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