Fundless or Independent Sponsor Economics
Understanding Independent Sponsor Compensation
Independent sponsor economics aren't typically advertised by capital providers, but as the independent sponsor model has gained traction and momentum in the eyes of institutional investors, family offices and the private equity community, sponsors and capital providers alike are searching for guidance and data on fundless sponsor economics and compensation packages (transaction fees, management fees, carry, equity ownership, broken deal fees, etc.).
It's fair to say that no two deals are alike, although there have become some perceived market norms or ranges that have been published or discussed publicly at various independent sponsor conferences.
These ranges set the stage for a discussion around sponsor compensation, broadly, however, there are a few points worth keeping in mind that can have a material impact on the way a sponsor or capital provider thinks about economics in any particular situation:
Different types of capital providers, generally, can offer different ranges of fundless sponsor compensation programs, often utilizing tailored structures or mechanisms to unlock value for themselves and the independent sponsor.
While there have become somewhat perceived ranges for fundless sponsor fees and carried interest structures, the private equity market for independent sponsors is still extremely inefficient. When running a broad capital raising process, there are often one or more groups that will get particularly aggressive when delivering an independent sponsor term sheet; this may stem from a particular knowledge of an industry or business model, a view on risk/reward that differs from others, an internal fund dynamic or some other factor.
Running a broad process, targeted at the right capital providers, or hiring an advisor focused on raising capital for independent sponsors that can do it for you, will almost always yield better results than showing an opportunity to a small collection of SBIC's, family offices and private equity funds.
Fit is vitally important. Virtually no one becomes an independent sponsor with the desire to enter into a bad or uncomfortable partnership- selecting the best capital provider based on the sponsor's goals can often outweigh the benefit of selecting the capital partner proposing the largest fees or carry.
Whether you're trying to gain an understanding of the landscape of independent sponsor economics or evaluating a specific term sheet, it's helpful to think about three elements of compensation common to the independent sponsor model:
Deal Fees or Transaction Fees
Ongoing Compensation, such as a management fee or salary and benefits
Upside Participation, either in the form of a promote or carried interest structure, profit sharing or common equity ownership
1. Deal Fees or Transaction Fees
Independent sponsor deal fees or transaction fees are fees paid to the sponsor upon the successful closing of the transaction. While some sponsors prefer to receive this fee in cash, it is extremely common for the majority of this fee to be rolled back into the transaction so the sponsor has some “skin in the game.” Unless creatively structured, this fee is usually taxed as ordinary income, so a sizable portion of the fee not invested into the transaction usually goes toward paying a tax obligation. It is generally not the intent of independent sponsors or their financing partners to get rich off of deal fees.
Independent sponsor deal fees or transaction fees usually range from 1% to 4% of the enterprise value of the business being acquired. In certain cases, the fees may be a fixed dollar amount, usually ranging from $100,000 to $1,000,000. Generally, a meaningful portion of this fee will be reinvested back into the deal, although it may be paid fully in cash at closing or rolled entirely.
Transaction Fee = Fee % x Enterprise Value. For example, if the agreed upon deal fee is 3% and the Enterprise Value is $20 million, then the transaction fee would be $600,000.
Smaller transactions (those with enterprise values under $10 million) usually receive a higher percentage of the total enterprise value, while larger transactions (enterprise values above $50 million) may receive the lower end of the transaction fee range. In some cases, fixed dollar amounts are used.
Deal fees for ACP transactions have historically ranged from 2% to 4% of enterprise value- in one case, the sponsor received $500k in cash, plus an additional profit sharing interest, which would have equated to an additional $500k in value. In some cases, the fee was paid entirely in cash, in others, the entire fee was rolled. In most cases, a meaningful portion of the transaction will be expected to be rolled back into the deal, alongside other capital providers so the sponsor has some additional vested capital, alongside other investment partners.
2. Ongoing Compensation: Independent Sponsor Management Fees or Executive Compensation (or both)
In almost all circumstances, the sponsor or executive focused on leading the deal and shepherding the company through various growth stages will be paid some sort on ongoing compensation for his or her efforts.
For the more traditional financial sponsor who takes a board-level role and regularly advises the management team, a management fee is generally the preferred form of compensation.
For sponsors or executives who take on a day-to-day operating role in the acquired company, you can expect to receive a healthy or market-based executive salary, plus benefits and bonuses.
Management fees may range from 1% to 7.5% of EBITDA, sometimes with floors or ceilings or they may be flat amounts ranging from $50,000 to $500,000+.
An example of a fixed management fee, would be quarterly payments of $75,000 totaling $300,000 annually.
In a variable management fee, the fee would be equal to the management fee percentage multiplied by the most recent quarter's EBITDA. For example, a management fee of 5% and a company whose quarterly EBITDA was $2.0MM, would be $100,000 or $2.0MM times 5%.
Management fees are a fairly common component of an independent sponsor's compensation for their efforts related to growing a business or coaching the management team through various operating initiatives. Certain types of capital providers often split the management fee with their independent sponsor counterparts, while others allow the sponsors to keep the entire management fee. For most capital partners, the payment of this fee is almost always subject to being in compliance with covenants or some other performance threshold.
