The Rise of Independent Sponsors. Part 1: Management Fees

Everyone seems to be talking about the increase in the independent sponsor asset class over the last 5-10 years, including the increased number of participants, capital provider interest, # of closed transactions, and even superior performance data. There are conferences dedicated to networking, and investment firms whose sole strategy is to back independent sponsors.

In turn, there are more-tenured deal professionals choosing this career path, when then leads to more capital providers leaning into the category, and the success begets more success.

One of major questions is why is this occurring? Is there something about the independent sponsor model that is structurally superior to the conventional GP/LP committed fund structure? Are we observing a bubble, or is the asset class here to stay?

Over the next few months, we attempt to explain the reasons why this asset class is here to stay.

My contention is this all stems from fighting over fees.

In the olden days of private equity, 2/20 was the norm, with 2% paid on committed capital throughout the fund life, regardless of the rate of deployment. LPs had no choice but to pay the fees if they wanted access to the high-returning private equity market. Even if the gross investment returns were high, the management fees resulted in lower than desired net returns to LPs. So as private equity market continued to expand, and more funds were raised and deployed, valuations were chased up, gross returns were tougher to achieve, causing pressure on net returns, and the battleline shifted to pushing back on management fees to reduce the gross to net spread. With more committed funds needing to raise capital, LPs gained the upper hand to demand lower fees. In turn, many fund managers pushed their fund sizes higher to ensure enough management fee income would exist to maintain its infrastructure (among other reasons for going upmarket, which we will cover in a future blog).  

Meanwhile, a precedent was set years ago for portfolio companies to also pay management fees to its private equity owner. For some fund managers, it was an additional profit center. But for most, and certainly most commonplace now, the management fees paid by companies will simply offset the management fees paid by LPs. Closing more portfolio company investments alone doesn't increase the fund managers' budgets, even though more resources are required for oversight and business-building. The fee does offset management fees required from LPs, thereby reducing the gross to net spread and making the carried interest easier to achieve, but it does not create budget for additional hires to cover the additional work (nor does it allow any existing employees to get paid more). So for the fund to hire another VP/principal to handle the additional workload, any compensation paid to that period is siphoned away from others since the amount of management fees is fixed, and less comp remains for the rest of the pool (which usually means the partners take a pay cut). All things equal, the firm has a bias towards doing additional deals but without adding another VP/principal, and putting more workload on its existing team.

Now, if an independent sponsor signs a deal up, the management fee paid by the portfolio company can go entirely to that independent sponsor. The capital provider foregoes an opportunity to reduce the gross to net spread, but does not need to make additional hires or overly burden their workload. An independent sponsor partner can be out hunting and screening deals, and working through business-building with management, to justify their fee. The capital provider will generally have negative control provisions if the deal goes sideways, but in an average to good-performing deal where an independent sponsor is running the show, the capital provider can earn a great return with minimal hours worked. 

Lastly, the independent sponsor landscape has seen scores of new entrants of accomplished deal professionals, many of whom were the former VP/Principals/Partners who were overworked without overly impressive salaries, and could see the opportunity to match or exceed what their fund could pay after closing just 1-2 days, plus all the other benefits of being independent and autonomous.  

So taken altogether...the management fee pressures faced by fund managers resulted in the pushing out (or crowding out) of many experienced dealmakers, who then saw potential for greener pastures as independent sponsors, while those same capital providers could now back those independent sponsor led deals (as contractors, essentially) for theoretically less post-closing involvement and without reducing their own take-home pay. Returns could be reduced by payment of carried interest paid to the independent sponsor, but lower margin on higher volume still gets the job done.

In the next article, we talk about how the trend in committed funds going upmarket has left small deal market open for independents to take advantage.