital and a second private equity firm to supply the bulk of the equity, with additional capital chipped in by the seller and by KCM itself. The deal closed late this summer.
“It was a really good fit for us,” said Sutton. Along with KCM “we cobbled together the capitalization and were able to put a deal together.”
Action Item: Learn more about the independent sponsor market from this October report by accounting firm Citrin Cooperman
Corrections: Independent sponsors may charge a percentage of EBITDA as an ongoing management fee. The original version of this column said they always do. Also, John Kim of New State Capital said that some independent sponsors don’t mind giving up control on deals. The original version of this column said that a growing population of independent sponsors don’t mind. Finally, the column was revised to emphasize that New State Capital and Isleworth will both play an active role in managing Martinez Steel.