Mike Palm of Charter Capital Partners discusses governance and seller rollover in independent sponsor deals with hosts Greg Hawver and Jason Griffith. Their conversation covers the importance of building trust and relationships with sponsors, aligning interests through rollover equity, and navigating board dynamics. Mike emphasizes the need for founder alignment, proactive communication, and trust in dealing with challenges such as performance issues and governance structures. He also suggests that early engagement with capital providers, transparency in decision-making, and fostering a collaborative approach can achieve successful outcomes in private equity transactions.

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This podcast was recorded and is being made available by McGuireWoods for informational purposes only. By accessing this podcast, you acknowledge that McGuireWoods makes no warranty, guarantee, or representation as to the accuracy or sufficiency of the information featured in the podcast. The views, information, or opinions expressed during this podcast series are solely those of the individuals involved and do not necessarily reflect those of McGuireWoods. This podcast should not be used as a substitute for competent legal advice from a licensed professional attorney in your state and should not be construed as an offer to make or consider any investment or course of action.

You're listening to Deal-by-Deal, a McGuireWoods podcast. Deal-by-Deal invites you to conversations with experienced independent sponsors and other private equity professionals. Join McGuireWoods partners, Greg Hawver and Jeff Brooker as they explore middle market private equity M&A to provide you with timely insights and relevant takeaways.

Hello, and welcome to Deal-by-Deal, a podcast for independent sponsors and other private equity investors in the middle market. I'm Greg Hawver. I'm a partner in the private equity group here at McGuireWoods in our Chicago office, and I'm excited to be joined today by my fellow McGuireWoods partner Jason Griffith and Mike Palm of Charter Growth Capital.

So Jason, do you want to give just a quick intro for yourself and then, Mike, we'll turn to you?

Yeah, Greg, great to be on today. As you mentioned, just down the hall from you here in Chicago, I mean, our private equity independent sponsor M&A practice, so just deals, Deal-by-Deal. I'm excited to join today, and we'll get into the topic a little bit, but looking forward to talking about how we think about governance with our partners that we're buying businesses from, how we think about rollover. And those are pretty important relationships, and so how do we set them up the right way and set ourselves up for success?

Great. Mike?

Thanks guys, again, for having me. My name is Mike Palm. I'm with Charter Growth Capital. We're a Michigan-based mezzanine debt and equity provider. We focus on writing smaller checks. We write $2 million to $8 million checks focused on the Great Lakes states, and then usually in our deals, we're writing up to 50/50 debt equity mix. Thanks again, guys, for having me on.

Great. So the topic here, and we have a new format for this podcast, which I think will be interesting. What we're wanting to do on this one is a topic that Jason, Mike and I think through a lot as we're doing acquisitions is seller rollover. So we're talking about the founder, whomever is selling the company and they're going to be not completely cashing out but rolling over a piece of their equity and will be a go-forward minority owner. How do we think about the equity that that rollover owner holds and provisions around that? And then also governance, generally, when we're thinking about the new platform company.

And in the mix on governance, you've got the investors such as Charter and others, you've got the independent sponsor and you've got the founder who's rolled over. And so coordinating all of those different concerns and constituencies to get to a result of a platform company that's going to be a big success, how do we balance that? So at a high level, that's what we're thinking about. And so jumping right in, Mike, just seller rollover generally, how do you think about that as a nice-to-have versus a need-to-have and just generally?

I'd say it's definitely a need-to-have. Maybe it was a nice-to-have back in the day, but it is becoming more and more of a need-to-have in transactions. It's certainly something that's encouraging to see. It's certainly something that when we work with, presumably, call it a founder-owner, it's who we're usually working with, and they own the majority of the business and they're willing to roll over a piece post-close in the new deal. Certainly signifies some alignment with us, but also signifies that they see growth in the business.

They didn't drain the gas tank as they grew it over the last however many years they've been running the business. We also think it's super supportive when it comes to just any transition that we might be looking for, if that person's going to keep running the business for a while, but then transition to someone else. They're signing on to own some of that and be a part of that and put money where their mouth is that they're going to help convey the business to the new CEO. Also, of course, it doesn't hurt when it comes to employees, their support, seeing that founder-owner still around and then, of course, with customers, too.