Historically ACP clients have received between 5.0% to 7.5% of EBITDA as a management fee, or healthy ongoing compensation as an executive. In one case, the Sponsor was also playing an operationally oriented role and received both a management fee, as well as ongoing compensation as an executive- this is atypical. There is always a fine balance between being fairly paid for your time and efforts directly to a business versus pulling out too much cash to the detriment of the business or other shareholders.
3. Independent Sponsor Upside Participation: Promote / Carry / Carried Interest, Profit Sharing, Common Equity
The independent sponsor’s upside participation should be, by far, the largest component of their compensation package. It’s also usually the largest point of contention between independent sponsors and their private equity partners.
The most common way to structure the sponsor’s upside participation is by creating a promote or promoted interest, which is effectively a financial incentive for the sponsor or manager of an investment to achieve strong returns to the investors. A promote, for a specific transaction, is similar to the carried interest paid to the general partner of a traditional private equity fund. For most traditional PE funds, the carried interest is approximately 20%, usually paid after a return of LP capital and some sort of preferred return.
Other details on the Promote:
There are generally three important variables that are negotiated when establishing an independent sponsor’s promote structure:
the Preferred Return or the "Pref": this is the return that the investors will receive before the fundless sponsor earns a promote. Generally, the lower the preferred return, the easier it will be for the fundless sponsor to earn a promote.
Ranges: an 8% to 10% preferred return is fairly typical, although we’ve seen as low as 6% and as high as 20%.
The ranges can vary widely depending on the situation and specific capital partner(s) involved.
the Catch-Up: A catch-up is established to allow the sponsor to receive all of the profit cash flows after the investors have received their capital and a preferred-return (assuming one is in place) until the split of proceeds is equal to the target promote level at the first return hurdle. This catch-up can be calculated to include both the return of principal, just the preferred return, or both. Note that this distinction can make a meaningful impact. It is also not uncommon to see the catch-up provision excluded entirely.
The hurdle rates and corresponding promote levels: independent sponsor promote structures are often set up as waterfalls with increasing promotes to the sponsor that correspond to better overall levels of investment performance.
Preferred returns typically range from 8% to12%, although we've seen prefs as low as 6% to as high as 20%.
For carried interest structures with multiple hurdle rates, the initial hurdle rates would be equal to the pref (described above). Thereafter, hurdles may be established at either IRR (Internal Rate of Return) or MoIC (Multiple on Invested Capital) targets. We've seen IRR hurdles range from 6% to 40% and MoIC hurdles range from 1.0x to 5.0x.
We've seen promote levels range from 5% to 50%, although ranges between 10% to 30% are reasonably common. In most cases, there are multiple hurdles and promote levels that start on the lower end of that range and increase as overall investment performance improves.
Promote structures can be fairly simple (e.g., 20% promote, beyond and 8% pref) or extremely complex with numerous hurdle rates and promote levels. As the independent sponsor model has become more prevalent, it's become common for capital providers to tailor the carry structure by using at least a couple hurdles and promote levels that ratchet up as overall investment performance improves, thus better aligning the sponsor and capital providers interests.
In part, the ability to create bespoke performance-based incentive structures is a key reason why the fundless sponsor model is gaining favor among institutional investors. They can create structures that pay the sponsors relatively less for mediocre outcomes, while offering huge incentives for superior performance. Most sponsors and capital providers would agree that if an investment does well for all parties (let's say, above a 4.0x MoIC) and a huge promote is being paid, that would be viewed by all parties as a win.
This has been the area where ACP has been able to add the most value for its independent sponsor clients. In all but one of the deals that ACP completed in the last 24 months, the sponsors retained between 40% to 75% of the common equity interest on day 1. This is a dramatic departure from what would be conventionally accepted as “market norms.” In the one transaction that had a more traditional independent sponsor promote structure, there was a carried interest structure that went up to 25% of the profits after the capital provider received a 4.0x- this transaction was fairly large relative to most independent sponsor transactions ($86 million in total enterprise value).
Designing a promote or carried interest structures can be as simple or as complex as the parties desire. Often, the sponsor and capital providers are solving for the alignment of interests, meeting internal return requirements, investment duration expectations, perceived value being added by the parties or other factors.
As mentioned above, it's worth highlighting that different types of capital providers approach the fundless sponsor's carry very differently.
While there is increased transparency around independent sponsor economics, the independent sponsor capital landscape remains extremely inefficient.
While there tighter market ranges for transaction fees and management fees, the upside participation component varies widely by situation, capital provider and the independent sponsor’s approach to raising capital.
To learn more about independent sponsor economics generally, or to discuss a specific situation, please contact Greg Tobben.
Other Independent Sponsor Resources
CAPITAL RAISING FOR
Access Capital Partners is a middle market investment bank focused exclusively on raising debt and equity capital for independent sponsors, executives and family offices.
Through years of raising capital in all types of situations and environments, ACP has developed a nuanced approach to consistently and efficiently secure the capital to support independent sponsors' acquisitions and recapitalizations.
ACP prides itself on a being a trusted partner and resource in the independent sponsor community.
In total transaction experience
Years of middle market experience
Relationships with capital providers