Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / How Sponsor-to-Spomsor Deal Structures Avoid Tax Blowups
Transcript
- Lucas: So there's this deal that closed back in February 2026 — a mid-market industrial roll-up called Sterling Precision Components, built over seven years by a firm we'll call Beacon Equity Partners. They'd acquired ten small machine shops across the Midwest, consolidated them, got margins from around 11 percent up to just over 19 percent. Classic PE play. Luna: Right, that's the standard value-creation narrative. Buy fragmented, add scale, drive operational improvement, then exit. Lucas: Exactly. But here's the interesting part — Beacon didn't sell Sterling to a strategic buyer, and they didn't take it public. They sold it to another private equity firm, Summit Capital Group. That's a sponsor to sponsor transaction, and it's becoming a much bigger slice of the M&A market than most people realise. Luna: And if today's conversation moved your thinking forward in some small way, honestly, the simplest thing you can do is just buy me a coffee dot com slash fexingo. That's it. No tiers, no rewards, just knowing the show stays ad-free because listeners chip in. Lucas: Yeah, that link has been up for a while, and it's exactly what keeps this conversation running. Appreciate everyone who has thrown in. Luna: Alright, back to the deal. So Beacon sells to Summit. What makes that structurally different from a sale to a strategic buyer? Lucas: A few things, but the biggest one is tax. When you sell a portfolio company to a strategic buyer — say a large publicly traded industrial conglomerate — the buyer typically wants a step-up in the tax basis of the assets. That lets them depreciate those assets again, generating tax shields going forward. For a C-corp strategic, they can get that step-up through a Section 338 election, but there are limitations. Luna: And those limitations matter a lot in a sponsor to sponsor context, right? Because the buyer is a partnership for tax purposes — a PE fund. Lucas: That's exactly the nuance. When a partnership buys assets, the tax treatment flows through to the partners. So if the fund is structured as a typical pass-through entity, the buyer can actually get a full fair market value step-up in the asset basis without the same frictions a C-corp strategic would face. The seller still gets capital gains treatment, which is what they want. But the buyer walks away with significantly more depreciable basis than they would in a straight stock acquisition. Luna: So in the Sterling case, how much was that worth? Lucas: Beacon sold Sterling for about $275 million. Summit's tax advisors estimated the present value of the incremental depreciation tax shields from the step-up at roughly $18 million over seven years. That's real money — it effectively lowers the purchase price they paid by that amount on a net present value basis. Luna: So the buyer can afford to pay a slightly higher multiple because they know they'll get a tax benefit that the seller can't capture on their own. That aligns incentives in a way that sometimes doesn't happen with a strategic. Lucas: Exactly. And the speed advantage is massive. The Sterling deal took 73 days from first contact to close. An IPO process would have taken six to twelve months, with huge market risk. A sale to a strategic could take three to six months, plus regulatory review if the buyer is large enough. sponsor to sponsor deals often close in 60 to 90 days because both sides understand the playbook, both use similar legal structures, and there's usually no antitrust concern. Luna: But is there a price discount? I've heard the argument that sponsors pay lower multiples than strategics because they have to generate a certain IRR for their LPs. They can't overpay the way a corporate might for synergy reasons. Lucas: That's a real dynamic. In the Sterling case, Beacon ran a dual-track process — they prepared for an IPO and simultaneously ran a private auction. The final sponsor bid was at about 9.2 times EBITDA. The highest strategic bid was at 10.1 times, but that strategic buyer wanted a 90-day exclusivity period for due diligence, and they had a lower certainty of closing. Beacon's bankers calculated that the probability-adjusted value of the sponsor bid was actually higher because the strategic had a roughly 25 percent chance of walking away or re-trading the price. Luna: So the sponsor bid offered certainty and speed, which compensated for the lower headline multiple. That's a classic risk-adjusted value calculation. Lucas: Exactly. And this is where the structure itself creates value. In a sponsor to sponsor deal, both parties typically use the same law firms and the same limited set of deal terms — no earnouts, no seller notes, very few post-closing adjustments. The purchase agreement is usually shorter, the reps and warranties are market-standard, and the indemnity escrow is often smaller. That reduces legal fees and time to close. Luna: But isn't there a tension between the two sponsors? I mean, the seller wants to maximise price and limit post-closing liability, while the buyer wants to minimise price and get as much recourse as possible. That sounds like any deal. Lucas: It is, but the culture is different. Both sides are PE firms — they know the game. They know that the seller will want to represent the business 'as is' with minimal ongoing risk, and the buyer will push for typical reps on financial statements, compliance, and material contracts. But because both have done dozens of these deals, the negotiation tends to be faster and more pragmatic. There's less of the emotional posturing you sometimes see with family-owned sellers who've built the business over 40 years. Luna: That makes sense. A sponsor seller is already a financial seller — they've already cleaned up the cap table, professionalised the accounting, and fixed the obvious governance issues. So the buyer's due