The success and rapid growth of the independent sponsor model has been well chronicled. At the same time, daily articles and commentary seem to imply a recession is around the corner. As part of McGuireWoods’ focus on the independent sponsor community, here are some thoughts on the potential interplay of these circumstances. Included with these insights are candid responses collected through a survey of thought leaders in the independent sponsor ecosystem who considered how a recession could impact independent sponsors and their capital partners.

Deal Flow: How Will a Recession Impact Opportunities for Independent Sponsors?

As with all participants in the M&A community, independent sponsors are supremely focused on deal flow — how to maximize it and what factors impact it. Jack Sadden at Valesco Industries provided an interesting overarching perspective. He noted that recessions mean opportunity and that “smart investing in recessionary times offers outsized returns.” With that being said, Jack also pointed out that the economy is still growing, despite some of the headlines, and Valesco is committed to increasing its partnership and support for the independent sponsor community. Jack expects a hangover from the hyper-valuation period the market is experiencing now — seller expectations and appropriately lower performance valuations will be tricky to reconcile in closing deals.

One sourcing strategy that can bear fruit in any market is “hanging around the rim.” With the potential disconnect between expectations of the seller and buyer, it would not be surprising to see more “broken deals,” and independent sponsors may be well-served to stay in front of companies and investment bankers even after “losing” a deal.

Many of the individuals surveyed shared the view that sellers with healthy companies will be on the sideline for the first half of a recession, so the aggregate volume of deals is expected to decrease, which will negatively impact both funded and independent sponsors. Todd Dauphinais from Clavis Capital put it very succinctly: “Any time there is a dislocation in a market, that should lead to fewer overall deals getting done as the bid-ask spread widens.”

However, the number of distressed opportunities likely will grow. Johannes Zwick, founder of Zwick Partners, sees more opportunities for those independent sponsors that can operate in a contractionary environment, and those opportunities will be more attractive in terms of valuations and structures. Dan Lenahan of Mitre Peak Capital added that he believes “independent sponsors’ share of deal volume will increase as many traditional private equity funds will need to focus on their portfolio companies and have less bandwidth for new investment opportunities.”

Another potential impact of a recession could be a reduction in the number of new independent sponsors entering the market. Jeremy Knox at Schoder Adveq Management US shared this insight: “Seasoned deal professionals at reputable sponsors are seeing an abundance of capital for independent sponsors today and are comfortable taking the risk to spin-out to start an independent sponsor platform, although many underestimate the difficulty and time needed to actually raise capital. If the realities of an economic recession take hold, it would not be surprising to see the growth in the number of new independent sponsors slow from the recent torrid pace.” This possibility may serve to make the competitive dynamics of securing exclusivity on a target a bit easier than in today’s environment. Similarly, as Ty Clutterbuck of Peninsula Capital Partners notes, “multiples should come down which will make independent sponsors more competitive and thus they might see an increase in their success of securing a deal.”

Capital: How Will the Availability of Capital for Independent Sponsors Change in a Recession?

Today, there is a glut of capital looking for investment opportunities, which has driven values and deal volumes to record levels. There generally has never been an easier time for an independent sponsor to source capital, but how a recession could impact the availability of capital for independent sponsors is not as simple a proposition.

Bruce Lipian of Stone Creek Capital pointed out that “private equity groups with committed capital are going to value credible independent sponsors just as much in a recession as they do in a healthy economic environment because they have a fixed investment timeline and they will need to deploy capital in an environment with fewer investment opportunities.” As a result, the “receptivity of private equity groups to independent sponsors with attractive investment opportunities is likely to be high.”

Ty Clutterbuck agrees and doesn’t expect there to be “any material difference since the biggest driver to independent sponsors is that they are an alternative source for deal flow. If deals are relatively scarce due to a recession, that should expand the universe of capital partners in the independent sponsor world as they search aggressively for investment opportunities.”

As the market has witnessed growth in the independent sponsor model and, to a degree, a fundamental shift in the funding of deals, the attractiveness of the independent sponsor structure is unlikely to diminish materially in a recession. Jacques Youssefmir from Ocean Avenue Capital has as good a perspective as any, and he does not see a recession changing the growing percentage of transactions financed on a deal-by-deal basis. “If you look at the share of deals done in the fund structure versus deals done outside of the fund structure (including independent sponsors) on a deal-by-deal basis, the deal-by-deal basis is going to account for a larger percentage, especially in the lower middle market.”

