Independent Sponsor Survey 2020 Special Report: Impact of COVID-19

At the beginning of this year, when we began planning for Citrin Cooperman’s fourth Independent Sponsor Report, the economic outlook was bright. The stock market was doing well, fundamentals were strong and few industries were in dire straits.

But then, the global coronavirus pandemic began to spread throughout much of the world. In a span of a few weeks, many economies came to a halt as non-essential businesses were forced to shut down and millions of people were ordered to stay at home.

Now, months later, hopes of a quick recovery in the United States have been abandoned as virus cases continue to escalate in many states. Uncertainty lingers over how long this recession and COVID-19’s impact on businesses will last.

Helping you focus on what counts

In the midst of this seismic shift in economic reality and expectation, it was important for us to continue our independent sponsor research and capture the significance of these challenging times while exploring their implications for the future.

As we noted in our inaugural 2017 report, the independent sponsor path “is not for the faint of heart.” Four years later, that phrase has never been more true. Virtually overnight, independent sponsors and their portfolio companies woke up to a new world, facing business shutdowns and changed consumer behavior.

As this year’s 2020 Independent Sponsor Special Report: Weathering the Storm (Report) shows, independent sponsors are rising to meet these challenges. They are helping their portfolio companies streamline operations, manage expenses and pivot as needed. They are being creative in how they approach valuations and deal structures and shifting more risk to sellers in response to an uncertain environment. And they are considering new capital sources and financing alternatives, recognizing the landscape may have shifted for the foreseeable future.

As our prior independent sponsor reports have shown and this year’s Report underscores, independent sponsors are adaptable, resilient and adept at managing uncertainty and risk. Now, in the midst of COVID-19, they are doing what they do best, riding the choppy seas, managing the risks on the horizon and weathering this storm. For those who can make it through, the potential for reward is great.

It is our hope that this year’s special report will provide benchmarks and guidance to independent sponsors as they surge forward in these uncertain times.

We are indebted to our survey respondents (comprised of 112 independent sponsors) and our esteemed group of external contributors, both independent sponsors and capital providers, for sharing their insights with us and for making this year’s Report possible.

We hope that you enjoy the Report, and we look forward to discussing our findings with you.

Sincerely,

Sylvie Gadant, Partner, Citrin Cooperman

THE RESEARCH

This is Citrin Cooperman’s fourth Independent Sponsor Report. Our Report incorporates results from an online survey, interviews, and recent webcasts with leading independent sponsors and capital providers. In response to an unprecedented global pandemic, this year, we are issuing a special report which focuses on the impact of COVID-19 on independent sponsors and their portfolio companies. The survey was conducted from May 14 to May 29, 2020, and interviews and webcasts were conducted in June and July 2020.

KEY SURVEY DEMOGRAPHICS:

112 Independent Sponsor (“IS”) Respondents.

63% of IS firms represented have been in business six years or more.

The majority of IS firms represented (57%) have two or three principals. 29% have one principal.

IS respondents represent all major U.S. regions, with a heavier concentration in the Northeast (39%) and Midwest (28%).

The majority of IS respondents (54%) invest in or target companies with a typical EBITDA from $2mm up to $5mm.

RESPONDENTS HAVE INVESTED IN OR TARGETED COMPANIES WITH EBITDA OF:

Less than $2mm

$2mm to less than $5mm

$5mm to less than $10mm

$10mm to less than $15mm

$15mm or more

PORTFOLIO COMPANY PERFORMANCE DURING COVID-19

Not surprisingly, many IS respondents have portfolio companies that have been hard hit due to the pandemic. Of those respondents who have portfolio companies, 52% say the pandemic has had a negative impact on most of their portfolio companies. For 34% of independent sponsors who have portfolio companies, their portfolio companies’ performance has been closely split during COVID-19.

HOW HAVE FIRMS HELPED PORTFOLIO COMPANIES THROUGH THE PANDEMIC?

Before COVID, AGI Partners met with its portfolio companies once a month, but now the firm talks to them once a week. “In addition to our P&L reviews, we take a harder look at pipeline reports and working capital,” explained David Acharya, Partner, AGI Partners. “We have also been very proactive, working with our portfolio companies to cut their discretionary spending, improve working capital, delay capital expenditures, and ensure their liquidity.”

Some independent sponsor firms have facilitated best practices sharing across their portfolio due to the pandemic. For example, Akoya Capital holds biweekly CEO calls that provide contentbased advice on topics like PPP applications and cybersecurity and offers an opportunity for CEOs to share information.

What percentage of your portfolio companies were strong performers prior to the pandemic but then experienced a drastic reduction in revenues due to the pandemic?

COOPERMAN

NEARLY ALL CAPITAL PARTNERS ARE SUPPORTIVE

Nearly all of our IS respondents’ capital partners have been supportive during the pandemic. Some capital partners have taken the lead on PPP applications and other government relief and on negotiations with lenders. Others have injected more capital into portfolio companies.

“We are very focused on working with our independent sponsor partners to help our portfolio companies weather this storm and preserve their core value proposition,” explained Brian Kerr, managing director, ORIX Private Equity Solutions. “We are also looking for areas where we can be opportunistic with product modifications or buy-side opportunities.”

“As long term-investors, we will make additional equity investments if we believe the original investment thesis remains intact and additional capital is necessary,” added Zoltan Berty, managing director, ORIX Private Equity Solutions.

