Grant Kornman, a partner at Align Collaborate, joins hosts Jeff Brooker and Jason Griffith for a primer on tiered carry structures and catch-ups in the private equity market. Grant shares insights about negotiating economics and governance terms, emphasizing the importance of aligning incentives and being a good steward of capital. He highlights the significance of valuations in determining hurdles and sharing percentages, as well as the need for sponsors to collaborate with investors for successful partnerships.

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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, everyone. Welcome to Deal by Deal. This is Jeff Brooker with McGuireWoods. I'm here today with my colleague Jason Griffith, as well as Grant Kornman from Align Collaborate. One of my favorite people in the space. But personal feelings aside, I think Grant also is one of the most informed, and thoughtful, and experienced actors in the independent sponsor segment of private equity.

I'll step back, Grant, and allow you to give a few minutes on your background before we delve into the episode.

Sure. Jeff, Jason, it's great to talk to you here before the holiday. Thanks for having me on your wonderful podcast. Jeff and I have been friends for, gosh, going on 10 years now, when we got started as an independent sponsor. I had a lot of success in the model. Built a firm called NCK Capital. It actually grew out of McGuireWoods' break room back in the day, when this whole thing was getting going.

We recently launched a new strategy called Align Collaborate. We have flipped over to the capital partner side of the equation. Very excited to be partnering with and investing with some of the best and brightest independent sponsors in the country. And hopefully giving them the gas they need to go build some great lower middle market companies into the next wave of middle market businesses.

Grant, that's great. This is Jason Griffith. I'm in our Chicago office. Jeff and I are excited to talk to you today. A big piece of our practice is working with independent sponsors on their transactions. One of the most important questions that they always are asking us is how should we approach the carry structure, what's market? How do capital providers look at it, both in terms of what are they willing to pay so we can do well? But also, what do they think is fair so we can do well by our capital partners as we go through the transaction?

What we're hoping to talk through today with you is the tiered carry structure a little bit. But mostly, how do we think about the role of catch-ups in the context of those tiers? I think there's the old private equity two-and-20 model, and then capital providers are getting 80%, the private equity fund's getting 20% after that. With independent sponsors, there's extra layers of nuance, where there's different levels and the participation percentage varies somewhere between 10% up to 15, 20, 25 and up.

One of the things that we're always looking at is when we get to the next hurdle in the tiered structure, is the independent sponsor catching up to where they were before? Maybe we'll take that all in turn, and if anybody wants to follow along at home, this comes out of a little bit, our independent sponsor survey. We talk about the different carry structures in there. We talk about the different hurdles, we talk about the different participation rates. We'll dive into all of that with you today, Grant.

Jeff, is there anything you want to add on that, or should we just jump right in?

Just to be clear on the catch-up, what that means is when you hit a hurdle and you are ready to go to the next percentage, the next higher percentage for the independent sponsor, do we pause, look back to dollar one of profits, and bring that independent sponsor up to that percentage? And then share at that percentage until the next subsequent hurdle. I just wanted to be clear for folks that may not be clear on that jargon or using a different jargon as to what we meant.

Jeff, maybe give me an example. If I said to you, "After we return capital to our capital providers, as the independent sponsor, I'm going to get 15%. But then after we get to a two-and-a-half MOIC, I'm going to get 20% with a catch-up." What do we mean when we say get that catch-up piece in there?

Yeah. That means that once the capital provider has achieved an MOIC of two-and-a-half, we're going to hit pause. The waterfall is going to have a step that provides for the independent sponsor to get up to 20% of the profits. That means that at the end of that step, that catch-up step, the profits will be in an 80-20 split between the capital provider and the sponsor. And then, from and after 2.5% MOIC, we will share at that 80-20, either forever or until the next hurdle is hit, if there is a next hurdle in your waterfall.

That makes a ton of sense.

Grant, one of the things that I think is an initial question people have, whether you're having a catch-up or not, is what do you think is a market approach to the first hurdle? Is it return of capital, one-and-a-half, maybe an 8% IRR, or something like that? What are you seeing out there?

