Artwork for podcast Deal-by-Deal: An Independent Sponsor Podcast
Lenders as Partners, with Source Capital’s Joe Rodgers and McGuireWoods’ Brian Coughlan
Episode 1130th August 2022 • Deal-by-Deal: An Independent Sponsor Podcast • McGuireWoods
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There’s a secret on how to secure more — and better — deals as an independent sponsor: build relationships and trust with your lenders. 

This may seem fairly obvious, but the reality is as the market has become more concentrated with traditional private equity funds, we’re losing this important part of dealmaking. And as the market remains uncertain, those relationships are going to be crucial for survival as an independent sponsor.

Approaching lenders as partners ensures a better outcome and establishes an “understanding that the lender is going to work as a partner to the extent that they can and [make] sure that the deal is done,” said Brian P. Coughlan of McGuire Woods’ Corporate and Private Equity Group.

In this episode of Deal-by-Deal, the hosts are joined by Brian, as well as Joe Rodgers of Source Capital, LLC, to discuss how to approach debt lenders and how to get the most out of those deals. They also explore the state of the current lending market, and how independent sponsors should approach deals in a time of uncertainty.

 

Featured Guests

Name: Joe Rodgers

Title: Managing Director at SourceCapital, LLC

Specialty: As managing director at SourceCapital, a lower-middle-market investing fund, Joe helps lead the credit strategy arm of the investment team.

Connect: LinkedIn 

Name: Brian P. Coughlan

Title: Partner at McGuireWoods

Specialty: As a partner in McGuireWoods’ Corporate and Private Equity Group since 2017, Brian represents investment funds and strategic acquirers in connection with mergers, acquisitions, investments, divestitures, and other strategic and financial investment activities, with a particular focus on debt financing structures.

Connect: LinkedIn


Acquired Knowledge

Top takeaways from this episode 

  • Approach debt deals as a partnership. As debt equity becomes more commoditized by a growing concentration of traditional private equity funds, one of the most important parts of the process is getting lost: relationship building. As the market continues to spiral into uncertainty, strong relationships with a variety of lenders could be a deciding factor in securing a deal. 
  • Get early leads from your debt providers. Debt lenders love looking at deals at every stage of the process. But as an independent sponsor, communicating with your providers early on will give them more time to prepare and iron out any potential issues, giving you a better chance of winning the deal.
  • The cost of deals may be going up. We still don’t know how the market will be permanently impacted by the economic tumult of recent years, but we do know that good deals are still going to happen. Independent sponsors should be prepared that costs of those deals will go up, but they might not necessarily remain high forever.

 

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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.

Transcripts

Voiceover (:

You're 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.

Jeff Brooker (:

Hi, everyone. This is Jeff Brooker with McGuireWoods. Our topic today is Best Practices in Selecting and Dealing With Debt Capital Providers in an Evolving Credit Market. I'm happy to have with me two guests to discuss the topic today, Joe Rogers, a managing director from Source Capital in Atlanta and Brian Coughlan, a debt finance partner at McGuireWoods in San Francisco. So Joe, maybe hand off the floor to you to give a brief introduction about your background and your firm.

Joe Rodgers (:

Yeah. Thanks, Jeff, and thanks again for allowing me to participate. I really look forward to having this discussion over the next 30, 45 minutes, so again, I really appreciate the invite. Source Capital is a private investment firm here in Atlanta that was founded in 2002. Today, we go to market with a bifurcated investment strategy both focused on the lower middle market. One side of the house is focused on controlled buyouts as an independent sponsor and over 20 years has closed 27 platforms and close to 50 add-ons. But the other side of the house is the credit strategy started up in 2011, and that's the side of the house that I help lead. Today, we're investing out of our fourth credit fund and our first SBIC. We got licensed last July and primarily we're focused on companies with minimum EBITDA of $2 million, and really trying to underwrite more flexible unitranche debt along with equity co-investments.