“The state-mandated shutdowns forced some companies to take actions that they believe will allow them to emerge stronger, with tighter management teams and in a better position to recover and excel long term. The goal for our portfolio companies was to find a way to weather the storm, keep people safe, and then formulate a plan to build equity value ”

Brian Kerr, managing director, ORIX Private Equity Solutions

NEARLY ALL LENDERS ARE SUPPORTIVE AS OF SECOND QUARTER

For those companies that were strong performers prior to the pandemic but that are now performing poorly, nearly all lenders (according to 92 percent of IS respondents) were supportive as of May 2020, when the survey was conducted. For previously strong performers, lenders have been willing to waive or defer interest and principal payments (cited by 46 percent of respondents), waive covenant defaults (41 percent), and lend more money (seven percent).

“We are still early in this process,” noted Gretchen Perkins, partner, Huron Capital. “Most lenders waived March covenants but are less likely to waive June covenants. This is when the rubber hits the road, and we may see less support from lenders going forward.”

Brian Kerr agrees, “All of our companies made their quarterly covenants in March, but the full impact of COVID restrictions materialized in April and May. Lender relationships will be tested as June covenants are measured.”

Some independent sponsor firms like Akoya Capital have taken a proactive approach in this regard. “Early on, we knew the second quarter was going to be an issue, and we negotiated and reset covenants with lenders to several of our portfolio companies,” explained Max DeZara, founder and managing partner, Akoya Capital. “Come mid-July, lenders may no longer be as friendly so it’s essential to have strong lending relationships you can depend on during times like these.”

For 71 percent of IS respondents, all or nearly all of their portfolio companies that applied for PPP funding actually received it. “The process was very convoluted but, if you had good advisors and lawyers, you were able to get funding,” said Richard Baum, founder and managing partner, Consumer Growth Partners.

“It’s surprising that so many of our IS respondents’ portfolio companies received funds given that many private-equity backed portfolio companies were barred from receiving PPP funds due to the affiliation rule,” observed Sylvie Gadant, partner, Citrin Cooperman. “Generally, PPP funds were limited to companies with fewer than 500 employees. If you own more than one company, you had to aggregate all employees to see if you exceeded the 500 employee threshold.”

For portfolio companies where IS respondents had already initiated the exit process:

60% 6%

HOW HAVE YOUR MANAGEMENT FEES BEEN IMPACTED? (Multiple answers allowed) Stopped

COVID-19’S IMPACT ON DUE DILIGENCE

The pandemic has brought significant changes to the due diligence process. Many of these changes are expected to outlast COVID-19.

A SHIFT TO VIRTUAL DUE DILIGENCE AND LONGER TIMEFRAMES

Not surprisingly, the pandemic has hastened a shift to virtual due diligence.

“Life didn’t change much for transaction professionals when we started working from home in the middle of March, almost overnight,” noted Sylvie Gadant. “Since then, most due diligence has been conducted remotely with the use of online data rooms and cloud-based engagement management software. Telephone conferences have been replaced by Zoom and Teams meetings. I expect that virtual management and diligence meetings will continue post-pandemic – no longer will you fly out (and waste most of the day) for a two-hour meeting.”

Many of our respondents agree, expecting this shift will outlast COVID-19.

“Post COVID-19, we plan to do a lot less travel,” said Gretchen Perkins. “People now know they can be incredibly productive virtually, while saving significant time and costs.”

Evan Gallinson, managing director of Merit Capital Partners, agrees. “We won’t close a deal virtually, but we have done virtual management meetings, and we’ll do board meetings virtually in the future.”

“I don’t think many people will close transactions without meeting the management team, unless it’s in isolated instances, such as for add-ons,” noted Richard Baum.

Many IS respondents also noted that the due diligence period has lengthened due to travel restrictions and economic uncertainty as respondents “wait and see” how a company recovers.

HEIGHTENED EMPHASIS ON BUSINESS RESILIENCY AND MANAGEMENT TEAM STRENGTH

With more threatened shutdowns, a recessionary environment, and the potential for future pandemics, independent sponsors are increasingly focused on the adaptability and resilience of portfolio companies’ business models and management teams.

“This has become and will continue to be a much bigger consideration during due diligence in the future,” noted Sylvie Gadant. “Sponsors will be conducting a much more detailed analysis of how management and the business were able to pivot and how they are incorporating lessons learned in future scenario planning.”

Zoltan Berty of ORIX Private Equity Solutions agrees. “Because of what we’ve seen in this pandemic, going forward, we plan to do a deeper dive on management teams to assess how they have responded and will respond in a future crisis, perhaps even conducting behavioral assessments,” he explained.

Prodos Capital will look at management’s response in prior crises such as the Great Recession. Douglas Song, co-founder and managing partner said: “It’s not a completely accurate prediction, but it does show how both the business and its leadership handled another significant disruption.”

DEEPER DIVE INTO COMPANY OPERATIONS

Many respondents and contributors stressed the importance of conducting more intense operational diligence in the future.

Many plan to take a detailed look at company performance during COVID-19, including whether the business successfully pivoted, the impact of changes to manufacturing, service delivery, and short-term metrics.

“COVID-19 has added a new dimension to operational due diligence including observing how management reacted to 2020 and how it re-pivoted itself if it did,” noted David Acharya. “Additional granularity will be reviewed including supply chain, IT, and communications mobility and healthcare/safety from this angle. We will definitely be spending a lot more time understanding the organization from this perspective.”

ORIX Private Equity Solutions plans to have a “more robust” focus on evaluating operating liquidity, said Zoltan Berty. As part of its analysis, the group plans to consider a 13-week cash flow forecast going forward, including stress testing the key variables. For supply chains, they’ll consider a more detailed review of both current and alternative vendors, including how quickly alternatives can be ramped up to optimize inventory levels and minimize potential disruptions related to the political climate. There will also be a heightened focus on company policies around employee safety and facility hygiene as well as the adequacy of company infrastructure to securely support remote operations.

