Enhancing Diversification Through Non-Sponsored Direct LendingEnhancingDiversificationThroughNon-SponsoredDirectLending

Untapped Opportunities and Benefits

Investors may wonder why the financing gap in the non-sponsored market emerged. In short, most private credit funds source their deal flow by networking with investment banks and private-equity firms, opening up lending opportunities with a large portfolio of companies. Private lenders do not need an expensive office network or large staff to source deals from sponsored companies.

The downside to this approach is the intense competition among private-credit firms calling on PE firms to obtain lending business. This competition can have the effect of reducing the pricing and returns earned by lenders, and potentially impact the protective terms that lenders get in those sponsored deals. Additionally, since the buyout activity of PE firms is highly dependent on M&A cycles, there are points in the cycle where sponsored deal flow can slow down meaningfully, leading to decreased deployment pace.

One potential benefit of accessing non-sponsored markets is deployment speed and consistency. There are more family-owned businesses than sponsor-owned businesses in the US and Europe,⁴ which means the non-sponsored market features many strong borrowers from which to choose and gives lenders the ability to remain selective. Additionally, these family-owned businesses tend to be well managed with a longer-term focus, while a PE owner is likely to be focused on near-term growth and more willing to take financial risk by leveraging the business. Working on a relationship basis with family-owned, non-sponsored businesses that take longer-term, less-risky approaches can significantly reduce the risk of losses for a lender. 

Family-owned businesses also tend to have more trust-based relationships with their lenders. This can provide key benefits, including better terms and covenants. With tighter covenants, lenders will be in a stronger position to achieve better loan outcomes if the borrower comes under financial stress. Options could include higher pricing to reflect the higher risk, a requirement for the owner to put in more equity, or a requirement to bring in a consultant.

Taken together, these attributes mean that despite a pervasive perception that non-sponsored deals can be riskier, with the right partner, the risk profile of a non-sponsored portfolio can be more conservative, with lower risk to their private credit fund lenders and ultimately to the investors in those funds.

Key Themes for Investors

When seeking access to both sponsored and non-sponsored markets, investors should consider whether a manager can programmatically source non-sponsored deals directly and has invested in a large, bank-like office and sourcing network. A broad, systematic sourcing program is key. There are thousands of family-owned businesses in every US state, scattered in cities and rural counties. Given the higher-touch relationships that non-sponsored companies require, it takes a broad-based geographic network of lenders to call on hundreds or even thousands of companies, just to find a few dozen successful corporate loans every year. Firms with a boots-on-the-ground approach to deal sourcing and strong relationships with borrowers will have a competitive edge.

Investors should also seek managers that have a track record in undertaking detailed due diligence. This is important for pricing risk and structuring deals across a range of industries and company types. In terms of underwriting, the non-sponsored middle market is less homogeneous than large company markets, and due diligence is not streamlined by PE owners.

Conclusion

A diversified portfolio with a mix of sponsored and non-sponsored loans can provide investors with access to more deal flow, a broader range of deals, and potentially better performance over time. With the right approach, adding non-sponsored deals to a direct lending portfolio can offer meaningful diversification and return benefits such as lower leverage, a yield premium, and stronger covenants.

^{Diversification does not assure a profit or protect against loss in declining markets. No investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment.}

^{1. Reserve Bank of Australia. (2024, October 17). Growth in Global Private Credit. https://www.rba.gov.au/publications/bulletin/2024/oct/growth-in-global-private-credit.html. Accessed December 2024.}

^{2. Preqin. (2024, April 8). Private Debt’s Rapid Growth Merits Closer Scrutiny, IMF Says. https://www.preqin.com/news/private-debts-rapid-growth-merits-closer-scrutiny-imf-says. Accessed December 2024. Forecasts are not guaranteed and may not be a reliable indicator of future results.}

^{3. Preqin. (2024, March 20). North America Is Consolidating Alternative Assets as Region Holds Almost Two-Thirds of Global AUM – Preqin Reports. https://www.globenewswire.com/news-release/2024/03/20/2849698/0/en/North-America-is-consolidating-alternative-assets-as-region-holds-almost-two-thirds-of-global-AUM-Preqin-reports.html. Accessed December 2024.}

^{4. McKinsey & Company as of 01/2024.}