Independent sponsors have evolved to become a separate asset class offering value to the ecosystem within the realm of private equity.

On this episode of Deal-by-Deal, hear McGuireWoods’ Jon Finger share his insights on the evolution of independent sponsorship and recent noteworthy developments. There have been larger deals, more hybrid structures, and an increased interest in first-time funds from within the independent sponsor space.

With his experience in the independent sponsor space, Jon offers advice for emerging fund managers looking to raise their first committed fund.

“Having a broad set of references from different parts of the deal ecosystem is important to show LPs,” Jon says of the key steps independent sponsors need to prepare for when raising a first-time fund.

Also on this episode of Deal-by-Deal, Jon and Jeff review what independent sponsors need to consider when it comes to their current deals. Including if they can roll them into a fund: “One of the key pieces is the deal pipeline, and providing LPs with that demonstrated ability to put money to work in a meaningful fashion relatively quickly,” Jon explains.  

Featured Guest

Name: Jon W. Finger

Title: Partner at McGuireWoods

Speciality: Jon’s practice focuses on private equity and corporate transactional matters, including mergers and acquisitions, fund formation, securities offerings, and corporate governance initiatives.

Connect: LinkedIn

Acquired Knowledge

Top takeaways from this episode 

★ The independent sponsor space is maturing. Over the past decade, the independent sponsor space has moved from individuals making deals at country clubs to being a valuable part of the ecosystem. As independent sponsors have matured, the deals have grown in value and begun to encompass more hybrid structures. 

★ The criteria to become a successful independent sponsor fund manager. More and more independent sponsors are looking to raise committed funds. To be a successful emerging manager, an individual will need to have previous successful exits, the ability to articulate their ESG focus, and the support needed to scale the fund. 

★ Key steps to consider when raising a fund. Reference checks are extremely important to LPs and for any independent sponsor considering raising a fund, it’s important to have a diverse lineup of references ready. Also, consider what investors are right for your fund and which backgrounds or specialties will drive the most value for you.

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

Hi, everyone. My name is Jeff Brooker. Welcome to episode nine of Deal-by-Deal, an Independent Sponsor podcast. I'm pleased to have with me today, one of the key members of our Independent Sponsor team here at McGuireWoods, Jon Finger.

Hey, Jeff.

Thanks Jon, for taking the time to be on this episode. We really appreciate you making the time. We wanted to talk today about some of the recent, really interesting developments that we've seen in the independent sponsor space. And that space has continued to see significant evolution in recent years. And I know where you sit seeing as many deals, really as anyone in the space, you get to see a lot of interesting stuff, tell me about some of those recent developments and some of the things that you think are really noteworthy.

Yeah. I think the first thing I would point out is we truly have seen the evolution of independent sponsors becoming a separate asset class within private equity. And as we take a look back many years ago, the independent sponsor model has been around, seems like forever. Way back then, it was guy or gal with a deal who was putting something together at the country club and it turned into what became known as fundless sponsors, which we all have found quite pejorative. And so, as we've started thinking about the independent sponsor and really over the past seven, eight years, that evolution to being a truly valuable part of the ecosystem within private equity, that validation, that acceptance, it truly has become a separate asset class. And you see that with private equity funds that have been raised solely or predominantly to invest in independent sponsor led deals.

And the reality is there's significant economics that get paid to the independent sponsor but I always tell people it's just math. If the deal is good enough, it can make sense. And so I think that evolution has been demonstrated by the fact that you do see funds being raised for that express purpose. I think over the past few years and there's multiple drivers for it, we've also seen an increasing number of larger, independent sponsored deals. I think from my perspective, the fat part of the bell curve in years past was 30, 40, 50 million enterprise value deals. And as you, Jeff, and others within our Independent Sponsor practice group have seen, doubling that and then multiple deals well over $200 million on the independent sponsor side being put together and then ultimately closed. That would be the second biggest, I think, change that I've seen within the community.

