The Basics of Independent (Fundless) Sponsors in M&A

Jacob Orosz headshot
by Jacob Orosz (President of Morgan & Westfield)

Executive Summary

What Is an Independent Sponsor?

  • An independent (aka fundless) sponsor is an individual or group of individuals seeking to acquire a company but who have not raised the equity committed to the transaction in advance.
  • Independent sponsors represent approximately 5% to 10% of buyers in the lower middle market.

Who Are Independent Sponsors and Their Investors?

Independent sponsors often come from the same backgrounds as private equity investors or investment bankers but prefer to invest on a deal-by-deal basis, as opposed to through a fund structure such as private equity (PE). Most independent sponsors consist of two to three principals (solo sponsors are less common) with strong track records and access to capital to acquire companies.

The limited partners (or investors) of an independent sponsor usually come from the same investor pool as private equity firms – hedge funds, other PE firms, family offices, wealthy individuals, fund-of-fund investors, insurance companies, university endowments, and lenders.

Independent Sponsors vs. Private Equity Firms

Independent sponsors operate similarly to PE firms with one primary exception – instead of raising capital in advance in the form of a fund from a group of investors, they first locate a potential acquisition and then seek to raise the equity capital. They do this on a deal-by-deal basis as opposed to accessing a fund, which is how private equity operates.

Independent Sponsors vs. Search Funds

Independent Sponsors:

  • View themselves as investors and view a transaction as one of many potential investments.
  • Continue as investors after the acquisition and build a management team to run the company.
  • Are usually seasoned PE professionals, investment bankers, or industry professionals.

Search Funds:

  • Take an active, full-time role as CEO in the companies they acquire.
  • View themselves as operators and entrepreneurs.
  • Are often younger, recent college graduates looking to acquire their first business.

Benefits of Independent Sponsors to Investors

The independent sponsor model is attractive to investors for a variety of reasons. This approach offers independent sponsors:

  • More control over investment decisions.
  • Greater flexibility in decision-making.
  • No fees on uncommitted capital.
  • More flexible time horizons.
  • Greater transparency.

Targeted Transaction Size

Most independent sponsors look for acquisitions with an enterprise value of $5 million to $75 million or companies with EBITDA ranging from $1 million to $10 million. Because it’s often difficult for them to compete against PE and strategic buyers, ISs prefer deals that aren’t overly shopped or sold through a competitive auction.

Should You Sell to an Independent Sponsor?

The primary upside is the increased flexibility and speed an independent sponsor can offer. Because they aren’t investing from a fund, they aren’t tied to its limitations and can structure their transactions in ways best suited to the particular target and focus on one deal at a time.

The primary downside is that independent sponsors don’t have the equity capital raised in advance, meaning there’s a risk they won’t raise the capital necessary to complete the transaction. Due to the downsides, sell-side advisors generally avoid working with ISs if private equity or corporate buyers have interest. Independent sponsors have a reputation for not being able to get a deal done, and many M&A advisors hold a negative bias against them.

Benefits of Selling to an Independent Sponsor

Additional benefits of selling your business to an independent sponsor include:

  • Decision-making is independent of other pooled investments
  • Independent sponsors are generally experienced operators
  • Access to “smart” money and creative deal structuring
  • ISs are typically very involved in the operations of the companies they acquire
  • ISs are willing to pay extra attention to the needs of a seller

The Deal Process

There are two main ways independent sponsors organize a transaction:

  1. They include investors early in the process and work closely with them throughout, or,
  2. They run the search process themselves and only include investors in the later stages of the deal.

Screening an Independent Sponsor

Sellers should diligence the IS’s funding sources early in the process so they don’t waste time with a buyer who can’t execute a transaction. Ask the independent sponsor the following questions:

  • Who does your investor base consist of?
  • Do you have any informal commitments from investors?
  • What are your personal relationships with your investors?
  • What is your track record of financing and exiting deals?
  • What is your related industry experience?
  • How much of your own capital are you able to contribute?
  • What operating value will you add to the company?

How Do Independent Sponsors Get Paid?