It's so interesting to me that you talk mostly about alignment shows the role as an investor and a steward going forward. One of the first things that pops to mind as the lawyer is the rollover can be a source of indemnity protection. Do you guys think about that? Is that an important piece of the analysis or is that something that is a nice little piece to have on the back side?

We don't normally think about it as from an insurance policy when things go the wrong direction. We do the indemnities for the reasons that they are, and frankly, knock on wood, I've been lucky to not have to go after too many of them. So I'd say, it's not really from an indemnity legal perspective, that's not something we think of. Although, of course, yes, you're right. There's probably offsets that, from a legal perspective, you'd think would be first to go with some rollover piece, but frankly, I think that's best handled by hold backs and whatnot traditionally.

The other thing that I think is interesting that we talk about with folks, I want to have your take on it, is do you think it influences how much you're willing to pay for the business? With rollover, you get the alignment piece, which I think suggests an upward pressure on valuation, but the other piece you get is, it's less cash that you have to have at the closing table. How does that dynamic play out?

It's not about less cash at the closing table. That can always get figured out with financing. It's really about the more you're willing to rollover, the more I'm willing to pay for your business. If you're willing to rollover more and more, and maybe as they understand the structure, maybe as they meet some of our advisors or who we're going to put on the board or what our growth plan is or how we're crafting a thesis around their space, they get more excited and they say, "Gosh, maybe I want to own 25% of this thing post-close instead of just 15%." That's a great conversation to have when they get more and more excited about the business.

I'd say these days, it's very seldom that we see, or we're going to do a deal where there's 0% rollover. There'd have to be some unique reason for it. But then, I'd also say, there's this new realm where the token rollover of 20% that shows up there, and you can calculate that as maybe the equity value at closing or something. So it's not necessarily 20% of the go-forward entity, but that just, oh, well the selling family will do 20%, is starting to become just almost a misnomer because it truly might not signify actually that much commitment to the business. So there's a lot to fair it out there.

How does that interplay with how you see with carry dynamics? The more of the equity that we're giving up to the rollover, probably the less money that's coming in that we're getting carry on. Do you see getting carry on rollover as part of the conversation? It's a dynamic we've seen pop up. I'm not sure it's that common yet.

Maybe I don't want to pull the curtain back here on the wizard, but as people may or may not know, we see these questions beforehand a little bit so I can at least read them. And that question really surprised me. In my mind, carry is for managing overseeing capital and if, say, a founder-owner or the selling CEO is going to stay in the CEO seat post-close, and then I, as the investor, is going to tell that CEO, I'm going to be better at managing and overseeing their rollover capital than they are as they run the business on the day-to-day. I don't know, you're going to have to send me someone's talking points for how they pull that off. It almost seems just ingenuous, frankly.

Yeah. And it's not the norm. And I tend to maybe side with your viewpoint on this one, Mike. Where I see it, the positioning is, "Look, we've got this deal. We, as buyer, are happy to do this deal without you rolling over into this platform, because we don't need your leadership or anything, but if you want to, you can invest some dollars. But they're subject to the same promote economics as the other invested dollars."

But I think that just a whole different philosophy and deal structure, whereas you are working with founders as an important piece of the puzzle go forward, whereas, I think in the model where you maybe do see it as it's sort of as add-ons perhaps, or it's others where they're not needed in the business at all. And maybe that dovetails to another question that we have. When you're actually running the company after closing, what are some good attributes or what do you look for in an ideal founder who has sold a majority of the business to you going forward?

That's tough to answer because it is such a wide range of things that you might see or frankly seek or they might be seeking from us on a post-close basis. The one thing I'd say though, of course, you can't force someone into something that they don't want to do. Or at least you can't force them into something that they're going to go and do well. So the reluctant staying on a CEO person is something I think we would get wary of, where they could get to a point of saying, "Oh sure, I guess, I'll stick around for six months, 12 months until we find that new CEO." If that's a tough conversation, maybe there's something else should be put in place there at closing. One of the most important things that we always want to ask sellers is, what do you want to do?

