Mid-market lending report: Kartesia on non-sponsored deals

For mid-market managers seeking differentiated deals, Europe’s non-sponsored space is a big draw. But a local presence is vital, says Jaime Prieto, managing partner with Europe-focused manager Kartesia.

Jaime Prieto

Why are non-sponsored deals in the European mid-market presenting an attractive opportunity at the moment?

There are lots of opportunities in both sponsored and non-sponsored deals, but the issue really is where the most opportunities are and how they are being served. Right now, non-sponsored is a much larger opportunity set that is also being underserved. It’s a part of the market that  has long been less interesting to banks, but has not yet benefited from the large increase in private credit funds over recent years.

The reason for this is most funds are focusing on sponsored deals in larger mid-cap firms which are easy to target from a London office. But everyone is vying for those opportunities.

“It’s absolutely essential to be local, you need to have your presence felt among the local business community. You have to be much closer to the company and its owners than in a sponsored deal”

Non-sponsored offers a significant opportunity for private debt funds, but requires a lot of exploration work and has far fewer intermediaries. The work is much more intensive and you need to spend a lot of time with the companies you are lending to. You’ve also got to do a lot more work on structuring the deals  when there is no sponsor.

Yes, we’ve seen a wave of interest in alternative lenders among non-sponsored firms because banks aren’t offering what they need. This is good for private credit because we offer a different and complementary service compared to what the banks are offering.

Is it getting easier to source deals in the non-sponsored space?

As businesses become more familiar with private credit as a source of lending, I think we will continue to see more dealflow. Across the whole industry, just 10 percent of direct lending is going towards non-sponsored. There is plenty of room for growth, though funds will always be at least partly involved in sponsored deals.

How do you go about sourcing these kinds of deals?

It’s absolutely essential to be local, you need to have your presence felt among the local business community. You have to be much closer to the company and its owners than in a sponsored deal. The relationship with the client has to be more intimate and much more service-oriented. After the transaction there is still a heavy workload to manage the debt and maintain contact with the business.

We also work closely with local banks, because they still work with these clients even if they can’t meet their lending needs. We work with banks to provide debt that they cannot, to enable them to continue servicing their customers in areas where they can be profitable.

Are you worried the non-sponsored space will become crowded?

It’s a very large market, so it won’t get crowded anytime soon. We think it is positive to see more private funds getting into non-sponsored deals, because it will normalise the use of private debt and also help to take some of the pressure off the sponsored space.

It will also be good for private equity sponsors over the longer-term as these companies, which tend to be smaller, will get more used to working with institutional investors. I also hope that Europe can move towards a more open market like that in North America, where companies access a lot of different sources of financing, from private equity to banks, to private debt.

Are there any legal and regulatory issues that funds need to consider if they source non-sponsored deals?

There are a number of soft issues that have to be considered. The first is a common issue for any European investor, where you have to know about all the different jurisdictional risks that exist in certain markets like Spain, Italy or France. You have to bear in mind that you are not able to fall back on a private equity sponsor to solve any issues you might have with the borrower.

Despite this, being non-sponsored can also give you a degree of flexibility to tackle these issues. For example, you might be able to structure the deal in such a way that you avoid some of the risks, perhaps through using a double LuxCo structure in Spain.

Regulation can also be a big driver of demand for private credit, with banks finding themselves quite limited in the kind of lending they can do. This leaves behind a large, underserved customer base that private debt can appeal to.

Are there any considerations over what type of business you support in a non-sponsored deal?

While we’re sector agnostic, we do focus heavily on the kind of downside protection we get from non-sponsored companies. For example, a lot of family-owned businesses will only have one substantial asset and you know that they will fight incredibly hard to keep their asset if things go badly.  We want a company that has the fundamentals in place that could allow the business to keep running without its family owners, where the management team could be replaced.

It’s also sensible to avoid areas that would quickly suffer from liquidity issues in more difficult market conditions. Sectors like retail or consulting can see very rapid deterioration when the economy turns. Other areas to be wary of include companies that are highly dependent on a single, big contract, or anything else which could cause their cashflow to be suddenly impacted.

What’s the limited partner appetite for non-sponsored deals?

LPs are getting more interested in non-sponsored, they can feel the competitive environment and know that in sponsored deals there are some funds that are taking on too much risk for too little return. There is a general feeling that non-sponsored is riskier, and that is broadly true, but the market is so big with so many businesses in it that a good management team should be able to mitigate those risks.

LPs also expect the same kind of standards from their non-sponsored investments. They still want the transparency and alignment of interest they are used to in sponsored debt investments.