While economics vary from deal to deal, they consist of three components:

  1. Closing Fee: 1% to 5% of the enterprise value (up to 7% for smaller transactions). Most ISs reinvest the closing fee into the deal to show the investors they have skin in the game.
  2. Management Fee: 3% to 7% of EBITDA is paid for the IS’s continued management of the company after closing.
  3. Carried Interest: 10% to 25% carried interest, which is equity paid upon exit in the event the investment exceeds specified hurdle rates (usually an 8% hurdle rate).

Financing the M&A Transaction

Independent sponsors usually finance a transaction in the following ways:

  • Their own capital contribution, which varies from 1% to 10% of enterprise value
  • Money raised from investors
  • Debt
  • Seller notes, earnouts, or other forms of contingent payments.

Introduction

As a business owner looking to take your company to market and attract the right investor to acquire it, you’re likely considering all kinds of interested parties. One important type of investor that may come knocking is the independent sponsor (IS).

In this article, we’ll help you navigate your relationship with independent sponsors and their limited partners (LPs) – who they are, where they come from, what their investment strategy looks like, and what you can expect in terms of fees, attitudes, and of course, risks when dealing with this emerging force in the world of M&A.

What Is an Independent Sponsor?

An independent sponsor – sometimes called a “fundless” sponsor – is an individual or group of individuals seeking to acquire a company but who have not raised the equity committed to the transaction in advance. In our estimation, independent sponsors represent 5% to 10% of buyers in the lower middle market.

The History of Independent Sponsors

Independent sponsors (ISs) emerged in the early 1980s in the form of two basic models: the search fund model and the independent sponsor model. While the difference was initially somewhat blurred, they have become distinct practices in recent years.

In the 1980s, the fundless or independent sponsor model operated more like traditional private equity. They were generally highly experienced financial acquirers with extensive networks and a strong track record of past investments. Until 2008, both models were rare, but the changing regulatory and investment environment has seen a rise in prominence for the independent sponsor in recent years.

The Dodd-Frank Act brought increased regulatory scrutiny, resulting in increased costs for private equity and reduced profits passed on to limited partners. LPs found themselves seeking direct investment opportunities and more control over their deal terms, and ISs offered attractive alternatives to more traditional fund structures, such as private equity. As a result, independent sponsors became serious competitors.

Independent sponsors rose to prominence in the 1980s, targeting companies for acquisition without raising capital in advance.

Who Are Independent Sponsors and Their Investors?

Independent sponsors often come from the same backgrounds as private equity investors, and many have a history in PE or investment banking but prefer to invest on a deal-by-deal basis, as opposed to through a fund structure such as private equity. Not limited by the constraints of a particular fund, independent sponsors come in many forms, from Fortune 500 executives to PE professionals to upper management looking to buy out ownership. Most ISs consist of two to three principals with strong track records and access to capital to acquire companies. Solo sponsors are less common.

Independent sponsors generally come from three main areas:

  1. Private equity professionals who want to transition from a committed capital model to a deal-by-deal model, which enables them to be more involved in the business and reap greater financial rewards.
  2. Investment bankers who want to build equity and move to more active ownership and development roles in the companies they represent.
  3. Industry experts and ex-C suite executives who seek increased financial rewards through equity ownership and who bring valuable industry expertise to the businesses they acquire.

The limited partners (or investors) of an independent sponsor usually come from the same investor pool as private equity firms – namely hedge funds, other PE firms, family and friends, family offices, wealthy individuals, fund-of-fund investors, insurance companies, university endowments, and lenders. PE firms are particularly interested in investing with independent sponsors for an under-the-radar, and thus less competitively-shopped, deal.

After locating a target, independent sponsors tend to rely on existing relationships they may have with their investor base – such as family offices, private equity firms, university endowments, insurance funds, pension funds, and mezzanine debt – to fund the acquisition. Ideally, the sponsor forms such relationships before they reach out to potential acquisition targets.

Independent sponsors are seasoned professionals from private equity, investment banking, or industry with a strong network of investors to partner with.

Independent Sponsors vs. Private Equity Firms

Independent sponsors operate similarly to PE firms with one primary exception – instead of raising capital in advance in the form of a fund from a group of investors, they first locate a potential acquisition and then seek to raise the equity capital. They do this on a deal-by-deal basis.

