What Is an Independent Sponsor in Private Equity?
Unpack the distinct model of independent sponsors in private equity, understanding their approach to deal origination and successful transaction execution.
Private equity involves investing capital into private companies to increase their value and sell them for profit. Independent sponsors have emerged as a distinct and relevant participant within this investment landscape. This article explores the independent sponsor model, outlining their operational approach, contributions throughout an acquisition, methods for securing capital, and compensation. This model offers insight into a flexible approach to private investments.
Understanding the Independent Sponsor Model
An independent sponsor is an individual or a small group of professionals who seek to acquire a company without possessing a committed pool of capital beforehand. Unlike traditional private equity firms that raise large, institutional funds with a fixed lifespan, independent sponsors identify a potential acquisition target first. They then proceed to raise the necessary equity capital for that specific deal on a transaction-by-transaction basis. This approach is often referred to as a “fundless” model because it bypasses the conventional structure of managing a blind fund.
Independent sponsors come from backgrounds in private equity, investment banking, or possess extensive industry expertise. Their operational model allows for greater flexibility, as they are not constrained by the predefined investment mandates of a larger fund. This enables them to pursue diverse opportunities across various sectors and transaction sizes.
This model offers a different pathway for experienced professionals to engage in direct investments. They operate with leaner overhead compared to traditional private equity firms. This structure allows for a more focused and tailored approach to each investment, appealing to both sellers and capital providers.
The independent sponsor model represents a convergence between traditional private equity and the discipline of raising capital for individual deal acquisitions. This distinguishes them from search funds, which involve an individual or small team raising capital to search for and operate a single company. Independent sponsors, conversely, view themselves as investors seeking multiple potential investments and build management teams to run acquired companies.
The Independent Sponsor’s Role in a Transaction
The independent sponsor initiates the transaction lifecycle by sourcing and identifying potential investment opportunities. This involves leveraging their professional networks, industry contacts, and proprietary outreach efforts to find companies not widely marketed for sale. They target businesses in the lower middle market, which have an enterprise value ranging from $5 million to $75 million, or an EBITDA between $1 million and $10 million.
Once a prospective target company is identified, the independent sponsor engages in preliminary due diligence. This involves an assessment of the target’s financial health, operational strengths, and market position. They conduct an in-depth review of financial statements to identify trends and potential areas for improvement.
During this pre-Letter of Intent (LOI) phase, the sponsor also begins to negotiate preliminary deal terms with the target company’s management and founders. They develop a potential post-transaction growth strategy and evaluate various capital structures that could be used for the acquisition. This stage requires a deep understanding of the business and its industry to formulate a compelling investment thesis.
Following the execution of a Letter of Intent, the independent sponsor intensifies the due diligence process. This involves an evaluation of legal and regulatory compliance, assessing the management team’s capabilities, and a market analysis. The sponsor aims to identify any potential risks and works to mitigate them through various negotiation tactics.
Capital Raising and Deal Execution
After identifying a suitable acquisition target and conducting initial due diligence, the independent sponsor focuses on securing the necessary capital. This process involves presenting the investment opportunity to a network of capital providers. These providers include family offices, high-net-worth individuals, other private equity firms, hedge funds, and institutional investors who invest on a deal-by-deal basis.
Capital is raised through an ad-hoc arrangement for each specific transaction, rather than drawing from a pre-existing fund. The independent sponsor prepares investor teasers and information memoranda to outline the opportunity. They then engage in discussions with interested parties, negotiating equity and debt underwriting terms to solicit term sheets.
To execute the deal, the independent sponsor establishes a single-asset limited liability company (LLC) or a similar partnership structure for the acquisition. This entity serves as the investment vehicle, through which both the independent sponsor and the capital partners contribute their funds. The independent sponsor contributes a portion of their own capital, demonstrating their commitment and aligning interests with investors.
Financing for the acquisition includes a combination of equity capital raised from investors, debt capital from lenders, and sometimes seller notes or earn-outs. The operating agreement of the newly formed LLC or partnership governs the relationship between the parties and outlines the independent sponsor’s role post-closing. This structure allows for a flexible and customized approach to financing each unique transaction.
Compensation Structures for Independent Sponsors
Independent sponsors are compensated through a combination of fees and equity participation, reflecting their involvement throughout the deal lifecycle and their commitment to value creation. A common compensation component is a closing fee, also known as a transaction or acquisition fee. This one-time payment is earned upon the successful completion of the acquisition.
Closing fees range from 1% to 5% of the enterprise value of the acquired business, though they can be up to 7% for smaller transactions. A significant portion of this fee is reinvested by the independent sponsor into the deal, demonstrating their commitment to the investment. While this fee helps cover the sponsor’s upfront costs, it is taxed as ordinary income unless rolled into equity.
Another form of compensation is a management fee, paid for the independent sponsor’s ongoing involvement in the acquired company after closing. This fee compensates them for providing strategic guidance, board oversight, or even taking an operational role. Management fees are calculated as a percentage of the target company’s earnings before interest, taxes, depreciation, and amortization (EBITDA), ranging from 3% to 7% annually.
The third and most significant component of an independent sponsor’s compensation is carried interest, also known as a “promote” or equity participation. This represents a share of the profits generated by the investment upon a successful exit. Carried interest ranges from 10% to 25% or 10% to 30% of the profits, but it is subject to a hurdle rate. This structure aligns the independent sponsor’s financial success directly with the profitability of the investment for their capital partners.