The sponsorless market – borrowers owned by entrepreneurs, families and shareholders other than private equity funds – is a compelling one for investors, say Lei Lei and Chris Rust, co-heads European credit opportunities at global investment manager Ninety One.
A combination of structural and cyclical factors is producing a compelling opportunity for investors who are looking to enhance portfolio diversification and earn meaningful investment returns. The demand for capital from Europe’s SME sector is greater than ever before.
A gap in the market
There is a growing need for private credit in the underdeveloped European market, where banks continue to retreat from lending and mid-sized firms seek flexible financing solutions.
The ongoing retrenchment of European banks is contributing to an estimated €400 billion1 funding gap in the European SME market. Meanwhile, the cyclical backdrop of slowing economic growth and rising inflation pressure is driving up demand for finance across the corporate sector. Many SMEs require flexible financing for expansion and other activities. This creates a gap in the market for investors who can provide bespoke capital solutions to performing mid-market ‘sponsorless’ borrowers. The term ‘sponsorless’ refers to borrowers owned by entrepreneurs, families and shareholders other than private equity funds.
An uncrowded market
The need for specialist credit skills and a differentiated approach to origination creates high barriers to entry and this increases the potential for compelling risk-adjusted returns.
To tap into the sponsorless market, private credit managers need deep origination networks to uncover opportunities across a wide range of countries and sectors – this means a focus on smaller advisors and independent introducers located in second and third tier cities who have strong relationships with locally based borrowers.
By sourcing off-market deals rather than partaking in competitive processes, lenders such as Ninety One can also command higher fees and better lending terms. And borrowers are willing to pay a premium cost of capital for a flexible, bespoke approach and execution speed. Debt structuring expertise is also vital for compelling risk-adjusted return outcomes and to allow a strong focus on downside protection. We think that a private equity-style approach to underwriting and managing downside risk is the best approach.
Presenting an attractive risk/return profile
Today, Europe is home to many small-to medium companies (with an enterprise value typically ranging from €50 million to €200 million) spanning founder-led businesses, entrepreneurs, and medium-sized corporates.
Among these are some really robust businesses that need capital to fund their expansion or for other purposes such as performing shareholder buyouts and refinancing their operations, but have limited avenues open to them, as outlined above.
Private credit managers with the right expertise can offer tailored private financings to these sponsorless borrowers and provide an attractive alternative to dilutive equity and restrictive bank debt; this may be the only option for some borrowers that are too small to access capital markets.
As many of these borrowers are asset-rich, lenders can ensure that their loans are fully asset-backed to ensure a compelling risk/ reward profile – this is particularly important given the challenging macro backdrop facing companies today. However, a careful approach to risk management is key.
While sponsor-focused direct lending strategies typically target gross returns of high single digits, the uncrowded European sponsorless market typically targets gross returns in the mid-teens.
A sweet spot in private debt markets
There are many more potential sponsorless borrowers in Europe than there are sponsor-backed. This means that the opportunity set for investors is much greater, allowing the lender to be highly selective and command attractive terms and lender protection.
Many sponsor-backed companies take on levered debt to maximise equity returns for their private equity owners – one of their key objectives. In contrast, sponsorless borrowers – firms managed by their entrepreneurial owners – in general require capital to grow their company and generate returns to repay their debt. Many sponsorless loans tend to generate more attractive risk-adjusted returns, due to lower loan-to-value (LTV) ratios and stronger lender protection.
- €400 billion estimated funding gap figure from Euler Hermes, April 2019 ↩︎