And then lastly, we have seen a real interest on both the independent sponsored and the capital partner side for what we call hybrid structures. In many cases, these were nothing more than just pledge fund type structures. And then ultimately running the gamut towards putting in place a structure whereby the capital partner and the independent sponsor have agreed upon economics, under which there's some level of committed capital. Oftentimes with discretion on the LP side as to what a deal has to look like in order to get closed. A certain number of deals that the LP has the ability to really exercise ultimately discretion over as to what deals get done and what deals don't. And if the situation's not working out right, how the parties get divorced. Those hybrid structures have certainly been evident, particularly over the past few years, there's clearly a lot of money out there chasing different ways to get deployed and independent sponsors it seems like are more interested in finding those structures that make sense. Those are probably the few things that I'd highlight to the group.

Yeah, I have seen, especially more recently, a lot of independent sponsors ask us to set up these little sidecar funds or pass the hat kind of funds where they're taking different economics within that fund or maybe trying to get increased security in their deals. But it does seem like it's taking, in those circumstances, baby steps toward a fund or a future kind of committed capital arrangement for them. Clearly, one of the important themes in recent years is the growing side and sophistication of the community of independent sponsors as a whole and a segment of those independent sponsors starting to think about starting private equity funds. What have you seen in that regard?

Sure. We definitely have seen a substantial increase within the broader private equity community, frankly of first time funds, but more specifically within the independent sponsor community, I think there are a few things at play. One there's clearly the recognition that the independent sponsor model while it is incredible, there are lots of very positive of components of it. It's also hard to raise capital on a deal by deal basis. It doesn't mean that we don't have a lot of success finding capital partners for deals. It doesn't mean that independent sponsors aren't doing it on their own. Obviously they've been able to use placement agents, so that growth in the independent sponsor community continues. At the same time, I do think there is clearly a recognition that there are challenges to it.

And so we've definitely seen an increase in independent sponsors, at least thinking about raising a committed fund. And then actually just got to initial closing on one of our longtime independent sponsors who raised their first committed fund and is very close to a final closing on that fund. There's definitely been an increase in independent sponsors thinking about it but there's also been a significant increase in independent sponsors raising committed funds. There's also been a real heightened focus from our LP community in encouraging independent sponsors to raise committed funds. Whether that's because they're looking for the ability to anchor those first time funds or really just an ability to get more money to work through a channel within private equity that those LPs have found very attractive, all coming back to a very strong increase in independent sponsors raising committed funds.

Yeah. Yeah, definitely an interesting development. If I'm an independent sponsor, I'm sitting at out here listening to this podcast and thinking, am I a candidate for this? When you think of the types of independent sponsors that stand out as particularly good candidates to become a fund manager, what do you think of as far as track record and et cetera?

Yeah. Well certainly one of the most critical hallmarks of a successful candidate to become an emerging manager is track record. And we can set aside for the moment, attributable track record for groups that are spinning out of private equity but track record is certainly key. And so the independent sponsor who has the ability to demonstrate a number of successful exits, how many exits it really depends, but the reality is to get limited partners to have conviction on a first time fund, there need to be as a general matter, a few exits that the LPs can diligence, understand and ultimately get comfortable with that sponsor's ability to exit transactions in a good fashion.

I think within the private equity community, as well as beyond the past few years, ESG has moved front and center for a lot of what LPs are thinking about and doing. An independent sponsor either as a woman or other diverse fund manager, where the LPs, many of which have particular requirements either because that's how they raised a fund to invest in emerging or other managers, whether it's just something that is important to the LP, maybe the family office patriarch, whatever it is, that ability to back minority fund managers is certainly something that we have seen LPs focus on. But then as a broader statement, the independent sponsors who demonstrate and articulate an ESG focus in whatever fashion, because that's such a broad term, but that paying attention to that part of their investment criteria has certainly been something we've seen being attractive to LPs.

