Insights From Q1: Key Takeaways for Independent Sponsors

Levenfeld Pearlstein’s Independent Sponsors team provides comprehensive legal services to independent sponsors and their capital providers, delivering tailored, strategic legal solutions to drive successful outcomes.

The year is off to a busy start: In addition to deal work and portfolio company matters, the team attended conferences and met with various capital providers, independent sponsors, placement agents, and service providers to keep on top of current trends and developments in the market. The following is a summary of key takeaways and insights.

Deal Flow and Continued Growth of the Independent Sponsor Model

• Deal flow picked up in the second half of last year, but some sponsors are not as busy as they would like to be. There is still optimism that 2025 will be more active due to seller demographics, a stable lending environment, and pressure to deploy capital, despite potential headwinds with tariffs and cuts to government spending.  
• There is an increasing supply of investors and sponsors embracing the deal-by-deal model, with a lot of tailwinds in the space given the growing acceptance and maturation of the model. This covers a wide spectrum, including searchers/search fund/ETA buyers (who typically target companies under $2M EBITDA), traditional independent sponsors, and retired formed PE fund partners and company executives that are participating as investors and sponsors in the lower middle market (LMM).
• The expected longer-term trend is that more PE deals in the LMM will be done on a deal-by-deal basis as the market gets more efficient and it becomes more difficult to raise blind pool funds. Larger PE funds are investing in independent sponsor deals to chase alpha in the LMM, and some larger independent sponsors are moving up market and pursuing $100M+ transactions.
• As the crowd increases, new sponsors are urged to identify their strengths and differentiate themselves through industry expertise and operational proficiency.
• Compliance reminder: Depending on AUM, sponsors may need to register as an investment advisor at the state or federal level. They should discuss this topic with their legal advisors.

Trends in Deal Sourcing

• Sponsors are finding more opportunities with so-called “semi-proprietary deals” that are being shopped in a smaller process by business brokers/smaller investment banks in secondary cities. This allows sponsors to access companies within a reasonable value range with owners that are ready to sell.
• Additionally, professional service firms (including law firms and accounting firms) with estate planning and other practices geared toward business owners and high-net-worth clients are also a source of deal flow outside of formal sale processes.
• Building relationships is fundamental to deal-making success. The best sponsors are constantly networking and nurturing connections with business owners, capital providers, lenders, and service providers.

Contingent Consideration and Seller Financing; Recapitalizations

• The market is still seeing earnouts, but not quite as many as in prior years. In addition, seller notes are becoming less common. In some cases, in lieu of a note, the seller will receive non-participating preferred equity because of lender requirements/debt limitations.
• Typically, when there is contingent consideration, it’s common to see 60-80% cash at close with a 20-40% deferral (rollover, earnouts, and/or seller financing).
• The market is seeing some recapitalizations of existing investments. For example, a recently closed full equity/debt recap involved a new investor coming in with mezz debt who preferred equity to take out prior to equity/mezz investor. Senior debt was also refinanced with a new senior lender. Sponsor and management cashed out a portion of the proceeds and rolled over a portion and stayed in the deal. Sponsor monetized its carry at FMV at the time of the recap.

Tax Considerations

• The market continues to see a lot of F-reorganization when sponsors are purchasing equity of an S-corp. The market is not seeing tax gross-ups, and some parties may push back when sellers ask. PTET often mitigates (if not improves) the tax impact for sellers. It remains to be seen if that changes with a new tax bill.
• The market continues to see increasing use of corporate structures to take advantage of potential 1202/Qualified Small Business Stock gain exclusion:
  • A common structure is to form a C-corporation buyer entity (either a corporation or an LLC that files a “check the box” election to be taxed as a corporation), which is considered the issuer of the 1202 stock. The buyer entity is owned by a holding company taxed as a partnership (LLC or limited partnership). The holding company is owned by the sponsor, capital provider, rollover seller(s), MIP, etc.
  • It is very important to analyze 1202 viability on the front end with the tax advisors and have alignment with capital providers.
  • It can be difficult (but not impossible) with roll-ups/many add-ons.

Capital Providers, Sponsor Economics, and Governance

Capital Providers

• Capital remains available, emphasizing the importance of selecting the right provider for successful deals.
• There are an increasing number of capital providers primarily focused on independent sponsor transactions. Some are backed by funds and run by former independent sponsors, such as Ocean Avenue and Align Collaborate. They typically pay market economics.
• There are some providers that write smaller checks to fill gaps. These often partner well with SBIC/mezz funds. For example, Penstock Equity is a committed fund formed by former independent sponsors and focused on independent sponsor deals under $30M. The typical investment size is $1M-$5M, so is typically a minority position.
• There are more PE funds looking to invest in independent sponsor deals. Proceed with caution: PE funds are control oriented; sponsors shouldn’t expect the same level of economics or control. However, this can be a viable path for newer independent sponsors that just need to close a deal, establish a track record, and lean on a capital partner that can bring more support.
• There are a growing number of boutique investment banks/placement agents focused on capital raising for independent sponsors that know the space very well and are good resources for independent sponsors, including: Access Capital Partners, J Wolf & Company, Davis Square Capital, Aviara Partners, and Frisch Capital Partners.
• Collaboration, transparency, and alignment are crucial factors when working with capital providers. Some key points:
  • Independent sponsors need to be intentional with choosing capital partners that align with the sponsor’s investment strategy.
  • Clear communication is important, as transparent, consistent updates help align all stakeholders. Independent sponsors should leverage their flexibility to set clear expectations up front while maintaining control as the GP. Aligning investors early on governance, distributions, exit strategies, etc. — then consistently communicating progress — builds trust and ensures long-term success.
  • Capital providers want to see true conviction from the sponsor about the deal — demonstrate that you’ve worked hard to lock up a good business at the low end of the fair value range and will be devoting your time and effort to make it successful. Independent sponsors need to explain to the capital provider the business being acquired, why the owner is selling, why the sponsor was able to lock it up, why they are excited about the business, how they are differentiated, and how they will create value.

