United States: Key Considerations For Independent Sponsors Regarding Portfolio Company Governance

Highlights

• An independent sponsor's rights largely depend on the motivations of its equity providers.
• The right equity providers bring strategic experience and industry contacts to the platform/portfolio company and can help drive value and operational efficiencies.
• Independent sponsors need to be careful, however, to avoid structuring transactions that could cause them to lose control or influence.

Holland & Knight's Independent Sponsors Team has seen an increasing number of independent sponsors taking part in transactions of seemingly all shapes and sizes. With increasing variation of transactions comes increasing variation of equity providers and their requests and requirements related to the governance of the investment vehicles they share with their independent sponsor partners.

The authors of this alert recently published a snapshot summary of the current state of the market for Independent Sponsor economics. (For additional information, see the Holland & Knight's previous alert, "Independent Sponsors: Market Trends and Industry Insights," Oct. 17, 2023.)

This Holland & Knight alert offers some insight into the types of governance-related structures that independent sponsors should expect in middle market transactions, in addition to providing a brief summary of key best practices related to negotiating these structures with potential equity providers.

Governance Structures: General Principles and Best Practices

"Soft-Circle" Equity Capital

The independent sponsor market is dependent upon the willingness of quality equity providers to partner with independent sponsors to help finance a particular transaction. An independent sponsor will typically "soft-circle" equity capital prior to, or in conjunction with, the negotiation and execution of a letter of intent (LOI) to acquire a given target company by spending a substantial amount of its pre-LOI time sourcing and engaging with a variety of potential equity partner(s) offering a variety of capital structuring options. Following the execution of the LOI, the independent sponsor will immediately turn its attention to finalizing the economic and governance terms of the transaction with its selected equity provider(s). Once the independent sponsor and equity provider(s) agree on the economic terms and the governance of the platform and/or portfolio company following closing, the parties will memorialize this agreement in a nonbinding agreement, often in the form of a memorandum of understanding (MOU) or indication of interest (IOI), which we discuss in more detail below.

It should be noted here that independent sponsors who do not "soft-circle" equity capital prior to the execution of the LOI risk running out of time to close the underlying transaction before exclusivity with their target expires.

Choose the Right Partner

There is no one-size-fits-all governance structure or standardized set of governance terms in middle-market independent sponsor transactions. The ultimate structure of a given portfolio company, however, is typically dictated by the equity provider(s) and most heavily influenced by two groups of factors: 1) the pedigree, industry experience and track record of the independent sponsor and 2) the requirements, preferences and motivations of the independent sponsor's partner equity provider(s). Certain equity providers may prohibit the independent sponsor from engaging or investing in any outside activities that directly or indirectly compete with the portfolio company. Additional requirements may be imposed on the independent sponsor's conduct of business by the equity provider, depending on the deal and any special requirements of the equity provider(s).

In addition to cold, hard cash, quality equity providers may also bring strategic experience and industry contacts that will help drive value and operational efficiencies far beyond what the independent sponsor is capable of on its own. With this, however, come the inevitable negotiations between the independent sponsor and equity provider regarding the governance of the platform and/or portfolio company following closing. Independent sponsors should decide before partnering with an equity provider(s) whether they want a silent partner, a controlling partner or something in between – and then manage expectations accordingly. Although some equity providers want only advisory board or board observer rights, those at the other end of the spectrum may see an independent sponsor as a glorified finder and want to control the board (and more broadly, the strategy and direction of the investment).

Retain Leverage Through Non-Circumvention Covenants

The MOU/IOI referenced above typically sets forth the investment size, any splitting of fees, relative equity stakes, management fees, promoted/carried interest provisions, the closing, integration or diligence fees payable to the independent sponsor and any agreed-upon expense reimbursements (i.e., the independent sponsor's legal and accounting fees). The MOU/IOI is typically nonbinding in the sense that the equity provider is not committing funds to the deal and the independent sponsor is not turning the deal over to the equity provider.

