Getting the mid-market mix right

Over the past decade, US mid-market direct lender Monroe Capital has been upping the ante on sector specialism. First came a healthcare-focused lending business, followed by business services, recurring-revenue software and technology, media, consumer and real estate. The firm was once a generalist targeting lower mid-market borrowers, but the drive to stand out led to a focus around industry verticals that has paid dividends.

Ted Koenig, chairman and CEO, says: “In private credit, we were generalists and I was finding the market competitive and investors hungry for yield. It is hard to show differentiated yield when there are a hundred private credit managers all chasing the same leveraged loans. In order to address the needs of our LPs, we continue to further differentiate our returns by going after sectors.”

Koenig says his investors are looking for portfolios that avoid crossover, which is hard to accomplish by putting money in several large generalist funds that are competing for deals. Monroe is offering something different, though such an approach is not without its challenges: “You need to achieve diversification in a credit business, so you need to go into sectors that are large enough to achieve diversification.

“And the challenge for sector-focused funds is that you have to hire sector-focused expertise. We have spent a fair amount of money hiring a team in real estate, healthcare, fintech, technology and so on. Not all private credit firms are willing to make those investments.”

In rude health

The healthcare sector has seen an outbreak of specialist credit funds in recent years as the industry has proved deep enough to deliver the diversification within portfolios that investors are looking for, covering everything from life sciences start-ups to multinational healthcare services.

But lenders are capitalising on similar sector-specific tailwinds in a growing array of markets. TerraCotta is a California-based lender that has pioneered the application of data-driven methodologies in commercial real estate credit investment. The firm has been successful over nearly two decades by combining deep mid-market real estate credit expertise with data analytics.

Founder and CEO Tingting Zhang says: “There are certainly advantages of being specialist and the benefits come down to that undisputed in-depth understanding of the market. But that sector specialism has to be thought out in the context of diversification – for a sector fund it can be challenging to really buffer through a market cycle if a sector is going through a cyclical challenge.”

“We think we can build better diversification if we go cross-sector”

Chris Bone
Partners Group

She argues that specialism is in the eye of the beholder. “We lend against commercial real estate, but within corporate real estate credit we are lending against retail, multifamily, commercial and office space. During covid, retail was very challenged but now retail is making a meaningful recovery and office is challenged. Multifamily property and industrial have been doing great, so we are sitting in a nice position.”

Jess Larsen is the founder and CEO of Briarcliffe Credit Partners, a dedicated private credit placement agency. He argues that there is still an advantage to being sector-agnostic when it comes to mid-market, sponsor-backed direct lending, but outside direct lending there is a growing demand for sector-specific managers.

“Private credit is much more than direct lending. When you are no longer simply underwriting a sponsor with an EBITDA that you are happy with, you can really benefit from a deeper knowledge of the market participants and the rules and regulations in a sector.”

He says Briarcliffe is seeing that approach from private credit funds launching with a focus on everything from industrials and manufacturing to shipping or technology. Non-sponsored deals in particular can benefit from sector specialism, he argues.

“If you are a direct lender with a sponsor-led strategy, then there is not a lot of premium for being sector-specific, but if you’re taking more complexity into your lending and offering credit directly to non-sponsored borrowers, then you definitely have an advantage if you are sector focused. We are seeing a growing proportion of the market outside direct lending taking that approach.”

At the same time, the biggest direct lenders are alive to the benefits of sector specialisation, making it even more difficult for others to stand out.

Anthony Fobel, chief executive at Arcmont Asset Management, says: “There is always a great benefit to any investment firm of having sector expertise, and that is not just because you can perform due diligence and understand businesses better, but also because you can actually target your origination efforts to specific private equity or advisory firms that specialise in those sectors. We have deep sector expertise embedded in our deal teams according to sectors that we prefer.

“My view is that private credit continues to be an asset class where scale is important. Within larger firms like Arcmont, having sector expertise gives a further advantage over smaller sector-specific firms or smaller generalists.

“If you were setting up a private credit firm today, you would want to distinguish yourself and a sector focus is one way of doing that, but I would question whether you are ever going to be more effective than a large firm that has already got that sector expertise embedded in a broader business.”

Case for generalists

But private credit is very different to private equity and many argue that the need for diversification and minimal risk taking means generalists will always have an edge. Chris Bone, head of private debt in Europe at Partners Group, says: “Our approach is to be generalist. We have our preferred sectors and themes that we follow, whether that’s business services, IT, healthcare or education; but we are not sector specialists, we’re agnostic. We want to build a diversified portfolio and in debt there’s no particular prize for getting it right, you just get punished if you get it wrong. We think we can build better diversification if we go cross-sector.”

