The rise of private credit is largely correlated to private equity and leveraged buyout activity. Sponsored lending thrived in the years immediately after the financial crisis. After all, the story was easier to tell: lend to a company with an institutional player with skin in the game. In the event of distress, the sponsor can inject more money into the company to turn it around.
However, sponsored lending can be less lucrative in a late-market environment. Increased competition among lenders has driven spreads tighter and yields lower. As yields have fallen, sponsored lenders have increasingly relied on fund-level leverage to keep headline returns attractive. At the same time, leverage ratios and loan-to-value metrics inch ever so higher.
The trend of covenant-light loans that gained attention in recent years starting with the syndicated bank loan market has since made its way into the sponsored lending world. To remain competitive in a syndicated funding opportunity, it's not uncommon for managers to make covenants and lender-protection provisions secondary in negotiations. There are also examples of loosening provisions in loan documentation. For example, the definition of EBITDA — earnings before interest, taxes, depreciation and amortization — used to be very clear. Now, something known as EBITDA add-backs — a way of adjusting a borrower's financials to account for boosts in revenues that may or may not materialize — can make the definition five paragraphs or more and difficult to understand. Similarly, many companies today can add leverage on property, plant and equipment that is separate from leverage on a company's cash flow. Benefits of bank-type lending in a late-cycle market
Whereas sponsored lending is a relatively new endeavor of the past 10 to 20 years, banks have been in the business of lending for hundreds of years. As new global regulations following the financial crisis have made the cost of underwriting certain loans too onerous for many banks, private sources of capital have stepped up to fill the void. Like bank-type lending, non-sponsored lending establishes direct relationships with the borrower. From a pipeline perspective, opportunities can be self-originated or sourced through networks of intermediaries such as service providers, commercial banks or local community banks. The bulk of small and middle-market companies globally today operate without private equity sponsors. Out of the some 350,000 small and middle-market companies the United States today, only about 13,000 of them have private equity sponsors. The pool of non-sponsored companies is larger and more resources are required to originate such opportunities, but the advantages for the investor can be well worth the efforts.
By working directly with the borrower, non-sponsored lenders often do not face the same competitive dynamics that dominate the sponsored lending market. By directly sourcing opportunities and offering flexible capital, timely execution and the appropriate lending product to a borrower, non-sponsored lenders can secure more terms that lead to closer relationships with borrowers.
From an investment perspective, non-sponsored loans can offer higher yields (via direct origination premiums) with stronger financial covenants and lender-protection provisions. Furthermore, direct lending offers product diversification advantages that are critical for investors in today's uncertain market. It's not uncommon for sponsored lenders to offer just one or two products — namely, term loans and unitranche loans. Structurally, both are typically long-duration loans, with light covenant protection, little to no amortization schedules, and are levered on a borrower's future cash flows. In non-sponsored lending, the product offering is more diverse — anywhere from five to 10 or more lending products that are tailored to a borrower's needs and businesses.
For the borrower, non-sponsored lending provides better structured funding solutions; for the investor, the product offerings provide the diversification benefits of different loan types, such as facilities with shorter durations, amortization schedules, asset coverage that support the loan and sector exposures. Strong lender-focused terms and loan type diversification are key ingredients for a well-positioned portfolio that can generate yield while being defensive in any market environment.
As investors become more sophisticated and well-educated in the asset class, the global demand for private credit will continue to remain robust. However, differentiation is key today more than ever before: In a market where lending to sponsored companies is increasingly crowded, the investor is better served by diversifying credit exposure and exploring lending opportunities that once were served solely by the banks.
Andre Hakkak is CEO at White Oak Global Advisors LLC, San Francisco. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.