Widen the net: the case for non-sponsored direct lending exposure

Peter Pulkkinen Portfolio Manager	Rhys Marsh Portfolio Manager	Adriana Becerra Cid Sustainability Manager	Gene Getman Business Manager

 

In this Q&A with the LOIM’s Sustainable Private Credit (SPC) team, Portfolio Managers Peter Pulkkinen and Rhys Marsh discuss some of the market dynamics in direct lending that have shifted the risk/reward pendulum, creating a compelling case for non-sponsored lending allocations in limited partners (LPs) portfolios.

 

Need to know: Some 80% of direct lending assets are concentrated on sponsored-companies1, which represent less than 10% of the middle market sector2. Inversely, non-sponsored strategies are far less crowded: they provide loans to private family-owned and owner-operated businesses, corresponding to those  90-plus percent of underfinanced companies The bespoke nature of non-sponsored deals allows managers to negotiate robust covenant and collateral packages with less competition. About 90% of sponsored deals are now ‘covenant-lite’ putting potential stress on the perceived private equity (PE) sponsor ‘safety-net’ in a higher-for-longer rate environment Structuring and accessing non-sponsored opportunities requires managers possessing distinct backgrounds that equip both a resourceful credit toolkit and an existing sourcing network Specialists experienced in the nuances of climate solution businesses, that can offer value-add sustainability resources beyond capital, have the potential to unlock ’green alpha3’ for LPs seeking profit with purpose

 

Preface: Direct lending comes into its own

Private credit and more specifically, direct lending – or providing credit to predominantly private companies – has existed for a long time. That said, it has come into its own as an asset class somewhat recently, proliferating over the past decade as it filled the lending void left by the Dodd-Frank Act of 2010. Conventional direct lending has historically been associated with sponsor-based loans. This refers to loans provided to companies that are backed or owned by a sponsor, typically a private-equity firm.  Non-sponsored lending, in contrast, works directly with borrowers, free of intermediaries. These non-sponsored loans are typically sourced off-market, with all the terms and covenants bilaterally negotiated (or within a smaller club) between the family-owned and owner-operated businesses seeking credit capital and the manager. 

The evolution of direct lending is reminiscent of trends in the 2000s era of hedge-fund (HF) investing. Much in the way that investors dipped their toes into the HF space through Fund of HFs (FOF) for access to scale and diversification, the bulk of direct-lending assets have gone to sponsored lenders. Over time, investors balanced their FOF exposure with direct HF allocations in search of better alpha, economics, transparency, or exposure to lesser correlated opportunities.

We believe we are approaching a similar tipping point in direct lending, where competitive tension and resulting concessions in the sponsored markets are causing LPs to evaluate the diverse opportunities among non-sponsored lenders.

 

How has private credit grown as an asset class, and which loan types are dominant?

Private credit represents an over USD 1.5 trillion asset class and is on course to nearly double in size by 2028⁴. Direct lending is leading the charge, annualizing at 27% AUM growth over the past decade to represent just under half of all private credit assets today.

Given its capacity to deploy in scale quickly, sponsor-based lending represents the vast majority of direct lending AUM, with considerable size bias towards the largest asset managers. In 2023, more than 50% of all private debt capital raised went to the 10 largest (sponsored) managers.

According to a recent Prequin survey⁴, investors cite “reliable income stream”, “diversification”, and “high risk-adjusted returns” as the top three reasons to invest in private debt. We believe investors can enhance their private-debt allocations to capture alpha (as opposed to experiencing levered market beta) by diversifying through nimble, focused strategies able to efficiently access non-sponsored markets.

 

The sponsored-loan market is fiercely competitive. Are non-sponsored loans subject to similar dynamics?

Sponsored deals represent over 80% of the direct lending market by AUM⁵ but less than 10% of the market by the number of middle market companies serviced⁶; that, to us, feels a touch crowded. There are more than 250,000 privately owned firms in the US, yet fewer than 15,000 are sponsored.

Conversely, non-sponsored loans represent a much larger potential investment universe that is under-served. Further, the regional US banking crisis of 2023 was a significant event as it tightened lending conditions and forced regional banks to retrench or exit from some markets entirely. For example, 62% of community solar financings were led or participated in by the now defunct Silicon Valley Bank⁷. Non-sponsored lenders are playing a large roll in filling this financing void, particularly for borrowers seeking less than USD 50 million of financing, in a direct-lending market where the average loan size is USD 79 mn⁸ and growing.

A number of limiting factors suggest that favourable dynamics in non-sponsored lending will continue. Without a sponsor-led auction process, non-sponsored deals must be sourced through a manager’s reputation-based existing network. Along with relevant relationships, managers must also have applicable historic skills and experience to reliably underwrite and structure bespoke transactions directly with owner-operators. We do not see consistent competition across our investment pipeline, and in many cases the families looking to borrow prioritise discretion and certainty of execution with lenders they already trust.

 

Are non-sponsored deals riskier?

There appears to be the perception that sponsor backing or larger deal size adds inherently to credit quality, or that the higher-yield on non-sponsored deals is a function of increased risk. We believe a well-structured senior-secured loan to a family-owned company that meets our highly selective criteria is often more attractive than a loosely-covenanted structure crafted under competitive tension in a market where sponsors are increasingly willing to ‘hand over the keys’ and walk away.

In the context of record inflows amid declining M&A activity – falling 46% in value from the 2021 peak⁹ – we see a greater potential risk as more money chases the same sponsored offerings. In competitive sponsored markets, it has become increasingly common to see more relaxed covenants or ‘cov-lite’ loans and other concessions offered as incentives for borrowers to choose one lender over another. These covenant lite loans have accounted for as much as 90% of sponsored issuance over recent years, up from just ~30% a decade earlier¹⁰.