PLANS FOR IN-PROCESS DEALS:

Plans to close? 63% of respondents plan to close buy-side deals in process, but 34% are unsure whether such deals will close.

Delaying close? 74% of respondents will delay the close date for in-process deals but 26% will not.

74% of IS respondents will delay the close date for in-process deals.

Whereas 26% of IS respondents will not delay the close date for in-process deals.

For deals with delayed close, 67% plan to close in 2020, 10% plan to close in 2021. The remainder (23%) are unsure regarding when they will close.

“The deal closing environment is much more challenging now through no fault of the buyer or seller. What might have been a meeting of the minds one week changes the next week, not because of a re-trading, but due to a risk or sensitivity that wasn’t contemplated. The good thing is that now you can see in real time how a business adapts to changing circumstances.”

Bruce Lipian, managing director and cofounder, StoneCreek Capital.

THE PANDEMIC’S IMPACT ON INVESTMENT STRATEGIES

IS respondents continue to be interested in new investments, despite the current economic upheaval. While some respondents may change their investment or sector focus – for example, considering distressed opportunities, many say their investment strategy remains unchanged. Add-on investments will also be an area of greater focus for IS respondents in the future.

An uncertain environment has not dampened IS respondents’ interest in new opportunities. Sixty-one percent say they are just as interested in new opportunities as they were before the pandemic. Thirty-two percent are less active but still opportunistic.

In terms of investment strategy, most IS respondents are generally staying the course, with few planning to change their investment focus (22 percent) or industry or sector focus (17 percent) because of the pandemic.

“Our investment strategy hasn’t really changed because

of COVID-19,” said Bruce Lipian, managing director and co-founder, StoneCreek Capital. “What will change is that there will be fewer deals with sound and defensible fundamentals in the future.”

Four of StoneCreek Capital’s key investment criteria have been impacted by the pandemic: sustainable cash flow, reasonable purchase price multiple, attractive risk-reward balance, and debt capacity. “All four criteria have suffered in most cases and as a result, there are fewer doable opportunities,” Bruce Lipian explained.

“When we talk about necessary fundamentals in this environment, a deal needs cyclicality resiliency and pandemic resiliency.” Bruce Lipian, managing director and co-founder, StoneCreek Capital

HOW HAVE YOUR STRATEGIES CHANGED BECAUSE OF THE PANDEMIC?

Many IS respondents will look for businesses less susceptible to pandemic risks in the future. As one respondent said, “Companies whose performance collapsed during COVID-19 will not be acquisition candidates for some time.” Some will focus specifically on sectors and businesses that are likely to benefit from the pandemic.

As Douglas Song noted, “During and post-COVID-19, we’ll consider infrastructure opportunities because we believe government will have little choice to pass an infrastructure stimulus bill, and the sector will benefit because of it and the needed upgrades. We’ll also explore areas like remote working, living, and education, but we’ll be avoiding cyclical industries.”

INDUSTRIES RESPONDENTS ARE MORE LIKELY TO INVEST DURING AND POST-PANDEMIC:

INDUSTRIES RESPONDENTS ARE LESS LIKELY TO INVEST DURING AND POST-PANDEMIC:

INCREASED FOCUS ON DISTRESSED COMPANIES

Thirty-six percent of IS respondents will consider investments in distressed opportunities. Of those, nearly all already have experience with distressed companies.

GREATER USE OF ADD-ONS

“To borrow from a hockey analogy, independent sponsors go where the puck will be,” noted Richard Baum.

“Right now, that puck is heading to distressed companies.”

“Even before the pandemic, independent sponsors tend to buy companies already in some sort of distress, whether because the company is in an industry with low multiples or because it has one or more flaws that the IS can cure,” Richard Baum added. “It’s not a huge leap from that to distressed companies.”

Forty percent of IS respondents are more likely to consider add-ons for current portfolio companies than they were in the past, before the pandemic.

“It makes sense that add-ons will be an increased focus for independent sponsors in the future,” noted Richard Baum. “Because of the pandemic, there are lots of smaller companies that don’t have much cash or liquidity on their balance sheet or they are at the end of their eight weeks of PPP funding. An exit makes sense for them, and, from our perspective, a strategic fit may be more important than profitability.”

CHANGES TO VALUATIONS AND DEAL STRUCTURES

Our IS respondents are grappling with uncertainty about the pandemic, economic recovery, and changes to consumer behavior and supply chains. Buyers, investors, and lenders are looking to minimize these risks, while sellers are looking to maximize value. In response, our IS respondents are looking for ways to share risks with sellers and overcome valuation challenges. Given the factors at play, it is not surprising that many of our IS respondents believe multiples will decrease and a higher percent of consideration will be tied to future performance.

“COVID is waking up businesses and investors to the fact that value and price are different,” noted Mandeep Trivedi, principal and Valuation Practice leader, Citrin Cooperman.

KEY VALUATION THEMES

Most expect lower valuations and EBIDTA multiples (1-2x reduction)

Variety of approaches to treat COVID period, including:

Assess one-time COVID impact to earnings and working capital (positive or negative)

Lower multiple off pre-COVID trailing twelve months (TTM) earnings depending on if the business returns to normal

Forecasted revenue and earnings

Multi-year average earnings

“From a valuation perspective, we are in no man’s land. In other economic contractions, there has always been a driving force behind them that has been based in finance. However, there was no economic cause for the world coming to a halt almost overnight. No one could have predicted this or its impact. I believe if a business has been able to adapt to these new circumstances and withstand some of the tribulations their peers have suffered, they inherently become a much more attractive investment.”

