Direct lending contemplates a change in direction

The sponsored buyout market has been the increasing focus of direct lending activity in recent years. But as that market comes under pressure, might non-sponsored deals finally thrive?

The dominance of the sponsor-led direct lending market in Europe has been pronounced. In the Q3 2022 version of Deloitte’s Alternative Lender Deal Tracker, sponsored deals accounted for 89 percent of the market in the UK and 85 percent in the rest of Europe.

It wasn’t always this way. The same survey shows that, back in the second quarter of 2013, sponsored deals made up 54 percent of the UK total – with non-sponsored deals (those with no private equity participation) accounting for the remaining 46 percent. But in the decade since – and despite more or less constant speculation that the non-sponsored share would rise – the sponsored deal has shoved any other type of transaction to the periphery.

At the risk of falling into the same trap as other misguided crystal ball gazers, has the era of the non-sponsored deal finally arrived (or returned, for those who were in the market a decade ago)? Some think the halo of traditional mainstream direct lending has slipped a bit, partly because the high-yield bond and leveraged loan markets have started to chip away at the illiquidity premium.

Furthermore, the market is now beginning to see (or at least imagine) the consequences of the erosion of terms and conditions in the direct lending market at a time when deal-doing was highly competitive. Future synergies and operating efficiencies that may have seemed plausible in a benign economic environment – and thus justified EBITDA adjustments – appear less so when margins come under pressure from labour and raw material cost inflation.

Rumour has it that some sponsor-backed deals, predicated on a full or part (and reasonably swift) refinancing, have real problems with debt sustainability given the rising cost of capital. If they can’t refinance, can they continue to service their current quantum of debt? The jury is out.

Given these concerns, it’s unsurprising that we hear fund managers and investors alike scrutinising the non-sponsored market with increasing interest – especially given that such deals often accommodate potentially lucrative upside from equity-like instruments and tend to have low upfront leverage (no EBITDA adjustments in this part of the market).

It’s been said before and bears repeating that starting a non-sponsored business line from scratch is tough – firstly, there’s the cost of setting up the infrastructure you need to effectively source deals and obtain referrals from intermediaries. There’s also the commitment you need to make to due diligence, given that sponsors are not on hand to simply share theirs. It is, in many ways, a completely different business model. But the challenges of all this are starting to appear less prohibitive in a changed investment world.

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