Independent sponsors to benefit from ‘equity cannon’ aimed down-market

15 October 2019

Independent sponsors are emerging as uniquely positioned participants in the middle to lower middle market, according to panelists at the McGuireWoods Independent Sponsor Conference.


Ballooning valuations continue pushing capital down-market, a phenomenon that has opened the door for independent sponsors to bring creatively-sourced, proprietary deals in the middle and lower middle market to traditional private equity firms, said experts at the event held last week in Dallas.


“The cannon of equity capital pointing toward the lower middle market and middle market isn’t pointed anywhere else,” said Nick Russell, a partner at Tuckerman Capital, which partners with independent sponsors to invest in industrial companies. As evidence of the growing interest in the space, McGuireWoods partner David McLean noted that attendance at the event has tripled since 2017, its inaugural year.


Panelists agreed that there are plenty of sub USD 10m EBITDA companies looking for investors, but sifting through those opportunities takes time and effort. Richard Baum, managing partner and co-founder of independent sponsor Consumer Growth Partners, described the lower middle market deal landscape as a fragmented, “wild, wild west” – a place where independent sponsors can serve a valuable role.


Independent sponsors, which raise capital on a deal-by-deal basis to acquire businesses, are at once helping coffers of dry powder find homes while diffusing the risk of having to find equity for transactions. Several speakers at the event were careful to note that independent sponsors are phasing out the term “fundless sponsor,” a linguistic evolution that seems to mimic the development of these dealmakers.


Michael Arguelles, a managing director at private equity firm Stonehenge Partners, said independent sponsors “bring us deals we would never see otherwise”. Stonehenge has approximately USD 1bn of capital commitments, and its investments range from USD 5m to USD 50m, according to its website


Most of the transactions independent sponsors chase tend to be lightly-shopped, Arguelles continued, noting the similarities in strategy between the two types of sponsors. “It’s harder to create value post-closing when you’re in a frothy process being run by a bulge-bracket investment bank.”


Without an established fund to pull from, independent sponsors should be establishing relationships with potential equity sources as soon as possible, especially as the risk of an economic recession continues to loom, panelists said.


But even in the face of a correction, the panelists agreed that independent sponsors would be particularly well positioned. “The deals that will be done in a recession will play to the strengths of the independent sponsor,” said Baum, adding that “those deals will have some hair on them.”


Independent sponsors can be nimble, taking advantage of the ability to court varying pockets of capital to fund deals, NCK Capital Managing Partner Grant Kornman told Mergermarket on the sidelines. They also are becoming more refined with expertise, many having spawned from traditional private equity firms, investment banks, or ex-operators. NCK is an independent sponsor focused on lower-middle market businesses.


An established independent sponsor with at least one deal under its belt feels less pressure to get a transaction done and can afford to pass on deals they perceive as overvalued or illogical, said Chris Sheeren, partner at independent sponsor Longhouse Partners. Sheeren was a partner at private equity firm Huron Capital before helping start Longhouse in 2018.

“There’s no outside pressure saying, ‘Gosh, I’ve got to get a deal done or my LPs are going to be breathing down my neck’,” Sheeren told Mergermarket. “And the nice thing is, in theory, we can tailor the equity solution and the equity partner to what the seller wants. If a seller is very nervous about bringing in a private equity group who they know will want to sell their stake in four to five years, maybe we’d bring in a family office [who would hold for longer.]”


In a hyper-competitive market, sector specialization is one way to demonstrate value to targets and capital providers, said Baum. He cautioned that generalist independent sponsors “frequently run the risk of being treated as a glorified broker,” stressing the importance of differentiation.


Independent sponsors are also in the hot seat to demonstrate consistency with deal track records. Haran Narulla, partner at independent sponsor Tygon Peak Capital, said capital providers often question how a transaction fits with what a firm has done historically. If, for example, an independent sponsor pivots dramatically from a focus on growth equity investments to turnaround acquisitions, this could be viewed negatively by a capital provider, he said.


As the independent sponsor community grows – and grows more credible – panelists said the model will persist as long as entrepreneurs and investors are interested in building their own businesses. Conference speakers and attendees agreed that independent sponsors are ready to break the buyer binary of strategic and private equity.


“We [independent sponsors] will truly have arrived when we’re treated as a separate asset class,” said Baum.