How has the sponsorless market evolved?
In the past, the private debt fund market mainly focused on private equity-led deals and, in particular, providing financing solutions for the buyout market. However, over the last 10 years, the willingness of the banks to provide term finance has been curtailed by regulatory changes. They have been less and less active in both buyouts and, even more so, in sponsorless deals.
This has created new opportunities for funds to generate interesting risk-adjusted returns.
What differences are there with sponsored lending?
There are a number of differences, including use of funds and origination. The sponsored market typically consists of buyers and sellers of businesses. Predominantly, money is required to finance the acquisition of a business by a private equity house. In sponsorless deals, finance is needed for a much wider range of uses – growth capital, buy-and-build, buyout of minority shareholders etc.
Another difference is in origination. Whereas, in sponsored deals, the sponsor rather than the lender is responsible for the origination and due diligence, in sponsorless deals it’s down to us – we do what the private equity firm would do in a buyout scenario.
What skill set do you need to bring to deals?
It’s not just about providing capital, it’s about providing a set of services to help the company grow. Usually it will be the first time a borrower interacts with a provider of institutional capital. We approach each deal as if it were a private equity transaction when it comes to diligence, reporting and corporate governance. We also attend board meetings of the companies we back.
Does the sponsorless market involve a higher or lower risk?
It’s neither higher nor lower, it’s a different risk. It’s a market where there tends to be less liquidity, so we are able to structure our own risk and return. Leverage is typically lower than in the buyout world, meaning our financial risk can be lower. The companies we back are often owner-managed and the business is where the bulk of the owners’ private wealth resides. This encourages a more conservative approach to leverage.
We work with smaller companies and have no additional back-up in the form of a sponsor, for example, so we have to support them through any stress. This means the business risk can be higher.
How are these deals typically structured?
We’re very flexible when it comes to how we think about the return and the deal features. We can provide bespoke solutions for the borrower, which differentiates us from the banks. Having worked out what the borrower wants, we try to deliver it.
Typically, it’s a bullet loan over five years on a first-secured basis and may include a revolving credit facility from a bank. We always insist on leverage and cash flow covenants, at least. We also try to attach some kind of equity return and always include call protection. What we don’t want is for the loan to be repaid quickly, which is what you can see in the sponsored market through early re-financings.
Presumably developing a strong relationship with the borrower is an important aspect of sponsorless deals?
Absolutely. Building a relationship and an understanding with management is key to our investment process. We believe our borrowers like the fact that Beechbrook is a manager-owned business, based and operating in the UK, because it suggests an alignment of values. Beechbrook’s success is dependent on the success of our borrowers, which is why we try to negotiate small equity positions and make co-investments to align our interests even further.
How do you prepare for the possibility of problems arising?
We know that our SMEs don’t trade in a linear way. We work with them to manage the risks. We stay very close to our portfolio companies through ongoing dialogue, attending board meetings and good information flow.
It is important for us to be a proactive portfolio manager. We stay close to decision-making and trading and can be supportive when there are bumps in the road, as there always are with SMEs.
What are your thoughts on the attractiveness and challenges of the UK market?
It’s our view that there are plenty of SMEs in the UK without our needing to look elsewhere. There is low fund penetration of the sponsorless market so we think there will be good scope for organic growth for Beechbrook over the next few years.
We are inherently aligned with the success of the UK economy, which needs to be healthy for the success of our portfolio. We are cautiously optimistic for the UK’s prospects. We do have to consider the potential impact of Brexit but we back companies that we think have the ability to navigate through it.
Will the banks come back into the market in an aggressive way?
I’d be very surprised if regulations suddenly ease. They are still hardening in many ways, so there will still be constraints. The banks are always keen to support their own clients and there will be some cases where we can’t compete for that reason as our risk/return is very different. We do monitor how regulations are affecting the banks, but we co-habit in the market happily.
What about the prospect of more competition from other sources?
What we offer is akin to a hybrid solution. We bump into the banks, and also equity investors, regularly; we’re all in the same market.
We are starting to see more fund capital in the sponsorless world. So we expect more competition from funds, as well as from banks, asset-based lenders and other similar providers. As things stand, it’s not a totally uncompetitive space – I’m not sure such a thing exists – but it is still less competitive than other areas.
What’s the investor view of the sponsorless market?
It’s a market that LPs are starting to consider as an area for investment and, over time, they are becoming more comfortable with it. The sponsorless market offers the ability to price and structure things in a way that you can’t do in more liquid markets. And the yield aspect is also very attractive to investors. n
Jon Herbert is managing director of the UK SME Credit Fund at Beechbrook Capital, the London-based fund manager.
This article is sponsored by Beechbrook Capital