Mandeep Trivedi, principal and Valuation Practice leader, Citrin Cooperman

DESPITE UNCERTAINTY ABOUT MULTIPLES, MANY EXPECT TO SEE A REDUCTION

“In this environment, multiples will vary based on the sector and industry, as well as the company’s resilience,” stated Mandeep Trivedi. “There is currently far less certainty regarding multiples. There is very little deal activity and thus few benchmarks for sales comparison. Performance is highly variable even within certain sectors and industries. Buyers need to analyze how the business fared during COVID, were there lasting negative effects, will there be recovery post-pandemic and when will that happen. For companies who outperformed during the pandemic, buyers need to determine whether that performance is sustainable. Valuation is the art of predicting the future which, in this uncertain environment, is a lot more difficult,” Mandeep Trived added.

For companies with demonstrated resilience or outperformance during COVID-19, they may be able to get a premium multiple, but that universe is very small.

“For those companies where demand is now greater than supply due to the pandemic, if you can get investors comfortable that this is the new normal instead of a peak, you can argue for the same multiple, unless you can’t access credit,” advised Bruce Lipian.

But, for those companies who have struggled during the pandemic, many of our IS respondents expect to see a one-to-two-times reduction in multiples going forward.

“I agree that we’ll see a one-to-two-times reduction in multiples,” noted Max DeZara. “Pre-COVID, we were at historically high multiples and in a frothy market. Now, we are clearly in a recessionary environment with a lot of uncertainty. Debt markets are reminiscent of 2008 and 2009, with lenders tightening and focusing inward on their existing portfolios, ensuring their companies have liquidity.”

“The debt market is one to one-and-a-half-times lower, and pricing on debt is 100 to 300 basis points higher,” observed Gretchen Perkins. “What senior and junior lenders are willing to provide very much drives valuation. When debt markets return, then valuations return.”

It is unclear whether these trends will change valuations long term.

“Due to the amount of capital available in the marketplace, and the lower volume of deals, in well-run processes, we have seen valuations remaining near pre-COVID levels (though the sample size is admittedly small),” Evan Gallinson explained. “In fact, in a few cases it seems that multiples may have actually gone up slightly due to the scarcity value of solid companies in the market. Having said that, there will be some deals that trade at lower pricing due to the tightness in the senior lending markets, but I believe that will be short-lived.”

“Unfortunately, mostly due to the abundance of middle market debt and equity capital, I don’t envision COVID resulting in a longer-term market reduction in valuation multiples,” Evan Gallinson added. “In order to find more attractive opportunities, we will continue to need to find under-banked, poorly-banked, and un-banked deals directly or from unique sources such as independent sponsors.”

“Fundamentals remain strong,” underscored Mandeep Trivedi. “At end of the day there was nothing fundamentally wrong with the economy, and very few industries were in dire straits prior to COVID-19. If we can get to the other side of this next year, then I do think we can get back on track.”

VARYING CALCULATIONS AND ADJUSTMENTS WILL BE USED

Among IS respondents, many say they will use a similar analysis as in prior years, relying on traditional valuation methodologies. However, there is considerable debate over what number to apply the multiple to.

“The multiple isn’t the toughest part of valuation; it’s the EBITDA,” noted Richard Baum. “At this point, that number is uncertain, and there is no good formula for it. And then, on top of that, once you figure out the right number, you have to get the seller to agree to it, which is not an easy task under the best of circumstances.”

Our respondents offered many different views. The most common approaches were: 1) assessing a one-time COVID impact to earnings and working capital (positive or negative), 2) taking a multi-year average of earnings, 3) forecasting revenue and earnings and 4) using a lower multiple off of pre-COVID TTM earnings depending on whether business returns to normal.

“I think this is more of a triangulation exercise, rather than a single point of analysis, so that buyers and sellers can get to an EBITDA number that everyone feels comfortable with,” added Richard Baum. “I think many of us will use these valuation methodologies in combination.”

“I think investors will want to be pretty conservative on the EBIDTA number used as a base, and there will likely

be some blend of trailing and future, with more weight given to trailing, and an adjustment to both trailing and future given COVID,” he explained.

“We’ll certainly be understanding of COVID-19 circumstances when valuing companies, but I don’t think we can consider COVID a non-repeatable event,” said Brian Kerr. “It will be important to look at companies’ performance on a two-to-three-year cycle, rather than a 12-month period. And time will certainly be spent understanding how they navigated COVID and any longterm implications.”

For deals currently under consideration, Akoya Capital is looking at TTM and forecasts, rather than taking a threeyear average, as the firm would have pre-COVID. “Many of the companies we are looking at are forecasting a decent

“Valuation is an analytical exercise but it is also an art. In a deal, you have three different constituencies: buyer, seller, and lender. You need to be able to clearly articulate the essence of how a business has been impacted and then convince the other parties on the reasonableness of adjustments to EBITDA.” – Bruce Lipian, managing director and co-founder, StoneCreek Capital.

rebound in the third and fourth quarters so we are trying to find common ground around risk-sharing and minimizing cash at close. We want to pay a fair price for the business they are delivering today and provide the opportunity to capture value during and post-COVID,” noted Max DeZara.

Prodos Capital plans to look at 2019 results, how the company performed during the trough of March and April 2020, and what recovery looks like in subsequent months. In addition, the firm plans to look at 2020 performance versus budget, as well as how the company performed during the Great Recession to assess its adaptability.