There may be, however, binding provisions in the MOU/IOI, such as 1) provisions whereby the equity provider receives "exclusivity" on the funding rights to the deal for an agreed-upon period of time, 2) some form of an agreed-upon expense reimbursement for the independent sponsor from the equity provider in the event the transaction does not close and 3) non-circumvention covenants agreed to by the equity provider (if not already contained in a binding nondisclosure agreement (NDA) with the equity provider).

Non-circumvention covenants contained in the MOU/IOI or contained in an NDA with the equity provider are an independent sponsor's best friend. Conversely, the lack of non-circumvention protection is an independent sponsor's worst nightmare. Non-circumvention protection is a binding restraint that prevents the equity provider(s) from going directly to the target or its advisors with the intention of bypassing (or circumventing) the independent sponsor and contracting with the target or its advisors directly, potentially leaving an independent sponsor without any economic interests in the transaction. Once the MOU/IOI is signed, non-circumvention protection may be the only leverage that the independent sponsor retains over the equity provider(s). This leverage will assist the independent sponsor in obtaining its desired outcome with respect to the economic terms and the governance of the platform and/or portfolio company following closing.

Key Structuring Considerations in Portfolio Company Governance

Typically, independent sponsors are "investor-minded" and view a transaction/target as a platform or as one of many similar investments – similar to a traditional private equity fund. This "investor-minded" view comes with the desire to 1) serve on the board of the target, 2) delegate the day-to-day operation and responsibilities of the target to its management team, and 3) devote the time and attention reasonably necessary to satisfactorily perform the management/board services.

While certain equity providers may allow the independent sponsor to serve on the board and manage the portfolio in a manner which comports with this "investor-minded" view, certain equity providers may also require the independent sponsor to devote a specified amount of business time and attention to the portfolio company – ranging from 1) the time and attention reasonably necessary to satisfactorily perform the management services to 2) a majority or substantially all of the independent sponsor's business time and attention.

Why an Independent Sponsor Should Retain "Control"

An independent sponsor with an "investor-minded" view on a transaction will often seek to retain as much control on the board of managers as possible in order to not only preserve its economic rights in the transaction, but also to help lead the charge in executing the vision it formulated when deciding to acquire the given target. An independent sponsor's ability to steer the target company in this direction may be diminished if an equity provider with a different agenda or strategy takes control. The power and authority granted to the board of managers by the investors in a given transaction will often include the power to make all decisions (subject to the "protective provisions" discussed below) with regard to the management, operations, assets, financing and capitalization of the portfolio company, including the power and authority to undertake and make decisions concerning:

• hiring and firing employees, attorneys, accountants, brokers, investment bankers and other advisors and consultants to the portfolio company
• borrowing money
• issuing equity interests
• giving guarantees and indemnities
• entering into contracts in the ordinary course of business
• merger and acquisition activity by the portfolio company
• dissolution of the portfolio company
• selling the assets of the portfolio company
• forming subsidiaries or joint ventures
• commencing and settling litigation

By retaining some modicum of control at the board level, an independent sponsor will be better positioned to help to maximize the value of its promote/carried interest economics and execute its vision for the given portfolio company.

Most Common Independent Sponsor Governance Structures

• Jointly Managed Boards: The most common independent sponsor model is one in which the independent sponsor controls two of five board seats, the equity provider controls two of five board seats, and the fifth board member is either the chief executive officer or an "independent" director selected jointly by the independent sponsor and equity provider.
• Investor-Managed Boards: The second common independent sponsor model is one in which the independent sponsor controls one of five board seats, the equity provider controls three of five board seats, and the fifth board member is either the chief executive officer or an "independent" director selected by the equity provider or jointly by the independent sponsor and equity provider.
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• Independent Sponsor-Managed Boards: While much less typical than the two structures described above, sometimes the equity provider may be "passive" to the point where they do not require a seat on the board at all, relying solely on customary investor "protective provisions" to keep the independent sponsor from making drastic or non-ordinary course decisions. In these circumstances, the independent sponsor typically controls the board with certain investors filling one to two seats on a five-person board. Alternatively, there may be no true board at all, with the independent sponsor serving as the managing member and certain investors are offered seats on a non-fiduciary/non-voting advisory board.