The last thing I would say is you really have to have an infrastructure in place in order to scale, to support a committed first time fund. And so in many cases, that's an independent sponsor who actually has a team of four, five, six investment professionals and others that can relatively cleanly transition to a committed fund. Sometimes it's more a few individuals who maybe worked together in the past that are coming back together that maybe were separate, to raise a fund. But I think having that infrastructure that the LPs can underwrite and get comfortable, is going to allow you to scale within the committed fund construct is very important.

Yeah. Yeah. You touched on ESG, which I know is a little bit, it's a hot topic today and it's a little bit hard to put your fingers on exactly what that is but paying mind to that is I think good advice. What else do you think LPs look for in a first time fund?

Sure. Well, taking a step back, certainly in many cases, LPs look to first time funds because of the ability and quite often reality of outperforming future fund five, fund six, fund sevens. And so LPs are valuing these earlier emerging managers. They crave that alignment with the GP, that focus of time from the general partner. In its simplest fashion, the GP can't get it wrong. If those first handful of deals or frankly, first deal or two within a fund one don't do well, that in many cases is going to be the end of fund two, fund three, fund four. And so it's that alignment that I think LPs find so attractive and they look for within these fund managers. At a macro level, in many cases, those first time funds or sub $500 million vehicles and that's providing LPs with exposure to what we describe as the lower middle market. And that is a huge focus for many LPs.

As particularly as funds have gone up market, a lot of candidates for potentially unbanked situations, it seems like the target size of companies has gone down. That in the sense, in many cases, companies that used to not have a banker involved, that universe of companies has gone down significantly. And so I think LPs recognize that by focusing on the lower middle market, there is that ability to find unbanked or under banked target companies.

There are a whole host of factors that LPs look for in first time funds. A few that come to mind, that ability transact, both entry and exit, at attractive points in diverse market times, demonstrating to the LPs that as a GP you have the ability to put money to work in a smart fashion, is critically important. Another important factor, many LPs are looking for specialization, whether that's sector specialists, sometimes it's how you approach transactions, whether it's theme oriented, it really is about differentiating yourself as a sponsor. It is a very crowded market out there. As many times as we can tell stories about first time funds being raised, it is a difficult fundraising environment and so it's about differentiating yourself. And is that your sourcing model? Is that your operational playbook for post closing? It doesn't have to be sector specialization but there has to be a story, an underwritable story about how you differentiate yourself.

I think being coachable is important as a first time fund manager. A lot of LPs are looking for an ability to influence direction, sometimes looking for reduced economics or truly opportunities to anchor the fund. I think as the fund closes and you look around the room, being coachable and taking those suggestions and really being flexible in how you work with your LP base, is something that LPs have found attractive.

Co-invest opportunities at its simplest state are very important to LPs, whether an emerging manager otherwise but I think in cases, demonstrating and showing a structure under which LPs are able to get co-invest opportunities is important.

The last two, Jeff, and I'll let you weigh in is team. I talked about it before but it's have you worked together? What skillsets does that team bring to bear? The football analogy, everyone can't be the quarterback or the star wide receiver. As you put together that team for your first time fund, it's thinking about what role is everyone going to play? And how does that get the LPs comfortable really with the infrastructure? Understanding lawyers, fund admin, all those different team members that go into a first time fund, demonstrating that infrastructure is something that LPs are heavily focused on.

Yeah. I've seen some sponsors who have really started to build out a team with a focus on building a fund in the future and when it's done well, you can really see how it just adds gasoline to the fire and the velocity of the deals. In really everything they do, the pacing picks up and when it's clicking, you can tell. Even as the lawyer, we can see it.

We talked about building out a team, what are some other key steps? If you're an independent sponsor who's thinking about preparing to raise a fund, what are some other key steps that they should start to think about in the early days?