Merit Capital Partners is considering a number of options. “I think we will adjust for the COVID period,” said Evan Gallinson. “I don’t think we’ll look at it in terms of traditional TTM EBITDA. Some advisors have told us to use 2021 projections for our current valuation. Others have told us to look at the first quarter and annualize that for 2020 projections.” So many uncertainties have caused many to avoid those companies impacted by COVID, at least until the dust settles.

“It’s too early to know,” stated Gretchen Perkins. “It doesn’t make sense for us to agree to COVID adjustments right now as we are still in the midst of it.”

in someone else’s capable hands. If COVID is a one-off, we can add back lost revenue or earnings to reflect true value, but if it has a more permanent effect to revenue and earnings, it’s not appropriate to add back the impact of COVID. There isn’t one clear answer: it depends on the business’s ability to deal with the pandemic.

2. A multi-year average of earnings may make sense, but only if a buyer is convinced that prior years accurately predict future performance.

3. Using a discounted cash flow model with future forecasts is an option. However, forecasts can be difficult, given the uncertainty around COVID, including the lack of clarity about future shutdowns, the upcoming presidential election, and how long until there is a safe vaccine. In addition, forecasts are always subject to considerable debate with management and pushback from investors, even in more settled times. If a business can present a compelling case about how it handled COVID early on, its current efforts, and its plans for the future in different COVID scenarios, then it may be able to command a higher price using this method.

4. Using 2019 results with a lower multiple could be reasonable if 2019 is reflective of the future and 2020 is a temporary adjustment. The use of a kicker for future performance thresholds could bridge valuation gaps between seller and buyer.

Analyzing

Valuation Options:

Insights from Mandeep Trivedi, Principal and Valuation Practice Leader, Citrin Cooperman

1. An EBITDAC approach is an interesting one. Typically, EBITDA adjustments, are made to the business’s historical earnings for things that are non-recurring in nature, with the intent to reflect what the business is capable of generating on a regular and consistent basis

“Of all of the great economic disruptions over the past few decades such as the tech bubble or the Great Recession, this is the first time we have seen a new EBITDA acronym: EBITDAC, where the “C” signifies COVID.” – Mandeep Trivedi, principal and Valuation Practice leader, Citrin Cooperman

DEAL STRUCTURE WILL CHANGE MEANINGFULLY

When faced with economic uncertainty and the need to bridge a gap in valuation expectations between buyers and sellers, the majority of IS respondents (64 percent) expect deal structures to change. Many expect earnouts, contingent payouts, and seller financing to be used much more frequently than in the past. Lower leverage is being seen now and is expected to continue for the foreseeable future.

Bruce Lipian agrees. “Earnouts, use of contingent payments, and seller financing will all be big factors going forward. In periods of economic weakness like the one we have now, sellers are very reluctant to sell and buyers are reluctant to pay up. If you can’t agree on a cash multiple, these options can help you bridge that valuation gap.”

“For businesses that should recover post-COVID, we want the seller to have an opportunity to maximize sale price and so we may extend

“Creative deal structuring is likely in the next 12-18 months – with heavy earnouts, true-ups, and contingencies as buyers and sellers manage the impact of COVID and the true worth of the business.”

Mandeep Trivedi, principal and Valuation Practice leader, Citrin Cooperman

earnouts to two years, whereas before COVID earnouts were typically one year,” noted Max DeZara. “We’ve also been using seller financing to offset the fact that there isn’t as much leverage available for deals.”

Bruce Lipian noted there are constraints to earnouts. “Earnouts are fraught with complications under normal circumstances. And, for example, if we tie an earnout to adjusted EBITDA that is complicated by subjective COVID items, I can see a lot of potential friction.”

In response to these issues, StoneCreek Capital has recently focused on tying earnouts to gross profit and not EBITDA. “So, even if a new owner is burdening the business with additional expenses, gross profit, and margin are less susceptible to debate.

“In addition, with earnouts, be sure to work with your lender to build in an additional mechanism for a liquidity event that allows the earnout to be funded,” Bruce Lipian advised.

“As a general matter, lenders have a huge impact on valuation and deal structure,” Gretchen Perkins explained. “Revolver draw-downs early in the pandemic caused many non-bank credit funds to seek capital injections, and, for those that remain undercapitalized, they have less ability and appetite to do new deals. As a result, many private equity funds are now more likely to go to traditional banks which means there will be less financing and leverage to do deals. Both will bring down valuations.”

LIMITED DEAL FLOW, WITH TOUGHER CAPITAL RAISING AND FINANCING

FEWER DEAL-MAKING OPPORTUNITIES AND MORE DIFFICULT CAPITAL RAISING

“The past 10 years have been a sellers’ market and there’s been a large amount of dry powder, mostly from private equity funds, which has continuously pushed valuation multiples to frothy levels. Today, private equity and strategic buyers are taking a break from investing due to the uncertainty caused by the pandemic. I am hopeful that M&A activity will rebound, once we have a workable vaccine.” - Sylvie Gadant, Partner, Citrin Cooperman

Deal flow halted in March and April as many companies struggled to adjust to abrupt shutdowns and the new reality of COVID-19. While that initial shock has worn off, deal flow continues to be anemic.

Interestingly, the majority of IS respondents say that most of their capital sources are actively looking for investment opportunities right now. However, as several of our contributors noted, in reality, many capital sources seem to be staying on the sidelines, either focused on the struggling companies in their portfolio or wary of committing to new transactions in an uncertain economic climate.

“Many investors are very conservative about new investments because of uncertainty and concerns about whether a second wave of COVID could change consumer behavior and the business landscape for the foreseeable future,” Brian Kerr explained.

