Despite a recent slowdown in broader mergers and acquisitions (M&A) activity, and specifically in private equity deals, the independent sponsor market has continued to expand and mature over the past several years. With the exception of certain proprietary deals, transactions that were not overly competitive or broken auction processes, industry factors have historically limited independent sponsors to lower middle market transactions. In addition to an increasing number of independent sponsors participating in lower middle market deals, however, there is also an increasing number of independent sponsors successfully consummating larger middle market transactions, a market segment that had previously been dominated by committed funds and strategics.

Although nascent independent sponsors still seem to be transacting primarily in the lower middle market, Holland & Knight's Independent Sponsors Team has been seeing a notable uptick in its more experienced independent sponsor clients consummating much larger transactions. This trend has also led to an increasing number and diverse array of co-investors and other capital providers seeking to transact with these more experienced independent sponsors. Further, sell-side advisers have become more inviting of these more experienced independent sponsors in auctions and other competitive processes.

The authors of this alert have published summaries of general market economic trends in arm's-length independent sponsor transactions. This alert is intended to be a snapshot of the current state of the market for independent sponsor economics, as well as provide a brief overview of a few notable middle market considerations about which independent sponsors participating in larger deals should be aware.

Market Update: Deal Economics

Though there is no one-size-fits-all deal structure or standardized set of investment terms, the independent sponsor market is rapidly maturing and has developed a fair amount of uniformity in lower middle market transactions.

Historically, market economic overviews for this space, such as what is provided below, were primarily dependent upon the pedigree, industry experience and track record of the independent sponsor. These days, the size of the transaction also plays a much more meaningful role in structuring independent sponsor economics than it had in years past.

Key Economic Terms

It should be noted that pedigree, industry experience and track record of the independent sponsor do still factor in significantly to whether co-investors and other capital providers are willing to participate in a given transaction. That said, provided below is a bifurcated analysis based on transaction size to highlight a few key differences that independent sponsors can expect in middle market vs. lower middle market deals. Keen observers will note that deal terms in middle market transactions are closer to similar terms in traditional private equity fund raises, which is intuitive as the next step for many independent sponsors engaging in serial middle market transactions is raising and investing out of a committed traditional private equity fund. For purposes of this discussion, we are contrasting middle market deals (i.e., transactions with $100 million to $500 million of enterprise values) with lower middle market deals (i.e., transactions with less than $100 million of enterprise value).

Sample Waterfall

A distribution waterfall is the mechanism used in an independent sponsor transaction to set forth the economic sharing arrangement among investors and the independent sponsor by providing how cash will be distributed, including distribution of the independent sponsor's promote based upon the returns received by the investors.

Below is a sample waterfall that independent sponsors can expect to see in both middle market and lower middle market transactions (subject to the differences highlighted in the chart above):

Primary Waterfall

• Step 1: 100 percent of distributable cash to the institutional investor until the institutional investor has received an amount equal to an 8 percent – accruing, not compounding – preferred return on its invested capital
• Step 2: 100 percent of distributable cash to the institutional investor until the institutional investor has received an aggregate amount equal to its invested capital, assumed for illustrative purposes to be $30 million

Carry Waterfall

• Step 3 (10 percent catch-up): 100 percent of distributable cash to the independent sponsor until the independent sponsor has received 10 percent of the amounts received by the institutional investor and the independent sponsor in Step 1 above and this Step 3
• Step 4: 90 percent of distributable cash to the institutional investor and 10 percent of distributable cash to independent sponsor until the institutional investor has received an aggregate amount equal to two times its invested capital, or $60 million
• Step 5 (15 percent catch-up): 100 percent of distributable cash to the independent sponsor until the independent sponsor has received 15 percent of the amounts received by the institutional investor and the independent sponsor in Steps 1 and 4 above and this Step 5
• Step 6: 85 percent of distributable cash to the institutional investor and 15 percent of distributable cash to the independent sponsor until the institutional investor has received an aggregate amount equal to two and one-half (2.5) its invested capital ($75 million)
• Step 7 (20 percent catch-up): 100 percent of distributable cash to the independent sponsor until the independent sponsor has received 20 percent of the amounts received by the institutional investor and the independent sponsor in Steps 1, 4 and 6 above and this Step 7
• Step 8: Thereafter, 80 percent of distributable cash to the institutional investor and 20 percent of distributable cash to the independent sponsor.