While the availability of capital for independent sponsors, as a general matter, may not significantly decline in a recessionary environment, the independent sponsors likely to succeed in finding capital partners will change during a recession. Duke Punhong at Graycliff Partners is of the view, which seems widely shared with capital partners, that high-quality independent sponsors with a portfolio of companies and a track record of creating value particularly in such an economic environment will “continue to attract capital and that a recession will most likely weed out weaker independent sponsors.”

Todd Dauphinais made a similar comment. He thinks investments during a recession receive even more scrutiny, so capital partners will have “less of an appetite to take a flyer on a new group or a marginal deal.” Johannes Zwick agrees, noting that “market participants will not be as willing to finance ‘higher risk newcomers’ than seasoned sponsors.”

Grant Kornman from NCK Capital added this: “There tends to be a flight to quality in all asset classes during a recession and I don’t think the independent sponsor ecosystem will be any different. Capital will be available to high-quality independent sponsors who have organizations that can drive value during a recession, but it could be tougher for folks with one or no portfolio companies as capital partners worry about their solvency in tougher times and their ability to be a strong sponsor.”

Economics: How Will a Recession Impact Independent Sponsor Economics, Both Going in and Coming out?

As with all great questions, the answer is not simple. There was no broad consensus among these thought leaders in the independent sponsor community. Generally, the returns on investments originated during a recession are expected to be higher, which in turn equals better outcomes for independent sponsors, as value may be derived from lower entrance multiples and the ability of independent sponsors to source deals in tough market conditions, as well as the ability of the independent sponsor to be another powerful steward of the business after closing. As Ty Clutterbuck stated, “if the theory holds that multiples come down during a recession this should benefit the independent sponsor’s economics as the going in multiple tends to have the biggest impact on economics.”

However, capital partners may be less bullish in their investment sentiment as pre-recession investments likely will be impaired by declining macro trends and multiple depreciation. Jacques Youssefmir put it well, stating a recession “will hurt all pre-recession deals, including independent sponsor deals. This is the time where the quality of the sponsor, the alignment of interest with the capital provider, and how much skin they have in the game (both economic and non-economic) will really matter.”

Johannes Zwick has a similar view, as his firm has a “decent data set which suggests that transactions entered into prior to a recession (12-24 months) tend to take longer to realize but often still have favorable outcomes (i.e., 2.5-3x MOIC, but maybe “only” 18-20% IRR) and transactions entered into coming out of a recession produce similar MOICs but much quicker realizations (so 30% IRRs).” Johannes added to his point that he believes it is impossible to time investments, and “bad practice” to do so, as good deals should be done in any environment.

Grant Kornman of NCK Capital shared an interesting perspective: “The market for independent sponsor economics has evolved over the last 5 to 6 years. There is a somewhat accepted framework in the marketplace that probably will not change in a recession. Unfortunately, some companies will need additional capital to get through a recession. When this happens, independent sponsors will find out very quickly which capital partners take a pragmatic approach that aligns incentives and those who don’t.”

It would not be surprising to see this framework tweaked to some extent during a recession. For instance, in these “frothy times,” it’s common to see parties spend a lot of time negotiating the “home run” and what the promote looks like in a 4x or more MOIC scenario. As participants potentially consider more conservative expectations and focus on downside protection, more attention may be devoted to negotiations of the first couple of hurdles in a tiered promote structure, as opposed to concentrating mainly on the final hurdle.

If a recession is in the cards, it is even more important for independent sponsors to focus on negotiations with their capital partners around the impact of additional investments, including approval rights, preemptive rights and implications on the promote. As Bruce Lipian noted, “if there is a need for capital partners to invest more capital than originally expected, there is a risk that the follow on capital will dilute the independent sponsor’s economics.” Jeremy Knox offered advice that others also shared: “It is important to work through these scenarios prior to close and to socialize such scenarios transparently among the investor group.”

As noted above, the truly valuable independent sponsor after closing will be in a better position. “The more dependent the lead investor is on the independent sponsor’s active engagement overseeing the investment, the less likely the lead investor will take action that materially impairs the independent sponsor’s economics,” said Bruce Lipian.

Ultimately, determining the timing, severity and impact on the lower middle market in private equity involves mere speculation. As Jack Sadden elegantly stated, “handicapping the scope and timing of a recession is beyond our skill set.” Therefore, as market participants make their own judgments about the economic future, it is important to understand and consider the potential impacts of a recession in the thriving independent sponsor sector.