As we think about both the debt and the equity across the overall platform, our goal is to hit an average 75/25 dead equity split on the capital deployed. We've been investing out of the fund now for about a year-and-a-half and have closed nine investments. Eight of those investments have been with independent sponsors, so I think we've naturally gravitated towards that universe. I really think we have a pretty unique model for our respective marketplace given all the years of doing deals, both debt and buyouts, and the independent sponsors that we work with are really able to tap into all of that experience, especially on the buyout side. So we do have two separate teams that support both strategies, but I am able to of pull in certain individuals from the buyout side that might possess certain sector experience. So that's Source Capital in a nutshell, and again, I really appreciate the opportunity to be on this podcast.

Jeff Brooker (:

Thanks for joining. I know you and your firm are very active in the space and are very knowledgeable about what's going on, so I'm really happy to have you here and interested to hear your insights. So handing off to Brian, Brian, I know we do a lot of work together in independent sponsor transactions, but why don't you tell folks who you are and what you're up to?

Brian Coughlan (:

Sure. I practice primarily in the debt finance space sitting in the San Francisco office of McGuireWoods. Within that space, a significant portion of my practice is representing borrowers and lenders in connection with the independent sponsor space, representing independent sponsors in connection with bioactivity and then supporting portfolio companies with ongoing financing needs as they continue to evolve throughout their life cycle. So from that seat, I've seen a tremendous amount of activity on both the borrower and the lender side that specifically focused on the independent sponsor segment of the market also flex up. So in addition to doing independent sponsor work, we also do a substantial amount of funded sponsor work.

So the differences between those two markets is something that I think that we're able to bring that expertise to bear in the independent sponsor arena and also, the overall depth of experience McGuireWoods generally both on the debt and equity side in the independent sponsor space gives us the ability to truly see what the market looks like and to provide pretty good advice as to what we're seeing in the market and where we think the market is going along with what deal terms we view as typical or potentially off market and what types of barriers may be to getting a deal done in a timely manner, because we certainly know that on the financing side speed is key to execution, and we want to make sure that we're pushing to get deals done in the timeframe that both buyers and sellers are expecting, so that's what we do out here.

Jeff Brooker (:

Okay. Thanks, Brian, and thanks again for joining. There's a lot of debt providers in the market today. There's a lot of capital out there. In your view, thinking from an independent sponsor's perspective, what makes a good versus a bad debt provider and how should an independent sponsor go about selecting the best provider for their deal?

Joe Rodgers (:

Yeah, Jeff, I'll start. I think that's a great question. I'll just really talk about what our goals and objectives are here on the debt side, especially working with independent sponsors. So I think that the deals that we've worked on, the sponsors that we've worked with, we really try to create that partnership with that independent sponsor. I'll be very honest, I think if someone's calling us up and they've got a deal under ROI, and they're just looking for as much debt as they can get and the cheapest debt that they can get, that's just not going to be for us. The independent sponsors that we've worked with, they will show us deals really early on. They want to get a quick buy-in from us. They want to get a better understanding on what do we think about the industry? What do we think about that deal in general? How are we already thinking about what that capital structure might look like?

How much leverage can we put on that deal? But it's interesting, because we play in this really small space that lower middle market. Like I said, our minimum EBIDTA is 2 million, and typically these companies are family-owned businesses. There's not a lot of sophistication in these businesses. These guys, these entrepreneurs have done a phenomenal job growing these businesses, but you come into these deals and typically, you're going to be the first institutional debt coming into these deals and the sponsor's going to be providing that capital. There's a lot that that sponsor needs to do with that company. It's probably a pretty thin management team. That sponsor is going to have to beef up the management team. They're going to have to spend some money in that business. Maybe they've got to beef up the CRM and put in some systems and that all costs money.

So I think in looking at these deals and the sponsors we've worked with, you have to provide a lot of flexibility on how you structure these deals and close because you really have to assume that EBITDA is probably going to go down before it goes back up because of the costs that they're going to have to incur to again, beef up the management team and to probably enhance the system. So I think a lot of these sponsors are looking for a lot of this flexibility. I think that's probably paramount, but then also, certainty of close. These guys, they want to go to that seller and they want to show that seller as much confidence as they can that they can get the deal done. So I think getting that early buy-in from that capital provider is going to be really important. A lot of times we can provide support letters along with Lois that the sponsor can give to those, to that seller, so I think that's also very important.

