Breathing life into ‘sponsor-less’ transactions

Institutional investors in favour of sponsor-backed, syndicated deals have typically overlooked the lower end of the private debt universe, but the EIF believes that will change. An analysis by Marco Natoli and Francesco Battazzi.

Sponsor-less transactions are entering a new era. What was once considered the ‘lower end’ of the private debt universe, with higher barriers to entry and a more specialist investment style, is now attracting institutional investors in search of yield, portfolio diversification and stronger contractual terms.

Indeed, the growth in allocations to private debt over recent years lays the foundations for an increasing number of investments into the non-sponsored area of the market.

Lacking a private equity sponsor, non-sponsored transactions are generally be less leveraged and more flexible on terms. Without the M&A component, they support instead an SME’s organic growth, innovation projects or capital expenditure. Critically, without a private equity sponsor, the fund managers can work directly with the company to negotiate terms, impose covenants, and enhance risk-adjusted returns.

While predominately long-term loans, these transactions can also take the form of asset-based financing, as well as funds that originate their lending through crowdfunding platforms. In this category, we include managers specialised in leasing, receivable financing and export financing.

Funds specialised in asset-based financing are exposed to lower volatility compared to M&A financing or unsecured lending. Portfolio downside protection is key to navigate through a potential downturn in the credit cycle, and these funds require specialised teams with significant network and competences in the specific niche and asset with which they deal. Funds that originate through crowd-lending platforms are also an exciting, and growing, area of the market.

Sponsor-less transactions therefore represent a big opportunity for investors to select high-quality SMEs, diversify their risk and de-correlate from sponsored deals, to exercise hands-on investment monitoring and enhance risk-adjusted returns compared to sponsored transactions.

However, institutional investors may find that they do not have the expertise or the resources to analyse funds focusing on sponsor-less financing or other niche strategies. This can particularly apply to investors such as pension funds and insurance funds, which invest in a wide range of assets, or smaller investors such as family offices, which may not have the resources to carry out extensive due diligence.

Being a cornerstone investor

Having an experienced investor involved can make this process easier. Since 2009, the EIF has invested in funds that primarily make smaller, sponsor-less debt transactions to SMEs, focusing first on mezzanine funds, and, since 2015, on senior credit funds.

Thanks to our access to data for more than 1.3 million SMEs from our guarantee business, we are credit-risk assessment specialists, able to select sponsor-less funds that have the sophisticated monitoring skill to follow up portfolio companies, investigate different exit routes, and offer different skills to the SME. In senior credit alone, the EIF has screened over 180 funds since 2015, investing in only 38.

We have supported the development of this market with EUR 4.5bn invested in 113 debt funds across Europe, of which more than EUR 1.5bn is invested in 38 senior credit funds, including strategies such as loans, bonds and asset-based finance. We are also selectively investing in funds that originate their lending through crowdfunding platforms, precisely six funds originating through more than 10 platforms.

A cornerstone investment from the EIF is often a ‘signalling effect’ to other investors that deep analysis of the asset class and extensive due diligence has taken place. Cornerstone investors typically provide a high degree of guidance regarding the economics, structure and governance of the fund.

Our experience in risk-adjusted returns of SME credit across Europe has made us a knowledge leader in this area, with unparalleled market reach and screening ability. This has resulted in a portfolio construction focused on diversification, low volatility and low correlation with mainstream strategies. Our pan-European approach means funds are diversified across strategy, manager, sector and geography.

Over this decade, we have witnessed the asset class offer predictable and stable cash flows and low performance volatility to investors. The cash flow generation of senior SME financing also mitigates the so-called ‘J-curve’ effect present in other alternative asset classes such as equity, infrastructure funds by generating returns in a shorter time frame.

Sponsor-less transactions not only offer interesting risk-adjusted returns, but also a conduit for institutional investors to make investments in the real economy — the SMEs that provide employment and economic growth.

However, due diligence and fund selection are not the only barriers to investment in the asset class. Deal origination is also more difficult in the sponsor-less arena. Without a private equity sponsor, the investor themselves must be more active in the SME’s management and growth. These challenging origination routes and unique investment management style pose high barriers to entry for the unsophisticated investor.

Accessing the fund pipeline

The EIF has found that a fund-of-funds structure provides a useful gateway through which institutional investment can flow into some of the specialist sectors in which it invests.

The Asset Management Umbrella Fund (AMUF) vehicle, currently investing in the EIF’s portfolio of top-performing venture capital, life sciences, and growth capital funds, leverages on the EIF’s unique market positioning and its capabilities of sourcing high quality managers across Europe and its capacity to analyse those funds.

By channeling private investment into our best-performing funds, we are ensuring the sustainable, long-term supply of capital to SMEs. At present, the AMUF vehicle focuses on venture capital, life sciences, growth capital and secondaries compartments. However in the future, it may add more.

The EIF’s market breadth and reach also benefits investors geared towards national investment opportunities, who now wish to pursue cross border investment opportunities.

How is the sponsor-less transaction market likely to develop going forward?

The US is a strong example of funds choosing to specialise in either sponsored transactions or sponsor-less. In Europe, funds broadly still consider both, but as the asset class deepens in liquidity and more funds are raised, a similar bifurcation could emerge.

Newer investors in search of the yield, diversity and low volatility are also likely to enter the asset class. Institutional investors such as insurance funds and pension funds are already making an appearance. In these cases, getting the fund selection right is crucial.

Yet the EIF is also aware that the asset class requires a wider, stable and diversified investor base to realise its growth potential.

The concentration of funds within established management firms and in certain geographies, means that fundraising activity in Europe is concentrated on a limited number of large management firms operating in mainstream markets such as France, Germany, the UK and the Benelux.

Therefore, as well as our top-performing funds, we support first time fund managers outside the traditional jurisdictions. To those fund managers that are raising first-time funds, we offer advice on market best practices and governance, analysing the underlying portfolio and encouraging the fund to implement portfolio covenants to improve the risk-return profile of the fund.

With interventions which encourage new funds to be raised, and interventions which offer new private investors a way to access the market, a larger, deeper, liquid and more sustainable investor base is growing in sponsor-less transactions. One that offers institutional investors an alternative asset class with strong portfolio downside protection.

Marco Natoli is the EIF’s equity investments head of division for northern, eastern and southern Europe. He is responsible for managing investments in private equity, mezzanine/hybrid and debt funds.

Francesco Battazzi is the EIF’s head of division for diversified debt funds. He is responsible for investments in private debt funds focusing on senior credit and portfolio diversification, across Europe.

This analysis was published in the Private Debt Investor’s Future of Private Debt report in November 2019.