It's a great question, Jason. It's funny how this world has evolved. When we got started in it 10, 11 years ago, it was really the wild, wild west. If you ask anyone on what market economics meant, you'd probably get a different answer from everyone you talked to.

I think your great survey and others out there have done a good job of defining what market means. From our perspective, Align Collaborate, we always want to pay market economics. We want to be the first phone call from the best sponsors on your best deals. We fully believe it's hard sourcing great companies, it's hard building great companies. When you do those things, you should definitely get market economics.

To your question, what is market economics? It's funny. I'm going to say it depends a little bit. It depends on a lot of things. An experience with a sponsor. Probably one of the biggest things is the valuation you're paying for the business. Obviously, the better deal you've cut on the company you're buying or investing in, those economics will probably be a little juicier for you to sponsor. Where that first hurdle is, in terms of whether it's an 8% preferred return, or a one-and-a-half times MOIC has a little bit to do with those factors.

We generally keep it simple. We need to get our money back plus an 8% preferred return. And then, there's a catch-up to the sponsor at whatever that first sharing percentage is. If it's a straight 80-20, they'd get caught up until they have 20% of profits, and then go thereafter. If it's more of a tiered structure, then it would be the first tier of the sharing percentage.

Your more simplified example, you guys want to get return of capital, and then an 8% return. And then the next stage is 100% of the values coming out to catch up the independent sponsor to their first hurdle, right?

That's correct. If the first hurdle was 15%, they would get 100% of proceeds until our 8% plus their share was 85-15.

Jeff, this goes to your point. What we're effectively doing, because we're probably not paying a ton of interim distributions unless this is one of those investments that's maybe spinning out cash. But I think the majority concept is we're looking at a significant event, a dividend recap or an exit, and we're going to push a bunch of money through the waterfall. The punchline is when we look at it at the end, it would basically at that point replicate, Grant, an 85-15 split on the ups from the deal after your preferred return, right?

Correct. It would actually look like an 85-15 once we get a return of principle back once you've gotten through the catch-up.

Got it.

There's a reason why investors ask for that. Whether you're a family office or you're a fund, at the end of the day, we tend to have a cost of capital and it tends to start with 8%. What we're basically saying is, "Hey, we got to get at least our cost of capital back before we start sharing some profits."

Do you have a particular point of view on if I said one-and-a-half versus an 8% IRR? I think that's the same thing four-and-a-half years into the investment cycle, right?

We tend to lead with 8% out of the gate. We're known as very independent sponsor friendly, and we're all about aligning our incentives and the sponsor's incentives. If they can get a great outcome in three years, we think a straight one-and-a-half times out of the gate is penalizing them a little bit for getting a great outcome early.

Do you think there's a lot of interplay between maybe the 8% versus the one-and-a-half, and where that first hurdle sits? Said differently, maybe it's a lower first hurdle but then a lower sharing percent, or a higher first hurdle and a higher sharing percent? Does that go to your earlier point of valuation of the underlying deal being a big driver, too?

I think where the hurdles land, either based on a MOIC or an IRR, or both, has more to do with the valuation the sponsor is paying for the business than it does where one relates to the other. If the sponsor has paid more than market for an acquisition, they could probably expect those hurdles to be higher.

Think of it as a simple market. If someone's really overpaid for a company, the capital that that company and that sponsor is going to attract is probably going to come with higher hurdles because the capital is taking more risk. Conversely, if the sponsor has negotiated great valuation, maybe a discount to market, it may be a simple 80-20 over an eight, or tiers with lower tiers to begin with and some kind of performance bonus over a certain MOIC hurdle. Your ability to drive the economics to your favor as a sponsor probably has more to do with negotiating a great valuation with your target.

Yeah. I think that's such an interesting concept. Jeff, I don't know if you have this experience, but from my side of the the able, I think our clients often ask us about the interplay between the hurdles and the thresholds. And the idea that a bigger driver to that math is actually the underlying value of the business, I think is such an important insight for independent sponsors to carry with them as they're putting together their structure.