Sure. One of the questions that you will get asked closer to the end of that process in many case of raising a fund, but it's reference checks and it's supremely important to a lot of LPs. I would be thinking about what does that base of references look like? And really starting to identify candidates within the broader deal ecosystem. Sometimes it's founders of companies you've acquired and they rolled over into investing alongside of you. CEOs that you've worked with or brought into companies. Certainly LPs, which we can get to in a minute, but even then just bankers. And when I say bankers, I mean investment bankers, boutique bankers. But having a broad set of references from different parts of the deal ecosystem is really important to show LPs.

And then tying back to the LP side, spending a lot of time thinking about, how are you going to select your preferred LPs for your fund? Who are the right type of investors for your fund? Are you going to focus on family offices? Are you going to focus on pensions and endowments? Are you going to focus on fund of funds? Finding in your strategy how you think about the right LP base is a key step along that process. And for that investor base, it's really about who is going to help you drive value in your fund formation process, whether that's introducing other LPs to invest in your fund directly. Merely attracting other LPs who want to invest alongside what are viewed as the preeminent curves of first time fund managers, really thinking about who truly wants to see you succeed as an emerging manager and will help you make that happen. I really think one of the most critical steps is in your mind thinking about the right investor base for your first time fund.

Sure. And so then when we think about, I guess, every independent sponsor is out there working on deals. And so for the folks who are thinking about starting a fund and maybe have started taking some concrete steps in that direction, how should they think about can I roll the deals I'm working on into my first fund? Should I roll those deals into that fund? And are there things that I should be thinking about if that's in my mind, when I'm thinking about the deals, negotiating the deals, are there things I should be doing and not doing so that I don't stub my toe and that I do it in a way that's as seamless as it can be?

Well, certainly first you want to as best you can, have alignment and it can be a chicken and egg thing but let's assume that you have an LP base in mind already. I always want the manager to be thinking about what is the right structure that the LPs are going to be comfortable with? Certainly pre-fund deals, it's fabulous in many ways. There are different structures and we can talk through some of those with managers as opportunities present but we certainly have put in place structures, for lack of a better term, warehousing a first deal where an LP provides the capital and then ultimately that capital gets bought down, for lack of a better term. But putting in place that warehouse structure can be really compelling. It just means you have to find alignment early on with the LP or LPs who are going to be warehousing that first deal.

Certainly thinking about if you truly are going to be quote, rolling all of that first portfolio company into the fund, there are also structures where some of our emerging managers have done a growth equity type investment into a deal and then ultimately had the fund invest into a deal. And so you always need to be mindful of conflicts in those growth equity situations. But again, one of the key pieces is the deal pipeline and providing LPs with that demonstrated ability to put money to work in a meaningful fashion relatively quickly. Rolling pre-fund deals is certainly one way to do it but again, you need to be doing that in tandem with your LPs. And then of course structuring that with counsel to make sure you think through those issues and ultimately get them documented where that quote, contribution if you will, to the new fund can be as seamless as possible.

Right. Right. And so those, you had mentioned that there are certain LPs that might be better as first time LPs, do you typically find that the folks who are willing to work with you on rolling those first deals into a first fund and be very cooperative and helpful in that regard, there's a lot of alignment with this set of folks who make for good LPs in a fund?

I do. And there's also very strong alignment with the independent sponsor world. In the sense that in many cases you have LPs who will back independent sponsors but will also back emerging managers. It's a nice, clean entree to say, "I ultimately expect to be raising a fund soon. Let's start talking about what that looks like. Also, we have this situation and we want to get a deal closed, so let's get a deal closed, but let's have them a structure whereby it all or some of it can be put into a fund structure." And so absolutely those characteristics of LPs that back independent sponsors can often be very strong proponents of a warehouse structure within putting that deal into a first time fund.

Yep. That makes a lot of sense. If there's an independent sponsor out there and they're considering raising a fund in the future and maybe want to start getting a little bit more concrete about it and maybe kicking the tires, what are your thoughts on some things that they could do to start explore that world?

