Independently Sponsored: M³ Capital Partners

5 Red Flags when Selecting a Capital Partner
(#4 may surprise you!)

An independently sponsored interview with Neal Doshi of M³ Capital Partners.

Tony Hill: Last month, with Akoya Capital, we discussed the impact COVID-19 has had on deal-making, portfolio performance and capital raising. Before we jump to this month’s topic, how are you and the team holding up?

Neal Doshi: First off, thank you for the invitation. We are honored to be here. During these unprecedented times, fortunately, we as well as our families are all healthy. The adaptation curve of working from home and virtual learning has plateaued allowing us to appreciate the extra family time.

The pandemic has caused all of us to accelerate our adoption of the technology curve. Since Covid-19 hit, we have made a conscious decision to leverage additional technologies to increase certainty and increase speed to close, paramount in our success as independent sponsors.  

TH: That’s great to hear, Neal. We’ve logged thousands of hours on Zoom over the past few months—something we would have never forecasted. That said, we’ve kept busy and productive. So far, through September of this year, we’ve closed 23 deals, six of them platforms. So, let’s get to it. The title you chose for this installment of Independently Sponsored is “5 Red Flags when Selecting a Capital Partner.” Tell us why.

ND: Definitely. Since the last great recession in 2008, the independent sponsor model has gained traction. We are the inverse of the funded PE firm: we raise capital after we have the framework of a deal to our potential investor partners, reducing the time and resources a funded PE firm needs to deploy to sign a deal. I think during these times as we brace for how the economy shifts in a post-COVID world, it is important for independent sponsors to have a concrete value proposition to our capital providers. However, in some ways, the independent sponsor model is in its infancy, and without proper education to capital providers, we function as more of buy-side broker devaluing our long-term importance. Providing five simple credos we follow when evaluating the proper capital provider allows both the sponsor and capital provider to work together to close deals in a win-win manner.  

TH: That’s a nice summary of the independent sponsor model, and I’m certainly looking forward to #4! To help set the stage for the countdown, start us out by walking us through the pros and cons of working with different types of capital partners. Most commonly, I suppose, we’re talking about the difference between PE groups and family offices or UHNWIs.

ND: Great question. We triage the benefits and differences into three groups: 1) check size, 2) timing, and 3) the role we play post-close. Most of our equity checks are greater than $10 million, even up to $50 million. And while proprietary deals are a source of deal flow for our team, the vast majority of opportunities we see come from brokers and lower-middle market bankers, which are competitive processes where speed to close is a determining factor.

In general, PE groups have the sophistication and capital to close deals quickly. With over a trillion dollars of dry powder they also have the appetite for future add-ons. For most deals we look at, they are our first outreach. The role Independent Sponsors play post-close varies by PE firm. Many PE firms take an active role in the deal post-close; others have an executive in their bullpen with industry experience to run the deal post-close, rendering the role of an Independent Sponsor as a pseudo buy-side broker. We prefer to leverage our operational and PE experience to increase the value of the business post-close, so we look for PE firms that allow us that opportunity.

Depending on the type of family office (single family or multi-family) both speed to close and capital are constraints for deals we look at. Primarily due to check size, traditionally, we do not look to syndicate deals, rather have one group speak to the equity. Family offices tend to use private equity deals as another vehicle in their investment portfolio, and as such, are hands-off post-close from a strategic standpoint.

Country club or high-net worth investors play a pertinent role in deals where there is a lead equity sponsor and we are looking to fill out the stack. Traditionally, the HNWI do not have formal processes and a team in place to grow the new company post-close and rely on the independent sponsor to drive strategy and assess management.

TH: Thanks for that. Very helpful. And which types of capital provider do you guys tend to work with and why?

ND: Most of our relationships reside in the private equity world, so by sheer volume alone, we tend to work with them. If that were not the case, we would still lean towards private equity due to the processes and value-added resources private equity firms bring to the table.

TH: Do you tend to work with the same capital providers on all your deals, or do you mix it up? If the latter, how are you finding new potential capital sources? Online? Networking?

ND: In an ideal world, we would welcome that type of symbiotic relationship. Unfortunately, private equity firms have internal strategies that do not coalesce with every deal we bring to the table. Through our history we have built relationships with a network of private equity firms who specialize in lower middle market deals. Annually, except for this year, we attend several networking events to nurture new relationships.

TH: That makes sense. Last question before we get to the countdown: how do you see the capital provider landscape for independent sponsors changing (if at all) over, say, the next 12 months?