Then as I mentioned earlier, we like to do debt and equity co-investments, and I think that equity co-investment can be really important because most independent sponsors when they get a deal under LOI, they're thinking about the entire cap structure and what does that look like? A lot of times we can provide a meaningful and a material equity check for that independent sponsor. Then something else to be thinking about is, sometimes we're going to write an equity check out of our fund, but depending on how much we might like a deal, we actually might even put together an SPV and we might take some additional equity to some of our LPs that might be interested in some equity in that deal. So all of a sudden, not only can we provide and write a material equity check out of our fund, but we can also provide some pretty decent equity through an SPV to help them solve for that capital structure.

Jeff Brooker (:

Yeah. Yeah. That can be very valuable when you're trying to fill out the rest of that capital stack or just ensure alignment with that debt provider. Brian, do you have thoughts from your view, what you would see as especially good or bad traits to have in a debt provider?

Brian Coughlan (:

Yeah. One thing that Joe mentioned that I think I want to touch on is the idea of a partnership. I think that from an independent sponsor perspective, the idea of a debt capital provider as a partner in making sure that you get the deal done is something that's important. I do think that sometimes we see that partnership potentially go a little bit too far and that there's sometimes independent sponsors that forget that the lenders are sitting in a different part in the capital stack and have slightly different objectives than they do. But at the same time, the certainty to close the partnership in structuring a deal that will work for all parties and understanding that although there are competing objectives from both debt and equity investors and so independent sponsors and just like all sponsors are likely investing over a different time horizon than debt capital providers are, and with different investment criteria, the understanding that the lender is going to work as a partner to the extent that they can and making sure that the deal is done.

So what we look for in that situation is we rarely see full commitment letters in the independent sponsor arena. We do see term sheets and otherwise and support letters to the extent that they're available. But we also want to make sure that everybody is working towards a general understanding of the same deal and an understanding of the same timeline. Where we see things start to get crossed between independent sponsors in particular and debt capital providers is where there's a misalignment on a fundamental understanding of the deal. So the independent sponsor thinks the deal looks like one thing, the lender thinks the deal looks like something else. If that's the case, that sort of conflict, you may get through to a closing, and that certainly is conceivable, but that type of relationship will be effectively tainted throughout the life of alone.

We would expect that's the contentious relationship that's going to end up driving everybody nuts throughout the course of the facility. Particularly with the types of companies that we see, independent sponsors invest in frequently companies that they maybe need some professionalization with respect to their operations, new CFOs, new accounting processes, new CRMs, all that sort of thing, they assume that they're walking into a fully professional organization on day one. I think as Joe mentioned, there is typically a ramp-up period immediately, and that does need to be accounted for both in the credit documents, but also in the understanding between the relationship between the two parties. So I think it's a partnership it's a certainty to close, and it's an understanding of exactly what the deal is.

Where we do see some misalignment there is where you see new participants on the debt side into the independent sponsor arena, particularly if they come from different parts of the market and they don't understand the independent sponsor model, we can see lenders really fundamentally confused about what exactly it is that they're getting into. And if that's the case, it can really breed some distrust and make for an overall difficult working environment, whether or not a deal gets done initially, just because people don't necessarily understand what they're investing in. So lenders just like Source Cap that have been in the independent sponsor arena for a period of time and done a number of deals in the space have a significant advantage over new participants, if only because they understand the deal, they understand the difficulties that an independent sponsor may have and how those are different from different parts of the market and how those difficulties may present themselves over the course of the deal or over the course of an investment.

Joe Rodgers (:

Yeah. Hey, Brian, I'll add to that, because I think you bring up a really good point. So when we are looking at a new deal and we've screened the deal and it's something that we definitely want to make a run at and we provide that independent sponsor with a term sheet. Over here, so we have three partners, myself, Ben Emmons, Ben really oversees the equity side of the house and then Tom Harbin, who's the managing partner, but the three of us really make up the investment committee for these investments. So when we are really pursuing one of these deals and again, we've provided that term sheet and we really want to go after that deal, most of the time the three of us will get on a phone call with that independent sponsor to talk about the deal.