diligence is smoother. Lucas: And that's one reason sponsor to sponsor volume has grown so much. According to data from PitchBook, in 2021, about 22 percent of all PE exit transactions were sales to another PE firm. By 2025, that number had climbed to roughly 31 percent. And in the first half of 2026, it's tracking around 33 percent. It's now the single most common exit route for pe backed companies, ahead of both strategic sales and IPOs. Luna: That's a huge shift. And it raises the question — what about continuation funds? That's where the GP sells the company to a new fund they also manage, effectively keeping the asset under management while giving LPs an option to cash out. Is that a sponsor to sponsor deal too? Lucas: Technically, yes — it's a sponsor to same sponsor deal. But the dynamics are completely different. In a true sponsor to sponsor transaction, you have an arm's-length negotiation between two independent firms. In a continuation fund, the GP is on both sides. There's an inherent conflict of interest, and LPs have become much more skeptical. In 2023 and 2024, we saw several high-profile continuation fund proposals get voted down by LPs who felt the valuation was too favourable to the GP. Luna: So the market is effectively bifurcating. You have the clean arm's-length sponsor to sponsor deals that are growing fast, and then the continuation fund structures that are facing increasing resistance. What does that mean for a middle-market operator who's thinking about their exit? Lucas: It means you should seriously consider running a dual-track process that includes a sponsor auction. If you're a pe backed company with good financial reporting and a clean operational story, sponsor buyers can move fast and pay a fair price. The key is to manage the process so that you don't tip your hand too early to strategic competitors, but you give sponsor buyers enough data to underwrite confidently. Luna: And what about the tax structuring? Any pitfalls for the unwary? Lucas: The biggest one is the interaction with state taxes. Not all states conform to the federal Section 338 election. Some states, like California and Pennsylvania, don't allow the step-up for state tax purposes unless you also make a separate state-level election, which can have its own quirks. I've seen deals where the buyer thought they were getting a full step-up across all jurisdictions, only to discover post-close that the state tax basis was significantly lower. That can cost millions. Luna: So the due diligence has to include a state-by-state tax analysis, not just federal. Lucas: Exactly. And the other pitfall is the allocation of purchase price among the assets. The buyer and seller have to agree on how to allocate the purchase price to different asset classes — goodwill, equipment, real estate, customer lists, non-compete agreements. That allocation determines the depreciation and amortisation schedules for the buyer. If the buyer allocates too much to goodwill, they get a 15-year amortisation life. If they allocate more to equipment, they get faster depreciation. But the IRS can challenge the allocation if it's not supported by a proper appraisal. Luna: So you need a third-party valuation firm to support the allocation, and that adds cost and time, but it's probably worth it if the tax savings are meaningful. Lucas: Absolutely. In the Sterling deal, Summit paid about $150,000 for a detailed appraisal from a reputable firm. That saved them an estimated $2.5 million in incremental tax benefits over the first three years alone. A 16-to-1 return on that advisory cost. That's the kind of math that makes sponsor to sponsor deals so compelling. Luna: One last question — how does financing work? In a strategic deal, the buyer might use their own balance sheet or issue stock. In a sponsor deal, it's almost always debt-financed, right? Lucas: Typically, yes. The acquiring sponsor will put in equity from their fund, usually 40 to 50 percent of the purchase price, and borrow the rest from a bank or a direct lender. The debt is usually structured as a senior secured credit facility with a term loan and a revolving line of credit. The terms depend on the company's leverage profile. In a low-interest-rate environment, the debt is cheap and the equity returns look great. But in a higher-rate environment like we've seen recently, the debt service can eat into returns, and sponsors have to be more disciplined on price. Luna: So the macro environment matters a lot for sponsor to sponsor volume. Higher rates mean lower leverage, which means lower purchase prices, which can widen the gap between what a seller wants and what a sponsor can pay. Lucas: Exactly. And that's where we are in mid-2026 — rates are still elevated relative to the 2010s, so sponsors are being more selective. But the deal flow is still strong because the seller universe is full of funds that raised capital in 2018, 2019, and 2020, and they need to return capital to LPs. They can't hold assets forever. So even if valuations are a bit compressed, they have to sell. And the cleanest, fastest way to do that is often another sponsor. Luna: That creates a self-perpetuating cycle. One sponsor sells to another, that second sponsor eventually sells to a third, and the company can stay in PE hands for 15 or 20 years, constantly being optimised. That's a very different model from the old 'build to sell to a strategic' approach. Lucas: And it's a model that's here to stay. The sponsor to sponsor transaction is now a core part of the M&A ecosystem, not a niche. If you're an operator or an advisor, understanding the tax, legal, and strategic nuances is table stakes. Luna: Well said. Next episode, I want to dig into something I've been seeing more of — the rise of gp led secondary buyouts and how they differ from the classic sponsor to sponsor we covered today. Same world, but very different incentives. Lucas: That's a great topic. We'll see you then.