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Independent Sponsor Financing: 6 Common Misconceptions

March 2, 2018

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Independent Sponsor Financing: 6 Common Misconceptions

March 2, 2018

Raising capital as an independent or fundless sponsor can be challenging and time consuming, especially for those who lack a long private equity track record or who don’t have hundreds of existing relationships with capital providers that focus on investing with independent sponsors. 

 

Based on our own experience raising capital on behalf of independent sponsors, as well as countless other conversations with new and established independent sponsors, we've highlighted six common misconceptions about raising capital as an independent sponsor, providing guidance to help you improve the probability of a successful independent sponsor financing process and achieve better economics.

 

Misconception #1: 

 

“The Independent Sponsor should accept below market deal fees, management fees or upside participation (carried interest / promoted interest or common equity ownership) as a new independent sponsor.”

 

When capital providers tell an independent sponsor that they should tolerate significantly below-market economics because they’re a new sponsor, it’s a self-serving negotiating tactic.

 

Being a new independent sponsor is certainly one dynamic that capital providers will factor into a transaction, but, by itself, is not enough for a capital provider to low-ball the sponsor, especially before reviewing the opportunity.  

 

Other, often more important, elements include: the attractiveness of the target business, the sponsor’s industry or situational expertise, deal valuation, transaction structure, capital structure, ability for the sponsor to provide management support and development of a thoughtful growth strategy

 

In practice, transactions are almost always evaluated independently, based on a variety of factors, and the sponsor’s economics rarely come down to a single factor. 

 

As a sponsor, be weary of any capital provider that tells you that you should simply accept below market economics, just because this is your first time using the independent sponsor model.

 

Furthermore, the private capital markets are extremely inefficient.  Experience has shown us that independent sponsor economics offered by funding sources vary widely, regardless of the deal characteristics and sponsor experience.

 

Key takeaways:  How do you avoid below market economics as a first-time sponsor?

  • Talk to as many funding sources as possible to understand the market and how you and your deal are perceived

  • Have the discussion about economics early in the conversation to signal you won’t just accept any offer.

  • Focus on adding value to the opportunity- source and develop attractive acquisition candidates and, if appropriate, bring industry or operational expertise to the table, along with the acquisition target, itself.

  • Utilize an advisor, such as an investment bank, focused on the independent sponsor space that knows what’s market and what isn’t and which groups will be the best fit for you and your deal.

 

Misconception #2:  

 

“The Independent Sponsor should select a capital partner before finalizing the letter of intent.”

 

There are some instances where timing or seller requirements make it necessary for an independent sponsor to bring in a private equity partner prior to negotiating a letter of intent; unfortunately, those circumstances are usually not accompanied by strong independent sponsor economic packages.  In these situations, most capital providers either:

  1. Won’t give you a clear view of your independent sponsor economics until a deal has been fully negotiated with a seller; or

  2. Will offer you a below-market economic package because you’re usually not in a position to push back, as you need them to advance the discussion with the seller.

Unless it is absolutely critical to partner with a capital source before finalizing the letter of intent, avoid doing so.

 

While it may get you a seat at the table, it leads to two primary risks:

 

First, it will almost always limit your ability to negotiate with capital provider.  At this stage, the sponsor needs the capital provider more than capital provider needs the sponsor, and the terms and sponsor economics will generally reflect it.

 

Second, by introducing a specific capital partner to the seller too soon, you run the risk of linking the viability of your offer to a specific funding source. 

 

If at some point prior to closing, that capital partner pulls out of the deal, the deal itself may be in jeopardy.  In this scenario, sponsors often find themselves scrambling under pressure to find another capital partner, while trying to hold the deal together.

 

At this point, most sponsors will accept just about any economics offered to them to salvage the deal.

 

Key takeaways: What should a sponsor do if the Seller requires proof of funds pre- LOI?

  • Have a preliminary list of multiple likely capital providers ready to access prior to starting an LOI process. Regardless of the situation, it’s almost always prudent to have discussions with multiple capital providers about an opportunity.  This is an area where an advisor can help target the optimal capital providers for the opportunity. 

  • Discuss sponsor fees and economics with the capital providers early.  You may not be maximizing sponsor economics in an absolute sense and the capital provider may still re-trade later on, but if you don’t address economics, it’s highly probable you won’t get the best available deal under the circumstances.       

  • Make sure that you have identified and addressed the biggest diligence and deal items before you team up with the capital provider.  This helps reduce surprises, which should help mitigate the risk of the capital provider backing out at the last minute.        

  • Rather than bring a capital provider to the table, introduce a credible advisor focused on raising capital for independent sponsors.  It’s not a obvious solution, but we’ve found that it often adds legitimacy to the independent sponsor’s letter of intent in the eyes of the seller or seller’s advisor.

 

Misconception #3: 

 

“The Independent Sponsor  should tolerate the same independent sponsor economics on all new deals with an existing capital partner relationship.”

 

If a sponsor uses an existing funding source to fund more than one deal, it’s important to view each deal separately. What often happens is that funding sources with existing independent sponsor partnerships try to use previous partnership dynamics for each subsequent deal. 