What do you want to do? And why are we talking about your business? What are you looking to go off and do? And oftentimes, of course, it's they want to diversify their time, diversify their wealth, maybe focus on charity, those kinds of things. But that's important. We want to understand what motivates people and whatnot. And some people truly do just want to take some trips off the table, but then are still gung-ho about rollover and want to keep growing the business. And those are great partnerships, but you can't get someone to begrudgingly fill those kinds of shoes. So I don't know if that was an exact answer for what you were looking for because it's such a wide range of what you're going to want from someone who's going to stick around and rollover.

Yeah, I think it's really informative and the legal structure of how you work with rollover. Is it typically a board seat and they're in board meetings? Any other mechanics around that? I know oftentimes, there'll be request for blocker rights with respect to the rollover. And how do you think about those?

So blocker rights for the rollover individual?

Yeah. If they're rolling over like 40%, call it, of the total go-forward equity, if they own 40%, sometimes you'll see requests that, "Hey, I own 40% and I want approval over, basic things like affiliate transactions." And sometimes they'll go further as far as, well, maybe if you want to put debt in excess of X amount on the business or if you want to do transformational M&A or something like that, we want a blocker right on that. I'm not saying those arguments are typically successful, but do you have those conversations and how do you think about that?

So some of those have come up. That can be a little bit tough because ultimately, he or she or a family is selling a business. We're providing cash for side business, we're moving on. And Charter, we are on our first fund for all of the equity positions that we had across 12 different companies, we were minority in every single one of them. So we were partnered with usually an independent sponsor that was leading the transaction and, they and their syndicate were majority owners.

So for a founder-owner rollover type person to come and want to have those blocking rights, we definitely want to protect them and we can definitely stand there and send them the dotted line. We're not going to screw them and do well and crazy things, but when it comes to our ability to run the business, to capitalize the business, to add on to the business, well no, the whole point of them selling the business in the first place was because they were going to be moving on in some respects.

Totally agree. Totally agree.

Mike, appreciate all the colors so far. Can you talk to us a little bit about how you fit into the structure of an independent sponsor deal, majority-minority place? And then what I want to talk about is how those dynamics play out for you in terms of governance? And then Greg and I can filter in a little bit how it looks in different kinds of models.

Yeah, absolutely. So in most cases, we are partnering with an independent sponsor to go and get a deal done, and they are bringing in 95% of the cases. They are bringing that deal to us. It's usually a deal that they've either different realm of where it's at in process, but they've got something, they're starting to raise money and they're looking for senior debt and they're looking for sub-debt and equity, all at once.

And they ask us how we can help and work through the best decision or not. So when we come in, we're what I'd say, they figure out their senior piece, they figure out their equity piece, and then we're the last piece of the puzzle they figure out. They're going to be their sub-debt. And then also, so equity co-invest, we would do along as well. We are, again, I think I had mentioned minority equity in all of our deals and fund one, owning anywhere from literally at one point as little as 2% to as much as 40% of our different portfolio companies. But the independent sponsor and their syndicate for the most part is they are the majority owners of the business post-close.

When you are working with them to constitute the board, do you want a seat on the board even if your vote isn't going to be enough to carry the day? Or would you rather just have information and access rights and can sense over the things that matter to you?

It goes both ways. We have done it both ways. We've done it in deals where you look at the board. We also are mindful of how much total capital we are in a deal. And when you're doing the sub-debt and if you're doing a decent sized... We're doing a decent sized equity piece, you start to say, G, we're 35%, 40% of the capital to get this deal done.

Now our equity only owns maybe 15% or 20% of the company, so maybe we should have one of five board seats. But that's where we then come in on the debt perspective. We know we've got certain blocker rights that come with a sub-debt agreement. So we've gone both ways. We've done it in ways where maybe we'll have two seats and maybe we give a break tie vote to the sponsor somehow. But then, we've also gone in to get those, as I like to call them, mutual consents, polite ways to basically say we have to agree to some certain things. So unfortunately, I think I just answered that question both ways for you, but it can go either way.

