Compensation Structures for Independent Sponsors

Introduction to Independent Sponsor Economics

Independent sponsorship appeals to individual investors who have more business acumen and industry insight than investment capital. The independent sponsor model is highly flexible and constantly evolving, as are the ways that sponsors are compensated for their efforts. Although the specifics of this model aren’t widely publicized, its increasing adoption by institutional investors, family offices, and the private equity sector has generated demand for more information about its workings.

Every independent sponsor deal offers a unique compensation blueprint, designed to motivate the sponsor, satisfy investors, and distribute cash flows appropriately. To craft a compensation structure that works best for you and your investors, consider the following three types of compensation and how they work together to represent the interests of everyone involved: transaction fees, management fees, and upside fees.

Transaction Fees

These one-time fees compensate independent sponsors for their initial sourcing and due diligence efforts before any returns from the deal are realized. It is common for a significant portion of these fees to be reinvested as shares into the deal, aligning the sponsor’s capital with that of other partners. While we generally see the following ranges, it’s important to note that these rates may vary depending on the complexity and size of the deal. The fee could also be influenced by the sponsor’s track record, market conditions, and geography:

• In the US, transaction fees of 1%-4% of the enterprise value, which can be the cumulative result of a series of smaller charges.
• In Europe, a sourcing fee of 1%-2% of the equity value is generally applied.

Management Fees

These fees acknowledge the pivotal role of independent sponsors in promoting business growth and steering management. Management fees are contingent upon the sponsor’s engagement, specific contractual arrangements made with capital providers, and may also be influenced by regional variations:

• In the US, these fees are typically based on a percentage of EBITDA, ranging between 2%-8% p.a. This range is often combined with a floor and a cap, or simply a floor. Some structures may include a fixed fee in addition to or in place of a percentage-based fee.
• In Europe the fees, typically calculated as a percentage of the required equity, range between 0.5%-1.5% p.a. This percentage may increase to 1.5%-2.0% p.a., e.g. in the case of ultra-high-net-worth individual and small family office investors.

Certain capital providers might split the management fee with independent sponsors, while others permit the sponsors to keep the entire amount. Any management fee structure must maintain a balanced approach to compensation. Sponsors should be fairly rewarded for their contributions, but excessive withdrawals can harm the business and, by extension, diminish the value of investments made by other shareholders. Crucially, a restrained approach to management fees underpins the principle that a significant portion of the independent sponsor’s compensation should come in the form of upside fees that align with value creation.

Upside Fees

The most intricate and hotly debated part of a sponsor’s compensation is the upside fee. Directly linked to the investment’s returns, this fee comes into play in the case of a liquidity event such as a company sale. It allows for customized arrangements that cater to the distinct needs of both sponsors and capital providers.

Understanding Promoted Interest

For independent sponsors, the promoted interest (“promote”), which is a portion of an investment’s proceeds received after compensating the investors, is paramount. The promote is akin to the carried interest seen in private equity funds. While a 20% carry has become the norm, transactions led by independent sponsors often show greater variation.

Example

Let’s consider an independent sponsor who leads a deal with a $1 million investment from a capital provider. The agreed-upon promote is 15%. Following a successful exit, the investment’s value grows to $2 million. After returning the initial $1 million to the capital provider, $1 million remains as available proceeds. In this scenario, the sponsor’s promote would be 15% of this $1 million, equating to $150,000.

Variations in the Promote

The typical promote range in most deals is between 10%-15%. This can vary significantly based on factors such as the risk profile of the investment and the independent sponsor’s negotiating power. Deals with significant upside potential and sustained effort by the sponsor (e.g. buy-and-build strategies) may warrant a promote exceeding the 20% mark. Furthermore, the promote rate is significantly influenced by the industry of the target company and its operational scale. Specifically, a transaction involving a high-growth sector and a company whose operations are not yet sizable enough to capture the attention of traditional private equity firms could warrant a higher promote.

Even more complex is the way promotes are structured, including how independent sponsors qualify for them. Several factors can come into play here: preferred return (the “pref”), catch-up, and hurdle rates.

Preferred Return

The pref defines the return paid to investors after they have recouped their initial investment capital and before any payments are made to the independent sponsor. Essentially, it serves as a hurdle at which the sponsor begins to earn performance fees toward achieving the promote.