It is a requirement over here that before we close a deal that two out of the three investment committee members will visit with that management team. We will make an on-site to that company because, to your point, when we close that deal and again, there's going to be a lot of movement with these deals post-close, just because of a lot of the stuff, a lot of the different initiatives that sponsor needs to do with that company. We want to make sure that we're completely aligned with that independent sponsor in regards to the game plan out of the gate, so that's really important. Jeff, when you talk about the good ones and the bad ones, I think the good ones just make sure that you're really trying to be completely aligned with those independent sponsors when you're working on these deals and you're trying to close these deals.

Jeff Brooker (:

What I've seen from bad, two things I would say make clearly a bad debt provider is, lack of flexibility, and then like we've touched on a few times here, lack of a partnership mindset. I've seen somewhere the investment starts to not perform quite as well as everyone wants, and I've seen some lenders that are very quick to tighten the screws at every available opportunity in ways that really felt to the sponsor like retrades and retrades in an unfair juncture. So those are the things that immediately jumped to my mind when I think of folks that probably wouldn't be the best partners.

Brian Coughlan (:

I would piggyback on that as well and say, okay in a slightly downside scenario, we would hope that a lender is willing to play ball and to continue to work through the company. But then the opposite is also sometimes true in that we have companies that are performing, potentially even exceeding the expectations and they want to be acquisitive, but in order to be acquisitive requires additional capital. We have seen lenders who have been in deals who decide halfway through the investment, "Well, we're not totally sure that we actually want to provide that additional capital, but we're happy to be a roadblock to preventing you from raising additional capital so you can follow on on your investment thesis."

That may be something that is not necessarily, it's not a downside scenario because the company's performing and seeking to grow and the investor or the debt capital provider just simply got cold feet. If that's the case, then really, that's an impasse. It's very hard for people to break because you really, now at that point, need to raise new debt capital from when the independent sponsor maybe didn't think that that was going to happen for another year or two. That can really hamstring a company in a very materially bad way.

Joe Rodgers (:

Yeah, for sure.

Jeff Brooker (:

So this is an independent sponsor podcast and a lot of folks who are listening, there's a lot of folks that are very experienced in independent sponsors, there are some that are less experienced, and there's some folks who are coming from a more traditional private equity background. What, in your mind, is the key differences between an independent sponsor transaction and then a transaction that is sourced and sponsored by a more traditional committed private equity fund?

Brian Coughlan (:

I would say that there are a couple of primary differences. The primary difference is the terms. A traditional private equity fund is able to drive terms in a way that they have more leverage in the market, and so they're typically able to get better terms. And so an independent sponsor has, unless there is a very substantial equity backer behind the independent sponsor that's able to help them lean on their capital providers to get better terms, the terms of a traditional private equity fund are just better than the terms that an independent sponsor will get. That's not to say that they're bad, it's just that they're better. But I would also say that what we often see on our side is that the process is different. So we see with a typical private equity process, the process of raising debt capital is pretty well understood in the sense that there are leads to a number of different potential debt capital providers.

Then usually, those leads are concentrated into a grid where we're going back out to a number of lenders and saying, "These are what our preferred terms are. We want you to respond to those terms and we want to evaluate multiple offers or multiple potential options at the same time." That's something that, for whatever reason, I rarely see in the independent sponsor arena. We do see it occasionally where we have an independent sponsor who's running a true debt process in the sense that they're evaluating multiple potential opportunities and running a grid and requiring lenders to effectively bid against themselves so that they are providing the best terms to the independent sponsors. You do see that occasionally, but it is rare. I would say that other than the differences in terms, which are partly driven by where independent sponsors sit in the market as opposed to traditional private equity funds, I think that that process may be the biggest difference between the two types of transactions.

Jeff Brooker (:

Yeah. Joe, what are your thoughts?

Joe Rodgers (:

Yeah, it's interesting. I have spent a big chunk of my career with middle market credit funds catering to middle market, private equity funds and Brian's spot on. Look, we all know that the middle market, I don't know if it's the last 10 years, 15 years, however long it is, but it's been going on for a while that it's just a very commoditized market, especially in regards to debt and the private equity guys, they can dictate their terms. They can essentially tell the lenders, "Hey, guys, this is what we need. If you're interested, great, give us a term sheet," and that's what the market's become.