No, that makes a lot of sense. And I think, the key piece that you had raised is the minority stake in the overall company. We see that shift sometimes with somebody coming in writing a majority piece of the equity, majority piece of the overall financing saying we actually, as the capital provider, want the board. And then that creates the inverse dynamic where the independent sponsor needs protections that protect against reorganizations that might nuke their carry, turning off the management fee and other things, just controlling their involvement in the investment as it goes forward. So it's always interesting to me how these capital structures get put together and the game theory that you run on, who's going to have a seat at the table, and what's that vote going to look like? What are the mutual consent rights? Or the negative blocks? Or the affirmative... All those things.

Everybody seems to have their own view on how they think it should work for them. And I just always think it's so important, even at the LOI stage, for people to spend time with their partners and understand how is this really meant to work and how is that going to show up in the documents and how's that going to show up in an actual board meeting two years from now? And I think really importantly, how's that going to show up when things aren't going as we hope they will? If things get hard, how are we going to work together to turn this business around?

How do you have those conversations with independent sponsors and how do you build that relationship at the same time as you're in the crucible of the deal? They're distracted trying to keep their seller focused. There's just so many things happening and you have to build this relationship. How do you get that done?

I think you arrive in a point of trust with your partner, with the sponsor. We do, what I guess, front door reference checks where we actually say, "Hey, who can we call?" And then, of course, you do back door reference checks of basically finding people that we have in common and then checking things through them. Even if it's, I've done it a dozen times where it's a very nonchalant conversation. I'm like, "Yeah, no, I actually know that person." And I've never actually been in a deal with them, but I can talk them through a situation where they did interact and maybe something went the wrong direction, but honestly they behaved in a way that wasn't troubling or whatnot. So when we've had independent sponsors, we've got a pretty high bar. We're looking for track record, we're looking for those reference checks, front door, back door to be come out clean.

We're looking for them to have a good thesis around the company that they're trying to buy. Why they want to do what they're going to do with it? And you're just sending us the CIM from the investment banker and, oh yeah, here's the LOI signed. It is tough for us to understand that that's a deal that we're going to get terribly excited about.

And the last thing is probably why. At the very end of it, when actually, you have that circle of trust with the sponsor, you're all aligned with where you want to take the business and grow and whatnot. We know in a deal we did recently, I actually said to the sponsor, as we know that there's no counting of the number of votes I have versus you have versus they have when you're actually at a meeting, actually trying to make a decision. And so that's why it's a board-managed situation and a lot of those decisions are made unanimously or if there is going to be any issue, it's handled frankly outside the meeting more than not.

That all makes a ton of sense. Let me ask you one more question on this subject and then I'll let you move on. One of the questions that we get asked the most by independent sponsors as they're putting together their brand and they're launching and they're doing their first deal, is when should we be talking to capital providers who we might want to partner with? Do we have to have the LOI? Do we have to have exclusivity? Should we do all of that beforehand so they can be underwriting us before we even have a deal? What's your view on that and what advice, hypothetically, would you give on a podcast that was listened to by people asking these questions?

Thanks for the reminder. It's the whole range. I've got a phone call tomorrow afternoon with a deal, I believe, post-issue, they're trying to polish their LOI bid and just wanting to talk about what we see in the business, what we like, what we don't like. They send us the CIM, they send us their initial thoughts, they send us their model. So that's pretty early. We do see some things that are indication of interest stage, "Hey, is this something you'd back or not? We're happy to take a look at that." It is harder when you say, it's pre-indication when you asked our thoughts on leverage. We can give you something pretty high level, but in reality it can get out there and try to win the deal and progress it a bit and then let's spend some time and actually talk Turkey about what can happen.

However, we then also get deals at the end of the spectrum. I've got ABC product, ABC locked up, we signed the NDA, and the next thing that comes over is the CIM, the sponsors' thesis deck, the quality of earnings is done. Here's the data book, here's our LOI, here's some rough ideas in our model on what senior leverage we're going to have in this thing. And we've got to round out X and Y for sub-debt and equity. What are your thoughts? And those, of course, obviously they're going to be shorter fused, because they're saying we want to close in maybe 45 or 60 days, and that's definitely something we can work with as well.

