Lending to corporates without the involvement of a private equity sponsor is often seen as the key to growing the private debt asset class to a level that could match or even exceed that of private equity. The expansion of non-sponsored lending has been slower than expected, in part because of the high barriers to entry it poses, but many in the industry believe the future for non-sponsored lending is bright for dedicated firms. So what does the future really hold for non-sponsored private debt?

When speaking to fund managers, it is rare to find one who dismisses outright the possibility of doing a non-sponsored investment. Although some vehicles might choose to focus on sponsored activities, fund documentation is often flexible and allows for non-sponsored investments if good opportunities arise. But this ad hoc approach may be on the way out as the private debt asset class matures and managers and their funds become increasingly specialised.

One fund manager that has opted to set up dedicated vehicles to invest in non-sponsored opportunities is London-headquartered Beechbrook Capital. The firm set up its first in 2015, closed it on £153 million (€174 million; $194 million) in 2017 and launched a follow-up fund earlier this year.

Paul Shea, co-founder of Beechbrook, explains why it decided to set up a non-sponsored lending vehicle: “When we were investing our second fund we received a number of enquiries from high-quality UK SMEs asking if we could lend to them. However, the fund strategy was sponsored lending, so we had to turn them down. So we researched the market opportunity and spoke to our advisor network and found there was a compelling investment case. We decided a separate fund would be the best approach.”

Enforcing a stricter divide between sponsored and non-sponsored activity seems to be a growing trend in the more mature alternative lending market of the US.

“The sponsored vs non-sponsored debate is one of the most polarising topics in our industry. Non-sponsored is a big part of our business,” says Ted Goldthorpe, partner at BC Partners. “A lot of firms used to do both, but now people tend to do either all non-sponsored deals or all sponsored because it’s very difficult to commit to both.”

A difference in skills

One reason fund managers might want to differentiate sponsored and non-sponsored activities is the different skills each style of investing requires. “It takes a lot of time to implement the reporting and cultural changes needed in a business to make it viable for private debt lenders,” says Maxime de Roquette-Buisson, managing director at Paris-based fund manager Idinvest. “This is very much the job of a sponsor.”

This sums up the main difference between doing a non-sponsored deal and working with a private equity sponsor. If you’re lending directly to a company’s management team, you may end up having to act much like a sponsor yourself.

“We act more like a private equity sponsor would in these deals when it comes to scoping due diligence, reviewing corporate governance and strengthening management where appropriate,” Shea says. “We typically discuss a 100-day plan once the transaction completes and help to professionalise the business and its reporting. Often we are the first institutional investor these businesses have ever had and we have to provide a service beyond just debt to these SMEs.”

Goldthorpe agrees: “A lot more sweat goes into these deals. There’s a lot of work to do to help with their financial reporting. It is typically the sort of work a sponsor would do in a private equity-backed deal.”

Deal prospecting

The challenges of lending to non-sponsored corporates do not start at the point of execution. Simply originating this kind of deal requires a different approach. Although sponsors will have a Rolodex of debt funds to contact for each deal, small business owners will be more used to visiting their local bank branch to get finance, and debt managers wanting to make contact with them have to be a lot more proactive.

“The route to market for non-sponsored is different,” says Shea. “It’s much more regional in nature and typically [occurs] through advisors or direct rather than through sponsor relationships. Hence, we opened an office in Manchester to help us originate loans in the north of England.”

The need for a strong local presence is why Beechbrook has limited its SME investing to the UK, despite its sponsored funds investing across Western Europe. It could also be a major limiter on the growth of non-sponsored lending as smaller fund managers may lack the resources to build up office networks in multiple geographies.

“It’s really hard to do this as a start-up platform,” warns Goldthorpe. “You need a lot of expertise and a lot of contacts. However, once you start successfully investing in non-sponsored companies you start to build a name very quickly and business owners will start contacting you.”

For a business willing to deploy the resources necessary to get started in the non-sponsored space, the investment could rapidly start to pay off. However, this underlines the point that a dedicated approach to non-sponsored might be more appropriate than attempting to do both types of deal.

Shea thinks firms that try to do both will find they lean towards sponsored deals: “When fund managers do both sponsored and sponsorless deals in their fund, it can be tempting to prefer sponsored deals. Sponsored transactions come with a nice package of due diligence, unlike most sponsorless opportunities which require more work.”

It is widely recognised that non-sponsored debt investing is a potentially lucrative opportunity, with thousands of businesses in both Europe and North America struggling to obtain financing from banks. However, it is less certain that the future of the private debt industry lies in this direction.

De Roquette-Buisson believes it will remain a niche: “In the small and mid-cap space, some firms will make sponsorless a core strategy. However, in larger deals that is less the case. I don’t think sponsorless activity will displace sponsored transactions.”

Goldthorpe says the prospects for non-sponsored are region-specific, with the US already saturated with alternative lenders, which have a 90 percent market share, and a small number of major players dominating: “In Europe, the banks are more competitive but there is a big opportunity for growth for the alternative lenders.”

It seems that smaller or newer managers looking to make it big in private debt will be forced to either go down the traditional private equity path or take a gamble and make the investment necessary to become a stalwart of non-sponsored SME lending.

Each route will require different structures and personnel. The biggest private debt players will still have the resources and networks to do non-sponsored deals as and when they wish, but the opportunities in their size range tend to be private equity-backed. The non-sponsored revolution may turn out to be more of an evolution.