With the private equity market showing signs of slowing and the number of direct lending funds in the market greater than ever before, the competition to lend on deals involving private equity sponsors is at an all-time high. As a result, a growing number of debt investors are now backing companies with no private equity sponsor involved. With the promise of better returns and more control, non-sponsor deals nevertheless require greater resource on the part of the lender and can take much longer to close. PDI sets out upsides and potential downsides of a non-sponsor strategy.
? Greater alignment with the business owner
One of the first things that most lenders on non-sponsor deals highlight as an attraction of the market is the greater alignment that they can achieve with the business owner. Given that most of these deals involve owner-managed companies, and building relationships with an entrepreneur or founding family, there can be a chance for credit providers to get pretty hands-on.
Paul Shea, co-founder of Beechbrook Capital, says: “The borrowers on these deals typically have a large amount of personal wealth invested in the business, and so they are risk averse. Plus the borrower is already in the business and knows the business well, and often lives and breathes the business, so it’s very different from someone acquiring the business and relying on their due diligence to try and make an assessment.”
Vipul Shah, a managing director and investment committee member at ArrowMark Partners (formerly Arrowpoint), says there is terrific alignment in having an owner-manager as your borrower: “This is normally a meaningful asset for the founder or family, and that creates great alignment. The focus tends to be on value-add versus maximising leverage in order to create tax shield, or financial engineering. They are looking to blend their cost of capital with debt and find a good long-term partner.”
? Better risk-adjusted returns
This different kind of partnership leads to differentiated risk returns, with some commentators saying that non-sponsor deals generate yield that is as much as 150 basis points above that on sponsored deals made to similar companies. That is because private equity sponsors can often negotiate cheaper finance, whereas a founder-owned, or family office-owned, business may be less focused on the interest rate and more on the partnership on offer.
Shea says: “It’s not necessarily the case that the returns are higher, it’s more the risk-adjusted returns, and that depends on your view of risk. If you take the view that the private equity firms bring high-quality selection, due diligence and corporate governance, then obviously their involvement mitigates the risk. But there are other risks in these deals, and manager-owned businesses don’t necessarily want to maximise leverage, or take on other risks that are hard to quantify. It comes down to experience, assessment and judgment, and if you can find good companies, we think there are compelling risk-adjusted returns for non-sponsored opportunities.”
?Lender-friendly deal teams
Though credit funds do not like to say it, there is no doubt that the power balance does not favour the non-sponsored borrower. Not only do lenders have less incentive to give concessions because there is not the lure of repeat business from private equity firms, but these one-time borrowers are also far less familiar with the dynamics of structuring deals than professional sponsors.
These borrowers are typically less motivated by maximising balance sheet leverage, or maximising value within a five-year investment cycle, according to Paul Echausse, head of US direct lending at Alcentra. He says: “The owner-entrepreneur views their obligations and their company a bit differently. They typically have a longer investment horizon than just five years, and will think about other issues and constituencies, like the involvement of family members. So the owner-entrepreneur-family business will invest capital perhaps more judiciously; with a longer investment horizon. In our experience, the entrepreneur does not like to put too much debt on their business.
“We believe the lower leverage mitigates the perceived risk that lending to this sector is more risky than the private equity sector, where sponsors have committed capital. The entrepreneur is looking for a financing partner in every sense of the word, so your knowledge of the business is important to them. The cost of capital is also important, but perhaps less important. The fact that we have invested in this sector for almost two decades, demonstrates our commitment to the entrepreneur and is a real differentiator.”
Daniel Sachs, CEO of Proventus, the Stockholm-based credit funder to European midsized companies, says: “Most of the big investors in private credit are currently going almost exclusively for sponsored situations, because that is much more accessible, so there’s certainly more pressure on terms in that market.”
Without the involvement of private equity firms, the onus is on credit funds themselves to originate deals, which can be the most labour-intensive aspect of direct lending. One downside of non-sponsor deals, therefore, is the time and resource involved in sourcing.
Sachs says: “Of course, it’s a much trickier sourcing process, because it’s much harder to find the situations and we spend a lot of time on the ground in our markets talking to banks, accountants, investment bankers and businesses, building very long-term relationships. We have cases where we have been in discussions with a company for three years before we actually provide any funding.”
Echausse adds: “You probably have to work two or three times harder to source these opportunities, and to close them, than you do with private equity firms. If you think about private equity, they are usually buying the business, they have a process, a depth of resources, and they get paid to deploy capital. So it would not be unusual for the private equity financing process to take 90 to 120 days from start to finish. An entrepreneur wants to get comfortable with his financing partner, and may not want to do a deal straight away. We have been involved in deals for six months and sometimes they still don’t come to fruition.”
?Competition from the banks
While it may be extremely competitive to secure the lending mandates for private equity-backed businesses, the efforts made by banks to compete for non-sponsored deals make competition a real challenge. Shah says: “Given the size and nature of the businesses we are focused on, which are typically growing, well-capitalised and family-owned, one of the challenges we face is the nature of the competition. You find you are dealing with different types of competition, rather than just bidding up against debt funds. If it’s a debt-only deal, and a local bank really wants that family’s business, we don’t try to compete with them on price… To a lesser extent, we do have deals that we lose to private equity firms because companies decide that they want to do a more control-orientated transaction.”
Finally, another labour-intensive aspect of the non-sponsor deal is the due diligence process. This can require a big investment on the part of the lender. “We can’t piggyback off a sponsor’s due diligence,” says Sachs. “But at the same time, we are quite used to due diligencing family companies and entrepreneurial businesses, and the benefit of doing it entirely ourselves is that we get to be very targeted and focus on the things we really care about.”
Shah also argues that the chance to do independent due diligence, even if it is costly, is an upside of non-sponsor deals.“We like the idea of being able to really lead the diligence, and be the folks working on the entire structuring and relaying that into the documentation,” he says. “We are a fundamental research-driven firm, and if you’re going to be in a capital-preservation, downside-protection mode, getting to lead your own primary research is definitely a positive.”