All posts by : Sergio van Luijk

Despite the pandemic, 2020 was a record-setting year for the wealthiest people in the world. In 2020, personal wealth surged by $5 trillion, producing more new billionaires than ever before. “Going direct” has become a trend over the last couple of years. It represents not only a shift of companies operating in the private tech and consumer space, but also a shift in family office investments. Family offices have become more sophisticated, and a passive Limited Partner (LP) structure may no longer the most practical. Wealthy families are investing directly in private companies. Direct investing happens through single-family and multi-family offices.

Today’s environment is characterized by low interest rates, unstable geopolitical conditions, and unpredictable financial markets. In this environment, wealthy families seek better returns, which often lead them to consider direct deals.

Why are direct deals appealing?

Direct deals provide greater decision-making authority, better transparency, and more control over other investment drivers. Direct investing gives family offices the opportunity to better align their objectives and interests with their investment strategies. Reduced fees and costs are also significant drivers of the direct-investment trend. Family offices have begun to broaden their networks, just like their private equity peers have done. They have done this to keep up with market trends and to stimulate proprietary deal flow. Direct deals also invite opportunities for themed collaboration, such as sustainable and impact investing. Such forms of investing are especially appealing to younger generations.

Family offices have characteristics that differentiate them from typical direct-deal investors. Direct investing has emerged as an important tool for family offices that aim for higher returns and more control. Because they are not restrained by strict mandates, family offices provide more flexibility than institutional investors. A family’s experience in a given industry can also give them an edge over the competition when chasing deal flow.

Is coinvesting sustainable?

Family offices must continue to focus on building out their platforms and budgets, just as private equity platforms do. However, the cost of this effort cannot be spread across several investors, since the office only has one client. This puts added pressure on investors to make profitable deals with high returns.

This trend shows the emergence of a new cooperative investing model in which family offices new to direct deals work with others who do have direct-deal experience. Larger family businesses are often willing to partner with smaller family offices while scaling up. Furthermore, these partnerships help disintermediate private equity funds and transfer knowledge while building a direct-deal team. Many family offices are eager to co-invest: 49% want to do more co-investing, while 44% want to maintain their current co-investing activity.

However, there are several challenges to co-investing. One of these challenges is the difficulty of identifying attractive deals. Other challenges are performing due diligence and aligning a given family office’s values and objectives with those of potential partners.

What is the best way to make direct deals?

Firstly, direct investments can be difficult. Family offices must build an in-house team to generate deal flow and provide operational support for their investments. Building a team internally can cause an inefficient use of resources. A well-considered process with assistance from external advisers can help family offices achieve desired results without committing long-term capital upfront. Family offices are often in contact with independent sponsors, investment funds, and other family offices. With the help of experts, family offices can leverage these connections profitably, helping ensure a steady deal flow.

For independent sponsors in Europe, family offices are a desirable source of capital, especially for smaller deals. The independent sponsor structure is mutually beneficial. Family offices find it appealing because they acquire controlling powers over the company’s investment terms, investment decisions, and projects.

It takes time to develop a successful direct investing strategy. Rise Point Capital advise your company about complementary partners. We support clients in areas such as strategic partnership negotiations. With our expertise and resources, we will help you find the best opportunities for your corporate strategy. We can assist you in going direct, as the current trend toward such deals is likely to endure.

Private equity helps growing businesses reach scale and new opportunities to thrive. Little wonder that it has become such an important feature of the global financial landscape: investment analysis firm Prequin estimates that private equity assets under management rose from less than $2 trillion in 2012 to nearly $4.5 trillion in 2020. In the US, private equity is no longer limited to investment firms drawing on large pools of capital.

Independent sponsors – formerly referred to as fundless sponsors – draw on their own capital and from funds raised within their networks to complete carefully chosen deals, typically no more than one per year. The independent sponsor model is beginning to take hold in Europe, particularly in the UK and the DACH region, where we estimate 150 independent sponsor groups to be currently active. Throughout Europe, independent sponsors tend to pursue transactions between € 5 million and € 100 million, with equity tickets typically ranging up to € 50 million.

Who are Independent Sponsors?

Independent sponsors are financially literate and experienced individuals with backgrounds in finance, private equity, and M&A who want to build a nest egg or develop a track record to raise a fund at a later stage. They have the skills and connections to source deals, acquire companies, and create value after closing transactions. In both the US and Europe, independent sponsorship is an increasingly popular option for experienced private equity professionals who prefer the greater autonomy and potential return made possible by independent deals.

Independent sponsor deals are structured similarly to the buyouts undertaken by private equity firms. Since independent sponsors do not rely on standing funds, they raise debt and equity when each new deal arises. However, sourcing new deals while raising capital poses significant challenges. Most pointedly, they may find it difficult to secure necessary funding on time, which can be detrimental to their reputation and ability to close future deals.

Where do Independent Sponsors Raise Capital?

