A continent at a crossroads

Jaime Prieto, managing partner at European lower mid-market private debt manager Kartesia, talks about the opportunities presented by Brexit, Emmanuel Macron and the non-sponsored market.

This article is sponsored by Kartesia

Why is the lower end of the mid-market attractive to private credit?

In this segment companies have historically had two sources of financing: bank loans and private equity capital. But bank loans are increasingly standardised and strict, and private equity funds typically request majority control of the company at the lower end of the mid-market.

Jaime Prieto

This creates an opportunity for alternative providers of debt, that can provide flexibility and allow family-owned companies to retain control. One important consideration is that banks usually require amortising loans. But if the company is expanding through new acquisitions or capital expenditure, amortisation gets in the way. For example, a casual dining company may want to invest cashflow in new restaurants rather than using it to make payments on a loan.

About half of your deals so far in your current fund, Kartesia Credit Opportunities IV, are in non-sponsored transactions. Is this a promising area for alternative lenders?

It will clearly grow more common as a source of deals for alternative lenders as the years progress, having already become widespread in the US. One reason for its appeal is the high penetration of private credit in mid-market sponsor transactions, which is already close to 50 percent in many markets. When penetration is 50 percent, you’re competing with lots of funds. By contrast, the non-sponsored market will drive growth in the private credit sector over the next 10 to 15 years, regardless of market cycles, because private credit penetration is so low.

But do you see some opportunities for lending to sponsored businesses?

Definitely. We can provide longer term financing to sponsored companies. We call this the primary market. There are also opportunities in providing liquidity to companies that want to exit the market in stress situations. We call this the secondary market.

On the subject of stress, is there a tailwind or a headwind at the moment for lower mid-market companies?

“The beauty of being in the lower mid-market is that you can be selective, because there are so many companies and so many potential non-sponsored deals”

Clearly the days of the tailwind, which was particularly strong for some southern European economies, are behind us. For example, the Spanish economy grew by 3 percent in 2017 as the country continued to recover from the credit crunch era, but now that the output gap has been closed growth will be more modest, with the European Commission forecasting only 2.2 percent this year and only 2 percent next year.

Looking at Europe as a whole, at this stage we do not see indicators of a distressed cycle. However, the disappearance of tailwinds forces us to think that we must be more selective, because not every company is going to perform well.

The beauty of being in the lower mid-market is that you can be selective, because there are so many companies and so many potential non-sponsored deals.

Which countries show the most promise?

We see opportunities across Europe, and this is reflected in the wide distribution of our offices. Our main teams are in London and Brussels, with local offices in Frankfurt, Paris and Madrid, and back and middle office services in Luxembourg.

France, the UK and Germany offer the greatest promise because of their size, but there are interesting pockets of opportunity elsewhere. The Nordic market is more difficult to penetrate because the banks are healthy and have a strong presence in the lower middle market, and Italy is difficult to penetrate because the cost of financing offered by the banks is very low. We have been successful in Spain, see good deals in Benelux, and have also done a small number of deals in Central and Eastern Europe, where we can find high quality companies, often with strong sales into Western Europe, in an environment of relatively modest competition among private credit providers. For example, last year we financed Groglass, a Latvian company with a niche making glass for picture framing.

Let’s take the three big markets in turn, starting with the UK.

In the UK we see an opportunity in the secondary market: providing liquidity to lenders looking for an exit. The country has seen massive growth in private credit over the last six or seven years, and many private credit firms have invested 20 to 30 percent of their funds into the UK. But UK companies are already experiencing headwinds related to Brexit, including higher input costs because of the fall in the pound. Aside from Brexit, companies in certain sectors have been hit by the rise in business rates and the minimum wage. Responding to this, lenders have already cut the volume of new lending, and many will cut their existing exposure to the UK – trimming exposure first in the sectors suffering most, such as retail and restaurants.

But we also see an opportunity in the primary market. As private credit providers cut their exposure, this may start to affect the supply of capital in sectors hit less by Brexit and other problems. Many service businesses are less affected, for example. We can take advantage of this gap in supply.

“We currently have very limited exposure to the UK and are coming to the UK with a clean mind, without preconceptions, to try and identify those situations where we can capture good value”

We currently have very limited exposure to the UK and are coming to the UK with a clean mind, without preconceptions, to try and identify those situations where we can capture good value.

How about France?

This is our biggest market. On the one hand it is not as creditor-friendly as the UK, and this requires lenders with experience specific to the country. On the other hand, France has high-quality businesses, and good management teams with experience of LBO situations.

We are also positive overall about the macroeconomic environment. Macron won a mandate for reform in a landslide victory, even though it has proved more difficult than expected to overcome some of the country’s social obstacles. The past six months have made me slightly less positive about the French environment, but I still think things are heading in the right direction.

Why do you like Germany?

The banks compete with private credit providers on very aggressive terms, but there is an enormous number of opportunities at the lower end of the midmarket because of the size of the country, so we should be able to find three to five opportunities every year. The global remodelling of the automotive sector should help us, because distress in the sector will probably make the banks more cautious, creating room for private credit. Reflecting this, we will open our second German office, in Munich, this year.

Finally, how do limited partners view this part of the market?

We currently see a lot of growth in appetite from insurers and pension funds across Europe, with many institutions establishing dedicated programmes to invest in it. They typically seek returns in the mid to high single digits, but some investors look to go even higher.

Within private credit, large institutions favour funds that complement their existing exposure, because they want a portfolio not exclusively focused on the core mid-market or sponsored transactions, which they feel have become rather overcrowded spaces. In response, some are seeking exposure at a different angle, such as a lower mid-market product, or specialty financing.