While 8%-10% is a common range for prefs in the US and Europe, specific factors like the investment horizon, market volatility, and sponsor track record can lead to variations. The lower end of that range is often seen in buyout transactions; in deals geared toward providing growth capital, higher prefs are more common. In some instances, we have observed prefs as high as 12% or more.

Generally, lower prefs favor independent sponsors—with one notable exception. When an independent sponsor chooses to receive transaction fees as investment shares instead of cash, the pref offers an opportunity to add value to these contributed fees. This occurs before the major portion of the sponsor’s performance-based compensation starts to accumulate.

Catch-Up

The Catch-Up Mechanism

The pref benefits investors by ensuring they receive their initial capital and a certain return before other financial considerations come into play. To balance the scales, the catch-up enables the independent sponsor to receive all subsequent returns—usually 100%—until the distribution levels align with the effective agreed-upon promote rate, assuming that the capital provider has already achieved their designated preferred return.

Example

Suppose an independent sponsor negotiates a deal with a 10% pref. Once the investment makes a 10% return, the catch-up mechanism kicks in. If the agreed-upon promote level is 20%, the catch-up will work to ensure the sponsor receives 20% of all proceeds, starting from the first dollar earned. So, let’s say the investment generates $100,000 in returns.

• First, $10,000 goes to the investor to meet the 10% pref.
• Next, the catch-up mechanism channels the subsequent proceeds to the sponsor until they ‘catch up’ to having 20% of the total proceeds.
• In this example, the sponsor would receive the next $20,000 to catch up and reach the 20% level.
• After the catch-up, proceeds would then be distributed according to the agreed-upon 20% promote level for the sponsor and 80% for the investor.

Essentially, the catch-up mechanism accelerates the sponsor’s earnings to reach the pre-agreed 20% promote level once the pref is met.

Variations in Catch-Up

Depending on the specifics of the agreement, the catch-up calculation may take into account one of two things or even both: the repayment of the initial capital invested and/or the predetermined percentage return on that investment. The catch-up is an optional feature and is sometimes difficult to negotiate in smaller deals and those organized by novice independent sponsors. While optional, the presence or absence of a catch-up can significantly affect the sponsor’s total compensation. It’s often a key negotiation point, especially in more complex or larger deals. Whether or not a catch-up clause exists, every agreement should clearly outline the rate at which sponsors are paid following the meeting of the pref.

Hurdle Rates and Resulting Promote Levels

Promote structures can vary widely in their complexity, offering options for multiple thresholds and rates. As the independent sponsor model matures, there is a trend toward increasingly intricate compensation frameworks. These usually feature a variety of hurdles with escalating promote rates, aiming to better align the interests of sponsors and capital providers. Institutional investors value this flexibility, as it allows them to craft tailored, performance-based agreements.

Beyond the pref, which is typically the first hurdle rate if included in the package, tiered systems designed to motivate performance throughout the investment lifecycle may come into play. These systems include various hurdle rates, often determined by IRR or MoIC values. For instance, an initial 8% pref could be followed by a 20% promote if an IRR of 15% is achieved. Generally, IRR thresholds range between 6% and 40%, while MoIC thresholds vary from 1.0x to 5.0x.

Distribution mechanisms in these deals often follow a “waterfall” model, where the abovementioned thresholds determine the distribution of proceeds to each stakeholder.

Example

For instance, after meeting the initial 8% pref, the sponsor may be entitled to 20% of any additional gains. If another performance hurdle is crossed—let’s say, an IRR of 20%—the sponsor’s share could increase to 30% or more. Although percentages typically lie between 10%-30%, some deals do allow for wider variation based on risk profile, industry, and other factors.

Cap Expand Partners’ Added Value

Independent sponsors can unearth investment opportunities in ways that might be challenging for larger institutional investors. Along with this advantage comes a responsibility to fully understand how each party is compensated throughout every phase of the investment process. These compensation structures serve multiple purposes: they not only allocate cash flows but also reflect the investment’s anticipated value, the trust investors bestow upon the independent sponsor, and the specific priorities of each involved party.

Promote structures can vary in complexity based on the preferences of the parties involved. The key objectives are to align interests, meet internal rate of return requirements, and recognize the value each party brings to the table. It is worth noting that different capital providers have distinct approaches to compensating independent sponsors. In this intricate landscape, Cap Expand Partners distinguishes itself by leveling the economic playing field for independent sponsors. Book a call to explore financing options for your deal.