There is an abundance of capital in the market, and with the current low-interest rates on bank deposits, private investors are turning to high-yield investment opportunities. From a wealth-management perspective, a balanced and diversified portfolio may include moderate exposure to private equity. However, private investors are searching for net returns higher than what traditional funds offer, as well as more flexibility and control over their investments. As a result, direct deals are becoming increasingly popular.

Direct deals offer more transparency, control, and decision-making authority (see separate article covering direct deals). This is a key reason for independent sponsors to team up with private investors to finance deals. They focus on building their networks of family offices and high-net-worth individuals so that when the opportunity arises, they can secure the equity in a timely manner.

Independent Sponsor Economics

Because the independent sponsor model is relatively new, especially in Europe, it is not supported by an industry-standard compensation plan. Generally speaking, an independent sponsor will charge a one-off payment as a transaction fee, paid when the deal is closed. The transaction fees can range between 1% and 2% of a transaction’s value. Beyond that, if an independent sponsor’s job is to manage the investment and actively oversee day-to-day operations, their compensation plan will also include a healthy salary and benefits. Active board-level advisors, on the other hand, receive a management fee. Lastly, performance fees represent the largest component of an independent sponsor’s compensation. These tend to run between 10% and 15% of realized returns. Hurdle rates typically range from 8% to 10% of IRR, depending on the sponsor’s strategy and goals.

Advantages of Independent Sponsorship

Independent sponsorship offers various benefits beyond potential financial upside. The independent sponsor model represents an opportunity for talented individuals to utilize their skill sets with a higher degree of autonomy than they would as employees of traditional private equity funds, offering the opportunity to create significant personal wealth. Private equity professionals working as employees of traditional funds may experience limited upside potential and unclear paths to partnership. By using external sources of funding, the independent sponsor model presents an opportunity to be rewarded more fully for value created.

The Entrepreneurs in Private Equity

Independent sponsors represent an entrepreneurial inflection of the traditional private equity model. Despite their relative novelty, they are acknowledged by private equity associations as a separate asset class. As the independent sponsor model becomes more mainstream, many talented individuals with backgrounds in finance are increasingly forming their own independent sponsor groups to take advantage of this exciting new model. For more information on the independent sponsor model in Europe, download our free PDF article or reach out to us to discuss financing options.

This was also published by VENTS MAGAZINE  on 01/09/2021

Independent sponsorship appeals to individual investors who have more business acumen and industry insight than investment capital. The independent sponsor model is highly flexible and constantly evolving, as are the ways that sponsors are compensated for their efforts. Although the specifics of this model aren’t widely publicized, its increasing adoption by institutional investors, family offices, and the private equity sector has generated demand for more information about its workings.

Every independent sponsor deal offers a unique compensation blueprint, designed to motivate the sponsor, satisfy investors, and distribute cash flows appropriately. To craft a compensation structure that works best for you and your investors, consider the following three types of compensation and how they work together to represent the interests of everyone involved: transaction fees, management fees, and upside fees.

Transaction Fees

These one-time fees compensate independent sponsors for their initial sourcing and due diligence efforts before any returns from the deal are realized. It is common for a significant portion of these fees to be reinvested as shares into the deal, aligning the sponsor’s capital with that of other partners. While we generally see the following ranges, it’s important to note that these rates may vary depending on the complexity and size of the deal. The fee could also be influenced by the sponsor’s track record, market conditions, and geography:

• In the US, transaction fees of 1%-4% of the enterprise value, which can be the cumulative result of a series of smaller charges.
• In Europe, a sourcing fee of 1%-2% of the equity value is generally applied.

Management Fees

These fees acknowledge the pivotal role of independent sponsors in promoting business growth and steering management. Management fees are contingent upon the sponsor’s engagement, specific contractual arrangements made with capital providers, and may also be influenced by regional variations:

• In the US, these fees are typically based on a percentage of EBITDA, ranging between 2%-8% p.a. This range is often combined with a floor and a cap, or simply a floor. Some structures may include a fixed fee in addition to or in place of a percentage-based fee.
• In Europe, the fees, typically calculated as a percentage of the required equity, range between 0.5%-1.5% p.a. This percentage may increase to 1.5%-2.0% p.a., e.g. in the case of ultra-high-net-worth individual and small family office investors.

Certain capital providers might split the management fee with independent sponsors, while others permit the sponsors to keep the entire amount. Any management fee structure must maintain a balanced approach to compensation. Sponsors should be fairly rewarded for their contributions, but excessive withdrawals can harm the business and, by extension, diminish the value of investments made by other shareholders. Crucially, a restrained approach to management fees underpins the principle that a significant portion of the independent sponsor’s compensation should come in the form of upside fees that align with value creation.

Upside Fees

The most intricate and hotly debated part of a sponsor’s compensation is the upside fee. Directly linked to the investment’s returns, this fee comes into play in the case of a liquidity event such as a company sale. It allows for customized arrangements that cater to the distinct needs of both sponsors and capital providers.

Understanding Promoted Interest

For independent sponsors, the promoted interest (“promote”), which is a portion of an investment’s proceeds received after compensating the investors, is paramount. The promote is akin to the carried interest seen in private equity funds. While a 20% carry has become the norm, transactions led by independent sponsors often show greater variation.