Private equity firms operate by raising funds with lifespans of 10 to 12 years and typically acquire 10 to 12 companies for each fund they raise. In the traditional PE model, the firm asks its network of investors to commit to a blind fund with no control over individual investments and with a defined time horizon of seven to 10 years.

Independent sponsors approach their potential investor group to gauge interest in a particular target company. Instead of investing in a fund, the IS’s limited partners invest directly into the company being acquired. Unlike a PE firm’s fund strategy, an IS and their partners invest wherever they see fit. We see many individuals who are either independent sponsors for life or who see it as a path to raising a more traditional fund.

Independent Sponsors vs. Search Funds

  • How do they view themselves?
    • ISs view themselves as investors.
    • Searchers view themselves as operators.
  • What role do they play in the company post-acquisition?
    • ISs continue as investors after the acquisition and build a management team to run the company.
    • Searchers take an active, full-time role in the companies they acquire, usually becoming CEOs.
  • What are their backgrounds?
    • ISs are usually seasoned PE professionals, investment bankers, or industry professionals.
    • Searchers are often younger, e.g., recent college graduates looking to acquire their first business.
  • How do they view the transaction?
    • ISs view a transaction as one of many potential investments.
    • Searchers view the transaction as an entrepreneur, especially when becoming the CEO.
  • What are the economics of the transaction?
    • ISs receive common equity through 10% to 30% carried interest, subject to performance-based hurdles, usually a multiple of invested capital (MOIC).
    • Searchers receive 20% to 30% of common equity subject to three tiers of vesting: ⅓ at closing, ⅓ in 4 to 5 years, and ⅓ that is performance-based, subject to internal rate of return (IRR) hurdles.
  • Do they take closing fees?
    • ISs may take 1% to 5% of the enterprise value as a closing fee.
    • Searchers do not commonly take closing fees.
  • Do they receive a management fee or salary?
    • ISs receive a management fee of 3% to 5% of EBITDA, paid on a quarterly basis, and subject to a minimum (floor) and a maximum (cap).
    • Searchers receive a salary ranging from $150k to $450k in addition to the equity they’re granted.
  • Do they have board seats?
    • ISs usually control two to three seats of a five-seat board.
    • Searchers usually control one seat of a five-seat board.
  • How much time are they required to commit?
    • ISs are required to commit a minimum amount of time to the companies they acquire.
    • Searchers are required to devote all of their business time to the companies they acquire.

Independent Sponsors and Family Offices

Family offices are increasingly taking more active roles in their investments and are partnering more frequently with independent sponsors due to the greater control an IS allows. Family offices differ from other investors in several ways, which makes them highly suitable partners for ISs. Family offices:

  • Prefer longer hold times.
  • Typically, do not make drastic changes to the management team.
  • Tend to invest in industries in which they have experience.
  • Prefer to avoid auctions and like to close quickly.
  • Tend to be open to minority investments and are willing to leave control to others.
  • Like to add value to the companies they invest in by lending their industry experience or professionalizing the company.

The Recent Surge in Independent Sponsors

There’s been a proliferation of independent sponsors in recent years. The model has become more accepted, and more capital is now available to support it. The biggest challenge for independent sponsors is finding solid companies at attractive valuations.

Independent sponsors are also playing a growing role in M&A, especially in the lower middle market where multiples are lower, competition is less intense, and the upside potential is considerably higher.

The following are more reasons for this recent growth:

  • Capital providers benefit from greater control and the ability to decide which companies to invest in, as opposed to the limitations presented by PE funds.
  • The investor marketplace is highly institutionalized and segmented, resulting in the growth of deal-specific fundraising. Capital has been more difficult to raise in the form of pooled vehicles, especially for newer entrants or those without a strong network of investors.
  • Most institutional investors are constrained by concentration limits (usually 10%) and minimum check sizes (usually $50 million). For them, the fund would need assets under management of at least $500 million.
  • Many ISs have been able to adapt nimbly to unpredictable market conditions and challenges such as COVID-19, whereas many pooled investment vehicles are less flexible due to their long-term fund structures.
  • Independent sponsors prefer to avoid the setup and management headaches of raising a fund. This suits investors who seek to reduce management fees, avoid fees on uncommitted capital, and break out of restrictive time horizons set by 10-year fund vehicles.