So in a way, it's become very efficient, but it's become extremely commoditized, and all of a sudden relationships now are not as important as maybe they were 15 or 20 years ago; where, again, in this space, the lower middle market working with independent sponsors, guess what? Relationships, there's a lot more value put on relationships with that debt provider, and candidly, I love that. I miss that and I love that, because you want to feel like you're important to that buyer, to that independent sponsor and they are relying on you. They have faith and confidence that you're going to give them the right structure and that you are going to close their deal. But man, it's a lot more fun when you do feel like you have a valuable relationship with that sponsor, and I think that's what you see in this space.

Jeff Brooker (:

Yeah, that's great. That's great. So we talked a little bit about process, but obviously having a smooth process for an independent sponsor is critical. They typically will get a deal under LOI with their target company and have a pretty limited window to conduct their diligence and get the capital in place so that they can close in a timing that is going to work and not frustrate the target or even potentially lose the deal. So what are your recommendations for best practices for independent sponsors to ensure that they have a smooth process and that they're able to land their debt financing in the way that they want and on the timing that they want?

Joe Rodgers (:

For me, that's a really easy one. Really simple terms, just look debt early reads from your lender, from your debt provider. So we view ourselves as deal junkies. I love looking at deals. We all love looking at deals and I get the question a lot from independent sponsors. They say, "Hey, Joe, when do you want to see a deal?" I tell them, I give them the same answer. I say, "Look, it doesn't matter to me. I will look at, or we will look at a deal at any stage of the process, and we will look at a deal pre-IOI LOI, it doesn't matter." We want to add value to that independent sponsor. We want to provide them some visibility on what we think the debt would look like, and that's going to help them.

We think it's going to give them the best chance of hopefully winning that deal. Like I mentioned earlier, if we see a deal early enough, and let's say it's in the LOI stage and we really like that deal, we can start telling that independent sponsor, "Hey, here's the debt that we can do. Here's the equity that we can do. We can put a chunk of the equity in the fund. We can put a chunk of the equity in an FPV. We can give you a support letter that you can attach to that LOI." Again, we can give that independent sponsor the best chance of winning that deal. So for me, it's a really simple answer. It's just, get early reads from the lenders, from the capital providers that you're talking to.

Jeff Brooker (:

Well, that's pretty straightforward. Brian, anything additional to add, or is it as simple as that, you think?

Brian Coughlan (:

I think, generally agree with Joe and pretty much getting people involved as early as possible. The other thing that I would make sure that independent sponsors are thinking about is making sure that as much information is shared as early in the process as possible and as early as it is known. So to the extent that there are wrinkles in deals, because there are always wrinkles in deals or potential diligence issues that arise that may cause some issues on the lender side, those are better resolved by disclosing them, and by making sure that your capital partners understand what those potential issues are so that they can be worked through, because one thing that can really cause significant problems in the process is if there's an issue and the independent sponsor, or even any traditional private equity fund knows about the issue but doesn't feel willing to share that issue until later in the deal where it feels like the lenders are committed at that point, because the only thing that that does is destroy trust in the process and destroy trust on both sides.

So that if the lender is understanding that the independent sponsor is conducting traditional diligence and going to share the diligence, and that's not exactly accurate, or the diligence is being conducted, but not shared, particularly if it looks like there are some works in the company that were not necessarily present when the initial conversations have been had that non-disclosure can really be problematic. So keeping everybody informed and just a good flow of information, consistent dialogue between the independent sponsor and the capital provider is something that we feel really helps smooth the process. Then I guess the other thing is being realistic with timing. If you must close by a certain date and close and then make sure everyone's aware that they need to close on that date, if you would just like to close on a date because you just want to close on the date and it's an artificial date, as a lawyer, I would say let's be realistic here, but also let's make sure that we know what the date is. If exclusivity runs two weeks after the proposed closing date, but you just want to close earlier just because everyone would like to be done, cool. That's great. Let's work towards that timeframe, but let's not tell everybody, "Oh, exclusivity runs two weeks earlier so that we can try to get everybody to move faster," that's just going to make everyone annoyed.

Joe Rodgers (:

Brian. It's funny you say that, because I might talk to some independent sponsors. I'm like, "Okay, well when do you want to close?" "Hey, can you close in 30 days?" I'm like, "Yes, sure, but I need to run legal parallel and I need to jump through all these hoops and it might cost you a little bit of money, but we can do it," but it certainly puts a lot of pressure on that process when that independent sponsor is really pushing the timeline.