We get asked all the time, "What should I ask for here?" That's a hard thing to ask a lawyer who can't really value the business. I can hold my finger up and try to guess. But there's a lot to it, and we as lawyers have a hard time trying to understand, "Well, what should a business like this actually trade for, versus what is your price?" Then I think there's a lot of signals that you're sending as well with your asks. How you go out communicates things about your expectations and such. I think someone like Grant, who's used to living in that world, is going to view it I think with a lens that isn't going to be quite the same as ours.

Grant, when an ask comes in from a sponsor, or maybe when you were a sponsor and you were communicating an ask, how are those being perceived across the table? For sponsors who maybe are less experienced, are they conveying messaging that they may not even be realizing?

Jeff, I think you touched on a really interesting point. Which is how you ask for these economics is almost more important than what you're asking for.

If a sponsor, and we definitely learned this the hard way, if you go to market with what is perceived as an above market ask on the economics, I think there are a lot of investors and capital partners out there who will immediately think to themselves, "I don't want to spend time on this opportunity because the sponsor doesn't understand the market." It can actually put you at a disadvantage if you get a little too aggressive with your ask. Now with that being said, if you don't ask, you don't get so there's a fine balance there.

At the same time, I think sponsors need to show a willingness to get to the middle quickly on these negotiations. What we've found, both as an independent sponsor and now a capital partner, is the best capital partners and the best independent sponsor relationships are ones where you can find common ground and understanding each other's needs quickly, and get to the middle in an efficient and painless way. Sometimes if sponsors don't understand that, and they don't understand the needs of the capital, then they grade out a little less strong as great capital steward. They may find it harder to raise money than they may have thought. Often times, investors really won't be that transparent with sponsors about it.

And then maybe talk about what you're signaling. If a sponsor is really gearing towards a certain outcome in their negotiations, I think it does send a signal to the investor like us that they really believe in this opportunity. Maybe they're a little bit less concerned about the downside scenario, and more concerned about the upside because that's what they think is the most probable outcome.

Is it attractive to you then if there's a sponsor that says, "I'm willing to give up some economics on the lower end multiples because I believe in this and think it's going to go a long way? In return, I'd like to get a bigger piece of the outsize, the outer ends of the carry."

You definitely can't have your cake and eat it, too. If you're going to be asking for that performance bonus, you got to give a little bit in the lower outcome scenarios.

I think when we see sponsors say, "Hey, I want to start at a 20% out of the gate and then get a big performance tier after that," they're saying, "I want it all." If they haven't negotiated a very low valuation, maybe that shows that the sponsor doesn't fully appreciate the needs of their investors.

I heard you call it a performance bonus at the end. I've heard others refer to it as the super carry, or just the last step. What's interesting as we looked through our data when we were putting the white paper together, it's pretty common to have catch-ups to each step of the waterfall. And it's also pretty common to have that last step not have a full catch up. I just thought that was interesting. It's anecdotally consistent with what we see in our negotiations as we talked around the firm. But it's interesting. You have a hurdle, catch up, have a very last performance hurdle with no catch up to it.

Do you have any reaction to that, or what that signals? Or why it would be the case that that last piece isn't caught up?

Jason, thanks for bringing that up. I think it's really common for sponsors will negotiate catch-ups through 20%, because they do a good job. The market's very clear, you get 20% of profits. In a super carry situation, or a performance hurdle where you're getting more than 20%, a catch-up puts a pretty big wall between the investor and their next dollar of proceeds. It really hurts returns for investors.

Going back to being a great steward of capital, I think sponsors who understand the market and understand what the needs are of their investors will really understand that that catch up after 20% on a 25 or 30 percent super carry takes too much of the upside away for an investor.

That's such a more nuanced and thoughtful answer. I think I've always thought of it as that's the horse trade at the end. We want one last higher threshold, and the capital provider says, "Okay, but you can't get caught up to it." I think it's interesting that it's really rooted in the idea that 20% makes a lot of sense on a good outcome. We're also really happy to share more proceeds in a great outcome, but that wall of capital presents an issue. And just being thoughtful about ...