Example

Let’s consider an independent sponsor who leads a deal with a $1 million investment from a capital provider. The agreed-upon promote is 15%. Following a successful exit, the investment’s value grows to $2 million. After returning the initial $1 million to the capital provider, $1 million remains as available proceeds. In this scenario, the sponsor’s promote would be 15% of this $1 million, equating to $150,000.

Variations in the Promote

The typical promote range in most deals is between 10%-15%. This can vary significantly based on factors such as the risk profile of the investment and the independent sponsor’s negotiating power. Deals with significant upside potential and sustained effort by the sponsor (e.g. buy-and-build strategies) may warrant a promote exceeding the 20% mark. Furthermore, the promote rate is significantly influenced by the industry of the target company and its operational scale. Specifically, a transaction involving a high-growth sector and a company whose operations are not yet sizable enough to capture the attention of traditional private equity firms could warrant a higher promote.

Even more complex is the way promotes are structured, including how independent sponsors qualify for them. Several factors can come into play here: preferred return (the “pref”), catch-up, and hurdle rates.

Preferred Return

The pref defines the return paid to investors after they have recouped their initial investment capital and before any payments are made to the independent sponsor. Essentially, it serves as a hurdle at which the sponsor begins to earn performance fees toward achieving the promote.

While 8%-10% is a common range for prefs in the US and Europe, specific factors like the investment horizon, market volatility, and sponsor track record can lead to variations. The lower end of that range is often seen in buyout transactions; in deals geared toward providing growth capital, higher prefs are more common. In some instances, we have observed prefs as high as 12% or more.

Generally, lower prefs favor independent sponsors—with one notable exception. When an independent sponsor chooses to receive transaction fees as investment shares instead of cash, the pref offers an opportunity to add value to these contributed fees. This occurs before the major portion of the sponsor’s performance-based compensation starts to accumulate.

Catch-Up

The Catch-Up Mechanism

The pref benefits investors by ensuring they receive their initial capital and a certain return before other financial considerations come into play. To balance the scales, the catch-up enables the independent sponsor to receive all subsequent returns—usually 100%—until the distribution levels align with the effective agreed-upon promote rate, assuming that the capital provider has already achieved their designated preferred return.

Example

Suppose an independent sponsor negotiates a deal with a 10% pref. Once the investment makes a 10% return, the catch-up mechanism kicks in. If the agreed-upon promote level is 20%, the catch-up will work to ensure the sponsor receives 20% of all proceeds, starting from the first dollar earned. So, let’s say the investment generates $100,000 in returns.

• First, $10,000 goes to the investor to meet the 10% pref.
• Next, the catch-up mechanism channels the subsequent proceeds to the sponsor until they ‘catch up’ to having 20% of the total proceeds.
• In this example, the sponsor would receive the next $20,000 to catch up and reach the 20% level.
• After the catch-up, proceeds would then be distributed according to the agreed-upon 20% promote level for the sponsor and 80% for the investor.

Essentially, the catch-up mechanism accelerates the sponsor’s earnings to reach the pre-agreed 20% promote level once the pref is met.

Variations in Catch-Up

Depending on the specifics of the agreement, the catch-up calculation may take into account one of two things or even both: the repayment of the initial capital invested and/or the predetermined percentage return on that investment. The catch-up is an optional feature and is sometimes difficult to negotiate in smaller deals and those organized by novice independent sponsors. While optional, the presence or absence of a catch-up can significantly affect the sponsor’s total compensation. It’s often a key negotiation point, especially in more complex or larger deals. Whether or not a catch-up clause exists, every agreement should clearly outline the rate at which sponsors are paid following the meeting of the pref.

Hurdle Rates and Resulting Promote Levels

Promote structures can vary widely in their complexity, offering options for multiple thresholds and rates. As the independent sponsor model matures, there is a trend toward increasingly intricate compensation frameworks. These usually feature a variety of hurdles with escalating promote rates, aiming to better align the interests of sponsors and capital providers. Institutional investors value this flexibility, as it allows them to craft tailored, performance-based agreements.

Beyond the pref, which is typically the first hurdle rate if included in the package, tiered systems designed to motivate performance throughout the investment lifecycle may come into play. These systems include various hurdle rates, often determined by IRR or MoIC values. For instance, an initial 8% pref could be followed by a 20% promote if an IRR of 15% is achieved. Generally, IRR thresholds range between 6% and 40%, while MoIC thresholds vary from 1.0x to 5.0x.

Distribution mechanisms in these deals often follow a “waterfall” model, where the abovementioned thresholds determine the distribution of proceeds to each stakeholder.

Example

For instance, after meeting the initial 8% pref, the sponsor may be entitled to 20% of any additional gains. If another performance hurdle is crossed—let’s say, an IRR of 20%—the sponsor’s share could increase to 30% or more. Although percentages typically lie between 10%-30%, some deals do allow for wider variation based on risk profile, industry, and other factors.