How Does an Independent Sponsor Get Paid?

The economics for an independent sponsor who leads a successful investment can be very lucrative, and for this reason many entrepreneurial-minded investment professionals are attracted to this career. The path is not without its risks, to be sure, as there are both opportunity costs from leaving a cushy corporate or PE job to search for a deal, and capital risk from broken deal expenses or diminished economics if the deal underperforms. 

There are four primary ways in which the independent sponsor can earn compensation through a transaction:

1. Upfront closing fee;
2. Ongoing management fee;
3. Return on invested capital; and
4. Carried interest on third-party capital

 

1) Closing fee. The lower middle market has a long-established precedent for equity and debt investors to receive investment points or closing fees as part of the closing date sources and uses. Thus, allowing the independent sponsor to earn a closing fee as well is not viewed by co-investment parties as controversial, especially given the independent sponsor had to source the deal, develop a compelling investment thesis, coordinate diligence, negotiate legal and close the transaction.

The amount of the closing fee depends on many variables, but generally 2% of enterprise value, with caps and floors, is considered a "market" amount. That said, most capital providers will expect sponsor to "roll" the fee into the transaction as equity, with perhaps a small cash distribution to the sponsor at closing to satisfy tax obligations on the fee.

 

2) Management fee. The independent sponsor will be able to earn an ongoing cash management fee, generally paid either monthly or quarterly, for their involvement and oversight. Such amounts vary, of course, but the "market rate" for a management fee hovers around 5% of EBITDA, with both a floor (e.g. $100k or $150k) and a cap (e.g. $750k).

The capital provider might require the fee to be shared. Further, the lenders will generally want the management fee to be subordinated to interest payments...meaning management fee payments might be deferred if the deal under-performs for a period of time.

Consequently, an independent sponsor will be tempted to either close larger transactions OR close multiple transactions over time to build back one's annual compensation to what he/she was making while in his/her prior corporate or private equity careers. In addition, the sponsor might also begin to incur operating expenses for website, office, travel expenses, support staff, etc., that a stream of management fees can help to fund.

 

3. Return on capital. Most independent sponsors will be asked by their capital providers to have "skin in the game". Doing so demonstrates the sponsor's conviction in the transaction, and evidences that there is "risk-sharing" between the parties. There is no straight answer for "how much" equity is required for an independent sponsor to invest, but generally speaking capital providers like to see a sponsor contribute an amount that is "meaningful" to that person/firm. The contribution could either be the writing of a check at closing, and/or "rolling in" the closing fee discussed above as an equity contribution. 

With this equity contribution, an independent sponsor now has an opportunity to gain appreciation on that capital position from a successful investment.

 

4. Carried interest. The component with the most upside potential for the independent sponsor is a share of the investor's profits, commonly referred to as a "carried interest" or "promote." The idea is that the investors are entitled to receive their money back plus a minimum return, and thereafter the independent sponsor can share in a percentage of the profits. Every deal is different of course, but most commonly the investors require a minimum internal rate of return (IRR) of 8% and/or a minimum Multiple on Invested Capital (MOIC) of 1.5-2.0 before any of the profits are shared with the sponsor. But after the thresholds are achieved, the sponsor has potential to earn 20% of all profits (including "catch-up" payments for profits used to calculate the minimum returns). Some transactions even allow for the percentage of the profits to increase as IRR and/or MOIC get larger.  

The concern with this component is that the cash is not distributed until the company is actually sold, which can be 5-7 years in the future. If bumps happen along the way, then it could make achieving the carried interest even more difficult, and can put the independent sponsor in an difficult position of deciding whether to continue working a transaction in which upside could be limited. However, when parties are working in good faith, often times we see capital providers being willing to re-negotiate terms with the independent sponsors to give them more "hope" of achieving an upside on the deal.

 

Taken altogether, the ability for an independent sponsor to earn significant amounts from multiple different avenues is what keeps enticing professionals to pursue this career. The economics become even more compelling if there are multiple deals managed by that same sponsor. Just like any other profession there is supply and demand in this market as well, but given how hungry capital providers are to see transactions from independent sponsors we anticipate the market terms for sponsors to remain fruitful for the foreseeable future.