One of the themes that I think I'm teasing out of everything you're saying, Grant, is be thoughtful about how your capital providers are coming into this investment. And be thoughtful about how they approach it as stewards for the people that invest with them.

You said something that was interesting earlier, which was not in our call prep so don't answer if you don't want to. It was interesting. Sometimes capital providers may not be totally transparent with why they're not engaging in the process if you're too aggressive in your first asks. If you're an independent sponsor out there, or when you were an independent sponsor out there, how do you try to find the sweet spot of asking so you can get it, but not over-playing your hand so that you turn people off?

It's a great question. I think when you are raising capital, people are trusting you with their money. They're trusting that you're going to generate a great return for them. When they feel that, at every turn, a sponsor is really negotiating for the best outcome for themselves, it just doesn't make that investor feel like you're going to be a great steward of their capital. If you're asking for out-of-market terms, either economically or governance, or whatever it may be, it just goes back to being a little bit tone-deaf to the needs of your investors.

Now putting the shoe on the other foot here, I think many investors are often times tone-deaf to the needs of the sponsors. I think that's one of the things we really want to be known for, in being very sponsor friendly. It really comes from our backgrounds being a sponsor. That both sides of the equation have needs, and if you're sensitive to them you should have a really great outcome for everyone involved.

That's might a good segue to talk about how does the carry negotiation interplay with the closing fee, whether it's cash or rolled, and how big the closing fee is? And then the ongoing management fee. Probably more about the floors and the ceilings on the management fee, because I think 5% is reasonably market at this point.

How do you put all that together? Particularly in light of the idea of we want to set up something that works for everybody. We want to be thoughtful to the independent sponsor. I think a lot of times, independent sponsors on their first deal or two are thinking a little bit about, "How am I going to pay my bills with the management fee?" How does that all fit together in a package because you negotiate it all at the same time, right?

It's true. I think one of the most difficult things for first time sponsors is they look at your great report, they look at where the averages all fall out. And they think, "Well, I should get the average across the board." I don't know if that's exactly true. Sometimes sponsors will push for different things on the carry and they'll give up a little bit on the fee side.

But the thing about today's market versus 10 or 12 years ago, when it comes to the fees, the upfront fee and the management fees, that's probably where there's the least amount of negotiations and the most clarity around where the market is. I think where some of the nuance comes in is around some of the softer terms of governance and what happens in downside scenarios that maybe drive some of the more economic terms.

When we talked a couple weeks ago, you said part of what you're doing when you're talking to independent sponsors is underwriting who they are and what kind of partner they're going to be in the deal, and what kind of steward they're going to be for the investment. Could you talk a little bit more about that? In the context of the economics, in the governance, in the soft points you just mentioned. How do you think about all that? And how does an independent sponsor show well?

That's a great question. I think that the best way to show well is to clearly articulate your position on an issue, listen to the needs of your investor or the other side. And really, try to find common ground versus being an edge player or having sharp elbows.

Where we play in the lower middle market, it's a really collaborative space of private equity, and especially in the independent sponsor world. That's why we named our firm Align Collaborate. I think the folks who do the best are the folks who really play well with others in the sandbox. I've used this analogy many times at your great conference, and I used to use it from the perspective of the independent sponsor. Go find investors who want to have friends in the sandbox with them. Don't find investors who want to have the sandbox all to themselves.

I think now as a capital partner, that analogy is really true as well for sponsors. The sponsors that attract the most capital, that build nice portfolios of companies, they really do a good job of collaborating. Not just with their investors, but with the management teams that they're backing and supporting, with really all the stakeholders in these transactions.

Grant, one of the things that I get asked a lot. Independent sponsors always want to ... Always is maybe an overstatement. But frequently want to transition to a model where they have a set of soft committed LPs that they can go back to and say, "Hey, would you like to invest in this one? Same documents as before." It's similar to an actual committed fund, except there's not that actual commitment. But you have that longterm relationship where you have a pretty good set of confidences that those investors are going to invest alongside you.