Benefits of Independent Sponsors to Investors

The independent sponsor model is attractive to investors for a variety of reasons. The primary benefits include:

  • More control over investment decisions. Investors have a greater opportunity to voice their opinions over each specific investment, including fees and economics. There is usually only one investor per transaction, so they can have a significant say in how the deal is structured.
  • Greater flexibility in decision-making. Investors can select which companies to invest in on a deal-by-deal basis, giving them greater freedom than partnering with a PE fund.
  • No fees on uncommitted capital. Management fees aren’t charged until an investment is made, unlike PE firms, which charge management fees before capital is deployed.
  • More flexible time horizons. Money isn’t tied up in a fund with a finite lifespan but can opportunistically match investments.
  • Greater transparency. Investors benefit from greater transparency since they’re likely the only investor and are more involved in the investment process.

Targeted Transaction Size

Most independent sponsors look for acquisitions with an enterprise value of $5 million to $75 million or companies with EBITDA ranging from $1 million to $10 million. It’s likely that the enterprise value targeted by ISs will continue to increase over the coming years as the cost of debt increases, the model gains wider acceptance, and private equity firms continue to target larger companies.

Because it’s often difficult for them to compete against PE and strategic buyers, ISs prefer deals that aren’t overly shopped and sold through an auction. Their preference is proprietary deal flow, which almost always yields favorable economics and ensures they don’t overpay.

Should You Sell to an Independent Sponsor?

The primary upside in selling to an independent sponsor is the increased flexibility and speed they can offer. Because they aren’t investing from a fund, they aren’t tied to a fund’s limitations and can structure their transactions in ways best suited to the particular target and focus on one deal at a time.

The primary downside, on the other hand, in selling to an individual sponsor is that they don’t have the equity capital raised in advance, meaning there’s a risk they can’t raise the capital necessary to complete the transaction. Additionally, since the IS generally doesn’t receive any fees until the deal closes, they’ll wait for the limited partners to commit before they invest their money into performing due diligence.

Due to these downsides, sell-side advisors generally avoid working with ISs if private equity or corporate buyers have interest. Independent sponsors have a reputation for not being able to get a deal done, and consequently, many M&A advisors hold a negative bias against them.

There are additional benefits to selling your business to an independent sponsor:

  • Decision-making is independent of other pooled investments if you roll over your equity into the new company since the new company will be independent of a fund. As a result, the time frame to sell can be made independently of a fund lifespan and can instead be based purely on the ideal time to sell.
  • Independent sponsors are generally experienced operators, so ISs can provide an exit opportunity to a business owner and take over the operations and management. In many cases, traditional PE firms require the owners to stay active in the business.
  • Owners can gain access to “smart” money if they are looking to retain ownership in their business. It’s wise for these owners to partner with investors who bring not only money but smart money, i.e., experience and access to a vast industry network. Most independent sponsors provide active support on day-to-day operations and can contribute to the growth of a company.
  • Independent sponsors are typically very involved in the operations of the companies they acquire, while the classic fund manager would take a board seat and get involved only on the surface level a couple of times a year. Independent sponsors tend to be much more engaged with sellers, involving them in succession planning and deciding future growth plans.
  • More attention is focused on the seller since deal sponsors must be attentive to the needs of a seller and their reasons for selling. The risk of a broken deal is higher for a sponsor, and as a result, sponsors place personal capital at risk to cover financial, legal, and other due diligence costs in the event a seller walks away. The result is that ISs are often willing to pay extra attention to the needs of a seller.
  • Creative deal structuring is more prevalent since, with no outside investment mandates, independent sponsors have the flexibility to set terms that can make the most sense for sellers.

Despite the positives of selling to an independent sponsor, remember the major drawback – the risk that they won’t be able to raise the funds to close the deal. For this reason, it’s critical that you do your homework on an independent sponsor before partnering with them.

Independent sponsors offer sellers experience, flexibility, and involvement, but they come with the risk of raising capital later in the process.

