Behind the allure of mid-market debt

Macroeconomic concerns and the need for diversification have driven investor interest in mid-market private debt. But how safe are these allocations?

Macroeconomic concerns, improving investment choices and the promise of attractive returns stimulated interest in private markets throughout 2018. A McKinsey report published in February found investments in private markets hit a record high last year at $5.8 trillion, noting that “signs already point to strong potential growth in 2019”.

Private Markets Come of Age highlighted an explosion of private credit and hedge funds dedicated to lending to mid-market companies, fulfilling a role previously occupied by banks. This finding was supported by separate figures from Alix Partners in its biannual mid-market debt report, released in March. It found private credit funds now account for 50 percent of all UK term financings, up from 38 percent at the end of 2017.

“There has been no let-up in the demand for ever-larger debt ticket sizes in the European mid-market, and competition for debt allocations remains fierce as more and more funds pivot from equity to debt,” says Richard Kitchen, leveraged finance partner at law firm Paul Hastings, explains.

“What’s driving this is a combination of both returns on private credit, which on many risk-adjusted measures is outperforming other asset classes, as well as the sheer enormity of capital that funds have already raised and are ready to deploy in the debt markets.” Kitchen says the growing sophistication of the European mid-market – defined loosely as companies with earnings ranging from $5 million to $100 million – is now being more distinctly divided into upper, lower and non-sponsored markets.

“The larger, more established funds often concentrate on the big deals where they can deploy the most capital at once, while smaller and speciality funds are finding a competitive advantage – and value – in smaller deals, where smaller ticket sizes may be a problem for bigger investors.”

In Europe, debt funds investing in the mid-market have been taking business from banks because of their ability to execute deals quickly and their willingness to offer innovative deal profiles with favourable terms. The increasing number of funds in the market has acted as a catalyst. This competition has also pushed funds to work harder to prove the growth potential that exists in smaller companies claiming to offer a strong growth story.

“Debt funds are continuing to out-compete and win market share from highly regulated clearing banks due to their speed of execution and greater creativity with the risk/reward profile on deals, and this is becoming ever more prevalent,” says Steve Carr, a London-based director with the debt advisory team at BDO, an advisory firm.

Market analysts say European institutional investors have been allocating a greater proportion of their portfolio assets to mid-market private debt over the past year as macroeconomic concerns relating to global trade and the UK’s departure from the European Union grow.

“There has been no let-up in the demand for ever-larger debt ticket sizes in the European mid-market, and competition for debt allocations remains fierce as more and more funds pivot from equity to debt”

Richard Kitchen

Nicolas Nedelec, managing director of European private equity firm Idinvest, says many investors consider mid-market debt to offer some protection against the global macroeconomic and cyclical risks: “This is down to the fact borrowers are active in niche markets with their own dynamics. Terms are generally better, both in pricing and contractual protection, since the markets have not been flooded with liquidities to the same extent as the large-cap space.”

Institutional investors, such as pension schemes and insurance companies, are also attracted by the typical return profile that fund groups say is achievable. Unitranche offerings, which combine senior and junior debt, can deliver gross returns in excess of 8 percent, according to Nedelec, with a typical investment time horizon of between five and seven years per fund.

Ongoing investor enthusiasm for the mid-market has stimulated fundraising activities during 2018. Ares, eQ Asset Management, ICG and Springrowth SGR were among the many investment groups to raise funds during the year, according to the Alix Partners survey.

Sector sensitivities

Technology, media and telecoms, healthcare and services businesses are proving particularly appealing in the current market environment, according to industry commentators, who say investors are seeking predictable returns and a haven from any future economic downturn.

“We’re focused on healthcare, tech and selected B2B services, as we view them as less cyclical,” says Nedelec. “Medical devices manufacturers or software-as-a-service solutions providers are less dependent on macro cycles, so we view this as a safer investment in light of the current geopolitical landscape.”

Anu Balasubramanian, global vice-chairwoman of private equity at Paul Hastings, agrees, singling out technology and healthcare in particular.

“Technology and healthcare are two areas with plenty of opportunity, regardless of their challenges. For institutions that can stomach and manage challenges such as policy volatility and inconsistent global regulations, there are certainly rewards and returns to be reaped,” she says.

“Medical devices manufacturers or software-as-a-service solutions providers are less dependent on macro cycles, so we view this as a safer investment in light of the current geopolitical landscape”

Nicolas Nedelec

“These sectors appear to be particularly ripe for consolidation in the mid-market. Investors that are in a position to exploit these opportunities and pursue buy-and-build strategies are likely to find a great deal of support from the private debt market.”

The current appeal of the telecoms sector has also been noted by Schroders, which has been investing in deals across Europe through its infrastructure debt arm. However, Claire Smith, an investment director within the company’s infrastructure finance division, says not all opportunities are as promising as they initially seem.

Smith says the fund group has leaned heavily on its in-house team of engineers to sift through the potential investments and passed up on several because the risk/return profile didn’t match their requirements.

“Sometimes, you have to say no and it may come back with better pricing. We have done a lot in telecoms, looking at everything from fibre optic networks to telecom towers, but this is a sector that has also seen a lot of activity,” she says. “There can be a premium because the opportunities tend to be a little more complex to understand the legal risks and agreements, but you have to be on the ground, to find the real pockets of value.”

Risk scrutiny

In private markets more broadly, institutional investors will be aware that higher levels of competition have driven down underwriting standards in some parts of the market, with covenant-lite loans becoming a more prominent feature. However, investors say mid-market private deals have, largely, maintained their risk controls, with more robust documentation.

“We are not putting in any cov-lite structures as we are very strict on ensuring we have the appropriate protections,” says Smith.

Her sentiments were echoed by a 2019 paper by Hermes Investment Management, which concluded that the mid-market offers “a more attractive and sustainable balance between risk and reward” with “better downside protection than the large-cap market due to maintenance covenants being a standard feature of loan documentation”.

Despite this, fund firms say investors should question the credentials of their asset manager, in case economic conditions shift and defaults begin to tick upwards.

Smith says: “Investors should ask, if something goes wrong, how do we maximise our recoveries? Would they have a seat at the table if there is an instance of a workout?”

She adds that frequent investment reporting in mid-market private debt is more important than in other asset classes because investors will not be able to access performance reports on private market assets through their Bloomberg terminal.