McGuireWoods recently hosted its annual Independent Sponsor Conference in Dallas, drawing more than 1,500 independent sponsors and capital providers from 47 states and the District of Columbia and eight countries. At the conference, McGuireWoods lawyers joined independent sponsors and capital providers to share insights on industry trends and best practices for sourcing, structuring, financing and executing independent sponsor transactions.
Here are some key takeaways from this year’s conference.
The market for independent sponsor-led transactions remains robust.
This year, activity levels for lower middle market private equity deals have slowed somewhat from the record pace of 2021 and 2022 but have remained robust, as the catalysts for sellers exiting (e.g., retirement, succession, capital needs) have not been stymied by lower internal-rate-of-return projections for investors and the value independent sponsors provide has attracted investors to support such transactions. Despite this high level of activity, panelists at the conference were nearly unanimous in their opinion that deal activity in the independent sponsor market will increase in 2024.
The most attractive assets continue to transact for high multiples, but most deals are requiring more time to close.
High-quality acquisition targets continue to be sought after and transact for high multiples, but even those deals can take longer to complete than in recent years due to investors being more cautious and thorough in diligence. Lower-quality targets often are requiring even more time to close, as finding the right capital and structuring solutions is more challenging in the current, tighter capital markets.
The distinctions between independent sponsors and traditional committed private equity funds continue to blur.
The blurring of these distinctions is occurring in a number of ways:
- More independent sponsors than ever are raising traditional committed private equity funds.
- Large numbers of emerging fund managers are raising capital on a deal-by-deal basis as independent sponsors until their fundraising is complete or to cement their track record.
- Independent sponsors increasingly are using committed and quasi-committed capital pools and other fund-like structures to finance all or a portion of the equity for their transactions, whether or not they intend to raise a traditional fund in the future.
- Many fund managers have pivoted to a deal-by-deal independent sponsor model in between funds or as a post-fund strategy.
- As fundraising is taking additional time for most managers, some managers are considering alternatives such as a “proof of concept” fund of sufficient size to do a limited number of transactions.
As the independent sponsor segment of private equity continues to evolve and become more complex, the lines between independent sponsors and traditional private equity funds are likely to become less clear.
Independent sponsors and capital partners are responding to economic headwinds by implementing creative structuring solutions to get deals done.
Seller pricing expectations often have not fully adjusted to the higher cost of borrowing, and economic trends frequently have resulted in choppy profitability results and less-certain projections. Independent sponsors and their capital partners have responded by implementing creative structuring solutions:
- Including favorable seller financing arrangements where possible, such as seller notes with favorable pricing and terms.
- Larger seller equity rollover and more frequent use of a junior class of equity for the seller equity rollover.
- Frequent use of earnouts and highly structured earnout formulas.
- Sale-leaseback financing, used as another capital source to reduce overall purchase prices despite bringing potential real estate risk into transactions.
The credit markets are tighter, but capital exists for good deals and independent sponsors increasingly are looking to alternative lenders.
Even in a more difficult debt financing environment, lenders are looking for deals and willing to provide credit, but terms have tightened. Independent sponsors should expect a deep dive from their potential lenders in the underlying fundamentals of a platform opportunity as lenders work hard to identify high-quality opportunities. In response to the tighter credit markets, independent sponsors more frequently are turning to nonbank lenders, including lenders offering mezzanine and unitranche debt capital solutions. While the debt from mezzanine and unitranche lenders is more expensive than traditional senior debt, the flexibility and patience of those lenders has proven attractive in many transactions.
Delivering value and building relationships remain critical to success as an independent sponsor.
Independent sponsors need to develop their value proposition and communicate that proposition to the market of capital providers, then deliver that value following the closing. A broad spectrum of independent sponsors, based on experience and expertise, and a range of capital providers, including control-oriented investors and more passive investors, are looking for the sponsor to control and lead the deal. It is important for sponsors to identify and build relationships with the capital providers that are the right match for them.
McGuireWoods continues its leading role in supporting the independent sponsor community. If you are an independent sponsor, please join one of our peer networking groups around the country. If you are an investor interested in getting to know independent sponsors, please reach out to us and allow us to help you connect with independent sponsors. Thank you to everyone who attended ISC 2023, making it another huge success.