Sure. Well, first and foremost, reach out to you and I, Jeff. I think leveraging people within your universe that can help guide you through the process, help you understand what it takes to get from A to B in raising a first time fund, introducing the right LPs in collaboration with you, once we've talked about who to prioritize but introducing the right LPs to emerging managers is something we as a firm do all the time. As you know, Jeff, lawyers not placement agents, we can't get paid fees for making those introductions, but that is a big part of what we do within the community. But then also we have the ability to introduce others, whether fund admin or otherwise, within the emerging manager ecosystem. We can be a very strong advocate and partner to emerging managers.

Relatedly, talking to the right placement agents. There are at least a handful, but in my book, a handful of good placement agents who focus on emerging managers. And so talking to those placement agents who happily will take time to get to know outstanding potential emerging managers, it's extremely valuable because the placement agents have a very good sense of how the market is going to view you as sponsor. They also will share what's going on in the broader LP community. But talking about the broader LP community and what LPs are focused on and what they value. I often think about it like someone who's declaring for the draft. Test the market a little bit, talk to placement agents, ultimately no obligation of course. Some of our emerging managers don't even use a placement agent for their first fund or for their first closing and may bring in a placement agent for their final closing. But the right placement agents are always happy to make investments in those relationships. Having those conversations is absolutely something I would recommend doing.

Build the deal pipeline. We talked about it with rolling pre-fund deals. Having the ability to show LPs within your deck and otherwise, what situations you are currently focused on, goes a very long way to get giving credibility to your model and giving LPs confidence that the money that they commit to your fund is going to get put to work and is going to get put to work in great opportunities. Spending that time to build the pipeline, which obviously is going to benefit the independent sponsor outside of the committed fund as well but not lose sight of how important that is to demonstrate to LPs.

Right. They also want to know that they're not going to make a commitment and then the money's going to sit on the sidelines for 12 months waiting for an opportunity to work.

Absolutely. It's huge for what LPs are looking for. And then lastly, I'd say, Jeff, refine your why. You talked about it earlier but you need to be able to articulate as an independent sponsor, why you are looking to raise a fund and whether that's, hey, I just don't want to do a deal by deal capital raise anymore. I can do more deals with a committed fund than an independent sponsor. I have a value truly whether distressed or otherwise orientation and having that committed capital allows me to move quicker. Really take some time to think about your why and then also how you're going to articulate that to the LP community as you think about what it would look like to raise a fund.

Yep. That makes sense. And I think this has all been really good advice and I hope that if there are any independent sponsors out there who are thinking about raising a fund or thinking it may be in their few future for them, that this has been helpful to them. And as Jon mentioned, don't hesitate to reach out to us. Relationships, as we've covered here, are very important. You can't do it by yourself and all of this referral work and kind of informal help, it's all unbillable relationship building that's just part of being part of in our friends and family network and we're happy to help and invested in seeing the community grow and do well. I would encourage you to reach out. As a firm and as individuals, we are very giving with our time and really interested in helping folks.

And Jeff, the last thing I would say is, I think it's always important to hear from others who have done it and are doing it and so there are a lot of things that you'll see from McGuireWoods. In particular, as you think about talking to and who are the right LPs and otherwise, we have another podcast. I know this is a great one focused on independent sponsors. The podcast is called Fund Flow and it'll be really for all sorts of emerging managers. And so we're going to have truly preeminent, emerging managers, LPs, placement agents and otherwise. This was a good first step Jeff, for emerging managers. But if you're an independent sponsor thinking about becoming an emerging manager, definitely make sure you listen to Fund Flow in the coming weeks as we have some really impressive guests who will be joining us there as well.

Well, that's great. And Jon, thank again for joining us. Your insights have been really incredible and I know that the folks who listen to this podcast are going to get a lot out of it. Thank you.

Thank you, Jeff.

Thank you for joining us on this episode of Deal-by-Deal, a McGuireWoods Independent Sponsor 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.