Jeff Brooker (:

In this vein, I think I've ruined Brian's last 4th of July and Memorial Day, so I will apologize to you publicly, Brian.

Brian Coughlan (:

I think you also may have got Thanksgiving in there and I think you avoided Christmas, but I think that's only because somebody else was during it. So I don't think I can blame you.

Jeff Brooker (:

Yeah. Yeah. Unfortunately.

Joe Rodgers (:

Jeff, don't you have to name your next son after Brian?

Jeff Brooker (:

I'm not sure whether that was Thanksgiving or 4th of July, but it was a painful trade. So at least he's not named Mephistopheles or something. So what kind of debt structures are you guys seeing in independent sponsor deals, and then piggybacking on that question as well, what are your thoughts on creating the best debt structure for any particular deal?

Brian Coughlan (:

Sure. I'll jump in there. So I see a typical independent sponsor structure as a term loan, traditionally from a private debt fund or an SBIC fund. Sometimes you get a type of a unitranche facility with a term loan plus a revolver built in; although, in an independent sponsor market, just because of the lenders that are playing in that space, that's a little bit atypical. The most frequent debt structure is a closing day term loan from an SBIC fund to a private lender and then a revolver from a traditional bank. Depending on the overall size of the deal, those revolvers can be pretty modest in size. There's typically an effort to try to get the revolver in place at closing. I would also say I see those revolvers layered in within the first three to six months after closing fairly typically, because the effort to try to get an acquisition closed and get a term loan in place or an acquisition term loan in place usually sucks up all the oxygen in the room.

So the ability to run a parallel debt process with a revolving lender at the same time that you're running an acquisition financing process often is too resource intensive, and so we see most independent, many independent sponsors willing to punt on that. If there's not a need to have revolver in place at closing for working capital purposes, it also gives the revolving lender a little bit of certainty in the sense that they can come in three to six months. They can look at the company on a post-acquisition basis and be able to make a slightly better determination. So you do, as an independent sponsor, have a possibility of getting slightly better terms from the revolving lender if you do it a little bit later, although, it's one other thing to add to your checklist as you're trying to ramp up operations with a new portfolio company.

Joe Rodgers (:

Hey, Brian, how often are you seeing these deals with independent sponsors where the cap structure includes seller notes? I guess my next question is really just of given, I guess, the overall market today and where the economy currently is, are you starting to see more structure in these deals where maybe that that seller is getting a little bit less cash than that seller might have gotten last year?

Brian Coughlan (:

I see seller notes very frequently. I think it depends a little bit on the strength of the equity capital that's supporting the independent sponsor. So if there's a very strong equity backer, there may be more equity dollars available and less of a seller note, we see a seller role pretty typically in, I think, almost every independent sponsor deal. Jeff, you would be able to speak better to that than I do. But I think I see them almost universally, some sort of seller role, whether it's in a new preferred class of equity or through a seller note or something like that.

I haven't seen the market change in the last two or three months with respect to how seller notes are being structured and whether there's less cash at closing, but I think that part of that has to do with people still trying to digest exactly what the new credit markets are going to look like and how they will have to deal with that situation going forward. But I would expect that to be a structure that we start to see, that there's maybe less cash at closing and a seller note included, but we haven't seen that filter, or maybe a larger seller note included, but we haven't seen that filter through yet.

Jeff Brooker (:

I'd agree with that. I think when there's deferred or contingent consideration, what I'm seeing most is an earnout. Since COVID, that was a blip in performance for a lot of different companies, most did worse, but some actually did better, and so there's that valuation gap that needs to be bridged. I've seen some folks try to use that as well with the uncertainty of a recession coming up and potentially a deep one, according to some folks' predictions, folks trying to solve some of that valuation uncertainty with a lot more earnouts than I think we used to see prior to COVID when I think we were blowing and going before that, and there wasn't as much nervousness, I don't think, in what the next year or two was going to look like.