No, that makes a lot of sense. So on the board rights, with respect to independent sponsor, the documents that we're working on sometimes based on structure that the documents we'll work on, whether it's on behalf of the independent sponsor or the capital partners, will have provisions around the independent sponsor controls the board. But if a series of events happens, then they would lose control of the board and it would flip to the majority investor or someone else. Same with the management fee. If certain events occur, the management fee shuts off.

Have you ever seen those provisions get triggered on any of your deals? Have you ever come close to something like that but then worked it out? Or just, I'm curious of your experience, not so much in the legal documents, but the real world.

Yeah, we had a thing called COVID about four years ago, and we had a few companies that we voluntarily stopped taking interest payments and those sponsor voluntarily stopped taking their management fee payments. And that was just in agreement. And thankfully, this is so long in the past, I can't remember how many companies and which ones went which ways. And senior lenders took a pause as well. And as soon as the senior takes a pause and we feel obligated, we should take a pause in our interests and then we both turn our heads to the sponsor and say, "Well, you're going to pause too?" And they usually do. And that's all done, again, not to your point about legal documents, not opening up legal documents saying, "Hey, this is where we can plot so-and-so."

Less on a springboard provision or whatnot. We've seen those. We have those in some... Not in any recent deals I guess, I've done. I have had those historically but haven't had to use them. We have had situations where just because of performance of the business, it's made sense for it to be recapitalized in conjunction with either new ownership or recapitalized with a new senior lender, some of our additional capital. And it's not a great situation, but if the independent sponsor doesn't have additional capital to put in to move the business along or get it out of the rut that it's in, those around the table with capital have to put their heads together to figure out what's going to happen. And then, of course, put the money into fix it. And by doing that, that means it can change things for the sponsor. It's usually, I should never give away ownership necessarily, but we have been in one situation where it did take away control.

Yeah. And that makes sense. I mean, it's just the practical reality. As you note that in a traditional fund portfolio company, when things start to hit the rocks, many of the answers relate to the PE fund putting in more money or guaranteeing things or things of that nature, and that's just not a tool that the independent sponsor has. So I totally hear that.

Mike, you've shared a lot of your philosophy with respect to partnering with independent sponsors and rollover founders, and we really appreciate that. Any final thoughts over your career when you see things go right at the board table and just governance generally? What are some attributes or some practices that you've seen that succeed?

I think when performance of the company is going in the right direction, that is, and in reality, as I alluded to before me, in most cases, we usually never have to ever open up the legal documents to understand what truly needs to happen if the rubber hits the road. So in the best examples of the governance, that's that kumbaya that you like. Business is performing, you're seeing growth, man, the team is happy, employees are happy, all the stakeholders are happy. That's what you ultimately seek. I don't know if that really answered your question. Yeah, growth is good.

In those scenarios, you're going to the board meetings or getting the good reports and you're not having to spend too many brain cells on it.

That's true. I guess, the opposite is then when we have more routine calls where we have to set up weekly or twice-weekly calls with different sponsors or management team to try to work on an issue or something. That happens also from time-to-time. But then to your point, I guess, others is we're on the phone doing a board call once a month and checking in here and there and helping out things where we can with email or whatnot, but it's not an overly burdensome multi-touchpoints per week thing.

Yeah. Great. Well, this has been a great conversation, Mike and Jason, really informative about the way that Charter operates, and thanks Mike for sharing all this knowledge. We appreciate it.

Yeah, thank you both for having me.

Thank you for joining us on this episode of Deal-by-Deal, a McGuireWoods podcast. To learn more about today's discussion and our commitment to the independent sponsor community, please visit our website at McGuireWoods.com. We look forward to hearing from you. This podcast was recorded and is being made available by McGuireWoods for informational purposes only. By accessing this podcast, you acknowledge that McGuireWoods makes no warranty, guarantee or representation as to the accuracy or sufficiency of the information featured in the podcast. The views, information, or opinions expressed during this podcast series are solely those of the individuals involved and do not necessarily reflect those of McGuireWoods. This podcast should not be used as a substitute for competent legal advice from a licensed professional attorney in your state, and should not be construed as an offer to make or consider any investment or course of action.