By Lou Sokolovskiy, Opus Connect

The Independent Sponsor Landscape

The independent sponsor model in private equity is thriving, but it also presents unique challenges to emerging sponsors that haven’t yet closed their first deal.  In a recent interview, Bruce Lipian, Co-founder of StoneCreek Capital, shared key lessons from his 30+ years in private equity. Drawing from his extensive experience, Bruce outlined seven potentially problematic areas where emerging independent sponsors are susceptible to making mistakes, as well as advice on how independent sponsors can protect themselves from those circumstances.

1. Underestimating the Complexity of the Model/Time Required to Close the Deal

Many individuals with prior experience in private equity, investment banking, or C-level operational management assume that their prior success will readily translate into success as an independent sponsor. However, since independent sponsors are burdened with the unique challenges of (i) overcoming the seller’s skepticism regarding funding certainty and (ii) raising capital on a standalone basis (versus having access to committed capital), getting that first deal closed has a steep learning curve and will likely take far longer than expected. 

2. Failing to Protect Against Broken Deal Expenses

After the LOI is executed, many emerging independent sponsors overlook the need to protect against broken deal costs, which can reach hundreds of thousands of dollars if a deal doesn’t close after the LOI is executed. To minimize the severity of this risk, (i) include broken deal downside protection in the document that governs the economic and governance arrangement between the independent sponsor and the lead equity financing source(s) and (ii) work with accounting firms, law firms and other service providers that are open to deferring and/or discounting fees if a transaction fails to close.

3. Agreeing to Exclusivity Benchmarks in the Letter of Intent

The independent sponsor ‘Holy Grail’ is signing an LOI and securing exclusivity before the equity portion of the acquisition capital has been identified because it enables the independent sponsor to preserve its negotiating leverage with capital sources (versus being dependent on one capital source to secure the transaction). This victory can be undermined, however, if the independent sponsor agrees to exclusivity milestones in the LOI that can potentially truncate the exclusivity period if those milestones aren’t met (such as identifying its equity partner 30 days after the LOI is signed).  Be cautious about agreeing to these types of exclusivity provisions. Not only can they add unconstructive pressure, but these types of time constraints can significantly impair the independent sponsor’s ability to (i) properly package the investment opportunity and (ii) find a supportive capital provider.

4. Choosing an Equity Partner that Lacks Experience Investing in Independent Sponsor Deals. 

Be cautious about picking a private equity partner, particularly if the equity group hasn’t ever invested in an independent sponsor deal. As control-oriented investors, an equity group with that profile has a learning curve of their own and may not realize how important it is to work collaboratively with the independent sponsor after the independent sponsor grants them deal exclusivity. At that critical juncture, the independent sponsor has gained the trust of the seller, but the seller hasn’t yet established that trust with the equity group.  If (i) the private equity group and the independent sponsor aren’t functioning as mutually supportive and compatible Co-Sponsors and (ii) the equity group marginalizes the independent sponsor’s involvement during the closing process, the seller may question whether the transaction will actually close at the price and on the terms that the seller negotiated with the independent sponsor, which could put the deal itself at risk. To protect against partnering with an equity group that’s likely to behave this way, conduct due diligence on the equity firm (including asking how many independent sponsor deals the equity group has invested in and asking for references from the independent sponsors who led those deals). 

5. Choosing Legal Counsel that Lacks Experience Investing in Independent Sponsor Deals

Once the independent sponsor finds its equity partner, it’s important to incorporate the agreed upon terms into legal documentation that protects the independent sponsor. There are typically three documents that cover this aspect of the transaction:  (i) the Co-Sponsor Agreement (governs the agreed upon terms between the independent sponsor and the lead equity partner(s)), (ii) the Management Services Agreement (which governs the independent sponsor’s economics and post-closing scope of services) and (iii) the Operating Agreement (which governs the distributions).  To assure that those agreements are properly documented, (i) work with legal counsel that has experience representing independent sponsors and (ii) prepare a spreadsheet to attach as an exhibit to the documentation that lays out the waterfall distributions (this will protect against misunderstandings at exit).

6. Ineffective Packaging of the Investment Opportunity

Many emerging independent sponsors underestimate the importance of properly packaging their investment opportunity. To maximize the likelihood of securing capital, think of the package as an approval memo and dedicate a section to major risks and mitigating factors. In addition, prepare at least two sets of projections with clearly articulated assumptions (management case and a conservative base case) and incorporate both the independent sponsor economics and the management incentive plan economics into those cases. 

If the targeted investor is a private equity fund, a well-structured investment memo provides several key benefits that will enhance the likelihood of successfully raising capital:

• It relieves the independent sponsor’s advocate from having to spend significant time re-packaging the investment opportunity for the investment committee,
• It expedites the approval process, which is critical when time is of the essence,
• It anticipates and addresses the investment committee’s challenging questions, and
• It helps the independent sponsor build credibility and strengthen its relationship with the private equity firm.

7. Overcoming ‘Certainty of Close’ Skepticism

The biggest obstacle standing in the way of independent sponsors securing deal exclusivity is certainty of close.  There are two common approaches to overcoming this challenge and getting to an executed LOI: (i) lining up the equity pre-LOI or (ii) attaching support letters from credible capital sources expressing interest (but not a commitment) in financially backing the independent sponsor. In addition, there’s a third approach worth considering that can maximize the likelihood of success and flatten the independent sponsor’s learning curve:  teaming up with an experienced independent sponsor and pursuing the deal together as Co-Independent Sponsors.  There are several potential benefits from entering into this type of relationship, including:

• Access to the experienced independent sponsor’s financing network,
• Securing exclusivity (i.e. executing a Letter of Intent) before securing the financing,
• Value-added assistance negotiating economics and terms with the equity funding source, and
• Exposure to documentation that incorporates the independent sponsor safeguards described above in 5.

Final Thoughts

The independent sponsor model is both rewarding and demanding. Avoiding these seven pitfalls can significantly increase the likelihood of success. As Bruce Lipian emphasizes, mastering the art of independent sponsorship requires adaptability, strategic foresight, and strong financial discipline.

By understanding these challenges upfront, emerging sponsors can better position themselves for long-term success in the evolving private equity landscape.

For more insights on navigating the independent sponsor path, check out Proven Strategies from Ice Miller’s Chase Stuart.

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