Joe Rodgers (:

Yeah, agreed. You know what? You're spot on with the earnout, because we're definitely seeing more of that, and I haven't done the analysis, I haven't really kind looked at specifically deals that we were looking at last year versus this year, but it does appear that really compared to last year that that earnout piece is probably bigger than what it was last year. Look, I will tell you that from a lender's perspective, I want to see as much skin in the game from that seller as possible. So there are a lot of deals that I will see from an independent sponsor when I look at the cap structure and they've negotiated obviously a pretty material rollover from that seller, but I'll see a seller note and then I'll see the earnout and I'm like, "I'm all for that, because that's just more skin in the game from that seller."

Jeff Brooker (:

Yep. Yeah, that makes sense. I agree with Brian's comment as well that most deals, the vast majority of deals do include a meaningful seller rollover and that I'm sure is for alignment purposes as well as managing the cash outlays. So we touched a little bit about the debt markets turning, and they're obviously getting more expensive. I've heard a lot of folks out there telling me that the debt markets are tightening up. Joe, what are your predictions for the future over the next, let's say, year or two? What do you think that we'll be seeing?

Joe Rodgers (:

Yeah, so it's an interesting time, because are we in a recession? I guess technically we are now, because you've had the two consecutive quarters with a down GDP, but if we aren't in one, are we heading into a recession and how severe is that recession going to be? So I think it's a really interesting time in the market because there's just so much uncertainty out there right now. The sponsors that we talk to, guys, it's really becoming even more challenging to underwrite EBITDA. Even if you can underwrite EBITDA today and try to figure out what is normalized EBIDA, given all the uncertainty out there. It's like, well, what could EBITDA be three months from now, six months from now, especially if the economy continues to slow down?

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Brian Coughlan (35:28):

Yeah, I would say, I wish I could have a really rock solid prediction because then I would not be practicing long. I would probably be playing the stock market more successfully than I am. So I do think that what Joe said is right, there's uncertainty in the credit markets and lenders don't like uncertainty. I think that it goes hand-in-hand with the idea that you really need to keep your lender informed of what you're doing because they can manage risks that they understand. They have a hard time managing risks that they don't foresee. So I think what we're seeing right now is that the credit markets are uncertain and the economy is uncertain, and it's not necessarily that it's going in one direction or another, it's that it's uncertain which direction it's going to go. That makes credit decisions difficult because you underwrite based on certain assumptions and look, those assumptions can be correct or they can be wrong.

Everybody understands that that is part of the game, but there's so much uncertainty right now that it's almost as if we have people who are questioning whether the core assumptions that they would make in connection with any investment are true, or if they're false and if that's the case, it gets hard to do a deal. So I think if I was going to be an independent sponsor trying to navigate this market, I think the first thing I would expect is that there's almost certainly increased pricing on the debt capital that you were looking for. If you're going to compare year-over-year, a deal being done today, as opposed to a deal being done a year-and-a-half ago or a year ago, the pricing, it is higher if only because the underlying reference rates have ticked up.

I haven't necessarily seen it tick up higher yet, but I think it probably will tick up in order to deal with the uncertainty. But that being said, good deals will still get done. They may just be more expensive, but they'll get done. The one way to mitigate that on the independent sponsor side is to be talking to as many different lenders as possible. We see a lot of lenders in the independent sponsor space that are focused on particular verticals, so they're focused on particular industries and they may have a different view within that industry than the overall economy. So if you are in a particular space, I would make sure that you're reaching out to as many different lenders as possible, because it may be that you run across a lender who is more bullish on the space that you happen to be into than other lenders may be.

By talking to as many potential that capital providers, you have the opportunity to get connected with the right group. It's a matter of always getting the deal done and making sure that everything checks the boxes, but deals will still get done. The people that we talk to still have robust pipelines and they still feel that there are plenty of deals to be done. There's a ton of drive powder out there on the traditional private equity fund side, the private debt capital fund side. There's a lot of opportunity out there, and I think that people will still do deals, they just might be a little bit more expensive in the short term. The other thing to think about is the idea you're going to buy a company and over the course of five to seven years, let's say a typical hold time for an independent sponsor is somewhere between three years on maybe a very short-term investment to maybe 10 years or 10 years plus.