In those scenarios, when you're negotiating your first set of terms with an investor, how should you view that as setting up that longterm relationship? Are we negotiating not just the economics in the deal for this deal, but essentially for this entire relationship? Or is that subject to modification over time? How do folks tend to think about that?

Our goal is to work with great sponsors and do multiple investments with them. Then hopefully, be the easy button for equity. When you've gotten through your first investment, and you've negotiated the docs, and all the different aspects of the relationship, it's much easier to rinse-and-repeat than to recreate the wheel with either a new investor or a new independent sponsor.

I think you're right, Jeff, that you're definitely setting a precedent. The question then becomes if you want to make a change as a sponsor, what's the catalyst for that change? When it comes to economics, where there's most likely to be a difference between one deal and the other, is the carry. The fee construct is probably the least controversial in these negotiations.

Going back to an earlier comment, I think the carry is going to be mostly driven by valuation. If a sponsor came to us and they bought a business at five-times that was probably worth seven, and that was the first deal. And they come back to us, and the next one's at eight-and-a-half-times, and the market's more eight-and-a-half, nine-times, we may be the one saying, "Hey, guys, we got to rethink this carry a little bit." Or conversely, your next investment is at a much lower valuation relative to market, you may be able to ask for a little more from an investor.

On the more soft terms around governance, look, if there's a good reason for a change ... Like, "Hey, I'm putting up a lot more of the capital today as the sponsor than I did on our first one." That's a good reason to go back and think about governance a little bit differently. Or, "Hey, on my last deal, you put up 100% of the equity and in this one you're putting up 25%." Another good reason to have a different discussion around governance.

I think what's probably more what you're signaling through your first deal is what are you like to work with as a partner. On both sides of the equation, the investor as well as the sponsor. If that goes smoothly and easily, it's probably going to be easy the second time, and the third time, and the fourth time.

That makes a lot of sense. You have talked a lot today and shared a lot. I think it might help folks who are listening if they got a little bit more information about Align, and what kinds of sponsors you look to work, what size checks you write, what kind of industries. Tell us, what's on the fairway for Align, and what kind of sponsors should be looking to you?

We really want to be the first phone call from equity by the best sponsors out there. We write checks for 10 million to 50 million. A real sweet spot is 10 to 25 million. We, as we mentioned earlier, love to pay market economics. We focus on a couple of key sectors. Services, manufacturing, distribution, and technology, so think of us as mainly a B2B products and services type investor. We love the lower middle market, so for us that's companies with a minimum of 2 million of EBIDTA and a maximum of 15 million. Definitely love opportunities where there's a strong buy-and-build component to the investment strategy. And that they're in industries that, when you take a lower middle market company and turn it into a middle market business, you get a nice multiple expansion. If you can check those boxes, we're going to be very excited about your investment opportunity.

Something that's a bit unique about us is that this is all we do. Think of us as a specialized investor for sponsors who raise their equity deal by deal when they're investing or buying in a lower middle market company.

Well, thank you, Grant. I really appreciate you taking the time to be with us today. Your answers were very thoughtful, as expected. We think the world of you and your firm, and your brother. And have seen you in action and worked with you on plenty of things to know that you're a great partner for independent sponsors. And would encourage all the sponsors who are out there listening to, if you've got a deal that seems like it might be a fit for Grant and his firm, to contact them and speak with them, because we know they are a great partner.

Jeff, thanks for those kind thoughts and endorsement. I have to return the favor here. We've been working together in the trenches for over 10 years. You, and Jason, and all your partners at McGuireWoods have built an incredible practice around the independent sponsor ecosystem. If there's any independent sponsors out there who are just getting going or been in this business for a while, you should be at the top of their list. Because not only are y'all great lawyers, you're truly counselors and can help folks navigate this world, and really land in the best position possible.

I do appreciate the kind words. With that, thank you, folks. We appreciate you listening. We'll catch you on the next episode.

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.