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Global credit funds & CLO's
March 2024 | Issue 262
Published in London & New York.
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March 2024 | Issue 262

Advantages of non-sponsored direct lending recognised as pensions increase allocations

Kellie Ell
Non-sponsored direct lending is on the rise despite its inherent challenges, with pension systems upping allocations to funds dedicated to non-sponsored private credit.
Despite the benefits, there are also hurdles to going sponsorless. These are often described as the challenges of working with less professional business owners. Sponsors are used to the complicated deal structures used in modern private credit and can help streamline due diligence requirements. They can also step in with a cash infusion if things go awry.
“As a lender, however, you need to remember that the sponsor is often incentivised to maximise the amount of leverage on a portfolio company,” Kless adds.
“The looser the terms on the debt, the more money the sponsor can take out of the business, driving up the equity return. Sponsors often enhance their returns by taking on as much debt as they can, as cheaply as they can. Both of those things are often contrary to what’s good for a lender.”
Non-sponsored transactions are more difficult to source and close. Marcus Maier-Krug, partner and co-head of portfolio management at Arcmont Asset Management, says: “You can invest two or three months of work and get to the end, and the founder or the family you’re dealing with can decide not to refinance the business and give it to their son who has other plans.
“All the work you’ve done is for nothing and that is very common. I don’t see a really significant risk premium that can be generated in that segment so, ultimately, it’s just not worth it.”
Racz agrees with the concerns, but doesn’t view them as criticisms. “I view them as barriers to entry,” he says. “Non-sponsored direct lending is not as scalable — it’s harder. That’s why most firms don’t do it. There aren’t too many people who have the experience, discipline, sourcing and underwriting expertise to do it well.
“Sourcing non-sponsored deals requires a robust origination network and capabilities,” he adds. “You can’t put an ad on the internet or social media.”
Recent examples include the Dallas Employees’ Retirement Fund, which in February made two separate commitments of USD 20m each to funds managed by firms that specialise in non-sponsor-backed lending: MGG Investment Group and Vista Equity Partners. West Palm Beach-based Comvest Credit Partners also said recently that it plans to continue offering solutions for non-sponsor backed lenders.
Despite the obstacles, proponents say working without a sponsor has advantages. “The big loans tend to be good for the borrower with no real lender protection. They often have too much leverage, come with low rates, and are cov-lite, cov-loose or cov-wide,” says Greg Racz, president and co-founder of MGG.
In non-sponsored deals, funds are lent directly to the owner of a company, who is much more aligned with the lender, he says. “We’re typically financing the growth of their crown jewel. As a result, we’ve usually been able to lend with materially lower leverage — given family and management-owners need to be more conservative with their main asset and given less competition — [and we can] charge a premium spread.”
When lending to non-sponsored borrowers, lenders typically receive a better risk-adjusted return, but pay for that with increased underwriting work, says Aaron Kless, managing partner and chief investment officer at Andalusian Credit Partners.
“We all live and work in a crowded marketplace and there’s a lot of money chasing the same deals. But a lot of people aren’t chasing non-sponsored deals,” he says. “So it’s less competitive. Your investors also get the benefit of being exposed to loans and companies that don’t look like those that everyone else is exposed to.”
“We can charge a premium spread”
Greg Racz, President | MGG Investment Group
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