  • If you’ve historically accepted low fundless sponsor economics, you may find yourself stuck with capital partners who will fund your deals, but offer you significantly below market economics. 

  • Coming back to our point in #1 above, every deal needs to be evaluated on its own merits. If a capital partner won’t do that, they are not a good long term capital partner.

 

Key takeaways: How do you get an existing capital partner to provide increasingly better economics on subsequent deals?

 

  • Approach each deal on its own merits.  If you brought a subpar deal to your capital partner, would they automatically fund it or give you great economics?  Of course not… so why should you arbitrarily accept your last deal’s economics?

  • Your capital partner needs to know that economics matter to you, and you need to raise the issue early. They should expect to discuss economics with you on every deal and you should to be prepared to support or defend the structure you are requesting.

  • Force them to compete with their peers by running a broad, but targeted capital raising process.  As good as a capital partner might be, a fundless sponsor should always be able to access new sources of capital, either by dedicating their own time or by hiring an advisor focused on raising capital for independent sponsors.  It’s always in a sponsors interest to understand the market and develop a thoughtful approach around selecting capital partners.

 

Misconception #4: 

 

“It makes sense for an Independent Sponsor group to raise its own capital”

 

Many independent sponsors have raised capital over the course of their careers and have longstanding relationships with great capital partners.  This approach, however, has some potential disadvantages:

 

  • Most independent sponsors don’t have a strong enough pulse on the ever-fluid private capital markets.  

Since the independent sponsor model only requires that you raise capital when you have an active opportunity, most sponsors choose to allocate their time to deal sourcing or growing existing portfolio companies, which makes complete sense.

 

They usually don’t spend enough time on an ongoing basis interfacing with enough different capital providers to build a reliable sense of: a) the viable or optimal capital structures based on the deal in question or for the different types of capital providers they’re approaching; b) the best types of capital providers for a situation; or c) how those capital providers’ interests shift over time.

 

When an acquisition opportunity does present itself, we often see sponsors revert to the familiar deal structures they used at their prior committed private equity or debt funds and reach out to the handful of capital partners with whom they have existing relationships.

 

While this approach works from time to time, this strategy is also a great way to leave independent sponsor economics on the table, waste precious time if those capital providers don’t respond favorably to the opportunity and leave out a lot of great fundless sponsor financing sources that could otherwise be a strong fit for your opportunity.

 

Furthermore, if the sponsor doesn’t have a strong sense of the right capital providers for the opportunity and misses the mark, it can be a risky proposition to put your faith (as well as dollars and reputation) in the hands of such a limited number of funding sources.

 

  • Most sponsors usually have some relationships with private equity firms, family offices or SBICs, but not enough to really create a competitive environment for funding their deals or running a capital raising process with dependable results. 

If you’re fortunate enough to be a fundless sponsor who does receive interest by approaching a small number of potential investors, it’s easy to get caught in the trap of saying yes to the first partner that agrees to fund a deal, but if maximizing the fundless sponsor economics to your group is an objective, running a broad and efficient financing process, targeted at the right capital partners for the specific transaction will almost always produce a better outcome.

 

If you’re not fortunate enough to receive interest after showing an opportunity to a limited number of capital providers, this is usually the point when sponsors either give up on the deal or start randomly calling SBIC’s, family offices or private equity firms, hoping someone will bite.  Running a broad, but targeted process from the outset (or hiring an advisor to do it for you), would have probably been a more reliable capital raising strategy that ultimately saved you time.

 

  • It’s hard to be a strong advocate for yourself, especially when your goal is to form a partnership with the people you’re negotiating with.

There’s a reason why most institutional investors hire a reputable investment bank to represent them and their interests.  They’re hiring a third-party advocate with deep market knowledge and transaction experience to get them a better deal and develop creative win-win solutions that stand in the way of closing a transaction.

 

As a third-party buffer, a strong advisor can generally ask for things that the sponsor may be uncomfortable in asking of their future potential partners for fear of damaging the relationship or turning the capital provider off.

 

  • The independent sponsor model is hard to scale if you choose to do everything yourself.  

If your goal is to create operational leverage, it’s critical to develop a sense of where your time is best spent.  For most independent sponsors, this means sourcing and closing deals, developing new operating partners or growing existing portfolio companies – and by the way, this is what capital providers expect you to do.

 

Capital raising activities like building models, assembling books and capital partner outreach are usually time intensive and a distraction from higher value activities.These activities should usually be delegated or outsourced if your goal is to scale.

 

Key takeaways: What is the most efficient way to raise independent sponsor capital?

 

If your objective is to: raise the capital you need, with a capital partner who is a good fit, at a reasonable cost of capital, with great independent sponsor economics then you must:

  • Have a constant pulse on the private capital markets.  Different deals require different capital partners and the markets are constantly evolving.

  • Run a competitive capital raising process.  Yes, it takes time.  Yes, you would rather not do it.  However, is there really any other way to raise capital to get the best terms available?  Your return on this effort, over the life of your deal, will be significant.

  • Consider hiring an advisor so you can focus on your highest and best use – sourcing and closing deals and growing the businesses you already have

 

Misconception #5: 

 

“Hiring an advisor to raise capital will eat into my independent sponsor fees and economics.”

 

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