If you want to hold it for a longer term, you will run through over that period, a number of different debt capital providers, just because the company will be in different stages of its life cycle. so if to get a deal done, you may have to have slightly more expensive capital today, that doesn't mean that capital is going to be more expensive in two or three years, if you go to refinance. So to the independent sponsors out there listening, I wouldn't say don't be too discouraged just because the pricing is slightly higher today than it was a year ago. Take a slightly longer term view. If the company still is a good opportunity, there will be a lender that will lend to you. It may be a little bit more expensive, but assuming that your thesis is right, the expectation is that you should be able to refinance that to a slightly better facility within a couple years.

Jeff Brooker (:

Yeah. Any final thoughts, Joe?

Joe Rodgers (:

No. Brian, quick question for you. The deals that you work on with independent sponsors and Jeff, you too, and the smaller deals, let's just say two to seven of EBITDA. Let's just say that these are sponsors that have real deal experience, maybe they've been an independent sponsor for several years. They've done deals. Do you typically find given the overall model and what an independent sponsor needs to do with these deals, with these companies post-close and maybe even just of given the overall market right now, do you typically find where a lot of these guys overequitize?

Brian Coughlan (:

That is probably a better question for Jeff than for me, but that is probably a better question for Jeff than for me, actually.

Jeff Brooker (:

Yeah. I would say it's hard to say. I definitely see some folks use a lot of equity, but it's hard for me from where I sit to say could they have obtained the more debt and on terms that would've made sense for the company? I'm not usually privy to how many conversations and what the conversations were with the debt providers, so it's probably hard for me to characterize. I would say it's not uncommon to see folks close with a lot of equity with the idea that they would get debt in place later and use the debt for add-ons, but never actually refi out the fact that they may have used a lot of equity at the closing. So may be that may be indicative of the fact that they did close with more equity. But again, I have a hard time saying definitively yes or no on that.

Brian Coughlan (:

Yeah. The one thing that I would say is that I do see traditional private equity funds, then this is not to say that there are not independent sponsors, particularly experienced independent sponsors who run the same type of strategy, but I find that my traditional private equity fund clients are more aggressive at utilizing the debt capital markets in a way that benefits both the company, but also benefits the private equity fund. So dividend recaps are something that are common in a traditional private equity structure.

They're less common in an independent sponsor structure. I do see traditional private equity being very comfortable, "Okay, we're closing with this amount of equity. We fully intend to do a dividend recap in the next two years because our growth trajectory is such that we can layer on a layer of debt to effectively refinance the equity that we put in and we can take money out of the company." I don't know that I've ever actually seen an independent sponsor do that. I think that it's a strategy that I think probably more independent sponsors should think about because it makes sense given overall capital structures.

Joe Rodgers (:

Yeah. You know when we will typically see it is where that independent sponsor, it's more of a buy-and-build strategy. Again, it's probably family-owned and they really need to professionalize this business. They need to professionalize this platform again to just be in a position to go after some tuck in acquisitions. A lot of times in that case, that sponsor will look to overequitize because again, they don't want to get overly aggressive with the debt at close, knowing that they've got to spend some money in the business, they've got to beef up the team. Then the fact is, "Okay, we're going to put in more equity that we probably need, but as we go after these tuck-ins, these add-ons, then we'll look to do most, if not all, of those tuck-ins with debt." That's typically when we'll see the sponsors overequitizing that deal at closing.

Brian Coughlan (:

Yeah. That would make sense.

Jeff Brooker (:

Yeah. I think that's consistent with what I've seen as well. So I think we're at time here. I want to thank you both for coming. I know and respect both of you immensely. I think as far as exposure and experience in the independent sponsor deal ecosystem, you'd be hard pressed to find two guys who have who've seen more independent sponsor deals, so really happy that you joined. I would encourage folks who are listening to the extent that you're an independent sponsor or anyone else in the private equity space, and you're looking for debt or equity in a way that would might make sense for Source Cap, please by all means, reach out to Joe. If you are looking for legal help on the debt side, Brian's fantastic. He's one of my go-to partners at McGuireWoods and can't say enough about him either.

Joe Rodgers (:

I paid Jeff to say that, so take that with a grain of salt.

Jeff Brooker (:

Thanks again, both, for joining. I thought it was a good discussion and I hope folks get a lot of value out of listening to it.

Joe Rodgers (:

Thanks again for the opportunity, Jeff.

Brian Coughlan (:

Yep. Thank you, Jeff.

Voiceover (:

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.

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