It takes a tremendous amount of effort to identify, acquire, grow, and finally exit a business, with the whole process usually lasting several years or more. This begs the question, how and when do independent sponsors get compensated for their work?
There are three broad forms of compensation: (1) a closing fee, (2) the management fee, (3) and carried interest. The latter is the one that gets private equity professionals—independent or not—the most excited. But since it only comes at the end of the process, sponsors need to be compensated somehow in the interim. That’s why all three fees are so critical.
As Ben Mackay, an independent sponsor with four acquisitions under his belt, told me in a recent interview, if it hadn’t been for the closing fee, he might have lost everything early on (see the interview for the full story).
So in this post, we explore the three forms of compensation in the order that they are received, starting with the closing fee.
Note: Excel template available for download at the bottom of this post.
1. A Closing Fee At Acquisition
As the name suggests, this is money paid to the sponsor when an acquisition successfully closes, and it is usually calculated as a percentage of the transaction value, often two percent. Think of it as an interim reward for the long, hard slog of identifying a potential deal and getting it across the finish line. And while a closing fee has become much more accepted and common in private equity deals in recent years, it is hardly a given. Plenty of acquisitions still happen without one.
In my experience, I’ve seen closing fees to sponsors range from $50,000 to $1 million. But it’s most likely to be within a tighter band of $250,000 to $500,000, with only one in four sponsors receiving a fee above $500,000, according to this report from Citrin Cooperman.
Unless your personal savings are formidable (often not the case after a long search process), you may want to negotiate a closing fee paid in cash. Just don’t expect it to be easy. Some investors will argue against any closing fee. Others will ask that it be rolled into more equity in the business. Be transparent and let such investors know that this fee will potentially be an important source of funds for you to live on during the hold period. I have seen sponsors misrepresent and inflate their personal financial status to investors, and it does not end well. If your backers are savvy, they will figure it out. And if they aren’t, you may want to question why you are working with them to start with.
2. A Management Fee While Holding
The management fee is paid to the independent sponsor in return for running the acquired company. It is often the larger of a percentage of EBITDA (usually 5%) and a flat fee. While it incentivizes the sponsor for the company’s ongoing financial success, most investors will also want to include a cap to keep the payment within a certain boundary (click here for a video explanation).`
As an independent sponsor with one portfolio company, this is your only form of annual compensation, and unfortunately, it’s not guaranteed. If something unexpected happens and your company’s earnings decline, it’s possible to trip debt covenants in your credit agreements and lenders can choose to turn the management fee off. In other words, you will not be getting paid, and if you don’t have sufficient savings, life may get difficult very fast. This is exactly when having a cash closing fee in the bank to fall back on can make all the difference.
3. Carried Interest Upon Exit
Also known as “carry” or “promote,” carried interest is simply a share of the profits from a successful exit. This is a culmination of all the past work, and it is seen by independent sponsors as the final crowning achievement of a successful private equity deal.
As an aside, the term comes from when ships’ captains received a portion of the profits generated by goods which their vessel had “carried” across an ocean. It’s an excellent metaphor for today’s independent sponsor, who pilots an acquired business through risky waters, and like a ship’s captain deserves a share of any financial gain that results.
To employ another widely-used private-equity metaphor, the carry is paid out via a “distribution waterfall,” which defines how the exit proceeds will be dispersed among the various parties. This distribution is what gets sponsors up in the mornings and keeps them motivated on the difficult days of acquiring and improving a business.
Distribution waterfalls can be structured in many ways. But one straightforward and fairly typical structure gives the sponsor 20% of any remaining upside beyond the capital return, but only after investors have first received an 8% “preferred” return. In a successful exit, this can work out well for everyone. According to the Citrin Cooperman study, 74% of independent sponsors reported exits that generated at least 3X the initial investment. To put some hypothetical numbers to this, imagine that a $10 million equity acquisition returns $30 million of proceeds five years later. Under a typical distribution waterfall, the independent sponsor would earn $4 million. And if the proceeds were $50 million, the sponsor would earn $8 million.
These and all of the terms above are, like so much in private equity, highly negotiable. And the more attractive the deal you put together is, the more leverage you will have at the start to negotiate the kind of terms you want. If you’re inexperienced, do your research and learn in advance as much as you can about how private equity deals are structured (Private Equity Training). Armed with insider knowledge, you can negotiate in good faith and begin enjoying a well-compensated journey in the world of independent sponsorship.
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