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This article is part of our forthcoming service, 9fin Private Credit. If you're interested in a free trial, contact subscriptions@9fin.com

People sometimes talk about how private credit is ‘private equity, but for the debt markets’. There’s some truth to that — just like taking a company private, lending in the private credit market allows you to manage your investment without the tyranny of mark-to-market. 

It’s also true in another sense, in that private equity-backed companies are some of the biggest and most frequent borrowers in the private credit markets. But these days, a growing number of private credit firms are lending to companies without the backing of PE sponsors.

This category encompasses a variety of ownership structures, of course, but perhaps the most obvious is family-owned businesses, or companies that are owned by management. 

Family-owned companies have been getting more and more popular as targets for PE firms in recent years, and the same is happening in private credit as firms like Carlyle lean into non-sponsored deals.

As is often the case with a new asset class, the attraction is generally that non-sponsored deals generate higher returns; that inevitably means more risk, but that in turn can mean better protections for lenders than financing a PE portfolio company.

“It's definitely become a little more attractive,” said Michael Ewald, head of Bain Capital’s private credit group. “Everyone understands and appreciates that they are more risky, and come with higher pricing because of the risk. And you also get to have tighter controls around them.”

Go to any private credit conference and there is almost always a discussion on the trade-offs between sponsored and sponsorless lending, but rarely a huge amount of data.

So we pulled some numbers. According to a recent earnings call from Whitehorse Finance, a BDC, the average loan-to-value ratio for sponsored deals is 40% to 50%, while non-sponsored transactions are at 30% to 50%. 

Whitehorse said that in the lower middle market — the area where most sponsorless deals exist — loan spreads are running at 600bps-675bps. The lender said that it recently financed a non-sponsored deal at a spread of 750bps, with a 45% LTV.

Equity cushion is one of the most fundamental piece of downside protection for lenders. That’s the factor that Jeff Haas, president of private credit firm SR Alternative Credit, looks at most closely in sponsorless deals.

“We want to make sure that a borrower has what we call ‘meaningful capital at risk’, in the transaction,” says Haas.

“In the event of a default, we look to the underlying asset as a source of repayment for our loan. A borrower’s skin in the game is an important part of our assessment for the loan to value ratio in a transaction.”

Sponsorless lending is a market without the same level of competitive pressure seen in sponsored lending.

Still, some firms that have become known for big-ticket sponsor-backed private credit deals are active in the sponsorless market. HPS, for example, is targeting a 50/50 split between sponsored and non-sponsored lending in its recently closed $10bn core direct lending fund.

Carlyle, too, has specific teams in the firm that specialize in providing funding to family-founded businesses. As with many parts of private credit, part of the reason this opportunity exists is because banks have pulled back from lending to smaller businesses.

“These companies have a more challenging time finding traditional forms of financing in the banking system and the traditional public credit markets,” said Andreas Boye, managing director and co-head of credit opportunities for North America at Carlyle.

Garrett Stephen, managing director and co-head of origination and structuring at First Eagle Alternative Credit, agreed that the benefit of less lenders in the space helps. But he also cautioned that the lower level of institutional involvement in the non-sponsor market created extra risk.

“With less investors circling the same deal, you have a better chance to structure that loan with higher pricing,” he told 9fin. “Higher yield is also typically driven by being the last leg of institutional capital creating higher risk.”

There is a certain degree of security in sponsor-backed deals, where a private equity firm with deep pockets (and access to fund-finance markets like NAV borrowing) can inject fresh equity into a business should things deteriorate. 

The other major consideration for PE-backed deals is the expertise, experience, resources and advice that such firms can offer when managing a company.

“We think about it as, who are the adults in the room, and what experience do they bring to the table?” said Stephen at First Eagle.

“We know that when something goes south, private equity firms have the experience to shepherd the business through times of disruption. They also have the capital to support the business and operating advisors who can swoop in and help steer the ship.”

That’s often more attractive than an unsponsored deal, where management’s experience might be more limited, and the governance structure might be different. For example, a management-owned company where the CEO and CFO control the board of directors in a 50/50 split. 

For lenders, the other benefit to having a private equity firm involved is that it simply makes deals easier to find. 

“It's more efficient to call on 50 to 100 private credit sponsors, versus calling on 100,000 small independent businesses,” said Ewald at Bain.

According to Boye at Carlyle, family-owned businesses tend to be run well and have good business strategies in place. 

“These businesses tend to be the lifeblood of the families, the founders, and their last name is typically also the company name, so they have a lot of pride in their businesses,” he said. “They've navigated through difficult times by doing the right thing and they are being managed for the long run.”

As painful as it might be for a family to part with their pride and joy, there are some good reasons to do so. Family-run companies often improve and innovate over multiple generations, but “at some point the company needs to be sold to the professionals,” said a private credit source.

This is a great argument for private equity firms trying to convince families to sell their business; for lenders to companies that are still family-owned, it’s an important investment consideration. 

“It just can’t be that there’s, say, six generations of the best possible widget manufacturers in the same family,” the source said.

“The first generation built the business. The second generation was really steeped in the business. But the third generation? We stay away from those,” he said, adding: “The third generation always screws things up.”

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