ND: Wonderful question. Krishnan and I have had several discussions around the impact of the pandemic and the independent sponsor landscape. What bodes well for independent sponsors is that liquidity in the private equity space, north of one trillion dollars. Family offices, who don’t have LP mandates, we believe will continue their conservative nature with respect to new platforms. Depending on the market and its ability for a V-shaped recovery, the HNWI population we believe will stay on the sidelines until “normalcy” is restored. Lastly, the future tax impact from the upcoming election winner could have an influence on deal closings. All in all, we feel in the next twelve to eighteen months that the bar will be raised for independent sponsors to find deals in attractive sectors like healthcare and technology, but with valuations that are below pre-COVID multiples.

TH: Yeah, that seems consistent with what we’re seeing as well. In the Q1-Q3 period, our deal flow from the I.S. community is up 300% year over year. Hopefully, that trend will continue.

Alright, let’s get to the countdown.

Now, if this were a late-night talk show, we could read them off one at a time. Unfortunately, the written format kills the suspense and humor a little, but we’ll do the best we can. So, let’s start at the top with Red Flag #5. Take it away, Neal!

ND: Ok, here we go…

Red Flag #5: We have a time limit! Understandably, capital providers have a large volume of deals to review, however unresponsive feedback to the independent sponsor is a big red flag.

Red Flag #4: Support Letters are our currency. Independent sponsors need to show Sellers they have capital. Capital groups that don’t believe in writing support letters kill independent sponsor deals.

Red Flag #3: We don’t qualify for valuation discounts! As an independent sponsor, we look to find deals that aren’t heavily marketed and as such might be lower in valuation multiple compared to a traditional auction process. The key word is might. More often than not, small bankers and brokers understand the valuation of the sector they are representing; our advantage lies in the ability to find these hidden opportunities and build strong relationships with the founder/ownership group.

Red Flag #2: (A lack of) Alignment, alignment, alignment. Too often capital providers assume independent sponsors are wealthy groups and should provide meaningful capital to the deal. If that was the case, we would have our own family office.

Drumroll, please…

Red Flag #1: We aren’t candy stripers. As an independent sponsor, we understand the probability of closing a deal and the amount of sweat equity poured into each opportunity.  When negotiating terms with a capital provider we are looking for terms that are reflective of that.

TH: Those were great, Neal. Though, I think #1 is my favorite. Trivest is on pace to see more than 3,000 deals this year. It’s a big deal (no pun intended) to close one when you consider the numbers. We all spend a LOT of time and energy working to find those rough diamonds, so we value our relationships with great independent sponsors.

I guess I’d be remiss if, now that we’ve covered the Red Flags to keep an eye out for, we didn’t also get your opinion on positive markers when looking for the right capital partner. What qualities or signals do you look for?

ND: First and foremost, expertise in the space. When a capital provider walks us through a similar transaction in the space or has an executive with experience in the space, we feel like that has the makings of an ideal partnership.

#2 is Terms. Not the structure of the terms, although we aren’t opposed to great terms. Rather, once a capital group is interested in moving forward, having the conversation and a high-level framework speaks to their belief in a partnership. The last thing an independent sponsor wants to do during diligence is spend several weeks negotiating terms with their capital providers.  

#3 is a willingness to participate on calls. As an independent sponsor, we prefer doing management meetings (now virtual management meetings) with a capital provider. Not only does the Seller build confidence in our ability to close, the capital provider has a better understanding of the team and expedites their go/no-go decision.

TH: Got it. Thanks for those. I particularly agree with the last one. And, not to toot our own horn, it’s something that we try very hard to do at Trivest. We do not get it right 100% of the time, but we definitely try very hard to.

Neal, as you know, we always end these interviews by asking our guest to recount a funny or interesting experience they have had as a dealmaker. Do you have a story ready for our readers? Pray do tell…

ND: Tony, over the past few years we have several head scratchers. Krishnan and I had signed up an interesting medical service deal. In fact, we had a great capital partner working with us throughout the process to ensure a timely close. The Banker representing the seller was reputable, in fact they had won Investment Banker of the Year in years prior. The process was moving along, until we got to QoE. Through our advisor we had come to find out that the Seller was not accruing revenue or expenses on their service contracts. We came back to the Seller with our findings and his response was, “we don’t need to accrue our revenue and expenses to be in accordance with GAAP. It’s too big of an administrative nightmare.” He then proceeded to provide us a letter from who we assumed was his accountant stating that cash-based billing was in accordance with GAAP. Needless to say, even though we had to swallow broken deal costs, we walked away from the deal.

TH: Thanks for that story and, even more so, for speaking with us today, Neal. Great insight on the independent sponsor model. We hope you continue to stay safe and healthy and that you have a strong finish in 2020.