One upshot of fierce competition for private equity deals in recent years has been increasing pressure on both equity and debt returns. As a consequence of this, more investors – whether debt funds, banks or others – are seeking to do deals with small to medium-sized corporates requiring finance for growth. Here, the universe is potentially larger and less crowded, meaning – in theory at least – an opportunity to make higher returns.
The statistics back up the hunch that here is a trend in the making. In the UK, the proportion of deals done by alternative lenders in the so-called non-sponsored market (versus sponsored) has risen from zero in the first quarter of 2013 to 27 percent by the end of last year, according to Deloitte’s Alternative Lender Deal Tracker.
However, there is a view that the opportunity is far from unlimited. While the universe of non-sponsored companies is vast, those prepared to engage with debt funds is much smaller. “The challenge is finding opportunities, as most companies that are potential targets are backed by high street lenders and have access to leverage,” says Simon Chambers, a managing director at GCA Altium, the European arm of global investment bank GCA. “You are trying to find those that want a loan that can only be done by credit funds.”
Debt fund loans tend to be more expensive for the borrower and are typically only in demand when that borrower needs more complex or flexible financing than banks are able to offer. Moreover, even when a company is potentially in a position to seriously consider a loan from a debt fund, the two parties may never come together.
“Most credit funds have small teams and can’t spend time reaching all these businesses,” says Chambers. “There are not many with a large origination effort. It’s time consuming and inefficient.”
That perfect match can happen however. One example was when GCA Altium advised on a transaction last November, which saw CVC Credit Partners and EQT Credit jointly provide a £110 million ($137 million; €129 million) unitranche facility to merchant services provider Paymentsense. The company was growing fast and had requirements that went beyond the comfort zones of potential lenders other than debt funds.
“[Paymentsense] were looking to reorganise their capital structure and had experienced extremely fast growth and needed someone to buy into the growth story,” says Chambers. “We did approach bank lenders and they were not willing or able to do it. CVC and EQT were able to roll up their sleeves and understand the credit story.”
Into the regions
Another firm rolling up its sleeves in the hunt for non-sponsored deals is Prefequity, a London-based fund manager currently looking to raise a fund of around £150 million to target individual investments in the £5 million-20 million range. “We get out into the [UK] regions and look for well-established profitable businesses that need some more fuel in the tank,” says managing partner Theo Dickens. “They are capital-constrained but don’t want controlling and dilutive private equity investment.”
Dickens believes credit funds are a great match for entrepreneurial companies as they can provide the finance required but typically exit quicker than private equity firms and then put the business back in the hands of those who have built it. He thinks the product is “a thing of joy for limited partners which want downside protection with high cash yield”.
However, like Chambers, he acknowledges that there is no easy money to be made from non-sponsored deals. “We think of this as ‘self-sponsored’ as we do all the work that the private equity guys normally do – not just origination but ongoing management as well. The trick is making the numbers work for the GP. On the one hand, you need a lot of good people and the economics of that can be challenging when you’re only a small fund. On the other hand, there have not been a flood of new entrants like there have been in the unitranche market.”
Despite the relative lack of competition, however, Prefequity chooses to avoid London and focus on the regions where deals are less fought over and the firm benefits from relationships with local advisors. Manchester, England, is one city where the firm is active, alongside other debt fund managers such as Muzinich & Co, which has an office there, and Beechbrook Capital, which is planning one.
But while non-sponsored transactions have been identified as a debt fund-related trend, amid the perceived retreat of banks from SME lending, some banks consider themselves to be very much still in the game. One example is Investec, the specialist bank and asset management group.
Callum Bell, head of Investec’s London-based corporate and acquisition finance team, says the firm has been ramping up its origination effort in the non-sponsored community and, from a standing start, has done 25 percent of its deals in the space over the last 12 months.
Foot in the door
He claims that, as a bank, identifying borrowers is made easier by the scale of the organisation. “We look to partner with clients where we already have a foot in the door and an existing relationship for example through our advisory, treasury or private client operations. A standalone debt fund does not have the advantage of that breadth of contact with corporate clients. It’s a bigger hill for them to climb.”
He acknowledges that the risk-return in the non-sponsored space is very attractive to debt funds compared with the sponsored market. But he stresses the point made by others: while 2016 saw great strides being made, the volume of non-sponsored deals is likely to increase gradually rather than taking off on a sudden trajectory. And the main reason for that is the heavy spadework required to make it a success.
“If you take a long-term view around client acquisition and partnerships then, for the sake of diversification, it’s well worth it,” says Bell.
“But you need to be smart around your origination activities and have the right people to execute this effectively. You can experience dry spells due to the longer gestation period of these deals and consequently you need deep roots and relationships in the sector. Trying to pick off the odd deal is not a long-term, value-adding, strategy.”
‘There always needs to be a reason for more expensive finance’
Last June, Floris Hovingh, the founder of Deloitte’s Alternative Lender Deal Tracker, spoke to PDI about non-sponsored finance. Below is an extract from that interview
How large is the non-sponsored market in Europe, and is it likely to
FH:At the moment, sponsorless deals account for roughly 25 percent of total deals. I think that figure will go up. In the US, the figure is about 40 percent, so I think there is a big opportunity.
Why is this type of financing typically required?
FH: When you see sponsorless deals, they are never for normal working capital type needs. There always needs to be a reason for more expensive finance. It may be for transformational acquisitions, new shareholder alignments, or where companies just haven’t got the track record to raise bank debt.
Why might using alternative lenders be attractive for borrowers?
FH: The attractiveness of alternative lenders is that they can do senior risk all the way through to equity risk. Private equity firms can only offer one product, which is majority-control equity, but alternative lenders can play anywhere between the senior debt and equity spectrum, and there is a big opportunity to provide growth capital for sponsorless companies which don’t want to relinquish control or dilute their equity stake and are looking for passive partners.