This article will consider what is holding back the scale-up of the sponsorless lending market. Why are fund managers not reaching out to the tens of thousands of middle-market companies across Europe seeking financing options and what is needed now to bring big investors into the market?
There may some perception of risk in the smaller sponsorless deals but industry analysts tend to point to data that shows sponsorless companies having less leveraged balance sheets than private equity-backed firms. Lenders are often able to negotiate more favourable terms – and higher returns – where a firm is independently owned and operating well.
There is certainly an element of the 'path of least resistance' at play. A manager can deploy a €2 billion fund in 20 buyout debt deals averaging €100 million each where a private equity firm has done the due diligence in each case and provided all the financial data in tidy packets. Otherwise the debt fund manager would need to do its own due diligence on perhaps hundreds of sponsorless borrowers where data is relatively scarce and financial sophistication is potentially low.
Faced with these two alternatives for a similar level of earned fees – between 1 percent and 1.5 percent per annum and a performance fee – it is hard to argue against the buyout option as long as it is available. And this is a paramount factor at this stage in the credit cycle.
Participants in the sponsorless lending sector stress that they would rather not take the risk of being beholden to a highly competitive and cyclical M&A and LBO market. They also argue that the two options are not 'apples to apples': the higher return and lower leverage in the sponsorless sector outweigh the greater difficulty of accessing suitable borrowers as they build their asset management firms.
From here I see four clear requirements for the direct lending market to break out of the private equity space and start to connect meaningfully with small and mid-sized companies. Some of these are indeed already in train and the prospects look fair. But without each of these four things happening, the big, profitable and sustainable direct lending market that many have envisaged may never emerge.
1. BRING IN THE LARGE GLOBAL PENSION FUNDS
To attract the big allocators such as sovereign funds and state pensions, the sponsorless lending market firstly needs to offer bigger funds. Few funds making sponsorless loans have a final target size of more than €400 million.
This is the actual ticket size of some sovereign funds, which is why they have to allocate to the €2 billion-plus private equity debt funds. What would be the attraction of such funds to these large allocators? Sponsorless lenders point to several.
The funds offer much-needed diversification from their private equity commitments, which may be exposing them to the same underlying deals across several debt and equity funds. Furthermore, sponsorless fund investors can typically be shown higher returns than buyout debt funds, while portfolios are themselves more granular than in the debt mega-funds.
But these positive investment attributes count for naught if they can't invest for technical reasons because the fund is too small for their ticket size. To run bigger funds, asset managers will need to build out well-resourced, fully AIFM-compliant platforms, so strong backing will be required.
2. SERVE THE INSURERS
Despite complications associated with Solvency II regulations, some of the most prominent insurance names in the UK, France, Germany and Scandinavia have begun to allocate small percentages of their vast asset books to illiquid debt funds to enhance yields. In most cases, however, insurance companies have been channeled to the senior debt of the private equity LBO market.
To make the sponsorless lending market investable for insurers, three things are required. Firstly, asset managers need to originate primarily senior debt rather than mezzanine or growth capital in sponsorless situations. This means operating alongside banks in Europe and adding extra capital where needed to senior corporate debt transactions rather than being in subordinated positions to banks.
Secondly, asset managers will need to establish credit platforms that insurance companies can invest with. This may mean independent credit groups or even ratings assignment processes which insurers can become comfortable with.
Finally, these funds will also need to be far bigger than the typical sponsorless offerings. Funds of less than €500 million will not be able to take the ticket size of insurers, which do not have the capacity to analyse many different fund managers.
3. 'PROFESSIONALISE' THE BORROWERS
The most common reason fund managers cite for not pushing more actively into sponsorless lending is a lack of professional processes when they deal with potential borrowers.
A sponsor-backed company will bend over backwards to make it easy for lenders to understand and get comfortable with a credit. In a true direct lending situation the lender may be working from scratch with limited financials and may be working with a management team who have never before worked with non-bank lenders.
This provides a big opportunity for advisers to potential borrowers and the fund management community. By providing a professional advisory service to management teams, an advisor can play a useful role. Typically, debt advisors have worked to place debt into the private equity community. As more capital comes into the sponsorless sector, advisory boutiques can gear up to play a crucial role in arranging new deals.
4. REVIVE THE FUNDS OF FUNDS
A crucial catalyst in the early development of the private equity and hedge fund sectors was the development of a large funds of funds market. For a large investor allocating for the first time to esoteric new asset classes, an efficient way to get exposed was to park money with a fund of funds which would do the due diligence on a range of different funds.
As those markets have matured, investors have become less willing to pay the double layer of fees that a fund of funds involves. However, for a large pension investor to access the smaller sponsorless debt managers which are lending in one country where they have deep local presence, a fund of funds may be the right model.
Funds of funds catering to the German market like Yielco Investments and Golding Capital Partners have successfully allocated to specialist debt managers on behalf of their own investor clients. Finnish direct lending and private equity expert Certior is advising clients on how to allocate into single country lending funds. Further development of this sector is required to further boost sponsorless lending.
If these challenges can be met over the coming period there is a good chance that a permanent funnel from the savings system into SMEs will open up. Yes, asset managers will need to work to set up the right systems, advisors will have to retool some of their processes and investors themselves will need to take the time to understand different risks.
The upside for investors will be greater diversification and more yield. Asset managers themselves will be able to develop new products and serve new clients. SME companies will be able to access patient and potentially more understanding capital pools. Collectively we will have laid a ground-stone for a more resilient, less cyclical credit system.
This article is sponsored by Arbour Partners. It appeared in Private Debt Investor's Sponsorless Finance supplement, published June 2016.