Direct lending to sponsors vs lending to non-sponsored or family businesses

Lending to non-sponsored or family businesses requires a different approach to lending to a sponsor-backed company. So much so that it’s often seen as being in the domain of the performing special situations funds or hybrid capital funds. There’s often a degree of uniqueness or complexity which isn’t present in sponsor-backed companies. Some of the key differences to watch out for are:

Owner-manager

: If the shareholder also sits on the board and is key to driving the business, does the business (and the lender) have protections if that person leaves? Does the business have in place appropriate governance, key person insurance and/or non-compete and non-solicitation provisions in the employment contracts? In a downside scenario, the owner-managers are likely to have a seat at the table because of the potential difficulties in running the business without them. This dynamic should be priced in and often justifies an equity-upside component to the financing. In certain circumstances, a personal guarantee may be useful.

Structuring

: Often in family-owned businesses, multiple shareholders own the shares directly in the operating business. Is getting a share pledge from each shareholder realistic? Is insisting on the insertion of a new holding company going to create a significant tax cost? Or is it going to make the financing offer less attractive? Could a more creative solution be employed within the existing equity framework such as a put option or a call option?

Affiliate transactions

: It’s worth being vigilant about affiliate transactions. Is the business reliant on certain assets or contracts which are owned or controlled by the shareholders? Often there are complex family arrangements which don’t fit neatly under a single entity. These arrangements are troublesome on enforcement, but even before that can represent a value leakage risk.

Economics

: Pricing can be more bespoke with OID, PIK margin, call protection, exit fees and minimum IRR and MOIC returns all being familiar mechanics in this space. Equity upside in the form of warrants or shares is regularly seen, but has the disadvantage of not being secured.

Tighter terms

: Comparisons are difficult but in most non-sponsored lending transactions, pricing will be higher and leverage will be lower compared to a similar sponsored deal. And in almost every case, the financing terms will be tighter. Maintenance financial covenants are commonplace – often quite bespoke to the business plan. And rarely will there be any EBITDA add-backs, growers, ratio tests or other borrower-friendly terms with which the sponsor-backed direct lending community are familiar.

Due diligence

: There may not be any ready-made due diligence. Alongside its advisers, the lender needs to think about what it needs to diligence and run a risk-adjusted approach. It’s worth being particularly prudent around “know-your-customer” and sanctions checks at an early stage.

Deal risk

: The lender should make sure that all the relevant stakeholders are on board and supportive of the transaction at the earliest opportunity. Owner-manager businesses, families and ultra high net worth individuals are not institutions and can (and do) change their mind without reputational consequences. Cost cover and exclusivity clauses (with alternate transaction fee arrangements or long tails) can be useful in mitigating risk and showing commitment, but lenders should be aware of the inherent opportunity cost.