The Dreaded "Board Flip"

A so-called "board flip" is a mechanism that equity providers often include in the governing documents of portfolio companies with a board of managers that is jointly managed by the independent sponsor and equity provider. These provisions typically provide that following the occurrence and during the continuance of certain "trigger events," either 1) the number of board members will be automatically increased so that the equity provider has the right to designate a majority of the board members or 2) the independent sponsor will be required to give up one of its designated board seats and the equity provider would gain the right to designate that board member for that board seat, each giving the equity provider the ability to control the board of managers.

The "trigger events" that give rise to a "board flip" may include one or more of the following actions by the independent sponsor:

• fraud, willful misconduct or gross negligence relating to the portfolio company (often qualified by whether it would reasonably be expected to be materially detrimental to the portfolio company)
• embezzlement, misappropriation or attempted misappropriation of any funds or material property of the portfolio company
• the commission and subsequent conviction of a felony
• a material breach of the management agreement by the independent sponsor
• a change of control of the independent sponsor

Other "trigger events" that give rise to a "board flip" may be more operationally focused on the portfolio company, such as:

• a material event of default under the portfolio company's senior credit facility
• a precipitous drop in adjusted EBITDA, below an agreed-upon threshold
• the operating company taking an action without obtaining the prior written consent or approval of the equity provider, to the extent such consent or approval is required by the portfolio company's governing documents

Target Governance – Sample Protective Provisions

The MOU/IOI referenced above may also set forth a list of the specific rights required by the equity provider to approve actions by the portfolio company (also called "protective provisions"). In structures where the independent sponsor does not have "joint-control" of the board, it is imperative that the independent sponsor also receive protective provisions which allow it to protect its economics. In these situations, the independent sponsor's consent is typically required for the target company to:

• enter into non-arm's length related party or affiliate transactions (subject to certain customary exceptions)
• make non-pro-rata redemptions of equity (subject to certain customary exceptions)
• change the size, composition or powers of the board of managers
• increase the size of the incentive equity pool (which is typically capped at 10 percent of the fully diluted equity of the target company or, if applicable, its parent company)
• create or hold the equity interests of any subsidiary that is not a wholly owned subsidiary
• issue or authorize of a class of preferred equity upon which the independent sponsor does not have a carried interest
• amend the governing documents in a manner adverse or materially adverse to the independent sponsor

Depending on the facts of the situation and the relationship between the independent sponsor and the equity provider, the independent sponsor's consent may also be required for the target company to:

• incur indebtedness (subject to certain customary allowances)
• enter into change of control transactions (i.e., acquisitions, mergers, etc.) or liquidation events
• hire, fire and set compensation or terms of employment of key management
• set annual budgets and make any material unbudgeted investments, dispositions or expenditures
• change the strategy or principal lines of business of the portfolio company

Independent sponsors should think carefully about the "protective provisions" that they require to protect their economics and involvement in the strategy of the investment. As stated above, these can be fact specific. Also, the independent sponsor does not want to burn any negotiating capital it has with its equity providers by asking for "protective provisions" that it does not need.

Conclusion

Structuring the governance-related aspects of an independent sponsor transaction is complicated by the unique nature of each transaction and the variety of institutional investors, family offices and high-net-worth individuals providing the equity financing to support these transactions. As stated in our last independent sponsor alert, the Holland & Knight Independent Sponsors Team anticipates that investor allocations to independent sponsor transactions will continue to grow and that market deal terms will continue to crystalize in both "lower middle markets" and "middle markets." Until this occurs, independent sponsors are encouraged to:

• "soft-circle" their equity financing well in advance of signing a letter of intent to acquire a target company
• retain as much leverage as possible with their preferred equity provider(s) to help ensure that the ultimate structure is satisfactory to the independent sponsor
• reach out to the Holland & Knight Independent Sponsors Team to help navigate these often-muddied waters to avoid giving up more than what is necessary to lock down a deal with selected equity providers

We encourage our independent sponsor clients to utilize the services of our HK Deal Flow℠ team, who regularly introduce our clients to quality equity partner(s) who are willing and able to back independent sponsors in their transactions.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.