Today, the mid-market private debt space can be broadly divided into three groups. While there is no set industry standard for defining the mid-market – especially when comparing mature markets like the US with elsewhere – many investors have a fairly similar interpretation.
For his part, Stephan Caron, head of European mid-market private debt at BlackRock, defines the group as the lower mid-market, companies with less than €10 million of EBITDA; the core mid-market with €10 million to €50 million; and the upper mid-market with €50 million-plus. “This [split] is key because it means that funds aren’t all competing for the same deals now,” he says. “Instead, they are able to take a more targeted approach.”
This differentiation has become increasingly important at the market has matured. It is just one of a number of trends shaping the future of the mid-market private debt as we near the end of the current cycle. Here are seven other trends worth noting:
1. Larger deals are more borrower-friendly amid competition
Larger capital raises have led to a mountain of dry powder for managers to deploy. AlixPartners’ H2 2018 mid-market debt report, for example, found over $75 billion of dry powder in the European direct lending market. Consequently, we are seeing larger loans in a crowded upper mid-market and looser documentation and fewer covenants. According to Caron, this is mostly because private equity funds are more sophisticated and able to command more aggressive terms.
2. More opportunities at the lower end of the market
The trend towards larger deals is creating opportunities in other areas. “There are opportunities for boutique lenders who can target smaller transactions which exhibit similar credit metrics to larger transactions but offer a spread pick up and the potential for documenting better lender protections,” says James Robson, CIO at RM Funds, a UK-based specialist provider of mid-market debt. “This is because the capital is flowing into the larger transactions and the smaller more complex deals still have trouble accessing lenders who can provide real funding solutions.”
However, with this comes the risk of increase default. Caron adds: “In the low end there are attractive yields, but the risk of default is higher. There are also more idiosyncratic risks because a lot of companies are founder-led with key man risks and can have concentration issues.”
3. Spreads are at their lowest
This is in line with concerns about how the sector will perform under stressed market conditions and comes “when default rates are likely to start rising as we move through the business cycle”, says Robson. The large capital inflows seen in recent years has led to significant spread compression. “If you look across the leveraged loan space there is more issuance deemed covenant-lite over recent years and this borrower ability to negotiate weaker lender protections is rippling out as capital chases transactions,” adds Robson.
In addition, spreads are at multi-year lows, although this is likely to be a floor. “This is because, firstly, where AAA spreads for CLOs are pricing there is no room for further spread compression; and secondly, where leverage loans are trading they are floating rate. Looking at where global yields are it will lead to increased overall funding costs should global yields rise.”
4. A greater focus on origination
With huge amounts of capital commitment to the asset class, the challenge is putting the money to work. The result has been that more managers have put a focus on building their teams and their resources for this purpose. Caron says that sourcing will become key in gaining an edge. “If you look at the US, some of the funds are investing in sourcing capabilities which they then syndicate to other funds. This hasn’t happened in Europe just yet, but we are getting to a point where larger platforms will be able to underwrite and syndicate deals for smaller funds. However, good managers should have local sourcing capabilities too,” he says.
5. Non-sponsored deals need to develop
Currently, many private debt managers rely on private equity sponsors for dealflow. However, this means they are dependent on the private equity sponsor funding cycles. While non-sponsored deals require more effort in terms of origination and due diligence, many managers recognise there is less competition and therefore it is more attractive when it comes to pricing. “The industry has relied heavily on financing leveraged buyouts from private equity firms,” says Caron. “We aren’t seeing that many unsponsored deals – yet – but this needs to happen more to make the asset class stand out on its own and not rely so much on private equity-backed transactions.”
6. The industry should expect to be tested
The last time there was a financial crisis, the private debt industry was at an infant stage compared to now. Many managers are yet to be tested in a downturn. Market participants can generate decent returns because there haven’t been any real economic challenges, though some anticipate this will change soon. “We anticipate that when the tide rises, it will no longer float all boats in the credit world as it has done in recent years,” says Alexander Ott, managing director for European private debt at Partners Group. “[The increased volatility] is likely to lead to a more attractive pricing of risk in the new-issue leveraged loan and private debt markets. It could shake out some of the recent excesses, such as very weak documentation.”
Caron says: “Until the sector has done a full business cycle we won’t be able to see which loans worked out and which ones didn’t. At this point, we will start seeing increasing differentiated outcomes in the market. It will truly test the infrastructure that funds have in place to manage risks and workouts.”
7. Expect more growth in Europe
Nearly 50 percent of private debt investors surveyed last year believe Europe offers the best opportunities over the next 12 months, according to Preqin. Caron says: “Growth across Europe … means investors have more options and breadth as to where they can invest – and also allows them to diversify away from the UK, which is seen as more challenging because of Brexit. Portfolios are better diversified now and this would have been more difficult to achieve five to six years ago.”