Reaching the promised land

Since its inception, the direct lending business has had a symbiotic relationship with the private equity sector. The similarities between the two, such as their fund structures, institutional investor relationships and the complex financing needs of private equity investors make this a natural partnership.

But beyond the private equity horizon lies a potential promised land of near unlimited deal flow, better terms and higher returns in the form of non-sponsored deals. Yet despite this rich seam of mid-market companies in need of financing, to date the private debt industry has barely scratched the surface.

Deal data from Deloitte’s Alternative Lender Deal Tracker, which analyses European mid-market direct lending since September 2012, show that, while non-sponsored activity has grown over the years in line with the general expansion of private debt, it has remained roughly stable at between 10 percent and 20 percent of all deal activity. This is despite the fact that the number of non-sponsored companies in need of financing in Europe dwarfs the private equity-backed space.

So why, despite huge growth in interest in private debt as an asset class, do private equity-backed companies continue to dominate?

More interaction

Jaime Prieto, co-founder of fund manager Kartesia, says originating high quality non-sponsored opportunities is a much more complex process than for sponsored deals.

“Origination requires a lot more interaction with M&A advisory firms. They’re important as they can offer contact with manager-owned companies, though often they will tend to think first of private equity sponsors as a way of funding their clients’ growth,” he explains.

“We need to make them aware of the value proposition and help them understand that credit funds can provide finance through a different model.”

Some investors, such as Ardian, divide the non-sponsored universe into two distinct categories depending on the background of management teams, which its co-head of private debt, Mark Brenke, says can result in very different approaches.

“There are two main channels of origination for non-sponsored deals, and they are very different,” says Brenke. “We have those non-sponsored deals where the business owner is new to leveraged finance, often family and founder-owned businesses; and we have those businesses with professional management teams, who have often gone through several private equity buyouts and are now ready to acquire the business themselves.”

One of the first hurdles to overcome in managing the additional complexity of a non-sponsored deal is the schedule. A typical sponsored deal goes through several stages, starting with beauty parades for investors, at which time financiers are approached, then due diligence is conducted and documents are produced. One origination specialist told PDI that sponsored deals are “driven by the imperative of the timeline, the flow of information is highly structured and paid for by the sponsor”.

But in the non-sponsored space, this sort of professional structuring simply does not exist. As a result, timelines are often significantly extended from an average of three months for sponsored deals to complete to six months or more for non-sponsored firms.

Brenke also highlights another risk factor of non-sponsored deals, saying: “Firms that are new to leveraged finance have a number of complexities, one of the biggest being the risk of the deal simply not happening. You can spend a lot of time and resource doing due diligence for the business owner to then decide not to do a deal so we need to decide early on how much of a risk that is.”

Balancing available resources with the pursuit of new business opportunities is something faced by firms of all types and the additional resources needed to pursue non-sponsored opportunities can be substantial. As well as the risk of processes going on for many months, direct lenders also need to conduct all of their own due diligence, often with firms whose record-keeping and reporting is more challenging than for financial-backed corporates, and all this requires personnel and money to pull off. But there are upsides as investors have a lot more control over the process.

“Non-sponsored is time consuming, it puts your structuring skills to the test to see how to get the best financing in place,” explains Prieto. “Sponsored is very different; debt advisers often have a fairly rigid termsheet and you need to be able to fit into that or you can’t do the deal.”

New avenues

The downside of heavily managed private equity processes is that the rigid timetables and highly standardised documentation can be too much of a constraint, with pricing, terms and covenants largely taken out of the hands of debt fund managers. For those ambitious firms that really want to test their own skills and deliver an enhanced return, non-sponsored deals can open up whole new avenues of innovation.

“You need to do a lot more work on a non-sponsored deal, and the hit rate may be a lot lower than for sponsored deals. But you also get much better returns and more control over terms. We aim to get between 250-400 basis points more per turn of leverage than we would in a sponsored transaction,” adds Prieto.

Brenke agrees, adding: “Generally, non-sponsored deals should demand an extra premium due to the increased risk. However, this is mitigated somewhat when dealing with a professionally managed business with strong alignment of interest.”

This more resource-intensive approach also continues after the deal is done as to varying extents, the company looks to the private debt fund in a similar way to an equity sponsor.

“When there is no private equity sponsor involved, the private debt manager may have to fulfil some of their role and become a more “hands-on” partner to the management team,” says Brenke.

Ardian usually seeks board seats on its deals whether they are sponsored or not, but says this is particularly important in non-sponsored transactions, where it will always take a place on the board.

Prieto says the longer-term relationship can often come up at the point of origination: “You have to introduce yourself to companies not simply as a credit provider, but as an institutional partner. There is a lot less focus on how much the finance is going to cost and more discussion about what else you can offer the company.”

While non-sponsored deals may be seen as a natural evolution of the private debt business away from its traditional roots in the private equity space, many barriers still exist which have prevented the steady stream of non-sponsored deal activity turning into a flood, but with so much untapped potential, Brenke believes the long-term prospects are good.

“There’s a strong argument that, over time, private debt will evolve from a primarily private equity-based opportunity as it is today, to being a much broader facet of the financing market. There is a lot of positive momentum there. I don’t think we will see a sudden change but a gradual evolution,” he explains.

The momentum behind non-sponsored is growing, and with a much higher ceiling of viable opportunities it may be that when private equity hits its next downturn, private debt is able to continue growing through the non-sponsored market. However, the culture in businesses and within debt funds themselves will need to continue changing to allow more of these deals to happen.