“Three types of deals are getting done now,” explained Richard Baum. “They are as follows: first, companies more or less unaffected by COVID or that benefitted

from COVID; second, businesses that are primarily or exclusively online; and third, add-ons, where a strategic fit matters more than profitability to a platform company with a buy and build strategy.”

Gretchen Perkins adds, “Deals with companies that have been steady performers during COVID-19 can get done, and possibly at a premium. Private equity firms have capital to deploy, but there is a dearth of new platform deal opportunities. A company with a steady performance is a safe port in the storm.”

“To get a deal done in this environment, you need to demonstrate cyclical and pandemic resiliency,” advised

How do you expect your capital raising and financing efforts will change during and post-COVID-19?

Bruce Lipian. “Until now, pandemic risk wasn’t reflected in underwriting criteria but now it is paramount.”

In addition, lenders may be placing further strain on capital raising.

“Even though financial institutions are in a good position from a capital standpoint, I think they have less appetite for risk which means more equity into deals,” explained Brian Kerr. “For an independent sponsor, that means they need to raise more outside capital, which places an emphasis on the importance of building relationships with multiple capital providers.” With all of these forces at play, it is not surprising that most IS respondents (71 percent) expect they will have to have to broaden their capital sources during and post COVID-19.

As Max DeZara noted, “Many of our historical coinvestors do not plan to deploy capital anytime soon during 2020 due to economic uncertainty plus current portfolio challenges. That leaves about 15 percent of our historical co-investors who are committed to deploying capital in this market, which means that we, like many other independent sponsors, will need to expand our capital sources.”

“It’s clear that capital partners are going to be much more selective in the future,” added Richard Baum. “I also think the process will take longer because most of us will need to go to new or additional sources.”

FINANCING WILL ALSO GET HARDER

Seventy percent of IS respondents believe it will take longer to secure financing for deals, and 50 percent expect lenders to charge higher rates.

Like capital partners, many lenders are on the sidelines as well, focused on companies in their current portfolios and ensuring they have liquidity.

“Lenders are definitely being more selective in this environment,” observed Richard Baum.

Given these factors, it is not surprising that 33 percent of our IS respondents plan to use more non-traditional lenders in the future.

“Leverage has come down across board by a turn or two,” Max DeZara noted. “Senior lenders and BDCs are on the sidelines, but mezzanine firms and one-stop shops are stepping up. However, in their case as well, the bar is definitely higher.”

WILL THE COVID-19 CRISIS CONTRACT OR GROW THE INDEPENDENT SPONSOR COMMUNITY?

Fifty-four percent of IS respondents believe the COVID-19 crisis will contract the IS community, whereas 19 percent expect it to grow. Seventeen percent expect it to stay the same.

DO YOU THINK THE COVID-19 CRISIS WILL GROW OR CONTRACT THE INDEPENDENT SPONSOR COMMUNITY?

Bruce Lipian agrees with the majority of survey respondents. “There’s been such a surge in independent sponsors over the past few years that I think the market was due to contract anyway.”

“Independent sponsors have a high mortality rate in any economy, and COVID makes that rate even higher,” Bruce Lipian explained. “They don’t have the benefit of sustainable cash flow from ongoing investor management fees. And, if you are a new independent sponsor in this market, doing a deal for the first time, and already on a steep learning curve, you may not be able to protect your downside if a deal goes sideways.”

Max DeZara agrees. “The independent sponsor market was flooded prior to COVID. Then, the pandemic made financing more challenging as equity players sat out and

sellers didn’t want to sell at lower values. It’s now a lot more difficult to do deals, and I’m not sure that first-time or early independent sponsors will have the stomach or staying power to weather the storm.”

Other contributors disagreed.

“I think the IS market will expand, just like it did after the Great Recession,” said Gretchen Perkins. “As the private equity industry shakes out, as it always does after great economic disruptions, I expect some PE professionals to choose the independent sponsor strategy.

In addition, as Richard Baum noted, “We have 40 million people currently unemployed, so I’m not sure what career opportunities are available to independent sponsors.”

“I think the biggest and most lasting impact of COVID will be on the self-sustainability of independent sponsors. If you are an independent sponsor with a portfolio that has been burdened by an underperforming business due to COVID, then your cash flow will be impaired. And, if you are inexperienced, the negative impact may be worse because you are going through a learning curve as a new independent sponsor anyway.” –Bruce Lipian, managing director and co-founder, StoneCreek Capital.

“I could argue both sides of the issue,” stated Douglas Song. “The $1.5 trillion of dry powder at private equity funds needs to be put to work, and independent sponsors are an important deal source. However, if you can’t source and do deals because of COVID, that puts pressure on the independent sponsor community.”

“In addition, if you are a new independent sponsor who doesn’t have management fees from two or three portfolio companies, this is a difficult environment because it’s so much harder to do deals,” Doug Song added.

Brian Kerr fears the IS community faces some strong headwinds that may limit the asset class’s growth. “As a preliminary matter, there’s a scarcity issue because we are seeing and will continue to see fewer deals brought to market. Meanwhile, credit markets are more

conservative, and private equity funds have a significant amount of capital to deploy. Investment bankers always worry about certainty to close, and, with so many private equity funds ready to deploy capital, that can make it a harder sell for an independent sponsor,” he explained. “I am still bullish about the asset class but we may see the number of firms plateau or, at minimum, grow at a slower rate.”

THE LASTING IMPACT OF COVID-19

COVID-19 ushered in the end of an 11-year bull market. Hopes of a quick recovery have dissipated as virus cases continue to escalate throughout the United States. Uncertainty lingers over how severe and how long this recession and COVID-19’s impact on businesses will last. But one thing that our IS respondents agree on is that COVID-19 will change the independent sponsor sector for the foreseeable future.

