To all those investors sceptical that yields on sponsored leveraged loans are enticing enough to make up for the illiquidity when compared with public bonds, there is an alternative.
It is to be found in the world of sponsorless finance: namely, lending by investors or investment funds to businesses that are not backed by private equity sponsors.
Long-established in the US, sponsorless finance is becoming more common in Europe, as banks trim their lending in response to rules such as the Basel III regulations for capital adequacy.
It accounted for 27 percent of the growing total of European deals done by direct lenders in the fourth quarter of 2015, according to the Deloitte Alternative Lender Deal Tracker survey.
“This area is very dynamic,” says Declan Canavan, head of alternative investment strategies EMEA at JP Morgan Asset Management in London. “Banks are exiting, so there's an opportunity for investors seeking yield.”
Indeed, one of the greatest attractions is the yield. Fenton Burgin, head of UK debt advisory at Deloitte, the professional services firm, thinks that yields for sponsorless deals in Europe are about 100-150 basis points higher, on average, than for sponsored deals made to similar companies structured with similar metrics.
In the US market, which is larger but no longer growing, Tom Aronson, co-founder and head of loan origination at Chicago-based Monroe Capital, puts the premium at about 150 basis points. Monroe Capital has assets under management of about $3.5 billion in loans to mid-market companies, split fairly evenly between sponsored and non-sponsored finance.
Private equity sponsors argue that the cheaper finance they can get largely reflects the lower risk borne by lenders in sponsored deals. This is partly a question of management depth: sponsored firms can tap into the ample management expertise of private equity firms.
However, lenders to unsponsored businesses are generally sceptical of the idea that the risk is greater.
“The perceived risk of lending to these businesses is sometimes very high,” says Aronson. “But when you peel back the onion, there is a much stronger structure than you might get when lending to a private equity-backed business.
“You sometimes don't get the management strength that you get in sponsor backed-businesses.” However, “you will get other attributes”. In family-owned businesses, one of these is the absolute dedication of the owner-manager to the company's survival.
Aronson concedes, however, that completing sponsorless deals can be time-consuming. “The private equity sponsor will give you largely completed due diligence information,” he says. By contrast, “a family will often say, 'I want to borrow from you, but I don't know what you need.'”
He estimates that it takes Monroe, on average, an extra 45-60 days more to complete an unsponsored deal than it does for a sponsored deal.
On top of this, lenders have to consider the greater effort involved in origination compared with sponsored lending, where a relatively limited number of private equity funds, at least in comparison to the huge number of possible unsponsored borrowers, actively hawk their deals.
The labour-intensive nature of sponsorless dealmaking is one factor limiting the number of new entrants into the market, though several big sponsored finance lenders on both sides of the Atlantic, such as Alcentra, Highbridge and Hayfin, also lend to unsponsored businesses. “Because of the sheer effort that goes into originating sponsorless deals, lenders need a large employee base,” says Callum Bell, who as head of corporate and acquisition finance at Investec Bank in London, lends to both sponsored and sponsorless businesses. “That means a large cost base.”
By limiting the number of market entrants and keeping competition less severe, this cost base helps to maintain the higher premiums available in sponsorless finance.
A final attraction of sponsorless finance lies in the power dynamics of the relationship, when compared with sponsored deals. “In the London market, where a sponsor might do 10 deals a year, sponsors have become very sophisticated when dealing with lenders,” says Sam Hamilton, finance partner in the London office of Latham & Watkins, the international law firm.
The power balance does not favour the unsponsored borrower. This is in part because lenders have less incentive to err on the side of generosity in the hope of future deals, and because non-sponsored borrowers are less knowledgeable in the art of structuring deals.
Sceptics might argue that even if the higher premiums, breadth of choice and sheer managerial enthusiasm available in sponsorless finance make it attractive in theory, now is not the right time to invest in it.
In the UK, spreads relative to sponsored finance have narrowed by about 100 basis points over the past 18 months, thinks Burgin, as more capital has entered the sector – even though observers maintain that competition remains less intense than for sponsored lending.
US sponsored lenders face their own problem: the loan market in general is looking riskier because of fears over a domestic economic slowdown.
However, market observers warn against excessive gloom. In the UK, Burgin believes that yields will not fall any further, because “we are in the twilight of the era of cheap capital availability for the European mid-market”. He attributes this partly to tighter US monetary policy.
In the US, “we're in the seventh year of economic expansion. We may have another 12-24 months of economic growth, but as a business, we are still being more cautious in our investment criteria”, says Paul Echausse, New York-based managing director and head of US direct lending at Alcentra, a BNY Mellon investment boutique.
“But this is a very large economy. Regardless of the economic cycle there are companies out there which look attractive because they're growing faster than GDP and faster than their peers.”
WHAT KIND OF NON-SPONSORED BORROWERS DO LENDERS LIKE?
“We're generalists: we like all different kinds of sectors,” says Tom Aronson, co-founder and head of loan origination at Monroe Capital in Chicago. However, he highlights two much-loved characteristics: “consistent performance” and “a market niche”.
Aronson gives a recent example. In 2015 it funded a management buyout by the minority owners of Mud Pie, an Atlanta, Georgia-based manufacturer of gift products and fashion accessories, such as newborn babies' clothes.
The minority owners had founded the business and still ran it, but had earlier sold out to a private equity firm, which wanted to sell on to another private equity buyer. The family wanted to buy it back themselves.
“We focus predominantly on growth companies,” says Paul Echausse, New York-based managing director and head of US direct lending at Alcentra, a BNY Mellon investment boutique.
He defines this as companies with revenue or EBITDA growth of more than three times US GDP growth – in other words, high single digits and above.
This is partly because growth is a token of corporate health and partly because of an alignment in the priorities of borrower and lender: “Fast-growing companies typically do not take on a lot of leverage, because they want the balance sheet flexibility to be able to invest in this growth, through capital investment, for example.”
Alcentra tries to keep its portfolio, including both non-sponsored and sponsored borrowers, at about half a turn lower than current prevailing market leverage.
He is, however, less catholic than Aronson when it comes to sectors. “We tend to focus more on service businesses,” says Echausse.
“Manufacturing has higher fixed costs and is more cyclical. High fixed-cost businesses have a tendency to underperform during periods of economic weakness or uncertainty.”