As noted in the chart above, in lower middle market transactions, independent sponsors are more likely to receive a carry in excess of 20 percent for home run exits (i.e., where the investors receive 3.5 times-plus returns on their invested capital). Here, such a home run carry provision might be 70 percent of distributable cash to the institutional investor and 30 percent of distributable cash to the independent sponsor if the institutional investor has received an aggregate amount equal to greater than three times its invested capital.

Market Update: Other Trends

Below is a handful of additional considerations for independent sponsors when venturing into middle market deals.

Governance

The most common independent sponsor model is one in which the independent sponsor controls two of five board seats, the other investors control two of five board seats, and the fifth board member is an "independent" director selected jointly by the independent sponsor and other investors. It should be noted here, however, that in middle market deals, independent sponsors are much more likely to cede control of the board to the investors.

Drafting Responsibilities

Typically, counsel to the independent sponsor drafts the definitive investment, governance and equity documents. This is true in both lower middle market and middle market deals. It should be noted here, however, that in middle market deals, independent sponsors may permit counsel to a large, lead co-investor to draft the equity documents.

Antitrust Filings

Independent sponsors accustomed to engaging in lower middle market deals may be surprised by the regulatory analysis and related structuring implications that arise when their deals increase in size. As middle market sponsors and practitioners are keenly aware, required filings and waiting periods under the Hart-Scott-Rodino Act (HSR) can significantly impact transaction structures and deal timing, turning otherwise straightforward simultaneous "sign-and-close" transactions into more complicated staggered "sign-then-close" deals with a mandatory pre-closing waiting period (not to mention the negotiation of contractual interim covenants, closing conditions and termination provisions and remedies).

The implications of HSR on conventional independent sponsor deal structures and equity cap tables requires thorough analysis by seasoned antitrust counsel, as many middle market independent sponsor transactions will not meet the "size of person" test and may not be required to make a filing under HSR. In the event the HSR Act analysis indicates that a filing will be required, independent sponsors will need to plan for the payment of pre-closing filings fees and some time-consuming information-gathering from co-investors in connection with the filing. There are strategies available to mitigate the impact of HSR on timing and deal point negotiations, but independent sponsors engaging in a transaction with approximately $100 million in enterprise value or more should put HSR analysis near the front of their initial transaction workstreams.

Representations and Warranties Insurance

Although lower middle market independent sponsors will likely be more familiar with representations and warranties insurance (RWI) than HSR, the importance of RWI increases with the size of a transaction. Sellers in lower middle market deals are frequently accepting of traditional escrow structures in which a material percentage – often around 10 percent – of the purchase price is escrowed as security for seller indemnity obligations. However, as deal sizes rise, sellers are less keen to foregoing large amounts of cash at closing and instead will require buyers to purchase a buyer-side RWI policy to serve, subject to a deductible and a small escrow as a "split" of the retention under the RWI policy, as the buyer's primary recourse for breaches of seller representations, warranties and, often, pre-closing tax liabilities.

RWI is a complex product, and implications of its use in a deal should be discussed with counsel that is not only familiar, but well versed in RWI deals – after all, whether and to what extent a buyer is indemnified for a seller breach will have a direct impact on the independent sponsor's carry. The use of RWI also presents additional deal orchestration considerations: the engagement of a broker and selection of a carrier, the payment of a pre-closing underwriting fee, the need to prepare and provide to the RWI underwriter formal due diligence reports from legal, accounting and certain other due diligence providers, the negotiation with the carrier of deal-specific exclusions or limitations of the RWI policy itself, and the negotiation with the sellers of specific indemnities for any deal-specific exclusions under the RWI policy.

It is true that while independent sponsors are going "up market" and increasing the size of their deals, RWI carriers are going "down market" and making their products – or certain versions of them – available and economically feasible for smaller deals. As a result, independent sponsors may gain RWI exposure and experience in even lower middle market deals, which can be useful when managing the RWI process in a middle market transaction that holds other additional complexities, including those mentioned here.

Conclusion

Even in today's maturing independent sponsor market, deal structuring and negotiation continues to be complicated by the unique nature of each independent sponsor transaction. Nevertheless, the independent sponsor model, which is open to growing numbers of institutional investors, family offices and high-net-worth individuals, remains a very attractive alternative to conventional private equity funds. It is anticipated that investor allocations to independent sponsor transactions will continue to grow and that market deal terms will continue to crystalize in both lower middle markets and middle markets.

Special thanks to Brandon Bloom, a partner on the Holland & Knight Tax Practice, for his assistance with the tax-related aspects of this article.