WHEN DO YOU BELIEVE THE US ECONOMY WILL REOPEN?

WHAT DO YOU THINK THE SHAPE OF THE RECOVERY IN THE US WILL LOOK LIKE?

CHANGES TO VALUATION, DEAL STRUCTURE, AND UNDERWRITING WILL LINGER

Many of our respondents and contributors predict the pandemic will cause lasting changes to company operations and deal-making.

“I think we will start to see companies operating differently in the future in terms of scenario planning, placing a greater emphasis on liquidity, and maintaining a crisis task force,” Richard Baum stated. “I think some of those changes will be permanent, not just for the lower middle market but for companies of all sizes.”

“Going forward, the underwriting process for buyers and investors will include more focus on companies’ ability to pivot and adapt, such as quickly moving their work force, changing their sourcing strategies, or adjusting their go to market strategies, for instance.” Gretchen Perkins, partner, Huron Capital

Gretchen Perkins expects to see lower valuations and greater use of earnouts and seller financing for years. “Most businesses are not COVID-resistant, and I expect their valuations will remain lower for years,” she said. “Bandwidth issues at lenders will also keep leverage multiples low. I don’t think we’ll see the debt markets back to normal until 2022. We’ll chip away at all of these changes over the next 10 years of recovery, but many of them will have a lasting impact.”

INDEPENDENT SPONSOR SPECIALIZATION WILL BE MORE IMPORTANT

“Because of COVID, I think it will be even more important for independent sponsors to have a unique angle or a point of differentiation on a deal,” advised Max DeZara. “That angle could be operating experience, deep sector expertise, or a connection with the business owner that justifies your value proposition. I think generalists will be challenged in this environment.”

David Acharya agrees. “In times like these I think the generalist model is very challenging. We saw this after the Great Recession, when companies and capital

providers looked towards partnering with professionals who had a strong track record and significant professional resources in their specific industry or sector.”

“From the investor perspective, we are trying to evaluate long-term changes from this in terms of consumer behavior and supply chain,” explained Zoltan Berty. “We see the greatest likelihood of long-term success will be from independent sponsors who bring a unique angle or sector expertise.”

UNIQUE OPPORTUNITIES EXIST FOR INDEPENDENT SPONSORS

“Independent sponsors can do very well in periods of disruption like now, when deal processes are more fluid and uncertain,” said Evan Gallinson. “They do a good job of uncovering good deals in unusual circumstances and can spend more time working on a deal with a longer process.”

As one IS respondent described, “I believe that independent sponsors will be in a unique position to help businesses/business owners that would normally have no choice but to file for bankruptcy [instead] have an

alternative path that could be mutually beneficial.”

With curtailed deal flow and the clock running on private equity fund mandates, there remains a pressure to deploy capital. Independent sponsors are well situated to bring quality and proprietary deals to funds.

“If an independent sponsor can bring a proprietary deal, that is very exciting to us,” noted Gretchen Perkins.

LOOKING FORWARD

We are in unprecedented times. Much remains uncertain and unknowable – when the pandemic will end, what recovery will look like, and how long COVID-19’s impact on businesses will last.

But one thing that our IS respondents agree on is that the pandemic has brought significant changes to the IS business landscape, many of which are expected to outlast COVID-19.

Due diligence will be altered, both in terms of mechanics - with more aspects handled virtually – and substancewith businesses’ ability to pivot and management team strength given heightened scrutiny.

And, while it may be too soon to tell how valuations will play out, many agree deal structures will change as independent sponsors try to share risk with sellers and overcome valuation challenges using earnouts, trueups, and contingencies.

Many also expect capital partners and lenders to be more selective and risk-averse for the foreseeable future. These factors, plus the fact that many

independent sponsors expect additional equity will be required to close deals, translate into longer and more time-consuming capital raising and financing processes for independent sponsors.

However, despite these headwinds, there is optimism among our respondents and contributors, both independent sponsors and capital partners alike.

Independent sponsors, the “road warriors of private equity,” are no strangers to risk. They are used to finding companies with unfulfilled potential or in some element of distress. They are used to being creative in how they put together a deal – the parties they bring together, as well as the deal structures they employ. And they are used to creating value for companies that others may have overlooked.

And so, while COVID-19 has brought unique challenges to independent sponsors, it also brings unique opportunities for those independent sponsors who can weather the storm. We hope that, by next year’s Report, the storm will have calmed, a vaccine will be imminent and there will be brighter days ahead.

“Independent sponsors are the road warriors of private equity.” – Bruce Lipian, managing director and co-founder, StoneCreek Capital.

ABOUT OUR CONTRIBUTORS

Sylvie Gadant, Partner, Citrin Cooperman | (O) 973-218-0500 | sgadant@citrincooperman.com

Sylvie Gadant is a partner with Citrin Cooperman’s Private Equity and Capital Markets Practice and is the Transaction Advisory Services (TAS) practice leader. She coordinates and leads buy and sell-side due diligence engagements for private equity firms, independent sponsors, family offices, and strategic buyers. Prior to joining Citrin Cooperman, Sylvie was the principal-in-charge of the TAS practice at a Top 20 national accounting firm, where she also spent more than 10 years in its audit and advisory practices. Learn more at: www.citrincooperman.com

Mandeep Trivedi, Principal, Citrin Cooperman | (O) 212-697-1000 | mtrivedi@citrincooperman.com