The Deal Process

How Independent Sponsors Work With Investors

There are two main ways independent sponsors organize a deal:

  1. They include investors early in the process and work closely with them throughout. The investor will become involved in negotiating the letter of intent, valuation, performing due diligence, etc. This approach is best for ISs who may lack M&A or deal-making experience. They’ll usually identify sources of capital well before they begin their search.
  2. They run most of the process themselves and only include investors in the later stages of the deal. This approach is best for ISs with significant M&A and deal-making experience who prefer to operate autonomously. The investors must also be comfortable delegating deal execution and due diligence to the IS. If the IS follows this model, it’s critical they get the valuation right because they won’t be able to find an investor willing to commit to the wrong deal structure or valuation.

Screening an Independent Sponsor

While many independent sponsors are experienced or reputable, some are less so. Perhaps they were fired from a PE firm for doing something less than ethical, or perhaps they make bold claims about their network in your industry or their potential investor base when the reality is superficial relationships and shallow pockets.

The risk is always that they submit a letter of intent with an attractive purchase price but can’t convince any of their investors to fund the deal. Sellers should diligence their funding sources early in the process so they don’t waste time with a buyer who can’t execute a transaction.

We recommend asking the following questions of an independent sponsor when verifying them:

  • What does your investor base consist of?
  • What other types of investors do you plan to approach?
  • Do you have any informal commitments from investors?
  • What are your personal relationships with your investors?
  • What is your track record of financing and exiting deals?
  • How many acquisitions have you completed?
  • What is your related industry experience?
  • How much of your own capital are you able to contribute?
  • What operating value will you add to the company?

Make sure your independent sponsor is as good as they say. Diligence their track record of investments and their relationships with investing partners.

Selling to Independent Sponsors: The Financial Structure

How Do Independent Sponsors Get Paid?

While the fee structure is quite standard, the economics can vary greatly from deal to deal. The general economics for an independent sponsor consists of three components:

  1. Closing Fee: The closing fee is 1% to 5% of the enterprise value (up to 7% for smaller transactions) and is paid to the IS for their role in finding the opportunity, structuring the transaction, and closing the deal. Most ISs reinvest the closing fee into the deal to show the investors they have skin in the game. Independent sponsors contribute an executed letter of intent to the investment vehicle as an in-kind contribution in exchange for an equity interest. The IRS considers this to be a tax-free contribution of appreciated property and not subject to income tax. An IS may be required to invest additional capital into the transaction in addition to the closing fee.
  2. Management Fee: The management fee is usually 3% to 7% of EBITDA and is paid for the IS’s continued management of the company after closing.
  3. Carried Interest: An IS’s primary motivation is receiving carried interest, which serves to align their interests with the investors’. Carried interest is equity paid upon exit in the event the investment exceeds specified hurdle rates (usually 8%). Carried interest means that investors must receive an 8% return on their investment before the IS receives their carried interest. The majority of carried interest percentage falls within 10% to 25%. An IS receives zero carried interest until the investor has met the specified hurdle rate.

Financing the M&A Transaction

To increase potential returns, it’s common to employ debt to add leverage when acquiring a company. To increase the attractiveness of the deal to LPs, independent sponsors will often have connections with lenders involved in the process.

Independent sponsors usually finance a transaction in the following ways:

  • Their own capital contribution, which can vary from less than 1% to more than 10% of enterprise value
  • Equity capital raised from the investor base
  • Debt capital
  • Seller notes, earnouts, or other forms of contingent payments

Legal Structures for Independent Sponsors

The most common deal structure involves the creation of an LLC in which the independent sponsor and the investors will invest their funds. The LLC is structured and taxed as a partnership, and the relationship between the IS and investors is governed by the LLC’s operating agreement.

The independent sponsor model has one primary advantage over the general partner’s (GP) model that is commonly seen in the private equity world – the lack of funds under management allows for fewer administrative obligations and costs associated with accounting, compliance, and regulation.

Conclusion

Now that you’re aware of the pitfalls and (checkable) promises of a typical independent sponsor, they can form a meaningful part of your selling strategy. You know when and where they raise their capital, what a healthy deal consists of, and how they match up against other types of investors in the field.

Most importantly, if you receive a letter of intent from an independent sponsor, that means one of the most entrepreneurial and experienced players in the market believes in your business. The lack of guaranteed funding is both a risk and a show of massive faith because now they’ll need to convince their closest allies of your worth.