Family offices looking for investment opportunities in the lower middle market may find them through independent sponsor transactions, a rapidly maturing space that offers direct, flexible investment options.
“In an independent sponsor model, the sponsor finds the deal and then has to raise the capital for the deal, concurrently with the closing,” says Sam Goodman, president of Five Points Family Ventures, a single-family office established to manage the assets of the Hawkins family, which owns Crown Automotive Group. “At its core, the independent sponsor world is a unique pocket of the lower middle market, in which capital is raised for transactions on a deal-by-deal basis, as opposed to through a traditional blind pool fund structure. Deals are generally for businesses that are founder-owned, or at a minimum, not owned by institutional capital.”
The ecosystem for independent sponsor transactions is developing and becoming more mature.
The market for independent sponsor deals “has grown a lot, and it is starting to become a competitive space,” says Brinda Yohannan, managing director at First Haven Capital, a New York-based private investment firm. Sometimes sponsors she speaks with tell her a deal is not available because they have all the capital underwritten already. “There is more and more capital going toward this asset class.”
There are a number of reasons for this increased interest. One is the prospect of knowing exactly what a deal will look like before investing.
“A lot of LPs [limited partners], particularly family offices, are disenchanted with the idea of giving money to a fund manager on a blind basis who then locks up the money for 10 years and finds deals to invest in,” Goodman says.
Independent sponsor transactions target deals that are not always of interest to larger firms.
“It is impractical for many middle market and above private equity firms to invest in the lower middle market because they have a certain amount of capital that they have to deploy through each of their funds,” Goodman says. “Deals below a certain size threshold just don’t make sense.”
The niche is also increasingly attractive to investment professionals.
“Investment professionals that work at investment funds generally look to carried interest as the real source of wealth creation for themselves. As fund lives drag on, with a record backlog of private-equity backed companies due to valuation mismatches, lower returns and limited LP distributions, talented private equity professionals are realizing that their carried interest may not crystallize on the timeline and at the scale they expected,” Goodman says. “And so, a lot of very talented PE professionals are leaving big firms to go and start their own independent sponsor shops — particularly those that have an entrepreneurial mindset.”
From access to expertise: benefits of independent sponsor transactions
Independent sponsor transactions can offer family offices a number of benefits:
Access to the lower middle market.
“The lower middle market, when done correctly, can offer really compelling risk-adjusted returns,” Goodman says. “There’s a lot less competition for transactions, although that is beginning to change.”
Yohannan sees similar benefits.
“We like the independent sponsor space primarily because a lot of them are focused on lower middle market deals,” Yohannan says. “They’re generally not part of an investment banking process, where someone wins the deal because they paid the highest price.”
Independent sponsor deals are often smaller than those handled by traditional private equity platforms. This makes the deals simpler — and often, there is less competition.
“Once the businesses get larger, there is usually an investment bank or a professional broker organizing the sale process, which means you’re competing with a lot of private equity groups,” says Jason Beren, CEO of single-family office the Eastbridge Group. These smaller businesses, which are often run by their founders, can offer another value enhancement opportunity if the buyer professionalizes the operations. “These are businesses that have a good team but can get better with a PE-type lens applied to them and more professional management.”
Goodman agrees that lower middle market companies can offer a lot of upside: “There is a lot more low-hanging fruit to drive value at the operating companies that are acquired,” Goodman says.
“Companies acquired in independent sponsor deals typically lack some of the institutional processes that you see at middle market and above companies, particularly those that are PE-backed,” Goodman says. “There is often a lot of opportunity to come in and establish more structured sales processes and technology initiatives. There’s usually a lot of work that can be done around the scope and accuracy and speed of financial reporting. There are usually a lot of things that founder owners can only do so well with the resources they have, such as talent or digital marketing. And so, there’s a really nice match when you bring in an institutional investor, particularly one with an operational bent, to address some of these issues.”
Transparency.
Another advantage is the lack of blind pool risk.
“When you invest with a PE platform, you’re subscribing to a fund and trusting the general partners to select and structure the new investments,” Beren says. “You must underwrite based on their historical track record and the depths of their relationships. With an independent sponsor deal, you’re able to fully underwrite the business yourself: go through all the diligence materials, run scenario analysis, and really test the management and their understanding of the deal and the market opportunity. You have a much deeper knowledge of what you’re investing in.”
Working together on deals offers an opportunity to get to know the sponsors.
“It’s hard to figure out a sponsor’s quality and how they see the world without looking at a deal together. You don’t really get that opportunity when you invest in a blind pool,” Goodman says.
Deal flow.
“We get a tremendous amount of deal flow and see smaller deals than we would otherwise: $2 million to $10 million EBITDA-type buyout opportunities,” says Rhett Madison, co-chief investment officer with The Jordan Family Office, a single-family office founded by John W. “Jay” Jordan II. “For a private equity firm, that’s such a small deal — they don’t need or want anybody else in there. There’s not enough to go around.”
Expertise of the independent sponsor.
“We find working with the independent sponsor community to be very attractive. As a family office with a lean team, we typically don’t lead transactions ourselves, but instead partner alongside like-minded investors on compelling opportunities,” Madison says. “Independent sponsors provide a strong ecosystem of partners who bring differentiated deal flow and execution capabilities, which allows us to leverage their expertise while participating in attractive investments.”
This means the expertise and skill set of the independent sponsor involved in the deal is critical.
“One of the big advantages to working with an independent sponsor is that we can invest in really interesting, high-quality companies — and we get to leverage that independent sponsor’s skill set and bandwidth and manpower,” Madison says.
Challenges of a maturing model
The independent sponsor model does have some built-in challenges — and some challenges that have grown as the field has expanded.
“One of the inherent challenges of being an independent sponsor is you find a deal and then you have to raise the capital concurrently with getting the deal closed. That’s challenging enough in itself. It also puts you sometimes at a disadvantage relative to funded sponsors if you’re competing for a deal and the seller perceives less certainty of execution,” Goodman says.
This translates to a corresponding challenge for funders.
“If you don’t have a pre-existing relationship with the sponsor, you are underwriting both the deal and the sponsor simultaneously, and typically on a pretty tight timeline. It’s a structural challenge,” Goodman says. “I think it also presents a real opportunity for groups like ours that are nimble and able to move quickly to underwrite both a partner and an underlying business.”
The surge in interest in these transactions also means that investors need to choose their independent sponsors carefully.
“The independent sponsor community has grown tremendously over the years, and I think there is a spectrum of operators: On one end, you have a deal person — a guy and his dog who has never done a deal before,” Madison says. “On the other end of the spectrum, you have highly sophisticated, highly experienced deal professionals that could have worked at the very best private equity funds but wanted to hang up their own shingle. They’re staffed up with big teams and very sophisticated. And then you’ve got everything in between.”
This means there can be a pronounced spread in quality across both investment opportunities and independent sponsors, Goodman says.
“The challenge is that it’s very hard to know whether a deal is good or a sponsor is good without doing that manual labor and spending time underwriting the deal and the manager. It’s not something that should be done haphazardly, or in a non-programmatic way,” Goodman says. “If you’re going do independent sponsor deals, you really need to commit to spending the time meeting the independent sponsor universe, understanding the business model, getting yourself immersed in the asset class and building relationships with other capital providers.”
For family offices willing to put in this work, independent sponsor transactions can be an attractive opportunity. “There is a lot of risk in this part of the market, particularly if the sponsor is not experienced, but focusing on independent sponsor transactions can provide access to a part of the private company ecosystem that it’s tough to get elsewhere,” Madison says.