This article is sponsored by Kartesia
As investor allocations to private debt have increased, so, inevitably, have fund sizes. Although the flow of capital towards the asset class witnessed in the 2017 peak has slowed in the past two years, the trend for larger funds remains unabated. In 2019, the size of the average fund raised stood at $875.6 million, according to Private Debt Investor figures, not far off the record $899 million of two years earlier and significantly above the $563 million in 2015.
Predictably, this has led many funds to move up the transaction size spectrum – after all, it’s less resource-intensive to deploy larger sums of capital in fewer deals. This leaves a significant opportunity for those able to tap into the lower mid-market efficiently. But how can firms achieve this, given that portfolio sizes are likely to be large? We caught up with Jaime Prieto, managing partner of Kartesia, a firm whose most recent fund – its fourth – closed on €870 million in 2017 with a focus on European companies with an EBITDA of more than €3 million, to discuss recent developments and what it takes to invest at scale in the lower mid-market.
What would you say have been the key trends in your part of the market over the past few years?
One of the biggest shifts has been a greater awareness among intermediaries, sponsors and companies of the advantages direct lending can have over banking finance. This started in the mid-market, but it has migrated to smaller company financing. There is now a much better understanding that the higher coupon required by direct lending doesn’t make it a worse option than bank lending when the whole package is taken into account.
The other key trend has been increased recognition that risk-adjusted returns at the lower end of the mid-market are very compelling. We don’t have the same competitive tension in our part of the market that is evident higher up the deal scale, and so there are higher standards of governance and more discipline, and EBITDA definitions have been maintained. This has led to a situation where you now have a good number of national and international direct lenders in our space that can create long-term value for companies and LPs.
Fewer competitors is clearly one element of this, but why else do you believe the lower mid-market is attractive?
The opportunity set is large – there is an abundance of companies of this size and so that’s a rich landscape in which to operate. That allows you to be highly selective and enables good diversification without having to finance every deal that lands on your desk.
It’s also a tougher market to reach. LPs have to gain access via funds because it takes the same amount of resources to invest in small ticket fundings as it does for larger ones. We can see that it’s possible to gain faster rewards in larger deals, but we believe more sustainable rewards can be achieved over the longer term in the lower mid-market. Then there’s the significant growth potential. The vast majority of financing in this part of the market is still done by banks – between 80 percent and 90 percent. If you look at Germany, direct lending further up the mid-market now accounts for 50 percent of financing; we’d expect the lower mid-market to follow a similar path.
As you mentioned, doing smaller deals is resource-intensive relative to capital deployed. So how can players in the lower mid-market do this cost-effectively?
It’s vital to be sharply focused on the needs of lower mid-market companies. You have to build credibility so that companies will spend time with you. Many funds will say they target the lower mid-market, but I’ve seen instances where they have left smaller businesses stranded because a larger deal has emerged elsewhere.
Added to that, you have to offer a suite of products that meet their needs at different stages of their developments. For example, we can offer an opportunistic credit product that helps companies exit a difficult situation – for example, to release them from bank financing that has become restrictive – or to help them fund an acquisition. We also offer plain vanilla direct lending in the form of senior secured first lien packages that are more customised than a bank offering. If you get these elements right, companies will find you.
Presumably, this means having local offices and therefore higher overheads?
You have to be present in the markets you operate. You can’t just originate and manage loans from one location. We are pan-European and we have seven offices across Europe because we recognise we can’t do this from London alone – we need to meet management and build relationships. And here, the culture really matters. We need to speak the same language as the management team of a lower mid-market company. You must have people with the skills, patience and trust in the long-term opportunity – from the managing partners, right through to junior team members. With all these in place, you can capture the attention of your target market and you can proceed quickly because you can standardise the processes required to execute deals. If you know the lawyers and advisors and there is trust between the parties, you create efficiencies. And if you invest in people and the right products, you can deliver before others gain a foothold in markets.
How important are bank partnerships in this?
They’re essential. There is a huge opportunity for partnerships that are mutually beneficial. If you can build reliable, long-term relationships with banks, you can offer companies a broader set of products together. We’ve worked with banks to help them exit situations where more flexible finance is more suited to a company’s needs. We can also provide junior or pari-passu capital or work with them on term loans. We can also work with banks that may have a strong relationship with a company but may not be able to syndicate a financing package for whatever reason.
And what about technology? How important is that in scaling investments at the lower end of the mid-market?
Technology is relevant for the first few deals, but as a firm reaches the next stage of growth, it becomes indispensable. You need to be able to track investments efficiently to highlight performance and identify issues and opportunities, and to understand sector and market trends. Technology won’t be able to solve execution issues in the next five years, but we are looking into how investment in technology can drive down our costs because we believe we have to think ahead. Technology allows you to delve into the portfolio and share information with ratings agencies as well as LPs, and we are investing in developing our own tools around analysing collateralised loan obligations, among other things. We are already implementing systems that we don’t need for now but will do in three years’ time when our portfolio is much larger.
How do you think your part of the market will evolve over the next few years?
There is exponential growth potential in the lower mid-market. We don’t expect the banks to disappear – many of them are putting in place their own direct lending solutions – but we do see opportunity in further partnerships.
And, while we are focused on sponsor-backed deals for now, we see our skills as well suited to investing where there is no private equity investment, and we are laying the foundations for expansion here. The medium- to long-term scenario could well be that 20 percent to 40 percent of sponsorless finance comes from private debt and it’s up to individual managers to decide where to allocate resources based on the strengths of their platform. In our case, we are firm believers in the growth of sponsorless deals, which is why we have emphasised local presence and built teams with the skills to originate and structure non-private equity-backed deals. We are also looking to develop complementary products.