Sponsor Economics

• Fees and carry are becoming more standardized — especially for established sponsors working with independent sponsor-focused capital providers. The McGuireWoods and Citrin Cooperman studies are good benchmarks.
  • For example, a common approach used by Ocean Avenue for sponsors that fit their criteria is a 5% monitoring fee with a floor and ceiling, 1-2% closing fee, and carry up to 20% after 3x with full catch-up, or sometimes up to 30% without catch-up.
  • It is best to try to keep it in the middle of the fairway — focus on a standard closing fee and monitoring fee. Carry terms will depend on the capital provider. Smaller deals that are financed by friends/family/HNW have more variability, and the sponsor can have better economics.
  • Good capital providers don’t want to squeeze the economics or look for a zero-sum game. Good deals and compelling opportunities should command market economics. However, if the sponsor paid the highest price in a competitive auction, it may be tough for the economics to work with a traditional capital provider.
• Most sponsors roll their closing fee into the deal in exchange for profits interests vs. using after-tax cash. Some contribute the LOI in exchange for a non-subordinated capital interest, but that is not as prevalent and comes with more risk.
• Capital providers prefer to see sponsors writing a check for each deal on top of the closing fee roll. For some sponsors (especially newer), rolling the entire closing fee isn’t practical because they need to feed their team and pay bills — that’s okay, but they need to have an honest discussion with the capital provider.
• The question of whether more sponsors should start taking an exit fee (which would equal one year of management fees) continues to be discussed in this space.
• Busted deals fees and capital providers: Some sponsors ask for a pro rata share based on economics. Some are willing to absorb more if they are getting more upside. Some take the risk and save bargaining chips for other items. It is important to have the conversation up front.

Governance and Board Seats:

• If the sponsor wants to ensure it maintains control, it should partner with capital providers that aren’t built for governance, such as SBIC/mezz funds that are conditioned to be in more of an oversight role. However, most traditional capital providers expect the sponsor to control the board subject to customary major action rights and board representation for anchor investors. As noted above, some committed funds may want effective control.
• Unless there is a compelling operational/strategic reason, the sponsor should generally resist giving board seats to non-anchor investors and should instead consider implementing a non-voting LP advisory board.
• Senior Lenders:It is just as important to build alignment with a lender as it is with a capital provider. When speaking with lenders, ask them what happens when a covenant is breached, as you will need to understand if they will try to charge large waiver fees or work with you.

• NAV lenders: There are NAV lenders entering the space to provide NAV funding/liquidity solutions to independent sponsors for GP co-invest, working capital, etc. For example: Henry Capital | Flexible Liquidity Solutions for PE Investments
• Value Creation Plan/First 100 Days:
  • It is critical to meet with key management team members well before closing to discuss the strategy and value creation plan (VCP) so that the VCP is locked and ready to go on day one.
  • After closing, the sponsor should meet with the management team in person and start working on the VCP right away. This sets the right tone by allowing the sponsor to get buy-in and build trust with the rest of the team. If the seller has rolled, focus them on the next finish line/bite at the apple.
  • Don’t underestimate the need to properly vet your key executives through background checks, multiple reference checks, etc. Also, if you have a key executive identified that you’ll be bringing in, consider if they should be engaged as a 1099 during the process so they are ready to go on day one.
  • Does the existing management team have the right aptitude for change? Long-term management teams can sometimes be a challenge when trying to make changes (“We’ve always done it this way”). It is important to build rapport and trust. Changes should be viewed as evolutionary.

New R&W Insurance Product

There is an insurance company offering a new type of RWI insurance for smaller deals in the $1M-$30M TEV range. Liberty Company offers a specialized type of sell-side R&W insurance called Transaction Liability Private Enterprise (TLPE). This is a compelling option for smaller deals where traditional R&W insurance may be cost prohibitive. Some highlights from Liberty about this product:  

• Terms are based on an application submitted by seller. No need for diligence reports or diligence calls with underwriters.
• No underwriting fee
• 2 to 3 day turnaround from submission to binding
• Lower policy retention can be used to negotiate lower escrows/withholds
• Cost at $15K to $20K per $1M in Limits is well below R&W
• Seller does not need Buyer’s consent to secure coverage
• Seller covers costs (premium + taxes), so it’s “free” to the Buyer
• Policy can cover 100% of EV (up to $20M), which is more than Buyers may recover from an uninsured transaction

Facing questions about your transaction? Reach out to Robert E. Connolly or another member of the LP Independent Sponsors team.