Tom Stein, head of private debt Americas at Partners Group, adds: “We do tap into the expertise of our BSL sector analysts and that’s really important. But if you’re a young person looking to join a platform, being a generalist gives you much more opportunity to look at different businesses and build a broader professional experience. Diversity builds muscle that you might not get from being purely sector-specific.”

“In order to address the needs of our LPs, we continue to further differentiate our returns by going after sectors”

Ted Koenig
Monroe Capital

At Park Square Capital, partner Osvaldo Pereira says challenges come with sector specialisation. “The danger is that if you have a hammer, everything looks like a nail,” he says. “If you have an individual tasked with investing in software, they will want to invest in every software deal and will overlook potentially attractive deals in other sectors. As a debt manager, you want to build a diversified portfolio and must choose from the deals actually happening in the market, rather than forcing a focus on one sector.

“We don’t have a partner responsible for healthcare, and that’s because that person would feel an obligation to do healthcare deals. When you layer geographies on top of that, and you have a healthcare specialist in France, for example, you can end up with perverse outcomes. We are just very clear about what we don’t do.”

Park Square is sector-agnostic but is very consistent in terms of the sectors it focuses on, with more than 75 percent of its portfolio in software and IT, business services and healthcare. “We have a preference for sectors without having dedicated sector specialists, and that’s because some end markets are inherently more volatile than others. No matter how long you spend investing in retail, that is by definition a volatile sector,” Pereira says.

Room for both

In truth, there is a place for specialists and generalists within firms, and certainly within portfolios. At Tikehau Capital, head of private debt Cécile Lévi says: “Our team has remained highly generalist and opportunistic, but the more deals you do in a specific sector, the more you are able to attract sponsors and better understand the players in that market.

“On the one hand, it’s important to be highly diversified and we always insist that private credit is all about diversification in terms of transactions, geographies, private equity sponsors and industries. But on the other hand, the more you penetrate an industry, the better you can capture management attention because you bring expertise and value-add.”

Tikehau Capital has built something of a competitive edge in several sectors, including IT consulting, software, telecommunications, healthcare and insurance. Lévi says: “Being a specialist in some sectors does help a lot. But in other sectors, like automotive or retail, you might be tempted to have one of those companies in your portfolio because you need an edge. You might know the sponsor well or consider the company worth looking at with limited leverage.”

But as soon as people see you are interested in that industry, which is really cyclical, you get offered more opportunities and you have to be really disciplined. Being a generalist is helpful because you can do some of those deals, but not too many.”

At placement agents Campbell Lutyens, co-head of global private credit Jeffrey Griffiths says: “We are working on sector-focused credit funds and we do believe they are an interesting component to a portfolio. But if an investor’s objective is stable downside protection, then diversification by sector is really important and most LPs want to get that through the fund itself.

“An investor might build a private equity portfolio by investing in the best financial services manager, the best healthcare manager and so on, but this will be harder to achieve in private credit. Sector concentration in isolation can be a dangerous thing to avoid.”

The end is not yet in sight for the mid-market, generalist, sector-agnostic direct lender.

The investor’s view: Both approaches have their strengths

A lack of risk is associated with diversification, but sector-specific experience can pay off

Investors are looking for low risk in credit, so the generalists will always be an important feature of portfolios, says Christine Farquhar, global co-head of the credit investment group at Cambridge Associates, who oversees manager and market research across public, hedge fund and select private credit strategies.

“The way we see this is that in senior secured the generalists are still dominating; this is credit and we don’t want extra risk. We just want to capture the illiquidity premium so the benefit of the generalist is that in credit you want to create as much diversification as possible. The generalist is also more likely to have the workout and legal expertise on hand if something goes wrong.”

But there is a place for sector specialists alongside, Farquhar says, adding: “Against that you have ballooning fund sizes and we have to ask whether those managers are really being as quality conscious as they say they are. And some of their fee scales are a bit sticky.

“We like some of the smaller managers if there’s a very clear expertise and a sourcing advantage. We look for people who understand the existential risks, the collateral quality and the structuring of the loans, and we are keen on grey hair and managers that have been through two or three cycles. The biggest established managers have the credentials and the experience, but specialist managers can also fit well alongside.”