Mandeep Trivedi is a principal in the firm’s Valuation Advisory Services Practice. As the leader of the valuation team, she brings more than 18 years of experience to complex business valuations and financial analysis. She works with clients in a diverse range of industry verticals, including hedge funds and other alternative investment vehicles, technology, software development and licensing, entertainment, construction, staffing, hospitality and restaurants, and medical and dental practices, as well as a broad variety of service, manufacturing, and wholesale distribution companies. Learn more at: www.citrincooperman.com

David Acharya, Partner, AGI Partners LLC | (O) 646-766-0602 | dacharya@agi-llc.com

David Acharya is a partner at AGI Partners LLC, where he is responsible for investment sourcing and performing due diligence, transacting/financing structuring, post-close value creation, and portfolio management. Mr. Acharya is a board member of Impact XM, a leading provider of experiential marketing solutions for global clients and a portfolio company of AGI. He has over 20 years of private equity investing, leveraged finance, capital markets, and investment banking experience. Learn more at: www.agi-llc.com

Richard Baum, Managing Partner, Consumer Growth Partners | (O) 914-220-8337 | rbaum@consumergrowth.com

Richard Baum co-founded Consumer Growth Partners (CGP) in 2005 as an investment and advisory firm with an exclusive focus on the retail and branded consumer products sectors. CGP is typically the first institutional investor in a company, but also serves as a primary business advisor to companies contemplating a capital transaction over a one- to three-year timeframe. Prior to co-founding CGP, Richard spent many years as one of Wall Street’s leading equity research analysts covering specialty retail. Learn more at: www. consumergrowth.com

Max DeZara, Founder and Managing Partner, Akoya Capital Partners | (O) 312-546-8322 | mdezara@akoyacapital.com

Max DeZara founded Akoya Capital Partners in 2005. He serves as Managing Partner of the company and is involved in overseeing all aspects of the operation. Max has sourced, evaluated, valued, and structured numerous investment opportunities across a variety of industries including manufacturing, professional information services, consumer foods, and specialty chemicals. Max is uniquely expert at partnering with industry-leading executives to develop proprietary investment opportunities for private equity cosponsorship. Learn more at: www.akoyacapital.com

Bruce Lipian, Managing Director, StoneCreek Capital | (O) 949-825-5557 | bruce@stonecreekcapital.com

Bruce Lipian is a founding principal and managing director of StoneCreek Capital LLC. Founded in 1992, StoneCreek is an independent private equity sponsor focused on investing directly in growth-oriented management buyouts. StoneCreek finances transactions on a stand-alone basis with equity provided by institutional investors, family offices, management, and the StoneCreek principals. StoneCreek targets transactions ranging from $10 million to $100 million. Learn more at: www.stonecreekcapital.com

Doug Song, Founder and Managing Partner, Prodos Capital | (O) 212.972.3619 | dsong@prodoscapital.com

Doug Song has a diverse background with over 20 years in principal investments, investment banking, and operational experience. Prior to co-founding Prodos Capital, Mr. Song was the head of investments and corporate finance for Verus International, a boutique merchant banking firm that was co-founded by Citigroup, where he led investments in both private and public companies in the emerging growth and middle market. Learn more at: www.prodoscapital.com

Zoltan

Berty, Managing Director, ORIX Private Equity Solutions | (O) 949.269.3254 | zberty@orix.com

Zoltan Berty is primarily responsible for business development and investment activities in the Western United States. His emphasis is providing equity to independent sponsors on buyout transactions, while also working with funded equity sponsors, family offices, and directly with entrepreneurs and management teams. Mr. Berty brings more than 25 years of transactional experience across multiple industries and diversified markets. Learn more at: www.orix.com

Evan R. Gallinson, Managing Director, Merit Capital Partners | (O) 312.592.6114 | egallinson@meritcapital.com

Evan Gallinson joined Merit in 2005. Evan previously worked in investment banking with BMO Capital, William Blair & Company, and PriceWaterhouseCoopers, where he focused on mergers and acquisitions advisor work for middle market companies in a variety of industries. Evan received an M.B.A. from Northwestern University’s Kellogg School of Management in 2002 with a concentration in finance. In 1997, he received a B.B.A. from the University of Michigan with a concentration in finance and accounting. Learn more at: www.meritcapital.com

Brian Kerr, Managing Director, ORIX Private Equity Solutions | (O) 610.937.0443 | bkerr@orix.com

Brian Kerr has spent 19 years working with lower middle market corporations and entrepreneurs on financial and strategic projects, including balance sheet recapitalizations, debt and equity alternatives, leveraged buyouts, and mergers and acquisitions.

Prior to joining ORIX USA, Brian was the founder of Clairemont Capital Group, a lower middle market private investment firm. Before forming Clairemont Capital Group, Brian was a managing director at Cornerstone Capital Holdings and Penn Mezzanine. Learn more at: www.orix.com

Gretchen Perkins, Partner, Huron Capital | (O) 313-962-5806 | gperkins@huroncapital.com

Gretchen Perkins has over 30 years’ experience in the finance and business development sectors serving a variety of capital market participants. Prior to joining Huron Capital, Gretchen led the acquisition sourcing efforts at Long Point Capital, a middle market private equity fund. Gretchen also served as vice president – Business Development for IRN, Inc., a market research firm, and has held senior business development positions at Fleet Capital Corporation and GE Capital Corporation. Learn more at www.huroncapital.com

Melissa McClenaghan Martin, President, M3 Strategic Alliances | (O) 917-715-8909 | melissa@m3strategicalliances.com

Melissa advises firms on the creation of business development, thought leadership and women’s initiative opportunities that increase firms’ visibility, reach and revenue. Melissa has 20 years of experience working with financial services firms, and her thought leadership and consulting span various sectors including private equity, hedge funds, venture capital, and real estate. Learn more at: www.m3strategicalliances.com