Funded or fundless, plenty of GPs fail to raise a successor fund. For investors backing independent sponsors, the real question is whether this sponsor will last.
Fundless sponsors, or independent sponsors, are GPs that buy companies without committed capital. Historically, this might have been seen as an interim approach until a firm could raise funds, but being a fundless sponsor is increasingly an intentional strategy.
The structure not only gives LPs more control over deals and greater freedom to adjust their exposure to specific market sectors, but it can also generate better returns. Independent sponsor deals generated a median equity IRR of 23.8%, compared with 18.5% for comparable US buyout deals, according to a June study by the University of North Carolina’s Institute for Private Capital and the Small Business Investor Alliance.
More emerging managers are turning to the independent sponsor model, but most don’t stay the course, according to a report Independent Sponsors: A Handbook for LPs and Prospective GPs published by Weight Partners Capital.
PitchBook spoke with Cameron Payne, co-head of European Investment at Federated Hermes, about how to derisk backing independent sponsors. This interview has been edited for clarity and length.
PitchBook: Do you think it is higher risk to back an independent sponsor than a fund?
Payne: Let’s think more holistically. In the current market with its fundraising challenges, when we assess a direct investment opportunity alongside a sponsor, we have to be very sensitive to the fact that the failure rate among GPs, in terms of the inability to raise successor funds, could be quite high across the board, irrespective of whether they are a funded or independent sponsor.
In all situations, you have to be very focused on the franchise’s stability, market traction with LPs and the alignment and motivations of the key people.
The typical challenge we hear from LPs assessing our activity in this space is that independent sponsors are small and thinly resourced organisations, and the perception is that the transactions they pursue, by virtue of not having committed funding, are at the lower quality end of the market, resulting in high dispersion of results.
PitchBook: How do you derisk investing in independent sponsors?
Payne: Firstly, in terms of independent sponsor partner selection, we are going to ideally try and partner with individuals and firms in this market that we have some common touchpoints in their history, where we either innately know what their capabilities and character are, or where we can very quickly get to a source of truth on that. So that will be people who come out of ecosystems we know, GPs we know, people who have shared experiences with friends of the firm, so that’s kind of one of the first qualifiers.
The second qualifier is that we give ourselves plenty of time in this space; it is very common for us that, by the time we dive into a specific investment opportunity, we have already looked at, say, three transactions and spent two years talking to these groups or individuals that are sponsoring the transaction.
What we are avoiding is that I am sitting at the desk one day, get a nice email about this great deal with someone, and then we dive straight in and execute on it. Occasionally, it happens, but very much by exception. It is normally a lot more deliberate, and there is a bit of a vintaging period.
The last pillar is to concentrate efforts on situations where we can bring something to the table, or where we can independently build conviction, so that we are not totally reliant on the GP partner to necessarily get us up the curve on the thesis.
It is much easier for us to do this in clusters where we have multiple pre-existing portfolio companies and a fact pattern of success, multiple GP relationships that have a view on this space, because then we can supplement and infill where needed some of the diligence, and make our own independent conclusion and corroborate that with what the independent sponsor is telling us.
PitchBook: So, despite it being deal by deal, it is still a long-term relationship?
Payne: It has to be. We are not in the business of being very transactional because it is neither how you build a reputation that drives referrals and warm introductions, nor, in our experience, does it underpin longer-term investment success. We want to find clusters of what we think are really good independent sponsors, who are equivalent to or higher quality than the funded GPs we will be investing with, and then concentrate time and effort on those names. Then, when the right situation comes up, we can move quite aggressively and with conviction to make those investments happen.
With independent sponsors, in Europe at least, what we want to do is pre-qualify the names, get to know them over an extended period of time, have a continuous dialogue where we think about what is in the pipeline, and then find the right situation that maps really nicely to the themes and the subsectors and the style of investments we want to make. But it is always a bit arbitrary thinking about how you weight them as in GPs versus asset—while the GP will likely be a qualifier as to whether we take an opportunity seriously and lean-in, ultimately, when it actually comes to making the decision, it will be asset-led.
PitchBook: Have you re-invested in some of the independent sponsors?
Payne: There is one independent sponsor we have done three transactions with, and a couple that we have done multiple transactions with. Some of these relationships are absolutely repeatable in nature, and these groups have elected to remain independent sponsors and not raise a blind pool fund.
Our job becomes a lot easier if we can find those groups where there is great alignment with our strategy and where we feel they’re really good fiduciaries and partners. It is always nice if you can concentrate effort and capital around those groups that you hold in very high regard and who have a lot of synergy with how you look at the world in terms of strategy and deal architecture. For us, that is usually profitable buyouts in the lower mid-market, operating in either technology, business and industrial services or healthcare.
PitchBook: How much do you value GPs’ skin in the game as an alignment?
Payne: Skin in the game is a difficult one because a lot of the people you back in this channel are mid-career. They might not have huge amounts of financial resources to invest, and they might be looking to roll over a fee or put in a relatively small amount of money. You have to make a judgment call on how you want to play that and how much is enough versus their resources.
And then, it is about structuring appropriate upside sharing. One of the things we had to get to grips with in this space is that there needs to be fair economics, so if you are a classical co-investor who is used to not paying any economics, that is not the right approach here. There needs to be an incentive for people to drive a certain outcome and share in the reward. So you have to get the balance right between skin in the game and upside sharing, with appropriate hurdle levels, vesting schedules and provisions attached.
PitchBook: Is there any further measure for risk protection?
Payne: The other aspect to consider is the legal documentation and making sure that it is used appropriately to mitigate some of the risks in this space. When you think about shareholders’ agreements and LPAs, we make sure there are protections in place. You hope not to use them, but for some scenarios, you have to be more sensitive to that because you are really investing in an individual or a small group of individuals to manage your investments as opposed to a firm.
So, you might need to think much more clearly about, for example, whether there is a no-cause removal event if the asset underperforms and you see a lack of engagement or whether you need to be able to compel an exit if there has been no liquidity after a certain timeframe.
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