Opportunistic lenders in non-sponsored markets may be able to negotiate bespoke investment structures and obtain superior financial terms or pledges. The potential benefits of less-competitive negotiating dynamics may include a broader collateral pool, tighter documentation, larger equity cushion, lower loan-to-value ratio and/or higher potential returns relative to sponsored transactions. The resulting structure could deliver improved risk-adjusted returns and offer downside protection should collateral values erode or market conditions worsen, in our opinion.

On average, there is as much as 800bps¹¹ of difference in the average gross loan rates between sponsored and non-sponsored deals for the same tranche of risk. While the common perception is that this is risk compensation, the reality is the premium is largely a function of the complexity involved with structuring creative credit solutions within less-competitive, fragmented markets – even if the initial credit need is smaller versus sponsored offerings. For borrowers with limited financing options and 2-3 year logistical needs, these flexible revolving credit facilities can be highly efficient, and the premium is often far less costly than more dilutive equity options. For LPs, this premium may help achieve their portfolio goals without the need of fund leverage, another layer of risk commonly used to boost sponsored returns.

Knowledge, experience, and deep networks are needed to consistently source high quality transactions and provide the confidence to pass on all but the most compelling investments.

 

Table 1. Differing approaches from traditional direct lending

	LOIM Sustainable Private Credit strategy	Traditional direct lending
Deal size range	USD 10 – 30 million	USD 80 – 200 million
Origination focus	Founder-owner-managers	Financial sponsors (PE)
Sourcing process	Off-market, less competitive	Competitive auction process
Sourcing channels	Relationship / referral-based	Bank / sponsor syndicates
Structural emphasis	Senior secured / shorter duration	Senior secured to junior mezzanine
Covenants	Robust & bilaterally negotiated	Market-based concessions
Documentation	Strong structural control	Less structural control
Typical duration	2-3 year logistical needs	5-7 year funding (PE risk transition)
Typical risk-off	Self-amortising structure	Cliff payment
Risk mitigation	Deal selection & structuring	Diversi­fication and workout capabilities
Source of alpha	Stewardship & complexity premium	Fund leverage
Equity participation	Additional upside via equity alignment	Not typically available

Source: LOIM. For illustrative purposes only. As at March 2024.

 

What role does private credit play in financing climate-focused firms? Are there any differences that non-sponsored exposure provides?

For impact-focused LPs, direct engagement and access increase the ability to tailor covenants that align with their priorities and desire for measurable impact. For investors seeking profit with purpose, we believe the non-sponsored market offers a few key advantages.

Non-sponsored loans provide compelling access to pure-play climate solution providers that are empowering the climate transition (our focus segments below). We find that many of the most innovative climate solution providers require smaller initial financial commitments on their path to scaling pools of distributed assets (USD 10-30 mn), essentially falling outside the scope of traditional debt financing. Subsequently, sponsored deals that are climate-aligned invest predominantly in established transitioning companies (looking to decarbonise etc.) that offer deployment at scale, rather than the businesses that enable the economic transition directly.

 

Specialist focus on distributed clean industries:

Distributed Renewables	Resource Efficiency	Energy Transition	Waste to Value	Storage and Microgrids	Digitalisation as enabling technology

Source: LOIM. As at March 2024. For illustrative purposes only.

 

Along with the measurable intentionality that investing in pure-play companies offers (please see highlights from our inaugural SPC annual sustainability report  in figure 1), we believe early access allows LPs to enhance returns by helping to scale these operators. Our borrowers have proven solutions that have hit price parity and often already have the contracted demand from large institutional allocators or consumer-brand companies, but limited financing to scale to meet that demand. We believe we have been able to deliver significant additionality through catalysing investee scale with more than 25x follow-on debt and equity capital invested by third parties into our portfolio companies since 2022.  This served to greatly de-risk our portfolio while enhancing potential returns¹² through modest equity alignment alongside our controlling debt positions.

 

FIG. 1. Projected environmental and social contributions achieved by our portfolio companies in 2022

Source: LOIM Analysis as of 31 of December 2022. For illustrative purposes only. Past performance is not an indicator of future returns. Holdings are subject to change.

 

Additionally, by seeking to work with climate-solution entrepreneurs providing essential goods and services at lower cost versus legacy solutions –  community solar saves 10% on power bills, for instance – we believe investments tend to be more insulated from public market speculation and volatility.

 

Why is LOIM’s approach well-suited to non-sponsored climate-solutions lending ?

Backed by the considerable resources of the first B-Corp rated¹⁵ global asset manager, including the support of LOIM’s sustainability and stewardship team, holistiQ¹⁶, we believe we are able to offer a high-intentionality SFDR 9 classified strategy that is compelling for aligned entrepreneurs and difficult to replicate.

We believe that our sustainability expertise and stewardship efforts can help our portfolio companies benefit from developing their own ‘green alpha¹⁷’ by supporting them in driving their corporate sustainability strategy and sustainability-related disclosures. LPs should expect to learn more about our targeted efforts and milestones in our annual sustainability report, which includes the sustainability performance of portfolio companies and quantifiable environmental and social impact.

The portfolio management team brings a demonstrated track record in creatively financing assets spanning specialty finance and infrastructure, catalysing some of the first municipal solar, distributed battery and generation projects of their kind. With more than 20 years of average experience in bespoke lending, we understand what businesses require and what makes a mutually beneficial transaction: 80% of our deals¹⁸ tend to be repeat business or referrals from family-owned and operated business that we have worked with in the past.

 

Sources

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